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

Proposition 98 Budget Priorities

The Governor's budget proposes to leave 2004-05 Proposition 98 appropriations at roughly the level provided in the 2004-05 Budget Act. The proposal would create $2.3 billion in General Fund savings over two years. While the Governor's 2005-06 spending plan for K-14 grows by $2.9 billion, it does not include funding to cover all K-14 operating expenses that districts would incur under the budget proposal.

Governor's Major Proposals

The Governor's budget proposes an increase in the Proposition 98 guarantee of $2.9 billion in 2005-06 compared to the revised 2004-05 spending level. This increase is sufficient to provide adjustments for K-14 growth in the student populations and the cost of living, a $329 million increase to K-12 school district revenue limits that partially restores reductions made during 2003-04, and $51 million for additional community college growth above the level suggested by demographic growth.

Budget Creates Costs Without Identifying Funding

The Governor's budget for K-14 education also includes several major policy issues that affect schools and community colleges. The budget, however, does not reflect the financial impact of these policy initiatives. Most importantly, the 2005-06 budget proposes to shift from the state to school districts and community colleges $469 million in annual State Teachers' Retirement System (STRS) costs. The state has contributed this amount of non-Proposition 98 funds each year to pay for a portion of the system's costs. Beginning in 2005-06, the Governor's budget proposes that school and community college districts assume responsibility for these costs. No additional funds are proposed in the budget to help school districts pay for these new retirement costs.

The Governor also proposes to shift to school districts fiscal responsibility for mental health services needed by special education students. Under current law, these services are provided by county mental health agencies under a reimbursable state-mandated local program. Based on the most recent county claims, costs of this program totaled $143 million (non-Proposition 98 funds). By shifting responsibility for these services to school districts, the budget would also shift the cost of these mental health services to local education agencies. The special education budget includes $100 million that could be used to pay for these costs. No additional funds are proposed to cover the remaining $43 million of services.

Two other important proposals follow this same pattern. First, the budget includes a major vocational education initiative, requesting $20 million in one-time funds for the community colleges in support of the proposed reforms. Given the Governor's goal—to bring a "renewed emphasis" on vocational education in high school—it seems probable that the long-term cost of the plan would be much larger than the $20 million included in the proposal. Second, a pilot program is proposed to assess the impact of greater school-level control over the use of funding. No support, however, is requested for additional district costs associated with schoolsite budgeting or for the costs of an evaluation to determine whether the reforms increase student achievement.

Proposed Constitutional Amendments Affect K-14

The Governor also called a special session of the Legislature to address four major changes to the State Constitution that would affect school districts or community colleges. Specifically, the proposals:

• Proposition 98. Revamp the constitutional spending requirements of Proposition 98 as part of a larger reform of the state budget process. The measure would eliminate options for the state to reduce Proposition 98 funding levels during difficult budgetary times (Test 3 and suspension). Funding for K-14, however, would be subject to "across-the-board" reductions to the state budget that could occur under certain circumstances.
• Retirement. Prohibit all public agencies in California, including K-12 and community college districts, from enrolling new employees in a retirement plan that guarantees a specific benefit level upon retirement (known as a "defined benefit" plan). Instead, public agencies could only offer new employees (beginning July 1, 2007) "defined contribution" plans. These plans do not guarantee specific retirement benefits, but offer employers and employees certain other advantages.
• Merit Pay and Tenure. Alter existing regulation of local school district employee practices. The proposal would require districts to base employment decisions only on employee performance and the needs of the district and its students. The proposal also would extend from two years to ten years the amount of time teachers must perform satisfactorily before receiving employment protections known as "tenure."
• School Budget Reports. Require school districts to annually report to the public each school's revenues and expenditures.

Current-Year Guarantee Level Is Pivotal

A central issue facing the Legislature in developing the 2005-06 budget is the amount of Proposition 98 spending that ultimately is approved for 2004-05. As part of the 2004-05 Budget Act, the state suspended the minimum Proposition 98 guarantee and set a target appropriation level that was $2 billion lower than the amount called for by the guarantee. The legislation authorizing the suspension—Chapter 213, Statutes of 2004 (SB 1101, Committee on Budget and Fiscal Review)—establishes a target funding level for K-14 education. The target suggests that higher General Fund revenues in 2004-05 would result in an increased funding level and lower revenues would reduce it.

The Governor's budget assumes that General Fund revenues in 2004-05 will be $2.2 billion higher than previously assumed. This would translate into an increase in the minimum guarantee of $1.1 billion in 2004-05. This higher current-year base also results in an increase in the guarantee of $1.2 billion in 2005-06. The budget, however, does not propose to appropriate these funds to schools and community colleges, only making technical adjustments to the current-year funding level. By leaving the level of Proposition 98 spending at roughly the level included in the 2004-05 Budget Act, the Governor's budget frees about $2.3 billion over the two years to help address the state's budget problem.

What Level of Appropriation Is Required in 2004-05? Under the State Constitution, a suspension overrides all other Proposition 98 formulas (or tests) and establishes a new minimum guarantee based on the amount appropriated for K-14 education in that year. Suspension means that any changes to the economy or student population have no impact on the required level of spending. Instead, the guarantee for that year is defined by the amount actually appropriated for schools and community colleges. Because the requirements of Proposition 98 are suspended in 2004-05, the $2.2 billion increase in General Fund revenues has no direct impact on the amount the state must spend.

While Chapter 213 signals the intent of the Legislature to appropriate additional Proposition 98 funding if revenues increased, the statute does not contain appropriation authority. Because the statute does not provide this authority, we believe the Legislature would have to take positive action in the future to do so. Absent such action, the minimum guarantee would "default" to the current level of appropriations. Thus, in our view the Legislature could achieve the $2.3 billion savings simply by not making additional Proposition 98 appropriations in the current year. For transparency, however, we would suggest that the Legislature amend Chapter 213 to clarify that the suspension level for 2004-05 should depend on the amount appropriated, and not a specified amount below the Proposition 98 minimum guarantee. This would eliminate any ambiguity.

LAO Forecast—Higher Revenues, Lower Guarantee

Our updated economic and revenue forecasts indicate that General Fund revenues will be significantly higher in 2004-05 and modestly higher in 2005-06 compared to the administration's revenue forecast. While this is good news for the state's overall fiscal picture, our projected increases would actually result in a lower estimate of the minimum guarantee under Proposition 98 in 2005-06.

Cost of Reaching Chapter 213 Target Would Increase to $4 Billion. Specifically, our forecast projects General Fund revenues will be $1.4 billion higher in 2004-05 and $765 million higher in 2005-06 compared to the amounts assumed in the Governor's budget. Figure 1 shows the impact that these revenues would have on the Proposition 98 obligations relative to the Governor's proposal. First, in the current year, the higher revenues would have no impact on Proposition 98 obligations if the Legislature concurs with the Governor's plan to remain at the current-year funding level ($47.1 billion). If however, the Legislature wanted to meet the target of Chapter 213, the Legislature would need to provide an additional $1.9 billion in the current year (using our revenue estimates). This would lead to an increase in budget-year obligations of $2.1 billion, for a two-year impact of $4 billion in additional costs.

More Revenues But Lower 2005-06 Guarantee? Our Proposition 98 forecast provides an unintuitive outcome. While we forecast higher revenues in both years, the growth rate in revenues between years actually generates a lower guarantee level in 2005-06 than assumed in the Governor's budget. As stated above, we project $1.4 billion higher revenues in 2004-05 and only $765 million in additional revenues in 2005-06. Thus, approximately one-half of the higher revenues are one-time in nature. Since Proposition 98 drives off of year-to-year growth in General Fund revenues, the one-time revenues in 2004-05 actually decrease the year-to-year growth in General Fund revenues between 2004-05 and 2005-06. As a result, the year-to-year growth in Proposition 98 is actually less under our revenue forecast compared to the Governor. Under our forecast, Proposition 98 would grow by $2.5 billion in 2005-06, roughly $420 million less than the Governor.

Balance State and Local Fiscal Needs

We recommend the Legislature base the 2005-06 Proposition 98 spending level on the amount schools and community colleges need to continue current programs.

Our recommendation on the appropriate level of Proposition 98 spending in both the current and budget years reflects our view that the state needs to resolve its structural budget problem by bringing revenues and expenditures into alignment. The Governor's proposal to leave the 2004-05 appropriation level essentially unchanged is a critical component of the budget's plan for closing the budget gap over the next two years. As a result, moderating increases in the minimum guarantee will greatly assist the Legislature in addressing the state's structural budget problem.

We are reluctant, however, to recommend that the Legislature reduce 2005-06 Proposition 98 spending consistent with our revenue forecast (that is, $420 million below the Governor's proposed level). Our lower estimate is an artifact of the Proposition 98 formulas and not caused by a worsening in the state's revenue situation. The May Revision will provide updated information on the overall General Fund condition and amount required under the minimum guarantee for the budget year. That will give the Legislature another opportunity to balance its spending priorities—including K-14 education—with the need to address the state's budget problem as it completes work on the 2005-06 budget.

To develop its Proposition 98 spending plan, we recommend the Legislature develop a budget for schools and community colleges that provides for adjustments in workload and other anticipated costs for 2005-06. This approach has a couple of advantages for the Legislature. First, it helps the Legislature create a funding base that would allow schools and community colleges to continue current programs under most circumstances. Second, developing a workload budget helps ensure that the spending plan adequately funds the workload and costs the budget would impose on schools and colleges.

A workload budget also would provide a base the Legislature could build on if it decides to appropriate a higher level of funds for Proposition 98. If the Legislature wants to follow this path, we recommend using any additional funds to begin reducing the education "credit card" debt—state obligations to schools and community colleges the state has failed to pay in past years. We discuss the credit card debt later in this section.

Building a Base Budget for 2005-06

Figure 2 displays the elements of a current services budget for K-14 in 2005-06. We made the following workload adjustments:

• Growth and Cost-of-Living Adjustments (COLAs). Updating the 2004-05 base for changes in K-14 enrollment and the cost of living adds $2.4 billion. Our estimate of the COLA is slightly higher than the figure used in the Governor's budget—4.1 percent compared to 3.93 percent—and adds $80 million in additional costs to the K-14 budget. Our higher estimate is based on data that were not available at the time the Governor's budget was developed.
• Ongoing Mandate Costs. We added $315 million to our workload budget for the ongoing cost of school district and community college mandates. The last time the state budget included ongoing funding for this constitutional obligation was 2001-02. The Governor's budget would continue the recent practice of deferring all Proposition 98 mandate costs in 2005-06—in effect, borrowing the funds from school districts. We recommend instead the Legislature include ongoing funding for this important state obligation.
• One-Time Funds. Another $185 million was added to restore to the ongoing budget program funding that was supported with one-time funds in 2004-05.

Our current services budget exceeds slightly the amount of the minimum guarantee projected in the Governor's budget and in our alternate estimate of the minimum spending level. Specifically, the current services budget is $43 million higher than the level proposed in the Governor's budget for 2005-06 and $463 million higher than our estimate of the guarantee under our revenue assumptions.

Align Budget With Workload Priorities

We recommend the Legislature delete $382 million for revenue limit deficit reduction and higher community college growth because the proposals represent increases that are not needed to maintain existing programs. In addition, we recommend the Legislature add $315 million for K-14 mandates.

Our current services budget highlights the fact that the proposed budget provides approximately the amount of funds needed to fund a current services budget. The budget contains two main proposals that exceed a current services level of funding—$329 million to restore cuts in K-12 revenue limits and $51 million for "excess growth" in community colleges (that is, above growth in adult population). The savings our budget achieves by excluding these discretionary increases are more than offset by increases for mandate costs and our higher COLA.

Our workload budget also shows that the proposed budget does not fully fund all K-14 costs it would create. Most significantly, the Governor's budget does not fund the ongoing costs of K-14 mandates. In our view, providing a funding source for ongoing K-14 mandates in the base budget constitutes a higher priority than discretionary increases for revenue limits or community college growth.

Therefore, we recommend the Legislature align the budget bill with the spending priorities of our K-14 workload budget. This would require the following specific changes:

• Delete $381 million in discretionary increases—$329 million for deficit factor reduction and $51 million for excess growth in community colleges.
• Restore annual ongoing funding for K-14 mandates ($315 million).

STRS Proposal Lacks Benefits

The Governor's budget also proposes to shift financial responsibility from the state to K-14 education for $469 million in annual contributions to STRS. Later in this section, we discuss this proposal and conclude that the Governor's plan fails to create short- or long-term benefits for the state. In the short run, the proposed shift is intended to save $469 million by requiring K-14 education to absorb these retirement costs. In our view, the proposal may not save the state any funds because we believe the Legislature could have to "rebench" the Proposition 98 guarantee and appropriate the $469 million to schools and community colleges to pay for the increased local retirement contributions.

In the long run, the Governor's proposal does not offer the state, districts, or local employees any significant advantages. For the state, the proposal misses an opportunity to clarify the state's responsibility for long-term retirement fund liabilities. For districts and local employees, the proposal fails to offer additional flexibility over retirement benefits. For these reasons, we conclude that there is no strong rationale to support the STRS proposal. (Please see our discussion of the proposal in the "Crosscutting Issues" section of this chapter.)

K-14 Priorities Under a Higher Guarantee

If the Legislature chooses to provide a higher level of funding than suggested by our workload budget, additional funds would help the Legislature address a number of borrowing issues that have resulted from the lingering budget crisis. We have referred to this as the education credit card to reflect the amounts the state has borrowed from schools and community colleges. Figure 3 displays the "charges" on the education credit card.

The figure shows that our estimate of the credit card debt totals $3.6 billion. The largest charge results from unpaid school district claims for the cost of state-mandated local programs. Funding for mandates in the annual budget act ceased after 2001-02. We estimate that the ongoing cost of mandated programs totals $315 million in 2005-06. The backlog in payments through 2004-05 totals $1.4 billion.

The second largest major contributor to the credit card is $1.3 billion in program deferrals. The deferrals created one-time savings by shifting costs from one fiscal year to the next. For instance, the budget shifts the June payment for school district general purpose funds (revenue limits) to July 1, thereby paying this obligation with funds from the succeeding year's Proposition 98 funds. Until the state pays the $1.3 billion one-time cost to retire this "loan," the state will need to extend this deferral each year if it does not want to negatively impact education programs.

The third element of the credit card is $646 million in revenue limit "deficit factor"—funds saved each year by the state resulting from past reductions in general purpose funding. While past-year savings from these cuts do not have to be repaid, restoring them would build these additional costs into the K-12 base budget. Repaying deficit factor, therefore, requires the Legislature to use ongoing funds. The 2005-06 budget proposes to spend $329 million to partially restore school district and county office revenue limits. If the Legislature wants to provide additional funding to K-14 education in either the current or budget years, we would suggest that it dedicate funds to reduce the outstanding obligations on the education credit card.