Analysis of the 2006-07 Budget Bill Legislative Analyst's Office February 2006

Proposition 98 Priorities

The Governor’s budget proposes to spend $1.7 billion more in 2006-07 for K-12 education and community colleges than the administration’s estimate of the Proposition 98 minimum guarantee. If approved, this increase would widen the state’s structural spending gap in 2007-08 and beyond, and raises the issue of whether the state would be able to sustain the budget’s proposed overall level of General Fund expenditures in the future.

Governor Proposes Significant New Resources

The Governor’s budget proposes to increase Proposition 98 expenditures by $4.3 billion in 2006-07 compared to the revised 2005-06 spending level. This increase is sufficient to adjust K-14 funding programs for the growth in student attendance and the cost of living and provide a $1.4 billion increase for new and expanded programs.

Figure 1 displays the major funding increases proposed in the budget for 2006-07. As the figure shows, increases in baseline costs consume $2.9 billion of the new funds. A projected 5.2 percent cost-of-living adjustment (COLA) accounts for most of this increase ($2.6 billion). Growth in attendance in K-12 education (0.2 percent) and the community colleges (3 percent) adds another $305 million. The budget also includes $134 million for K-14 state-mandated programs in the budget year. This represents the first time funding has been included in the Governor’s budget for the ongoing cost of education mandates since 2002-03. The amount included in the budget would support about three-quarters of likely claims in 2006-07.

The budget plan also proposes $1.4 billion for a variety of new or expanded K-14 programs. Implementing the requirements of Proposition 49 accounts for $426 million. The initiative requires the state to expand existing after school programs for K-8 students by a specific amount starting in 2006-07. An additional $406 million in revenue limits is proposed to equalize K-12 general purpose funding levels ($200 million) and restore past-year reductions in revenue limits ($206 million). For the community colleges, the budget proposes funding for equalization ($130 million) and several smaller funding increases totaling $60 million. Finally, the budget proposes to spend almost $400 million for a number of new K-12 categorical programs, including programs to help attract and retain teachers in low-performing schools ($100 million) and an arts and music block grant ($100 million).

By appropriating more than Proposition 98 requires for 2006-07, the Governor’s budget would restore K-14 funding roughly to the funding target set in Chapter 213, Statutes of 2004 (SB 1101, Committee on Budget and Fiscal Review). This act suspended the Proposition 98 minimum funding guarantee for 2004-05 by about $2 billion and provided a target spending amount if revenues increased. Although General Fund revenues in 2004-05 were significantly higher than originally estimated, Proposition 98 expenditures in both 2004-05 and 2005-06 fell short of the target.

Minimum Guarantee Insufficient to Maintain Base Program

The proposal to provide more than the minimum Proposition 98 funding level is significant for another reason-a portion of these additional funds supports baseline program costs of providing growth and inflation adjustments and restoring funding for ongoing K-14 mandates. As Figure 1 indicates, these baseline adjustments account for $2.6 billion of the budget-year increase in spending. The administration’s revenue forecast, however, would result in an increase in the minimum guarantee of only $2.4 billion. This would leave schools and community colleges at least $200 million short of a fully funded base budget. The Legislature has two basic choices for fully funding base K-14 programs-redirecting a portion of the existing Proposition 98 budget or appropriating more than the minimum guarantee.

Our revenue forecast reduces the difference between the minimum guarantee and the baseline K-14 budget for 2006-07. As we discuss in the previous write-up, our projection of General Fund revenues in the budget year translates into a minimum guarantee that is $115 million higher than proposed in the budget. Our estimate, therefore, reduces, but does not eliminate, the amount of spending above the minimum guarantee needed to fully fund the base budget for K-12 and community colleges.

State Still Exposed to Significant Fiscal Threats

It is important for the Legislature to consider the Governor’s Proposition 98 proposal in the context of the administration’s overall General Fund spending plan. Viewed from this perspective, the increase in total spending proposed by the 2006-07 Governor’s Budget raises the issue of whether the higher level of expenditures-including funding for education-could be sustained in 2007-08 and beyond.

As we discuss in The 2006-07 Budget: Perspectives and Issues (P&I), we think the Governor’s budget proposal misses an opportunity to achieve a better long-term balance between expenditures and ongoing revenues. There are three factors underlying our concerns. First, while the administration’s 2006-07 budget is balanced, we estimate that the state still has a structural budget gap-the difference between the cost of programs and the level of ongoing revenues-of several billions of dollars. This suggests that, under the administration’s plan, the state would be unable to sustain the proposed level of spending without some combination of budget reductions or additional tax revenues in future years.

Second, in addition to the structural budget gap, other fiscal challenges require attention. For example, the State Teachers’ Retirement System estimates that annual appropriations into the fund fall about $1 billion short of the amount to fully fund the projected level of benefits for retirees over the long run. In addition, the state needs to begin addressing its liability for retiree health benefits. In our discussion of this issue in the P&I, we estimate the state’s liability for these benefits is likely in the range of $40 billion to $70 billion.

Third, we are concerned that the extraordinary increases in General Fund revenues experienced recently may not be sustainable in the future. Our long-term forecast assumes steady economic growth of about 6 percent annually. The near-term economic outlook, however, is mixed. Because General Fund revenues are quite sensitive to changes in these conditions, a small reduction in economic growth could add several billions of dollars to the state’s budget gap. With virtually no General Fund reserve projected at the end of 2006-07, the Governor’s budget would leave the state with little fiscal flexibility to adjust to the lower revenues.

K-14 Funding Is Linked to State’s Fortunes

The fiscal health of the state is important to K-14 education. When times are good, state spending on schools and community colleges results in new and expanded programs and extra base increases. When the economy-and state revenues-slow, the state tends to cut categorical programs and inflation adjustments. While Proposition 98 was initially proposed by the education community to stabilize state funding, the level of support provided by the state is heavily influenced by changes in state revenues, particularly during economic slowdowns.

There are ways the state could mitigate the fiscal stress to K-14 education when General Fund revenues slow. For example, the state could use a portion of new General Fund revenues generated in good economic times to establish a healthy reserve that could protect state programs when revenues slow or fall during economic downturns. A healthy reserve could allow the state to supplement the Proposition 98 minimum guarantee and minimize funding reductions to schools and community colleges. Alternatively, the state also could establish a Proposition 98 reserve that would create a cushion within the minimum guarantee to protect against slow economic times. Without some type of significant “rainy day” reserve, the Legislature has few options-other than program reductions or tax increases-to help schools and colleges weather tough economic times.

How the state chooses to spend-or cut-Proposition 98 resources also influences the amount of flexibility local education agencies have to accommodate spending reductions. Typically, the state determines how new K-14 spending is allocated among the many state funding programs as part of the annual budget process. Depending on the nature of new or expanded activities approved by the Legislature, the funds are often spent on programs that are difficult to reverse during times of spending reductions. As a consequence, districts must find other sources of funds to substitute for the state’s budget cuts, thereby triggering disproportionately large program cuts at the local level when the economy slows.

An example of this pattern occurred only a few years ago. Large increases in Proposition 98 spending in 1999-00 and 2000-01 were followed by funding cuts in 2002-03 and 2003-04. During 2000-01, the budget distributed much of the increase as general purpose funding to K-12 districts, although then-Governor Davis made it clear that the increase was intended to support increased teacher salaries. Many districts complied with the Governor’s wishes, and, as a result, wage increases of 8 percent to 10 percent were common across the state.

The budget reductions made by the state in 2002-03 and 2003-04 did not reverse the wage commitments of the early 2000s, however. At the local level, wage “roll-backs” were rare, which required districts instead to reduce the level of educational services beyond what was required by the state reductions. Districts also used budget strategies such as deficit spending and borrowing from restricted funds. As we discuss later in this chapter, district finances have not fully recovered from the recent economic slowdown.

The fiscal fate of K-14 education is tied to the state’s financial health. The experience over the past six or seven years suggests that the state’s good intentions can sometimes result in very difficult fiscal situations for local educational agencies. In our view, therefore, it is critical that the Legislature recognize the volatile nature of the state’s revenue base and take the steps needed to increase the likelihood that new spending provided in the budget year can be sustained in 2007-08 and beyond. The Legislature could lessen the impact of a slowdown in revenues on programs by creating a substantial General Fund reserve. Similarly, an annual Proposition 98 reserve could cushion the impact during an economic slowdown on K-14 education.

Minimize Impact of Proposition 98 on Structural Gap

We recommend the Legislature reject all proposals for new K-14 programs and fund Proposition 98 at the level needed to fully fund base program costs in the budget year. While this would result in $1 billion less in K-14 spending than the Governor’s budget, it would still provide an increase of $3.3 billion over the current year.

The weakness of the state’s fiscal health suggests that the Legislature should get the state’s financial “house” in order before approving large increases in spending for new programs. In addition, proposed funding augmentations could actually weaken school district and community college financial health if those increases cannot be sustained in the future. Because many districts base local wage increases on the level of general purpose funds provided to the districts, a significant portion of the $406 million proposed for revenue limit deficit factor and equalization could be used for that purpose. If the General Fund condition cannot sustain the proposed level of Proposition 98 spending in 2007-08, districts could be left in a similar position as in the early 2000s-facing slowing or reduced Proposition 98 funding levels, but with less fiscal flexibility to accommodate those cuts. As a result, we believe the current situation calls for a different approach to Proposition 98 funding than proposed by the Governor.

Instead, we recommend the Legislature increase K-14 funding to provide a fully funded base budget for existing programs. This entails providing growth and inflation increases and fully funding those parts of the school and community college budget that are not adequately addressed.

Figure 2 displays our recommended spending increases for 2006-07. Our estimate of the amount required to fully fund the K-14 base totals $3.3 billion, or $359 million more than the base augmentations proposed by the Governor. There are three main differences that account for our higher estimate. First, as discussed earlier in this chapter, recent economic data indicates that the statutory COLA will be larger than projected by Department of Finance. Specifically, we estimate a 5.8 percent K-14 COLA, up from the 5.2 percent adjustment proposed in the budget. This accounts for $307 million of the difference.

Second, we increased funding for growth in K-14 attendance by $13 million, which is the net result of two adjustments. We added $75 million to reflect our higher estimate of the cost of the declining enrollment adjustment. Based on the 0.2 percent increase in K-12 attendance growth anticipated by the administration, the budget understates the growth in costs of the one-year hold harmless payments provided to districts experiencing declines in student attendance. Our proposal also reduces community college growth by $62 million to reflect our projections of enrollment growth rather than a higher level proposed by the administration.

Third, we added funding for two programs to more fully reflect the state’s financial commitments to districts. We added $39.4 million to fully fund K-12 state-mandated local programs in 2006-07. The Governor’s budget only partially funds these expenses. We also recommend approval of the $20 million increase in funding for remedial instruction for students who have failed the California High School Exit Examination. Because of the importance of the test to students, the new funds give districts additional resources to help students who have failed the test.

We would not recommend funding for any other proposals for new or increased spending. This would save the state $1 billion relative to the Governor’s budget. It also would reduce the state’s structural budget gap in 2007-08 by about the same amount. While we recognize the desire to use available funds to improve local education programs, we do not believe state finances are sufficiently strong to guarantee that a large infusion of new funding could be sustained in future years. A more modest K-14 budget in 2006-07 could work to the advantage of local education agencies in the future if, for example, the state used the savings to increase the size of its General Fund reserve.

Moreover, our recommendation would still provide more than $3.3 billion in new resources to schools and colleges. Almost all of this increase results from the large increase in the inflation index used for K-14 education. As discussed earlier in this chapter, the 5.8 percent COLA probably overstates the actual inflation in K-14 costs in California. Large increases in energy and construction costs are responsible for the significant jump in the index. The portion of the inflation index for state and local government purchases shows only a 3.8 percent increases in wages and benefits. Since local education agencies spend most operating funds on wages and benefits, the budget-year COLA would likely provide a measure of new discretionary funds for districts and colleges.

If, on the other hand, the Legislature wants to provide a total level of Proposition 98 spending similar to the amount proposed in the budget, we recommend that the Legislature consider two alternatives to the Governor’s proposed allocation of funds. The first alternative would provide additional one-time funds to local education agencies above the baseline budget level. The second option would provide additional ongoing funds but targeted at improving school district financial conditions. We discuss each of these options below.

Option 1: Supplement Base With One-Time Funds

If the Legislature desires to provide K-14 resources at levels consistent with the Governor’s budget, we recommend the Legislature spend $1 billion on a one-time basis to reduce the state’s K-14 “credit card” debt.

In addition to the state’s structural budget gap and other financial threats, the state has essentially “borrowed” from school districts and community colleges during the recent economic slowdown. The state has two types of outstanding commitments to Proposition 98. First, the state owes $1.4 billion in Proposition 98 “settle-up” payments, primarily as the result of the final determination of the minimum guarantee in 2002-03 and 2003-04. While state law requires paying these one-time settle-up balances within one year after the end of the fiscal year, only a relatively small amount of this obligation has been retired. As part of the 2004-05 budget agreement, the state enacted legislation specifying that this obligation would be paid over a ten-year period starting in 2006-07. The budget’s proposal for $133 million in one-time spending to retire past mandates represents the 2006-07 payment for settle-up.

The second type of obligation the state owes to K-14 education is internal to Proposition 98. We have called this the “education credit card,” because the districts and community colleges incurred costs for certain programs that were not fully funded during the fiscal year in which services were provided. Figure 3 displays the balance on the credit card from 2003-04 through 2005-06 and our estimate of the amount owed in 2006-07. Funding deferrals-shifting payments for services provided during the budget year to the next fiscal year-account for $1.3 billion. Another $1.2 billion stems from the fact that the budget has omitted payments in past years for the ongoing costs of mandated local programs. In addition, state law promises to repay K-12 districts “deficit factor,” which represents foregone inflation adjustments to revenue limits in 2003-04. The Governor’s proposal to spend $200 million to pay off a portion of deficit factor would reduce this outstanding obligation to only $100 million in 2006-07.

The amount owed to K-14 education has slowly declined throughout this period. In 2006-07, however, the state still owes $2.6 billion. The reduction in the balance over time results from repaying revenue limit deficit factor and one-time payments for past mandates. In addition, the budget proposal to partially fund the ongoing cost of mandates also avoids a large increase in the amount owed to K-14 in the budget year.

Pay Off Mandates, Reduce Structural Gap

To a large extent, the higher Proposition 98 funding level proposed in 2006-07 is supported by one-time funds reflected in the higher ending balance from the current fiscal year. Because of higher-than-expected revenues in 2004-05 and 2005-06, the administration forecasts that the state will enter the 2006-07 budget with a $6.5 billion reserve. Because this entering reserve is one-time in nature, spending those funds on ongoing augmentations and new programs is not fiscally prudent. If the Legislature wants to use some of these one-time funds to provide additional resources to K-14 education, we would suggest addressing one-time issues in K-14 education.

The existence of the credit card and the outstanding settle-up obligations present the Legislature with an option for providing the same level of K-14 education resources as the Governor’s budget in a way that does not widen the structural budget gap in 2007-08 and beyond. Specifically, the Legislature could appropriate $1 billion in one-time funds to retire most of the state’s liability for unpaid mandate claims.

There would be three benefits to this approach. First, one-time payments would retire most of the K-14 settle-up obligations. Because the $1.4 billion in these obligations were scheduled to be paid off over the next ten years, paying them off early would reduce the state’s debt obligations for future years. Thus, compared to the Governor’s budget, this option allows the Legislature to provide the same amount to K-14 education in 2006-07 while reducing the state’s structural gap in future years.

Second, using one-time funds to retire the state’s obligation for past mandate costs also would reduce the K-14 credit card balance. The credit card represents a way the state has maintained program while cutting expenditures during slow economic times. If the credit card is not repaid before the next economic slowdown, the state will have much less flexibility to respond to revenue shortfalls. For this reason, we believe the state needs to address existing deferrals and unpaid mandate claims. Directing $1 billion in one-time funds to satisfy a portion of these claims would virtually eliminate this component of the credit card.

Third, a large infusion of one-time funds to school districts would help them address pressing financial issues. As discussed later in this chapter, many school districts find themselves on shaky financial ground, due to the lingering effects of the recent economic slowdown and declining student attendance. In addition, many districts-like the state-must address the problems presented by unfunded liabilities for retiree health benefits. Using $1 billion to pay for past mandate claims would give K-12 districts a source of unrestricted one-time funds to address these fiscal issues.

Our assessment of the state’s fiscal health suggests that this is not the time for major budget augmentations. The Legislature can, however, provide additional support for K-14 education by addressing past Proposition 98 settle-up obligations, which represent one of the “off-book” budgetary borrowing mechanisms used by the state during the recession. While this does not reflect our recommended legislative action, it does represent a reasonable compromise between a desire to increase support for education and the need to improve the condition of state finances.

Option 2: Target New Funds at Highest Local Needs

We recommend that, if the Legislature wants to provide a higher ongoing level of Proposition 98 expenditures similar to the amount proposed in the 2006-07 budget, it (1) eliminate new after school funding and place the repeal of Proposition 49 before the voters, (2) commit new K-12 discretionary funds for a fiscal solvency block grant, and (3) approve community college funding to achieve the Legislature’s equalization goal.

If the Legislature desires to fund Proposition 98 at a level similar to that proposed in the Governor’s budget, it faces the issue of whether the administration’s specific spending proposals for the use of discretionary funds meet the needs of schools and community colleges in the state. As discussed above, we estimate that the Governor’s proposed Proposition 98 spending level results in about $1.4 billion in discretionary augmentations.

Address K-12 Fiscal Issues

In K-12, the budget would spend these discretionary funds to expand after school programs as required by Proposition 49 and create seven new K-12 categorical programs-each relatively small and targeted at specific state objectives. We continue to recommend repeal of Proposition 49 because it reduces the state’s flexibility to establish spending priorities and expands services at a time when the state faces a long-term spending gap. In addition, existing state and federal after school funds are going unused. Later in this chapter, we also recommend that the Legislature disapprove funding for all of the seven new categorical programs because they represent a further splintering of K-12 funding at a time when the state has just consolidated categorical funding into block grants. In addition, the seven programs have basic policy problems and contain virtually no planning, reporting, evaluation, or accountability components.

We do not believe the Governor’s uses of discretionary funds address the most pressing issues facing K-12 districts. Specifically, weak district financial conditions left over from the recent economic slowdown, loss of funding due to declining enrollment, and the need to begin budgeting for retiree health care costs present fiscal challenges that many districts will be unable to meet satisfactorily. In the short-term, statewide data show increasing numbers of districts in very poor financial shape. Over the long-run, retiree health costs represent an ongoing fiscal threat that, if not addressed, could force districts to seek state assistance.

Figure 4 summarizes our recommendations for the proposed uses of ongoing funds for K-12 education. To help districts address these fiscal issues, we recommend the Legislature reject the new program proposals included in the Governor’s budget. Instead, we recommend the Legislature (1) eliminate from the budget new funds proposed for after school programs and (2) devote the remaining discretionary funds available to adequately fund baseline increases for K-12 education and our proposed fiscal solvency block grant. The block grant would provide a flexible source of funding that districts could use to improve their fiscal health, adjust district operations to reflect lower student attendance, and begin the process of setting aside funds needed to pay for future retiree health care costs. While the block grant may not result in short-term dividends to the quality of many local educational programs, in the long run, we think the returns to restoring the fiscal health of districts are significant. We discuss our block grant approach later in this chapter.

Achieve California Community Colleges (CCC) Equalization Targets

Compared to K-12 school districts, community colleges have more flexibility in adjusting to state budget changes. For example, in response to state budget reductions in 2003-04, many colleges reduced the number of courses they offered or focused their course offerings in less costly disciplines. In addition, while many colleges offer retiree health benefits and therefore face long-term cost pressures similar to K-12 schools, outstanding liabilities for community colleges may be somewhat less because some colleges have set aside funds for these retiree health expenses. As a result, community college districts appear to be in better financial shape than school districts.

We have therefore taken a different approach for community colleges. Specifically, as we describe in the “California Community Colleges” section later in this chapter, we believe completing ongoing efforts to equalize CCC apportionments would be a top priority for discretionary spending on the community colleges. The Governor proposes $130 million for this purpose. We recommend that any new spending on CCC equalization be accompanied by legislation that changes how future apportionment funding is allocated among the community colleges. This is because the existing program-based funding method would erode the state’s equalization efforts over time.

In addition, we suggest that the Legislature more closely monitor the issue of retiree health benefits at community colleges in order to determine whether additional state action is needed to ensure community colleges are addressing the associated long-term financial issues. Specifically, we recommend that the Legislature require the Chancellor’s office to provide data on the outstanding obligations in the various districts, and to report on steps that the system and districts are taking with regard to this issue.