Analysis of the 2007-08 Budget Bill: Education

Proposition 98 Update

Compared to the Governor’s budget, we estimate less General Fund revenue in both the current and budget years. Given the particular formulas that drive Proposition 98, our revenue estimates result in a higher minimum guarantee in 2007-08. This counterintuitive result means the Legislature is likely to face more challenging trade-offs in its budget deliberations. In this section, we also discuss various other issues related to Proposition 98. Specifically, we (1) provide an update on outstanding Proposition 98 “settle-up” obligations, (2) describe the effect of a declining K-12 student population on the Proposition 98 minimum guarantee, and (3) discuss factors that might lead to the Proposition 98 Test 1 factor becoming operative in the near future.

Governor’s Budget

Before reviewing the Governor’s Proposition 98 proposals for 2007-08, we first describe the budget’s adjustments to prior- and current-year Proposition 98 funding levels. These adjustments are primarily due to updated local property tax revenue and student attendance data.

Prior-Year Adjustments

Due to technical adjustments and changes in property taxes, the spending level for 2005-06 increased by $73 million above what was assumed when the 2006-07 budget was enacted. This higher spending level offsets the obligation relating to the recent K-14 settlement, reducing it from $1.3 billion to $1.2 billion. Please see the “Quality Education Investment Act” section later in this chapter for additional information about this settlement.

Current-Year Adjustments

Figure 1 shows that overall spending for Proposition 98 in the current year decreases by $100 million—from $55.1 billion to $55 billion. Most of these savings are associated with a greater decline in K-12 attendance from what the 2006-07 Budget Act assumed—from -0.27 percent to -0.39 percent. Additionally, estimates for local property tax revenues increase by $384 million. Together, these two factors result in estimated General Fund savings of $483 million as compared to budget act levels.

Spending Level at Minimum Guarantee Plus Appropriation for Proposition 49. When the 2006-07 budget was adopted, the Proposition 98 spending level was roughly $600 million above the minimum guarantee. About $426 million of this additional funding was for Proposition 49 after school programs. (Proposition 49 required Proposition 98 spending to exceed the minimum guarantee by $426 million in the first year it took effect.) As a result of slight changes in revenues and attendance, Proposition 98 spending now exceeds the Governor’s estimated minimum guarantee only by the Proposition 49 requirement ($426 million).

Continues to Be a Test 3 Year. As was the case when the budget was enacted, the Governor’s budget continues to project 2006-07 as a Test 3 year (meaning the minimum guarantee is based on growth in per capita General Fund revenue). This is because year-to-year growth in state General Fund revenues is relatively sluggish. During such times, the state is allowed to provide less than would be required by the Test 2 factor. (In a Test 2 year, the minimum guarantee is based on growth in per capita personal income). The gap between the Test 2 and Test 3 levels is called the “maintenance factor.” The maintenance factor is tracked over time and Proposition 98 contains a mechanism to restore it in future years.

Under Governor’s Budget Assumptions, About $436 Million in Maintenance Factor Created in the Current Year. The state entered the current year having restored all outstanding maintenance factor obligations, but a new maintenance factor obligation is created because 2006-07 is a Test 3 year. Specifically, under the Governor’s forecast, the Test 3 minimum guarantee is $862 million below the Test 2 level for 2006-07. Because Proposition 49 requires the state to provide $426 million above the minimum guarantee in the current year, the new maintenance factor is $436 million. (Because of the specific statutory language contained in Proposition 49, both our office and the Department of Finance [DOF] interpret the measure such that the additional after school funding would count as restoring maintenance factor. Some in the education community disagree with this interpretation.)

Budget-Year Estimates

As discussed in the “Overview” section of this chapter, the Governor’s budget proposes a spending level of $56.8 billion for Proposition 98 in 2007-08. This is a $1.8 billion, or 3.3 percent, increase over revised current-year spending. The proposed Proposition 98 spending level is $627 million less than the calculated minimum guarantee. This is a result of the Governor’s proposal to pay for the $627 million Home-to-School Transportation program from the Public Transportation Account and reduce—or “rebench”—the Proposition 98 minimum guarantee by a like amount. (We have serious legal and policy concerns with the proposed rebenching of Proposition 98, which we discuss later in this chapter.)

Around $144 Million in Maintenance Factor Would Need to Be Restored in 2007-08. As a Test 2 year, under the Governor’s budget General Fund year-to-year revenue growth requires the state to restore about $144 million in maintenance factor obligation. (This amount is already included in the Governor’s proposed overall Proposition 98 funding level.) After adjusting the outstanding obligation by the Proposition 98 growth factors, this would leave approximately $310 million in maintenance factor to be restored in future years.

Legislative Analyst’s Office Forecast

Due to the timing of the budget’s release, the Governor had to develop his budget before data from the end of 2006 was available. We benefit from receiving economic information on the final quarter of 2006 as well as revenues from year-end tax payments. Based on these data, our updated economic and revenue forecasts indicate that General Fund revenues will be lower in 2006-07 and 2007-08 compared to the administration’s estimates. (Throughout this chapter we use the term “General Fund revenues” to refer to revenues received from taxes—the revenues used in the Proposition 98 calculation. These differ slightly from overall General Fund revenues.) Our projections result in somewhat different outcomes for the Proposition 98 minimum guarantee, as shown in Figure 2. The figure also shows our different assumptions for local property tax revenues and the resulting General Fund obligation. Below, we discuss our estimates for Proposition 98 in the current and budget years. (None of the updated data would change the guarantee for the prior year.)

Current-Year Adjustments

State Could Reduce K-14 Spending by $609 Million in the Current Year Due to Decrease in the Minimum Guarantee. Our forecast projects General Fund tax revenues will be roughly $940 million lower in 2006-07 compared to the administration’s estimates. This projected drop in General Fund revenues lowers the Proposition 98 minimum guarantee. Specifically, as shown in Figure 2, we estimate the minimum guarantee is $609 million below the administration’s—for a total required funding level of $54.4 billion instead of $55 billion. (Like the administration, our estimate for the minimum guarantee includes the additional Proposition 49 spending requirement.)

This means that the state could reduce Proposition 98 spending in the current year by up to $609 million, realize a like amount of General Fund savings, and still meet the constitutional requirement for K-14 education. We discuss options for realizing such savings in the next section of this chapter, “Proposition 98 Priorities.”

Because 2006-07 is a Test 3 year, any further reduction in Proposition 98 spending creates a like amount of additional maintenance factor. The maintenance factor would need to be restored in future years.

Budget-Year Estimates

Under Our Forecast, the Minimum Guarantee for 2007-08 Is $261 Million Higher Than Assumed in Governor’s Budget. Despite our estimates of General Fund revenues being lower than the administration’s in both the current year (by roughly $940 million) and the budget year (by roughly $500 million), our estimate for year-to-year revenue growth actually is greater. This is because Proposition 98 drives off the year-to-year growth in General Fund revenues, not the actual amount of revenues. The stronger year-to-year growth, in turn, results in a higher minimum guarantee and more maintenance factor restoration. Specifically, as shown in Figure 2, we estimate the Proposition 98 minimum guarantee for 2007-08 is $261 million higher than assumed in the Governor’s budget—increasing total spending from $56.8 billion to $57.1 billion. That is, relative to the Governor’s budget, the state would need to provide an additional $261 million to meet the K-14 funding guarantee. Under our forecast, roughly all of the outstanding maintenance factor (around $450 million) would be restored in the budget year.

Lower Property Tax Estimates Further Increase State’s General Fund Obligation (by Additional $204 Million). Also shown in Figure 2, we believe the administration overestimates property taxes for the budget year by $204 million. The Governor’s budget assumes property taxes will increase by 10 percent over 2006-07 levels—to $15.6 billion. Given the current slowdown in the real estate market, we project an 8.7 percent growth rate ($15.4 billion). Property tax revenues generally offset the General Fund share of Proposition 98 (except in a Test 1 year). Thus, a $204 million drop in property tax revenues increases the Proposition 98 General Fund obligation by a like amount.

Adding the effect of lower projected property tax revenues ($204 million) to the $261 million resulting from the higher minimum guarantee, our forecast suggests the Proposition 98 General Fund 2007-08 obligation is actually $466 million higher than what is assumed in the Governor’s budget.

Legislature Faced With Tough Decisions

Based on our forecast, the Legislature will confront even more difficult decisions in balancing its 2007-08 budget. While these estimates will change again with the Governor’s May Revision, we suggest the Legislature begin considering options now for making the needed trade-offs between K-14 education and the rest of the budget.

Reducing Current Year Spending Could Be Critical Part of Budget Solution. As noted, our forecast suggests the state is spending around $609 million more on Proposition 98 in 2006-07 than is required by the minimum guarantee. Because the budget year’s Proposition 98 requirement is based upon the spending level in the current year, reducing spending in 2006-07 would also reduce the K-14 obligation for 2007-08. We discuss this option further in the “Proposition 98 Priorities” section of this chapter.

Update on Other Proposition 98 Issues

Below, we discuss three issues relating to Proposition 98: (1) outstanding settle-up and settlement obligations, (2) declining K-12 attendance, and (3) dynamics related to the Test 1 factor.

Proposition 98 Settle-Up Obligations

In some years, the state generates “settle-up” obligations (or outstanding balances which need to be paid) relating to the Proposition 98 minimum guarantee. These settle-up obligations are generated when attendance counts or revenues change after the budget is enacted and the minimum guarantee increases above the level of funding that was provided.

Chapter 216, Statutes of 2004 (SB 1108, Committee on Budget and Fiscal Review), required the Superintendent of Public Instruction and Director of Finance to jointly determine settle-up obligations for the Proposition 98 minimum guarantee for fiscal years 1995-96 through 2003-04. This process, completed in January 2006, determined the state owed schools roughly $1.4 billion to meet the minimum guarantee for four prior years—1995-96, 1996-97, 2002-03, and 2003-04.

Chapter 216 continuously appropriates $150 million annually beginning in the 2006-07 fiscal year for the purposes of repaying these settle-up obligations. The 2006-07 budget included a $133 million payment for the current year ($17 million was “prepaid” in 2005-06), as well as an additional $150 million to prepay the requirement for 2007-08. As directed by Chapter 216, these funds repaid schools and community colleges for the costs of prior-year mandates. This $300 million retired the settle-up obligations for 1995-96 and 1996-97. As shown in Figure 3, the state still has existing settle-up obligations totaling roughly $1.1 billion—$483 million for 2002-03 and $618 million for 2003-04.

In addition to these settle-up requirements, the state last year created a new $2.8 billion obligation relating to the California Teachers Association (CTA) settlement. In that settlement, the state agreed to pay $1.6 billion for 2004-05 and approximately $1.2 billion for 2005-06. Chapter 751, Statutes 2006 (SB 1133, Torlakson), established a seven-year payment schedule for providing these additional funds. Figure 3 also shows these new settlement-related obligations.

Although $300 million is being provided in the budget year to meet the terms of the CTA settlement, DOF has scored these funds as an adjustment to the entering balance in 2005-06 rather than a budget-year expenditure. We have concerns with this method of accounting. For more discussion of this issue, please see the “Quality Education Investment Act” section of this chapter.

The Effect of Declining Attendance on the Proposition 98 Minimum Guarantee

Except under Test 1 or suspension scenarios, the Proposition 98 minimum guarantee is determined each year by taking the prior-year’s Proposition 98 appropriation and adjusting it by growth in statewide K-12 average daily attendance (ADA) and by growth in either per capita personal income (Test 2) or per capita General Fund revenues (Test 3). (The community college growth rate is not a factor in determining the overall Proposition 98 minimum guarantee.) In most years, the state’s K-12 population has grown, contributing to increases in overall Proposition 98 funding.

Proposition 98 Protected From Decline for Two Years. Proposition 98 includes a two-year “hold harmless” clause for when K-12 population declines. That is, for each of the first two years of K-12 ADA decline, the Proposition 98 guarantee is calculated using a 0 percent growth rate. In a third consecutive year, the Proposition 98 calculation uses the actual statewide K-12 ADA rate, and the minimum guarantee is reduced to reflect the decline in K-12 population from the previous year. The downward adjustment is intended to reflect fewer students and, correspondingly, less need.

Proposition 98 Will Be Adjusted Downward for First Time in 2007-08. Between 2004-05 and 2005-06, statewide ADA declined for the first time since the passage of Proposition 98 in 1988. As shown in Figure 4, the Proposition 98 growth factor of 0 percent was used in the funding formula for 2005-06. In the same way, overall K-14 funding is protected from the projected ADA decline in 2006-07. However, the figure also shows that statewide ADA is projected to decline for a third consecutive year in 2007-08. For the first time ever, this leads to a negative ADA-based adjustment for the Proposition 98 minimum guarantee.

For as many years as ADA continues to decline, the Proposition 98 minimum guarantee will continue to be adjusted downward. However, the hold harmless clause “resets” once the state experiences one year of positive ADA growth. That is, if ADA grows and then begins to decline again, Proposition 98 funding will receive another two-year reprieve from any associated reduction.

Overall Proposition 98 Funding Still Increases. Despite the negative ADA-based adjustment, Proposition 98 funding still experiences a net increase of $1.8 billion in 2007-08 compared to the current year. This is because in addition to ADA growth, the Proposition 98 formula also adjusts the current-year’s funding level by the Test 2 factor (per capita personal income). For the budget year the Test 2 factor—4.6 percent—provides a significant amount of growth even after accounting for the -0.4 percent attendance factor.

Proposition 98 Program Funding Based on Separate Calculation. That the overall Proposition 98 minimum guarantee reflects the decline in K-12 attendance does not necessarily mean that funding for each K-14 program will receive a negative adjustment. While some programs do experience attendance-related reductions, others actually receive increases. Still others experience no attendance-related adjustment. The K-12 revenue limit apportionments, or general purpose funding, do adjust automatically to reflect growth and declines at individual school districts. Moreover, the Governor’s budget adjusts downward about one-half of the 50-some categorical programs by the statewide ADA growth rate of -0.4 percent. In contrast, it funds several other programs at different statutory growth rates. (Most of these latter programs serve populations other than K-12 students, such as child care, adult education, and Regional Occupational Centers. Community college apportionments and categorical programs are also funded at a different growth rate—2 percent in 2007-08.) Additionally, the budget proposes to hold about 20 categorical programs harmless at 2006-07 levels (in lieu of applying the negative adjustment).

Legislature Can Adjust Growth Funding for Categorical Programs. For the most part, the Governor uses his discretion as to which categorical programs to “protect” and which to adjust downward. With fewer students in the system to participate in the categorical programs, there is some question as to why certain programs would require additional funding. The Legislature has the option of decreasing by 0.4 percent all those categorical programs the Governor chooses to protect. This would free up around $13 million in Proposition 98 funds to be redirected to other purposes. Alternatively, if the Legislature believes certain programs should receive additional funding despite the decline in student population, it can choose its own selection of programs to protect from the negative growth adjustment.

The Underlying Dynamics of the Proposition 98 “Test 1” Factor

Under Test 1, the Proposition 98 minimum guarantee is set at roughly 40 percent of General Fund revenues. The Test 1 factor is operative if it yields a higher Proposition 98 funding level than either the Test 2 or the Test 3 factors. To date, Test 1 has been operative only in 1988-89, the year after Proposition 98 was passed. In subsequent years, Test 2, which grows the prior-year K-14 funding level by the percent change in per capita personal income, quickly moved the guarantee above the Test 1 level. This was because slow growth in General Fund and property tax revenues were coupled with fast growth in K-12 attendance. The combined effect was to increase the K-14 share of total General Fund spending.

Statewide Dynamics Are Changing. Over the past several years, these dynamics have begun to reverse—a healthy economy has increased total General Fund and property tax revenues, while K-12 attendance has dropped. Figure 5 shows the effects of these changes. Since 2001-02, even as General Fund spending for K-14 education has increased, the Proposition 98 share of overall General Fund revenues has been steadily decreasing. As K-14 education’s share of the General Fund decreases, the state gets progressively closer to hitting the Test 1 level of roughly 40 percent.

Test 1 on the Horizon. Figure 6 summarizes the factors that would contribute to Test 1 becoming operative. Based on the Governor’s proposed level of spending and our estimates for revenues, attendance, and local property taxes in the future, we project that Test 1 may become operative again as early as 2009-10.

What Is the Practical Effect of Hitting Test 1? Once the K-14 share of General Fund spending declines to about 40 percent and Test 1 applies, the K-14 share of General Fund spending will be fixed at that percentage. Under this scenario, the minimum guarantee is no longer determined based on changes in ADA or the Test 2 and Test 3 factors. This has a number of policy and budgetary implications, including:

• Further declines in K-12 enrollment do not yield additional savings for the state. Instead, K-14 education will continue to get the fixed share of General Fund revenues regardless of how many students are in the system. Thus, a declining student population likely will result in higher per pupil spending levels.

• Under Test 2, increases in local property tax revenue offset General Fund contributions for Proposition 98 but do not affect the net amount of resources going to schools. Under Test 1, increases in local property tax revenues will supplement rather than supplant General Fund spending. This means K-14 funding levels can benefit substantially from healthy increases in local property tax revenues.

In the “Proposition 98 Roadmap” section of this chapter, we offer recommendations as to how the Legislature can effectively plan for and use the increased resources that would be available for K-14 education when Test 1 becomes operative.

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