Legislative Analyst's Office
The 2002-03 Budget Bill:
To What Extent Does the Governor Rely on Borrowing-Related Solutions to Address the Budget Shortfall? What Should the Legislature Focus On in Evaluating Such Options?
The 2002-03 Governor's Budget proposes to use several different types of borrowing to help balance the budget. These borrowing-related proposals amount to about $4.8 billion in 2002-03, and together account for over one-third of the Governor's $12-plus billion set of solutions to eliminate the estimated budget shortfall.
This analysis summarizes the various types of borrowing-related actions that are either proposed in the budget or could be considered by the Legislature for budget-balancing purposes. It also describes their main features, and identifies their estimated fiscal effects.
We then discuss the key factors that the Legislature should focus on in evaluating both the Governor's borrowing-related proposals and others that could be considered.
The first of these factors is the interest rate that must be paid—either directly or indirectly—on different types of borrowing. A second factor is the amount and timing of future borrowing repayments, and the implications of these repayments for the General Fund's condition beyond the budget year. A third factor is how different borrowing options "stack up" against the alternatives for addressing the budget shortfall, such as reducing expenditures and/or augmenting revenues.
The Legislature's ultimate decision regarding what borrowing options to use should depend on which of the above criteria it values most highly and where its relative priorities lie.
As discussed in "Part One" of this volume, the January budget proposal offers the Governor's plan for addressing his estimated $12.5 billion projected budget problem for 2002-03. Our own estimate of the 2002-03 shortfall is even larger, and suggests that an additional $5 billion in solutions beyond those proposed by the Governor would be needed to bring the budget into balance.
Among the many different budget-balancing proposals offered by the Governor, there are several that involve borrowing as a means of helping to address the shortfall.
These budget-balancing borrowing options are fundamentally different from the two traditional types of borrowing routinely undertaken by the state. These traditional types include (1) the annual use of short-term cash-flow borrowing in order to "bridge" temporary intrayear mismatches between revenue inflows and expenditure outflows, and (2) the issuance of long-term bonds to finance capital outlay projects.
Neither of the two traditional types of borrowing has budget balancing as its primary goal. In contrast, the borrowing options we are speaking of in this piece are being considered for the specific purpose of helping to address the budget shortfall—by enabling the state to either get revenues sooner or delay expenditures until later.
In the remainder of this piece, we discuss the specific budget-balancing options proposed by the Governor, their individual features and characteristics, and considerations that the Legislature should focus on in evaluating them. We also discuss other borrowing-related options not specifically proposed by the Governor.
The Governor's plan includes four proposed major types of budget-balancing borrowing. As summarized below and discussed in greater detail later, these include:
Taken together, it is estimated that these options would produce a combined $4.8 billion in budget-year expenditure savings and/or added resources, or well over one-third of the Governor's $12.5 billion estimate of the 2002-03 budget shortfall.
In addition to the Governor's proposals involving borrowing, the following budget-balancing borrowing options have also been proposed by various parties:
Overall Fiscal Effect. These additional two options could provide a combined $2.7 billion in added budget-year resources. They could be used either in lieu of or in combination with the Governor's proposed borrowing-related options. For example, they could contribute to the $5 billion in additional solutions beyond those proposed by the Governor that we identify in "Part One" as necessary to balance the budget.
General Background. Under the terms of a 1998 agreement which California and most other states signed with the four leading tobacco companies, California will receive annual payments in perpetuity. It is currently estimated that these payments will total about $21 billion for the 25-year period 1998 through 2023. One half of that total—about $10.6 billion—will go to the state, while the other half will be divided among California's local governments. It should be noted that these TSR estimates are just that—estimates. As such, they are subject to a variety of uncertainties, such as future tobacco sales, litigation, and the financial health of tobacco companies.
Pursuant to legislation passed in conjunction with the 2001-02 budget (Chapter 171, Statutes of 2001 [AB 430, Aroner]), the receipts from the tobacco settlement are deposited in the Tobacco Settlement Fund, from which they are used to fund recently enacted expansions to health care programs.
Specific Proposal. The state would sell about 45 percent of its rights to future expected TSRs in exchange for up-front cash to help the state balance the budget.
To accomplish this, the state would issue a $2.4 billion revenue bond whose debt service payments (principal and interest) would be backed by TSRs. The remainder of the TRSs left over each year after the debt service was paid, would continue to be deposited into the Tobacco Settlement Fund. As discussed later in this piece, the amount of these remaining funds would depend on a variety of factors, including the interest rates on the bonds, other provisions needed to market the bonds, and whether the entire estimated TSR stream is realized. (For a more detailed discussion of this proposal and its implications for health-related programs, see the "Crosscutting Issues" writeup in the "Health and Social Services" section of our accompanying Analysis.)
Fiscal Effect. According to the budget, the tobacco bond issue would be sold in August 2002, thereby raising 2002-03 General Fund revenues by this amount. Offsetting this would be the ongoing expenditures over the bond issue's lifetime for the debt service needed to compensate investors for loaning the state the $2.4 billion. According to the administration, these debt service costs would be $62 million in 2002-03 and $190 million thereafter over the bond issue's 23-year lifetime.
General Background. The state's General Fund makes annual contributes to both the Public Employees' Retirement System (PERS) and the State Teachers' Retirement System (STRS). Contributions to PERS cover state employees and nonteacher school employees, whereas those to STRS cover public school teachers.
Specific Proposal. The Governor's budget proposes to postpone payment of a combined total of about $1 billion in state retirement contributions to PERS and STRS during 2001-02 and 2002-03. In exchange, the administration has pledged to support increased retirement benefits for PERS annuitants in the form of better "purchasing power protection" for their retirement benefits. (For a detailed discussion of this proposal, see the "General Government" section of our Analysis). The added costs of this increase would be funded with annual contributions to the PERS fund beginning in 2006-07 and continuing for 20 years. The administration has also agreed to support as-yet-unspecified benefit increases for STRS.
Fiscal Effect. As indicated above, this proposal would result in state General Fund savings of about $1 billion in the current and budget years combined. The payback would have two components:
In 2003-04, the General Fund cost of the basic loan repayment would be $52 million for PERS. (The STRS repayment would not start until 2004-05.) When the added payments associated with financing the increased benefits begin in 2006-07, the annual General Fund payments would amount to $167 million for PERS. The annual cost to STRS for the payback of the deferral is $61 million in 2006-07. These costs will be higher once the as-yet-unspecified benefit increases are finalized.
General Background. In 2000, the Legislature enacted the Traffic Congestion Relief Program, which created a six-year funding plan for state and local transportation needs (later extended to eight years by legislation passed in 2001).
Specific Proposal. The budget proposes loaning $672 million from the Traffic Congestion Relief Fund (TCRF) to the General Fund in 2002-03. It also proposes a variety of other funding shifts among various transportation funds in order to prevent a shortfall in the TCRF (see details of this proposal in the "Transportation" section of our Analysis). This loan would be repaid over the subsequent three years—2003-04 through 2005-06.
Fiscal Effect. This no-interest loan would augment General Fund resources by $672 million in 2002-03. The General Fund would then make loan repayments to the TCRF over the next three years.
General Background. Each year, the budget includes funding to support capital expenditures for state facilities and equipment in a variety of different program areas, mostly involving higher education, corrections, and resources. The funding for these projects can come from either direct appropriations or bond proceeds, with the latter including general obligation bonds, revenue bonds, and lease-payment bonds. The debt service on lease-payment bonds, which do not require voter approval, is paid for from lease payments appropriated by the Legislature to the state departments and agencies who occupy the facilities the bonds are used to finance.
Specific Proposal. The Governor proposes to shift support for about $115 million in current-year capital expenditures from the General Fund to lease-payment bonds.
Fiscal Effect. This proposal will result in a reduction in direct General Fund appropriations for capital outlay of $115 million in the budget year. In the future, the General Fund will pay slightly over $8 million annually to fund lease payments necessary to pay the debt service on the bonds.
General Background. This option would involve expansion of the partial tobacco securitization proposal offered by the Governor and discussed above.
Specific Proposal. This alternative would involve the securitization of an additional portion of the state's expected future TSR stream, versus only the partial securitization noted above. Under the Governor's proposal, the state would securitize, and thus collect in the form of an "up-front" payment, $2.4 billion of its future TSR revenue stream. The "present value" of the full TSR stream over the next 25 years is currently valued at roughly $5.3 billion. This option would involve selling an additional portion of this full stream, not just the rights for the TSRs necessary to pay the debt service on $2.4 billion in bonds.
Fiscal Effect. The additional General Fund money that could be raised under this option in 2002-03 would depend on the amount of money investors would be willing to pay for the remaining part of the TSR stream. (The present value of this remaining part of the stream is $2.9 billion—the $5.3 billion full amount minus the Governor's proposed $2.4 billion.) This, in turn, will depend on such factors as the perceived risks to the stream in the future. However, if the state were able to sell 75 percent of its entire stream, this would amount to $4 billion in total sales. Thus, under this option, an additional $1.6 billion of TSRs could be sold beyond the $2.4 billion the Governor proposes.
The additional General Fund debt service costs under this option would be about $40 million in the budget year and $130 million annually thereafter over the bonds' lifetime. These debt service payments would reduce the amount of TSRs currently earmarked to fund certain health programs.
General Background. California currently has about $20 billion in outstanding general obligation bonds on which the General Fund pays debt service (principal and interest). One option that has been suggested to help deal with the budget shortfall is to essentially "stretch out" the maturity structure of some of its individual bonds, thereby reducing debt service costs in the near term.
Specific Proposal. The way this could be accomplished mechanically would be to issue a "refunding" bond, the proceeds of which would be used to make principal payments that come due on existing debt. The refunding bond would be structured to avoid principal repayments until after the budget year. Existing tax and bond law allows this refinancing to be done as long as the maturity dates within the refunding bond do not exceed the maximum maturity dates of the original bond issues.
Fiscal Effect. The State Treasurer has identified about $2 billion in general obligation principal repayments owed to investors between January 2002 and June 2004 that could be refinanced. The Treasurer has also estimated that the near-term General Fund savings from refinancing these principal repayments would amount to $223 million in 2001-02, $866 million in 2002-03, and $832 million in 2003-04. Thus, this option could provide $1.1 billion toward addressing the 2002-03 budget problem. These savings would more than be offset, however, when the new loans have to be repaid in the future.
In evaluating the different types of borrowing that potentially can be used to help address the budget shortfall, the Legislature may find it helpful to focus on three key questions:
This information is important for understanding both the true underlying cost of a borrowing option, as well as assessing the relative costs of different options.
The pattern of required repayments can differ markedly for different borrowing options, even if their underlying interest rates are not dissimilar. Depending on how these repayments compare to underlying revenue and expenditure trends, one option may be preferable to another if it makes managing future budgets easier. As an example, an option that imposes heavy repayment liabilities at the same time than an operating deficit (expenditures in excess of revenues) is already likely may not be desirable.
The answer to this question involves legislative policy priorities. For example, even if two options are similar in terms of their interest costs and repayment characteristics, one may be preferable to another in terms of the programs it adversely impacts and/or individuals it affects.
In applying the above information to arrive at a decision regarding different borrowing options to help address the budget shortfall, some alternatives may score well on one or more of the above criteria but poorly on another, and vice versa. Thus, the Legislature will need to decide which criteria it values most highly and where its relative priorities lie. For example:
Thus, weighing the relative costs and benefits of different borrowing options will be important for the Legislature to focus on in considering the role that borrowing should play in addressing the state's current fiscal problem.