LAO 2004-05 Budget Analysis: General Government

Analysis of the 2004-05 Budget Bill

Legislative Analyst's Office
February 2004

Tax Relief (9100)

The state provides tax relief—both as subventions to local governments and as direct payments to eligible taxpayers—through a number of programs contained within this budget item. The budget proposes total 2004-05 tax relief of $4.7 billion, of which $668 million is appropriated through the budget bill. The remainder is spending on the vehicle license fee (VLF) "backfill," which is distributed to localities and funded through a continuous appropriation.

After the backfill, the second largest tax relief program is the homeowners' exemption ($433 million), which provides property tax relief to over 5 million homeowners. This program, which is required by the State Constitution, grants a $7,000 property tax exemption on the assessed value of owner-occupied dwellings, and requires the state to reimburse local governments for the resulting reduction in property tax revenues. The exemption reduces the typical homeowner's taxes by about $75 annually. In order to accommodate the expected growth in the number of homeowners claiming the exemption, the Governor's budget proposes an increase of $5.6 million, or 1.3 percent, over the amount budgeted for 2003-04.

VLF Issues

Vehicle License Fee Backfill

Background on the VLF. The VLF is an annual fee on the ownership of a registered vehicle in California, levied in lieu of taxing vehicles as personal property. The revenues are collected by the Department of Motor Vehicles (DMV) and distributed (after deduction of certain minor ad ministrative expenses) to cities and counties. The rate is assessed on the depreciated value of the vehicle according to a set schedule.

Prior to 1991, all VLF revenues were available for local governments to use for general purposes. However, under the 1991 realignment plan, a new vehicle depreciation schedule was put into place and the additional revenues generated by this change were dedicated on an ongoing basis to the support of various health and social services programs subject to the state-local realignment plan. As a consequence, approximately three-fourths of VLF revenues now are general purpose revenues or "base VLF" while the remaining one-quarter is "realignment VLF."

Recent VLF Rate Reductions and Advent of Backfill. Due to the state's then-healthy budget position, the Legislature adopted in 1998 a schedule of cuts in the VLF rate, resulting in a cumulative reduction of 67.5 percent. As a result, the rate fell from the 2 percent level that had been in effect since 1948 down to 0.65 percent by 2000. In conjunction with these VLF reductions, cities and counties continued to receive the same amount of revenue that they would have under the 2 percent rate, with the reduced VLF revenues from vehicle owners replaced by General Fund revenues. Thus, the state made up the difference between what would have been raised with the 2 percent rate and the amount actually raised under the 0.65 percent rate. This spending for local government subventions is known as the General Fund backfill. Statute provides that, in the event that the state has insufficient funds to make backfill payments, such payments are to cease and a corresponding increase in the VLF rate "triggers" so that local governments are held harmless.

Backfill Eliminated and Trigger Pulled. In the January 2003-04 Governor's Budget, the previous administration (as part of its approach to dealing with the state's budget problem) proposed eliminating the base VLF backfill to local governments while continuing the realignment VLF backfill. This would have resulted in General Fund savings in 2003-04 of approximately $3 billion and an equivalent loss to local governments. This proposal was not adopted by the Legislature.

In May 2003, the administration revised its plan, based on its assumption that there would be insufficient monies to fund the backfill, thereby triggering a VLF rate increase. In June 2003, the administration did, in fact, make a determination that there were insufficient funds for the state to continue making General Fund backfill payments to local governments. As a result, the backfill ceased as of June 20, 2003 and the VLF trigger was pulled, resulting in an increase in the VLF rate to the full 2 percent effective October 1, 2003. The "gap" period between when the backfill ceased and the increased VLF rate occurred resulted in a loss in local revenue.

Chapter 231, Statutes of 2003 (AB 1768, Oropeza), provides that lost revenues in 2003-04 would be treated as a loan from local governments and repaid by 2006. (This language may suggest that revenue losses during the June 20 through June 30 period would not be treated as a loan.) The loan amount was originally estimated to be around $850 million. This was later revised to $1.3 billion by the administration, based on cash-flow considerations.

Decision Reversed: VLF Rate Decreased Again. In November 2003, the current administration reversed the previous administration's determination regarding the VLF rate and lowered it once again to 0.65 percent, although no action was taken at that time regarding the General Fund backfill. In December 2003, the administration and Controller acted to pay the full General Fund backfill to local governments for the remainder of 2003-04, even though the Legislature had not provided the required appropriation authority. The Legislature's action in the 2003-04 Budget Act limited the backfill in the current year to $1,000 regardless of the VLF rate (by "in lieuing" the continuous appropriation).

Ongoing Effects of Backfill. As a result of these administrative actions, the 2003-04 budget is expected to result in VLF backfill payments to local governments of $2.7 billion. In addition, the loan amount estimated by the administration totals $1.3 billion as discussed above. For 2004-05, the continuous appropriation will be back in effect, with backfill payments expected to total $4.1 billion.

Legislative Considerations. Given the lack of clarity and agreement over the definition of the gap period as well as the amount of the loan from local governments, the Legislature may want to address these issues in clarifying legislation. This would eliminate uncertainty for both the state and local governments regarding the gap period and its related revenues.

Local Government Hardship

We withhold recommendation on the proposal to appropriate $51 million to provide Vehicle License Fee backfill hardship payments to local governments pending the receipt of additional information from the State Controller's Office.

As part of the 2003-04 budget agreement, the Legislature sought to cushion the impact on certain local governments of their lost VLF revenues during the gap period (as discussed above). For instance, there was specific concern expressed regarding Orange County, which has dedicated VLF revenues to pay off certain bonds. Based on this situation and related concerns with other local governments, Chapter 231 provided for hardship payments under certain circumstances. While Chapter 231 ex presses legislative intent to set aside $40 million for this purpose, it does not provide an appropriation. It also does not specify whether any payments to Orange County are to be included in this amount. To the extent that the Legislature appropriates funds to provide VLF hardship payments to local governments, these payments would reduce the loan from local governments by the same amount.

Hardship Requirements. Chapter 231 established that local government hardship cases would include—but not be limited to—situations involving the following circumstances:

Pursuant to this legislation, the State Controller's Office established an application process for the funding of such hardship situations. In addition, it included a fourth category of qualification for hardship payments—specified as "other." Chapter 231 states that monies advanced under its provisions may be paid by the Controller with the approval of the Department of Finance.

Orange County Payments. Based on its interpretation of debt service requirements relating to Orange County bonds (which the county incurred in the aftermath of its fiscal problems in the 1990s), the Controller determined that the county should receive the full VLF backfill owed to it for the gap period. Consequently, the Controller made full backfill payments to the county from the state General Fund totaling approximately $27 million. Since the Legislature has not appropriated funds for this purpose, it is not clear what appropriation authority the Controller had to make such payments. These are the only hardship payments the Controller has made to date.

Hardship Applications Mount Up. Through January 2004, the State Controller's Office has received hardship applications totaling $63 million, including an additional $9 million request from Orange County—well in excess of the $40 million originally anticipated. In addition, given that there is no date by which applications must be received, it is likely that the total requested amount will increase in the future.

However, based on the information available to us, it is not clear exactly how many of the applications relate to a "true" hardship situation. For example:

In short, it is likely that some applications do not represent specific hardships related to the lack of VLF funding, but represent instead other conditions—such as general fiscal or budgetary stress. The extent to which this is the case is not apparent at this time due to the lack of information provided to the Legislature.

LAO Recommendation. We withhold recommendation on the administration's request for an appropriation of $51 million for local government hardship situations, pending the receipt of additional information from the State Controller's Office. Specifically, the Controller should report on (1) the specific statutory and appropriation authority used to make hardship payments to Orange County, (2) the precise nature of the hardship claims filed by local governments under the "other" as well as "debt" categories, and (3) the validity of the claim amounts filed in relation to the actual amounts necessary to relieve hardship. This information would assist the Legislature in determining (1) the amount to appropriate for hardship payments (including payments to Orange County) and (2) which claims—as well as the portion of such claims—should be considered actual hardships.

Medically Indigent Adult Program

We recommend that the Legislature approve the administration's proposal to retain the current Vehicle License Fee depreciation schedule and preserve revenue support for locally realigned programs.

Background on Realignment VLF. As indicated previously, the VLF (and the corresponding General Fund backfill) is comprised of two components: (1) the base VLF and (2) the realignment VLF. The base VLF may be used by local governments for any spending purpose, while the realignment VLF is restricted to expenditures for programs associated with the 1991 realignment of various health and social services programs. As noted, the realignment portion of the VLF is based on an adjustment to the vehicle depreciation schedule that occurred in 1991 in conjunction with the realignment of programs from state to local control. The change slowed the rate of depreciation for vehicles resulting in an increase in VLF revenues of approximately $1.5 billion annually in today's dollars.

Background on Medically Indigent Adults. In 1982, the state transferred responsibility for the Medically Indigent Adult (MIA) program within the Medi-Cal Program to the counties. The MIA pays for medical care for low-income adults, largely through clinics and hospitals. Funding for the program shift was provided by the state at roughly 70 percent of program costs. Such funding was deemed adequate since the program was not obligated to meet more expensive Medi-Cal standards of care.

Poison Pill Provisions. The 1991 realignment legislation included "poison pill" language, specifying that in the event that the courts find against the state in proceedings relating to the transfer and funding for the MIA, the depreciation schedule adopted as part of the 1991 realignment legislation would be inoperative. If this occurred, the schedule upon which the VLF is based would revert to the one that existed prior to the realignment agreement, and VLF revenues would decline by $1.5 billion.

In September 2003, the Fourth District Court of Appeals found against the state in an MIA case brought by the County of San Diego. The court said that the county expended funds for MIA activities in excess of the amounts provided by the state, and thus the program constitutes a reimbursable mandate. The state was ordered to reimburse the county $3.5 million. The state appealed the decision to the California Supreme Court, which denied the petition for review in December. There are certain administrative steps that would be required prior to the activation of the poison pill—such as notification to the DMV of the change. Nevertheless, the court action essentially starts a process that would rescind the 1991 change in the depreciation schedule.

Statutory Antidote. The administration has proposed statutory changes that would eliminate the poison pill provisions of the 1991 realignment. This proposed measure would keep in place the current programmatic structure of the realigned programs as well as their sources of funding—including the current vehicle depreciation schedule—irrespective of the final disposition of the San Diego case.

LAO's Recommendation. The 1991 realignment was predicated on the receipt of funding from the VLF and other sources to deliver health and social services at the county level. We agree with the administration's efforts to stabilize funding for these programs and are supportive of the administration's statutory proposal that would retain the current vehicle depreciation schedule regardless of the outcome of current or future litigation.

Williamson Act—Subventions for Open Space

We recommend that the Legislature provide for the gradual elimination of payments to local governments for the local revenue losses associated with Williamson Act contracts. (Reduce Item 9100-001-0001 by $3.9 million.)

Background Information. The Williamson Act allows cities and counties to enter into contracts with landowners to restrict certain property to open space and agricultural uses. In return for these restrictions, the property owners pay reduced property taxes because the land is assessed at a lower-than-maximum level. The amount of the state subvention to localities is based on the amount and type of land under contract, but is always less than the actual reduction in local property tax revenues. The Department of Conservation (DOC), which administers the program, estimates that individual landowners save anywhere from 20 percent to 75 percent in reduced property taxes each year, depending upon their circumstances.

The contracts entered into between local governments and property owners are ten-year contracts. Such contracts are typically renewed each year for an additional year, such that the term on the contract remains at a constant ten years. In the event the contract is not renewed, the tax on the property gradually returns over a ten-year period to the level at which comparable but unrestricted land is taxed.

State Role in Open Space. The continued development pressure on open space and agriculture land poses a serious policy challenge for state and local governments. Both levels of government have some role to play in designing and implementing policies that preserve a certain amount of open space, while allowing for appropriate land development and continued economic growth at the state and local levels.

The policy approach embodied in the Williamson Act subvention has the advantage of involving both levels of governments in the process, but we believe there are substantial weaknesses in the program that diminish its overall effectiveness. We have previously questioned the effectiveness of the Williamson Act subventions for several reasons. Our main concerns involve the following issues:

Costs to State Are Substantial. The budget calls for allocating $39.8 million for city and county revenue losses due to the establishment of Williamson Act contracts. In addition, however, the state bears added costs for educational funding since reductions in assessed value also reduce the amount of property taxes flowing to schools. The school share of the property tax is approximately 52 percent; thus, the total state cost for the program is in excess of $80 million annually. Given that the open space subvention represents only a portion of the local property tax loss, it is possible that total costs to the state (subventions plus increased education funding) are substantially higher—although no statewide figures are available.

Explore Open Space Alternatives. Given the state's current budget situation and the issues associated with the Williamson Act program identified above, we do not believe an expenditure of almost $40 million for local subventions is an effective use of funds. While the state clearly has an important role to play in open space preservation, we recommend that the Legislature explore more efficient and permanent solutions to the issues related to open space and development pressures. In addition, we believe there are alternative means for open space preservation at the local level—including the direct purchase of land most at risk of development and the adoption of suitable regulatory and zoning policies.

If, however, the Legislature wishes to continue funding the Williamson Act program, there are certain measures that could be taken that would increase its efficiency and allow the state to exercise more control over its expenditures. For example, the state may wish to be a party to the contract between the local landowner and the county and thus be in a position to safeguard its interests. In addition, it may wish to make the criteria for eligibility for the program more stringent and thus help assure that only those properties genuinely "at risk" of development are allowed to participate in the program.

LAO Recommendation. We recommend that the Williamson Act subventions be phased out over time, reducing the funding for the program 10 percent per year over a ten-year period. This phase-out could be timed to coincide with the gradual increase in property taxes received by local governments as the land returns to its "normal" assessment. It would also allow the state and local governments time to implement new and more effective means of open-space preservation. This approach would save $3.9 million in 2004-05 with the full amount of annual savings realized at the conclusion of the ten-year phase-out period. In addition, DOC's administrative costs to oversee the subvention program—currently around $700,000 annually—would be gradually reduced over the phase-out period.

Return to General Government Table of Contents, 2004-05 Budget Analysis