Analysis of the 2005-06 Budget Bill Legislative Analyst's Office February 2005

State Fiscal Picture

The state continues to face a substantial structural shortfall in its General Fund budget. The Governor's budget released in January proposes to eliminate the shortfall in 2005-06 through significant program reductions (mainly in K-12 education, social services, and employee compensation), a suspension of Proposition 42 payments, and the use of $1.7 billion in remaining deficit-financing bonds. The Governor has also called the Legislature into special session to consider several Constitutional changes involving the budget process, Proposition 98, pensions, and transportation funding.

LAO Bottom Line

2005-06 Budget. We believe that revenues will be significantly higher and expenditures will be slightly lower than forecast by the administration. As a result, we estimate that adoption of the Governor's budget would result in a 2005-06 budget reserve of $2.9 billion, or $2.4 billion more than assumed in the budget. Adoption of the plan would also significantly reduce the longer-term structural shortfall facing the state, although a significant shortfall would persist.

While this improvement is a welcome development, it is important to keep in mind that it depends on adoption of ongoing savings that are similar in magnitude to those proposed by the Governor. As it establishes its priorities for 2005-06, the Legislature should aim at achieving the magnitude of ongoing solutions proposed in the budget.

Reforms. As we discuss in "Part V," we believe that the proposed budget reforms work against the administration's goal of reducing autopilot spending and addressing future shortfalls. Before adopting reforms, it will be important for the Legislature to determine what is wrong with the structure of the present budgeting system, and what actions will most effectively remedy the problem.

The Budget Proposal

The Budget's Economic and Revenue Projections

The U.S. and California economies expanded at a healthy pace in 2004, leading to major gains in business-related earnings, and moderate growth in employment and wages. The major growth in business profits resulted in sharp increases in state tax receipts in the first half of 2004-05.

The budget forecast assumes that economic growth will continue at a moderate pace in 2005 and 2006, with jobs and personal income benefiting from an accelerated pace of hiring by businesses. Reflecting the recent gains in tax receipts and continued growth in the economy, the budget assumes that revenues from the state's major taxes will increase by 8.7 percent in the current year and by 7 percent in 2005-06.

Total State Spending

The budget proposes total state spending in 2005-06 of $109 billion (excluding expenditures of federal funds and bond funds). This represents an increase of 4.4 percent from the current year. General Fund spending is projected to increase from $82.3 billion to $85.7 billion, while special funds spending rises from $22.1 billion to $23.3 billion.

General Fund Condition

Figure 1 shows the General Fund's condition from 2003-04 through 2005-06 under the budget's assumptions and proposals.

• 2003-04. The prior year concluded with a positive reserve of $2.9 billion. The reserve amount is up significantly from the $2.1 billion assumed in the 2004-05 Budget Act, due toboth higher-than-expected revenues and lower-than-expected expenditures for 2003-04 and prior years.
• 2004-05. In the current year, the budget assumes that revenues will be $78.2 billion and expenditures will total $82.3 billion. The resulting $4.1 billion operating deficit is covered through (1) the use of $2 billion in deficit-bond proceeds and (2) $2.1 billion of the carry-over reserve from 2003-04. This leaves the current year with an estimated reserve of $783 million.
• 2005-06. In the budget year, General Fund revenues and transfers are projected to increase to $83.8 billion, or $1.9 billion less than the proposed expenditure total of $85.7 billion. The budget bridges the gap between revenues and expenditures with $1.7 billion of the remaining deficit-bond proceeds, and a $0.3 billion drawdown of the reserve balance. This leaves 2005-06 with a year-end reserve of $500 million.

How the Plan Addresses the Budget Shortfall

The Governor's budget includes about $9.1 billion in solutions to (1) eliminate a projected budget deficit of $8.6 billion and (2) build a small reserve of $500 million. About $1.1 billion of the savings are proposed for the current year, and $8 billion are proposed for 2005-06. Figure 2 allocates the budget's proposed solutions into four main categories—program savings, funding shifts, loans, and revenues.

Program Savings. About one-half of the solutions fall into this category. The main proposals are:

• Proposition 98 Education. The administration is proposing to hold Proposition 98 spending roughly at the 2004-05 Budget Act level (instead of providing schools with additional funds to meet the target suggested by language adopted with the 2004-05 budget). This results in state Proposition 98 savings of slightly over $1.1 billion in each of the current and budget years.
• Social Services Grants. The budget proposes a 6.5 percent reduction in California Work Opportunity and Responsibility to Kids (CalWORKs) grants beginning in the budget year, plus the elimination of the statutory cost-of-living adjustment (COLA) for CalWORKs grants. It would suspend COLAs for Supplemental Security Income/State Supplementary Program grants in the budget year.
• Employee Compensation. The budget proposes $408 million in employee compensation savings from (1) an increase in state employees' share of annual retirement contributions, (2) a reduction in state holidays, and (3) employee furloughs. These changes would need to be negotiated through the collective bargaining process.
• Noneducation Mandate Suspensions. The budget would suspend most noneducation mandates in 2005-06, for a savings of $219 million.
• In-Home Supportive Services (IHSS) Wage Participation. The budget proposes to limit state participation in IHSS provider wages to the minimum wage, rather than the $10.10 per hour level currently authorized.
• Senior Citizens' Property Tax and Renters' Assistance Programs. The budget proposes elimination of the senior citizens' property tax assistance program and a reduction in the senior citizens renters' tax assistance program.
• Other Savings. The remaining $599 million in savings is related to a variety of proposals throughout the budget. These include: a package of Medi-Cal reforms such as a modification of dental benefits for adults; tiered reimbursements for child care providers for CalWORKs recipients and the working poor; procurement savings; and an across-the-board reduction to state operations.

In other areas, the budget provides funding for workload and, in some cases, price adjustments. It proposes funding increases for higher education consistent with the Governor's compact with the University of California and California State University.

Funding Shifts. In this area, there are three main proposals. First, the administration is proposing that the state no longer fund annual base program contribution costs for the State Teachers' Retirement System. Under the proposal, these costs would be borne by the school districts or their employees. Second, the budget proposes to retain Public Transportation Account "spillover" funds in the General Fund in 2005-06, instead of transferring them to transportation-related special funds, as is required by current law. Third, the budget proposes to replace General Fund support for certain prenatal care services with new federal funds.

Loans. In this area, the administration is proposing the following:

• It would use $1.7 billion of the remaining deficit-financing bonds in 2005-06, leaving slightly less than $2 billion of the original $15 billion in Proposition 57 related bonding authority for 2006-07 and beyond.
• It would suspend the Proposition 42 transfer of sales taxes on gasoline from the General Fund to transportation funds. The budget proposes to repay the suspended amount under certain conditions. Specifically, the Governor's reform proposal includes a provision requiring that all Proposition 42 payments suspended prior to 2007-08 be paid off over a 15-year period beginning in 2007-08.
• It would issue a "judgment bond" to finance a pending $464 million settlement of flood-related litigation (Paterno case) against the state.
• It would defer about $31 million in noneducation local mandate payments.

In addition to these proposals for new borrowing, the budget assumes $765 million in proceeds from pension obligation bonds that will be sold in the budget year. This amount is not shown in Figure 2 (which highlights new proposals), because the pension bonds were previously authorized in the 2004-05 budget package.

Revenues. The budget does not include proposals for state tax increases. It does, however, include some funding for increased tax compliance (see discussion in "Part III" of this document).

Ongoing Savings in Budget Plan

Of the $8 billion in solutions proposed for 2005-06, slightly over $4 billion are ongoing in nature. We estimate that these savings would expand to roughly $5 billion in 2006-07, as the full-year impacts of some of the grant reductions and other proposals take hold.

Budget's Reform Proposals

In addition to the 2005-06 budget, the Governor is proposing several changes to the state Constitution. These changes, which are discussed in "Part V" of this document, involve Proposition 98, the budget process (including a provision for automatic across-the-board reductions), and pensions for future state employees. They also would prohibit future suspensions of Proposition 42 transfers to transportation and borrowing from special funds. Finally, the proposal would require that certain outstanding obligations be paid off within 15 years.

LAO Outlook

In this section, we examine the implications of the Governor's 2005-06 budget on the near-term and longer-term General Fund condition, using our own revenue forecast and our estimates of the impacts of the Governor's proposals. Our estimates do not reflect any of the programmatic recommendations that we make in our 2005-06 Analysis of the Budget Bill. The causes of our differences from the budget projections are limited to (1) assumptions about the economic and revenue outlook and (2) estimation differences 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 2005-06 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 3, while our estimates of revenues, expenditures, and the General Fund's condition are shown in Figure 4.

2005-06 Budget Would Have $2.9 Billion Reserve

As indicated in both Figures 3 and 4, we estimate that if all of the budget's proposals were adopted and nearly all of its savings realized, the state would end 2005-06 with a reserve of $2.9 billion, or $2.4 billion more than assumed in the Governor's budget. Of the total, $2.2 billion is related to higher revenues and about $250 million is related to lower costs.

Higher Revenues. Total revenues in December and January were up from the administration's new budget forecast by over $800 million, reflecting stronger-than-expected year-end estimated payments by individuals and corporations toward their 2004 income tax liabilities. As discussed in "Part III," these year-end payments often provide an early indication of the strength of payments associated with final returns remitted in March (for corporations) and April (for individuals). Coupled with other evidence that California concluded 2004 on a strong note, we are forecasting that the revenue trend is higher than assumed by the administration. Accordingly, we are projecting that revenues will exceed the budget forecast by $1.4 billion in the current year and $0.8 billion in 2005-06.

Lower Costs. Our expenditure total is down from the administration by $152 million in the current year and $104 million in the budget year. We estimate that local property taxes available to Proposition 98 education will be higher than estimated by the administration. This would reduce, dollar for dollar, the amount of General Fund spending that is needed to meet the guarantee. Partly offsetting these savings are higher costs that we anticipate in trial courts, noneducation mandates, corrections, and other state operations.

Reserve Estimate Provides Overly Optimistic Picture Of State's Fiscal Condition

The higher reserve we are projecting would clearly be a positive development for the state. We warn, however, that it is subject to the following important qualifications:

• First, the 2005-06 budget includes $1.7 billion in proceeds from deficit-financing bonds. Absent these borrowed funds, the reserve would be about $1.3 billion.
• Second, the year-end reserve balance will be needed in 2006-07, when temporary solutions (such as the two-year diversions of local property taxes and onetime proceeds from pension obligation bonds) expire and past obligations come due. As indicated in Figure 4, even if the full reserve were carried over and used to support expenditures in 2006-07, that fiscal year would still conclude with a deficit of about $1.1 billion.
• Third, the budget faces many risks. In particular, it continues to assume the sale of a $765 million pension-obligation bond originally authorized in 2004-05, which is currently subject to court challenge. The $408 million in employee compensation savings are dependent on collective bargaining negotiations. The budget also includes savings from unallocated reductions to state operations in most program areas, and procurement reforms are anticipated to generate more savings in the budget year. Savings related to collective bargaining negotiations, unallocated reductions, and procurement reforms, however, have often fallen short of expected levels in the past.

Budget Reduces, But Does Not Eliminate, State's Structural Shortfall

Assuming our revenue forecast, this budget makes significant progress toward resolving the state's out-year structural budget shortfall, but still leaves a significant portion of the gap to be dealt with in future years.

Current Law Shortfalls. As background, in November we indicated that under current law, the state faced annual operating deficits (that is, shortfalls between current revenues and expenditures) reaching a peak of $10 billion in 2006-07 and averaging roughly $9 billion in the subsequent two years.

Out Years Under Governor's Budget. The Governor's budget plan would eliminate over one-half of the current-law operating shortfalls. The estimate takes into account the ongoing solutions in the Governor's plan, the administration's stated intention of suspending the Proposition 42 transfer in 2006-07, and the elimination of COLAs for CalWORKs grants. As shown in Figure 5, the annual shortfalls under these assumptions would be about $4 billion in 2006-07, $4.5 billion in 2007-08, and $3.3 billion in 2008-09.

The $4 billion operating shortfall in 2006-07 could be covered with the $2.9 billion in carry-over reserves and remaining deficit-financing bond proceeds. Because these one-time resources would then be nearly exhausted, the state would need to find additional savings to cover the operating shortfalls in 2007-08 and 2008-09.

"Consolidation Proposal" Would Reduce Shortfalls in 2007-08 and 2008-09. As discussed in "Part V," one of the Governor's budget reform proposals involves the consolidation and payment within 15 years of outstanding obligations related to transportation, education, local governments, and special funds. If this proposal were implemented, the state could save about $1 billion relative to current law in both 2007-08 and 2008-09 (when large transportation loan repayments would otherwise be due). However, the net impact of the consolidation on the state's overall fiscal condition in subsequent years is uncertain, and would depend on a variety of factors.

Operating Shortfalls Do Not Include Reserve Contributions. Under the terms of Proposition 58, the state is required to make annual transfers into a newly created budget stabilization account beginning in 2006-07. The annual transfers are 1 percent of revenues in 2006-07 ($880 million), 2 percent in 2007-08 ($1.9 billion), and 3 percent in 2008-09 ($3 billion) and thereafter until the balance in the reserve reaches $8 billion. The annual transfers can be suspended by the Governor during periods in which the state is facing fiscal shortfalls. Given the state's ongoing structural shortfall, we have not added the costs of these transfers to our calculation of future operating shortfalls. Inclusion of these transfers, however, would increase the size of the out-year funding gaps that would need to be covered.

Impacts of Adopting Fewer Ongoing Solutions. The improvement in the state's projected longer-term fiscal picture is predicated on the Legislature adopting ongoing solutions that are similar in magnitude to those in the Governor's budget. Absent these savings, the out-year budget shortfalls will remain formidable. As one illustration, if the Legislature were to reduce the magnitude of ongoing solutions in the 2005-06 budget by $2.5 billion relative to the Governor's budget, the out-year operating shortfalls (the difference between current revenues and expenditures) would expand to roughly $7 billion (see Figure 5).

Considerations for the Legislature

The Legislature faces significant policy decisions related to both the Governor's specific proposal for balancing the 2005-06 budget, and his longer-term reform proposals.

Aim at Ongoing Solutions Similar in Magnitude to Governor's Proposal. Regarding the budget, we strongly urge the Legislature aim at achieving ongoing solutions in 2005-06 that are of similar magnitude to those proposed in the budget. This is because in 2006-07 the state will face a $4 billion operating shortfall even if all of the budget's solutions are adopted. As illustrated in Figure 5, if the magnitude of ongoing savings is diminished significantly, the out-year problem becomes much more formidable.

Be Cautious About Reforms. Regarding the Governor's reform proposals, we strongly support the objectives of eliminating the state's long-term structural problem, paying off its debts, and maintaining balanced budgets in the future. However, we believe that specific proposals relating to Proposition 98, Proposition 42, and the across-the-board reduction work against these goals. As we discuss in "Part V," before undertaking major Constitutional reforms, it will be important for the state to have a clear understanding of "what is broken" in the existing process, and what steps would most directly address the problems without compromising other objectives of good fiscal policy.

For instance, the administration suggests that a key problem is that state spending is on autopilot. If the Legislature believes that this is the case, the solution would not be placing more spending on cruise control—as the administration is proposing for Proposition 98 and other areas of the budget. The solution would be to eliminate these types of provisions that limit the Legislature's and Governor's authority to make annual budgetary decisions.

Similarly, the perceived deficiency may be that the recently enacted balanced-budget and mid-year correction provisions in Proposition 58 are not adequate to maintain fiscal balance. If so, there may be alternative proposals which strengthen the existing process while not diminishing the Legislature's central authority in budgetary appropriations.