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

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 2004-05, the budget proposes $31.4 billion from local property taxes and the General Fund for school district revenue limits, an increase of $2.7 billion from the revised 2003-04 budget. Revenue limits represent about two-thirds of all state and local property tax funds districts receive.

Several significant increases account for the rise in revenue limits:

• $1.9 billion due to the proposal to shift funding for 22 categorical programs into revenue limits.
• $545 million for a 1.84 percent cost-of-living adjustment (COLA).
• $293 million to pay for a 1 percent anticipated increase in the number of K-12 students in the budget year.
• $225 million due to significantly higher district Unemployment Insurance ($129 million) and Public Employees' Retirement System (PERS) costs ($96 million).
• $110 million to further equalize school district revenue limits.

These increases are offset by a $447 million reduction due to increases in revenue limit payment deferrals and deficits.

Below, we discuss three issues regarding the budget proposal for revenue limits. First, we review problems with the existing structure of the revenue limit formula. We also examine the budget's proposal to provide equalization funds in 2004-05. Finally, we discuss the 2004-05 Governor's Budget proposed restoration of reductions made in the current year to "excess tax" districts.

Simplify The Revenue Limit Formula

We recommend the Legislature revise the system of district revenue limits by merging funds provided through six "add-on" programs into base revenue limits. This would greatly simplify the computation of general purpose funding, make school funding easier to understand, and allow the state to equalize over time the amount of general purpose funds districts actually receive.

In December 2003, we issued The Distribution of K-12 Education General Purpose Funding, which examines how well the existing system of revenue limits serves the state in creating a reasonably uniform distribution of general purpose funding. The report concludes that the formula has become unnecessarily complex and results in district general purpose funding levels that are significantly less uniform than is usually recognized.

Figure 1 displays the major elements of the revenue limit formula and the budget's proposed amount for each part of the formula. As the figure illustrates, there are ten existing elements in the formula that affect district funding levels. The formula begins with the base revenue limit. The state has assigned each district a base revenue limit, which is based on a variety of historical factors. The base revenue limit is the amount typically used to measure the fairness of the distribution of state funding to districts, and past legislative efforts to equalize general purpose funding has focused on reducing differences in this grant.

Except for Necessary Small Schools (NSS), each of the other elements provides add-on support to districts. That is, for each district that qualifies for the various adjustments, the state adds to—or, in the case of the PERS reduction, reduces—district revenue limit funds. The NSS program is an alternative funding source to revenue limits, and small schools receive NSS funds in lieu of revenue limit funds. In total, the budget proposes to spend $2 billion in state funds and property tax revenues for these nine adjustments to base revenue limits.

Continuation school funding provides a good example of these add-on programs. State law requires all high school and unified school districts to operate a continuation school to provide an alternate educational setting for students. Districts that opened new continuation schools after 1978-79 are eligible for supplemental funding. Funding for schools existing in 1978-79 was added to base revenue limits as part of the Proposition 13 revisions to school finance.

In 2002-03, 361 districts received an average of $53 in additional general purpose funds for each student in the district. The per-student amount varied significantly—ranging from $0.50 per average daily attendance (ADA) to $853 per ADA—in part because the continuation school formula is designed to ensure that very small continuation schools can operate. The other 57 districts operated continuation schools in 1978-79 and, therefore, received no additional funding.

Which Add-Ons Provide General Purpose Funds?

The nine adjustments are similar to the continuation school add-on in several ways. Each alters base revenue limits to reflect the Legislature's action to pay for a specific initiative. Except for one, the adjustments date from the 1970s and 1980s. Finally, the add-ons are similar in that each adjustment treats districts differently, usually for reasons that were important at the time the Legislature created them.

Because the add-ons support a specific funding "program," however, we reviewed each adjustment to determine whether they provide categorical rather than general purpose funding. We developed two criteria for determining whether the adjustments—from our perspective—should be considered general purpose funding:

• First, is the funding free of any state-imposed conditions on districts that accompany the money? If the answer is yes, the funds are clearly general purpose in nature.
• Second, if the answer to the first test is no, do all (or virtually all) districts participate in a program supported by the funds? If the answer to this question is yes, the activities are, in essence, a part of the base program for K-12 schools in California and the supplemental funds should be considered general purpose.

After reviewing the nine add-on programs, we conclude in our report that eight of the nine adjustments provided general purpose funds. The only adjustment that we identify as categorical in nature is the Minimum Teacher Salary Incentive program. Below, we briefly discuss how the eight add-ons meet our criteria as general purpose funds.

Funds That Are Free of State-Imposed Conditions. Three of the eight adjustments place no state requirements on districts in exchange for the additional state funds, as follows:

• Necessary Small Schools. This program supports the cost of very small schools that operate in small districts. The program operates as an alternate funding source rather than as a supplement to base revenue limits—that is, districts do not receive a base revenue limit for students attending a school funded through the small school program. The higher level of funds provided through this program may be used for any district cost.
• Excess Tax Revenues. In 2002-03, property tax revenues in 60 districts exceeded these districts' revenue limit entitlement. Districts are permitted to keep these additional local revenues, which may be used for any district purpose.
• Meals for Needy Pupils. This program provides funding to districts that enacted property tax levies to support free or reduced-price meals prior to Proposition 13. Despite the name of the program, the 372 districts receiving these funds have complete freedom over their use.

Programs in Which All Districts Participate. Five programs met our criteria as general purpose funds because the programs have become part of the state's "base" K-12 education program. These programs include:

• SB 813 Incentive Programs. Three programs created by Chapter 498, Statutes of 1983 (SB 813, Hart), provide incentive funds to districts in exchange for increasing instructional time and teacher salaries. Since virtually all districts participate in these programs, the programs have become part of the state's base K-12 education program, and the incentive money is essentially general purpose funding. In fact, both the state Departments of Education and Finance include these incentives in their cost estimates of base revenue limits (although the payments are excluded for equalization purposes).
• Interdistrict Attendance Agreements. Since 1993, state policy has encouraged interdistrict attendance. The state does not, however, provide additional funds to districts that allow students to use "choice" to attend school in a different district that where they reside. Two districts, Capistrano Unified and Fallbrook Union High, receive a revenue limit adjustment pursuant to an interdistrict attendance agreement affecting the two districts. As a result, funding provided for this arrangement constitutes an increase in general purpose funding for the two districts.
• Continuation Schools. The state provides additional funds for continuation schools created after 1978-79. Since state law requires all unified and high school districts to operate at least one continuation school, this program's subsidies result in an increase in general purpose funds to districts that have opened continuation schools more recently.
• Unemployment Insurance (UI) Reimbursement. This program pays district UI costs that exceed the amount each district incurred in 1975-76. All districts are required to participate in the UI program. By paying for these costs, the state increases general purpose funding to districts.
• PERS Reduction. This adjustment reduces the amount of general purpose funds districts receive by the difference in each year's PERS contribution rates and the rate required in 1981-82. Virtually all districts experience a reduction in revenue limit funds because of this adjustment. If it did not exist, districts would have a larger amount of general purpose funds.

One revenue limit add-on, the Minimum Teacher Salary Program, did not meet our criteria because a relatively large proportion of districts—about 13 percent—do not participate in the program. Even this program, however, was a close call. For many districts, the incentives clearly are general purpose funds, as districts were eligible for incentive payments even if their minimum salaries exceeded the program's required minimum at the time the program was established.

Add-Ons Distort Funding Distribution

The eight adjustments add an average of $238 per ADA in large unified school districts. Figure 2 displays the average per-pupil amounts this group of districts received for base revenue limits and the eight add-on programs in 2002-03. The data do not represent actual figures for any one district. Instead, they represent the average amounts distributed to all large unified districts through the various adjustments in the revenue limit calculation. 

Figure 2 also shows the high and low amounts large unified districts actually received for base revenue limits and each adjustment in 2002-03. The range in base revenue limits is about $2,200 between the highest- and lowest-funded large unified districts. After including funding from the add-on programs, the range is more than $6,000 per pupil. While excess property taxes and Meals for Needy Pupils contribute the largest increases, several of the other adjustments provide per-pupil increases in the hundreds or thousands of dollars to some districts while providing other districts nothing. Even the SB 813 Incentive programs—in which all large unified districts participate—show a $215 per pupil difference between the highest and lowest funding level.

Because some districts receive large increases through the add-on programs while other districts receive little, the adjustments to base revenue limits increase disparities in district general purpose funding levels. In 2002-03, 66 percent of large unified districts received a base revenue limit that was within $100 per ADA of the average for the group. Using our definition of general purpose funding, however, only 22 percent of these districts fell within $100 per ADA of the $4,809 average general purpose funding level received by large unified districts. 

Consolidate Add-Ons Into Base Revenue Limits

We recommend the Legislature revise the revenue limit formula by consolidating six of the add-on programs in the current formula into one general purpose grant. This would have several important benefits. From a fiscal standpoint, folding these adjustments into the base revenue limit 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.

A second important benefit of the consolidation is that it would simplify the state's funding system. This would reduce an extensive amount of state and district paperwork and add transparency about school funding for the education community, policy makers, and parents. Thus, by simplifying this part of the state's funding system, our proposal is consistent with one of the goals of the Governor's categorical reform plan.

For these reasons, we recommend the Legislature consolidate the following revenue limit adjustments into district base revenue limits: Meals for Needy Pupils, SB 813 Incentive Programs, Interdistrict Attendance, Continuation Schools, Unemployment Insurance, and the PERS Adjustment. We recommend against including the NSS subsidy in the base because the current program allows the state to tailor these grants each year as the size of the school and other conditions warrant. In addition, excess tax revenues also should not be included in the consolidation, as this would permanently award the higher funding levels resulting from the high level of property tax revenues to these districts.

Delete Equalization Funds

We recommend the Legislature delete $110 million in General Fund support for revenue limit equalization proposed by the Governor due to the state's fiscal situation. We also recommend the Legislature adopt trailer bill language directing the Quality Education Commission to establish new equalization targets for small school districts.

The 2004-05 Governor's Budget proposes $110 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, historic differences in revenue limit funding levels have no analytical foundation to suggest that these differences reflect local need for general purpose funds.

Given the state's fiscal situation, however, we recommend the Legislature delay equalizing revenue limits to future years. This would pro vide the Legislature with $110 million in General Fund support that could be used to reduce the structural budget gap between ongoing state program costs and General Fund revenues.

If the Legislature desires to maintain Proposition 98 appropriations at the level proposed in the budget, we recommend using the $110 million to reduce the Proposition 98 "credit card" obligations. As discussed earlier in this chapter, the budget proposes to continue the current-year level of payment deferrals ($1 billion) and revenue limit "deficits" ($900 million). In addition, the budget proposes to defer paying the $300 million budget-year cost of state mandated local programs (bringing total deferred mandate costs to more than $1.5 billion).

For instance, using the $110 million on a one-time basis to reduce the proposed level of deferrals would generate two benefits. First, by improving district cash flow, reducing the level of deferrals would improve district finances. Second, using the funds for this one-time purpose would provide the Legislature with additional discretionary funds in 2005-06. This would help ensure that funds are available in the future to adequately support base K-12 programs.

Assess "Size and Type" Funding Distinctions

The budget's proposal to equalize revenue limits sets a goal of bringing all districts to the amount currently provided to the district at the ninetieth percentile of all districts within each size and type. This is calculated by listing all districts beginning with the lowest-funded district and counting the average daily attendance of each district until the ninetieth percentile student is reached. The base revenue limit of that student's district would establish the proposal's long-term equalization goal.

In comparing revenue limits, the state groups districts by size (large and small) and by type (elementary, unified, and high school). These groupings were created by the Legislature in the 1970s and are based on the idea that some types of districts (small and high school) are more costly to operate than others (large and elementary). For instance, certain fixed costs—such as a superintendent and school board—result in some administrative costs which are higher (on a per-pupil basis) in small districts than in large districts. Unified district funding levels were intended to reflect a blend of elementary and high school district funding levels. While in theory these size and type funding differentials make sense, we are not aware of any assessment of whether the current funding levels are appropriate.

In the past, state equalization efforts have increased district base revenue limits to the previous year's average for each size and type. Because of historical factors, however, the average for some size and type groups was disproportionately affected by a relatively small number of very high funded districts. As a result, these groups of districts experienced significantly larger equalization increases than other groups. This occurred simply because of the way equalization was implemented and not for particular policy reasons.

Proposal Has Unintended Consequences. The approach proposed in the Governor's budget is intended to treat different types and sizes of districts similarly. Unfortunately, district data from 2002-03 indicate the budget proposal would result in somewhat arbitrary increases that would further distort average revenue limits for districts of different sizes and types. Figure 3 shows the 2002-03 median (or fiftieth percentile) and ninetieth percentile revenue limits for the six size and type groups. The difference between these two figures is the amount a typical district would receive if the equalization targets proposed by the budget were fully funded. For instance, the median large unified district would receive a $68 revenue limit increase (1.5 percent). By comparison, the median small unified district would receive a $206 increase, or 4.2 percent. The smaller adjustment for large districts is due to the fact that their revenue limits are much more uniform than for small districts.

The figure shows that the budget proposal would result in significantly different increases for districts in the different size and type groupings. For instance, the budget proposal would give small unified districts a 4.2 percent increase but only a 1.5 percent increase to large unified districts. If we assume the current median revenue limit represents the relative costs of each size and type, the budget proposal would distort these relationships by providing very different amounts to districts in the various groups.

The problem with the budget proposal is that it would equalize revenue limits based on the existing distribution of revenue limits (ninetieth percentile district) rather than on an amount that is derived from the relative costs facing districts in each size and type category. Because of the many changes made to revenue limits in the past 25 years, we think equalizing based on the current distribution of revenue limits, such as the budget proposes, would result in equalization targets that are somewhat arbitrary and may have unintended consequences. For this reason, we believe the state should reexamine the size and type categories and develop new equalization targets.

Quality Education Commission Should Examine Targets. We think the state Quality Education Commission could develop new targets relatively easily as an extension of what it is already required to do by state law. The commission was created by the Legislature in 2002 to develop an estimate of reasonable funding levels needed to allow all students to meet state performance levels. The authorizing legislation requires the commission develop adequate funding levels for elementary, middle, and high schools. This information would provide the data needed to establish new targets for large districts.

Existing law, however, does not require the commission to examine the differential for small districts or to reassess the existing definitions of small districts. Given the large number of districts that qualify as small under existing definitions, it would seem reasonable for the commission to revisit these issues as part of its work. Therefore, to provide the Legislature with the information to establish sound equalization targets for all types and sizes of districts, we recommend the Legislature adopt trailer bill language to require the commission to develop definitions of the appropriate maximum size of a "small" elementary, unified, and high school district and the adequate funding level needed by these districts.

Reinstate Reductions for Basic Aid Districts

We recommend the Legislature enact trailer bill language to reduce $9.9 million in funds proposed to restore categorical program reductions to "basic aid" districts until the state also restores the 3 percent revenue limit reductions for all other K-12 districts.

The 2003-04 Budget Act reduced district base revenue limits by about 3 percent. This reduction (also known as the revenue limit "deficit") was accomplished in two parts. First, base revenue limits were reduced to offset the statutorily required 1.8 percent COLA in 2003-04. Second, an additional 1.2 percent reduction was applied to the 2002-03 funding levels. The budget proposes to continue these reductions in 2004-05 for a savings of $907 million.

The Legislature also reduced funding for basic aid districts by a similar proportion. The State Constitution requires the state to provide a minimum of $120 per pupil (or $2,000 per district, whichever is higher) in state "basic aid" funds. Districts receiving basic aid payments receive all or almost all revenue limit funds from local property taxes. In 2002-03, the state provided this minimum level to 61 districts through the revenue limit.

In 2003-04, the Legislature made two changes to funding for basic aid districts. First, it eliminated the revenue limit payment of $120 per pupil by counting categorical funding toward the constitutionally required minimum. Second, because basic aid districts receive no or almost no state revenue limit funds, the Legislature reduced categorical program funding for these districts by up to 3 percent of their base revenue limits. This resulted in a $9.9 million savings to the state. Each district was required to identify the categorical programs from which funds would be taken to accommodate this reduction.

The 2004-05 budget proposes to restore the $9.9 million reduction to categorical funds of basic aid districts. According to the Department of Finance, it believes the reduction was intended as a one-time savings. While the Legislature drafted the statutory language implementing this reduction to apply only to the current year, this does not necessarily imply the Legislature intended to restore the reduction to basic aid districts while maintaining the cuts to revenue limits. In fact, the Legislature also enacted trailer bill language as part of the 2003-04 Budget Act that expressed its intent to eliminate the 3 percent revenue limit reduction as soon as possible.

In our view, the Legislature made the reduction to basic aid districts in an attempt to implement a consistent base funding reduction to all districts. Treating basic aid districts and all other districts inconsistently seems at odds with this intent. Therefore, we recommend the Legislature adopt trailer bill language to eliminate $9.9 million proposed to backfill in 2004-05 the current year cut to basic aid districts. By making this reduction, the Legislature would have additional funds to meet its other budget priorities or reduce the structural General Fund gap between revenues and expenditures.