May 24, 1996

Overview of the 1996-97 May Revision

A sharply improving revenue picture has led to major increases in K-14 education funding required by Proposition 98 in the May Revision. The revenue increases have also partly offset the loss in health and welfare savings that has occurred because of delays in federal actions that had been assumed in the January budget. Despite the revenue improvement, however, the state budget outside of K-14 education remains tight, with the Governor proposing new welfare reductions in 1996-97. This Budget Brief highlights the major features of the revised 1996-97 Governor's Budget.

Figure 1 shows the major changes contained in the May Revision to the 1996-97 Governor's Budget. It shows that both revenues and expenditures are up significantly since January.
(View Figure 1 in Graphic Format)

Figure 1 May Revision Changes a (In Billions)

Increased Revenues	$2.7
Spending Changes	$2.6
Proposition 98	$1.9
Lack of federal actions	1.3
Offsetting savings
Caseload and other savings	-0.4
New proposals	-0.2

a Includes changes for 1995-96, 1996-97 and prior years.

Upward Revenue Revisions. Primarily as a result of major increases in personal income tax collections in recent months, the administration has raised its forecast of General Fund revenues by $1.1 billion in the current year and $1.5 billion in the budget year. When combined with a prior-year upward revision of $100 million, the three-year increase in revenues totals $2.7 billion.

Upward Expenditure Revisions. General Fund expenditures have increased by a total of $2.6 billion, driven by two major factors:

• A $1.9 billion increase in new K-14 education funding, due largely to the impacts of higher revenues on the required Proposition 98 minimum funding guarantee. The Governor proposes to spend the new funds on a variety of new initiatives, including class size reduction, additional reading materials, and one-time local block grants.
• About $1.3 billion in new costs needed to "backfill" savings included in the January budget that were dependent on assumed federal actions which have not materialized.

These major cost increases are partly offset by about $400 million in savings related to lower caseloads, borrowing costs, and other technical factors assumed in the May Revision. In addition, the Governor proposes a new 3.4 percent reduction in Supplemental Security Income/State Supplementary Program (SSI/SSP) grants, along with other changes in health and welfare programs, for savings of about $200 million.

Budget Priorities Unchanged

Aside from the major changes in Proposition 98 funding, the May Revision retains most of the same priorities as the Governor's January proposal. It includes the January budget's proposals for a phased 15 percent across-the-board income tax reduction, targeted cuts in health and welfare, significant increases for higher education, and full funding for Department of Corrections. The May Revision also retains the January proposals to eliminate the renters' credit, and make permanent the existing temporary cuts to Aid to Families with Dependent Children) AFDC and SSI/SSP grant levels which are scheduled to sunset in 1996.

Small Increase In Reserve

The May Revision spending plan would result in a small deficit at the end of the current year, but a $516 million reserve at the conclusion of 1996-97 (see Figure 2). The revised estimate for 1996-97 is slightly higher than the January estimate of a $404 million reserve. As noted below, the revised reserve estimate assumes that federal actions will allow the state to realize over $1.2 billion in savings.
(View Figure 2 in Graphic Format)

Figure 2 General Fund Condition May Revision (In Millions)

	1995-96	1996-97
Prior-year balance	-$477	$235
Revenue and transfers	46,137	47,057
Total Resources	$45,660	$47,292
Expenditures	$45,425	$46,470
Fund balance	235	822
Reserve	-71	516
Other obligations	306	306

Economy and Revenues

Modest Adjustment to Economic Forecast. The May Revision economic forecast is similar to, but slightly more optimistic than, the January budget forecast. The outlook continues to assume that both the California and U.S. economies will experience moderate growth in 1996 and 1997. Personal income in California is now projected to increase by 6.1 percent in 1996 and 6.0 percent in 1997.

Strong Income Taxes Lead to Major Revenue Revisions. In contrast to its modest revisions to the economic outlook, the administration's revenue revisions have been substantial. The bulk of the total $2.7 billion revenue increase is due to higher projected income tax receipts. Much of the income tax increase is, in turn, related to higher-than-expected withholding payments. The administration is assuming that most of the current-year revenue gain is from ongoing sources and will be reflected in the revenue base next year.

Revisions Are Reasonable. We indicated in February that the administration's January revenue forecast was somewhat conservative in view of its generally upbeat view about the economy. As a result of the major upward revisions in its May forecast, the administration's revenue forecast now appears to be generally consistent with its economic projections. Our own projections for the current and budget years combined yield about $130 million in additional revenues above the Governor's May Revision. While this difference is significant in dollar terms, it is quite small given the magnitude of total revenues.

Expenditure Changes

New Proposition 98 Spending

Primarily as a result of the higher revenue outlook, the May Revision reflects an increase in the K-14 Proposition 98 minimum funding guarantee of $209 million in prior years, $643 million in 1995-96, and $1.0 billion in 1996-97, for a total of $1.9 billion.

About $1.6 billion of the total increase in Proposition 98 funding would be spent on grades K-12. Of this total, $460 million would be earmarked for class-size reduction initiatives in grades K-3. The balance would be spent for a variety of programs, including block grants to schools, new instruction materials, deferred maintenance, and the Governor's Reading Improvement Initiative.

Community College funding would increase by $269 million. The Governor proposes new increases in general apportionments, block grants, deferred maintenance, and other purposes.

Proposition 98 Funding Underestimated. The May Revision estimate of the Proposition 98 minimum funding guarantee used an average daily attendance estimate for the current year that was based on incomplete data from school districts. Using more recent attendance data raises the Proposition 98 minimum guarantee --and reduces the General Fund reserve--by about $220 million over two years.

Developments Involving Federal Actions

The January budget was dependent on federal actions for about $2.6 billion in state savings in 1995-96 and 1996-97 combined. The lack of federal progress on welfare reform to date, along with a shortfall in funds for illegal immigrant costs, has caused the Governor to reduce the amount of assumed state savings from federal actions by $1.3 billion. This has resulted in a commensurate increase in state costs in the current and budget years.

The revised budget plan assumes that federal actions will be taken which will enable the state to achieve about $1.2 billion in budget savings in 1996-97 (see Figure 3 on page 4). About $655 million of this total depends on elimination of federal maintenance-of-effort requirements which would allow California to reduce welfare grants. The remainder is primarily related to new federal reimbursements for state costs of incarcerating illegal immigrant felons and providing emergency Medi-Cal services to illegal immigrants.

Based on recent federal funding history, we believe that the $239 million in funding associated with the incarceration of immigrant felons has a reasonable probability of occurring. However, the remainder of the assumed savings require significant changes to existing federal policies and thus poses risks to the state budget. As an indication of the sensitivity of the budget's assumptions, each month that federal actions are delayed would translate into approximately $80 million in additional state costs in the AFDC and SSI/SSP programs.
(View Figure 3 in Graphic Format)

Figure 3 State Savings Dependent on Future Federal Actions May Revision (In Millions)

	Amounts
Maintenance-of-Effort Relief
AFDC	$228
SSI/SSP	427
Subtotal	($655)
Illegal Immigrant Funding
Prisons	$239
Medi-Cal	216
Subtotal	($455)
Other	$101
Total	$1,211

Issues Facing The Legislature

Despite the major revenue increases since January, the 1996-97 budget proposal remains closely balanced, and is dependent on a variety of federal and state policy changes to be fully implemented. In this regard, the Legislature continues to face significant policy choices as it completes its work on the 1996-97 budget. These include:

• The trade-offs involved with the Governor's tax cut proposal, which would have major short-term and long-term economic and fiscal implications.
• The level of risk the Legislature is willing to accept involving federal actions (as indicated above, about $1 billion of state savings that depend on federal assumptions are vulnerable).
• Decisions on several of the Governor's policy choices relating to health and welfare, many of which were presented in January. These include the proposals to make permanent past welfare grant reductions, and to impose new reductions to AFDC and SSI/SSP grant levels. In addition the budget continues to make permanent the suspension of the renters' credit.
• Whether the Governor's proposals for spending Proposition 98 funds match the Legislature's priorities.

This report was prepared by Brad Williams, and Daniel Rabovsky, , under the supervision of Jon David Vasché,.

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