SACRAMENTO — Just when it looked like Democrats had devised a way out of their suffocating impasse with Republicans over the state budget, Gov. Arnold Schwarzenegger stepped in Thursday afternoon with this message: Not so fast.

In a dramatic day at the Capitol that alternately had on display exultant Democrats, angry Republicans and a frustrated Schwarzenegger, the governor announced he would veto a Democratic gambit to raise billions in new revenue.

By exploiting a legal loophole over the definition of taxes vs. fees, Democrats had hoped to sidestep the state's two-thirds majority hurdle for raising taxes. But the part of the package that offended the governor most did not involve the end-run on taxes; instead, Schwarzenegger said the proposal did not go far enough to trim spending and stimulate the economy.

"I hope they go back to the drawing board and take this more seriously, rather than playing games," the governor said shortly after Democrats passed their proposal in a near-party line vote.

The veto announcement sends legislative leaders back to square one, although Democrats may have won at least a partial victory in that Schwarzenegger — unlike Republicans and taxpayer advocates who have threatened to sue — did not challenge the overall design of the plan.

It was unclear Thursday when negotiations might resume, but when they do, they're expected to primarily involve the governor and Democrats, with Republicans who've blocked earlier tax proposals relegated largely to the sidelines.

The minority party was not pleased by that prospect. "It's an outrageous abuse of power," said Sen. Dennis Hollingsworth, R-Murietta.

The plan would have generated $18 billion — slightly more than half from new taxes — to help reduce a deficit pegged at $40 billion through mid-2010. Californians would have paid a new fee on gasoline, a higher sales tax and an income tax surcharge. Democrats coupled the new tax revenue with cuts of $7.3 billion, affecting schools, health and human services and public transportation.

In announcing his veto, Schwarzenegger zeroed in on a list of items he requested to stimulate the economy, such as easing environmental regulations for construction projects, making it easier for the state to contract with private companies to fix roads and giving him broader authority to furlough state workers.

Democrats granted some, but not all, of his requests.

"They call it economic stimulus, but there's nothing there," said the governor, who also argued that new taxes must be paired with deeper cuts.

The budget package, as expected, sailed through both houses of the Legislature. Democratic leaders announced afterward that they were sending rank-and-file members home until the new year while urging Schwarzenegger to get on board.

"This is a golden opportunity for the governor to take a 44 percent bite out of the deficit," Senate President Pro Tem Darrell Steinberg, D-Sacramento, told reporters. In a written statement after the veto announcement, the Senate leader asked: "Is there any other credible, politically acceptable plan put forward by anyone to make an $18 billion-plus dent in California's budget deficit? The answer is no."

Schwarzenegger implored legislators to stay in Sacramento until Christmas, if need be, to continue work on the budget. The state is slated to run short of money to pay its bills in February, possibly forcing it to issue IOUs. Earlier this week, a state board cut off nearly $4 billion for infrastructure projects because the money is needed for cash flow.

"I don't think anyone should go home and celebrate," the governor said.

If he and Democratic leaders can resolve their differences, the controversy would almost certainly head to court.

Any legal battle with taxpayer advocates will have far-reaching implications. If the Democrats' approach — in essence replacing taxes, which take a two-thirds vote, with fees, which need only a majority — is deemed valid, they could return to the same strategy in the future. Steinberg said Thursday that he expects his party would do just that if the state's fiscal woes persist and Republicans continue to block taxes.

Legal experts said it's difficult to predict how a judge might rule, given that the proposal appears to be unprecedented, at least on the scale that Democrats propose. But on the basic fee-versus-tax argument, Democrats appear to be on solid footing, one legal expert said.

"Does it pass the laugh test, and would I defend it? Yes," said Jonathan Zasloff, a professor at UCLA School of Law. "Is it a slam dunk? No."

Democratic plan
Here are the highlights
of the plan:
Tax increases
  • Total: $9.3 billion
  • Raises the state sales tax by 3 4 of a percent starting in February
  • Imposes a 2.5 percent surcharge on state income taxes beginning in January. Taxpayers would pay an additional $25 for every $1,000 they pay in personal income taxes
  • Require independent contractors to pay a 3 percent tax on work valued at more than $600 million
  • Levy a 9.9 percent tax on each barrel of oil extracted from the state beginning in July
  • Eliminate the 18-cent-a-gallon state gasoline tax and a state sales tax on gasoline that varies depending on the price of gas, and replace those taxes with a 39-cent-per-gallon fee, essentially raising today's gas prices by 13 cents a gallon
    Spending cuts
  • Total: $7.3 billion.
  • $4 billion in education cuts, $2.5 in the current fiscal year and $1.5 billion in fiscal 2009-10
  • $132 million in support for the University of California and California State University systems
  • $656 million in income support payments to low-income elderly, blind and disabled Californians
  • A 3 percent rate cut for regional centers that provide services to individuals with developmental disabilities
  • A $156 million cut in public transit funding.
  • A $91 million reduction in cost-of-living increases for trial court employees. Transfers money from a court improvement fund to the state general fund
  • $30 million cut for anti-gang programs and various other programs
  • $657 million cut in state employee compensation