Nearly everyone agrees that California and its localities need a new fiscal relationship, but few expect any dramatic changes in 1994.

An election year and the state's continuing budget crunch could make Sacramento wait before tackling what most policymakers consider a serious problem, political observers say.

"There is perhaps no more important issue facing the Legislature than the structure of state and local governments," the state Legislative Analyst's Office said in an annual budget report earlier this year.

Under the current system, "the component parts have no common conception of mission, and often work at cross-purposes with each other," the report continues. "In short, we find that California's existing ~system' of government is dysfunctional."

With various reform efforts simmering, it is increasingly clear that municipal market participants have a stake in the results.

"Generally speaking, the locals are feeling an increasing loss of control over their fiscal future," said Timothy J. Schaefer, a senior vice president of Evensen Dodge Inc., a financial advisory firm.

Market Concerns

Public officials' concern is filtering into the financial community as well.

Municipal bond analysts have been on the alert ever since the state laid claim to $2.6 billion of local property tax revenues earlier this year and diverted the money to school needs.

Given that background, market faith in the creditworthiness of local issuers could be affected by a real restructuring of the ties between the state and localities.

Whatever happens, a great deal of discussion lies ahead.

The Assembly's Select Committee on Restructuring Government plans a retreat next week to focus on the restructuring issue. In November, the Senate Committee on Local Government plans a day-long hearing to study proposals on the same topic.

In August, Gov. Pete Wilson established his own Local Government Policy Council "to solicit, analyze, and develop proposals for restructuring local government in California to meet the needs of communities within the fiscal capacity of the tax base."

The council has already formed a "restructuring advisory panel" of almost 50 city and county officials, and it is expected to present recommendations to the governor later this year.

A proposed Constitutional Revision Commission would also be likely to explore restructuring ideas. The bill to create the panel is now before the governor.

"I think there's a lot of legislative interest" in the topic, said Peter Detwiler, principal consultant of the Senate Local Government Committee.

There is definitely "a very clear sense that things are wrong," Detwiler said, but not necessarily "a clear sense what to do or what's doable in terms of political will."

Some state senators recently tried to force the issue with S.B. 1234. The legislation, known as the "blow up" bill, would have formed a joint legislative committee on realignment. It also called for the committee to restructure state and local programs by next July. Otherwise, all property tax revenues and 70% of the localities' share from the sales tax would be withheld from local governments.

The bill was passed by the Senate this summer but failed to move out of committee in the Assembly. City officials pushed hard against the bill. The latest version of the measure, which might be revived next year. has deleted the sequester provisions.

A spokeswoman for the League of California Cities said it was "outrageous" to propose bringing people to the negotiating table by sequestering local government revenues.

Some state officials found the cities' position disingenuous, given a recent message from the league's executive director that appeared in Western City, a monthly publication for city officials.

Under the legend "Basic Reform Should Begin Now," Don Benninghoven wrote that "reform can take place only, when there is genuine belief that a crisis exists. Six months from now this whole crisis could be forgotten, so now is the time to begin a short- and long-term plan to provide a more responsive, fiscally accountable, and consumer-oriented pattern of governance at all levels in California."

Fiscal Arm-Twisting

The league spokeswoman said those remarks are not inconsistent with the cities' opposition to S.B. 1234.

City officials "fully support" restructuring efforts, she said. But reform needs to be careful and well thought out, not rushed into law with a threat to disrupt municipal services with a funding stoppage, she argued.

Nevertheless, some political observers believe a financial threat is needed to keep restructuring's momentum from disappearing in the face of election-year politics and a budget pinch.

"I hope it's not just a fad like missing children on milk cartons," Detwiler said of restructuring.

A principal author of the legislative analyst's restructuring report has his fingers crossed. "I'm hopeful that the agenda will keep moving forward to some extent," said Peter Schaafsma, director of the analyst's state and local finance section.

Detwiler said the analyst's report provides a framework for discussions.

"Clearly it's a starting point," he said. The Senate Local Government Committee touched on the topic last winter during a hearing that gave local officials a chance to respond to state budget plans.

In general, however, the hearing "produced superficial responses" rather than ideas for true basic restructuring, Detwiler said.

The discontent with relations between California and its localities is another sign of the pinched times brought by the 1990s. The problems with the state's governmental structure stayed hidden until the softening economy created a series of multibillion dollar deficits.

As one response, state officials began undoing financial measures that helped bail out local governments after passage in 1978 of Proposition 13, the property tax-cutting initiative. In one of the most controversial moves, the state reclaimed billions of local property tax revenues and used the money to meet its school funding requirements.

The tax shift made it impossible to ignore the mismatch between public expectations for local government services and the resources actually available.

"Yanking off some of the band aids exposes the wounds that have been there all along," said David Brodsly, vice president and manager of the western regional office for Moody's Investors Service.

Many public finance participants believe the problems are aggravated by a patchwork quilt of voter initiatives embedded in the state's constitution.

At some point, Schaefer said, voters need to ask themselves whether these straitjackets "defy any explanation of fiscal prudence or responsiveness to changing environments."

Backing into Reorganization

The voter initiatives and other revenue- and spending-related measures have already contributed to de facto government reorganization, one market participant said.

"Restructuring goes on all the time, you just don't recognize it all at once," said Greg Clark, a vice president of Capital Guaranty Insurance Co.

Investors would prefer, however, that the state undertake reforms "in a rationale pre-planned way rather than on an ad hoc basis," he said.

Clark, for example, would advise the state that "it should not as a matter of policy" strip away local property tax revenues, even if a legal right exists to do so. Such a move hurts the autonomy of local governments and undercuts their financial stability, he said.

"I can't imagine us doing any county COPs right now," Clarke said. Counties have been the entities most affected by the revenues shift.

Other market participants expressed particular concern about counties and schools, arguing they will be be turned into virtual wards of the state unless they are given more revenue-raising flexibility.

Some of the potential solutions also can raise other problems.

For instance, many localities are turning to sales taxes instead of property taxes. But sales tax levels fluctuate with economic cycles, and often decline just when pressures for health and welfare spending increase, said Steven Zimmermann, a managing director of Standard & Poor's Corp.

The office of legislative analyst's restructuring model contemplates three major types of changes: adjustments in the way programs are controlled and delivered, changes in state and local revenue sources to support the adjustments, and establishment of new incentives and sanctions to promote the achievement of broad public goals.

"One of the key objectives of our proposed restructuring model is to avoid the fragmentation and lack of coordination that characterizes current service delivery," the report says.

The report,acknowledges that the proposed changes would take time to achieve and "we do not underestimate the difficulties inherent in overcoming the implementation problems."

Nevertheless, "we see no alternative to such a reorganization in the long run," the report concludes.

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