Over the summer, the most populous state in the US struggled to keep itself from financial collapse after a $26 billion hole opened in California’s budget.  Instead of taking the painful but necessary step of steep cuts in spending in order to deal with the shortfall, the legislature cut only as far as their political allies would allow, and then relied on funding gimmicks and budget sleight-of-hand to paper over the rest of the shortfall.  To the surprise of no one outside of Sacramento, it has only taken ten weeks for California to flop back into the red:

California Governor Arnold Schwarzenegger will know within a month whether a $1.1 billion drop in revenue collections is part of a growing budget shortfall or an isolated event, his budget spokesman said.

Revenue in the three months ended Sept. 30 was 5.3 percent less than assumed in the $85 billion annual budget, state controller John Chiang reported yesterday. Income tax receipts led the gap, as unemployment reached 12.2 percent in August. …

The latest figures show that California is facing resurgent fiscal strains brought on by the U.S. recession. Since February, Schwarzenegger and lawmakers have cut $32 billion from spending, raised taxes by $12.5 billion and covered $6 billion more with accounting gimmicks and borrowing. Even with those actions, state budget officials predict an additional $38 billion in deficits in the next three fiscal years combined, including $7.4 billion in the year starting July 1.

How did California overestimate its tax revenues for the coming year?  Part of the answer is political.  By overestimating income tax revenues, the legislature allowed itself to avoid further budget cuts, or for that matter, tax increases.  The latter would have brought California’s overburdened taxpayers to the capital with pitchforks, torches, tar, and feathers, and the legislators know it.

California also has a structural problem in its tax system.  It has grown so progressive that it relies much too heavily on investors, which makes tax revenue streams very unreliable and difficult to predict, as the Sacramento Bee’s Dan Walters writes:

We cannot continue to depend on a few thousand high-income Californians as the core of the state revenue structure. Their taxable incomes are increasingly erratic, and sooner or later, many will flee California’s high marginal tax rates to states such as Florida, Nevada or Texas that have no income taxes.

Did Tiger Woods, the first billion-dollar athlete, relocate from California to Florida because of better weather or nicer golf courses? Somehow, one doubts those were his motives. Getting his mail in Florida saves Woods millions of dollars a year.

California gets a quarter of its general fund revenues from fewer than 200,000 wealthy taxpayers whose incomes, tied to capital markets, vary greatly from year to year. That’s why California’s revenues go up and down like a yo-yo and, in turn, why the state periodically wallows in money, overspends and suffers from huge deficits as tax revenue declines.

It’s called “volatility,” and it’s a fairly recent phenomenon. Once, sales taxes were the state’s fiscal backbone. But changes in spending patterns — shifting from taxable goods to untaxed services — and the progressive nature of the income tax dramatically shifted the burden to that tax, which now accounts for well over half of state revenues.

This is something to watch on the federal level as well.  Under Barack Obama’s policies, less than half of all Americans will pay federal income tax, making us increasingly reliant on the wealthy, whose income varies greatly from year to year depending on their investment choices and their success.  As the actual tax base gets narrower and narrower, the volatility of income-tax revenues increase — on top of the dampening effect that punishing capital investment creates, as we have also seen in California.

The solution?  A flat-tax system would create a far more stable tax base, especially as it would tend to encourage rather than discourage investment.  Schwarzenegger put together a panel to look at tax volatility and came up with a two-tiered tax system that would shift more of the burden to the middle class, which will probably be a non-starter politically.  A flat tax would be politically cleaner as well as easier to administer.

Of course, the big problem in California isn’t taxation, but spending.  The state has to go back to the drawing board a mere ten weeks after falsely claiming to have solved the budget crisis.  Will they finally learn the lesson?