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The 2003 California budget crisis was a budget crisis resulting from a legislative deadlock over a $38 billion budget deficit.

The extended crisis saw California's credit ratings near junk bond status, a recall petition resulting in Arnold Schwarzenegger replacing Gray Davis as governor, and a budget balancing exercise .

• https://lao.ca.gov/2003/spend_plan_03/1003_spend_plan_main.html
• https://lao.ca.gov/2003/major_features_03-04/major_features_03-04.html
• https://lao.ca.gov/2003/budget_overview/03-04_budget_overview.pdf
• https://ebudget.ca.gov/2008-09-EN/BudgetSummary/INT/32270918.html
• https://www.mikemcmahon.info/legislate.htm
• https://pubs.aeaweb.org/doi/pdf/10.1257%2F0895330041371330
• https://www.wsws.org/en/articles/2003/02/cali-f05.html
• https://governors.library.ca.gov/addresses/s_37-davis5.html
• https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3490509
• https://www.ncbi.nlm.nih.gov/books/NBK559771/
• https://siepr.stanford.edu/publications/policy-brief/californias-budget-crisis-what-happened
• https://thedailyrecord.com/2004/02/16/california-faces-15b-question/

Background

Since Proposition 13 was passed in 1978, cutting property tax rates by 57%, California had had to rely more heavily on income tax revenue. California's revenues and expenditures were rising but balanced all through the 1990s. However, the bursting of the dot-com bubble and the subsequent recession caused California's revenues to fall significantly. Because spending was not cut in response, a budget deficit emerged.

Additionally, it has been argued that because parts of California's budget were ringfenced by ballot initiatives, legislators had less power over budget decisions which made it harder to make cuts to certain sectors. For example, Proposition 98, which was passed in 1988, earmarks 40% of public funds for schools, limiting the amount that the education budget can be reduced. However, John G. Matsusaka from the Initiative & Referendum Institute has suggested that only 32% of the 2003-2004 budget was 'locked-in' by ballot initiatives and that almost all of that money would have been spent for those purposes even without constitutional requirements in place.

Budgets in California must receive the support of a two-thirds majority in each chamber in order to pass.

The crisis

Budget shortfall emerges

The 2001/2002 budget saw tax revenues drop sharply by around 17% but the state government's spending was not cut. In May 2002, Governor Gray Davis announced that the 2002/2003 budget would have to deal with a $23 billion deficit, $19 billion of which he attributed to decreased earnings from stock markets.

A $98.9 billion budget was approved by the California legislature in the early hours of September 1, 2002. Davis signed the 2002/2003 budget on September 5. The budget was balanced thanks to spending and revenue strategies which were projected to close the budget shortfall. $10.5 billion of the shortfall was covered by spending deferrals, loans, funding shifts and temporary tax increases, $7.5 billion was filled by spending cuts, and a further $4.5 billion was accessed by borrowing against California's future payments from the Tobacco Master Settlement Agreement. The budget assumed that $1.1 billion more federal funds would be made available to the state over the course of the year, including increased match funding for Medi-Cal and more assistance with homeland security; these funds did not end up appearing until the next financial year.

In December 2002, Standard & Poor's and Fitch Ratings downgraded California's to A2. In February 2003, Moody's followed suit, making California tied with Louisiana and New York for the agency's lowest state credit rating.

Davis' 2003 budget

In creating the 2003/2004 budget, California had to close a general fund budget shortfall estimated to be $38 billion by the state government and $30 billion by the California Legislative Analyst's Office. This was a cumulative result of the failure to properly remedy deficits from the 2001/2002 and 2002/2003 budgets which had resulted in the state's general fund having operating shortfalls of over $11 billion in both years.

Davis claimed his budget would close the deficit, but this was achieved with only $9.2 billion in cuts with the rest of the shortfall being made up by $16 billion in borrowing and with the knowledge that an $8 billion deficit would emerge by the time of the next budget. The budget also increased taxes, including reversing prior reductions in the vehicle license fee.

The budget included bond sales which were approved on the assumption that they would be paid back using 0.5% of local sales tax revenues, amounting to around $2.5 billion per year. Local government plugged the loss of their revenue by diverting property taxes used by K-14 education and in turn, the education funding was replaced by greater state funding from the general fund. This approach, called the 'triple flip', relied on the general fund growing which was conditional on the economy recovering.

• Loans and borrowing: More than $16 billion of the deficit was plugged through borrowing both internally and from credit markets. The largest part of this borrowing was planned to be a $10.7 billion deficit financing bond which would eliminate the deficit from the last financial year. The budget also included plans to issue $1.9 billion in pension obligation bonds, defer mandate payments to local governments, and take loans on special funds (funds earmarked for a specific purpose).

By the end of the summer, Davis signed a plan including a $10.7 billion deficit bond financed through existing tax dollars. The plan was strongly opposed by anti-tax groups such as the Howard Jarvis Taxpayers Association and was challenged in court. A Sacramento Superior Court judge ruled that the plan violated the state constitution because it had not been approved by voters.

Response

Democrats supported only modest cuts to public services while increasing taxes on the rich, tripling the car registration fee, and increasing the state sales tax.

Republican legislators were reluctant to support any Democratic solution, fearing their re-election chances. Jim Brulte, Republican leader in the Senate and the state senator for the 31st district, promised to back primary challengers to any Republicans who voted with Democrats. Similar threats had been made before when four Republicans (Anthony Pescetti, Dave Kelley, Mike Briggs, and Richard Dickerson) were pushed out after supporting the Democratic budget in 2001. Republicans instead suggested a short-term loan to cover a part of the deficit, initially supporting a $10 billion loan paid back over five years using revenues from sales tax.

Markets reacted negatively to the budget and in July 2003, Standard & Poor's downgraded California's bond ratings from A to BBB, giving it the lowest rating of any US state. In August, Moody's also downgraded the state's ratings, from A2 to A3.

Recall election

Main article: 2003 California gubernatorial recall election

The budget crisis was seen as closely linked to Davis, making him deeply unpopular and helping to fuel a recall petition. The recall petition was certified in March 2003 and had 160 days to gather 897,159 signatures. California Republicans were supportive of the effort, with Darrell Issa (the Representative for California's 48th congressional district) personally contributing more than $1 million to fund petition drives. Over the summer of 2003, it became "difficult to avoid" signature gatherers. By July 24, Secretary of State Kevin Shelley announced that the recall effort had collected 1.3 million signatures and an election would be held.

By the time of the election on October 7, "it was clear Davis was doomed"; exit polls predicted he would be recalled. The recall was approved by 55.4% of voters and Arnold Schwarzenegger was elected governor with 48.6% of the vote.

Schwarzenegger becomes governor

One of Schwarzenegger's first actions as governor was to cut the vehicle license fee, costing the state $4 billion in tax revenue. This revenue cut was passed onto local government; Santa Clara County and Contra Costa County faced spending cuts of $84 million and $54 million respectively and Alameda County lost $67.5 million per year from its budget. This prompted Moody's to further downgrade state debt from A3 to Baa1, costing the state $22 million in penalty fees from banks guaranteeing its last bond offering.

To combat the deficit, Schwarzenegger proposed to issue a state bond initially worth $15 billion, but later increased to $17 billion to pay for underwriting, fees and other costs.

2004 ballot measures

Schwarzenegger put forward Proposition 57 and Proposition 58 as his central policies to solve California's budget crisis. Proposition 57 allowed the sale of $15 billion worth of bonds to pay off the state's deficit. Proposition 58 required future budgets to be balanced, banned further sales of bonds to fill a deficit, and created a process by which the state would build a reserve of $8 billion or 5% of the budget, whichever is greater. Proposition 58 would only take effect if Proposition 57 also passed.

Schwarzenegger said that California would face "Armageddon" if the measures were not approved, with potential for cuts of up to $22.5 billion and for the state to lose control of its finances to banks.

Opponents, state treasurer Phil Angelides proposed a 'Plan B' that included making up the state's deficit using 0.25% of the state sales tax to cover $4 billion and increasing income tax to the highest earners for three years to generate an extra $6.8 billion.

Both Propositions passed.

Interest payments on Proposition 57 bonds began on 1 July 2004. The final payment on the Proposition 57 bonds was made in August 2015, having paid a million dollars a day solely in interest payments for 11 years.

Effects

The crisis led to warnings from credit agencies; Standard & Poor's placed the state on a "negative credit watch" and Moody's announced it was reviewing the status of more than $30 billion of California's state debt.

Public reaction

In June 2003, a survey by the Public Policy Institute of California found that more than two-thirds of Californians disapproved of the way the legislature was handling the budget. The same survey found Davis had an approval rating of just 21 percent, the lowest for any California governor on record; around half of respondents reported that they would vote to remove him if a recall election were held that day.

Schwarzenegger had strong approval ratings for the first part of his term, with a high point of 65% approval coming after the 2004/2005 fiscal year budget was finished. However, these decreased as he became more confrontational with the legislature and trade unions, falling below 40% by June 2005.

Aftermath

Propositions 57 and 58 did not definitively move California out of its deficit. The next budget after they were passed, for the 2004/2005 fiscal year, was also in deficit. The state's deficit problems resurfaced in another budget crisis which lasted from 2008 to 2012.