SACRAMENTO, Calif. – Against a backdrop of IOUs and expanding government furloughs, Gov. Arnold Schwarzenegger and legislative leaders expressed optimism Saturday that they were moving toward a compromise that could end California's fiscal calamity.

Negotiations to close the state's $26.3 billion deficit restarted after two weeks of inaction and partisan bickering. Top lawmakers from both parties said a budget-balancing deal was possible in the coming week.

"I would say we're getting very close to a general framework, but there are still outlying questions," said Assembly Minority Leader Sam Blakeslee, a San Luis Obispo Republican, after emerging from a closed-door meeting between lawmakers and Schwarzenegger.

They negotiated about 2 1/2 hours Saturday before ending talks for the day. They were expected to return to the Capitol on Sunday.

Negotiations centered on the extent of budget cuts — which are expected to range from $14 billion to $15 billion — and what other steps might be taken to close the deficit.

The shortfall, which is the difference between the amount of tax money coming into the state and its previously approved spending obligations, amounts to more than a quarter of California's general fund, its main account for paying operating expenses.

Schwarzenegger and Republican lawmakers also want reforms to welfare, pension, health care and in-home supportive service programs. They say preventing waste and abuse will save the state money, which in turn can be used to prevent cuts elsewhere in the budget. The governor's office has estimated its reform proposals will save $1.7 billion this fiscal year alone.

Democrats have criticized the reform proposals as peripheral issues that do not have a direct effect on the immediate budget deficit. They also say Schwarzenegger has overstated the savings.

"There's a general appreciation that many of these reforms will produce savings, but we want to make sure we approach them in a thoughtful manner," Blakeslee said.

Despite the differences, both Democratic leaders appeared upbeat as they left Schwarzenegger's office after a second round of talks that began Friday night.

Assembly Speaker Karen Bass, who walked out of negotiations earlier in the week, said there did not appear to be any insurmountable obstacles to reaching a deal. She described the talks as complicated.

"I think what has happened over the last 48 hours has been the most productive in the last several weeks," the Los Angeles Democrat said. "We are just not finished."

Besides the welfare and social service reforms, education funding is one of the key negotiating points. Lawmakers are trying to decide whether it can be cut and, if so, by how much. Funding for K-12 schools and community colleges accounts for roughly half of annual state spending.

The possibility of a breakthrough in resolving California's mammoth budget shortfall comes a week after the state began issuing IOUs to thousands of vendors as a cash-saving move. State workers also have begun taking three days off a month without pay, cutting the salaries of more than 200,000 government employees by 14 percent.

The state's fiscal picture has become progressively worse since Schwarzenegger and lawmakers passed the budget for the current fiscal year last February during an unusual midyear session.

Personal income taxes declined 34 percent during the first five months of the year, a slide that has accelerated as the recession continues to strangle California's economy.

On Friday, the state controller's office reported the state had spent $10.4 billion more than it collected in the fiscal year that ended June 30. It is now without sufficient cash to cover all of its payment obligations.

If the budget isn't balanced by late August, the state will have to defer payments to its pension funds and may issue IOUs instead of paychecks to state employees.

The unprecedented drop in tax revenue is forcing Schwarzenegger and lawmakers to make difficult choices, with deep cuts proposed to education, health and social service programs.

At the same time, Schwarzenegger and Republican lawmakers are standing fast against additional tax increases, limiting lawmakers' options for closing the deficit.

The two-year budget package approved in February increased sales, personal income and vehicle license taxes, and Republicans say the state's economy cannot absorb additional tax hikes.

While the governor and lawmakers try to reach a compromise, some of the state contractors who are being issued IOUs will have to start scrambling to find banks that will cash the warrants. Bank of America Corp. and other major banks said Friday was the last day they would honor the IOUs, which cannot be redeemed until Oct. 2.






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