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

Special Education

In 2003-04, 682,000 students age 22 and under were enrolled in special education programs in California, accounting for about 11 percent of all K-12 students. Special education is administered through a regional planning system consisting of Special Education Local Plan Areas (SELPAs). In 2003-04, there were 116 SELPAs.

Figure 1 displays the amounts proposed for special education in 2004-05 and 2005-06. The Governor's budget proposes total expenditures of $4.4 billion for special education in 2005-06, an increase of $215 million, or 5.1 percent. Under this proposal, General Fund support for special education would increase by $135 million or 4.9 percent. The budget proposes sufficient funding to accommodate a projected 0.79 percent increase in the number of students in the state, a 3.93 percent cost-of-living adjustment (COLA), and an augmentation of $25 million to base SELPA funding levels.

Our review of the 2005-06 proposed budget identifies several major issues:

• Technical Budgeting Issues. There are two significant technical issues with the proposed special education budget. Addressing these issues would increase the Legislature's fiscal flexibility in the budget year.
• Mental Health Services. The Governor's proposal does not provide a long-term solution regarding the provision of mental health services for special education students.
• Incidence Adjustment. The budget includes no proposal for updating the special education incidence adjustment, despite the fact the adjustments are based on data that is now eight years old.

We discuss these issues in detail below.

Technical Issues Offer Savings

The state's special education budget is supported from three sources: local property tax collections, federal special education funds, and the state General Fund. Together, the state uses these three sources to maintain a system of relatively uniform per-pupil SELPA funding levels.

The Department of Finance (DOF) developed the 2005-06 special education budget by adding funding for the anticipated level of growth in the student population in 2005-06, a COLA, and other adjustments to the 2004-05 special education budget. As part of that process, DOF revised the 2003-04 and 2004-05 figures to reflect more recent estimates of program expenditures and growth in the student population. These base adjustments are important, as they can have a significant effect on the 2005-06 budget proposal.

We have identified two major technical budgeting issues with the 2005-06 special education budget that could reduce program costs by $61 million. First, we propose an alternative method for calculating the amount of federal funds that can be counted as an offset to the General Fund. Second, we identify technical problems in the special education budget that would, if corrected, generate significant General Fund savings.

Revise Federal Supplanting Calculation

We recommend the Legislature adopt an alternative calculation for complying with new federal supplanting rules. This recommendation would reduce General Fund special education costs in 2005-06 by $9.9 million.

Congress reauthorized the federal special education law in 2004. One new provision in the act prohibits states from using federal funds to pay for "state-law mandated funding obligations to local educational agencies, including funding based on student attendance or enrollment, or inflation." It appears the new language is designed to prohibit states from using federal funds to supplant state funds for normal budget increases such as growth and COLA.

California has used federal special education funds in ways that the new federal law appears to prohibit. The 2004-05 Budget Act, for instance, used $124 million in new federal funds to pay for growth and COLA for the entire special education budget—including the state's share. Using federal funds in this way reduced the state's cost of special education. It appears, however, that the new federal law prohibits this from occurring in the future.

The budget proposes to comply with the new federal restriction, proposing to use $38.1 million of the increase in federal funds to offset growth and COLA and $24.8 million to augment the base program. We think the budget's new supplanting calculation would not work, for two reasons. First, despite the administration's intent to comply with the new federal law, the proposal uses a portion of the federal funds to pay for state growth adjustments—something specifically prohibited by the new federal rule. Of the $38.1 million in new federal funds the budget would use to pay for prior-year adjustments, we identified $5 million in budget increases that fall into the category of "state-law mandated funding obligations." Second, we think the calculation would disadvantage the state in 2006-07 and beyond. The budget's proposed new supplanting formula works for only one year—in future years the state likely would have to pass through to SELPAs all new federal funds in the form of program augmentations.

We think there are simpler options for complying with the new federal supplanting rules that would continue to allow the state to satisfy the new law but also not disadvantage the state over the longer run. Our proposal accomplishes this goal by separating the state and federal funding for budgeting purposes. The state would be responsible for providing growth and COLA adjustments on the portion of special education funds supported by state and property tax funds. The federal government would provide funding for growth and COLA increases on the portion support by federal funds. Any increase in federal funds above the level needed for growth and COLA would be used for statewide program augmentations. Any federal increase below that level would mean that SELPAs would not be fully compensated for the effects of growth and inflation. Under this proposal, only $14.9 million must be passed through to increase special education funding—$9.9 million less than proposed in the Governor's budget.

In sum, we recommend the Legislature adopt our alternative methodology for budgeting special education federal funds at the state level. Our proposal provides a simpler, more straightforward way to comply with the intent of the new federal law than the calculation proposed in the budget. In addition, our methodology would generate $10 million in General Fund savings. The purpose of our proposal, however, is to comply with the new federal law while protecting the state's system of local grants—not to generate short-term savings. Below, we discuss our proposal for the use of the $9.9 million and the $14.9 million in "pass-through" funds.

Significant Technical Problems With Budget Proposal

We recommend the Legislature make two technical corrections in the proposed special education budget that will free more than $36 million in funds for other special education and Proposition 98 programs.

As noted above, the DOF revised the 2003-04 and 2004-05 estimates of special education spending in the development of the 2005-06 proposed budget. Our review found two major technical problems with the adjustments to the 2003-04 and 2004-05 budgets:

• Lower Estimated 2003-04 Growth. The Governor's budget fails to recognize $16.1 million in savings resulting from the revised estimate of student growth in 2003-04, which is significantly lower than assumed in the 2003-04 Budget Act. Because of federal "maintenance of effort" rules, these funds must be spent on special education.
• Overbudgeting the New Licensed Children's Institution (LCI) Formula. The 2005-06 budget inadvertently assumes a $19.2 million increase in 2004-05 special education costs of students residing in LCIs compared to the level included in the 2004-05 Budget Act. This technical error results in overbudgeting the LCI formula by $20.2 million in the 2005-06 budget.

We recommend the Legislature correct these technical errors, for a total savings of $36.3 million.

Use Funds to Meet Special Education and Other Priorities

We recommend the Legislature spend $61 million resulting from our recommendations for various special education programs in 2004-05 and 2005-06.

Figure 2 summarizes the impact of the technical budgeting recommendations made above. The figure includes the $24.8 million in funds discussed in our recommendation for an alternative supplanting calculation. It also contains the $36.3 million in savings from our recommendation to correct two technical errors in the special education budget. This brings total funds available from our recommendations to $61.1 million.

Figure 2 also shows our suggested uses of the $61 million. The 2003-04 savings are one-time in nature and, therefore, should be spent on one-time activities. The remaining funds represent 2005-06 funds that may be used for any special education purpose. Our proposal also is shaped by issues raised by the Governor's proposed special education budget for 2005-06. Specifically, we recommend the Legislature use the savings as follows:

• $42.8 million to increase support for mental health services for special education students. This would use most of the ongoing funding that is available from our savings recommendations. We discuss this issue further below.
• $4.4 million ($2.2 million in 2004-05 and $2.2 million in 2005-06) to add to the LCI formula a class of group homes that was inadvertently excluded by the enabling legislation. We discuss this issue further below.
• $13.9 million in 2003-04 funds would be distributed to SELPAs in a per-pupil block grant that could be used for any local purpose. Federal MOE rules require the state to spend these funds for special education. By using the funds as a one-time block grant, the Legislature would honor the federal rules but not permanently increase special education funding.

Make Mental Health Shift Permanent

We recommend the Legislature eliminate two county mental health mandates. We further recommend the Legislature provide a total of $143 million in state and federal funds to support Special Education Local Plan Areas costs of providing mental health services to special education students.

Federal law requires schools to provide mental health services to help special education students benefit from educational services. In practice, mental health services for this population range from short-term counseling on an outpatient basis to long-term psychiatric therapy for students in residential care facilities.

In the early 1980s, the state shifted responsibility for providing more intensive mental health services from school districts to county mental health agencies. This shift created a reimbursable state-mandated program that, by 2002-03, resulted in annual county claims of $123 million. This mandated program is often referred to as the "AB 3632" program, in reference to its enabling legislation. In 1996, the state also shifted responsibility for mental health services of students placed in out-of-state residential facilities to county mental health agencies. Claims for these out-of-state students totaled $22 million in 2002-03, resulting in total claims for the two mandates of $145 million.

As with most other education mandates, the state deferred payment of the two mandates in the 2004-05 Budget Act—that is, the mandate was kept in place but no direct county reimbursement was provided in the Department of Mental Health's budget. To help pay for these mental health services, however, the special education budget included $69 million in federal funds for distribution to county mental health agencies. These funds provide partial state reimbursement for county AB 3632 costs. An additional $31 million from the General Fund was appropriated to support mental health services provided by SELPAs.

Budget Would Suspend Mandates

The Governor's budget proposes to suspend the two mandates in 2005-06. The passage of Proposition 1A in fall 2004 requires the state to either fund or suspend local government mandates each year. Suspending the mandate frees local government from the service requirement for 2005-06.

The budget proposes no county funding for AB 3632 or out-of-state students. Because state law would not require county mental health agencies to provide services to special education students in 2005-06, responsibility for services would fall to SELPAs and school districts. (This is because federal law requires these services to be provided to special education students.) The special education budget proposes to continue the 2004-05 funding set-asides for mental health services ($69 million in federal funds for counties and $31 million from the General Fund for SELPAs). The administration has not stated its long-term intent for funding the two mental health mandates.

We recommend the Legislature permanently assign this program responsibility to SELPAs, for several reasons. A one-year suspension, as proposed in the Governor's budget, would place SELPAs in a form of limbo: Does the proposal represent a permanent shift of responsibilities to education or would the mandates be funded in the future (thereby shifting program responsibility back to county mental health agencies)? A one-year suspension, therefore, would inhibit SELPAs from making the significant local administrative changes they would need to make if the shift in responsibilities is intended to be permanent.

In addition, the proposal muddies what have been clear lines of local responsibility. By continuing to funnel $69 million in special education funding to county mental health agencies, for instance, the budget proposal gives SELPAs financial responsibility for services, but does not give them administrative or policy control related to the services provided.

Finally, we recommend the Legislature make the shift of responsibility permanent because we are convinced that, by assigning full responsibility for these services to education, the state would foster a more efficient and effective service delivery system of mental health services to students. We discuss these issues further below.

Education Would Have Incentives to Provide Services Efficiently. In our view, the shift in responsibilities would result in a more efficient system primarily because educators would have strong incentives to be a "prudent purchaser" of services. Under the existing reimbursement system, educators and county mental health agencies have incentives to increase the state's mandated costs. Educators have the incentive to shift all mental health costs to the county agencies—including the cost of services that remained education's responsibility after the passage of AB 3632. County mental health agencies have the incentive to include all mental health services needed by students under the mandate—even if they are not required under federal law. In addition, by reimbursing 100 percent of a county's program costs, the system also reduces pressure on county agencies to limit the unit cost of services.

Recent audits by the State Controller's Office (SCO) confirms our view that the mandate reimbursement system encourages counties to inflate the actual cost of providing required mental health services to special education students. For instance, an audit of Los Angeles County's AB 3632 claim for services provided from 1998 through 2001 disallowed 21 percent, or $8.8 million, of the county's charges. These costs were disallowed because the county charged the state for (1) services that were not covered by the mandate, (2) services that were funded by other programs, (3) offsetting funding that was not identified, and (4) costs associated with overbilling and data entry errors. The county concurred with the SCO findings. Audits of other county AB 3632 claims show similar problems.

Placing SELPAs in charge of mental health services would strengthen local incentives for the efficient use of state mental health funds. By adding funding for these services into base special education grants, SELPAs would have the resources needed to provide mental health services directly or through county mental health agencies or other contracting entities. The SELPAs, however, would have the incentive to keep these costs to a minimum—any funds not needed for mental health services could be used to pay for other special education services. As a result, by giving SELPAs a reasonable amount of funds to pay for mental health services, we think the state would establish the incentives needed for a more efficient program structure.

Shift Could Improve Effectiveness of Services to Students. Returning responsibility for mental health services to SELPAs also would result in a more effective delivery system if it encouraged educators to increase the use of less-intensive preventive mental health services. As noted above, one consequence of AB 3632 is that the program creates an incentive for educators to shift as many mental health costs to county agencies as possible. In legislative discussions on AB 3632 last spring, county mental health agency staff expressed the belief that many schools fail to provide the early intervention services that remained the responsibility of education even after AB 3632 was enacted. To address this concern, the Legislature included $31 million in the 2004-05 special education budget to require SELPAs to provide more early intervention services.

Placing SELPAs in charge of mental health services, however, would encourage schools to recreate the capacity to provide these intervention services. Early intervention often is more cost effective. The proposal to shift responsibility back to education, therefore, may encourage educators to intervene earlier when behavioral problems can be treated with less intensive services. This would be good for students (avoiding the need for more intensive services) and it would represent another way that changing the local incentives for mental health services would benefit the state.

For the above reasons, we recommend that the Legislature eliminate the existing mental health mandates on counties. Federal law requires school districts provide these services. By eliminating the state mandate on counties, our recommendation has the effect of returning these responsibilities to school districts.

We also recommend the Legislature revise the proposed Budget Bill language and add the full $100 million earmarked for mental health services into the base special education funding formula. In addition, we recommend the Legislature redirect $42.8 million more in funding to SELPAs for mental health services (we discussed the source of these funds earlier in this section). This would provide a total of $142.8 million to SELPAs for mental health services in 2005-06. Based on past claims (and the magnitude of disallowed county costs), we believe our proposal provides a reasonable amount to allow SELPAs to pay for the needed mental health services.

Other Issues

Cleanup Needed on New Formula

We recommend the Legislature adopt trailer bill language to recognize the special education costs for residents of a class of licensed children's institutions that was inadvertently excluded from last year's trailer legislation. Fixing this error would cost $2.2 million in both 2004-05 and 2005-06.

As part of the 2004-05 Budget Act, the Legislature revamped the funding formula for the support of special education students who reside in an LCI. In 2002-03, more than 50,000 K-12 students lived in an LCI (including foster family homes or group homes) because the youth's family was unable to provide needed care. The Department of Social Services licenses group homes based on the services needed by youth living in each home.

Since the enactment of the new formula, however, the State Department of Education (SDE) discovered that the trailer legislation inadvertently omitted a class of group homes from the formula. Specifically, the formula failed to include 129 community care facilities that serve disabled youth who are referred by regional centers for the disabled. Adding these group homes to the new LCI model increases costs by $2.2 million in both 2004-05 and 2005-06.

To correct for this oversight, we recommend the Legislature adopt trailer bill language that adds the community care facilities to the list of group homes used to distribute special education funds. We also recommend the Legislature add $4.4 million ($2.2 million in one-time funds that must be spent on special education programs for the 2004-05 costs and $2.2 million in ongoing 2005-06 funds) to the special education budget to pay for costs associated with the additional facilities.

Incidence Factor Remains Outdated

We recommend the State Department of Education report to the budget subcommittees before March 1 on the feasibility of assuming responsibility for calculating the special education "incidence" adjustment.

The 2005-06 budget proposes $84 million to pay for the special education "incidence" adjustment in 2005-06. State law calls for these supplements to local apportionments as a way of acknowledging that, for a variety of factors, some SELPAs experience higher costs than the typical SELPA. The current adjustments were calculated in 1998 using 1996-97 cost data. Since the factors underlying local cost profiles change over time, the existing adjustments likely no longer reflect actual SELPA costs.

To update the adjustments, the Legislature required SDE to contract for a study in 2002-03. This study was completed in the fall of 2003. Despite significant data problems, the study recommended a new set of incidence adjustments. The data problems, however, were so severe that they clouded the legitimacy of these new adjustments in the eyes of many SELPA administrators. The credibility of the incidence adjustments is very important, as the adjustments are designed to increase the fairness of the state's system of uniform base special education grants.

The study identified data quality as a prime concern. The SDE maintains a comprehensive special education database that provided the data for the 1998 and 2003 incidence factor studies. According to SDE, changes to the database made in 2001-02 resulted in local coding errors that reduced the accuracy of the data. The department believes these problems have been corrected with the 2002-03 data.

The study also suggested that the state update the incidence adjustments annually in order to avoid "radical changes in funding for some SELPAs" that may occur if the adjustments are reassessed only every five years. Indeed, changes to the adjustments identified in the 2003 study were so large that the study recommended a phased approach to implementing the new adjustments. The study suggests that a more frequent calculation of the adjustments would ease transition problems.

In our view, the problems with the 2001-02 data require updating the incidence adjustments. This would be no small task, however. The study presents a series of technical and policy issues that have to be resolved each time the adjustment is recalculated. In our discussion on this issue, we asked SDE to assess the feasibility and cost of assuming responsibility for this task. At the time this analysis was written, the department was in the process of determining what resources would be needed to replicate the study.

In our view, the long-term viability of the incidence factor rides on the department's capacity to update the adjustment. The current reliance on the 1998 adjustments can no longer be defended given the many changes to SELPA costs that have occurred over the past eight years. In addition, the use of outside contractors to recalculate the adjustment is expensive and time-consuming—particularly if the Legislature would like to update the adjustment more often than every five years. If the department does not believe it can reasonably develop the capacity to assume this responsibility, the Legislature will need to either (1) consider eliminating the adjustment or (2) spend about $150,000 each year or two to update the adjustment.

To assist the Legislature in assessing its options for the long-term viability of the incidence adjustment, we recommend SDE report to the budget subcommittees on the costs and feasibility of the department assuming responsibility for calculating the special education incidence adjustment.