Jan. 9 (Bloomberg) -- California Governor Jerry Brown proposed arecord $106.8 billion budget as state coffers brim with the biggestsurplus in more than a decade, setting up a fight with fellowDemocrats who want more spending.

The 75-year-old Brown, who may seek a fourth term this year,called for an 8.5 percent increase from current spending, with $11billion to pay off loans that papered-over previous deficits, and$1.6 billion in reserves, while increasing funds for schools,welfare and health care for the poor. Brown also said he’ll back aconstitutional amendment to stockpile unpredictable capital-gainstaxes and deal with looming shortfalls in public pensions.

“This year the news is very good, but by no means are we out ofthe wilderness yet,” Brown said today at a briefing.“We must bevery prudent in how we spend public funds.”

California has seen its fiscal health improve with higherincome- and sales-tax levies Brown persuaded voters to approve in2012, better-than-expected capital-gains revenue from profits instocks and spending curbs under the governor last year.

Investors and credit-rating companies are watching to seewhether Democrats use the money to prepare the biggest issuer ofmunicipal bonds to better weather future downturns.

Democrats, who control the Legislature and can override a Brownveto, have their eyes on new programs. Senate President Pro TemDarrell Steinberg of Sacramento, for instance, wants to expandtransitional kindergarten to children as young as 4 years old, at acost of almost $1 billion annually by 2020. That’s not included inBrown’s proposal.

‘Spend It’

“It is the nature of politics that when there is extra money,politicians will spend it,” said Tom Metzold, co- director of munisfor Eaton Vance Management, speaking before the budget wasreleased. The Boston-based firm oversees about $28 billion of cityand state debt. “When there isn’t enough money, they cut to balanceand we tend to let the pendulum swing too far in each direction.”

State and local governments are poised to increase spending thisyear, adding to the U.S. economic expansion, even as their federalcounterpart cuts back. Outlays by state and local authorities willadd about 0.2 percentage point to gross domestic product in 2014,according to a forecast by economists at Morgan Stanley in NewYork.

Issuing IOUs

California has seen a sharp turnaround from the past decade,when it was seen as ungovernable, facing budget gaps that exceeded$100 billion combined, and was forced to issue IOUs to paybills.

“The state’s fiscal history is riddled with budgets that madepermanent obligations -— both spending increases and tax cuts -—based on temporary revenue increases,” Brown said in an letter tolawmakers. “After these spikes in revenues disappeared -— as theyalways do -— the state was forced to cut programs and raisetaxes.”

His budget projects that the state will have $6 billion ofadditional revenue in the fiscal year that begins July 1. It spends9 percent more on schools and 10.5 percent more on publicuniversities. Health and human services will get an additional $460million.

Proposed Spending

Brown also proposed spending $500 million to build more prisonsand local jails, and said he’d ask a panel of federal judges togrant a two-year extension to their deadline for California toreduce its inmate overcrowding.

The governor said he intends to pay off early the remaining $1.6billion from the $15 billion of deficit bonds former GovernorArnold Schwarzenegger championed after voters ousted Democrat GrayDavis over his handling of state finances.

Brown proposed using $250 million from state-sold carbonallowance auction proceeds, required by law to be spent ongreenhouse gas emissions-cutting efforts, to help jump-startconstruction of a high-speed rail line linking San Francisco andLos Angeles. He borrowed $500 million from the auction proceedslast year and plans to repay a fifth of that this coming year.

Brown estimates that the state owes as much as $217 billion inpublic-employee pension and health care costs. He dedicates none ofthe additional revenue toward that debt, including the $80 billiongap facing the California State Teachers’ Retirement System that,if left unattended, will leave the fund broke within 30 years.Brown said he intends to work with lawmakers this year to come upwith a plan to pay down some of that liability.

Constitutional Amendment

The governor said he would push for a constitutional amendmentsimilar to one proposed by Assembly Speaker John Perez, a LosAngeles Democrat, that would require the state to funnel surplusrevenue from capital-gains taxes into a reserve fund to avert cutswhen the economy sags.

It would to set aside excess funds when revenue from capitalgains exceeds 6.5 percent of projections. Once the reserve tops 10percent of general-fund spending, which pays for most basicservices -- about $97.8 billion in the fiscal year that ends inJune -- the excess could be spent on one-time needs.

The proposal would replace one already on the ballot. That plan,favored by Republicans and opposed by public-employee unions, wouldfill the reserve whenever all tax revenue exceeds 3 percent ofgeneral-fund spending. Democrats can alter the ballot measure usingtheir two-thirds majority.

Credit Rating

The state’s fiscal turnaround led Standard & Poor’s lastJanuary to raise California’s credit rating to A, its sixth-highest level. It was the first time it lifted the state since2006. Fitch Ratings followed in August with a boost to A, thestate’s highest score from Fitch since 2009.

Investors demanded as little as 0.3 percentage point of extrayield to buy California debt instead of benchmark munis in October,the least since 2008, data compiled by Bloomberg show. The state’sbonds beat the $3.7 trillion local-debt market for a fourthstraight year, the longest streak since 1999, S&P data show.While the whole market has lost 2.6 percent last year, Californiadebt was down 1.8 percent.

As California’s credit ratings have been lifted and stateofficials began forecasting surpluses about a year ago, municipalinvestors have viewed the state as a safer bet, said Bud Byrnes,president and chief executive officer of RH Investment Corp., amunicipal-bond trading company in Encino, California.

The perceived risk of California debt always was overblown, hesaid by telephone.

“Now we’re arguing over a surplus,” he said. “That’s a whole lotdifferent than arguing over a deficit.”