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

Governor's Budget-Related Reforms

Description of Provisions

At present, the main vehicle for the budget-related provisions is ACA 4x (Keene). Our description of the proposals generally relies on the language in this measure as introduced. We note, however, that the measure differs in key respects from the descriptions of the proposals contained in the Governor's budget summary. We highlight the differences in our descriptions of the specific provisions below.

The Governor's major budget-related proposals are highlighted in Figure 1 and discussed in more detail below.

Proposition 98

Proposition 98 establishes in the State Constitution an annual funding mechanism for K-14 education, where school spending is based on the interaction of three different "tests." Under the test that is normally operative, total spending for K-14 education is based on the actual amount of Proposition 98 spending in the prior year as adjusted for changes in average daily attendance and per capita personal income. This adjustment is often referred to as the "Test 2" growth factor.

Suspension, Test 3, and Maintenance Factor

Current Law. K-14 school funding can be reduced below the level required by Test 2 when either (1) the guarantee is suspended through a two-thirds vote of the Legislature or (2) an alternative funding formula becomes operative during low-revenue years ("Test 3"). When reductions from the Test 2 funding level occur, a "maintenance factor" is created, which is equal to the difference between actual appropriations and the higher level required by Test 2. In subsequent years, the maintenance factor is restored (thereby causing spending to rise up toward the Test 2 level) through a formula that allocates extra funding to education in above-average revenue growth years. The maintenance factor can also be eliminated through additional appropriations by the Legislature. The operation of Test 3 and maintenance factor allows K-14 education funding to automatically slow down during "bad times" and rise again during "good times."

Proposal. The Governor's proposal would eliminate the ability of the state to suspend Proposition 98. The proposal would also eliminate operation of Test 3 and maintenance factor. Thus, spending could not be reduced below the Test 2 level, regardless of the budgetary circumstances. The maintenance factor outstanding as of June 30, 2006 (along with other items discussed below) would be paid within 15 years. However, in contrast to existing law, the maintenance factor payments (currently estimated to total $3.9 billion at the end of 2005-06) would not raise future Proposition 98 minimum guarantees.

Impact on K-14 School Funding. The net impact of the proposal on K-14 schools would depend on a variety of circumstances. For example:

• If the state experiences above-average revenue growth over the next several years, the changes in the treatment of the existing maintenance factor would result in smaller increases in the minimum funding guarantee than would be the case under current law.
• If the state experiences below-average revenue growth, however, the Proposition 98 minimum guarantee would be higher than under current law, since the measure eliminates both suspension and Test 3.

Treatment of Overappropriations

Current Law. If the Governor and Legislature fund Proposition 98 above the minimum guarantee in a given year, the higher spending level becomes the "base" from which future minimum guarantee calculations are made. In this regard, an overappropriation in one year raises minimum requirements in subsequent years.

Proposal. Under this proposal, overappropriations would be considered "one-time" payments to K-14 schools. They would not raise future minimum guarantees.

Late Budgets and Midyear Adjustments

Current Law

Legislative and Executive Powers. The Constitution vests the power to appropriate funds with the Legislature.The annual state budget is the Legislature's primary method of authorizing expenses for a particular year. The Constitution requires that the Legislature pass a budget by June 15 with a two-thirds vote of both houses. When the Governor receives a budget bill, he or she may either sign or veto it. The Governor may also reduce certain individual appropriations in the budget before signing the measure. However, this line-item veto authority cannot be applied to some programs where expenditures are governed by separate laws. Also, once the budget is signed, the Governor may not unilaterally reduce any appropriations.

Balanced Budget Requirements. As amended by Proposition 58 (approved by the voters in March 2004), the budgets passed by the Legislature and ultimately signed into law must be balanced, meaning that expenditures cannot exceed revenues.

Late Budgets. When a fiscal year begins without a state budget, most state programs do not have authorization to make payments. Over time, however, a number of court decisions and legal interpretations of the Con stitution have expanded the types of payments that may continue to be made when a state budget has not been enacted. Consequently, when there is not a state budget, payments now continue for some portion of state employees' pay, debt service, and various programs authorized in statute or by federal law.

Midyear Adjustments. Under the terms of Proposition 58, if an enacted budget falls out of balance, the Governor may declare a fiscal emergency and call the Legislature into special session to consider proposals to deal with the fiscal imbalance. If the Legislature fails to pass and send to the Governor legislation to address the budget problem within 45 days after being called into special session, it is prohibited from acting on other bills or adjourning in joint recess.

Proposal

The Governor's proposal makes changes relating to late budgets and midyear adjustments.

Late Budgets. If a budget is not enacted prior to the beginning of a new fiscal year, the appropriation levels in the prior year's budget would remain in effect until a new budget is enacted. If the Department of Finance finds that the continuing budget is out of balance by more than $250 million, then the Legislature would be required to send legislation to the Governor within 30 days that addresses the shortfall. After the 30-day period, the administration would be required to calculate a percentage reduction in General Fund spending that would be necessary to eliminate the projected shortfall. The State Controller would then be required to reduce each payment by that percentage until a budget is enacted.

Midyear Adjustments. Following the enactment of a budget, if the Governor finds that the budget is falling out of balance by more than $250 million, he or she is required to issue a proclamation of fiscal emergency and call the Legislature into special session to deal with the emergency. If legislation that eliminates the shortfall is not passed within 45 days, all General Fund appropriations would be reduced proportionally by an amount sufficient to eliminate the shortfall, in the same manner as described above

Application of Proportional Reductions. The proportional reductions would apply to all General Fund spending except for (1) amounts required by federal law and (2) state bonded indebtedness. These reductions would pertain to all contracts, collective bargaining agreements, or laws signed after the effective date of ACA 4x.

Different Versions of Budget Provisions. As described above, ACA 4x exempts payments required by federal law from across-the-board cuts. However, as described in the Governor's Budget Summary, exemptions would only be allowed for payments required by federal constitutional law. Also, under ACA 4x, the across-the-board reductions would be initiated only if the Legislature failed to pass a budget or bill addressing a midyear shortfall. The proposal does not require that these legislative measures be enacted into law. The Governor's Budget Summary, however, suggests that the across-the-board reductions would go into effect if the Governor and Legislature failed to agree on a plan to address the budget imbalance—presumably meaning that such a plan would need to be passed by the Legislature and signed into law by the Governor.

Proposition 42 Transfers

Current Law. Under Proposition 42 (approved by the voters in November 2002), sales taxes on motor vehicle fuel are transferred to the Transportation Investment Fund (TIF) for public transit, capital improvement, and maintenance projects. Proposition 42 included a provision allowing for its suspension when the Governor finds (and the Legislature concurs) that the transfer will have a significant negative effect on General Fund programs. To help address the state's major budget shortfalls, the Governor and Legislature fully or partially suspended Proposition 42 transfers in 2003-04 and 2004-05. Legislation passed with the 2003-04 and 2004-05 budgets designated the suspensions as "loans" from the TIF, which will be repaid in 2007-08 and 2008-09.

Proposal. The state would be prohibited from suspending annual Proposition 42 transfers after 2006-07. The total amount of transfers that were suspended in 2003-04 ($856 million) and 2004-05 ($1.1 billion), as well as any additional amounts suspended through June 30, 2007, would be paid within 15 years, at an annual rate of no less than one-fifteenth of the cumulative amount owed.

Loans From Special Funds

In 2004-05 and prior years, the Governor and Legislature have borrowed balances in special funds to cover General Fund shortfalls. The state currently owes $2.4 billion to these special funds. Under this measure, such loans would be prohibited beginning in 2006-07 (except for short-term cash-flow borrowing purposes). Outstanding loans from special funds as of July 1, 2006 would be repaid within 15 years.

Payment of Obligations Within 15 Years

The measure requires that several items be paid within 15 years. As noted previously, these include suspended Proposition 42 payments, K-14 education maintenance factor payments, and outstanding special fund loan balances. The proposal also requires the following other items to be paid off within 15 years:

• Noneducation local mandates. (We estimate that these claims would total $1.5 billion at the end of 2005-06. Current law requires payment over five years.)
• Education mandates. (We estimate this obligation will total $1.8 billion at the end of 2005-06, payable from within Proposition 98.)
• Proposition 98 "settle up" obligations. (These obligations are estimated to total approximately $1.3 billion.)

Key Issues Relating to Governor's Proposals

Before undertaking major constitutional reforms, we believe that it is important for the Legislature to consider three major issues related to these proposals.

• First, what problems do the proposals address and what criteria should be used for evaluating the proposals?
• Second, how do the proposals stack up and what are the key issues and concerns that they raise?
• Third, are there alternative changes which would more directly address the perceived deficiencies in the current process?

What Problems Do the Proposals Address?

The administration has offered several reasons for its individual proposals. These include the need to (1) eliminate chronically late budgets (2) strengthen the midyear budget-adjustment provisions in Proposition 58, (3) create a more certain funding stream for transportation, and (4) pay off certain obligations.

Administration's Main Concern—Autopilot Spending

The main reason for the constitutional budget reform offered by the administration, however, is the need to control spending. For example, in his budget transmittal letter to the Legislature, the Governor asserts that the problem facing California is "laws that have put much of our spending on automatic pilot," and that "we have a budget system that forces us to spend more than we take in."

What Is Autopilot Spending? There are many factors that affect General Fund spending. These include caseloads and utilization of entitlement programs, federal or state laws, and court decisions. For purposes of this discussion, however, we define autopilot spending as expenditures which arise from predetermined commitments made through state and federal statutes, voter-approved initiatives, collective bargaining agreements, or administration compacts. Some specific examples are shown in Figure 2.

Policy Choices—Not Autopilot Spending—Drive Shortfalls. While the various provisions shown in Figure 2 can create budgeting challenges, we do not believe that they have been the principal factor behind the state's fiscal problems. For example, the large increases in spending that occurred in the late 1990s were largely related to policy decisions to expand funding above the levels required by then-existing formulas. During this period, the state expanded programs in a variety of health and social services areas, and overappropriated the Proposition 98 minimum funding guarantee five years in a row. It also raised state spending for tax relief (mainly in the form of increased funding to local governments to replace—or "backfill"—reductions in the vehicle license fee). The effect of these policy changes was to increase ongoing spending commitments to a level that ultimately became unsustainable when revenues fell in 2001-02.

Why Do We Continue to Face Fiscal Problems? The budget shortfalls have persisted since revenues plummeted in 2001-02 because the Governor and Legislature have not been able to agree on a sufficient amount of ongoing solutions—involving either revenues or expenditures—to bring revenues and expenditures back into line. Much of the annual shortfalls have been covered with borrowing, deferrals, and other one-time factors. Because the state has not sufficiently changed underlying spending commitments or revenue generation, renewed shortfalls occur both as the one-time savings in annual budgets expire and as repayments of past borrowing come due. For example, about $4 billion in projected annual expenditures during the 2006-07 through 2008-09 period is related to repayments of past budgetary borrowing.

Out-Year Prospects. The administration suggests that major reforms are needed because future spending will grow faster than revenues. However, we disagree with that assessment. As noted above, the state faces a structural budget shortfall because policymakers have not been able to agree on sufficient ongoing solutions to cover the gap between revenues and ongoing expenditures. However, once the state resolves its structural imbalance, we project that growth rates in revenues can cover growth in current-law expenditures over the forecast period.

What Are the Main Budgetary Challenges? We believe the main challenges confronting policymakers are related to managing budgets through times of volatile revenues and rapidly changing fiscal circumstances. (We discuss the volatility of the state's revenue structure in a January 2005 report entitled Revenue Volatility in California.) In this regard, provisions in law that direct funding to specific purposes can complicate budgeting. Although most of the provisions can be suspended or modified, these requirements can create a sense of entitlement for certain programs at the expense of others, and can shift the focus toward formulas and away from debates about programs' effectiveness, needs, and relative merits.

What Does This Imply for Reform Proposals? Given the causes of our current structural shortfall and the challenges that lawmakers will continue to face related to volatile revenues, we believe that any reforms should enhance—rather than limit—the amount of flexibility and tools that lawmakers have to manage future budgets.

How Do the Governor's Proposals Stack Up?

We believe that the Governor's specific proposals would not reduce autopilot spending. Rather, they would increase autopilot spending and reduce the flexibility that policymakers need to balance budgets in a rational way. Figure 3 highlights some of the key concerns raised by the proposals.

Proposition 98 Proposal Seriously Constrains Legislative Flexibility

Our main concern with the Proposition 98 proposals is that they would undo the very provisions that voters put in place 15 years ago to deal with the flaws that were perceived to exist with the original versions of the measure. Proposition 111 added Test 3 and maintenance factor to Proposition 98 to allow for slower growth in the guarantee in low revenue years. (A detailed description of how the various provisions of Proposition 98 have worked over time is contained in a report released by our office in February 2005 entitled Proposition 98 Primer.) Since that time, Test 3 has been operative four times. Also, the suspension provision in Proposition 98 (which has been in law since the measure was first enacted in 1988) was used in 2004-05 to help deal with a major shortfall in that budget. Without the maintenance factor and suspension provisions, the state would have needed to find even more major reductions in non-Proposition 98 programs—or more revenues—to balance its budgets in the early 1990s and in recent years. For example, if the state had not been able to suspend the minimum guarantee when the budget was enacted for 2004-05, Proposition 98 would have required the state to provide $3.1 billion more than was actually budgeted—an amount which already funded growth and cost-of-living adjustments and provided limited program expansion. The added funding for K-14 would have necessitated a correspondingly greater amount of solutions from either other program reductions, more borrowing, or more taxes.

The elimination of Test 3, maintenance factor, and the ability to suspend would place the roughly 45 percent of the budget devoted to K-14 education "off limits" for purposes of eliminating fiscal shortfalls. The provisions eliminating future suspension and operation of Test 3 would appear at first blush to be advantageous to schools. However, the much greater amount of solutions that would be required from other budget areas or taxpayers could push the state toward the default of across-the-board reductions (which would apply to Proposition 98 spending), as discussed in more detail below.

Across-the-Board Reductions—A Blunt Tool

The provisions requiring across-the- board reductions to state programs under certain circumstances raise a myriad of serious policy and technical concerns. For example:

• Scope of Federal Law Exclusions Uncertain. It is not clear how broadly or narrowly the courts would interpret the federal law provisions involving benefit entitlements, maintenance of effort requirements, provider rates, and other factors. If a significant amount of spending for health, social services, and criminal justice programs were exempted because of federal law requirements, the impact on remaining spending in education, transportation, and other programs would be relatively greater.
• No Distinction Between High- and Low-Priority Programs. After the federal-law exclusions were made, spending in remaining areas—ranging from the state's highest priorities down to its lowest priorities—would be treated exactly the same.
• Starting Point for Reductions Could Create Inequities. Since the across-the-board reductions arising from a late-budget scenario would be based on prior-year appropriations levels, programs that had taken major one-time reductions in the prior year could be disadvantaged, while programs that received one-time augmentations would be advantaged under the mechanism. Similarly, programs with increasing caseloads could be affected more severely than programs with flat or declining caseloads.
• Late-Year Proclamations Could Require Dramatic Cuts. For example, if the across-the-board reductions were not implemented until May, all of the burden of covering the shortfall would fall on payments made in the final two months of the fiscal year.
• Contracting Could Be More Cumbersome and Expensive. The uncertainties created by the proportional reductions could affect the terms of future contracts entered into with service providers.

Diminution of Legislative Authority. Finally, theacross-the-board reductions that would go into effect when the Legislature could not agree on how to cover a budget shortfall would represent a major shift of authority from the legislative branch to the executive branch of government. The administration's revenue and expenditure estimates would serve as the sole basis for the determination of the existence and size of budget shortfalls. Thus, the administration would have full control regarding the timing and magnitude of emergency proclamations. More fundamentally, the default to across-the-board reductions in the event that the Governor and Legislature could not agree on budget solutions represents a diminution of the Legislature's constitutionally vested power to determine appropriations and make reductions in them.

Issues Raised by Other Provisions

While not of the same magnitude as the Proposition 98 and budget process proposals, the Governor's other proposals raise significant policy issues. For example, the Governor's proposal to pay off existing loans over 15 years would mean less money for transportation programs that, under current law, are scheduled to receive loan repayments in 2007-08 and 2008-09. The Governor's proposal to eliminate the ability to suspend Proposition 42 transfers after 2006-07 means that transportation programs would have somewhat more stable revenue sources in the future. We note, however, that the Proposition 42 transfer would be subject to the across-the-board reductions discussed earlier, causing continued funding uncertainty for transportation programs. The state budget tradeoff is that the proposal to eliminate the suspension would leave the General Fund with still less flexibility to deal with budgetary shortfalls.

Regarding restrictions on future borrowing from special funds, such restrictions would take away another budget balancing tool used by this and previous administrations.

Finally, the inclusion of noneducation local mandates among the items that must be repaid within 15 years would override a commitment made to local agencies last year that would require that these mandates be repaid within five years.

What Alternatives Could the Legislature Consider?

As noted above, we believe that the main longer-term challenge for the Legislature and Governor will be managing budgets in the face of revenue fluctuations and rapidly changing fiscal circumstances. The state has already adopted provisions in Proposition 58—some of which have not yet taken effect—that should help protect the state against revenue fluctuations and instill more discipline in the budget process. These include an enhanced reserve requirement, a balanced budget requirement, a midyear adjustment process, and restrictions on future borrowing.

To this end, we believe that new reforms considered by the Legislature should (1) build on the reforms that have already been enacted by voters in Proposition 58 and (2) provide lawmakers with more flexibility to deal with changing budgetary circumstances. Specifically, the Legislature may wish to consider options that:

• Strengthen Reserve Provisions of Proposition 58. A large budget reserve is potentially a powerful tool for dealing with budget fluctuations. Proposition 58 has a mechanism that would build up substantial reserves to cushion the state against budget shortfalls. If the provisions of Proposition 58 are not considered adequate to ensure a large reserve, the Legislature may consider strengthening the provisions by, for example, making the annual transfers to the reserve more difficult to suspend and payments out of the reserve more difficult to make.
• Unlock Budget. If the goal is to maximize budgeting flexibility, then the solution would be to modify or eliminate the existing provisions in law that earmark General Fund dollars for specific purposes.

Finally, we would generally argue against any delegation of legislative authority to determine appropriations, especially with respect to the enactment of a budget. However, if the Legislature wished to grant limited authority to the administration to deal with, for example, budget shortfalls that emerged when the Legislature was out of session, it could do so by modifying existing provisions of Proposition 58 to include provisions for such a delegation. It would be important, however, that the administration's authority (1) only apply when the state was headed toward a significant shortfall, (2) be limited to once per year (in November or December), (3) apply only to areas of the budget previously specified by the Legislature, and (4) be subject to a predetermined cap.

In summary, we share the administration's basic goals of regaining fiscal stability in California. However, we believe that the specific proposals work in the opposite direction. They would leave the state with more autopilot spending and fewer options to deal with budget challenges that will continue to occur in the future. To the extent that the Legislature wishes to consider budgetary reforms, we believe the emphasis should be on increasing budgeting flexibility and building on existing provisions in the Constitution relating to balanced budgets, midyear reductions, and budgetary reserves.