(Recasts with layoff order, adds background)

SAN FRANCISCO, Dec 19 (Reuters) - California Gov. Arnold Schwarzenegger declared a fiscal emergency on Friday to call lawmakers into another special session to tackle the state’s weakening finances, and separately ordered state officials to prepare to furlough and lay off employees to cut costs.

His two actions mark a dramatic escalation in the budget battle waged in recent weeks in Sacramento, the capital of the most populous U.S. state and world’s eighth-largest economy, as its revenues fall harder and faster than expected.

California’s state government now faces a $40 billion budget shortfall over its current and next fiscal years and is on track to run out of cash in February.

California’s Democrat-led legislature concluded its prior special session on Thursday by approving an $18 billion budget package, but Schwarzenegger, a Republican, said he would veto it because he wants lawmakers to both address the state’s budget gap and ease regulations to speed construction projects to help stimulate the state’s economy.

Assembly Speaker Karen Bass said the Democrats’ package would have provided for $3 billion in revenues for transportation projects, accelerated $3 billion in bonds for transportation projects and made it easier for hospital construction and expansion projects to move forward.

The dispute over which approach would better boost California’s ailing economy, underscored by its 8.4 percent unemployment rate last month, comes on the heels of a decision on Wednesday by the state’s Pooled Money Investment Board to halt $3.8 billion in loans for public works.

The state government needs funds from the Pooled Money Investment Board to pay for vital services. The board’s action affects almost 2,000 projects, including highways, schools, levees, housing and parks.

The legislature now has 45 days to pass and send a bill or bills addressing the state budget to Schwarzenegger.

In the meantime, the state’s Department of Personnel Administration will under Schwarzenegger’s executive order adopt a plan that would go into effect in February to furlough state employees and supervisors for two days per month.

The order also calls for state agencies and departments to initiate layoffs and other “program efficiency measures” to post savings of up to 10 percent in the state’s general fund.

“Every California family and business has been forced to cut back during these difficult economic times and state government cannot be exempt from similar belt tightening,” a statement from Schwarzenegger office said.

Assembly Majority Leader Alberto Torrico and two other top Democratic lawmakers issued a statement that said Schwarzenegger’s order “adds insult to injury for the state’s economy” and chided him for failing to win over either Democrats or Republican lawmakers to his budget plan.

“The governor has shown he can’t negotiate with Republicans, he doesn’t negotiate with Democrats, and now he’s refusing to negotiate with employees,” their statement said. “It’s the same lack of leadership that has kept him from coming up with a single vote for any budget solution. And now that lack of leadership has resulted in his making a scapegoat of employees who are not the source of the problem.” (Reporting by Jim Christie; Editing by Gary Hill)