Analysis of the 2006-07 Budget Bill Legislative Analyst's Office February 2006

State Fiscal Picture

The Governor’s budget released in January uses unexpected revenues to raise ongoing budgetary commitments, prepay some budgetary debt, and provide baseline funding increases for most other programs. Along with the budget plan for 2006-07, the Governor is also proposing a ten-year Strategic Growth Plan to improve state infrastructure in the areas of education, flood control, water supply, public safety, and courts.

LAO Bottom Line. California has benefited greatly from an over $11 billion three-year revenue increase since the 2005-06 budget was enacted; yet, the Governor’s budget plan would still leave the state with major structural budget shortfalls and a large amount of other financial obligations outstanding. In this regard, we believe the proposal misses a real opportunity to finally get the state’s fiscal house in order by meaningfully addressing what is still a formidable fiscal problem. Capitalizing on the opportunity presented by these added revenues is particularly important at this time, given the inherent uncertainties about how long the strong revenue performance the state has been experiencing will last. Accordingly, we recommend that the Legislature reduce the amount of ongoing spending increases proposed in this budget, and either hold more of the unexpected revenues that this frees up in reserves or use them to pay down more of the still-formidable budgetary debt the state owes.

The Budget Proposal

Budget’s Economic Forecast-Moderate Growth

The U.S. and California economies generally outperformed expectations in 2005, although their growth did slow late in the year. The administration assumes that moderate economic growth will continue in 2006 and 2007, although at a more subdued pace than in 2005. It specifically projects that U.S. real gross domestic product growth will ease from 3.6 percent in 2005, to 3.2 percent in 2006, and 3 percent in 2007. Similarly, it projects that California personal income growth will slow from 6 percent in 2005, to 5.8 percent and 5.5 percent during 2006 and 2007, respectively.

Budget’s Revenue Forecast-Up Substantially

The Governor’s budget assumes that revenues will be up strongly from the estimates included in the 2005-06 Budget Act. It specifically estimates that revenues were $82.2 billion in 2004-05-a full $2.3 billion more than the estimate in the 2005-06 Budget Act. It further projects that revenues will rise to $87.7 billion in 2005-06 (up $3.2 billion from the 2005-06 Budget Act) and $92 billion in 2006-07 (up $3.7 billion from the preliminary out-year estimates made at the time the 2005-06 Budget Act was adopted). These increases, which total $9.2 billion over the three years combined, are largely related to much-stronger-than-expected revenues from volatile sources, such as corporate profits and investment earnings. (As discussed below, we also believe that there will be an additional $2.3 billion in revenues beyond what the administration is projecting, bringing the total three-year improvement to $11.5 billion.)

Policy Changes. The budget contains no general tax increases. However, it does include $252 million in new 2006-07 revenues from targeted changes to existing law. The majority of this increase is related to the proposed one-year extension of two measures that were set to expire this year-specifically, the suspension of the teachers’ personal income tax credit ($210 million) and the recent change in the application of the use tax to vessels and aircraft ($35 million).

Budget Overview

The budget proposes total state spending in 2006-07 of $123 billion (excluding expenditures of federal funds and bond funds). General Fund spending is projected to increase from $90.3 billion to $97.9 billion (an increase of 8.4 percent), while special funds spending falls slightly from $25.4 billion to $25 billion. The decline in special funds spending is due to one-time factors affecting current- and budget-year totals.

General Fund Condition

Figure 1 shows the General Fund’s condition from 2004-05 through 2006-07 under the budget’s assumptions and proposals. It shows that: 

• 2004-05. The 2004-05 fiscal year concluded with a reserve of $9.1 billion. This reserve amount is up sharply from the $6.9 billion estimate included in the 2005-06 Budget Act. The improvement is due mainly to large upward revisions to year-end revenue accruals to the three major taxes. More generally, the large 2004-05 reserve is a reflection of strong amnesty-related payments received last year, and includes the proceeds of the deficit-financing bonds issued in 2003-04.

• 2005-06. In the current year, expenditures are expected to exceed revenues by $2.6 billion, leaving $6.5 billion in the reserve.

• 2006-07. In the budget year, projected expenditures increase to nearly $98 billion, while revenues are projected to reach $92 billion. The resulting large (nearly $5.9 billion) operating shortfall results in a further decline in the reserve, to $613 million by the close of the budget year.

Key Features of the Budget Proposal

The key programmatic features of the budget are shown in Figure 2. They include the following:

Program Augmentations Totaling Over $2 Billion. The majority of the increase is in K-14 Proposition 98 education funding, where the Governor is proposing to spend $1.7 billion more than required by the Proposition 98 minimum funding guarantee in 2006-07. In addition, the budget proposes $426 million in new spending for K-12 after-school programs (as required by Proposition 49). In higher education, the Governor is proposing to “buy out” student fee increases at the University of California and the California State University in 2006-07. In the criminal justice area, the Governor is proposing additional funds for inmate and parolee programs, as well funding for the phase-in of 150 new judgeships over three years.

Savings of Roughly $500 Million. Most of these reductions are in the social services area, where the Governor is proposing to (1) further delay the pass-through of the federal cost-of-living adjustment (COLA) for Supplemental Security Income/State Supplementary Program recipients from April 2007 to July 2008, and (2) reduce funding for child care and welfare-to-work services. Other savings are proposed in the areas of state operations and county administration of health and social services programs.

Prepayment of Budgetary Debt Totaling About $1.4 Billion. This includes $920 million toward the $1.3 billion loan repayment due to transportation in 2007-08, and $460 million toward prepayment of outstanding deficit-financing bonds (per Proposition 58).

LAO Outlook

In this section, we examine the implications of the 2006-07 Governor’s Budget proposal on the near-term and longer-term General Fund condition, using our own revenue forecast and our own estimates of the impacts of both current law and the Governor’s proposals on expenditures. Our estimates do not reflect any of the programmatic recommendations that we make in our Analysis of the 2006-07 Budget Bill. The causes of our differences from the budget 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. In cases where there are budgetary risks related to court cases, we have given the administration “the benefit of the doubt,” and thus have not included their potential added costs.

2006-07 Budget Would Have a $2.6 Billion Reserve

As indicated in both Figures 3 and 4, we estimate that if the Governor’s budget were fully adopted, the state would end 2006-07 with a reserve of $2.6 billion, or $2 billion more than assumed in the Governor’s budget. This increase is largely related to our higher revenue projections, partly offset by higher costs.

Higher LAO Revenues. We believe that the recent strength in personal income tax and corporation tax receipts is indicative of the fact that 2005 tax liabilities, once tabulated, will prove to be even higher in 2005 than assumed in the Governor’s budget. As discussed in “Part III,” these higher payments and the liability trend generating them will likely translate into additional receipts this spring, when final returns are due for the 2005 tax year. We also expect the higher payments trend to continue into 2006-07. Accordingly, we are projecting that revenues will exceed the budget forecast by $1.3 billion in the current year and $1 billion in 2006-07, or $2.3 billion for the two years combined.

Higher LAO Costs. On the expenditure side, we estimate that General Fund expenditures under the Governor’s budget proposal would exceed the administration’s estimate by a two-year amount of about $340 million. This is the net effect of higher costs associated with Proposition 98, local mandates, and state operations, partly offset by lower spending for Medi-Cal.

State Would Continue to Face Structural Shortfalls Thereafter

The 2006-07 fiscal year would end with a meaningful reserve, but only because the operating deficit of about $5 billion is more than covered by the $7.6 billion in carry-in reserve funds. As Figure 5 shows, the operating shortfalls would continue under the budget proposal, reaching nearly $4 billion in 2007-08 and nearly $5 billion in 2008-09.

Projections Subject to Significant Risks

Although our fiscal projections reflect our assessment of the most likely fiscal outcomes for the state, it is important to understand that there are several very significant budgetary risks and pressures that lurk beneath our forecasts. These are highlighted in Figure 6. These risks and pressures could add several billions of dollars to the operating shortfalls during the next several years, were they to materialize. They include:

• Steeper Economic Slowdown. Our projections assume that California’s economy and General Fund revenues, while slowing some from current levels, expand at a moderate pace through the forecast period. However, as we discuss in “Part II” and “Part III,” the state faces significant economic risks during the next year associated with such factors as higher energy costs and a steeper-than-expected slowdown in real estate sales, prices, and construction activity. A more pronounced slowdown in California’s economy during the next two years than we are projecting could easily reduce General Fund revenues by as much as $4 billion from our projected level in 2006-07.

• Lawsuits. The state is currently appealing three lower court rulings that would result in about $1.5 billion added General Fund costs. These rulings (whose fiscal effects are not included in our projections) include: the Guillen lawsuit, where a lower court ruled that an October 2003 COLA for California Work Opportunity and Responsibility to Kids grant levels is required by state law; a State Teachers’ Retirement System (STRS) case, where a lower court ruled that the state’s suspension of about $500 million of contributions in 2003-04 was illegal; and a pension bond validation suit, where a lower court ruled that the $525 million pension obligation bond authorized in conjunction with the 2005-06 budget was illegal. The administration assumes the pension bond-related savings will occur in 2007-08.

• Federal Actions. The federal Deficit Reduction Act of 2005 will likely have an adverse fiscal impact on California. Over federal fiscal years 2006 through 2010, the act would result in several hundreds of millions of dollars annually in increased state costs, mostly in health, social services, and higher education.

Financial Obligations Are Looming

In addition to the near-term risks and pressures shown in Figure 6, the state also faces in the tens of billions of dollars in financial burdens from unfunded liabilities related to employee retirement. Although not necessarily imposing immediate costs on the state budget, these unfunded liabilities are very important from the standpoint of the state’s overall fiscal health. They are similar to other forms of budgetary borrowing (discussed below), in that they will require future taxpayer dollars to be diverted to fund state employee and teachers’ services already rendered. Figure 7 highlights these factors.

Retiree Health Care. State costs to pay for retired employees’ health care premiums have been rising sharply, and will increase even more dramatically in the future as more of the workforce reaches retirement age. Like most state and local governments, California currently funds retiree health benefits on a “pay as you go” basis. However, the Governmental Accounting Standards Board (GASB) has issued a new financial reporting standard (GASB 45) that requires states to recognize such retirement health benefits being accrued by their employees (thereby accounting for accrued health care benefits in the same manner as accrued retirement benefits). Under the revised standard, we estimate that California state government faces an unfunded liability associated with health benefits already accrued of between $40 billion to $70 billion.

As discussed in “Part V,” we recommend that California begin to partially prefund the accrued health care benefits of its current employees. For example, if the state were to pay the costs of retiree health benefit costs accruing in 2006-07, it would need to raise annual General Fund contributions by over $1 billion annually. (The cost to pay off past unfunded liabilities would be considerably more.)

The State Teachers’ Retirement System. Both of the state’s main retirement funds face unfunded liabilities in the range of $24 billion. While employer contribution rates for the Public Employees’ Retirement System’s (PERS) members have been automatically adjusted upward to address its unfunded liability over a 30-year period, the STRS fund has no such “catch up” mechanism. If the STRS contribution rates were adjusted upward in the same manner as PERS, and the state were to pay these additional contributions, the added annual costs would be more than $1 billion.

State Still Coping With Past Budgetary Borrowing

The risks and financial pressures discussed above come on top of the substantial costs the state is already incurring related to its past budgetary borrowing. At its peak, this borrowing reached $25 billion. Although the 2005-06 and 2006-07 budgets make progress toward reducing these outstanding liabilities, we estimate that over $20 billion in budget-related obligations will remain at the close of the budget year. As discussed in “Part IV” of this volume, the outstanding borrowing includes about $15 billion from private markets (which includes the deficit reduction bonds and tobacco bonds) and another $5 billion from local governments, schools, transportation, and other special funds. Annual costs of repaying this budgetary debt rise from about $3.7 billion in 2006-07 to a peak of over $5 billion in 2008-09 (when a $1 billion Proposition 42 loan repayment is due).

Legislative Considerations

When one takes a narrow view of the state’s 2006-07 budget with its projected $2.6 billion year-end reserve, it is easy to mistakenly conclude that the state’s finances are not all that bad and that there is no need to feel any urgency about taking difficult budget-balancing actions. However, the reality is that the 2006-07 surplus masks large General Fund fiscal pressures both now and in the future when one considers both the risks associated with the economy, litigation, and the federal budget, as well as outstanding budgetary borrowing and unfunded retiree obligations. Given this, we believe that the first priority for the use of new revenues should be to strengthen the state’s financial position and flexibility, rather than expanding state programs. Accordingly, for example, in our accompanying Analysis of the 2006-07 Budget Bill, we recommend that spending growth in Proposition 98 be limited to 6.6 percent versus the Governor’s proposed 8.7 percent, and that the state take other actions to reduce future pressures on the General Fund. For instance, we recommend that the Legislature place measures before the voters that would repeal both Proposition 42 (which requires annual transfers of sales taxes on gasoline to transportation special funds) and Proposition 49 (which requires increased funding for after-school programs). We also propose replacing the reduction in Proposition 42 transfers with an increase in the excise tax on gasoline, thus holding transportation harmless.

While addressing the state’s fiscal problems can mean less funding for some state programs in the near term, we believe that holding new revenues in reserves or applying them to budgetary debt reduction will yield important fiscal benefits to the state that will be of value in the longer-term context. For example, it will be in a stronger position to address high-priority matters and withstand future economic slowdowns when they occur.

The state’s experience of recent years has shown how difficult it can be to eliminate structural budgetary imbalances once they take root, even in the midst of highly favorable revenue circumstances. It also has demonstrated that getting the state’s fiscal house in order can only occur if it is made a top priority, along with the willingness to make the difficult choices that balancing the budget will require.