Uploaded by Ben Morehead, Associate Publisher of Policy Review magazine and authorized agent for the copyright owner(s). WEST OF EDEN California's Economic Fall by Steven Hayward From the Summer 1993 issue of Policy Review To subscribe to Policy Review, call (800) 544-4843 Economic catastrophe has struck California with the violence of an earthquake. For decades, California has been the most socially and economically dynamic state in the nation and one of the entrepreneurial capitals of the world. It truly has been America's Golden State -- the El Dorado with its beaches and mountains, its sunshine, its majestic forests, its fountain of eternal economic opportunity. In the 1980s, California outperformed even the booming national economy. The gold rush is over. California recently has been buffeted by natural and social disasters -- drought, fires, flooding, earthquakes, riots -- and by a recession that has hit California harder than any other state in the nation. With 12 percent of America's population, California has accounted for one-third of the total national job loss. California often has led the nation out of recessions. Now, the collapse of the country's most enterprising economy is holding back the national recovery. All forecasts call for California to underperform the national economy in the 1990s, with employment and income declining through 1995. California's crisis has revealed a state government with out-of-control spending and burdensome bureaucracy, with even worse news to come in the next few years if changes are not made. Meanwhile, despite a steady flow of foreign immigrants, California is experiencing net domestic outmigration (more people leaving for other states than arriving from them) for one of the few times in its history. In 1988, 100,000 people moved to California from other states; this year, nearly 100,000 may leave. Economic Fault Lines Fault lines in the California economy were cracking open beneath the surface of the 1980s boom. Government regulation increased rapidly, taxes crept back up to their ruinous levels before the Proposition 13 property-tax revolt of 1978, and rapid spending growth left the state budget vulnerable in a recession. Although the California economy was booming, per-capita income growth was actually lagging behind the national rate. As early as 1983, then-chairman of Hughes Aircraft, Allen Puckett, criticized California for being anti-growth and declared that Hughes no longer would invest in new plants in California. Hughes kept its word throughout the rest of the 1980s, but with a growing economy, a high rate of new business formation, and vigorous job growth, it didn't seem to matter if or why businesses moved or expanded out of state. This attitude of invincibility persisted through the beginning of the national recession in the second half of 1990. When Forbes published a cover story about California's deteriorating business climate in October 1990 -- "Is the Golden State Losing It?" -- the article was greeted with a flurry of dismissive criticism by the local media. State government joined in the miscalculation. In fall 1990, the Commission on State Finance, which makes independent economic and employment projections, predicted that California would experience a loss of 30,000 to 40,000 jobs in the coming year. By fall 1991, the number of jobs lost already had passed 300,000, and had not yet reached the half-way mark. The projected state budget "shortfall" for the fiscal year beginning on July 1, 1991, which was thought to be $7 billion in January, quickly grew to $10 billion in February, $12 billion in late March, and finally to more than $14 billion the following May. Budgets for 1992-1993 and the coming fiscal year are each more than $10 billion in the hole. The causes of California's collapse, and whether some of them could have been avoided, are debatable. Almost everyone agrees that California's economic "bio-rhythms," so to speak, were all out of synch at once: a general recession, a cyclical real estate slump, a decline in foreign, especially Japanese, investment, and steep defense cuts. California enjoyed a bigger real estate and construction boom than the rest of the country in the 1980s, and it has suffered from a bigger bust, as overbuilding in commercial real estate led to the savings and loan crisis and credit crunch. Although California's population continues to grow by more than 500,000 people a year, housing construction has fallen from 237,000 units in 1989 to just under 100,000 in 1991. In Southern California, which has been hit hardest by the slump and where most of the new population growth is, only one housing unit has been built for every 25 new residents in the past two years. Non-residential construction also has fallen by more than half since 1988. Construction-industry employment has fallen by nearly 30 percent since 1990. Japan's Setting Sun Less widely noticed has been the precipitous decline in Japanese investment in California. This decline probably owed as much to the collapse of the Tokyo real estate and stock markets as to the decline in investment opportunities in California. Japanese investors poured $7.4 billion into 68 California companies in 1990; in 1992, the Japanese invested only $620 million in 27 ventures. Japanese investment in California real estate has suffered a similar steep decline, from more than $5 billion in 1988 to less than $300 million in 1992. Perhaps the most symbolic example of the decline was Japanese developer Minoru Isutani, who paid $850 million in 1990 to buy the famed Pebble Beach golf resort -- only to sell it for $500 million last year. Meanwhile, Japan's California banks hold $60 billion in loans, a third of which are in commercial real estate whose value has fallen sharply over the last two years, leading to write-downs of loan values. Indeed, Japanese real estate investors in California suffered from many of the same speculative excesses they suffered in Japan. In 1992 Japan's California banks lost money for the first time since becoming a major presence in the state's banking industry. (California's banking industry in general has done as poorly as the rest of the economy, with 31 percent of the state's banks, including two of the 10 largest, reporting losses in 1992, up from 25 percent reporting losses in 1991.) Military Meltdown A third major factor in the crumbling California economy is defense cuts. California always has been a key state for the defense industry, accounting for more than 20 percent of the nation's defense-procurement spending. The end of the Cold War has meant anything but a "peace dividend" for California, however, where more than 120,000 defense and defense-related jobs have been eliminated in the past two years. Another 50,000 defense jobs may go by the end of 1993, and California will probably lose another 50,000 to 60,000 military jobs through base closures during the rest of the decade. The decline in defense spending is a prime reason why California, which received $1.22 in federal spending for every $1 in federal taxes paid 10 years ago, only receives about 90 cents for every $1 in federal taxes paid today. What makes this round of defense cuts more significant is not the seeming finality of the post-Cold War defense downsizing, but the concurrent decline of the related civilian aerospace and high-technology sectors, where defense workers used to be absorbed in years past. Losing massive numbers of jobs in competitive sectors like civilian aerospace, electronics, and other manufacturing should raise a red flag that something else is at work -- a deteriorating business climate. Peter Ueberroth, appointed chairman of a special Council on California Competitiveness by Governor Pete Wilson in 1991, concluded that "California's economic wounds are mostly self-inflicted." Numerous business leaders agree. Jerry Jasinowski, president of the National Association of Manufacturers, recently declared that California "clearly has the most anti-business climate in the country." Many liberal policymakers in California still deny that there is anything seriously wrong with the state's business climate. But the evidence seems overwhelming: a stampede of companies has moved or expanded out of the state. According to a survey conducted by several public utilities, 668 manufacturing facilities either have moved or expanded outside of California since 1987, costing the state 92,000 manufacturing jobs; no one knows how many other jobs these plants would have supported. The survey found that 87 percent of these companies cited California's business climate as a major factor in their decision to relocate. A California Business Roundtable survey of 1,325 companies found that 44 percent intend to relocate or expand outside of California. The trend has become so pronounced that a 3M plant in Stockton recently made the news when it announced it was not leaving the state. The resulting loss of revenue to the state is staggering. And it is only a fraction of a multi-billion-dollar exodus to greener state pastures. Hughes Aircraft chairman Michael Armstrong estimates that Hughes' move to Arizona will cost state and local government more than $600 million in tax revenue every year. Hot Tub to Cold Shower Californians would not have to worry too much about businesses leaving the state if new companies relocated there to take their place. But in 1990, California suffered the biggest decrease in the number of new business startups nationwide, and business failures soared. As recently as 1988, California ranked third in the nation in the number of new manufacturing plants. By 1990, California did not even rank in the top 10 states. The sorry business climate results partly from the high costs of doing business -- costs that often are driven up by government regulation. True, some costs are functions of high demand in a dynamic marketplace; utility rates, for instance, are as much as 50 percent higher in California than in neighboring states. However, the state's high housing costs also make it difficult for employers to attract skilled workers. California's median home price is $211,000; the national median price is $103,000, while the median home prices of neighboring western states are below the national average. This price disparity is a recent development. In 1974, California's median home price was only slightly above the national median. There is abundant evidence that government regulation, more than market demand, is the chief cause of soaring housing costs California has experienced. In addition to development-impact fees that can add up to more than $40,000 per house in many parts of California, planning delays and permit conditions can nearly double the cost of building a new home. Stressed Out The most expensive example of government-imposed costs is workers' compensation, which is driving small and medium-sized businesses out of California. Between 1981 and 1991, the cost of California's workers' compensation program rose more than 200 percent. Over the same period, the workforce grew only 25 percent, and the rate of disabling injuries per 1,000 workers declined. A clue to the problem is revealed in the following fact: while California's workers-comp system ranks among the top five in the nation for cost, California ranks 44th in benefits paid to injured workers. A large number of middlemen obviously are feeding at the trough as well. A potent political combination of lawyers, doctors, clinics, and insurers prevailed upon the legislature over the last decade to enact an expansive definition of compensable disability. Under this enlarged definition, an able-bodied person can collect on a "cumulative stress" claim, even if the job only contributed to 10 percent of the "stress." Virtually anyone who commutes in California's legendary freeway traffic can qualify under this absurd standard. Not surprisingly, stress claims have increased 700 percent in the last decade. Fraud is rampant, as a "60 Minutes" segment exposed last year. Yet, with such elastic thresholds of "injury" through "stress," it is hard to tell fraud from legitimate stress. A favorite tactic of laid-off or terminated workers is to file a stress claim immediately. Many are successful. When the Good Companies, a furniture manufacturer in the Los Angeles area since 1956, moved to Mexico chiefly to escape the prohibitive cost of local air quality regulations, they laid off 600 workers. When the company announced the layoffs, a workers-compensation attorney parked vans in front of the plant and ferried workers to the attorney's office. Of the 600 workers, 530 filed workers-comp claims against the company. The result of such a system is skyrocketing insurance premiums that render California companies uncompetitive with out-of-state producers. Total workers-comp insurance costs now top $10 billion a year in California -- not much less than the state takes in through the corporate-income tax. McDonnell-Douglas reports that it pays $785,000 in workers' compensation premiums for every MD-80 airplane it builds in California. Seattle-based Boeing pays only $235,000 per similar aircraft. Not surprisingly, many companies that have moved from California have been able to recoup their moving costs in the first year from savings in workers comp costs alone. McDonnell-Douglas is now among the exiles: having already announced that it would build components for its C-17 transport plane in Missouri, McDonnell-Douglas recently announced that two major new programs, the AH-64 helicopter and its next generation MD-12 jumbo passenger jet, also will be made outside of California. L.A. Law McDonnell-Douglas and other manufacturers say that other government regulations, especially environmental regulations, are as damaging to business as workers' compensation. California's environmental standards are tougher than the federal government's. Perhaps the most serious obstacle to economic activity comes from the complexity, delay, and uncertainty of the environmental review and permit process. In Los Angeles County, for example, businesses must get environmental permits from as many as 27 local agencies and up to 32 state agencies. Federal agencies also get in on the act, bringing the possible total permit gauntlet to over 70 agencies. Environmentalists frequently use legal challenges under CEQA to prolong the lengthy review process for up to a decade. For instance, it took one company 10 years to move from initial permit application to groundbreaking for a $140 million recycling and waste reduction center. During that time, the project was hit with 20 CEQA lawsuits from citizens, all but one of which was unsuccessful. Companies that operate in several states -- retail distribution warehouses, for example -- routinely report that identical projects are up and running in other states before the review process is even half finished in California. As one exasperated businessman told a state Senate committee hearing last year, "I would rather have a `no' in two months than a `yes' in two years." The worst example of regulatory overkill and perverse bureaucratic incentives is the South Coast Air Quality Management District (SCAQMD). The South Coast AQMD is charged with battling smog in the greater Los Angeles area. While L.A.'s worst-in-the-nation smog should be attacked aggressively, the SCAQMD and its regulatory strategy are a textbook model of an unaccountable anti-business bureaucracy. The district has its own governing board that is constituted through a fragmented and Byzantine process. Unlike the federal EPA, which must get an appropriation from Congress and submit to congressional oversight, the SCAQMD does not have to answer to the state legislature. It sets its own budget and raises its own revenue through permit fees and fines levied directly on businesses in the region -- up to $25,000 a day. An older school of jurisprudence probably would have found the SCAQMD's autonomy to be an unconstitutional violation of the separation of powers. Not surprisingly, the SCAQMD emphasizes regulations that generate revenue through permit fees on stationary sources of smog -- which means businesses -- even though two-thirds of the smog in L.A. is generated by cars and trucks. SCAQMD did its best to conceal the extent to which its overall plan would become an albatross around the neck of the region's economy. The district originally estimated that its regulations would cost about $3 billion a year. However, two independent estimates, one by the National Economic Research Associates (NERA) and another by Resources for the Future (RFF), placed the cost at $10 to $12 billion a year, or nearly $2,700 per household in the region. NERA researchers noticed that the district's estimate left out any cost figures for more than half the regulations contained in its 20-year plan. When the district added up its estimated costs, it simply added a "zero" to the bottom line whenever it came upon one of these uncalculated measures. When pressed in a public forum about this peculiar methodology, the chairman of the District's board said they didn't want to use "arbitrary figures." The NERA and RFF estimates reasonably suppose, however, that the uncosted regulations would cost something rather than nothing. Under pressure, the SCAQMD has softened somewhat its anti-business attitude and has moved to adopt a market-based tradable permit system that has long been advocated by market-oriented economists and environmentalists. Meanwhile, efforts to streamline the environmental review and permit process are reaching a fever pitch. The secretary of the California Environmental Protection Agency, James Strock, describes the environmental review process as "convoluted, overly complex, and unnecessarily burdensome." Strock has made streamlining a major priority, but legislative action is required to cut away the thicket of red tape. Leading the Tax Pack All of this economic misery and regulatory excess would seem to provide conservatives with golden opportunities to advance a conservative agenda; however, conservatives have had a hard time finding their voice. For the past 10 years, California's Republican governors have taken the blame rightfully belonging to the liberal legislature. Along with the sorry fortune of President George Bush, Republicans received the lion's share of the voters' wrath last November. California provided Clinton with one-third of his national vote margin over Bush. In addition, Republicans actually lost a seat in the State Assembly, where they had been expected to pick up several seats on account of a favorable reapportionment following the last census. Along with liberal dominance in the legislature has come staggering growth in California's government. Between 1958 and 1991, state per-capita spending (adjusted in real 1991 dollars) increased from $629 to $1,716. While real state spending per capita tripled, real per-capita income less than doubled. Hence, state government's share of personal income has risen from about 4.8 percent in 1962 to over 8 percent today. California is one of nation's 10 highest-taxed states on a per-capita basis. The booming economy of the mid-1980s generated huge revenues that allowed the state budget growth at times to hit double-digit rates. Even with this rapid revenue growth, however, the state budget was still running a cash deficit every year. Each year the state budget would include a $1 billion or more "contingency reserve," but every year except one the reserve would finish the year several hundred million dollars below the budgeted figure. As long as the budget was technically in surplus, no one complained. The onset of the recession in 1990 quickly exposed the unsound basis of state spending, and turned the small deficits into a huge gap. Revenues have been billions of dollars below forecasts, but the growth of spending continues unabated, actually rising in 1991 and 1992. Incredibly, even though the state's private sector has lost over 800,000 jobs, state government employment has risen by more than 5,000 employees during the past three years. Coast Accounting The state budget is driven largely by earmarking and automatic spending increases for entitlement programs. The caseload for entitlement programs such as welfare and Medical (California's version of the federal Medicaid program) is growing at double-digit rates, while the number of taxpayers is not. The ratio of taxpayers to subsidy recipients is falling rapidly, so much so that even a vigorous economic recovery is not likely to generate enough revenue growth to balance the budget in the next few years. Governor Wilson has called this "the taxpayer squeeze." By the year 2000, the Department of Finance estimates, the budget could still be $15 billion in the red. "There is simply no revenue system in the world that can pay for this kind of spending," a Department of Finance official told Policy Review. Governor Wilson hurt himself badly in 1991 by agreeing to a $7 billion income and sales tax increase -- the largest in state history -- to help close the $14 billion budget gap. As supply-siders predicted, the tax increases failed to generate the revenue projected. Governor Wilson has since said that the tax increase was a mistake and has tried to hold the line on taxes in the face of successive combined budget deficits of more than $20 billion. Last year, the state had to resort to issuing IOUs to pay its bills, as the legislature bickered for more than two months at the beginning of the fiscal year before finally passing a budget. Governor Wilson now is proposing to roll back a part of the state's sales tax, reduce entitlement spending, and privatize some parts of state government. Fixing California requires a massive overhaul of its budget process and regulatory laws. Fundamental budget reform should include the elimination of earmarking and automatic increases based on social program caseloads. Earmarking and "workload" budgeting remove spending control from the domain of legislative deliberation and accountability. Several studies have shown that state budgets grow more slowly in states without such spending discretion. In order to reform the budget process and slow down overall spending growth, such spending programs as entitlements and corrections must be reduced first. State and local governments spend over $3 billion a year on entitlement programs for illegal immigrants; California's welfare grants are among the highest in the nation. Spending for corrections has soared by nearly 600 percent since 1978. California's incarceration costs rank among the highest in the country. Privatizing some medium-security prisons in addition to some other cost-cutting measures could make a huge dent in budget spending. Second, taxes need to be lowered and redistributed. One of the unintended consequences of Proposition 13 was the centralization of revenue at the state government level. Local governments in California have been gradually transformed into administrative units of state government because the state tightly controls the money flowing back to local government. Not only should taxes be lowered, but a portion of the tax base should be shifted directly to local government control. Third, some of the functions of state government need to be downsized and privatized. A few of the nearly 400 state boards and commissions, including such august bodies as the Pet Bird Advisory Committee, have been abolished, and the Wilson administration has dozens more on the chopping block. But this isn't where the real money and trouble is. There is still a lot of redundancy and unnecessary bureaucracy that can be eliminated. Does California need, for instance, both a free-standing Integrated Waste Management Board, and a Division of Recycling in the Resources Agency, who are tripping over each other while doing the same things? Fourth, environmental and other regulations must be reformed. California needs to reevaluate whether its own environmental standards, which usually are tougher than federal standards, have been set unrealistically or unscientifically. Conservatives need to press not only for a streamlined review process, but also for the adoption of market-based or incentive-based environmental policies, which are a less costly and more effective alternative to the bureaucratic "command-and-control" regulation now in place. The good news is that some environmentalists in the state are sympathetic to these ideas. Conservatives have a unique opportunity to form coalitions with moderate environmentalists against the bureaucrats and the radical environmentalists. Much of this agenda probably cannot be accomplished without a conservative majority in the state legislature. But conservatives can hope to gain strength in California with the right themes and a strong voice. The split between conservatives and moderates in the California GOP has been overblown in the media. Although disagreements and enmity exist, the disastrous result of the last election has had a chastening effect on both camps -- with both reaching for the common ground that does exist, especially on economic issues. Term limits soon will take effect, throwing the legislature wide open for a complete change. A bold school-choice initiative is on the ballot for a special election in November, around which conservatives can emphasize the themes of empowerment and opportunity, especially for the state's large minority population. School choice would also break the power of the teachers' union and reform inefficient education spending. Above all, California conservatives need to regain the dynamic themes of opportunity and growth that have served them well in California and elsewhere in the past. The huge budget deficits should be regarded as an opportunity for conservatives to press for the kind of changes in government that thus far have eluded them both in California and across the nation. There simply is no other way to avoid the economic equivalent of a tectonic shift along the San Andreas. STEVEN HAYWARD is research and editorial director for the Pacific Research Institute in San Francisco, and a contributing editor to Reason magazine. To reprint more than short quotations, please write or FAX Ben Morehead, Associate Publisher, Policy Review, 214 Massachusetts Avenue, NE, Washington, DC 20002, FAX (202) 675-1778.