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

Major Expenditure Proposals In the 2007-08 Budget

In this section, we discuss several of the most significant spending proposals in the budget. For more information on these spending proposals, and our findings and recommendations concerning them, please see our analysis of the appropriate department or program in the Analysis of the 2007-08 Budget Bill.

Proposition 98

Background

California voters enacted Proposition 98 in 1988 as an amendment to the State Constitution. Proposition 98 establishes a minimum annual funding level (or “guarantee”) for K-12 schools and the California Community Colleges (CCCs). Typically, it derives this funding level by taking the prior-year funding level and adjusting it by the year-to-year change in K-12 average daily attendance (ADA) and per capita personal income. In any particular year, the Legislature can provide more than the minimum guarantee, though this permanently raises the long-run K-14 funding level. The Legislature also can suspend the guarantee for one year with a two-thirds vote. In the years following a suspension, however, Proposition 98 has built-in mechanisms to ensure K-14 funding is restored to the level it otherwise would have been absent the suspension.

Proposition 98 is funded by a combination of state General Fund and local property tax revenues. It constitutes about three-fourths of total K-12 funding and total CCC funding. In addition, K-14 education receives funding from non-Proposition 98 state General Fund, the state lottery, the federal government, and various other local sources. The community colleges also receive revenue from student fees.

Governor’s Proposal

Figure 11 summarizes the Governor’s Proposition 98 budget proposal. For 2007-08, it provides $56.8 billion in total K-14 funding ($50.5 billion for K-12 education and $6.3 billion for CCC). This represents a 3.3 percent increase over revised current-year spending.

Governor Proposes “Baseline Budget.” The administration proposes essentially a baseline budget for K-14 education. Specifically, the Governor’s budget proposes to increase Proposition 98 expenditures by $1.8 billion over the revised 2006-07 spending level. Figure 12 shows how the new 2007-08 funding would be spent. The budget proposes $2.2 billion in baseline adjustments to pay for growth in the student population ($38 million) and a 4 percent cost-of-living increase ($2.1 billion). These baseline increases are partially offset by a net reduction of $358 million that results from several budget-year policy proposals. The largest of these proposals involves the Home-to-School Transportation program and California Work Opportunity and Responsibility to Kids (CalWORKs) program.

Home-to-School Transportation Proposals. The Governor proposes to shift ongoing funding for school transportation ($627 million) from Proposition 98 to the Public Transportation Account (PTA). In a related action, the administration proposes to reduce (or “rebench”) the Proposition 98 minimum guarantee by a like amount. Taken together, these actions are intended to achieve ongoing General Fund savings.

Child Care Proposal. The Governor also proposes to achieve $269 million in General Fund savings by shifting the state and federal shares of CalWORKs Stage 2 child care costs. Specifically, the Governor proposes increasing Proposition 98 support by $269 million while reducing federal Temporary Assistance for Needy Families (TANF) support by a like amount. This frees up TANF monies to cover CalWORKs costs that currently are covered by the state General Fund. Unlike the transportation proposal, this proposal does not involve rebenching the Proposition 98 minimum guarantee.

Issues for Legislative Consideration

In 2007-08, the Legislature faces several major issues—some directly related to the Governor’s budget proposal, some related to prior-year actions, and some related to our five-year budget outlook.

Rebenching Proposal Risky. We think the Governor’s rebenching proposal represents a substantial budget risk and is unlikely to achieve $627 million in General Fund savings. This is because the proposal very likely is unconstitutional and violates the intent of the minimum funding guarantee. The proposal also sets bad policy precedent in that it offers no reasonable explanation as to why a program historically funded from Proposition 98 should now be excluded from it. Under the administration’s approach, the state could shift funding for any K-14 program from Proposition 98 to another source and reduce the minimum guarantee anytime it wanted to achieve savings—rendering the guarantee virtually meaningless. In addition to these Proposition 98 issues, the Legislature faces difficult trade-offs in the use of PTA monies and uncertainty whether PTA will have sufficient funds to support the Home-to-School Transportation program in the future.

Other General Fund Challenges. The Legislature also faces other major General Fund threats. We estimate that General Fund tax revenues will be about $1.4 billion lower than the administration estimates (roughly $940 million lower in 2006-07 and $500 million lower in 2007-08). Despite the drop in both years, our estimate of year-to-year revenue growth actually is greater, which results in a Proposition 98 minimum guarantee that is about $260 million higher than assumed in the Governor’s budget. In addition, we believe the administration overestimates property taxes for the budget year by about $200 million. A roughly $200 million drop in property tax revenues increases the Proposition 98 General Fund obligation by a like amount. Together, these factors result in a Proposition 98 General Fund obligation that is roughly $460 million higher than assumed in the Governor’s budget. Combined with the school transportation risk, the Legislature could be facing more than $1 billion in additional K-14 Proposition 98 General Fund obligation relative to the Governor’s budget.

Reducing Current-Year Spending Could Be Major Part of Budget Solution. Although our estimate of the guarantee is higher than the administration’s in 2007-08, the drop in current-year revenues lowers the Proposition 98 minimum guarantee by slightly more than $600 million in 2006-07. Because the budget-year Proposition 98 requirement is based on the current-year spending level, reducing current-year spending can produce major one-time and ongoing savings. Thus, we recommend a package of actions to reduce spending in the current year by slightly more than $600 million. This would reduce the budget year Proposition 98 requirement by about $630 million. As a result, the Legislature could achieve substantial one-time current-year savings while also achieving budget-year savings comparable to the Governor’s rebenching proposal. That is, under our set of recommendations, the Legislature could achieve even more savings than under the Governor’s plan but without the same risk.

Still Sufficient Funding to Support Baseline Budget. For the budget year, our package of recommendations would ensure the Legislature still could fund a baseline K-14 budget, including growth and cost-of-living adjustments (COLAs). As part of this package, we recommend not increasing the Proposition 98 share of Stage 2 child care costs, as Proposition 98 could no longer accommodate the shift without having to take reductions to K-14 education programs. Our package of recommendations also includes achieving savings from unneeded community college enrollment growth funding.

Changes to Settlement Programs Could Strengthen Reform Efforts. The Legislature faces other major existing K-14 education obligations. The most notable of these is the $2.8 billion obligation stemming from the recent California Teachers Association settlement. Chapter 751, Statutes of 2006 (SB 1133, Torlakson), authorized a seven-year payment schedule for these additional funds. In 2007-08, the state is to provide a total of $300 million in settlement monies ($268 million for a new K-12 education programs and $32 million for community colleges career technical education programs). This payment and the subsequent six annual payments are in addition to otherwise required ongoing Proposition 98 funding.

• K-12 Program Has Notable Shortcomings. The K-12 funds are designated for a new top-down, one-size-fits-all, highly prescriptive reform program that assumes all low-performing schools can benefit from the same class size reduction initiative. The program also generates large funding inequities, even among those schools serving disadvantaged students. Given serious concerns with this reform approach, we recommend the Legislature maximize the program’s potential benefits by running it as a well-structured pilot program.

• Career Technical Education (CTE) Program Also Could Be Improved. The CCC funds are to be coupled with existing CTE monies and used to improve CTE linkages and pathways between high schools and community colleges. We are concerned the existing CTE plan lacks long-term goals and a way to evaluate effectiveness. We suggest CTE funds would have a greater impact if the Legislature provided more flexibility over the use of the funds while clarifying the goals of the program and establishing performance measures to gauge the effectiveness of the local improvement process.

Developing a Proposition 98 Roadmap. Although our forecast indicates that resources in 2007-08 likely will be able only to support a baseline budget, our out-year forecast shows sizeable Proposition 98 increases are on the horizon. We project Proposition 98 will have significant amounts of new discretionary funds (that is, more than needed to cover baseline cost increases) in each of the next five years. In fact, by 2011-12 Proposition 98 will have a cumulative increase of $6.6 billion in ongoing discretionary funds available for program expansions. We think the possibility of significant and sustained Proposition 98 increases over the next five years makes this an opportune time for the development of a long-term plan, or roadmap. Moreover, the results of a foundation-supported effort to study the issues of funding adequacy and efficiency in K-12 education are expected to be released in the spring of 2007. These studies may help inform the Legislature’s discussions about needed investments and the types of policy reforms that should accompany these investments.

Benefits of a Proposition 98 Roadmap. A K-14 roadmap could have a number of significant benefits. Most importantly, it could help the Legislature identify problems in the K-14 system and how best to use available new funding—whenever it becomes available—to address those problems. In our suggested roadmap, we provide data showing the notable achievement gap that continues to persist between K-12 special education, low-income, and English Learner students and other K-12 students. To address these gaps, we offer fiscal reforms and accompanying policy improvements relating to child development and programs for at-risk students. For the community colleges, we provide data showing the large percentage of degree- and transfer-seeking students that fail to graduate or transfer to four-year institutions. To address these issues, we suggest “student success” block grants that would provide incentives to improve while still allowing community colleges flexibility to develop local solutions. For both segments, we also suggest the creation of fiscal solvency block grants to help districts’ address the unfunded liabilities related to retiree health benefits.

Higher Education

Background

The state’s higher education system includes the University of California (UC), the California State University (CSU), and CCC, as well as agencies charged with coordinating higher education policy and administering state financial aid programs. Annual adjustments in the state’s cost of providing higher education funding largely arise from three major factors: (1) enrollment, (2) inflation, and (3) student fee levels.

Enrollment Growth. The state uses a “marginal cost” formula that estimates the added cost imposed by enrolling each additional full-time equivalent (FTE) student at the public universities. An increase in the state’s college-age population is a key determinant of increases in those who are eligible to attend each segment. Therefore, most enrollment growth projections begin with estimates of the growth of this population group. As shown in Figure 13, the rate of growth in the college-age population will peak in a couple of years, after which population growth for this age group will slow.

Inflation. Higher education costs rise with general price increases. For example, inflation increases the costs of supplies, utilities, and services that are purchased by campuses. In addition, price inflation creates pressure to provide a COLA to maintain the buying power of faculty and staff salaries.

Student Fees. Student fees constitute an important source of general revenue for all three segments. Through these fees, nonneedy students pay a portion of their own education costs. (In general, financially needy students receive financial aid to cover their fees.) The state currently has no formal policy for setting fees. Thus, fees can be adjusted annually to increase, decrease, or maintain the share of cost borne by students. Cost increases not covered by a student fee increase are generally covered by increased General Fund spending.

Overall Funding Trends. Despite the state’s difficult budget situation in recent years, general-purpose funding (including student fee revenue) received by the higher education segments has generally kept pace with cost increases due to inflation and enrollment growth.

Governor’s Proposal

UC and CSU. The Governor’s budget proposes General Fund support of $6.2 billion in 2007-08 for the state’s public universities. This represents an increase of $357 million (6.1 percent) over the current year. This amount would fund enrollment growth of about 2.5 percent, which would accommodate 5,000 additional FTE students at UC and 8,355 additional FTE students at CSU. The proposed enrollment growth funding is based on a marginal cost methodology that the Governor had proposed last year for his 2006-07 budget, and which the Legislature rejected.

The budget also includes General Fund base increases of 4 percent for the segments. In addition, the Governor’s budget assumes that student fees would increase by 7 percent and 10 percent at UC and CSU, respectively. The budget is silent on how the segments would use the resulting new revenue, which amounts to $105 million for UC and $97.8 million at CSU, essentially leaving allocation decisions to the segments.

Finally, the Governor’s budget would reduce General Fund support for UC and CSU outreach programs by $19.3 million and $7 million, respectively. It would also eliminate $6 million in funding for UC’s labor institutes.

CCC. The budget proposes $4.2 billion in General Fund support for CCC, almost all of which counts towards the state’s Proposition 98 appropriations. Under the Governor’s proposal, General Fund spending would increase by $117 million, or 2.9 percent, from the current year. When student fee revenues and property taxes are also considered, the budget proposal would increase funding for CCC by $271 million, or 4.3 percent. The CCC’s share of proposed Proposition 98 appropriations would slightly exceed its statutory share of 10.9 percent. The Governor’s budget proposal includes augmentations of $109 million for enrollment growth of 2 percent, $238 million for a 4.04 percent COLA, and $32 million for career technical education. The budget would maintain student fees at $20 per unit.

Issues for Legislative Consideration

As discussed in “Part I,” we estimate that the Governor’s overall budget proposal would result in a General Fund deficit of over $700 million at the end of the budget year and a $4 billion structural shortfall in 2008-09, absent corrective action. Given this situation, in our Analysis of the 2007-08 Budget Bill we recommend several ways that the Legislature could create General Fund savings in higher education relative to the Governor’s budget without reducing base programs. We highlight the major issues raised in that analysis below.

Fund Expected Levels of Enrollment Growth. The Governor’s proposed base increases for the three segments far exceed our projected 1.1 percent growth in the underlying college-age population. They also exceed the Department of Finance’s own projections of increases in the enrollment at the segments. We recommend the Legislature instead fund 2 percent enrollment growth at UC and CSU, and 1.65 percent growth at CCC. We also recommend capturing savings from unspent CCC enrollment funding from the current year.

Fund Cost Increases Caused by Inflation. The Governor proposes 4 percent unrestricted base increases for UC and CSU in 2007-08. We estimate that inflation will cause costs to increase by about 2.4 percent in 2007-08. Accordingly, we recommend base increases of 2.4 percent. Because a statutory formula using a lagged index is customarily used to fund COLAs at the CCCs, we do not take issue with the Governor’s proposed augmentation based on that formula.

Maintain Current Share of Cost Covered by Fees. Absent an explicit state fee policy, we recommend that student fees be adjusted in 2007-08 so that they cover the same share of education cost as in the current year. Given our recommendation to fund inflation-based base increases of 2.4 percent at UC and CSU, maintaining the same share of cost in the budget year would require 2.4 percent increases in fee levels. The corresponding increase for student fees at CCC would be less than 50 cents per unit. Given that CCC fees are traditionally charged in whole dollars, and given that current fee levels were adjusted very recently (January 2007), we do not recommend any change to CCC fee levels in 2007-08.

Fund Nursing Programs Using Standardized Approach. The Governor’s budget includes augmentations for nursing programs at UC and CSU. While we agree with the need to increase the supply of nursing graduates, we have concerns with several of the Governor’s proposals. We recommend a more consistent, simpler way to fund the expansion of nursing enrollment in order to improve outcomes and budgetary transparency.

Health Services

Background

California’s major health programs provide health coverage and additional support services for various groups of eligible persons, but primarily poor families and children as well as seniors and persons with disabilities. Medi-Cal is by far the largest state health program with an average monthly caseload estimated to reach 6.7 million persons in the budget year. The Healthy Families Program (HFP), which provides coverage only to children, is assumed in the Governor’s budget plan to reach an enrollment of 916,000 by June 2008. In addition, the state supports various public health programs, community services and state facilities for the mentally ill and persons with developmental disabilities, and community substance abuse programs.

Overall Growth Trend. If the spending levels proposed in the 2007-08 budget are adopted, General Fund spending on health services programs will have grown by $8.3 billion, or 68 percent, from 2000-01 through 2007-08. This represents an average annual growth rate of about 7.7 percent.

Main “Cost Drivers.” Much of the increase in General Fund expenditures has been driven by increases in caseload, costs, and utilization of services in Medi-Cal. Increased expenditures for prescription drugs, hospitalization, and long-term care for the aged and disabled have been a significant component of this increase in program costs. Growth in caseloads for community services for persons with developmental disabilities and the mentally ill have also contributed significantly to the increase in General Fund spending for health services.

Governor’s Proposal for Health Care Reform Independent From the Budget. On January 8, 2007, the Governor announced a health care proposal aimed at ensuring that all Californians have health care coverage. This proposal did not provide a timeline for implementation and is not reflected in the budget plan. However, we note that the Governor’s proposal would have a significant impact on future funding for state health programs if it were enacted as proposed.

Department of Public Health (DPH). Effective July 1, 2007, the budget plan implements Chapter 241, Statutes of 2006 (SB 162, Ortiz), that creates a new DPH and Department of Health Care Services (DHCS) from the existing Department of Health Services. The DPH will administer a broad range of public and environmental health programs while the DHCS will administer the Medi-Cal Program. This change is intended to result in increased accountability and improvements in the effectiveness of both public health and Medi-Cal by allowing each department to administer a narrower range of programs. The legislation creating the two departments requires that the change be cost neutral to the state.

Governor’s Proposal

The Governor’s budget plan includes a number of budget proposals that would result in significant ongoing commitments of General Fund resources for the support of health programs. The budget plan also includes a number of budget proposals that would result in General Fund savings. We discuss the most significant proposals below.

Staffing Expansions. The administration proposes to add about 177 positions for the support of DHCS programs and about 280 positions for the support of DPH programs. Many of the positions proposed by the administration for DHCS and DPH would provide staff to perform activities required by recent legislation. The budget would also add about 151 positions to the state hospital system in the current year and about 508 in the budget year in response to new laws that are expected to increase the number of sexually violent predators committed to state hospitals.

Major Savings Proposals. The Governor’s budget plan proposes elimination of the Integrated Services for Homeless Adults with Serious Mental Illness program for savings of almost $55 million General Fund. Increases in General Fund support for regional centers (RCs) that provide services to developmentally disabled individuals would be partly offset by a one-time shift of $144 million in PTA funds to pay the transportation costs of RC clients that previously were paid from the General Fund. The Governor’s spending plan also includes a reduction of $44 million General Fund to the RC budget as a result of an initiative to draw down an increased federal funds match for certain residential care facilities. Finally, the Governor’s spending plan proposes a reduction of $25 million General Fund for Substance Abuse and Crime Prevention Act (Proposition 36) programs.

Issues for Legislative Consideration

In “Part I” of this volume we discuss our assessment of the significant budget challenge facing the state in 2007-08. Federal policies affecting California’s health programs may further aggravate the state’s fiscal situation. For example, we project that the state is likely to exhaust its carryover of surplus federal funds for the support of HFP in 2008-09. Without a significant increase in federal funds, it is likely that General Fund support for HFP would have to increase markedly if the present eligibility and benefit levels were to be maintained.

Under these circumstances, the Legislature should carefully consider its opportunities for achieving health program savings in the near term. For example, we recommend that the Legislature reject some of the DHCS and DPH staffing requests that we found lacked sufficient workload justification. The Legislature should also carefully consider whether the Governor’s proposed reduction in funding for Proposition 36 programs would result in savings. Based on our analysis, a reduction in funding for Proposition 36 would probably result in future increased prison costs that are the same or greater than the amount of the reduction.

Invest in Reforms Offering Future General Fund Savings. We believe that the Legislature could initiate cost-cutting reforms in health programs that, perhaps with some initial state investment, are likely to pay off over time in significant savings in state health program costs. These reform options include the following:

• Assist Veterans to Obtain Federal Health Care Benefits. We recommend the Legislature explore ways to assist Medi-Cal beneficiaries who are military veterans, and are thus entitled to the comprehensive health coverage offered by the U.S. Department of Veterans Affairs (VA), to apply for and receive those benefits. To facilitate this process, we have identified a federal computer data matching process known as the Public Assistance Reporting Information System that could likely be implemented at a low cost and would allow the state to easily identify veterans enrolled in Medi-Cal. We estimate a shift of veterans from Medi-Cal to the VA health care system could save the state as much as $250 million in General Fund monies.

• Shift Emergency Room Patients to Primary Care. The state could improve access to community-based primary care programs and create appropriate incentives and referral systems to encourage patients to use less expensive clinics and doctor’s offices instead of hospital emergency rooms for nonemergency services.

• Expand Managed Care for Seniors and Other Groups. More seniors and persons with disabilities could be placed into managed care where their medical services could be better coordinated and their high costs for hospitalization reduced through greater access to preventive care.

• Audit Purchase of Service. Weaknesses evident in the fiscal controls for the purchase of services by RCs could be addressed by conducting an audit of this program. We believe such an audit would likely lead to tighter scrutiny and savings expenditures for this program.

• Link Provider Rates to Objective Measures. Provider rates for state programs are often set on an ad hoc basis with increases or decreases depending on the state’s near-term fiscal condition. Instead, the state could link provider rates, such as those for regional center vendors, to objective measures which would determine the minimum rates needed to ensure appropriate access to services as well as quality of services for program beneficiaries. Over time we believe this approach would hold down state costs.

• Monitor HFP Funding. If future allocations of federal funds by Congress for HFP remain limited, the state faces the choice as soon as 2008-09 of either backfilling a major shortfall of funding for HFP completely with General Fund support or reducing program eligibility and benefits. One alternative, however, would be to shift some children now eligible for HFP into Medi-Cal, which is generally funded 50-50 with state and federal funds. Other options for resolving the HFP shortfall are also worth considering.

The Governor’s proposal for health care coverage expansion is analyzed in more detail in “Part V” of this volume “Major Issues Facing the Legislature.” The above proposals for state savings in health care programs are outlined in the ”Health and Social Services” chapter of the Analysis of the Budget Bill for the years 2005-06, 2006-07, and 2007-08.

Social Services

Background

California’s major social services programs provide a variety of benefits to its citizens. These include income maintenance for the aged, blind, and disabled; cash assistance and welfare-to-work services to low-income families with children; protecting children from abuse and neglect; providing home-care workers who assist the aged and disabled in remaining in their own homes; and subsidized child care for families with incomes under 75 percent of the state median. Under the Governor’s budget proposal, General Fund expenditures for the state’s social services programs would be $9.3 billion in 2007-08, about 9 percent of proposed General Fund expenditures for all purposes.

Overall Growth Trend. From 2000-01 through 2002-03, General Fund spending for social services increased by about $1 billion (16 percent). Since 2002-03, total General Fund spending for social services programs has been essentially flat, rising from $8.8 billion to just over $9.3 billion proposed for 2007-08. The $500 million increase over these five years represents an annual average growth rate of 1.1 percent. In contrast, General Fund spending on all other programs has increased at an average annual rate of 5.9 percent during this time period. As a result, social services share of the total General Fund budget has declined from 11.4 percent to 9 percent.

This relatively flat growth in social services is attributable to many factors. These include additional federal funds (and corresponding General Fund savings) for In-Home Supportive Services (IHSS), periodic suspensions of state COLAs for welfare grants, shifting habilitation services (previously provided in the Department of Rehabilitation) to the Department of Developmental Services, not funding inflationary cost increases for county administration, and the recent cessation of federal penalties for failing to complete a statewide automated child support enforcement system.

Governor’s Proposal

The budget provides the 3.7 percent Supplemental Security Income/State Supplementary Program COLA at a cost of $172 million, but suspends the CalWORKs COLA, resulting in a cost avoidance of $124 million. In addition to COLAs, the most significant social services policy proposals in the Governor’s budget concern CalWORKs participation sanctions, CalWORKs time limits, and the state share of IHSS provider wage increases.

Increasing CalWORKs Sanctions. Currently, when an able-bodied adult does not comply with CalWORKs participation requirements, the family’s grant is reduced by the adult portion, and the children continue to receive a “child-only” grant. The budget proposes a “full family sanction” whereby the reduced grant for the children is eliminated if an adult is out of compliance with participation requirements for at least three months. In response to this increased sanction, the budget estimates that many families will enter employment, resulting in child care and employment services costs of $28 million. In cases where families do not comply, the budget estimates grant and administrative savings of $17 million, so the net cost of this proposal is about $11 million.

Time Limits for Children Receiving CalWORKs. Currently, after five years of assistance, a family’s grant is reduced by the adult portion, and the children continue to receive a child-only grant in the safety net program. The budget proposes to eliminate the safety net grant for children whose parents fail to comply with the federal work participation requirements (20 hours per week for families with a child under age 6 or 30 hours per week for families where all children are at least age 6). The budget also proposes to limit assistance to five years for most other child-only cases (such as those with parents who are undocumented or ineligible due to a previous felony drug conviction). These time limit policies are estimated to result in savings of about $336 million in 2007-08.

Limit State Participation in IHSS Provider Wages. Currently, counties negotiate the wages paid to individuals who provide home care services to IHSS recipients. Under current law, the state participates in IHSS provider wages up to $11.10 per hour during 2006-07, rising to $12.10 per hour in 2007-08. (The increase to $12.10 per hour is pursuant to a revenue “trigger” whereby additional state participation is triggered when year-over-year revenues increase by at least 5 percent.) The Governor’s budget proposes to freeze state participation in wages to the level provided in each county as of January 10, 2007. The administration now indicates that it will continue to participate in post-January 10 wage increases during 2006-07 until the date when its urgency legislation proposal prospectively limiting state participation in wages is enacted by the Legislature. The budget scores savings of $14.1 million in 2007-08.

Issues for Legislative Consideration

CalWORKs Full-Family Sanction and Time Limit Proposal Not Needed to Meet Federal Work Participation Requirements. The Governor’s budget states that increased CalWORKs sanctions and new time limits are necessary to increase the state’s work participation rate so that the state can avoid substantial federal penalties. However our review of the Governor’s assumptions about the impacts of current law and the ability for the state to obtain a caseload reduction credit indicate that these policy changes are not necessary in order for the state to attain federal compliance by federal fiscal year 2008. We offer an alternative sanction policy which would combine an “up-front engagement” strategy modeled on a sanction prevention program in Los Angeles County with an increased sanction amount if the adult is unwilling to meet participation requirements after three months.

Alternatives to the Governor’s IHSS Wage Freeze Proposal. By freezing state participation in provider wages, the budget eliminates the state’s exposure of about $350 million from wage increases that counties may grant in future years. Alternatively, the Legislature could eliminate the final revenue trigger, thus limiting future exposure to $225 million. This would provide all counties with an opportunity to increase wages to $11.10 per hour and receive state participation. Finally, the Legislature could delay the final trigger indefinitely.

Budget Faces Substantial Risks From CalWORKs Lawsuit and Reduced Federal Funding for Foster Care/Child Welfare Services. A superior court has ruled in the Guillen court case that the October 2003 CalWORKs COLA is required by current law. In December 2006, an appellate court heard the state’s appeal and a decision is anticipated in early 2007. Unless the appellate court overturns the prior decision, the state faces one-time CalWORKs grant costs of approximately $434 million. The one-time costs are for 45 months of grant payments (October 2003 through June 2007) owed to recipients on aid during this time period. In addition, the state would face ongoing grant costs of $114 million each year, unless it enacted legislation to reduce grants prospectively.

The state also faces a potential disallowance of $100 million in federal funds for foster care because the state was out of compliance with federal rules concerning identical treatment of relative and nonrelative foster parents back in 2000-01. Finally, the state faces potential child welfare penalties of approximately $20 million in 2007-08 unless it substantially improves its performance on three outcome measures.

Criminal Justice

Background

The criminal justice portion of the budget consists primarily of funding for the California Department of Corrections and Rehabilitation (CDCR), the Judicial Branch, and the Department of Justice (DOJ). The CDCR is responsible for the incarceration and supervision of more than 320,000 offenders, including about 172,000 adult inmates and almost 123,000 adult parolees. The Judicial Branch includes the Supreme Court, Courts of Appeal, 58 trial court systems, the Judicial Council, and the Habeas Corpus Resource Center. The DOJ enforces state laws, provides legal services to state and local agencies, and provides support services to local law enforcement primarily through the operation of the state’s 11 crime laboratories.

Spending for criminal justice programs represents about 13 percent of total General Fund spending. Since 2000-01, the budget for these programs has grown at an average annual rate of about 8.3 percent. Below we discuss some of the factors that have led to increased spending, as well as briefly summarize recent budget initiatives.

Corrections. In recent years, corrections spending has primarily been driven by (1) growth in the number of inmates, (2) correctional officer salary increases, and (3) court mandates related to inmate health care. Recent budget initiatives to reduce spending have sought to reduce the number of parolees returned to prison for nonviolent offenses, as well as to better control spending on staff overtime.

Judicial Branch. Growth in state spending for court operations has resulted primarily from annual adjustments for growth and inflation on certain trial court expenditures provided in accordance with the State Appropriations Limit (SAL). These adjustments are used to fund increases in court employee salaries (excluding judges) and services provided to the courts (for example, court security). Budget strategies to reduce General Fund spending included one-time and ongoing unallocated reductions, as well as the establishment of new and increased court fees.

Governor’s Proposal

The budget proposes General Fund expenditures of about $13 billion for criminal justice programs. This amount—which includes support for operations, capital outlay, and debt-service for related facilities—represents an increase of about $1 billion, or 8.7 percent, above the revised level of current-year spending for these programs.

Corrections. The Governor’s budget proposes to increase spending from all sources for CDCR operations by $607 million, or about 7 percent. The primary causes of this proposed increase are projected increases in the prison and parole populations, salary adjustments, federal court mandates to improve inmate health care, and the implementation of new laws related to the management of sex offenders. In addition, the budget plan includes $10.1 billion in capital outlay projects (funded mainly through lease-revenue bonds) to expand state prison and county jail capacity and to make improvements on the grounds of existing state prisons.

Judicial Branch. Overall, the budget proposes to increase spending for the judicial branch by $196 million, or 5.6 percent. This includes funding for the Trial Court Funding program (primarily superior courts), as well as the judiciary (Supreme Court, Courts of Appeal, Judicial Council and the Habeas Corpus Resource Center). The overall net increase is primarily the result of annual SAL adjustments for growth and inflation, adjustments for the cost of new or expanded programs, and increases for the cost of implementing recent legislation to increase oversight of conservators and guardians.

Issues for Legislative Consideration

Prison Capacity Package. In order to address a high level of overcrowding of inmates in the state prison system, the administration has presented a 14-part package of proposals that would both build additional capacity to incarcerate offenders at the state and local level and reduce the number of state prison inmates. The Legislature should carefully consider the total impact of all of the components of the proposal on the prison inmate population, including the number of beds relative to the projections in inmate growth, as well as the specific classification levels of offenders affected by the proposal. Our analysis indicates that the administration plan, which includes changes in sentencing laws and parole supervision practices, is more balanced overall than one offered in a special legislative session last summer. However, we find that it goes too far in terms of the total number of beds established and provides the wrong mix of beds. The Legislature should consider alternatives to the Governor’s approach, including one we have developed that we believe remedies these problems.

California Prison Receivership. The federal court appointment last year of a Receiver to take over the state’s prison medical care system is already resulting in a number of actions intended to improve inmate care. At the same time, there is significant uncertainty regarding the costs and savings likely to result from the Receiver’s actions. So far, the Legislature has received only limited information about the fiscal implications of the changes to the medical system that the Receiver is pursuing. Given this situation, it will be important for the Legislature to apply its standard budgetary processes to carefully review and act upon each support and capital outlay budget request submitted to it in behalf of the Receiver. We also believe there are opportunities for legislative oversight of these major changes in the prison medical system. For example, the Receiver is to submit a plan to improve the inmate health care system to a federal court in May 2007. Legislative hearings could be conducted to better understand the fiscal and operational implications of the plan, as well as the metrics to be used to measure progress in improving inmate medical services.

Juvenile Justice System Changes. The budget plan for CDCR’s Division of Juvenile Justice reflects administration proposals to (1) shift some offenders from the state to the local level and (2) enact a new state grant program to build county juvenile facilities. As regards the grant program, the budget proposes to provide $400 million in state lease-revenue bond financing to build as many as 5,000 local juvenile beds. The proposed shift in offenders presents an opportunity to mutually benefit the state, counties and the offenders and their families. As the Legislature considers these proposals, it may wish to take into account that a decline in the county juvenile institutional populations and past programs to build additional local juvenile capacity have resulted in about 4,000 beds of excess capacity at the local level.

Courthouse Bond Proposal. The administration is proposing a $2 billion general obligation bond issue for the construction and renovation of courthouses to be placed before voters in November 2008 for their consideration. It is also proposing changes in state law to authorize the Judicial Council to leverage “private-public partnerships” for the construction of court facilities. Such arrangements could be an effective way for the state to attract additional capital and help offset the costs to the state over time of building and operating these facilities. However, the potential benefits are dependent on key aspects of such agreements that are not detailed in the administration proposal. Moreover, if the Legislature does choose to approve such a bond issue, it should consider funding only courthouse projects where responsibility for the facility has been transferred to the state.

Transportation

Background

California’s state transportation programs are funded by a variety of sources, including special funds, federal funds, and bonds. While state transportation programs have traditionally been funded on a pay-as-you-go basis from taxes and user fees, last year’s passage of Proposition 1B provides almost $20 billion in bond funds for state and local transportation programs.

Traditional State Fund Sources. Two special funds—the State Highway Account (SHA) and PTA—have traditionally provided the majority of ongoing state funding for transportation. The SHA is funded mainly by an 18-cent per gallon tax on gasoline and diesel fuel (referred to as the gas tax) and truck weight fees. Generally, these funds have provided a predictable source of funding for transportation.

The PTA is funded by sales tax on diesel fuel and a portion of the sales tax on gasoline. Some PTA revenues come from “spillover”—the amount that gasoline sales tax revenues at the 4.75 percent rate exceed the amount generated from sales tax on all other goods at the 0.25 percent rate. Most PTA revenues are fairly stable; however, spillover can vary greatly from year to year, as it corresponds with fluctuations in gasoline pump prices and the total economy.

More Recent State Fund Sources. In 2002, voters approved Proposition 42, which amended the State Constitution to dedicate revenue from the sales tax on gasoline to transportation. Proposition 42 requires that these revenues fund projects in the Traffic Congestion Relief Program (TCRP) through 2007-08, and on an ongoing basis, fund projects in the State Transportation Improvement Program (STIP), local streets and roads improvements, as well as transit purposes funded by PTA.

When the state faced fiscal difficulties in 2003-04 and 2004-05, Proposition 42 funds were loaned to the General Fund. Proposition 1A, approved by voters in November 2006, restricts the state’s ability to borrow these funds and requires that about $750 million in prior-year loans be repaid to transportation by June 30, 2016.

In addition, the recent passage of Proposition 1B at the November 2006 election provides $20 billion in bonds to fund transportation projects over multiple years. The measure creates several new programs to fund a variety of transportation purposes, including highway and transit capital, facilities for goods movement, local road improvements, as well as safety and security enhancements. All funds in the Proposition 1B bond program are subject to appropriation by the Legislature.

Overall Growth Trend. Figure 14 shows expenditures for state transportation programs from state and federal fund sources from 2000-01 through 2007-08. The figure shows that expenditures were relatively stagnate prior to 2004-05, but have grown steadily since. Increased expenditures in 2004-05 reflect a one-time change in accounting methodology. Since then, increased expenditures are due to full funding of Proposition 42 in 2005-06 through 2007-08, proposed expenditure of Proposition 1B bond funds in the current and budget years, as well as reauthorization of the federal transportation program in August 2005. While gas tax and weight fee revenues remain the primary source of state funding for transportation in California, they have remained relatively flat and therefore do not contribute significantly to the increase.

Governor’s Proposals

The 2007-08 budget includes a number of proposals related to transportation funding. In the aggregate, these proposals would increase funding for major transportation programs in 2007-08 compared to estimated current-year funding. Specifically, the budget proposals include:

• Fully Fund Proposition 42, Partially Repay Past Loan. The budget proposes $1.5 billion, of which $602 million is for TCRP projects, $698 million is for STIP projects, and $175 million is allocated to PTA for transit purposes. The budget also proposes to repay from the General Fund $83 million in past loans.

• Begin Using Proposition 1B Funds. The budget proposes to appropriate $7.7 billion in Proposition 1B bond money in 2007-08. Of that amount, about $2.8 billion would be for projects in the budget year. The budget also proposes to expend $523 million in bond funds in the current year.

• Use Tribal Compact Revenues to Repay Debt, Instead of Bond Funds. The budget proposes to use $100 million in tribal compact revenue in each of the current and budget years to repay a portion of a transportation loan to the General Fund. This is in lieu of bond funds, backed by tribal compact revenues, to repay the transportation loans, an approach which is currently the subject of litigation.

• Use Transportation Funds to Offset General Fund Expenditures. The budget proposes to use $1.1 billion in PTA funds to offset General Fund expenditures, including:

— Debt Service on Transportation Bonds. Use the first $340 million in spillover revenues in 2007-08 to pay debt service on outstanding transportation bonds, which has traditionally been paid from the General Fund.

— Home-to-School Transportation and RC Transportation. Use $771 million in PTA money to fund transportation purposes generally paid for by the General Fund. Of that amount, $627 million is proposed to fund Home-to-School transportation on an ongoing basis and $144 million is for one-time support of RC transportation.

— Reduce Funding for State Transit Assistance (STA). First, the budget proposes to permanently discontinue allocation of spillover revenue to STA, which funds transit operations. Second, the budget proposes to reduce the amount of other PTA revenues that are allocated to STA in 2007-08 to compensate for an overappropriation to STA in 2006-07, relative to the amount required under current law.

Issues for Legislative Consideration

Appropriating Proposition 1B Funds. The budget includes two proposals related to Proposition 1B funds, which would circumvent legislative oversight. First, the budget requests three-year appropriations of Proposition 1B bond funds, totaling $7.7 billion for various transportation programs, even though only $2.8 billion would be spent in the budget year. Second, it proposes budget bill language that would allow the administration to transfer appropriated funds among Proposition 1B programs. These proposals run counter to the bond measure’s intent that the Legislature appropriate specific amounts for particular transportation programs. The “power of the purse”—appropriation authority—is one of the Legislature’s most powerful tools to ensure accountability. By providing three-year appropriations and allowing the administration to transfer the funds from one purpose to another, as the Governor proposes, this appropriation authority would be circumvented. Accordingly, we recommend that the Governor’s proposals be rejected.

Slim PTA Balance Could Evaporate; Expenditure Priorities Should Be Established. The budget curtails certain transit expenditures in 2007-08 in order to use $1.1 billion in PTA funds to offset General Fund expenditures. Moreover, it leaves only a small balance of $69 million at the end of the budget year. Because of the volatility of certain revenues, total available PTA funds could be significantly lower than projected, resulting in an account shortfall in 2007-08. Higher than assumed expenditures for transit projects could also bring about a shortfall in PTA. Accordingly, we recommend that the Legislature establish priorities for PTA expenditures in 2007-08, including what expenditures would not be made in the event of insufficient PTA funds.

Reduce PTA Volatility; Increase STA Funding Predictability. The passage of Proposition 42 renders the spillover mechanism unnecessary. This is because Proposition 42 results in all state gasoline sales tax revenues being used for transportation, thus ensuring a total level of funding for transportation from gasoline sales tax that is unchanged by the spillover mechanism. In order to simplify the state’s funding structure, we recommend the enactment of legislation to eliminate the spillover mechanism for generating revenue into PTA beginning in 2008-09. This action would leave the total level of state funding for transportation unchanged and would reduce the volatility in PTA. While eliminating spillover would result in less funding for STA in some years, it would increase the predictability and stability of annual program funding. Moreover, additional funds could become available for broader transportation purposes.

If Tribal Bonds Not Issued, Repayment to Transportation Would Span Far Into Future. Because of pending litigation, the state has not yet issued tribal bonds to repay certain transportation loans and probably will not be able to do so in the near future. As a result, the budget proposes to use available tribal compact revenues to repay loans in 2006-07 and 2007-08, rather than issuing bonds. This would provide almost $200 million for highway rehabilitation over the two years. However, if bonds are not issued, it could take another ten years (until 2016-17) to repay all of the loans with tribal compact revenues as they become available on an annual basis. This delayed repayment could impede construction of TCRP projects, which are intended to relieve congestion. We recommend actions the Legislature can take so that congestion relief projects are completed in a timely manner, including setting project deadlines and reverting funds when projects are no longer viable.

Maintenance and Rehabilitation Needs Outpacing Available Funds. As the state‘s highways age, the costs to maintain and rehabilitate them are increasing. While the Governor’s budget proposes more funding for highway maintenance and rehabilitation in 2007-08, it does not address the long-term issue that needs are growing faster than the revenues which pay for these activities. The Legislature should consider actions to ensure sufficient revenues are available to address long-term maintenance and rehabilitation needs. We recommend actions including raising and indexing the gas tax and exploring mileage-based fees.

Resources

Background

Resources and Environmental Protection Programs. The state’s resources and environmental protection programs are administered under the Resources and California Environmental Protection (Cal-EPA) Agencies, respectively. The Resources Agency, through its 26 departments, boards, commissions, and conservancies, is responsible for the conservation, restoration, and management of California’s natural and cultural resources, including state parks and wildlife habitat. The Cal-EPA, through its six departments, boards, and offices, is responsible for the protection and improvement of the state’s environmental quality and public health, mainly through regulatory programs that control, mitigate, and clean up the impacts of pollution on the environment.

Overall Growth Trend. State expenditures for resources and environmental protection programs have increased from about $4.6 billion in 2000-01 to $6.5 billion in 2007-08 (excluding costs of debt service). This reflects a 42 percent increase, or an average annual increase of about 5 percent. The increase mostly reflects growth in expenditures from fee-based special funds and bond funds. General Fund expenditures proposed for 2007-08 are substantially below the 2000-01 spending level—a decrease of $1.3 billion.

Bond fund expenditures increased during this period, reflecting the availability of these funds from five resources bond measures (totaling $11.1 billion) approved by the voters between 1996 and 2002 and two measures (totaling $9.5 billion) approved by the voters in November 2006. These bond measures provide funding for a mix of water, flood control, park, and land acquisition and restoration purposes. While the five 1996 through 2002 resources bond funds are running out—at the end of 2007-08, roughly $700 million will remain available for new projects—the November 2006 bonds provide a substantial influx of funds that will be available for many years.

The bulk of the increase in special fund spending during this period is due to new or increased fee revenues. A significant proportion of the increases in special fund expenditures since 2000-01 reflect expenditures that fully or partially offset General Fund reductions. This has occurred mainly in regulatory programs where fees are levied on the regulated parties that benefit directly from the state program. In this regard, fees have replaced General Fund revenues to a significant degree in the Air Resources Board, Department of Pesticide Regulation, and the State Water Resources Control Board.

Cost Drivers. Some resources departments own and operate public facilities, such as state parks and boating facilities, which drive their costs. In addition, the state’s resources and environmental protection programs include a number of regulatory programs whose costs are driven by their regulatory activities. Finally, some resources activities have a public safety purpose, and the cost drivers include emergency response costs that can vary substantially from year-to-year.

Governor’s Proposal

Flood Protection and Water Management. The budget proposes significant expenditures for various flood protection and water management activities, reflecting a major infusion of funding for these purposes from the Propositions 1E and 84 bond measures.

For flood protection, the budget proposes total spending of $725 million (mostly bond funds) in the Department of Water Resources’ flood management program in 2007-08—an increase of $510 million, or 70 percent, above current-year funding for this purpose. In addition, the budget proposes to use $200 million of Proposition 1E funds to reimburse the General Fund for flood control expenditures that were incurred prior to bond passage and were made from a $500 million continuous appropriation in Chapter 34, Statutes of 2006 (AB 142, Nuñez).

For water management, the budget includes $473.6 million of state funds (mostly bonds)—spread throughout eight state departments—for the CALFED Bay-Delta Program (CALFED) in 2007-08. This level of expenditure is essentially the same as the current-year level. The program is awaiting the findings of a number of ongoing planning efforts and program assessments that will guide its future direction and funding requirements.

Also as part of water management, the budget requests 78 new positions for the State Water Project (SWP)—the state’s main water conveyance system. The SWP is “off budget”—meaning that funds to support the positions, as well as all other functions of SWP, are not appropriated in the annual budget bill.

Resources Bonds. The budget proposes about $2.3 billion in bond funds for various resources programs in the budget year. Of this amount, about $1.8 billion is from the November 2006 bonds—$1.1 billion from Proposition 84 (parks, resource conservation, water management), $624 million from Proposition 84 (flood control), and $98 million from Proposition 1B (transportation and air quality).

The Governor has proposed that a $4 billion water management bond be placed before the voters in 2008. The proposed bond would provide $2.5 billion for surface and groundwater storage projects; $1 billion for conveyance, water quality, ecosystem restoration, and levee improvement projects in the Delta; and, $450 million for water conservation and various restoration projects.

Wildland Fire Protection. About $1.2 billion, or 94 percent, of the California Department of Forestry and Fire Protection’s (CDFFP’s) proposed expenditures in the budget year is for its fire protection activities. These activities primarily take place on “state responsibility areas (SRA)”—over 30 million acres of primarily privately-owned timberlands, rangelands, and watersheds located throughout the state. The vast majority of the funding for the department’s fire protection activities comes from the General Fund, with the balance coming from reimbursements (for fire protection services provided to other levels of government) and lease-revenue bonds (for capital outlay projects).

State Parks Maintenance. The state park system includes 278 units, of which about 250 are directly managed by the Department of Parks and Recreation (DPR). These park facilities vary from state beaches to historic parks to off-highway vehicle recreation areas. The budget proposes about $67 million to operate and maintain the state park system, funded mainly from the General Fund and park fee revenues. While the 2006-07 Budget Act appropriated $250 million from the General Fund to begin addressing a backlog in deferred maintenance projects at state parks, the administration proposes to spend only $90 million of this amount and transfer the remaining balance ($160 million) back to the General Fund. The budget provides no funding for deferred maintenance in 2007-08.

Issues for Legislative Consideration

Flood Protection. Given the substantial infusion of funds for flood management, we think that it is particularly important for the Legislature to be advised of the administration’s criteria for selecting projects for funding, and to set its own expenditure priorities. We also find that legislative oversight of would be enhanced by providing for independent review of and reporting on flood-related capital outlay projects, and reporting on expenditures from the $500 million AB 142 appropriation. We think that there is an opportunity to create General Fund savings by transferring unspent funds from the AB 142 appropriation back to the General Fund, replacing these funds with bond funds.

Water Management. Regarding CALFED, we think that the performance measures that CALFED is currently developing would be used more effectively if they were tied to the budget process. We also recommend denying a number of CALFED budget proposals, on the basis that that they either are premature, funded from an inappropriate funding source, or lack matching funds.

As for SWP, we find that its off-budget status complicates the Legislature’s capacity to address the state’s water policy issues, including Delta issues, in a comprehensive way. This is particularly the case because of SWP’s ties to a number of other major on-budget programs, such as CALFED. We therefore recommend that SWP be brought on budget in order to facilitate legislative oversight.

Resources Bonds. We offer a number of recommendations to ensure the effective and efficient implementation of Propositions 1E and 84, consistent with legislative priorities. First, we recommend the enactment of legislation establishing eligibility criteria for new Proposition 84 programs and for bond-funded flood control programs, and to address the funding eligibility of private water companies. Second, the Legislature should establish appropriate state-local cost sharing arrangements for bond-funded flood control projects, and assess the likelihood receiving federal matching funds. Next, the Legislature should consider opportunities to coordinate similar programs across bonds. For example, we recommend consolidating the administration of Propositions 1C and 84 funding for local parks under DPR. Finally, we make a number of recommendations regarding legislative oversight of bond expenditures, including recommendations to hold hearings, establish reporting requirements, and set parameters on bond-funded administrative costs to ensure that they are reasonable.

Wildland Fire Protection. The CDFFP’s fire protection budget has increased significantly over the last decade, growing an average of 8 percent annually. We make a number of recommendations to control the department’s rising costs. First, we recommend the Legislature clarify the roles of the state and local government for emergency services in SRA. We also recommend the enactment of legislation to levy a fire protection fee on private landowners in SRA, so that the beneficiaries of state fire protection pay a portion (50 percent) of its cost. Finally, we recommend that the Legislature consider modifying the current criteria for designating SRA, such that local governments take more responsibility for fire protection on lands where locally-approved development is occurring.

State Parks Maintenance. Despite a growing backlog of deferred maintenance in state parks—totaling around $900 million—the budget proposes no funding for this purpose in the budget year. We make a number of recommendations to address the existing backlog and to slow its growth in the future. Specifically, we recommend appropriating $160 million from Proposition 84 bond funds to backfill the Governor’s proposed reversion, requiring the department to develop a strategy to use outside funding sources to help fund deferred maintenance projects, and augmenting the department’s ongoing maintenance budget by $15 million from fees.

State Employment and Retirement

Background

Pay for State Employees. The state’s costs for paying state employees are determined primarily through collective bargaining with employee unions. The pay, benefits, and working conditions for these employees are typically spelled out in memoranda of understanding (MOUs) negotiated between unions and the state. Costs for state employees (including higher education) are projected to total more than $28 billion in 2007-08, over one-half of which is supported from the General Fund. Nineteen of the state’s 21 bargaining units—all except attorneys and correctional officers—have MOUs that remain in effect until at least the end of 2007-08.

Retirement Costs. As part of the employee compensation package, the state makes annual contributions to various retirement programs to fund benefits for state employees and teachers that will be paid out in the future. In recent years, the state’s retirement costs have increased significantly. For instance, state General Fund retirement costs (excluding payroll taxes for state employees’ Social Security and Medicare benefits) have increased from $1.2 billion in 1998-99 to a projected $4 billion in 2007-08. Key factors explaining this increase are the poor investment performance of retirement funds in the early part of the decade and rising health care costs. The state’s General Fund retirement costs during the past decade are summarized in Figure 15.

Governor’s Proposal

Increased Pay for 19 of 21 Bargaining Units With Current MOUs. The Governor’s budget would increase employee compensation by an estimated $1.2 billion in 2007-08, with over one-half of these costs to be paid from the General Fund. The vast majority of these funds address costs related to current labor agreements, court orders, and arbitration decisions. Most state employees will receive an inflation-based salary increase in 2007-08. Over $100 million of the funds—primarily in the budget of CDCR—would increase pay for prison and other state health care personnel as a result of court orders in prison health care cases. The budget plan also includes funds to address a recent arbitration decision awarding $440 million in additional pay to correctional officers. (These funds cover 2005-06, 2006-07, and 2007-08.) There are no funds budgeted for any additional pay increases for correctional officers or attorneys in 2007-08, pending outcomes of the state’s negotiations with these bargaining units for new contracts.

Retirement Costs. The Governor’s budget includes three proposals to change the way the state funds retirement benefits. First, the budget proposes to reduce contributions to the California State Teachers’ Retirement System’s purchasing power account—which protects retired teachers’ benefits from being eroded by inflation—by $75 million on an ongoing basis. The reduction in contributions would be implemented in exchange for the state’s guaranteeing that teachers’ benefits will be maintained at no less than 80 percent of their original purchasing power. In addition, the administration proposes to use the state’s $38 million of annual employer drug subsidies under the Medicare Part D program to cover a portion of the state’s payments to the California Public Employees’ Retirement System (CalPERS) for state retiree health benefits. This proposal would reduce state General Fund costs by a commensurate amount. Finally, on a one-time basis, the administration proposes to offset 2007-08 General Fund contributions to CalPERS by $525 million by issuing debt. Relying on existing state law, the administration proposes to issue pension obligation bonds. Thus far, the state’s courts have ruled that such a sale is unconstitutional without voter approval.

Issues for Legislative Consideration

Correctional Officer Salaries. Since state negotiators are currently at the bargaining table with the state’s correctional officers union, the Governor’s budget includes no funds for a 2007-08 pay raise or increased state contributions to health premiums for the officers. The state’s labor agreement with correctional officers expired in July 2006, and under state law, the terms of expired labor contracts continue in effect until a new agreement is approved. Because correctional officers, their supervisors, and managers receive more than 40 percent of the salaries and salary-driven costs paid from the General Fund (over $3 billion per year), a realistic budget plan requires decisions about correctional officer pay. Each 1 percent increase in officer salaries will increase state General Fund costs by about $35 million.

Unfunded Liability for Retiree Health. Under state law, the state pays for most of the costs of health plan premiums for retired state and CSU employees and their dependents. Annual payments are rising significantly to pay for existing retirees’ benefits. Like most governments across the United States, the state has not set aside assets that could be used to fund part of the future costs of benefits for the state’s current and past employees. Under a new governmental accounting rule to take effect soon, the state and other governmental entities will be required to calculate the unfunded liability for retiree health benefits (similar to the one already calculated for pension benefits). As we discussed in The 2006-07 Budget: Perspectives and Issues, this liability will be very large—for the state, some school districts, many local governments, and the UC. We anticipate that the state will receive the draft results of its first retiree health liability valuation during calendar year 2007. We estimate that the state’s unfunded liabilities for retiree health benefit will be $40 billion to $70 billion or perhaps more. We recommend that the Legislature begin to set aside funds for these benefits to moderate long-term budgetary pressures.

Pension Unlikely to Be Issued. Due to court rulings to date, we believe it is unlikely that the sale of the pension obligation bonds will occur during the budget year, if ever. Consequently, it is a risky assumption to credit such a sale as helping the state budget’s bottom line in 2007-08. Even if the bonds could be sold, however, we would advise on a policy basis not to proceed with a sale. We have consistently recommended against issuing the bonds since they would incur debt for an annual operating expense.

Legislative Oversight of Employee Compensation. Recent agreements with unions, arbitration decisions, and administration actions have all undermined the Legislature’s ability to effectively oversee the compensation that is paid to state employees. In “Part V” of this publication, we offer recommendations geared toward the Legislature focusing state employee compensation expenditures within the context of a balanced budget. Among our recommendations are for the Legislature to (1) limit the authority of arbitrators to order large payments based on their interpretation of future labor agreements and (2) end the use of automatic pay raise formulas tied to actions by other governmental employers.

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