Analysis of the 2007-08 Budget Bill: Perspectives and Issues

State’s Fiscal Picture

After 2006-07, a year in which state policymakers were able to use surging revenues to significantly increase education spending and prepay budgetary debt, the state faces a challenging outlook. The Governor’s budget attempts to bridge a significant shortfall in 2007-08 through a variety of means, including a major redirection of transportation funds, significant reductions in social services, and a substantial increase in tribal gambling revenues from amended compacts.

LAO Bottom Line. Based on our revenue and expenditure projections, we estimate that the adoption of the Governor’s budget plan would result in a $726 million deficit in 2007-08 (compared to the administration’s January 10th estimate of a $2.1 billion reserve). The difference in these numbers is due principally to our lower estimates of revenue in both the current and budget years, but also due to higher expenditure estimates, primarily related to Proposition 98. Adoption of the plan would also leave the state with large operating shortfalls in future years, unless additional corrective actions are taken. Thus, the Legislature will face major challenges in crafting a budget for the coming year. We believe that the primary focus should be on finding additional budget savings and/or revenues to address the near- and longer-term shortfalls. Should these solutions be insufficient to cover the full magnitude of the budget shortfall, however, the state can also achieve some near-term savings by reducing the amount of supplemental repayments on deficit-financing bonds relative to the $1.6 billion proposed in the budget.

The Budget Proposal

Economic Forecast—Sluggish Growth Through Mid-2007

The U.S. and California economic expansions slowed over the first three quarters of 2006 in response to both the declining real estate market and soaring fuel prices. The budget forecast assumes that the slowdown will persist through the first half of 2007 before stabilizing real estate markets provide support for an upturn beginning in the second half of the year. On an annual average basis, the budget forecasts that U.S. gross domestic product growth will slow from 3.3 percent in 2006 to 2.4 percent in 2007, before partially rebounding to 2.9 percent in 2008. In California, wage and salary employment growth is projected to slow from 1.8 percent in 2006 to 1.2 percent in 2007, before rebounding to 1.6 percent in 2008.

Revenue Forecast—Modest Growth in 2006-07, Larger Increase in 2007-08

The budget forecast is based on economic and revenue trends through November of 2006. Tax receipts during the first five months of the current year fell slightly short of the 2006-07 Budget Act estimate, which itself assumed only modest growth in 2006-07. The administration’s forecast assumes that current trends will improve somewhat in the second half of the current year, but that total revenues and transfers will still increase by only 1.7 percent from the prior year—reaching $95 billion for all of 2006-07. Major taxes are projected to increase by a slightly stronger rate of 2.7 percent. In 2007-08, the budget forecast projects that revenues and transfers will be $102.3 billion, a 7.7 percent increase from the current year. Adjusting for policy-related changes, underlying revenues and transfers are projected to increase a more moderate 6.5 percent during the year.

Revenue-Related Policy Changes. The budget contains no major tax law changes. It does, however, include $506 million in new revenues from amended tribal gambling compacts, and $290 million from tax-related changes and compliance measures. About $165 million of this total is related to the elimination of the teacher tax credit.

Total Budget Spending

The budget proposes total state spending in 2007-08 of $130.8 billion (excluding expenditures of federal funds and bond funds). General Fund spending is projected to increase from $102.1 billion to $103.1 billion (an increase of 1 percent), while special funds spending rises from $24.5 billion to $27.7 billion.

General Fund Condition

Figure 1 shows the General Fund’s condition from 2005-06 through 2007-08 under the budget’s assumptions and proposals. It shows that:

• 2005-06. The prior year concluded with a reserve of $10.1 billion. The large reserve reflects major increases in revenues in 2004-05 and 2005-06, as well as strong amnesty payments received in 2004-05. It also reflects the proceeds of the deficit-financing bonds issued in 2003-04.

• 2006-07. In the current year, expenditures (at $102.1 billion) are expected to exceed revenues (at $95 billion) by $7.1 billion, leaving $2.9 billion in the reserve.

• 2007-08. In the budget year, projected expenditures increase to $103.1 billion, while revenues are projected to reach $102.3 billion. The resulting $800 million operating shortfall reduces the year-end reserve to $2.1 billion by the close of the budget year.

  Figure 1 Governor’s Budget—General Fund Condition
  (Dollars in Millions)
  			Proposed 2007‑08
  	2005‑06	2006‑07	Amount	Change
  Prior-year fund balance	$8,981	$10,816	$3,670
  Revenues and transfersa	93,427	94,990	102,300	7.7%
  Total resources available	$102,408	$105,807	$105,970
  Expenditures	$91,592	$102,137	$103,141	1.0%
  Ending fund balance	$10,816	$3,670	$2,830
  Encumbrances	$745	$745	$745
  Reserve	$10,071	$2,925	$2,085b
  Budget Stabilization Account	—	$472	$1,495
  Reserve for Economic Uncertainties	$10,071	2,453	590
  Detail may not total due to rounding.
  a  2006-07 amount includes $472 million and 2007-08 amount includes $1.023 billion in General Fund revenues transferred to the Budget Stabilization Account, which the administration excludes from its revenue totals. These different treatments do not affect the bottom-line reserve shown.
  b  As reflected in the 2007-08 Governor's Budget. Does not account for added costs associated with recent arbitration ruling involving correctional officers' pay, which the administration has acknowledged since the budget's release.

Key Features

Relative to a current-law baseline budget, the Governor proposes about $1.2 billion in additional spending, but also $3.4 billion in various solutions to keep the budget in balance and establish a sizeable reserve. Some of the key programmatic features of the budget are shown in Figure 2.

New Spending. This consists of a $595 million supplemental payment toward retirement of outstanding deficit-financing bonds, $132 million to fund the Governor’s compact with higher education, and about $471 million in various other state programs.

Budget Solutions. About one-third of the $3.4 billion in solutions is related to the redirection of $1.1 billion from a transportation special fund to support certain transportation-related General Fund expenditures. The spending is in Proposition 98 home-to-school transportation, general obligation bond debt service, and regional center transportation services in the Department of Developmental Services. The remaining two-thirds of the solutions are related to proposals in a variety of different areas, including:

• $506 million in new revenues from amended tribal gambling compacts;

• $496 million in reductions in the California Work Opportunity and Responsibility to Kids (CalWORKs) program. These are primarily due to (1) the suspension of the July 2007 cost-of-living adjustment (COLA), (2) a proposed full-family sanction eliminating the grant for children in families that are out of compliance with the program, and (3) a five-year time limit for children unless an adult family member meets federal participation requirements;

• $200 million from bond fund proceeds to reimburse the General Fund for flood protection expenditures and $160 million from the elimination of General Fund support for deferred park maintenance;

• $269 million from a shift of CalWORKs childcare to Proposition 98 (thereby reducing General Fund spending in the CalWORKs budget);

• $200 million in revenues from the elimination of the teachers’ tax credit and permanent extension of recent changes involving the application of the use tax to out-of-state sales of vessels, aircraft, and vehicles.

LAO Outlook

In this section, we examine the implications of the 2007-08 Governor’s Budget proposal for the near- and longer-term General Fund condition, using our own revenue forecast and our own estimates of the impacts of the Governor’s proposals on revenues and expenditures. Our estimates do not reflect any of the programmatic recommendations that we make in our Analysis of the 2007-08 Budget Bill. The causes of our differences from the budget projections are limited to (1) assumptions about the economic and revenue outlook and (2) estimation differences in the level of expenditures that would be needed to fund the Governor’s budget plan. In cases where there are legal risks associated with the budget proposals, we have generally given the administration the benefit of the doubt, and thus have not included their potential added costs.

2007-08 Budget Would End With Deficit

As indicated in Figures 3 and 4, we estimate that if the Governor’s budget were fully adopted, the state would end 2007-08 with its reserves exhausted and a deficit of $726 million. (See box below figures for a discussion regarding the Budget Stabilization Account [BSA] in this context.) This year-end deficit results from an operating shortfall (that is, an excess of expenditures over revenues in 2007-08) of $2.6 billion, which is only partly covered by the $1.9 billion reserve available from 2006-07.

 

 

 

The BSA and the Budget Background Proposition 58 (approved by the voters in 2004) established a new General Fund budget reserve, called the Budget Stabilization Account (BSA). The measure requires that annual transfers be made to this account totaling 1 percent of revenues in 2006-07 (equivalent to $944 million), 2 percent in 2007-08 (equivalent to $2 billion), and 3 percent thereafter, until the balance of the reserve reaches either $8 billion or 5 percent of General Fund revenues, whichever is greater. One-half of the annual transfers (or $1 billion in 2007-08) is allocated to a subaccount to make supplemental payments on the outstanding deficit-financing bonds, until they are paid off. The other half is available to support General Fund expenditures (as is the case for the state’s other reserve, called the Reserve for Economic Uncertainties). June 1 Deadline Important. Proposition 58 permits these annual transfers to be suspended by the Governor no later than June 1 preceding the beginning of the fiscal year. This deadline is significant, particularly in the context of balancing the 2007-08 budget. If the transfer is not suspended by June 1, 2007: The full transfer ($2 billion) will be made to the BSA. Of that amount, $1 billion is immediately allocated for supplemental payments on the deficit-financing bonds, and thus is unavailable to address the 2007-08 budget shortfall. Only the remaining $1 billion would still be available for budget-balancing purposes. Alternatively, if the transfer is suspended, an additional $1 billion would be available for budget-balancing purposes. BSA and the General Fund Condition Our display of the General Fund condition for 2007-08 (see Figure 4) reflects the Governor’s proposal to make the full $2 billion transfer to the BSA during the year. Thus, our expenditure total includes the one-half of the BSA transfer that would be dedicated to supplemental payments to pay off the deficit-financing bonds ($1 billion). Given the deficit that we are projecting under the Governor’s plan, we assume that the full balances in the BSA and in the Reserve for Economic Uncertainties would be tapped to support the Governor’s plan. Thus, in Figure 4, we show zero balances remaining in these reserves. Even after drawing these reserves down to zero, the state would still be short by $726 million in balancing its 2007-08 budget.

Our estimate of a year-end deficit contrasts with the administration’s forecast of a $2.1 billion reserve. The difference reflects both our lower estimate of revenues and higher estimate of expenditures for the prior, current, and budget years.

 Lower Revenues. We forecast that General Fund revenues in 2006-07 and 2007-08 will fall below the budget forecast by a combined total of $2 billion. About $1.4 billion of the difference is related to our lower estimate of revenues from the state’s major taxes. A key factor behind our lower tax projections is much weaker-than-expected receipts from year-end personal income tax estimated payments. As indicated in “Part III,” we believe that these lower payments are indicative of lower tax liabilities associated with volatile investment income and real estate-related business earnings. The softness in these volatile sources is mitigated somewhat by recent evidence that the economy is emerging from its recent slowdown somewhat earlier than assumed in the budget.

The remaining one-fourth of this total is related to our less optimistic assumptions about receipts related to tribal gambling and pension obligation bonds. Specifically, we assume that if the Governor’s proposed amended compacts were approved by the Legislature, new tribal gambling revenues would be about $200 million in 2007-08, or more than $300 million less than the administration’s forecast. We are also assuming that the $525 million pension obligation bonds assumed by the administration will not be sold due to continued legal problems. These bonds have been invalidated at the lower court level, on the grounds that they constitute debt and therefore must be approved by the voters. About $252 million of the total bonds show up on the revenue side of the budget, while the remaining $273 million shows up as reduced expenditures.

Higher LAO Costs. We estimate that General Fund expenditures under the Governor’s budget proposal would exceed the administration’s estimate by a net amount of $825 million over the prior, current, and budget years combined. The single largest difference is in the area of Proposition 98, where we estimate that General Fund spending will exceed the budget estimate by $465 million, for two reasons:

• First, we are assuming that the slowdown in real estate activity in California will reduce property tax growth below the administration’s forecast, resulting in $204 million less local property tax revenues available to school districts. This is significant because local revenues offset, dollar for dollar, General Fund expenditures for Proposition 98.

• Second, our pattern of General Fund revenue growth (a smaller increase in the current year but a larger increase in the budget year) boosts the Proposition 98 minimum guarantee $261 million above the administration’s estimate in 2007-08. This is counterintuitive, given that our revenue estimates are below the budget estimates for both years. It occurs because, while the smaller current-year increase would lower the minimum guarantee relative to the 2006-07 Budget Act estimate, the actual level of funding will not fall unless the Legislature takes action to reduce the current-year Proposition 98 appropriation level. Absent such a current-year reduction, the year-to-year change in revenues we project would then raise the guarantee above the level proposed in the 2007-08 budget. (This is because Proposition 98 drives off the year-to-year growth in General Fund revenues, not the actual amount of revenues.)

Other factors accounting for our higher expenditure estimate are (1) added pension-related expenses associated with our assumption that the pension obligation bonds will not be sold, (2) added prior-year costs related to a recent arbitration ruling involving correctional officers’ pay, and (3) lower savings from unallocated reductions than assumed by the administration. These added costs are partly offset by (1) our higher estimate of savings that would accrue from the Governor’s proposals for parole reform and (2) estimates of caseload and COLA savings in social services programs.

Structural Shortfalls Would Persist …

As shown in Figure 5, the annual operating deficit would expand in 2008-09 under the Governor’s budget plan, and remain significant thereafter. Specifically, we estimate that the shortfall would grow to $3.4 billion in 2008-09, before dropping back to about $2.5 billion in 2009-10 and then $1.4 billion in 2010-11 (when there are no deficit-financing bond payments left to make). These estimates assume that the economy and state revenues grow at a moderate pace through 2010-11. They also take into account the out-year revenue and expenditure implications of the Governor’s key solutions.

… As Would Other Risks and Pressures

The state faces a number of risks and pressures beyond those that we have explicitly accounted for in our near- and long-term fiscal projections. Key risks include:

• Serious legal issues related to the Governor’s proposal to reduce the Proposition 98 guarantee by $627 million in 2007-08 to reflect the funding shift for home-to-school transportation to the Public Transportation Account.

• Potential added CalWORKs costs related to the Guillen case. In this case, a lower court ruled that the October 2003 COLA (which was tied in statute to reductions in the vehicle license fee) is required by current law. Unless the lower court ruling is overturned at the appellate court or Supreme Court level, the state faces one-time CalWORKs grant costs of over $400 million and potential ongoing costs of over $100 million.

• The state is currently dealing with a variety of federal lawsuits related to its correctional health care system. We have included significant spending, both in 2007-08 and in the out years, to reflect costs associated with these lawsuits. However, the full magnitude of these costs is unknown, and could exceed our estimates by a considerable margin.

• The state is appealing two lower court decisions which found that California’s application of the Limited Liability Company fee is unconstitutional. Unless the appellate court overturns the lower court decisions, the state could face potential losses ranging from roughly $100 million to over $1 billion (depending on whether the appellate courts’ decisions involved modifying the fee or eliminating it altogether).

Finally, our estimates do not include the added cost pressures associated with retirees, particularly related to health care costs. The state faces an estimated unfunded liability of between $40 billion and $70 billion for retiree health benefits promised to its employees, and local governments and school districts similarly face large obligations. If the state were to prefund its costs for retiree health benefits accruing in 2007-08, it would need to increase annual General Fund spending by over $1 billion. The cost to start paying off past unfunded liabilities would be billions of dollars more each year.

Issues and Considerations

As discussed above, the Governor’s budget is based on a number of optimistic assumptions. Using our estimates of revenues and expenditures under the Governor’s plan, we estimate that the state would conclude 2007-08 with a $726 million deficit, and would face a continuing structural shortfall thereafter. Beyond this, some of the budget’s key proposals raise significant policy issues, and the state faces legal risks that could have substantial impacts on the fiscal picture over the next several years.

In view of these factors, it will be necessary for the Governor and Legislature to find additional solutions in order to bring this budget into balance. Two types of solutions include:

Budgetary Savings. The accompanying Analysis of the 2007-08 Budget Bill includes numerous specific recommendations regarding the budget proposal, some of which would produce significant General Fund savings. For example, in Proposition 98, we estimate that current-year K-14 school spending now significantly exceeds the minimum funding guarantee. By selectively reducing current-year Proposition 98 appropriations (with minimal impact on programs), the state could not only achieve 2006-07 savings but also avoid increasing costs above the Governor’s proposal for 2007-08. In higher education, we recommend reductions in the Governor’s proposal for the University of California and the California State University totaling $138 million, primarily reflecting our estimates of expected inflation and enrollment growth for the coming year.

Reduced Supplemental Repayments Toward Budgetary Debt. If it is not possible to fully restore budgetary balance through program savings and revenues, the state could also reduce the supplemental payments it is making to pay off the deficit-financing bonds. The Governor’s budget assumes about $3 billion in repayments of deficit-financing bonds during 2007-08. About one-half of this total is related to annual payments from the quarter-cent sales tax, and the other is from supplemental payments—about $1 billion from the BSA (as required by Proposition 58 unless suspended by the Governor) and $595 million from a proposed separate appropriation. The state could eliminate the proposed $595 million supplemental payment in 2007-08, as well as a portion or all of the $1 billion payment from the BSA. We fully appreciate the administration’s goal of paying off these bonds to make room for additional infrastructure borrowing. However, we believe that extending the repayments of these relatively low-cost bonds is preferable to accelerating the payments and then incurring new, higher-cost debt such as the pension obligation bond.

Finally, given the magnitude of the ongoing operating shortfalls, it will be particularly important that the Legislature avoid raising ongoing budget commitments without identifying alternative reductions or new revenues to pay for them.

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