Fiscal storm turns tempest: California struggles to overcome the largest shortfall in state history. It's not alone.

• Author: Weintraub, Daniel M.

When California Governor Gray Davis started spending the last of the dot-corn surplus in the spring of 2001 and drained the state's dwindling reserves, he was asked why he was not saving some of that extra money for what might be even more troubled times ahead.

"Reserves are for rainy days," the governor replied. "It's starting to rain. We're getting out our umbrella."

But the fiscal storm that Davis and majorities in the California Legislature thought would be a passing shower turned into a deluge that still hasn't let up. State revenues have taken blow after blow, first from the stock market decline and then from a generally sluggish economy.

Spending, propped up for two years by loans, shifts and transfers, has now outpaced tax receipts by a giant margin, leaving the state with a structural deficit equal to roughly a quarter of its revenues.

The Legislature, which needs a two-thirds vote to pass a budget, is polarized along ideological grounds, thanks in part to a 2001 redistricting plan that catered to the most liberal members of the Democratic Party and the most conservative wing of the Republican. Davis, narrowly re-elected last November against a weak opponent, is now facing the threat of a recall election. And interest groups across the political spectrum are preparing to do battle in the way California knows best: through the ballot initiative.

With all those elements in place, the coming months are sure to produce an historic ending to the state's budget debacle. Either a grand compromise will evolve that somehow manages to close the gap or the state's finances will implode, leaving California deep in debt, unable to pay its bills and at the mercy of Wall Street. It's hard to imagine the state somehow avoiding either outcome and muddling through another year without facing reality.

Developments in mid-March offered a glimmer of hope. Lawmakers passed a package of budget cuts to trim $8 billion from the shortfall over two years, but those cuts were largely deferrals and suspensions of planned growth. The real work still lies ahead.

"We have a long way to go," said Assemblyman Darrell Steinberg, Appropriations Committee chairman. "This is no time to relax. But it's good to get over this particular hurdle and to start focusing on aggressively dealing with the rest of the problem."

Like many states, California's deficit has its roots in the stock market boom of the late 1990s and the subsequent bust. The state has a progressive income tax and a skewed distribution of income, meaning high-income earners pay a disproportionate share of the state's personal income tax. That makes the state's finances dependent on the fortunes, literally, of a very few people.

In the early 1990s, the state was collecting about $2.5 billion a year in taxes on capital gains and stock options, which amounted to about 5 percent of the general fund. As high tech companies began paying their workers in stock options and the price of that stock began to soar, so too did the state's revenues. By 2000, the state was taking in $18 billion from those two sources, and...