What happens when backers of two government services– both strongly supported by voters– say they should get first dibs at an unexpected increase in revenues?

Stay tuned this week… and next… for the answer.

Governor Schwarzenegger weighed in on the debate this afternoon, by formally proposing to not divert some $1.3 billion of transportation funding towards other state budget items, using instead the extra revenue for those items.

Schwarzenegger made the announcement in a short appearance at the annual meeting of the California League of Cities here in Sacramento. These are city leaders who have been loudly complaining about the pothole effect caused by all of the transportation cuts. And after several weeks of bad PR, the standing ovation from local officials in the room was probably just the photo op that the governor and his advisers wanted.

But the governor’s endorsement does not solve the woes caused by several years worth of borrowing money voters earmarked for transportation under Proposition 42. His proposal would only restore next year’s funding. In fact, it sounded like the governor had to correct himself on that very point during his speech; after saying he would “fully refund” Prop 42, he hesitated and quickly changed it to say “restoring” Prop 42.

Fully refunding the last 5 years worth of transportation money that was siphoned off for balancing the state budget would probably cost another $2 billion or so, according to transportation experts.

Nonetheless, the decision to remove Prop 42 borrowing from the 2005-06 budget solution raises some interesting questions.

No one knows exactly what number the governor’s staff is using when budgeting for all of the unexpected revenue… although it’s generally considered to be somewhere between $2 and $3 billion. If transportation gets its slice, then what about the money that was borrowed from K-12 education?

Education funding has been a political hot potato this spring, but it’s also a tricky policy problem. Consider the following scenario, floated by budget advisers to Assembly Democrats: a portion of the unexpected revenues are from a one-time tax amnesty program. But those tax receipts are counted as revenue that occurred in the tax year for which they were due, NOT this year. That would mean the funding formulas which are based on revenues in years past might have to be revised upward. And the most prominent of those… is the constitutionally protected school formula in Proposition 98.

As was stated above, stay tuned.