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

Revenue Limits

The largest source of school district revenues comes in the form of revenue limits. Revenue limits provide general purpose funds-money districts may use at local discretion for the support of local programs. In 2006-07, the budget proposes $33.4 billion from local property taxes and the General Fund for school district revenue limits, an increase of $2 billion from the revised 2005-06 budget.

This increase in school district revenue limit funding contains several significant adjustments in 2006-07, including:

• $1.7 billion to fund a 5.2 percent cost-of-living adjustment (COLA) ($1.7 billion) and a 0.2 percent anticipated increase in the number of K-12 students ($46 million).

• $200 million to equalize school district revenue limits.

• $200 million for “deficit factor” reduction, which would restore foregone COLAs from a prior year.

• $129 million in savings due to a reduction in costs for Unemployment Insurance ($111 million) and Public Employees’ Retirement System (PERS) contributions ($17 million).

Below, we discuss several features of the Governor’s revenue limit proposal: the funding provided for COLA and deficit factor reduction, the adjustment provided to districts with declining enrollment, and funding for equalization.

Redirect Funding for Deficit Factor to COLA

We recommend the Legislature redirect the proposed $206 million for deficit factor reduction to pay for the increased costs of a higher COLA.

The deficit factor payment restores a portion of the foregone COLA to revenue limits that the state could not afford to provide to schools in the 2003-04 budget. Over the last two years the state has restored a base reduction to revenue limits and a portion of the foregone COLA. The proposed $200 million in funding would restore roughly two-thirds of the outstanding deficit factor, leaving approximately $100 million to restore in future years. (The budget provides an additional $6 million to reduce the revenue limit deficit factor for county offices of education and corresponding categorical program reductions for basic aid districts.)

As discussed in the “Proposition 98 Update” section at the beginning of this chapter, recently released data indicate that the factor used to calculate COLA for K-12 programs will be significantly higher than the rate assumed in the Governor’s budget-around 5.8 percent instead of 5.2 percent. (The actual COLA amount will be known in April.) A higher COLA will result in higher overall costs for revenue limits. Assuming a COLA factor of 5.8 percent, we estimate the cost of fully funding the COLA for K-12 apportionments (school districts and county offices of education) will be around $202 million higher than budgeted. This would require a total of $1.9 billion for revenue limit COLA costs.

We recommend the Legislature redirect the $206 million proposed for restoring deficit factor to instead fully fund the anticipated needs of the base program resulting from higher COLA costs.

Increase Funding for Declining Enrollment Adjustment

We recommend the Legislature score an additional $75 million to fund the costs of the declining enrollment adjustment to continuously appropriated revenue limits.

Generally, revenue limit funding is provided to a district at a per-pupil funding rate multiplied by the average daily attendance (ADA) in the district for that fiscal year. Under current law, school districts that experience a decline in student population in a given year may instead opt to be funded based on the number of students they served in the prior year. This one-year “hold harmless” provision is intended to provide a temporary financial cushion to districts as they adjust to serving fewer students and, correspondingly, receiving less revenue from the state.

The Governor’s budget includes a total of $268 million to fund the declining enrollment adjustment in 2006-07. This represents a $26 million increase from 2004-05, which is the most recent actual data available. The budget-year estimate assumes the same rate and cost of declines as in 2004-05, adjusted by the 2005-06 and 2006-07 COLAs.

In the past, the Department of Finance (DOF) did not specifically identify the costs of funding the declining enrollment adjustment in its annual revenue limit estimates. Since statewide student population was growing rapidly, the costs of the declining enrollment adjustments were minor, and DOF was able to make technical adjustments when actual data were available. However, demographic changes in the K-12 population over the past several years have led to an increasing number of districts experiencing declines in their student populations and using the adjustment.

Figure 1 shows selected data on K-12 attendance growth and the cost of the declining enrollment adjustment. As the figure shows, the growth rate in statewide student population fell each year from 2001-02 through 2004-05. At the same time, the cost of the declining enrollment adjustment more than tripled from 2001-02 to 2004-05, increasing the state’s cost of the declining enrollment adjustment from $74 million to $242 million. In 2004-05, the last year actual data are available, the $242 million provided to 438 school districts was to help them adjust to a decline of 49,000 students compared to the prior year. The students that are funded but not actually in the district are commonly referred to as “phantom” ADA.

Governor’s Budget Underestimates Cost of Declining Enrollment Adjustment. Because of these changing dynamics, DOF recently included estimates for this adjustment in its annual budget projections. Our analysis indicates the Governor’s budget underestimates the cost of this adjustment in 2006-07. The DOF’s current methodology is to increase the past-year cost of the adjustment by COLAs. However, using this methodology for the 2004-05 budget underestimated the cost of the adjustment by about $115 million.

We believe DOF’s methodology similarly underestimates the cost of the adjustment in the budget year. Because the Governor’s budget projects almost no attendance growth in 2006-07, we think the cost of declining enrollment will be significantly higher in the budget year.

Cost Will Depend on District-Level Trends. Projecting revenue limit costs is an especially difficult task in a low-growth environment. Accurately projecting costs requires an understanding of which districts are growing and which are declining, and the reasons behind the divergent trends. Using the statewide aggregate attendance growth rate worked fine in times of rapid growth, but when growth rates are down, it can mask the interaction between different trends occurring in growing and declining districts. In the current environment of rapidly slowing statewide growth, the DOF methodology of budgeting for the declining enrollment adjustment based solely on prior-year funding levels has not proven to be very effective at predicting costs. We believe a better approach is to study statewide and local growth patterns and, to the extent possible, make an estimate based on anticipated trends.

Cost of Adjustment Requires Additional Funding. We estimate the declining enrollment adjustment will cost $343 million in 2006-07, or $75 million more than proposed in the budget. Our projection is based on the most current district-level attendance data available, as well as DOF’s long-term enrollment projections. We think the fact that attendance growth is projected to decrease from 0.5 percent in the current year to 0.2 percent in the budget year indicates that both the number of districts experiencing declining enrollment and the size of the attendance decline will be greater than in 2004-05 and 2005-06. Additionally, DOF’s county-level enrollment projections for the budget year project negative net growth rates in almost half the state’s counties, including the three largest.

Given the way the state funds revenue limits (they are continuously appropriated), the actual costs of the declining enrollment adjustment in 2006-07 eventually will have to be paid. Consequently, it is important for the Legislature to have the best estimates of this General Fund obligation going into the fiscal year. Therefore, we recommend the Legislature score an additional $75 million to reflect the likely costs of the declining enrollment provision.

Despite the one-year adjustment the state currently provides, districts report significant difficulties adjusting to shrinking student populations. In the “Fiscal Solvency” section of this chapter, we discuss these concerns and suggest additional support the state could provide.

Redirect Equalization Funding to Fiscal Solvency Block Grant

We recommend the Legislature redirect the proposed $200 million for equalization to address the serious fiscal solvency issues faced by many districts in the state. If the Legislature chooses to fund equalization, we recommend allocating the funds based on a formula that consolidates revenue limit “add-on” programs into base revenue limits.

The Governor’s budget proposes $200 million to make progress towards establishing more uniform district base revenue limits. In past years, we have argued in favor of equalizing revenue limits for two reasons. First, equalization funding provides general purpose funds that districts can use to meet local needs. Second, we are not aware of any analysis showing that historical differences in revenue limit funding levels reflect different local needs for general purpose funds.

However, given the difficult fiscal situations currently faced by many districts in the state (including those that would not qualify to receive equalization funding), we recommend the Legislature delay equalizing revenue limits to future years. We believe these funds would be more effective if targeted specifically at addressing school district fiscal solvency issues. We discuss this proposal in further detail in the “Fiscal Solvency” section of this chapter.

If the Legislature chooses to provide funding in the budget for equalization, we would recommend using a different formula for distributing the funds. In the next section we describe: (1) how the Governor’s approach would not address all the existing inequities in general purpose funding and (2) our recommendation to improve the equalization methodology.

Including Add-On Programs Would Lead to More Uniform Funding Levels

School districts currently receive funding through both a “base” revenue limit and various revenue limit “add-on” programs. Past legislative efforts to address historical inequities in district funding have focused on the base revenue limit. This is also the case with the Governor’s current proposal. As a result, the budget proposal misses an opportunity to simplify the revenue limit system and create a more uniform distribution of funds to districts.

As discussed in our Analysis of the 2004-05 Budget Bill (please see page E-88), the majority of revenue limit add-on programs provide general purpose funds to all or virtually all school districts in the state, and therefore are in essence a part of the state’s base K-12 program. Because some districts receive large amounts through the add-on programs while other districts receive little, these revenue limit add-ons create further disparities in general purpose funding. So even if the state fully equalized base revenue limits, inequities in total general purpose funds would continue.

Figure 2 describes the four primary general purpose revenue limit add-on programs and displays the average per-pupil amounts large unified districts received for these programs and for base revenue limits in 2004-05. The data do not represent actual figures for any one district. Instead, they represent the average per-pupil amounts distributed to all large unified districts through the various adjustments in the revenue limit calculation. In addition to these averages, the figure also shows the highest and

lowest amounts large unified districts actually received for base revenue limits and each adjustment in 2004-05. The range in base revenue limits is about $2,100 per pupil between the highest- and lowest-funded large unified districts. As shown in the figure, the add-on programs can provide hundreds of dollars of funding increases to some districts, while providing other districts with very little. This variance increases the disparity in general purpose funding levels above and beyond the range that exists among base revenue limits.

Consolidate Add-Ons Into Base Revenue Limits, Then Equalize. The budget proposal would help equalize base revenue limits, but ignores large differences in add-on funding that, in effect, would continue even after the equalization targets were reached. Therefore, if the Legislature pursues equalization we recommend it revise the current revenue limit formula by folding the four add-on programs displayed in Figure 2 into the base grant. (We would also recommend including an additional set of interdistrict adjustments that provide general purpose funding to six school districts.) This would allow the Legislature to equalize the amount of general purpose funds districts actually receive, not just the amount represented by the base revenue limit. Over the long run, this would result in a more uniform distribution of funds to districts and simplify the revenue limit calculation.