Analysis of the 2004-05 Budget Bill Legislative Analyst's Office February 2004

Proposition 98 Budget Priorities

The Governor's budget offers a good starting point for addressing the 2004-05 budget problem. Given the structural budget situation the state faces, we believe the Governor's proposed suspension of the Proposition 98 minimum guarantee is appropriate. If suspension is approved, we recommend the Legislature balance K-14 funding priorities with other General Fund priorities without regard to the exact Proposition 98 funding level proposed in the Governor's budget.

The Governor's budget proposal (1) suspends the Proposition 98 minimum guarantee by $2 billion in 2004-05 and (2) spends below the minimum guarantee in 2002-03 and 2003-04 by a combined $966 million. Thus, the overriding issue for the Legislature in crafting the 2004-05 budget for K-12 education and the community colleges (both funded largely through Proposition 98 funds) is whether to approve the proposed suspension. If suspended, the Legislature then could set the funding level for K-12 education and the community colleges at whatever level it felt appropriate. How the Legislature addresses these two issues of suspension and the K-14 funding level will shape K-14 budgets for the next several years. 

Within the budget's proposed Proposition 98 funding level of $46.7 billion, there are sufficient resources available to fully fund enrollment growth, cost-of-living adjustments (COLAs), and some program expansions and restorations. The Governor's budget generally funds these priorities, including statutory COLAs, but does not provide a COLA for the community colleges and some K-12 categorical programs. The budget also provides school districts and community college districts greater fiscal and programmatic flexibility by transferring $2.4 billion in categorical funding into revenue limits and community college apportionments. However, the budget continues to rely on funding deferrals—increasing future K-14 obligations to almost $3.8 billion. Below, we discuss the Governor's approach to the 2004-05 budget, addressing: (1) overarching Proposition 98 issues, including Proposition 98 suspension, certification, and K-14 deferrals; (2) K-12 issues, including categorical flexibility and LAO proposed spending reductions; and (3) major California Community Colleges (CCC) budget issues, including enrollment growth, equalization, and categorical reform.

Governor's Suspension Proposal Reasonable

Given the size of the structural deficit and Proposition 98's share of General Fund expenditures (roughly 40 percent), it would be very difficult to close the budget gap without suspending Proposition 98. The following two examples explain the difficulty of balancing the budget without suspending the minimum guarantee:

• Additional Non-Proposition 98 Reductions. On the one hand, the Legislature would need to make an additional $2 billion in reductions in non-Proposition 98 programs (health, social services, higher education, and corrections), which would be difficult on top of the Governor's proposed reductions in those program areas.
• Additional General Fund Tax Revenues. Alternatively, if the Legislature were to increase tax revenues, much of the new revenue would need to go to Proposition 98. If, for example, the Legislature increased General Fund revenues by $5 billion, $4 billion of the increase would need to be appropriated for Proposition 98 (absent suspension). This is because the higher General Fund revenues would significantly increase the minimum guarantee level.

As noted above, even with suspension, the Governor's proposed Proposition 98 funding level provides sufficient resources to fully fund growth, COLA, and some additional expansions and program restorations. Accordingly, we recommend the Legislature suspend the minimum guarantee for 2004-05.

The Governor proposes suspending the minimum guarantee by $2 billion from the 2004-05 minimum guarantee level. If at the May Revision, the minimum guarantee is higher or lower, the Governor's proposal would adjust the proposed K-14 appropriation level to keep the suspension amount at $2 billion. If the Legislature chooses to suspend, we recommend the Legislature determine the appropriate level of K-14 funding by balancing K-14 priorities with its other General Fund priorities—without regard to the dollar amount of the suspension. In other words, the Legislature should just spend at the Proposition 98 level it deems appropriate.

If the Legislature were to suspend Proposition 98 and fund K-14 education below the guaranteed level in 2004-05, this would create real General Fund savings (relative to the guarantee). In some future fiscal year the state would be required to fund K-14 education at the same level that would have been required in that year if suspension had never occurred. But our analysis suggests that this level of spending will not be required for several years, and in the meantime the state would realize General Fund savings each year by spending below this "long-term" guaranteed level. We discuss this scenario below.

How a Proposition 98 Suspension Would Work

Over the long run, the Proposition 98 minimum guarantee is determined by the growth in K-12 attendance and growth in per capita personal income (commonly known as the Test 2 factor). The Constitution allows the Legislature to appropriate funding for K-14 education below this "long-term Test 2 level" under two circumstances: (1) the Legislature suspends the requirements of Proposition 98 or (2) per capita General Fund revenues (commonly known as the Test 3 factor) grow more slowly than per capita personal income.

In either of these circumstances, the Constitution requires the state to provide accelerated growth in Proposition 98 funding in future years until the state has "restored" funding to the long-term Test 2 level. During this restoration period, the state calculates the difference between the actual level of spending and the long-term Test 2 level of spending. This difference is referred to as the "maintenance factor" and it is restored in one of two ways:

• When General Fund revenues grow faster than personal income, the state must reduce the maintenance factor by providing additional growth funding for Proposition 98.
• The Legislature can opt to provide funding above the minimum guarantee ("overappropriate")—restoring the maintenance factor faster than required under law.

When the maintenance factor is fully restored, K-14 spending is returned to the long-term Test 2 level. However, the state is never required to "pay back" the earlier savings achieved in the years when Proposition 98 funding was below its long-term Test 2 level. These savings therefore are not "loans" from prior years, but actual savings. The Department of Finance estimates that absent suspension, the state would end the 2004-05 fiscal year with a $2 billion maintenance factor (resulting from recent Test 3 years). The proposed suspension would create an additional maintenance factor of $2 billion, resulting in a year-end maintenance factor obligation of $4 billion.

Governor's Proposal Would Save at Least $2 Billion Annually for Several Years

Figure 1 shows our estimate of the annual savings to the state from the Governor's proposed suspension. The figure shows that the $2 billion of savings in 2004-05 actually grows to $2.4 billion by 2008-09. The fiscal impact of the 2004-05 suspension grows by roughly $100 million annually (to $2.1 billion in 2005-06 and so forth). In other words, the savings grow with the annual growth in the minimum guarantee. We explain in detail below why the additional maintenance factor resulting from the Governor's proposed suspension does not decline over the forecast period. 

Current Maintenance Factor in Effect Paid Off First. Figure 2 shows the impact that a $2 billion suspension would have on widening the gap (maintenance factor) between the required minimum guarantee and the long-term Test 2 level. Under current law but absent suspension, the state would slowly close the gap between the Proposition 98 funding level and the long-term Test 2 level over the forecast period. (We estimate this maintenance factor payoff at over $200 million annually on average.) Lowering the 2004-05 spending level by $2 billion through suspension widens the gap from the long-term Test 2 level. The shaded area between current law absent suspension and current law with a $2 billion suspension represents the savings to the state from the Governor's proposal.

Since the state does not pay off its preexisting maintenance factor over the period shown, the maintenance factor created by suspension ($2 billion) generates savings of that magnitude each year. (As noted above, it actually grows slightly because of growth in ADA and per capita income.) When the state fully restores all maintenance factor and returns to the long-term Test 2 level (which based on our forecast would be after the period shown in Figure 2), the savings to the state from the $2 billion suspension would end. However, in the interim, the state would generate annual savings from the Governor's proposed suspension. 

What Would It Take to Restore the Entire Maintenance Factor? Based on past experience, sudden turnarounds in General Fund revenues can require rapid restorations of maintenance factor. Under our forecast, General Fund revenues would grow from $75.9 billion in 2004-05 to $95.1 billion in 2008-09, or 5.8 percent, annually on average. In order to fully restore the maintenance factor by 2008-09, we estimate that, other things held constant, revenues would need to grow to about $103 billion, or almost 8 percent annually.

Legislature Can Eliminate Prior- and Current-Year Proposition 98 Obligations Through Suspension

We recommend the Legislature suspend the minimum guarantee in 2002-03 and 2003-04 to eliminate $966 million in Proposition 98 "settle-up" obligations the Governor proposes to postpone until at least 2006-07.

For 2002-03 and 2003-04, the Governor proposes to fund Proposition 98 below the existing minimum guarantee, but does not propose suspension in these years. Thus, for these years, the state would need at some future time to appropriate additional resources to "settle up" to the minimum guarantee. However, the State Constitution does not specify a timeline by which the state must accomplish this. Under the Governor's proposal, the state would not begin paying the settle-up obligation of $966 million until 2006-07. This effectively creates a $966 million loan from Proposition 98 to the General Fund until that time. While this would help the state's balance sheet in the short run, the "tab" would have to be paid starting in 2006-07. Given that the budget does not fully address the state's structural problem (see "Part I" of the 2004-05 Perspectives and Issues), the loan would add to the state's problem when the settle-up payments were made in 2006-07.

For similar reasons that we recommend suspending the minimum guarantee for 2004-05, we recommend the Legislature suspend the minimum guarantee for 2002-03 and 2003-04, thereby eliminating the $966 million out-year obligation. If the state does not suspend the minimum guarantee for 2002-03 and 2003-04, the state will be obligated to pay off the $966 million in the near term regardless of the state's fiscal situation at the time.

Proposition 98 Certification Process in Need of Reform

We recommend the Legislature (1) "close the books" (certify) the Proposition 98 funding level for fiscal years 1995-96 through 2001-02 and (2) certify the 1995-96 and 1996-97 funding level at the existing appropriation level—eliminating a potential obligation of $251 million.

Current law requires the State Department of Education (SDE), CCC, and the Department of Finance (DOF) to jointly certify the Proposition 98 calculation—including the formula inputs (ADA, per capita General Fund revenues, per capita personal income) and the overall Proposition 98 appropriation level within nine months of the end of a fiscal year. However, these parties have ignored the statutory requirement for a number of years. The last time that the calculation was certified was when the Legislature certified fiscal years 1990-91 through 1994-95 as part of the implementing legislation for the settlement of the California Teachers Association v. Gould lawsuit. So, technically changes to any of the Proposition 98 calculation inputs could lead to a change in the minimum guarantee for any year after 1994-95.

Lack of Proposition 98 Certification Only Leads to Increases in State Costs. The practical implication of these unreasonably long delays in certification is that the state's Proposition 98 obligation could increase unexpectedly in any future year due to a change applied retroactively to some fiscal year in the distant past. Just such an obligation has been identified for fiscal years 1995-96 and 1996-97. Data from the 2000 census adjusted the state's estimate of state population for the late 1990s, slightly lowering the prior estimates. This adjustment results in higher per capita General Fund revenues, which in turn increases the Proposition 98 guarantee. If the Proposition 98 calculation were adjusted to reflect this revision, the state would owe schools and community colleges an additional $251 million ($85 million for 1995-96 and $166 million for 1996-97) settle-up obligation. If, on the other hand, adjustments to the inputs had resulted in a lower Proposition 98 minimum guarantee, the state could not ask the schools to return funding for those prior years. Thus, by allowing fiscal years to remain uncertified, the three agencies put the state at risk of increased funding obligations. Moreover, any additional funding applied to the distant past would represent a windfall provided to schools without any associated oversight or accountability.

Close the Books. We believe that the intention of the Legislature is clear. The SDE, CCC, and DOF should work collaboratively to certify the Proposition 98 guarantee within a reasonable time period after the close of a fiscal year. At the end of this period, they should "lock in" the Proposition 98 funding level for a specific year. Because of the fiscal risk to the state, we recommend the Legislature adopt trailer bill language to certify the Proposition 98 calculations for 1995-96 through 2001-02. As part of that certification, we recommend the Legislature certify the Proposition 98 calculation based on the state's population estimates available in the late 1990s and used to determine the state's minimum guarantee for 1995-96 and 1996-97. By certifying now (using the most accurate estimates that were available in the late 1990s), the Legislature would eliminate a potential out-year liability of $251 million.

Develop a More Definitive Certification Process. Because of the potential state liabilities that can arise from not certifying the Proposition 98 calculation in a timely fashion, we recommend the Legislature work with the administration to develop a more definitive statutory certification process. We believe it would be ideal if the state certified a given fiscal year's Proposition 98 level prior to the start of the second following fiscal year. For example, the 2002-03 Proposition 98 amount would be known and certified prior to the start of 2004-05. This would limit uncertainty over unanticipated changes in the Proposition 98 spending level to developments which occurred in 2003-04. We acknowledge that even after the end of a fiscal year, estimates of population, attendance, and General Fund revenues can change. But the Legislature needs to balance the marginal improvement in accuracy provided by these adjustments with the uncertainty caused by leaving fiscal years open.

Credit Card Balance High and Growing

Starting in 2001-02, the Legislature opted to defer significant education program costs to the subsequent fiscal year rather than make additional spending cuts. Under the Governor's proposal, the recent trend of increasing future state obligations to fund current or prior costs continues. The result has been a steadily growing balance on the state's education "credit card." Figure 3 shows the year-end spending obligations that the state has agreed to pay in the future. There are two distinct portions of the education credit card balance—(1) deferrals requiring one-time payments by the state and (2) revenue limit "deficit factor" which requires ongoing payments. Combined, the credit card balance would grow from $3.5 billion in 2003-04 to $3.8 billion in 2004-05 under the Governor's budget, an increase of $321 million. Most of the increase in the credit card balance results from lack of funding for state-reimbursable mandates in the budget. We estimate that the annual costs of K-14 mandates in 2004-05 will exceed $300 million. Given the large and growing backlog of mandate claims, the mandate deferral presents special problems for the state. By the end of 2004-05, the state is likely to have a total of almost $1.6 billion in outstanding Proposition 98 mandate liabilities. We provide several mandate reform proposals to reduce out-year costs later in this chapter and in the 2004-05 Budget: Perspectives and Issues.

A major component of the 2003-04 Proposition 98 budget solution was a 1.2 percent reduction in revenue limits, and a foregone 1.8 percent COLA. Combined, these reductions saved the state almost $900 million. However, the Legislature created an obligation to restore the reduction—referred to as the "deficit factor"—by 2005-06 at the latest. It also adopted trailer bill language stating that the first priority for increases in Proposition 98 funding is to restore these revenue limit reductions.

The cumulative impact of all these deferrals and out-year obligations has maxed out the education credit card. Each year the state relies on deferrals and other one-time solutions rather than ongoing solutions, the problem intensifies the following year.

Establish Deferral Repayment Plan. We recommend the Legislature begin gradually paying off deferrals and develop a repayment plan to eventually restore all deferred funds. We note that since school districts and community colleges have already spent the funding to meet the program obligations of the deferred programs, any funding provided to reduce deferrals is effectively general purpose in nature at the local level. In the budget and future years, we recommend the Legislature make it a priority to repay deferrals before making expenditure increases or funding new programs. Below, we identify almost $400 million in K-14 savings recommendations. We suggest that if the Legislature decides to appropriate at the Governor's proposed Proposition 98 funding level, the freed up funds be used to reduce the credit card debt.

Other Issues

LAO Recommended Reductions

Throughout this chapter, we recommend more than $400 million in Proposition 98 funding reductions that the Legislature could use to reduce the balance on the education credit card or redirect to other General Fund priorities. Figure 4 summarizes these reductions. Redirecting identified savings to pay off K-14 debts would keep the credit card from growing above its 2003-04 level. Most of these reductions are discussed in detail later in the chapter. Two that are not are discussed below:

• Current-Year K-3 Class Size Reduction Participation Rate Falls (Reduce $50 Million). Several school districts have stopped or reduced participation in K-3 class size reduction (CSR) in the current year because of lack of local funding to fully fund the cost of the program. As a result, early data collected by SDE suggest the state may save as much as $100 million in the current year. Given that more accurate data will not be available until June, we suggest the Legislature plan conservatively and redirect only half of the potential savings to other K-14 priorities. The declining participation reemphasizes the need for reform of the enrollment caps for K-3 CSR, which we recommended in the Analysis of the 2003-04 Budget Bill.
• State Will Receive Higher Federal Funds for Special Education ($33 Million). In the recently adopted federal budget, California will receive additional federal funds. The state can use $33 million of the increase to cover the costs of special education growth and COLA in 2004-05 and still meet the federal maintenance-of-effort requirement.

Increase K-12 Local Fiscal and Program Flexibility

The Governor proposes to consolidate $2 billion in funding for 22 existing categorical programs into revenue limits. With this change, districts would have complete discretion over the use of these funds. The proposal would balance this new flexibility by requiring a district plan that is intended to increase local accountability for district spending decisions. In addition, the budget proposes to provide additional flexibility for five small school safety competitive grant programs.

We believe these proposals take a significant step toward the goal of establishing a streamlined system of categorical programs. In particular, consolidating categorical funds into revenue limits results in several benefits, including greater fiscal and program flexibility, savings in state and local administrative costs, and more local focus on outcomes rather than program rules.

In our analysis of the administration's reform proposal, we provide the Legislature with criteria to use when determining which categorical programs are good candidates to move into revenue limits. We focus on whether local incentives might cause a school district to underinvest in specific activities. Based on our assessment of local incentives, we recommend several modifications to the list of programs included in the revenue limit shift. Most significantly, we recommend the Legislature move only 17 categorical programs into revenue limits. We recommend the Legislature exclude from the shift both staff development programs and programs that support services for special-needs students because we are concerned that local incentives are likely to lead districts to underinvest in these two areas. Instead, we recommend (1) creating a teacher quality block grant from ten existing categorical programs and (2) restructuring Economic Impact Aid by adding programs serving special needs students.

Of the 17 programs we recommend shifting into revenue limits, three are not ones the administration proposes shifting. Specifically, we recommend shifting K-3 and high school class size reduction, as well as a deferred maintenance. Given the popularity among parents and teachers of smaller classes, we think school boards would have to make a convincing case that alternative uses of class-size reduction funds would lead to better outcomes for students. For deferred maintenance, recent state bond acts improve local incentives for providing adequate maintenance by requiring a minimum level of spending by participating districts. Because of the new bond act requirements, the deferred maintenance program does little to further increase local maintenance spending. By consolidating this program into revenue limits, the Legislature would clarify that long-term facility maintenance is the responsibility of school boards, not the state.

We also suggest modifying the budget's school safety program proposal. Specifically, we recommend creating a block grant that would contain funding from all existing categorical and state-mandated local programs in this area. This would give districts greater flexibility over the use of funds and reduce the state and local administrative burden of existing categorical programs and mandates.

CCC Spared From Higher Education Reductions

While the Governor's budget makes a variety of programmatic reductions to the University of California (UC) and the California State University (CSU)—including reductions in freshman enrollment funding, the elimination of outreach programs, increases in student-faculty ratios, and cuts in general administrative funding—CCC receives almost no programmatic reductions. Instead, CCC would receive an augmentation of about $121 million for a 3 percent increase in enrollment, and $80 million to fund equalization. The budget, on the other hand, does not provide a COLA. Total funding for CCC (including General Fund, local property taxes, student fees, and federal and other funds) would increase by $507 million, or 8 percent, from the current year.

Deferral Affects Proposition 98 Funding. The 2003-04 budget package allows CCC to defer $200 million in costs from June to July 2004. This deferral of current-year costs to the budget year creates Proposition 98 savings in the current year without affecting CCC's programmatic support. By reducing CCC's Proposition 98 appropriations in the current year, however, the deferral distorts traditional measures of CCC's "share" of Proposition 98 resources. It also distorts measures of year-to-year change in CCC's level of support. Adjusting for the deferral (that is, counting the $200 million towards CCC's 2003-04 budget) provides a more meaningful measure of how CCC's funding will increase under the Governor's proposal. With this adjustment, CCC's total funding would increase by $307 million, or 4.7 percent. This includes an adjusted Proposition 98 increase of $120 million, or 2.6 percent. Other significant new funding comes from a proposed fee increase ($91 million) and non-Proposition 98 General Fund support ($96 million).

Funding for 35,000 Additional Students. The proposed budget would provide $121 million for 3 percent growth in general apportionments, plus an additional $4 million for growth in noncredit instruction. The combined $125 million would fund about 35,000 additional full-time equivalent students, or 3.2 percent more than in the current year. This is significantly higher than the 1.8 percent growth rate called for by statutory guidelines. The budget recognizes the additional enrollment demand that will likely be diverted from UC and CSU because of a proposal to reduce the number of first time freshman at those segments. While we believe the 3 percent growth in general apportionments is reasonable, we are concerned that the $4 million in special growth funding for noncredit instruction deviates from longstanding practice and would hinder the efficient allocation of growth funding.

Equalization Proposal Deserves Broader Consideration and Longer Review. The Governor proposes $80 million to help equalize per-student funding among CCC districts. While we support the goal of equalization, we believe that the state's fiscal situation requires that funding for new programs instead be directed to existing obligations. We nevertheless recommend the Legislature move forward in adopting an equalization plan that reflects its priorities, in order to expedite equalization efforts when funding is more readily available.

Categorical Reform Proposal Falls Short. The Governor proposes a "categorical reform" of funding for some CCC programs. While we agree that the categorical funding of CCC programs is in need of reform, we are concerned that the Governor's proposal lacks adequate accountability measures. In addition, we think that a substantial part of the Governor's proposal would have no meaningful effect on how community colleges are funded.

Additional Budget Options Provided in Perspectives and Issues

As discussed above, we believe that suspending the Proposition 98 minimum guarantee makes sense given the overall budget picture. If the Legislature chooses to suspend the minimum guarantee, we suggest that the Legislature balance its priorities between Proposition 98 funding and other General Fund spending independent of the minimum guarantee requirements. In order to assist the Legislature in the 2004-05 budget deliberations, we provide a list of additional Proposition 98 cut options in "Part V" of the 2004-05 Budget: Perspective and Issues.