Analysis of the 2004-05 Budget Bill Legislative Analyst's Office February 2004

State Fiscal Picture

The basic budget problem currently facing the state involves an unfunded gap of slightly over $17 billion. Most of this—$15 billion—represents an ongoing projected structural imbalance between current-law revenues and expenditures in 2004-05 and beyond. The remaining $2 billion reflects a shortfall in the current-year budget. This latter amount—which was not included in our January budget overview—takes into account the administration's January 2004 announcement regarding the maximum size of the previously authorized deficit reduction bond. The significance of this technical issue is discussed further below.

The Governor's proposed 2004-05 budget seeks to address the projected budget shortfall in 2004-05 through a combination of major and wide-ranging spending reductions, additional borrowing, and a diversion of local property taxes for the benefit of the state. The Governor's plan does not include new taxes as part of the solution. In addition, it recognizes that it only partially addresses the underlying structural budget problem projected beyond 2004-05.

A key element of the Governor's plan is the assumed approval of a $15 billion economic recovery bond on the March 2004 statewide ballot to pay off the accumulated 2002-03 budget deficit and help address the remaining budget shortfall. This bond would replace the smaller statutorily authorized deficit-financing bond assumed in the 2003-04 budget plan but currently facing a legal challenge.

LAO Bottom Line

We believe that the Governor's proposal is a solid starting point for budgetary negotiations. However, a considerable amount of work remains to be done to bring 2004-05 into balance and to fully resolve the state's chronic budget-related problems. In particular, our own evaluation of the proposal indicates that even if all of its elements were adopted, 2004-05 would end with a General Fund deficit of $0.8 billion. We further project that an ongoing General Fund structural deficit of close to $7 billion would exist beyond the budget year, absent corrective action.

In the remainder of this part, we summarize the 2004-05 Governor's Budget proposal and present our own perspective on the budget outlook. We then discuss key considerations that the Legislature may wish to take into account as it develops its own plans and priorities for dealing with the state's fiscal situation.

The Budget's Economic and Revenue Outlook

The budget's economic forecast, which we discuss in detail in "Part II," assumes that the recent strengthening of economic activity will continue for both the nation and state in 2004 and 2005. For example, it forecasts that California personal income, a key determinant of state tax revenue performance, will grow 5.6 percent in 2004 and 5.9 percent in 2005. The budget further assumes that the expanding economy will boost collections from the state's major taxes by roughly 6 percent in both 2003-04 and 2004-05. As detailed in "Part III," the administration's updated tax revenue forecast is up about $2 billion from the 2003-04 budget estimate. Its projections for both the current year and budget year are similar to the forecasts in our California Fiscal Outlook report that was published in November 2003.

The Budget Proposal

Total State Spending

The budget proposes total state budgetary spending in 2004-05 of $97.2 billion (excluding expenditures of federal funds and bond funds). This represents a decrease of 0.2 percent from the current-year total of $97.4 billion. General Fund spending is projected to fall from $78 billion to $76.1 billion while special funds spending rises from $19.4 billion to $21.1 billion. As discussed below, however, the way in which the proceeds from the assumed economic recovery bond are treated for budgetary purposes somewhat distorts the underlying expenditure trend. Absent this factor, total spending would be up from $94.4 billion in the cur rent year to $100.2 billion in the budget year, a difference of 6.1 percent. Much of this increase is related to the expiration of one-time savings in 2003-04 associated with federal funds, debt-service restructuring, accounting changes, and other factors.

General Fund Condition

Figure 1 shows the General Fund's condition from 2002-03 through 2004-05 under the budget's assumptions and proposals.

Prior Year

$2.1 Billion Improvement. In a very significant positive budgetary development, the 2002-03 budget's condition has improved by about $2.1 billion since the 2003-04 budget was enacted last summer. As a result, the prior-year's estimated deficit has been lowered—from the earlier $10.7 billion assumed in the 2003-04 budget to $8.6 billion. This improvement means that the state needs about $2.1 billion less than previously thought in savings and/or other budgetary solutions to keep its budget in balance in 2004-05. About one-half of the improvement relates to recent increases in prior-year revenue accruals made by the Controller, based on information from the state's tax agencies for 2002-03 and earlier years. The other half relates to lower expenditures and reduced encumbrances in 2002-03.

This reduction in the year-end deficit has enabled the administration to both propose using fewer bond proceeds and fund a reserve. Specifically, it has reduced the amount of the proposed economic recovery bond proceeds applied to 2002-03 from $10.7 billion down to $9.2 billion, a reduction of $1.5 billion. (This reduction is significant because any unused bond proceeds will be available to offset budgetary shortfalls in the current and budget years or thereafter.) Second, along with the smaller bond size, the administration has chosen to increase the size of the 2002-03 reserve from zero at the time the 2003-04 budget was enacted to a modest $679 million. As a result, the state is able to start the current fiscal year in a stronger position than previously anticipated, and have more bond proceeds "left over" to address future budget shortfalls.

Current and Budget Years

Under the administration's budget plan, the large projected General Fund shortfall for the budget year would be eliminated and 2004-05 would conclude with a small reserve. Specifically:

• Revenues are projected to grow from $74.6 billion in the current year (exclusive of any economic recovery bond proceeds) to $76.4 billion in 2004-05—an increase of 2.4 percent. As discussed below, the revenue totals in both the current year and budget year are affected by numerous policy actions associated with prior budgets, as well as with the new budget proposal.
• Expenditures are projected to decline from $78 billion in 2003-04 to $76.1 billion in 2004-05. As shown in the figure, the current-year spending totals have been increased by the proposed transfer of $3 billion in bond proceeds to a new "deficit recovery" special fund. These bond monies are then proposed to offset General Fund spending in 2004-05. Absent these bond-related shifts, proposed General Fund expenditure growth in 2004-05 is 5.4 percent.
• The reserve at the end of 2004-05 is projected to be $635 million.

How the Plan Addresses the Budget Shortfall

The Governor's plan addresses the shortfall by proposing roughly $18 billion in budgetary solutions. The proposed budget incorporates most of the mid-year savings reductions proposed in late November by the Governor, and includes major new savings proposals in 2004-05. As shown in Figure 2, about 40 percent of the total solutions relates to program reductions/savings. The remaining 60 percent relates to the use of the proposed economic recovery bonds; other loans and borrowing; a cost shift to local governments; and a variety of other revenues, transfers, and funding shifts.

One-Time Versus Ongoing Savings. Of the $14.4 billion in total savings shown in 2004-05, we estimate that about $5.3 billion, or 37 percent, are one-time and the remaining $9 billion, or 63 percent, are ongoing in nature—meaning that they will provide budget benefits in future years.

Program Reductions/Savings

The budget includes $7.3 billion in program reductions and related cost savings in the current and budget years combined. These include:

• A $2 billion reduction in Proposition 98 spending.
• A $950 million reduction in transportation spending related to suspension of the Proposition 42 transfer (the remaining portion of the $1.1 billion suspension is reflected in the local government category).

In addition, the budget includes:

• A $1.4 billion reduction in social services related to grant reductions, cost-of-living adjustment deletions, and elimination of state-only services in In-Home Supportive Services.
• A $1.1 billion reduction in Medi-Cal, primarily related to 10 percent provider rate reductions, and a $400 million unallocated reduction to corrections.
• Significant reductions in higher education, backfilled partly by student fee increases.

Economic Recovery Bond

This category accounts for about $5 billion of total solutions, including about $3.7 billion in net new borrowing and $1.3 billion from debt-service savings.

Background. The 2003-04 budget assumed that the state would sell a $10.7 billion deficit reduction bond as authorized by the Legislature in 2003, and that the proceeds would be used to eliminate the then-estimated $10.7 billion accumulated 2002-03 budget deficit. (As noted in the nearby box, on January 29 the administration announced that the allowable size of the statutory bond has declined to $8.6 billion.) Repayment of this bond would require annual General Fund expenditures equal to one-half cent of the state sales tax, or somewhat over $2.4 billion annually, beginning in 2004-05. The 2004-05 budget proposes instead to use $12.3 billion in proceeds from the larger, up to $15 billion, economic recovery bond that will be considered by the voters in March 2004.

Fiscal Implications. The use of the larger bond would result in near-term budget-related savings in two ways:

• More Bond Proceeds. The proposal would use a total of $12.3 billion in proceeds from the Governor's proposed economic recovery bond to offset a portion of the budget problem, with any unused balance of the net proceeds in excess of this $12.3 billion available for use in the future. This $12.3 billion in bond proceeds is $3.7 billion more than the $8.6 billion in proceeds now allowed under the statutory bond.
• Less Debt-Service Costs. Repayment of the proposed economic recovery bond would involve annual General Fund payments to investors equivalent to one-quarter cent of the sales tax, or roughly $1.3 billion annually, beginning in 2004-05. This would produce ongoing near-term annual General Fund savings of a like amount, given that the other bond's debt service would have been twice as much—equivalent to one-half cent of the sales tax.

Other Loans and Borrowing

This category accounts for $2.6 billion of the budget's overall solutions. It includes about $930 million related to a proposed pension obligation bond sale, $947 million related to Proposition 98 "settle-up" obligations for 2002-03 and 2003-04 which are being deferred until after 2005-06, an increase in the loan amount to local governments associated with 2003-04 backfill payments, and loans from transportation funds.

Local Government-Related Actions

This category accounts for $1.8 billion of the total solutions. It includes a $1.3 billion property tax shift from local governments to schools, reduced funding for juvenile probation, the elimination of booking fee reimbursements, and a reduction in transportation funding related to the suspension of the Proposition 42 transfer.

Transfers/Other Revenues and Fund Shifts

This category accounts for $1.6 billion of the total solutions. It includes a one-time shift of about $685 million of transportation funds to the General Fund in 2003-04, $350 million in new federal funds, a net of $75 million from a Medi-Cal proposal involving a quality improvement assessment fee on managed care plans, and $55 million in proceeds from a land sale at the University of California at Riverside.

Key Programmatic Features

Figure 3 summarizes the budget proposal's main programmatic features. Its specific proposals are discussed in more detail in "Part IV" and in our 2003-04 Analysis of the Budget Bill.

The LAO's Budget Outlook

In this section, we examine the implications of the Governor's proposal on the near-term and longer-term General Fund condition, using our own estimates of revenues and expenditures that would occur under the Governor's proposal. Our estimates do not reflect any of the programmatic recommendations that we make in our 2004-05 Analysis of the Budget Bill. The causes of our differences from the budget's projections are limited to (1) assumptions about the economic and revenue outlook, and (2) estimation differences in the level of expenditures that would be needed to fund the Governor's budget plan. We have also reduced total savings modestly to reflect "erosion" of potential savings from certain current-year proposals—mainly in the health and social services areas—that have not been adopted by the Legislature by the date of our analysis. In these cases, our estimates continue to assume the Governor's policies, but with implementation dates of April 1 or later (depending on the program).

The intent of these estimates is to provide the Legislature with our assessment of the extent to which the budget solutions proposed by the Governor address the full magnitude of the short-term and longer-term fiscal imbalance facing the state. Our key budget-related findings are high lighted in Figure 4, while our estimates of revenues, expenditures, and the General Fund's condition are shown in Figure 5.

More Solutions Will Be Needed for 2004-05 to Balance

As shown in Figure 4 and Figure 5, we estimate that if all of the budget's provisions and proposals were adopted, the state would end 2004-05 with a deficit of $783 million. This compares to the budget estimate of a $635 million surplus. The difference—about $1.4 billion—relates to our forecast of lower revenues and higher costs in both 2003-04 and 2004-05.

Lower Revenues. Based on somewhat weaker-than-expected wage trends in 2003, we have forecast lower receipts from the personal income tax in both the current year and budget year. As a result, we project that General Fund revenues will be lower than the budget forecast by about $1 billion over the current and budget years combined.

Higher Expenditures. We estimate that General Fund expenditures would exceed the amount in the budget proposal by about $400 million over the prior, current, and budget years combined. Part of the net increase is related to the erosion of current-year savings related to certain proposed mid-year reductions in health and social services that the Legislature has not adopted. For purposes of these estimates, we are assuming implementation dates of April 1 or later, which are about three months later than assumed in the budget. We also project higher spending for the vehicle license fee backfill and for various state operations. Partly offsetting these increases is a reduction in K-14 education funding related to (1) the interaction of the Proposition 98 minimum funding guarantee with our lower revenue estimates, and (2) our higher estimate of local property taxes (which offset General Fund spending dollar for dollar).

The 2004-05 budget shortfall we project assuming the budget's proposals is relatively small compared to both the overall size of the budget and the uncertainties inherent in the revenue and expenditure assumptions and projections. However, it is important to stress that the estimate assumes that all of the budget's proposals are implemented and the anticipated budgetary benefits associated with them are fully realized. Thus, our deficit estimate gives the "benefit of the doubt" to the administration, and if anything could prove conservative. 

Major Threats Could Increase Shortfall to About $4 Billion

The budget plan faces real and imminent threats from court challenges and certain other factors which could push the shortfall much higher. Among these threats are the following:

• Pension Obligation Bond Proposal ($930 Million). A Superior Court has invalidated a similar bond proposed for the current year, and the state is currently appealing the decision.
• Corporation Taxes ($0.5 Billion to $1.5 Billion). The state is facing large potential near-term corporation tax revenue losses related to a legal challenge involving the state's treatment of dividend income received by corporate taxpayers (see discussion regarding Farmer Bros. Co. case in "Part III").
• Medi-Cal Provider Rates (Several Hundred Millions of Dollars). A federal district court has blocked, for now, the 5 percent reduction in provider rate reimbursements that was scheduled to take effect in January 2004. Unless overturned by a higher court, the decision could eliminate the related savings assumed in the 2003-04 budget, as well as the additional savings proposed in the 2004-05 budget. We have scored the risk at this level because we believe savings attributable to portions of the administration's proposal are achievable.
• Other Assumptions (Over $1 Billion). The state also faces risks associated with its assumption of $350 million in new federal funds, and $500 million in new tribal gaming revenues. Finally, the budget includes savings in several areas where the proposals are undeveloped. Of particular concern is a $400 million unallocated reduction in corrections. In addition, savings have been scored for reforms in the areas of foster care, judiciary, and developmental services, for which detail are limited.

Collectively, these factors could push the cumulative shortfall in 2004-05 to over $4 billion. While unused portions of the proposed economic recovery bond, if approved, could be used to address some of any added shortfall, other actions and solutions of a substantial magnitude would still be needed if most or all of the above threats were to materialize.

Nearly $7 Billion Operating Shortfall to Remain in 2005-06

We estimate that the growth rate in ongoing revenues would outpace ongoing expenditure growth rates for most major state programs in 2005-06 and beyond. Despite this, we project that the state would face an operating shortfall in 2005-06 and beyond under the Governor's plan. As indicated in Figure 5, annual spending would exceed annual revenues by roughly $7 billion in 2005-06, absent corrective action. This shortfall would occur even if all of the savings and other solution assumptions in the Governor's plan were fully realized. When combined with the nearly $800 million deficit carried over from 2004-05, we estimate that the year-end 2005-06 deficit would be over $7.7 billion. This large projected 2005-06 shortfall is the result of two main factors:

• First, about $5.3 billion of the budget's proposed 2004-05 savings are one-time in nature, and thus do not provide benefits to the General Fund in 2005-06 and subsequent years. These include the above-noted use of the $3 billion in economic recovery bond proceeds to support expenditure programs in the budget year, about $1.1 billion from the suspension of Proposition 42, and about $930 million related to the proposed sale of the pension obligation bond.
• Second, under current law, the state will be faced with roughly $2 billion in additional expenditures in 2005-06 related to (1) a scheduled large loan repayment to the Transportation Congestion Relief Fund ($1.4 billion), and (2) a resumption of mandate payments to local governments (about $600 million for both current costs and a portion of past-year liabilities). 

Although our longer-term forecast indicates that the General Fund's operating shortfall would narrow some over time, the annual gap still will remain in the range of $5 billion through 2008-09. Thus, further significant ongoing budget solutions will have to be found beyond those currently proposed by the Governor to bring the budget into balance over time. We would note that the administration has alluded to out-year savings from several reform proposals. However, since the details for these proposals will not be available until later this spring, it is not possible for us to currently review their potential savings in 2005-06 and subsequent years.

Considerations for the Legislature

We believe that the Governor's budget proposal contains many positive features. It includes, for example, significant ongoing savings from a wide variety of program areas. As such, it offers a solid starting point for budget deliberations. At the same time, however, the budget poses serious questions and concerns for the Legislature in several areas.

More Solutions Will Likely Be Needed in 2004-05. Given our projections, it is likely that the Legislature will need to find additional solutions of at least $783 million to bring the budget into balance in 2004-05. Furthermore, this amount could rise sharply if either (1) some or all of the budget threats noted above materialize or (2) the Legislature rejects key savings proposals or other solutions incorporated in the budget plan without adopting alternatives of a similar magnitude.

Does the Budget Push Too Much Off Into the Future? One of the main features of recent budgets is that they have not meaningfully addressed the ongoing structural budget shortfalls that have confronted the state since 2001-02. While this budget proposal does contain large amounts of real and ongoing savings, it still leaves a significant amount of the underlying structural problem for future years. As noted above, we estimate that the Governor's plan would leave the state with a budget shortfall of roughly $7 billion in 2005-06, even if all of the savings and other solution assumptions in the plan were fully realized. Furthermore, the unaddressed budget shortfall would be even larger if some or all of the risks noted above materialize. The fundamental issue for the Legislature is thus how the projected multibillion-dollar out-year problem should be dealt with and whether it should be more completely addressed at this time.

Should Additional Revenues Be Considered? There are several reasons to ask this question. One involves the large magnitude and potentially far-reaching effects of the proposed budget reductions on state programs. A second is the multibillion-dollar ongoing budget shortfall that would still remain unresolved, even under the Governor's plan, and would have to be dealt with through more borrowing or further spending cuts if additional revenues are "left off the table." We believe the Legislature should consider whether solutions involving taxes—such as the elimination of selected tax expenditures or increased tax rates—should be part of the 2004-05 budget plan. Even if limited tax increases have certain negative effects on the economy, these consequences should be weighed against the negative consequences of the alternatives, including deeper cuts in public spending in infrastructure, education, and other areas, or more borrowing.

What About Budgetary Reforms? The Governor has stressed his intent to undertake a broad-based comprehensive review and restructuring of state operations that will improve efficiency and produce fiscal benefits. While the budget plan does include some examples in these areas, such as an outline of future reforms in the Medi-Cal area, many of the ideas are not very well developed at this point. In fairness, the administration has only been in office for four months. However, if significant fiscal benefits in these areas are to be achieved, it will be important for the administration to translate its ideas into specific proposals which can be considered in a timely fashion by the Legislature.

Timely and Decisive Action Is Needed. Finally, as was the case last year, we believe that it is important that the Legislature act in a timely and decisive manner to address the budget shortfall, and that it seek to maximize the amount of ongoing solutions to the budget problem. Otherwise, the state will both forego the full potential benefits that different solutions have to offer, and will face renewed budget shortfalls in subsequent years.