The California Factor Jude Wanniski August 11, 2003

When we remember California represents one-sixth of the $11 trillion Gross Domestic Product, we can easily infer that what happens in the political swirl over the next two months will bear upon the national economy and on the financial markets. That is, if Governor Gray Davis manages to survive the recall election on October 9, it will mean one thing for the future of the state’s economy and its relationship to the rest of the economic system. If we assume he will be turned out of office and then replaced by another Democrat or by one of the Republicans in the free-for-all, it would mean other outcomes. At this point the variations are myriad, so there is not much point in trying to pin things down in one direction or another. It is useful to address some broad concepts.

If we go back 25 years to June 6, 1978, when Howard Jarvis triumphed with Proposition 13, we can clearly see the importance of the state’s weighting on political matters of this kind. Prop 13 cut back the property taxes that had had swelled with the Nixon inflation that followed the end of the gold standard in 1971. Gold had quadrupled to $140 from $35 by 1973, prompting the OPEC countries to quadruple the oil price to $12 bbl. from $3. President Carter’s Treasury boys pushed the Federal Reserve for an even weaker dollar, which put gold at about $240 as Jarvis was leading his tax revolt. With no noticeable exceptions, the Nobel Prize economists united in predicting economic disaster if Prop 13 passed. The supply-siders were alone – with Ronald Reagan – in predicting an economic boom on the Laffer Curve. Except for a few tiny media outlets in the cow counties, every newspaper in the state opposed Prop. 13, which proceeded to pass by a 2-to-1 margin. In the year that followed, the national economy stayed out of recession, but if California’s 5% growth rate were subtracted from the total, there would have been a recession. If Prop.13 had been defeated, the stock market would have swooned in anticipation of serious weakness in the national exchange economy. 

For that reason alone, I am encouraged by the developments of recent days, especially with Arnold Schwarzenegger’s decision to run. His positions on social issues supposedly make him anathema to the state’s hard-right conservatives who lost badly last November when they tried to defeat Gray Davis with William Simon Jr. Of all the GOP entrants, though, Schwarzenegger is the one who could take the kinds of steps that Ronald Reagan would to pull the state out of its fiscal crisis – and be able to get the Democratic legislature to go along with him. The other Democrats in the field would be just as stymied as Davis. The other Republicans in the field might make the right proposals, but would not likely have the charm to get them through the legislature. 

The crisis is not all that critical, if you remember that the $38 billion deficit facing the state is really only $19 billion averaged over the two budget years. If we round out the numbers for a $2 trillion economy, the deficit is only 1% of the total. The state’s bond rating has slipped somewhat given all the dire predictions of where the crisis might lead. But the rating would bounce back if the Terminator recommended a Reaganesque approach, which I suggest would be the elimination of California’s capital gains tax. Most certainly there would be no need for any kind of tax increase, as the state’s economy is running a huge deficit because it is already burdened with excessive tax rates that are sending financial and human capital east. The top income-tax rate is 9% or higher in those jurisdictions that have local add-ons. California should have gotten rid of its capgains rate years ago, but it would be easy now that so little revenue from that source is dribbling into Sacramento. The state’s economy would suddenly become a magnet for capital formation, and the growth that would occur would bring higher revenues to every city, county and hamlet within its borders. At the margin, it would increase revenues in every state in the union. A Governor Schwarzenegger might have to settle for a 50% exclusion on capgains, but even at that rate Californians would be able to see the way out of the woods. That would be especially good as the national economy is now being helped with the second round of Bush tax cuts. 

There is more good news coming, I think, when Congress returns in September. We’re still keeping watch on the action expected in the House Ways&Means Committee, which must come up with a solution to the question of the Foreign Sales Corporation. At least some of the latest upward trend on Wall Street is the result of Chairman Bill Thomas proposing a series of supply-side changes on taxes and regulations to make up for the losses companies might feel with the abolition of the FSC. 

The first speculation was that Thomas would not have the votes in the House to get his package through, as enough Republicans would prefer the bipartisan alternative being recommended by Rep. Phil Crane [R IL] and Rep. Charles Rangel [D NY], which focuses the $50 billion in funds freed up by FSC to the companies that would lose out. The Thomas package seems to be winning out at the grass roots, though, and by the time Congress returns, members may have had an earful from the smaller companies that get to share the wealth in the Thomas version. The benefits would be felt keenly in California, which suggests a new governor with the right kind of approach would have everything going for him at once. Then again, I’m assuming a lot about how Gray Davis and the other candidates will play their roles in the next two months. My educated guess is that things will turn out for  the best, as they did in 1978 with the populist Jarvis.