It’s being called the mother of all state government battles.

By calling for massive budget and government restructuring, and threatening to take his proposals to the people if the Legislature doesn’t act, Gov. Arnold Schwarzenegger has set off the biggest political scramble in decades over how California should be governed.

Republicans and business interests are lining up behind the governor as he tries to push through his ambitious agenda. Democrats and their labor allies are preparing their own alternative proposals to present both in the Legislature and possibly later to the voters.

“I’ve never seen anything quite like this in the 35 years I’ve been up here,” said Barbara O’Connor, director of the Center for the Study of Politics and the Media at California State University Sacramento. “There are war rooms everywhere up here. Everyone’s got their wagons circling.”

At the center is Schwarzenegger and his efforts to both overhaul the redistricting process and rein in state government spending, which he termed “out-of-control.” Those proposals include across-the-board cuts that take effect once spending exceeds revenues at any time during the budget year, reducing government contributions to public employee pension plans, and re-examining many of the spending formulas that have built-in cost escalators.

“Balancing this year’s budget is the sideshow. The real show is over these structural reforms, taking on the powerful interests in Sacramento,” said Republican political consultant Allan Hoffenblum.

Three-dimensional chess

Schwarzenegger’s strategy is three-fold.

First comes this year’s budget talks between the governor and the Legislature to address the projected $8 billion budget deficit. Those negotiations promise to be contentious, especially since Schwarzenegger has incensed teachers’ unions and other constituencies with lower-than-expected allocations.

Next is the concurrent special legislative session that the governor convened last week to consider his reform proposals. In what could be an important tactical advantage, laws passed during this special session would take effect sooner than they would otherwise. But more broadly, the session shines the spotlight on the Legislature, thereby putting additional pressure on Assembly members and Senators to act.

If the governor isn’t satisfied with what emerges, the last step would be to call for a special election to consider a host of government reforms, including redistricting and budget restructuring. No date for a special election has yet been set; it could be as early as mid-summer and as late as next November.

“We must address this structural budget deficit, whether in the Legislature or with a vote of the people,” said Sen. Charles Poochigian, R-Fresno, one of Schwarzenegger’s leading allies. “If we don’t address it this year, then it means the solutions that we have to adopt in future years will be that much more austere and Draconian.”

Schwarzenegger goes in with two key advantages: his popularity among voters remains at historically record-high levels and he’s shown that he can persuade voters to side with him on ballot measures.

“This is the first time I’ve seen in decades where there is such an imbalance of power,” Hoffenblum said. “Former Gov. Pete Wilson wanted to do this, but he never had this much influence. Not even (former Gov. Ronald) Reagan had this much influence.”

But Schwarzenegger must watch his right flank. The conservative elements in his own party rebelled last year over his willingness to cut a budget deal with Democrats and they could do so again.

“Schwarzenegger can’t afford to ignore them if he wants to run for re-election next year,” said Bruce Cain, director of the Institute of Governmental Studies at the University of California Berkeley. “He has never had to run in a Republican primary before and the conservatives have their eye on him. They think he’s a RINO (Republican in Name Only).”

Democrat resistance

Democrats, meanwhile, are trying to maintain their relevance. While they are not taking the politically unpopular step of calling for tax increases, they are preparing their own counterproposals. Assembly Speaker Fabian Nu & #324;ez last week said he intends to introduce legislation to close what he calls corporate tax loopholes as a way of raising revenues.

“We’re not going to be on the defensive and simply react to the budget,” Nu & #324;ez said. “We’re going to propose alternatives. We’re not going to let corporate interests completely off the hook. We’re going to be more aggressive in getting back our fair share from the federal government.”

While Nu & #324;ez said he was willing to work with Schwarzenegger on addressing the structural budget deficit, the Democrats are not likely to agree to Schwarzenegger’s key proposal to rein in spending: the authority to implement across-the-board cuts.

“They definitely will not cede budget authority to the governor or to the state controller,” said Sherry Bebitch Jeffe, senior scholar at the USC School of Policy, Planning and Development.

Democrats are also unlikely to yield to Schwarzenegger’s call for public pension reform, especially a proposal to switch from a defined benefit to a defined contribution, such as 401(k) plans. Public employee unions, a key pillar of support for Democrats, are up in arms over the idea.

One concern for Democrats is the ongoing FBI investigation into Senate president pro-tempore Don Perata’s business relationships with campaign contributors. Having won a contentious election last fall by just one vote, Perata’s hold on the Senate leadership is already tenuous. The investigation could distract him just when he needs to devote his energies to rallying Senate Democrats during budget negotiations.

Initiative battle

The key question for Democrats is whether they will try to cut deals with Schwarzenegger or face off at the ballot box with their own slate of proposals, including raising the minimum wage, expanding health care coverage for employees and taxing wealthy Californians to fund other social or health care programs.

“If competing structural reforms make it onto the ballot, it’s hard to say who wins this right now,” Cain said. That would also make for yet another round of expensive ad campaigns, on top of the $100 million-plus spent on initiatives this past November.

The unpredictability itself can carry several consequences. First, it means that even if the 2005-06 budget succeeds in reducing the deficit, bond rating agencies are not likely to boost the state’s “A” credit rating, the lowest among the 50 states. Raising the credit rating would save the state hundreds of millions of dollars in bond interest payments every year.

“The reason why California has such a low rating now is twofold: the state has made little headway in reducing its structural deficit and there is so much uncertainty from year to year on the budget,” said Steve Zimmerman, managing director of Standard & Poor’s western region office in San Francisco. “Don’t forget, looming on the horizon next year is an even bigger deficit once the deficit financing bonds are exhausted” and the state can no longer rely on $1.5 billion in local government property tax revenues.

Zimmerman and other bond rating analysts say that Schwarzenegger’s proposal for the authority to go back into a budget in mid-year and make cuts if spending exceeds revenues is an essential tool.

“California has in the past had trouble making these mid-year budget adjustments,” he said, “which only makes the next year’s budget deficit that much worse.”