Legislative Analyst's Office The 2003-04 Budget Bill: Perspectives and Issues

STATE FISCAL PICTURE

California faces an unprecedented budget shortfall in 2003-04. This shortfall—which is roughly one-third of the General Fund budget—is due to an unexpected dramatic decline in state tax receipts combined with ongoing increases in state government costs. The Governor's budget proposal lays out a comprehensive plan for dealing with this enormous problem. The plan incorporates a variety of specific proposals, including tax increases, program realignment, deep spending cuts, and major reductions in local government subventions.

The actions proposed by the Governor reflect his priorities for dealing with the shortfall. In evaluating and acting on these proposals, the Legislature will be confronted with applying its own priorities to make fundamental decisions about the scope of government services; how these services are distributed among the citizenry; and what the nature, amount, and mix of taxes in California should be. Given the unprecedented scope of the problem, any budget that seriously addresses the budget imbalance will necessarily involve difficult choices that will likely affect all Californian's to one degree or another.

In this part, we summarize the 2003-04 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 priorities for dealing with the state's fiscal problem.

The Budget's Economic and Revenue Outlook

The budget's economic and revenue outlook is down sharply from the 2002-03 Budget Act estimates. The new projections reflect the persistent softness in U.S. and California economic activity and the associated weakness in General Fund revenues through the end of 2002. The budget forecast assumes that economic softness will continue throughout much of 2003, with California personal income—a key determinant of state revenues—growing by just 3.3 percent this year, before accelerating to a more moderate pace of 5.3 percent in 2004. Based on this subdued economic forecast, the budget assumes that General Fund revenues will grow from $72.2 billion in 2001-02 to $73.1 billion in 2002-03, before falling to $69.2 billion in 2003-04. After excluding the numerous one-time revenue changes involved in both the prior and current years, underlying revenue growth is forecast to be sub par—just 1.4 percent in 2002-03 and only 2 percent in 2003-04.

The Budget Proposal

Total State Spending

The budget proposes total state spending in 2003-04 of $89.2 billion (excluding expenditures of federal funds and bond funds). This represents a decrease of 5.7 percent from 2002-03. General Fund spending is projected to fall from $75.5 billion in the current year to $62.8 billion in the budget year, while special funds spending will rise from $19.2 billion in 2002-03 to $26.5 billion in 2003-04. These totals reflect the proposed $8.2 billion realignment program and elimination of the current base vehicle license fee (VLF) backfill to localities, as discussed below.

General Fund Condition

Figure 1 shows the General Fund's condition under the budget's assumptions and proposals. It indicates that:

• Revenues are projected to fall from $73.1 billion in 2002-03 to $69.2 billion in 2003-04, a decline of 5.5 percent. This decline is due to weak underlying growth in revenues from major taxes, and the large amount of one-time receipts in 2002-03 from tobacco securitization and loans from special funds.
• Expenditures are projected to decline from $75.5 billion in 2002-03 to $62.8 billion in 2003-04, a drop of 16.8 percent. The decline reflects both major program reductions and the above-cited proposed program realignment to local governments.
• The large decline in expenditures results in an operating surplus (that is, revenues in excess of expenditures) of $6.5 billion in 2003-04. This causes the cumulative year-end reserve to increase from a minus $5.9 billion in 2002-03 to a positive $531 million in 2003-04.

How the Budget Addresses the Shortfall

The administration has identified a budget problem of $34.6 billion in 2003-04. As we indicated in January, we believe that the administration has somewhat overstated the problem facing the state, primarily because its baseline expenditure estimate includes spending for education and other areas that is above what would be required under current law or current practices. (As we also have noted, these added baseline costs do not diminish the need for real solutions necessary to bring the budget into balance. Instead, they result in differences in the scoring of the size of the problem and the corresponding size of the budget solutions that are embedded in the budget's proposals.)

However, using for the moment the administration's definition of the budget problem and its corresponding size of the solutions needed, Figure 2 (see next page) shows how the Governor's solutions are distributed among major categories and by fiscal year.

It indicates that, of the total solutions, roughly 40 percent are related to program savings; slightly less than one-fourth are related to realignment; about one-sixth are related to a shift of local government resources to the state; and the remaining one-fifth is split between fund shifts, transfers/other revenues, and loans/borrowing. Regarding each of these major categories:

• Program Savings. The budget contains approximately $13.7 billion in program savings. This includes $2.7 billion in current-year reductions (mostly in K-14 Proposition 98 spending) and $11 billion in savings in 2003-04. Most programmatic areas of the budget are affected.
• Realignment. The budget would raise a net of $8.2 billion in new taxes to fund the shift of a like amount of primarily health and social services responsibilities to local governments. The tax increases consist of (1) a 1 percent increase in the sales and use tax (SUT), (2) the imposition of 10 percent and 11 percent personal income tax (PIT) marginal rates on the earnings of high-income taxpayers, and (3) a $1.10 per-pack increase in the state cigarette tax rate.
• Local Government Reductions. Aside from the realignment proposal (which is intended to balance estimated expenditure responsibilities with new resources in 2003-04), the budget shifts $5.1 billion in resources away from local governments in order to produce General Fund savings. Key components of this shift include (1) the elimination of about three-fourths of the subventions to backfill the VLF revenue losses sustained by localities when the VLF rate was lowered in past years, (2) a shift of redevelopment-related funds from local governments to schools, and (3) the elimination of open-space subventions and booking fee reimbursements. These amounts do not include the non-Proposition 98 mandate deferrals which, as noted below, we are classifying as loans/borrowing.
• Funding Shifts. These total $2.2 billion and include (1) student fee increases in all three of the higher education segments, (2) other fee increases for trial courts and various resources programs, and (3) use of federal funds to support some child-care costs.
• Transfers and Other Revenues. These account for $2.1 billion in revenues. The major component is $1.5 billion in new revenues associated with tribal gaming pacts, which are up for renegotiation in March 2003. This category also includes about $95 million in General Fund revenues from tax proposals involving the eligibility for the investment tax credit and taxation of regulated investment companies.
• Loans and Borrowing. This category accounts for $3.3 billion of total budget solutions. The largest components are the deferral of local government and education mandates, and the deferral of contribution costs to the state's pension funds (either through direct loans from the funds or the issuance of some sort of pension obligation bonds).

Program Savings Overstated. As noted above, we believe that the budget overstates both baseline costs and budget program savings in various areas of the budget. Adopting our definition of baseline costs would reduce both the size of the budget problem and the corresponding value of the solutions shown in Figure 2 by roughly $5.5 billion. The main area affected in Figure 2 by this adjustment is the program savings category, which would fall by approximately $4 billion. The effect of this change would be to reduce the proportion of the total budget solution due to program savings from about 40 percent to roughly one-third, with the other components' shares increasing commensurately.

Programmatic Features

Figure 3 (see next page) 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 2003-04 Analysis of the Budget Bill. Nor do they take into account legislative actions that have been taken to date on the budget. The causes of our differences from the budget's projections are limited to (1) contrasting assumptions about the economic and revenue outlook; and (2) estimation differences, such as from caseload projections, in the level of expenditures that would be needed to fund the Governor's budget plan.

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 highlighted in Figure 4, while our estimates of revenues, expenditures, and the General Fund's condition are shown in Figure 5 (see next page).

Budget Plan Would Balance

As shown in Figure 4 and Figure 5, we estimate that adoption of all of the budget's provisions and proposals would result in a positive reserve of about $1.6 billion at the conclusion of 2003-04. This reserve amount is about $1 billion higher than the $531 million included in the Governor's budget. The increase is due to our higher revenues, partly offset by the additional spending requirements that we believe would be needed to fund the Governor's plan.

• Higher Revenues. Despite current-year softness in PIT receipts, we project that General Fund revenues will exceed the budget forecast by $1.3 billion over the current and budget years combined. Our forecast assumes that an earlier and stronger economic acceleration in California will produce more revenue growth in 2003-04 than the administration is anticipating.
• Additional Expenditures. Partly offsetting our higher revenues are about $273 million in net added costs that we believe are needed to fund the Governor's proposal. This increase primarily reflects added General Fund costs needed to fund proposed spending in the Healthy Families program, likely cost deficiencies in the California Department of Corrections, and added cash-flow borrowing expenses.

Many Threats Exist

There are a number of key risk factors that could easily consume the total $1.6 billion year-end cushion that we are projecting for 2003-04. For example, our estimates include the budget's assumption of $1.5 billion in new tribal gaming revenues. The amount of these revenues, however, is dependent on the outcome of negotiations with the Indian tribes involved, and early indications are that it is unlikely that the state would achieve the targeted amount of revenues.

Similarly, while the budget does not rely on significant amounts of new federal funds, it nevertheless faces risks associated with its assumptions about the continuation of existing federal reimbursements. Specifically, the budget includes $155 million in both the current year and budget year in federal reimbursements for costs associated with the incarceration of undocumented felons. While this is consistent with prior-year funding levels, neither the President's budget for the current or subsequent federal fiscal year nor the Congressional versions of the 2003 federal spending bill include funding for this purpose.

Just these two factors could easily consume our estimated $1.6 billion budget-year reserve—even if all the budget's provisions were adopted.

Governor's Plan Would Also Address State's Structural Imbalance . . .

We believe that the Governor's budget plan—to the extent its assumptions and proposals are realized—would meaningfully address the longer-term structural shortfall facing the state. Based on current law, we believe this structural imbalance—defined as the annual excess of expenditures over revenues—would likely be in the general range of $18 billion yearly. In contrast, as indicated in Figure 6, we estimate that under the budget proposal, revenues would slightly exceed expenditures in 2004-05, boosting the cumulative reserve at the end of that year to $2.3 billion. Our longer-term projections further suggest that revenues would continue to exceed expenditures in subsequent years. Thus, the structural imbalance would be gone.

The favorable impact of the plan on the state's structural shortfall results from the fact that most of the budget's major proposals involving education, health, social services, realignment, and local governments, would produce ongoing savings.

. . . But Only if Major Actions Are Taken

Our fiscal estimates do not imply that it will be easy for the state to regain fiscal balance in 2003-04 and beyond. On the contrary, a restoration of California's fiscal health will occur only if the Legislature either (1) adopts the major savings and revenue proposals included in the budget plan or (2) finds alternative solutions of similar magnitude that are real and largely ongoing in nature. Absent this, the modest positive fiscal balance we are projecting would be quickly transformed into a large deficit.

Illustration. Figure 6 (see next page) demonstrates the cumulative adverse impact that the rejection of two key administration proposals would have on the state's fiscal picture—if they were not replaced with alternative solutions of similar magnitude. For example:

• Rejection of the proposal to eliminate the base VLF local backfill would result in lost annual savings of $1.3 billion in 2002-03, $2.9 billion in 2003-04, and $3 billion in 2004-05. The figure shows that the cumulative impact of these lost savings would be a $4.2 billion deterioration in the cumulative reserve by the end of the budget year, and a $7.2 billion deterioration by the close of 2004-05.
• Rejection of the realignment-related tax increases and the accompanying shift of program responsibilities to localities would reduce annual state budgetary savings by about $8 billion beginning in 2003-04. The figure shows that this would lead to a two-year deterioration in the reserve of nearly $15.9 billion by the end of 2004-05.

The figure shows that the rejection of both of these proposals would transform the projected $2.3 billion 2004-05 reserve into a $20.8 billion deficit.

Rejection of other key savings proposals in the areas of Medi-Cal, social services, or transportation, would also have major adverse impacts on the reserve.

Considerations for the Legislature

Given the enormity of the budget problem and the large number of major proposed solutions included in the Governor's plan, the Legislature will be faced with many important policy issues and questions as it considers the 2003-04 budget. Among the more important of these are the following:

• How Do the Proposal's Spending Priorities Square With the Legislature's? In general, the budget's deepest cuts are in local government, K-12 education, community colleges, Medi-Cal, SSI/SSP, and CalWORKs. At the other extreme, only modest reductions are included for criminal justice programs, UC, and CSU. In considering current-year actions on the budget, the Legislature has already indicated its intent to include reductions in corrections. In our accompanying 2003-04 Analysis of the Budget Bill, and in "Part V" of this volume, we offer recommendations and options that the Legislature may wish to consider in addressing the budget problem.
• Is the General Nature, Overall Amount, and Distribution of the Proposed Tax Increases Appropriate? Roughly one-fourth to one-third of the Governor's proposed budget solutions are related to increased taxes (depending on how the budget problem is defined). The basic questions in this area include whether the aggregate amount and mix of taxes proposed are appropriate. We discuss the Governor's tax proposals in detail in "Part V."
• Can Local Governments Realistically Absorb a $5 Billion Funding Reduction? The Governor's proposals to eliminate the base VLF backfill and transfer redevelopment funds to schools would have a significant adverse impact on many city and county services. This raises such issues as whether the Legislature should increase the VLF rate itself and/or provide localities with other options for raising revenues.
• What About Mandates? For the second year in a row, the budget would defer state payments for local government mandate claims. The accumulated liability for such claims now exceeds $1 billion. As discussed in "Part V" and in various sections of the Analysis, the Legislature may wish to consider alternatives to mandate deferrals, including the outright elimination or suspension of certain mandates, and the inclusion of education mandate funding in a block grant.
• Does the Governor's Realignment Proposal Make Sense? In evaluating the administration's realignment proposal, the Legislature may wish to consider such issues as: (1) will counties have sufficient program authority and flexibility to effectively and efficiently manage their new responsibilities; (2) would other programs benefit from realignment, either in lieu of or in addition to those being proposed; and (3) will the realignment revenue stream match future growth in program costs? In "Part V" we review the Governor's realignment proposal in more detail, and suggest other programs that the Legislature may wish to include in a realignment plan.
• What Are the Long-Term Budgetary Implications of Alternatives? As indicated above, we believe that the Governor's budget proposal would address the state's current multibillion dollar long-term structural fiscal imbalance, assuming that it was fully implemented and its assumptions held up. As the Legislature considers modifications and alternatives to the Governor's proposal, it will be important that it try to avoid diminishing the long-term fiscal benefits that are inherent in the current proposal.

Conclusion

The state clearly faces an enormous challenge in getting its fiscal house in order. We therefore continue to recommend that the Legislature put everything "on the table" including both program reductions and taxes, and adopt solutions that are both real and ongoing.