With a day to go until a cash crisis would force the state to stop paying its bills, lawmakers and Gov. Arnold Schwarzenegger worked into the night Tuesday but failed to reach a budget agreement.

The state Senate, in late session, voted several times as midnight approached in a last-ditch effort to approve $3.3 billion in cuts to education and other programs and stave off, at least temporarily, the IOUs that California Controller John Chiang is set to begin issuing Thursday in lieu of some payments.

Democrats had been hoping to use the funds to help defray the state’s projected $24-billion deficit. But the money was allocated for the fiscal year that ended Tuesday, and after that it was too late to make the cuts.

“We have that duty to make sure that no one starves,” state Sen. Jenny Oropeza (D-Long Beach) said as she pleaded with GOP senators for their votes.


But Republican senators blocked the plan, which the Assembly approved last week. Schwarzenegger had vowed to veto the legislation because it did not meet his demand that any agreement close the state’s entire deficit, an argument echoed by the Republicans in the Senate.

“No one wants to see IOUs issued, but equally important, no one wants to see us continue to avoid the problem,” said Senate Minority Leader Dennis Hollingsworth (R-Murrieta).

Beyond any loss of the $3.3 billion in savings, state officials said, failure to make the education cuts could increase the budget deficit by up to several billion dollars, because education funding is based on the prior year’s appropriations.

The governor and lawmakers met the legal requirement to approve a budget for the new fiscal year with an agreement they reached in February; however, declining revenues have thrown that budget out of balance, and forced the current negotiations.


A state appeals court panel clouded the budget picture further Tuesday with a ruling that could cost the state nearly $3.5 billion. The judges in the 3rd District Court of Appeal said that since 2007, gasoline-tax funds intended for mass transportation had been improperly diverted by the governor and lawmakers to cover other expenses. The state will appeal to the California Supreme Court, said H.D. Palmer, a spokesman for the Department of Finance.

Meanwhile, Chiang, who acts as the state’s banker, has scheduled a meeting for Thursday morning of a state board that will determine what interest rate the state will pay on the $3 billion a month in IOUs it will begin issuing to contractors and some of California’s neediest citizens, including the elderly, the disabled and the poor. California last issued IOUs in 1992.

Doing so again could have serious repercussions. According to Treasurer Bill Lockyer, the decline in the state’s credit rating that is likely to follow IOUs -- as it did 17 years ago -- would cost the state $3.4 billion in higher interest rates over 30 years, adjusted for inflation.

Wall Street rating agencies have already warned that they are weighing downgrades to the state’s credit, which would probably take years to recover, Lockyer’s aides said.


So far, no banks have formally committed to honoring the IOUs, said Chiang’s spokeswoman, Hallye Jordan. At least one financial institution, the Golden 1 Credit Union, said Tuesday that it plans to accept the state’s IOUs from its 710,000 members, some of whom are state contractors.

The governor and legislators can avert the IOUs if they reach a budget deal before they are issued Thursday. But once they are issued, those who receive them will have to cash them with banks that may accept them, or wait until the IOUs come due Oct. 1, Jordan said.

As state leaders searched for a resolution Tuesday, there had been some signs of compromise. But they were fragile.

Democratic lawmakers signaled a willingness to reverse their opposition to Schwarzenegger’s plan for borrowing $2 billion in property tax revenues from cities and counties. The idea had angered local officials, and the governor had backed off but apparently embraced it again.


Lawmakers were also discussing some of Schwarzenegger’s proposals to curb the growth in Medi-Cal, the state’s health insurance program for the poor; to tighten enrollment procedures for food stamps and welfare; and to crack down on fraud and reduce services in the state’s multibillion-dollar in-home healthcare program.

Speaking to reporters outside his office, Schwarzenegger blamed legislators for wasting time deliberating over budget solutions, such as tax increases, that were not acceptable to him, but he said that the dynamics appeared to have shifted.

“For the last month there were debates, there was finger pointing, there was dialogue, accusations, but none of that will really solve the budget,” the governor said. He added, “In the last few days, I have seen an effort is being made to get together with us and to start moving closer together.”

In a letter sent Monday, however, two top Democratic lawmakers asked administration officials how the governor would replace the $3.3 billion in cuts they were trying to make. Mike Genest, the governor’s finance director, said the administration had not come up with a plan yet.


“I cannot imagine why a chief executive who has a year and half remaining on his term would want to put the state in the hole $3 billion more,” said Senate President Pro Tem Darrell Steinberg (D-Sacramento).

Schwarzenegger’s aides said he would call an emergency special session today to propose new cuts.

Amid the flurry of activity Tuesday, a panel that sets compensation for elected statewide officials cut car allowances, health benefits and tax-free living-expense payments for California legislators.

“The state of California is in dire straits, and we have to do our bit to adjust the benefits to help with the budget problem,” Citizens Compensation Commission Chairman Charles Murray said after the 5-0 vote, which came despite the panel’s lawyer advising that the commission did not have the authority to reduce the living-expense payments.


The 18% benefits reduction by the panel follows a salary cut of 18% enacted previously to affect lawmakers elected after this year. The decrease in benefits, however, will take effect Dec. 1 of this year and save $1.2 million annually.

That action, if it stands, will cut the $36,000 tax-free annual living-expense benefit by about $6,480 a year.

The state also pays $350 in monthly car costs for each lawmaker who drives a state-purchased car in his or her district. The commission’s action would cut that by $63, which the legislators would have to absorb.

California taxpayers have spent $3.2 million during the last three years buying the cars, covering gas expenses and paying to repair the vehicles when they break down or are damaged in accidents.


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shane.goldmacher@ latimes.com

michael.rothfeld@latimes.com

Times staff writer Patrick McGreevy contributed to this report.