California’s Fiscal Outlook: The 2011-12 Budget

The 2011-12 Budget: California’s mac Taylor Legislative Analyst Fiscal Outlook November 2010 LAO Publications The Legislative Analyst’s Office (LAO) is a nonpartisan office which provides fiscal and policy information and advice to the Legislature. To request publications call (916) 445-4656. This report and others, as well as an E-mail subscription service, are available on the LAO’s website at www.lao.ca.gov. The LAO is located at 925 L Street, Suite 1000, Sacramento, CA 95814. Table of Contents Chapter 1 The Budget Outlook ...................................................3 Chapter 2 Economy, Revenues, and Demographics ...............13 Chapter 3 Expenditure Projections ..........................................23 Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook www.lao.ca.gov Legislative Analyst’s Office Executive Summary $25 Billion Budget Problem Needs to Be Addressed in Coming Months Our forecast of California’s General Fund revenues and expenditures shows that the state must address a budget problem of $25.4 billion between now and the time the Legislature enacts a 2011‑12 state budget plan. The budget problem consists of a $6 billion projected deficit for 2010‑11 and a $19 billion gap between projected revenues and spending in 2011‑12. 2010‑11 Deficit. We assume that the state will be unable to secure around $3.5 billion of budgeted federal funding in 2010‑11. This assumption is a major contributor to the $6 billion year‑end deficit we project for 2010‑11. We also project higher‑than‑budgeted costs in prisons and several other programs. In addition, our forecast assumes that passage of Proposition 22 will prevent the state from achieving about $800 million of budgeted solutions in 2010‑11. 2011‑12 Deficit. The temporary nature of most of the Legislature’s 2010 budget‑balancing actions and the painfully slow economic recovery contribute to the $19 billion projected operating deficit in 2011‑12. This gap is $2 billion less than we projected one year ago. Actions taken during the 2010‑11 budget process to reduce Proposition 98 education spending are a major contributor to the decline. Ongoing Annual Budget Problems of $20 Billion Persist Similar to our forecast of one year ago, we project annual budget problems of about $20 billion each year through 2015‑16. In 2012‑13, when the state must repay its 2010 borrowing of local property tax revenues and the full effect of Propositions 22 and 26 hit the state’s bottom line, our forecast shows the operating deficit growing to $22.4 billion. Because our methodology generally assumes no cost‑of‑living adjustments, our projections probably understate the magnitude of the state’s fiscal problems during the forecast period. Additional Savings From Proposition 98 Will Be Very Difficult Our forecast indicates that General Fund revenues and transfers will decline by over $8 billion in 2011‑12 due to the expiration of the temporary tax increases adopted in 2009. Because the Proposition 98 minimum school funding guarantee is affected by this drop, our budget forecast already reflects a $2 billion fall in the minimum guarantee between 2010‑11 and 2011‑12. This reduction would come at the same time that school districts exhaust the billions of dollars of one‑time federal money they have received through the stimulus program and other legislation. Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook For these reasons, it may be very difficult to achieve substantial additional budget reductions in Proposition 98 in 2011‑12, compared to the levels already reflected in our forecast. In other words, if the Legislature funds schools at our projected minimum guarantee in 2011‑12, it would mean billions of dollars in programmatic cuts to education but not contribute a single dollar to closing the $25 billion budget problem. Key Choice: Painful Decisions Now…or Pass Problems to Future Californians Too often, discussions of California’s budget situation are framed in extreme terms: the state about to go “bankrupt,” debt‑service payments hypothetically poised to default, the state government on the verge of collapse. None of these scenarios is remotely likely to occur. History tells us that the state can find ways to temporarily “patch over” its annual budget problems in ways that prove sufficiently palatable to policy makers of both major parties. Periodically, large influxes of capital gains allow for temporary relief, and this too aids in patching over the state’s now‑recurrent budget challenges. The Legislature and the new Governor will be tempted in the next few years to continue patching over the budget problems with temporary fixes. Unless plans are put in place to begin tackling the ongoing budget problem, it will continue to be difficult for the state to address fundamental public sector goals—such as rebuilding aging infrastructure, addressing massive retirement liabilities, maintaining service levels of high‑priority government programs, and improving the state’s tax system. Accordingly, the state faces a basic choice: begin to address today’s huge, frustrating budget problems now…or defer the state’s budgetary and policy problems to future Californians. Huge Longer-Term Fiscal Challenges Already Can Be Foreseen One major reason to stop passing the state’s problems to future Californians is that the state’s long‑term fiscal liabilities—for infrastructure, retirement, and budgetary borrowing—are already huge. The costs of paying down these liabilities already are reflected, to some extent, in the state’s recurring deficits, but these costs will only grow in the future. By deferring hard decisions on how to finance routine annual budgets of state programs to future years, the state risks increasing further the already immense fiscal challenges facing tomorrow’s Californians. Time for a Multiyear Approach to Fixing the Budget We continue to recommend that the Legislature initiate a multiyear approach to solving California’s recurring structural budget deficit. In 2011‑12, such an approach might involve $10 billion of permanent revenue and expenditure actions and $15 billion of temporary budget solutions. In 2012‑13, 2013‑14, and 2014‑15, another few billion of permanent actions each year could be initiated, along with other temporary budget solutions, and so on until the structural deficit was eliminated. Barring another sharp economic decline, such an approach could fix California’s near‑term budget problems by the end of our forecast period in 2015‑16 and give the state flexibility to begin (1) building reserves needed to address the next economic downturn and (2) addressing long‑term fiscal liabilities. The solutions needed to balance the budget will mean unavoidably painful sacrifice by today’s Californians. The benefit of this sacrifice would be putting the state on a sound fiscal footing. That sound footing may allow future Californians to live in a place where the annual state budget process is a chance to improve government’s ability to serve its residents. 2 www.lao.ca.gov Legislative Analyst’s Office Chapter 1 The Budget Outlook This report provides our projections of the 2010‑11 TO END IN DEFICIT state’s General Fund revenues and expenditures for 2010‑11 through 2015‑16 under current law, Projected 2010-11 Year-End Deficit of absent any actions to close the state’s budget gap. $6 Billion Our projections primarily reflect current‑law $3.5 Billion of New Funding or Flexibility Not spending requirements and tax provisions, while Yet Approved by U.S. Government. At the time relying on our independent assessment of the the Governor signed the 2010‑11 budget package outlook for California’s economy, demographics, in October 2010, the administration estimated revenues, and expenditures. The report aims to that the General Fund would have a $1.3 billion assist the Legislature with its fiscal planning as it reserve at the end of 2010‑11. A key assumption in begins to consider revisions to the 2010‑11 budget that calculation was that the state would receive and adoption of the 2011‑12 budget. The basis of our around $4 billion in federal funding (or additional estimates is described in the nearby box (next page). flexibility in operating state‑federal programs like Medi‑Cal) that had not yet been approved Figure 1 shows our estimate of the condition by the federal government. Recently, the federal of the General Fund through the end of 2011‑12 government approved a waiver affecting Medi‑Cal assuming no corrective action. The 2010‑11 and other health programs that provides annual fiscal year would end with a $6 billion deficit. Figure 1 In 2011‑12, expenditures would exceed revenues LAO Projection of General Fund Condition if No by $19 billion and leave Corrective Actions Are Taken the state with a year‑end (In Millions) deficit of over $25 billion. 2009‑10 2010‑11 2011‑12 Accordingly, we estimate Prior-year fund balance -$5,375 -$5,371 -$4,591 that the Legislature and Revenues and transfers 87,041 93,284 83,530 the new Governor will Expenditures 87,037 92,505 102,756 have to address a budget Ending fund balance ‑$5,371 ‑$4,591 ‑$23,817 problem of $25 billion Encumbrances 1,537 1,537 1,537 between now and the time Reservea ‑$6,908 ‑$6,128 ‑$25,354 that they agree to a 2011‑12 a Special Fund for Economic Uncertainties. Assumes no transfer to the state’s Budget Stabilization state budget plan. Account. Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook General Fund savings that is initially estimated to flexibility incorporated into the 2010‑11 budget total around $500 million per year. Our forecast package. Accordingly, based on that assumption assumes that the state fails to secure the remaining alone, our projections show a General Fund deficit $3.5 billion of additional federal funding or at the end of 2010‑11. Basis for Our Estimates Our revenue and expenditure forecasts are based primarily on the requirements of current law, including constitutional provisions (such as the Proposition 98 minimum guarantee for school funding), statutory requirements, and currently authorized federal funding. In other cases, the estimates incorporate effects of projected changes in caseloads, federal requirements, and other factors affecting program costs. The estimates are not predictions of what the Legislature and the Governor will adopt as policies and funding levels in future budgets. Instead, our estimates are intended to be a reasonable baseline of what would happen if current‑law policies continue to operate in the future. We intend the forecast to provide a meaningful starting point for legislative deliberations involving the state’s budget so that corrective actions can be taken. No COLAs or Inflation Adjustments Assumed. In line with the Legislature’s policy in recent years, we generally have not made annual cost‑of‑living adjustments (COLAs) or price increase adjustments over our forecast period. (Health programs are an exception since the costs of current‑ law benefits are subject to inflationary increases.) In particular, in the 2009‑10 budget package the Legislature added to state law a provision stating that most programs, including universities, the courts, and various social services programs, would no longer receive “automatic” COLAs and inflation adjustments. The impact of not adjusting for COLAs and inflation means that the purchasing power of current state expenditures will be eroded by inflation over the forecast period and the state will not be able to maintain a “current services” budget. Should the Legislature choose to provide these adjustments in future years, we estimate that the state’s annual budget problems would be even greater than those indicated in our forecast—by about $400 million in 2011‑12 and, if inflation adjustments were provided each year during the forecast, by as much as $3 billion in 2015‑16. If the Legislature were to approve additional state employee pay or benefit increases (beyond those included in recent labor agreements), that also would increase costs above those indicated in our forecast. Impact of Future Ballot Measures Not Considered. In keeping with our use of current law as the basis for our forecast, our projections do not consider any future impact of measures scheduled for future statewide elections—the $11 billion water bond and the budget reserve and spending measure passed as part of the 2010‑11 budget package. We do, however, incorporate our preliminary estimates of the fiscal effects of propositions that were passed on November 2, 2010. State Victories in Court Cases Assumed. Our forecast generally assumes that the state eventually prevails in active, budget‑related court cases. (By active cases, we mean open cases at the trial or appellate court level.) The state faces an array of active cases, including ones related to the budgeted shift of redevelopment funds and various health and social services reductions. The state also is appealing a three‑judge panel’s order to reduce the prison population to the U.S. Supreme Court. 4 www.lao.ca.gov Legislative Analyst’s Office California’s Fiscal Outlook A Net $3 Billion of Other Budget Solutions therefore, is over $400 million higher in our Likely at Risk. In addition to the inability to secure forecast for 2009‑10 and 2010‑11 combined. federal funding, we assume the state will be unable to achieve the following 2009‑10 and/or 2010‑11 budget • Information Technology Savings. The solutions counted on in the 2010‑11 budget package: budget package assumed the admin‑ istration would reduce departmental • Prisons and Medical Care Receiver. We budgets by $130 million in 2009‑10 and expect that expenses of the prison medical $140 million in 2010‑11 to capture savings care Receiver will exceed budgeted amounts from recent efficiencies implemented in by about $780 million and that other prison information technology programs. Our expenses will surpass budgeted totals by forecast assumes that much of this savings $185 million. does not flow to the General Fund’s bottom line. • Employee Compensation. Recent collective bargaining agreements and other personnel 2009‑10 and 2010‑11 Revenue Projection actions are projected to achieve over Down $447 Million. The 2010‑11 budget package $400 million less in savings than assumed essentially relied on our office’s May 2010 revenue in the 2010‑11 budget. In addition, in forecast for 2009‑10 and 2010‑11, which was 2009‑10, the state enacted a one‑day payroll $1.4 billion higher than the administration’s. Our delay to achieve one‑time savings of about current projection has General Fund revenues $1 billion. Estimates now indicate the delay $447 million below the budget package forecast for achieved savings of $800 million. 2009‑10 and 2010‑11 combined. • Medi‑Cal. Around $400 million of Proposition 22 Reduces General Fund Solutions budgeted savings are estimated to be by Nearly $800 Million. There is some uncertainty unachievable in Medi‑Cal due to (1) the late about what Propositions 22 and 26 mean for state passage of the 2010‑11 budget and (2) our finance in the short term, as discussed in the projection that the program will be unable nearby box (see page 6). Our forecast, however, to achieve an unallocated budget reduction assumes that Proposition 22 prevents the state from of $323 million. achieving nearly $800 million in budgeted 2010‑11 solutions—about $400 million in now‑prohibited • In‑Home Supportive Services (IHSS) borrowing from the Highway Users Tax Account Program. As part of the 2010‑11 budget and $400 million in now‑prohibited use of trans‑ package, a variety of solutions were portation funds to pay bond debt service. estimated to reduce IHSS costs by $300 million. We estimate that only about $6.1 Billion General Fund Deficit Forecast one‑half of this savings will materialize. for 2010‑11. As shown in Figure 1, given all of In addition, $45 million of budgeted these expenditure and revenue issues, we forecast savings from previously enacted anti‑fraud that 2010‑11 will end with a General Fund deficit activities will not be achieved. of $6.1 billion, absent any corrective action by the Legislature. Various cash management • Lower Property Tax Estimate Affects actions—including payment delays approved by General Fund Education Spending. Our the Legislature and borrowing from both investors forecast assumes lower local property tax and state special funds—will facilitate continued revenues than the 2010‑11 budget package. General Fund operations despite the forecasted General Fund spending on Proposition 98, deficit, as described in the nearby box (see page 7). 5 Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook MAJOR NEW BUDGET expenses will be exhausted. For these reasons, the state will be left with a large operating shortfall (the PROBLEM IN 2011‑12 difference between annual General Fund revenues and expenditures) problem in 2011‑12 totaling With the “Carry‑In” Deficit, a $25 Billion $19.2 billion. In addition, the Legislature must Problem to Address. The vast majority of the address the 2010‑11 year‑end deficit at or before roughly $20 billion of budget solutions enacted as the time it enacts the 2011‑12 budget package. part of the 2010‑11 budget process were one‑time Accordingly, the total budget problem that the or temporary in nature. At the same time, by the state must address between now and passage of the end of 2010‑11 about $8 billion of temporary tax 2011‑12 budget totals $25.4 billion in our forecast, increases expire, and about $4.5 billion of federal as shown in Figure 1. stimulus funding used to reduce General Fund Effects of November 2010 Ballot Measures on Our Forecast Three major budget‑related measures were approved by voters at the November 2 general election. Proposition 25 changes the vote threshold needed to send a budget bill to the Governor from two‑thirds to a simple majority of each house of the Legislature. This may help make it easier for the Legislature to pass an on‑time budget each year. At the same time, voters approved Propositions 22 and 26, which restrict the Legislature’s ability to use certain local funds to help balance the budget and raise the vote threshold for passing certain fees from a simple majority to two‑thirds, respectively. Our Assumptions Concerning Propositions 22 and 26. We assume that Proposition 22 prevents the state from borrowing certain transportation special funds for the General Fund, as was assumed in the Legislature’s 2010‑11 budget plan. We also assume that loans from such special funds prior to November 3 (the effective date of the measure) are not affected by Proposition 22. Accordingly, in our forecast, about $400 million of not‑yet‑executed loans from the Highway Users Tax Account are assumed to be prohibited by Proposition 22. This worsens the condition of the General Fund in 2010‑11 by a like amount. The budgeted use of certain transportation funding to offset General Fund debt‑service costs also is assumed to be impermissible in 2010‑11, thereby hurting the General Fund’s bottom line by another $400 million. In 2011‑12, we assume that Proposition 26 fully reverses the “fuel tax swap” adopted by the Legislature earlier this year, beginning November 2011 (one year after voter approval). Accordingly, state sales taxes on gasoline resume (thereby increasing General Fund revenues), excise taxes on gasoline decline, and the General Fund’s payments for transportation programs resume pursuant to Proposition 42 (2002). A timing lag in Proposition 42 payments means that the net effect of these measures is near zero for 2011‑12. The ongoing effect of Propositions 22 and 26—approaching $1 billion or more annually—does not hit the General Fund until 2012‑13 in our forecast. Some Uncertainty. Propositions 22 and 26 are complex measures. It is possible that some of the fiscal effects we describe above would not materialize until a stakeholder successfully sues the state in court to force these budgetary changes. Accordingly, our forecast presents a preliminary point of view about their effects on the budget. The actual effect may be different in any given fiscal year. 6 www.lao.ca.gov Legislative Analyst’s Office California’s Fiscal Outlook Key Considerations Regarding the drives down the Proposition 98 minimum funding 2011-12 Budget guarantee in our projections. The Proposition 98 Sharp Reduction in K‑14 Programmatic minimum guarantee is forecasted to decline from Spending Already Reflected in Our Forecast. $49.7 billion in 2010‑11 (when the Legislature Because of the expiration of temporary tax increases suspended Proposition 98) to $47.5 billion in and other factors, General Fund tax revenues are 2011‑12. The General Fund’s share of Proposition 98 forecast to decline significantly in 2011‑12, which funding is forecast to decline as well—from $36.2 billion in 2010‑11 to $34.2 billion in 2011‑12. Cash Management Background. As we described in our January 2009 report, California’s Cash Flow Crisis, the state suffers from a basic cash flow problem, even in good years. Most revenues are received during the second half of the fiscal year (January to June), while most expenses are paid in the first half of the fiscal year (July to December). In order to meet payments in the early part of the year, the state obtains short‑term borrowing that is paid back within the fiscal year, referred to as revenue anticipation notes (RANs). The state also relies on a pool of “borrowable resources”—balances in state special funds—that can be borrowed for cash flow purposes. Billions of Dollars of Payments Delayed in 2010‑11. The Legislature enacted two sets of cash payment delays for the 2010‑11 fiscal year in order to assist with cash management. The first was enacted in special session legislation and allowed for delays of up to $5 billion of scheduled payments to schools, universities, and local governments at almost any given time within the fiscal year. The second set of delays was enacted in the October budget package and allowed for an additional $4.7 billion of payments to be delayed in October and November in order to avoid the issuance of registered warrants (IOUs) and facilitate the issuance of a 2010‑11 RAN. The Controller also used his executive authority to delay other payments in October, such as tax refunds. These various payment delays will be repaid within the 2010‑11 fiscal year. Payment Delays Will Be Needed for 2011‑12. With a few exceptions, there are no statutory provi‑ sions for intrayear payment delays in the 2011‑12 fiscal year. Given our forecast for the significant deficit at the end of 2010‑11 and the accumulated deficit in the General Fund, the state will likely require significant external cash flow borrowing again in 2011‑12. In addition, to avoid the issuance of IOUs at certain points in the year, payment delays similar to those approved in 2010‑11 likely will be needed. Local governments, schools, and community colleges previously have indicated that early adoption of payment delays helps them execute their own annual cash borrowings. Curbing the Deficit Would Reduce Cash Pressures in Future Years. Many temporary or one‑time budget solutions—such as borrowing from special funds—increase cash pressures by reducing overall borrowable resources. If the Legislature acts to eliminate operating shortfalls in the coming years, we would expect cash pressures, and hence the need for payment delays, to decline. While removing the payment delays will not have a significant impact on the state’s budget situation, it should reduce the external borrowing costs of local entities and provide more certainty in fiscal planning efforts of schools and community colleges. Reducing cash pressures can also reduce the state’s need for external borrowing, thus reducing the state’s borrowing costs. 7 Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook At the same time, it is expected that schools will 80 percent federal matching rate available under have spent most of the billions of dollars of recent, TANF ECF for increased CalWORKs grant costs one‑time federal stimulus and jobs funding approved above the state’s base costs in 2007 had been a by Congress. Accordingly, it may be very difficult for deterrent to cutting General Fund support for the Legislature to achieve additional Proposition 98 CalWORKs cash assistance, but it is no longer in savings as part of its 2011‑12 budget package. In effect. other words, if the Legislature funds schools at the forecasted minimum guarantee in 2011‑12, it would Revenue Uncertainty. As we discuss in mean billions of dollars in programmatic cuts to Chapter 2, there are a lot of challenges with education but not contribute a single dollar to closing forecasting economic activity and revenues in the $25 billion budget problem. California following the unprecedented recession that ended in 2009. One of the key challenges is State Faces Ongoing Constraints on Reducing forecasting capital gains. This is always difficult, but Health Programs. Our forecast reflects sharp is even more so this year given the huge unrealized General Fund increases in Medi‑Cal, the state’s stock and housing capital losses of recent years second‑largest General Fund program, that are and uncertainties about federal tax policy with the required under current law and as a result of the pending expiration of various tax cuts. Action or expiration of federal economic stimulus funding. inaction by Congress on the expiring tax cuts in The American Reinvestment and Recovery Act the coming weeks could affect taxpayer behavior (ARRA) of 2009 provided an enhanced federal and the resulting timing of hundreds of millions match in state support for Medi‑Cal that will be of dollars in state revenues related to capital gains. phased out as of the end of 2010‑11. The state’s receipt of billions of dollars in federal assistance Of perhaps even greater concern is uncer‑ under ARRA, however, was on the condition that it tainty about the federal estate tax. Currently, maintain the eligibility standards, methodologies, our forecast—like the 2010‑11 budget package— and procedures that were previously in place for assumes $2.7 billion of estate tax revenues for the Medi‑Cal. These constraints originally were to General Fund in 2010‑11 and 2011‑12 combined expire along with the provision of ARRA funding. based on current law. There has, however, been However, provisions in the federal health care significant speculation that Congress will change reform law essentially extended these maintenance‑ estate tax law to eliminate the state’s ability to of‑effort requirements for Medi‑Cal and also generate any of these revenues. Should Congress applied them to the Healthy Families Program. This do this, the budget problem for 2011‑12 would essentially takes off the table many options to scale increase by $2.7 billion above the level indicated back these programs that could result in several in our forecast. hundreds of millions of dollars in state General Fund savings annually. LINGERING BUDGET In other areas, such as California Work Opportunity and Responsibility to Kids PROBLEM OF $20 BILLION (CalWORKs), the expiration of federal economic FOR YEARS TO COME stimulus funding (known as the Temporary Assistance for Needy Families Emergency Roughly $20 Billion Annual Problem Forecast Contingency Fund, or TANF ECF) does open Through 2015‑16. As shown in Figure 2, our forecast up additional options for state savings. The high of General Fund revenues and expenditures shows 8 www.lao.ca.gov Legislative Analyst’s Office California’s Fiscal Outlook an annual budget problem of Figure 2 around $20 billion through Huge Operating Shortfalls Projected 2015‑16. With the economic Throughout Forecast Period recovery remaining very weak and the lack of many General Fund (In Billions) permanent budget solutions $0 in the 2010‑11 budget package, the ongoing struc‑ -5 tural deficit has not changed much since our forecast one year ago. The annual -10 operating shortfall peaks at $22.4 billion in 2012‑13, -15 when the state must repay its $2 billion Proposition 1A -20 loan related to local property tax revenues. Thereafter, -25 Annual Operating Shortfall Carry in Deficit From 2010-11 revenues grow a bit faster than expenditures as the -30 state’s economic recovery 2011-12 2012-13 2013-14 2014-15 2015-16 becomes stronger. By 2015‑16, the annual budget (CalSTRS) estimates that it needs billions of dollars problem is $19.4 billion. more per year in contributions—not included in our forecast—to retire its unfunded liabilities within Projections Likely Understate the State’s Fiscal about 30 years and continue operations past the Woes. We believe that our projections probably 2040s. Similarly, there are no funds assumed in understate the magnitude of the state’s fiscal our forecast to begin retiring the University of problems during the forecast period. First, our California Retirement Plan’s (UCRP) growing forecast generally assumes no cost‑of‑living adjust‑ unfunded liabilities. State retiree health liabilities ments or inflationary increases in departmental continue to grow, driving upward the associated budgets. Second, by including only current‑law General Fund expenditures. The Legislature took expenditures, our forecast does not include funding action earlier this year to modify state pension to address a number of large liabilities that pose a programs, providing some budget relief now and risk to future state finances, as discussed below. greater relief in the future. The unfunded liabilities of state retirement systems, however, loom over the Massive Liabilities Growing. Unfunded state’s budget prospects. Left unaddressed in the actuarial accrued liabilities in pension and retiree near term, costs to service CalSTRS, UCRP, and health funds for state employees, teachers, and retiree health liabilities will only grow, burdening university employees now total $136 billion. future Californians more and more and requiring (Possible upcoming actions by the state’s two largest even harder decisions about taxes and services. The pension systems to lower their assumed annual rates state should look for ways to address these problems of investment return would expand this number.) soon, to avoid passing these huge obligations to The California State Teachers’ Retirement System future Californians. 9 Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook MULTIYEAR APPROACH TO ongoing deficit, the Legislature should minimize the use of risky budget solutions that contribute to BALANCE THE BUDGET… year‑end deficits. Instead, budget solutions need BEGINNING NOW to be real—by which, we mean those that have a high probability of achieving budgeted savings. Current Budget Problems Hinder Ability to The Legislature can maximize the probability of Plan for the Long Term. As discussed throughout achieving solutions by passing budgets on time this report, California faces immense short‑term (preferably early) and, in the case of spending budget problems and perhaps even more troubling reductions, providing specific direction and longer‑term fiscal challenges. Without immediate authority to the administration in well‑crafted action to begin tackling the structural deficit for legislation on how reductions are to be realized. the long term, the state may not be able in the Revenues Need to Be Part of the Mix. Just as foreseeable future to move beyond its current the Legislature will have to prioritize its spending stumble from one terrible budget problem to the commitments in order to address the ongoing next. As such, it will continue to be difficult for the deficit, it will need to examine the revenue side of state to address fundamental public sector goals— the ledger. There are several specific revenue policy such as rebuilding aging infrastructure, addressing areas that the Legislature should consider, such as: massive retirement liabilities, maintaining service levels of high‑priority government programs, and • Tax Expenditure Programs. Through tax improving the state’s tax system. expenditure programs—special credits, deductions, and exemptions—the state Not Possible to Solve the Whole Problem in provides subsidies to certain groups or One Year. In a state as complex as California, with individuals in ways that often have not an economy as weak as the one we have right now, been shown to be cost‑effective. Their it is not possible to solve this $20 billion ongoing modification or elimination raises revenues budget problem all at once. The solutions necessary without having to increase marginal tax to address the whole problem are probably not rates. obtainable in the current environment. Instead, this problem will take several years to solve. Sound • Increasing Charges for Program financial planning requires that the state’s leaders Beneficiaries. The Legislature should also agree now to a broad framework for a multiyear look to increasing charges in those cases approach to tackling the stubborn budget problem. where the costs of state programs currently supported by the General Fund can appro‑ Multiyear Approach Requires Real Budget priately be shifted to specific beneficiaries. Solutions. The current fiscal year is the third consecutive one that will end with a General Fund • Extending Certain Temporary Tax deficit. Key contributors to year‑end deficits have Increases. The Legislature may also have been enacted budget solutions that have not been to revisit some of the temporary tax achieved. For example, earlier in this chapter we increases that are set to expire by the end discussed a net $3 billion of 2009‑10 and 2010‑11 of 2010‑11. We think the best candidates expenditure solutions that are unlikely to be for extension would be the vehicle license achieved. Year‑end deficits have to be “carried in” to fee, where a good policy case can be made the next fiscal year and make the task of balancing to tax vehicles at a rate similar to all other the next year’s budget much more difficult. To property, and the dependent exemption make progress over several years in tackling the credit, where the current level is more 10 www.lao.ca.gov Legislative Analyst’s Office California’s Fiscal Outlook consistent with the practice of almost all Given our forecast of a $25 billion budget other states. problem in 2011‑12, we suggest that the Legislature and the new Governor target $10 billion of • Reconsider the Optional Single Sales permanent budget solutions in 2011‑12 and Factor. The Legislature may wish to $15 billion of temporary budget solutions. This reexamine some corporate tax provisions, would be a “down payment” on the multiyear such as the existing option of multistate approach to ending California’s structural deficit. companies to switch annually between the new “single sales factor” method In a Multiyear Approach, More Permanent of profit apportionment and the state’s Solutions Each Year. Figure 3 graphically illus‑ traditional method of apportionment for trates—in very simplified form—how a multiyear these companies. Making the single sales budget‑balancing approach would work, assuming factor apportionment mandatory, instead the accuracy of our budget deficit projections, for of optional, for multistate companies could each fiscal year: increase General Fund revenues and help the state’s competitiveness. (For more • 2012‑13. By taking $10 billion of permanent information, see our May 2010 report, budget actions in 2011‑12, the size of the Reconsidering the Optional Single Sales 2012‑13 budget problem we forecast might Factor.) be reduced from $22 billion to $12 billion. In 2012‑13, the Legislature could address the Both Permanent and Temporary Budget budget problem with about $3 billion of new Solutions Are Needed in 2011‑12. The basic additional permanent actions (or the growth framework we suggest for policy makers to balance in savings from previously adopted solutions) the 2011‑12 budget would involve a mix of: and $9 billion of temporary actions. • Permanent, real and Figure 3 ongoing expenditure Multiyear Approach Could Involve Mix of reductions and Permanent and Temporary Solutions revenue increases. General Fund Budget Solutions (In Billions) • Temporary budget solutions, such as $30 Addressed by Prior Permanent Actions short‑term revenue Temporary Budget Actions or expenditure 25 Permanent Actions changes, asset sales, special fund 20 loans and transfers, extended state 15 employee furloughs Balanced or personal leave 10 Budget programs, and delays in lower‑priority 5 bond‑financed infra‑ structure projects. 2011-12 2012-13 2013-14 2014-15 2015-16 11 Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook • 2013‑14. Adding together the effects of the Naturally, the real work of balancing the budget permanent budget‑balancing actions in would not be this simple. This scenario assumes 2011‑12 and 2012‑13, the budget problem that our revenue and expenditure forecast assump‑ we forecast for 2013‑14 could be reduced tions are correct, ignores the interaction between from $20 billion to around $7 billion. The any increased revenues and Proposition 98 funding Legislature could address this problem with requirements, and assumes that no temporary $3 billion of new additional permanent budget‑balancing actions—such as borrowing— actions and around $4 billion of temporary increase costs (and deficits) in later years. The basic actions. concept we offer, however, is that the Legislature can earnestly “chip away” at the budget problem, • 2014‑15. The prior permanent budget but only by beginning to enact permanent and real actions would reduce the 2014‑15 budget solutions to reduce spending and increase revenues. problem from $20 billion to about $4 billion. Roughly another $3 billion of The solutions needed to balance the budget new, permanent budget actions could be will mean unavoidably painful sacrifice by today’s adopted, along with $1 billion of temporary Californians. The benefit of this sacrifice would solutions. be putting the state on a sound fiscal footing. That sound footing may allow future Californians to live • 2015‑16. In this simplified scenario, there in a place where the annual state budget process is would no longer be a structural deficit a chance to improve government’s ability to serve facing the state in 2015‑16 due to the its residents. accumulated effects of the permanent budget actions passed in the previous four years. 12 www.lao.ca.gov Legislative Analyst’s Office Chapter 2 Economy, Revenues, and Demographics THE ECONOMIC OUTLOOK The U.S. Economy Slower Recovery Than Previously Expected. The National Bureau of Economic Research Our recent economic forecasts already assumed has determined that the national recession that a slow recovery, compared to past economic began in December 2007 ended in June 2009. It was rebounds. Following the deep 1981‑82 recession, the longest recession since World War II and the for example, the U.S. economy bounced right most severe downturn since the Great Depression back—with real gross domestic product (GDP) The 2007‑2009 recession was precipitated by growing 4.5 percent in 1983 and 7.2 percent in the implosion of overheated housing markets in 1984. Our updated forecast, by contrast, assumes California and throughout the United States, the that real GDP growth will be 2.6 percent in 2010, resulting balance sheet deterioration of financial 2.2 percent in 2011, and no higher than 3.1 percent firms and households, and the near collapse of in any of the years between now and 2016. world credit markets. (Figure 2 [see page 15] summarizes our forecasts of quarterly changes in GDP.) Unemployment—now California’s recession started even earlier than 9.6 percent nationally—is forecast to remain above the nation’s and was deeper. Unemployment in the 9 percent through 2012. Our forecasts of U.S. state—under 5 percent as recently as 2006—has economic growth in 2011 and 2012 are somewhat topped 12 percent for over a year now, as 1.4 million lower than our forecasts from the past year. jobs have disappeared. In 2009, personal income in California dropped 2.4 percent—the first annual What Is Causing the Slow Recovery? The slow decline since 1933. recovery results from a combination of (1) excess inventories of residential and commercial real Slow Recovery Expected to Continue. The estate, (2) severely depressed economic confidence latest evidence suggests that the state and national among both individuals and firms, and (3) for many economies continue their very slow recovery consumers, a considerably weakened financial from this staggering economic drop‑off. Our capacity to spend and invest. Consumers are economic forecast—summarized in Figure 1 attempting to restore their personal finances amidst (see next page)—generally reflects the current the weak labor markets and diminished housing consensus that the state and national economies wealth. Credit remains very tight. While businesses will continue to recover slowly and sluggishly in have been spending more in recent quarters to the coming years. address equipment, software, and other needs they deferred during the recession, they remain Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook very reluctant to hire. The construction industry the consensus view that a double‑dip recession will remains flat on its back—with few immediate not occur. While employment, personal income, prospects—due to the massive fall in residential output, and housing permit growth, among other and commercial real estate markets. While massive measures, are very weak by historical standards fiscal stimulus from the federal government helped during a recovery, they are not shrinking. Similarly, cushion the fall, the 2009 stimulus program while we expect low inflation through 2015‑16, we spending will taper off in the coming quarters, and do not forecast a period of deflation in the U.S. the likelihood that Congress will enact additional economy. In large part, our economic outlook fiscal stimulus appears remote. The Federal Reserve reflects the view that some key economic measures continues to take actions to stimulate the economy, (such as construction activity) have fallen so far that but, with interest rates already at very low levels, there is little room to fall even more. its ability to achieve much in this regard is limited. The California Economy “Double‑Dip” Recession Not Likely. While Employment Losses Subsiding. While U.S. our economic and revenue forecasts reflect very employment has dropped about 5 percent since modest assumptions about near‑term growth, they 2007, employment in California has declined are by no means a worst‑case scenario. A minority 9 percent (1.4 million jobs). In 2010, however, the of economic commentators have suggested that a level of job losses in the state has been subsiding— double‑dip recession—another period of dimin‑ a trend we expect to continue. We forecast that ished economic output—is possible due to the California will begin to experience a net increase coming declines of federal economic stimulus, in employment again in early 2011, causing continued weakness in consumer spending, unemployment to creep below 12 percent later in turmoil in the world’s sovereign debt and currency the calendar year. We expect employment in the markets, and other factors. Our forecast reflects state to grow by only about 100,000 jobs during Figure 1 The LAO’s Economic Forecast (November 2010) Forecast Actual Estimated 2009 2010 2011 2012 2013 2014 2015 2016 United States Percent change in: Real Gross Domestic Product -2.6% 2.6% 2.2% 3.1% 2.9% 2.8% 3.1% 2.8% Personal Income -1.7 2.8 3.2 3.9 4.3 5.5 5.4 5.7 Wage and Salary Employment -4.3 -0.5 0.9 2.2 2.2 1.5 1.4 1.2 Consumer Price Index -0.3 1.6 1.6 1.9 2.0 2.1 2.1 2.1 Unemployment Rate (percent) 9.3 9.7 9.6 9.1 8.3 7.9 7.3 6.9 Housing Permits (thousands) 554 596 789 1,243 1,465 1,565 1,689 1,686 California Percent change in: Personal Income -2.4 2.8 3.5 4.3 4.8 5.7 5.9 5.7 Wage and Salary Employment -6.0 -1.7 0.7 2.2 2.4 1.8 2.0 1.3 Consumer Price Index -0.4 1.6 1.6 1.9 2.0 2.1 2.1 2.1 Unemployment Rate (percent) 11.4 12.5 11.9 10.5 9.1 8.2 7.1 6.6 Housing Permits (thousands) 34 42 67 79 99 113 121 121 14 www.lao.ca.gov Legislative Analyst’s Office California’s Fiscal Outlook 2011—a slower level of job growth for the year than expects housing permits to continue to grow in any of our recent forecasts. In 2012, we project slowly. Commercial building also continues to slow employment growth in the state, a trend that Figure 2 should keep unemployment Modest Growth Expected During Recovery at or above 10 percent for much of that year. Growth (Percent Change From Prior Quarter [Annual Rate] in later years also remains U.S. Real Gross Domestic Product) fairly sluggish, as shown in 6% Figure 3. Total employment in Forecast California does not return to 4 its 2007 pre‑recession levels in 2 our forecast until 2016. 0 Housing Weakness Casts Formidable Shadow Over -2 Economy. The main cause of the economic implosion -4 of recent years has been the housing market. For -6 now, at least, the collapse -8 of California’s residential housing sector appears to 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 have ended. As depicted in Figure 4 (see next page), however, our forecast for Figure 3 California housing prices Slow Employment Growth Expected shows a very weak recovery— with minimal average gains Percent Change in California Average Annual Employment in prices through 2016. While 6% house prices now are more Forecast affordable—particularly in 4 light of low mortgage interest rates—credit remains very 2 tight. A large (but difficult to measure) “hidden inventory” 0 of homes in default or facing foreclosure heavily influ‑ -2 ences our forecast. While residential building permits -4 are up in 2010, they are still below 2008 levels—which, -6 at the time, was the worst year in recent memory. Our -8 forecast, as shown in Figure 1, 1991 1996 2001 2006 2011 2016 15 Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook be exceptionally weak. For all of these reasons, Figure 6 (see page 18) shows the differences California’s construction sector—having endured between our forecasts of 2009‑10 and 2010‑11 a crushing 40 percent employment decline since revenues, as compared with those assumed in the 2007—is not on track to regain its pre‑recession 2010‑11 budget package. For 2009‑10 and 2010‑11 strength in the foreseeable future. combined, we now project that the big three and other revenues will be $447 million below the Personal Income Poised to Rise With Job budget package assumptions. In addition, due to Growth. As job growth resumes, personal income our assumption that passage of Proposition 22 in the state rebounds in our forecast—first, fairly will prevent the borrowing of some transportation slowly in 2011 and 2012, and then with some funds, our net transfer and loans forecast is increasing strength thereafter. By 2014, we expect $378 million lower. In total, for 2009‑10 and 2010‑11 annual personal income growth for California in the combined, our revenue and transfer forecast is 5.7 percent to 5.9 percent range—a level consistent $826 million below that assumed in the 2010‑11 with what we would consider a healthy growth rate budget package. for the state in the long run. Gradually climbing interest rates contribute to much stronger growth Personal Income Tax in dividends, interest, and rent income in the later End of Temporary Tax Increases Affects years of our forecast. Government benefits also grow 2011‑12 Forecast. We estimate that PIT revenue in the later years of our forecast, buoyed by growth will increase from its 2009‑10 level of $44.6 billion in the aging “baby boom” population and, to some to $46.7 billion in 2010‑11. It will then drop off extent, the implementation of federal health care to $44.3 billion in 2011‑12 as the temporary reform. All of these factors should help households 0.25 percentage point rate increase and dependent in California continue to repair their finances, boost credit reduction enacted in February 2009 expire consumer confidence, and contribute to several years at the end of calendar year 2010. These temporary of increased consumption. Figure 4 Minimal Growth in California Housing Prices Expected REVENUE (Blended Case-Shiller and Federal Housing Finance Agency Indicesa) PROJECTIONS 300 Forecast California’s General Fund 250 is supported by revenues from a variety of taxes, fees, licenses, 200 interest earnings, loans, and transfers from other state funds. About 90 percent of the 150 total, however, is derived from the state’s “big three” taxes— 100 the personal income tax (PIT), the sales and use tax (SUT), 50 and the corporate income and franchise tax (CT). A summary of our revenue projections is 1987 1990 1993 1996 1999 2002 2005 2008 2011 2014 shown in Figure 5. aUses Case-Shiller data for the California metropolitan areas it covers and Federal Housing Finance Agency data for the rest of the state. First quarter of 2000=100. 16 www.lao.ca.gov Legislative Analyst’s Office California’s Fiscal Outlook tax increases contribute over $2 billion to PIT Fund revenues. For example, for each $10 billion revenues in 2010‑11. We project PIT collections to increase in capital gains, General Fund revenues increase steadily in the out years as the economy increase by approximately $800 million. continues to recover, but we do not expect collec‑ tions to exceed their 2007‑08 level of $54.2 billion Currently, there are two big variables that makes until 2015‑16. us particularly uncertain about capital gains. First, there is a large stock of unused losses. Taxpayers PIT Forecast Marked by Capital Gains, racked up far more capital losses than they could Federal Tax Uncertainties. Capital gains are claim on returns in 2008 and probably again in important for PIT projections because these gains 2009. Accordingly, we expect that these unused are concentrated among taxpayers who pay the losses will hinder revenue growth for many years highest marginal PIT tax rates. As Figure 7 (see as taxpayers use 2008 and 2009 losses to offset page 19) shows, capital gains fluctuate wildly future gains. relative to personal income depending on the state of asset markets, and this always makes them Second, there is significant tax policy uncertainty difficult to forecast. They peaked at $120 billion in at the federal level regarding congressional action on tax year 2000 at the height of the dot‑com bubble expiring tax cuts. In 2001 and 2003, lower tax rates, but fell to $33 billion in 2002. Similarly, capital including capital gains tax rates, were adopted, and gains peaked at $132 billion at the height of the these federal tax rate reductions are to expire this housing bubble in 2007, only to fall to $56 billion year. Our forecast assumes that this higher federal in 2008. We estimate that capital gains fell further tax rate on capital gains returns to its higher level to $34 billion in 2009. Our forecast reflects modest in 2011. This would cause some taxpayers to take future growth in capital gains through 2016 due to gains in 2010 that otherwise would be taken in 2011. improving stock prices and slowly increasing real The actions Congress takes could affect the timing estate values. If our forecast is off, this could have of these capital gain receipts and other economic a significant effect on PIT collections and General and revenue variables in different ways. It seems as Figure 5 LAO General Fund Revenue Forecast (Dollars in Millions) Revenue Source 2009‑10 2010‑11 2011‑12 2012‑13 2013‑14 2014‑15 2015‑16 Personal income tax $44,575 $46,731 $44,252 $47,909 $50,868 $54,072 $57,507 Sales and use tax 26,741 27,310 25,370 27,725 29,137 30,397 31,622 Corporation tax 9,500 10,418 8,567 8,125 8,531 9,255 9,963 Subtotal, “Big Three” ($80,816) ($84,460) ($78,189) ($83,760) ($88,536) ($93,724) ($99,092) Percent change 5.4% 4.5% -7.4% 7.1% 5.7% 5.9% 5.7% Insurance tax $2,020 $2,033 $2,060 $2,093 $2,129 $2,168 $2,223 Vehicle license fee 1,380 1,428 159 34 — — — Estate tax — 850 1,838 1,988 2,150 2,325 2,515 Sales of fixed assets — 1,286 1 1 1 7 7 Other revenues 2,378 2,205 2,136 1,861 2,072 2,233 2,342 Net transfers and loans 447 1,021 -853 -1,014 -180 21 18 Total Revenues and $87,041 $93,283 $83,530 $88,723 $94,708 $100,478 $106,197 Transfers Percent change 5.2% 7.2% -10.5% 6.2% 6.7% 6.1% 5.7% 17 Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook though the federal tax picture will be somewhat consumers, including a significant portion on light clearer by the time the new Governor releases his vehicles and trucks. Other important categories of budget proposal in January. taxable sales are the purchase of building materials involved in new construction and business–to– Sales and Use Tax business transactions, where a business is the item’s End of Temporary Tax Increase and final consumer. Taxable sales in California appear Proposition 26 Affect 2011‑12 Forecast. In to have hit bottom in the second half of 2009, and 2010‑11, we expect SUT receipts of $27.3 billion, are bouncing back. a 2.1 percent increase over the prior year. The 1 percent temporary SUT rate increase adopted As shown in Figure 8, overall consumer in 2009—which contributes $4.7 billion of SUT spending remains low relative to the levels of revenue in 2010‑11—will expire on June 30, 2011. recent decades, when viewed as a percentage For 2011‑12, SUT revenues are projected to fall to of personal income. It appears there has been a $25.7 billion, reflecting the net effect of this rate long‑term trend toward lower taxable sales, relative drop, projected growth in the SUT taxable sales to personal income, which has been influenced base of nearly 7 percent, and our assumption that by: (1) the major recessions of the early 1990s and voter approval of Proposition 26 on November 2, 2007‑2009; (2) a trend toward more consumption 2010 will undo the “fuel tax swap” adopted earlier of nontaxable services and other products (such as this year. Under the terms of that measure, the those purchased online, for which the collection gasoline sales tax is reinstated in November 2011, of sales and use taxes is more difficult); and thereby also increasing General Fund spending (3) increased household savings, particularly in the on transportation. After 2011‑12, taxable sales are last few years. expected to grow by 4 percent to 7 percent annually. Corporate Tax Taxable Sales Bottomed Out Last Year and Corporate Tax Forecast to Bottom Out in Now Are Recovering. The main determinant of 2012‑13 Before Rebounding. The CT receipts for SUT receipts is taxable sales. About two‑thirds 2009‑10 are estimated to have totaled $9.5 billion, of taxable sales result from retail spending by virtually unchanged from the previous fiscal Figure 6 November 2010 LAO Revenue Estimates Compared With 2010‑11 Budget Package (General Fund, In Millions) 2009‑10 2010‑11 LAO LAO November Budget November Budget Revenue Source Forecast Package Difference Forecast Package Difference Personal income tax $44,575 $44,820 -$245 $46,731 $47,127 -$396 Sales and use tax 26,741 26,618 123 27,310 27,044 266 Corporation tax 9,500 9,275 225 10,418 10,897 -479 Subtotal, “Big Three” ($80,816) ($80,713) ($103) ($84,460) ($85,068) (-$608) Other revenues $5,778 $5,760 $18 $7,802 $7,762 $40 Net transfers and loans 447 447 — 1,021 1,399 -378 Total Revenues and $87,041 $86,920 $121 $93,283 $94,230 ‑$947 Transfers 18 www.lao.ca.gov Legislative Analyst’s Office California’s Fiscal Outlook year. Due to the slow recovery and policy changes have been a significant reduction in CT receipts in enacted by the Legislature, we project CT receipts 2009‑10. Recent tax policy changes also will boost will fall sharply in 2011‑12 and 2012‑13. The receipts in 2010‑11 by increasing collections by a tax bottoms out in 2012‑13 at around $8 billion before Figure 7 rebounding back to around Capital Gains Expected to Grow Slowly $10 billion by 2015‑16. Capital Gains as Percent of Personal Income Corporate Profit Rebound 12% Does Not Necessarily Translate Into Higher Revenues. The Forecast 10 main factor underlying CT receipts is the level of corporate profits that California taxes. 8 California’s corporate profits, in turn, reflect the economic 6 conditions facing Californians, as well as national and interna‑ 4 tional economic conditions. At times, higher profits do not fully translate into higher CT 2 receipts because these higher profits also make it possible for businesses to use more deduc‑ 1990 1995 2000 2005 2010 2015 tions and credits. Precise data on California taxable profits Figure 8 for 2009 and 2010 are not yet Taxable Sales Depressed as Consumers Save More, available, but our forecast Spend Less assumes that corporate profits hit bottom in 2008‑09 and (As Percent of California Personal Income) rebounded rapidly in 2009‑10. 45% Profits in the final years of Forecast 43 our forecast grow at about 5 percent each year. 41 39 Policy Changes Reduce 37 Long‑Term Revenues. Policy changes made over the past 35 few years have significant 33 impacts on corporate tax 31 receipts over the forecast 29 period. As shown in Figure 9 (see next page), increases of CT 27 receipts due to policy changes 25 negated what otherwise would 1990 1995 2000 2005 2010 2015 19 Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook net amount of around $1 billion. For the remainder These changes, collectively, are estimated to of the forecast period, however, these same policy bring in around $1.2 billion in 2010‑11 but changes diminish CT receipts by between $1 billion have the effect of decreasing CT revenues and $2 billion each year. The major policy changes after 2011‑12. affecting the forecast include: • Expanded Credit Use. Recent legis‑ lation also affected the use of tax credits. • Changes in Multistate Business Taxation. Changes in this area include the creation The elective single sales factor—the new of new temporary tax credits for qualified option for businesses to annually choose employment and film production. Also, which method is used to determine credits are now easier to use under a law California taxable income—and associated that allows transfers of certain credits tax law changes are estimated to reduce between companies that are treated as General Fund CT revenues by up to parts of a single unit for tax purposes. $1 billion per year within a few years. These changes reduce revenues by up to • Revenue Accelerations. The Legislature $500 million per year throughout the has enacted several measures over the last forecast period. couple of years that will allow the state to Other Revenues and Transfers collect revenues earlier and delay the use of Estate Tax Highly Uncertain and Could Swell tax deductions or credits. The accelerations 2011‑12 Problem by $2.7 Billion. Above, we include the suspensions, for 2008 through discussed how congressional action in the coming 2011, of larger businesses’ use of net months could affect capital gains and PIT receipts. In operating loss deductions. Recently enacted addition, congressional action or inaction on estate penalties on corporate taxpayers who are taxes could significantly affect the state’s ability to found to have significantly underpaid their taxes also serve to accelerate CT collec‑ Figure 9 tions. This occurs Recent Corporate Tax Changes Help Short-Term as businesses try to Revenues, But Hurt Longer Term Fiscal Outlook avoid the penalties by (In Billions) paying upfront some of the tax they might $12 have been forced to Forecast pay later following 10 an audit. In addition, legislation limited the 8 amount of tax credits a corporation could 6 use in 2008 and 2009 Baselinea 4 to 50 percent of its Current law LAO forecast tax liability for those 2 years. This boosted near‑term receipts but leads to increased 2008-09 2010-11 2012-13 2014-15 use of those credits in 2010 and beyond. aBaseline revenues exclude policy changes made by the state since 2008. 20 www.lao.ca.gov Legislative Analyst’s Office California’s Fiscal Outlook receive any of the $850 million of current‑law estate and the Orange County Fairgrounds proceed tax receipts we project for 2010‑11 (a half‑year of as planned, our forecast projects $1.3 billion of receipts), as well as around $2 billion of annual one‑time General Fund revenue in 2010‑11. This receipts in each subsequent year of the forecast. As total is about $100 million higher than assumed we discussed in prior reports, a 2002 federal law in the 2010‑11 budget package. phased out estate taxes so that, by 2010, the estate tax was eliminated entirely. In 2011, this provision End of Temporary Vehicle License Fee (VLF) sunsets so that estate tax laws revert back to 2001 Increase Affects 2011‑12 Forecast. The temporary law—which means that tax rates would return to VLF increase enacted as part of the 2009‑10 2001 levels and the state pickup tax is restored. budget package expires at the end of 2010‑11. This This pickup tax reduces federal estate taxes by the temporary increase generates $1.4 billion of revenue amount of state taxes levied on each estate, up to a for the General Fund in 2010‑11. Thereafter, the certain level. As a result, many states—including General Fund VLF rate declines again to zero California—set state tax levels at the maximum in our forecast, although small amounts of VLF exemption level under federal law. There have been payments trickle in during subsequent fiscal years considerable efforts in recent years to change this due to late payments. Figure 10 summarizes the current federal law to permanently limit both the VLF and other revenues that the state has received federal and state estate tax. If Congress were to act from the temporary tax package. to change the federal law, it appears there is a good Special Fund Loans Dominate the General chance the pickup tax exemption would not be Fund Transfers Forecast. In addition to tax, fee, restored. In this event, the 2011‑12 budget problem and other revenues, the General Fund receives would increase by $2.7 billion (recognizing the transfers from the state’s special funds and transfers effects of both the half‑year projected estate tax money out to those same special funds. During receipts of $850 million in 2010‑11 and the first the forecast period, the state’s transfers are to be full year of receipts projected to be $1.8 billion in dominated by loans received from special funds (the 2011‑12). Later budget problems would grow by major component of the $1.4 billion of net transfers up to $2 billion per year above our forecast. (These assumed in the budget package for 2010‑11) and amounts do not account for any Proposition 98 loan principal repayments back to special funds interactions.) ($853 million of projected net transfers out in Fixed Asset Sales Slightly Above Enacted 2011‑12, $1 billion in 2012‑13, and $180 million in Budget Forecast in 2010‑11. Assuming that 2013‑14). Our forecast assumes that approval of recently announced sales of state office buildings Proposition 22 on November 2, 2010 eliminates the possibility of the state borrowing $378 million Figure 10 of funds from transpor‑ Estimated Revenues From Temporary Tax Increases tation accounts assumed Enacted as Part of the 2009‑10 Budget Package in the 2010‑11 budget (In Billions) package. This reduces net transfers and loans in 2008‑09 2009‑10 2010‑11 2010‑11 to $1 billion in our Sales and use tax—1 percentage point increase $1.1 $4.4 $4.7 projections. Personal income tax—dependent credit decrease 0.1 1.2 1.1 Personal income tax—0.25 percentage point increase 0.8 1.8 1.0 Vehicle license fee—0.5 percentage point increase 0.2 1.4 1.4 Totals $2.2 $8.7 $8.3 21 Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook DEMOGRAPHIC depress net international migration into California for the next several years. Births increase slowly PROJECTIONS as women continue to delay childbirth until later ages. Accordingly, as shown in Figure 11, our office Department of Finance (DOF) Population estimates that total annual population growth in Estimates Differ From Census Estimates. The DOF California will be 0.55 percent in 2010 and projects estimates that California’s July 1, 2009 population that population growth will be under 1 percent was 38.5 million and that the state’s population annually through 2015. increased by 1 percent (or greater) in each year between 2001 and 2008 and by 0.93 percent in Baby Boomers Will Swell Over‑65 Population. 2009. By contrast, the Census Bureau—in its annual Baby boomers born immediately after the end of estimates released prior to next year’s release World War II began to reach the age of 65 earlier of 2010 Census data—believed that California’s this year. As this huge population cohort continues July 1, 2009 population was 37.0 million. The to reach this age, this group will swell in the coming Census estimates differ from DOF’s because they years. We project the over‑65 population generally assume that California’s net annual population will grow over 4 percent per year throughout our growth rate has been somewhat under 1 percent in forecast period. several years during the past decade. Data from the 2010 Census to be released in March 2011 should Modest Growth for K‑12 and College‑Age help resolve this demographic dispute. Population Groups. Our forecast assumes the K‑12 population grows by 0.2 percent or less through Economic Downturn Probably Has Resulted 2013‑14 before increasing slightly more rapidly. in Fewer Newcomers. Relatively poor economic The 18‑24 college age group is projected to increase performance in California can make it less very modestly through 2013 before beginning to attractive for residents of other state and countries decline thereafter. During the forecast period, this to migrate here. Based on historical experience, our college‑aged group largely consists of the offspring population model suggests that the recent trend of the relatively small “Generation X”—those born of Californians leaving the state probably is accel‑ in the two decades after the baby boom. erating and will continue to do so through 2011. At the same time, the economic downturn will Figure 11 LAO’s California Demographic Forecasta (In Thousands) 2009a 2010 2011 2012 2013 2014 2015 2016 Totals (July 1st) 38,488 38,699 38,863 39,137 39,453 39,803 40,191 40,643 Percent change 0.93% 0.55% 0.43% 0.70% 0.81% 0.89% 0.98% 1.12% Change in population: Births 553 548 527 526 534 542 549 557 Deaths -237 -236 -241 -245 -249 -253 -257 -261 Net domestic migration -173 -190 -225 -121 -98 -85 -54 -12 Net foreign migration 210 89 104 114 130 145 152 167 Net Change 353 211 165 274 316 349 389 451 a Population figures listed for 2009 reflect Department of Finance estimates, which are 1.5 million higher than U.S. Census Bureau estimates released prior to tabulation of the 2010 Census. 22 www.lao.ca.gov Legislative Analyst’s Office Chapter 3 Expenditure Projections In this chapter, we discuss our General Fund Supportive Services (IHSS), and employee expenditure estimates for 2009‑10 and 2010‑11, compensation—will be unable to achieve the full as well as our projections for 2011‑12 through amount of budgeted reductions. 2015‑16. Figure 1 (see next page) shows our forecast Expenditure Growth During the for major General Fund spending categories for Forecast Period all of these years. Below, we first discuss projected Sharp Growth in 2011‑12 as One‑Time Savings general budgetary trends and then discuss in more Measures Expire. In 2011‑12, our forecast shows detail our expenditure projections for individual General Fund spending climbing by 11 percent. major program areas. This is principally the result of billions of dollars of one‑time saving measures expiring. For example, Medi‑Cal expenditures will increase by about GENERAL FUND $5 billion—the majority of this is due to expiring BUDGET TRENDS federal funds. Lower Growth Projected After 2011‑12. Our 2010-11 Outlook forecast shows General Fund spending growing General Fund expenditures in 2010‑11 are by 8.2 percent in 2012‑13, 3.6 percent in 2013‑14, billions of dollars below their normal levels due 4.8 percent in 2014‑15, and 4.1 percent in 2015‑16. to one‑time or temporary actions, including As shown in Figure 1, this equates to an average (1) billions of dollars in federal stimulus funds annual growth rate of 5.2 percent between 2011‑12 received, (2) suspension of Proposition 98, and 2015‑16—slightly higher than the forecasted and (3) funding shifts to non‑General Fund rate of personal income growth in the state sources. However, General Fund expenditures are during that period. The period is characterized forecast to increase from $87 billion in 2009‑10 by consistently high rates of growth in two areas to $92.5 billion in 2010‑11—an increase of that represent over half of the General Fund 6.3 percent. This is much more than the budgeted budget in 2015‑16: (1) Proposition 98 spending increase of 0.2 percent that was expected when the for K‑14 education, and (2) Medi‑Cal. Although budget was passed in October—due principally to Proposition 98 spending for K‑14 education is our projection that a significant amount (around forecasted to drop in 2011‑12, spending over the $3.5 billion) of assumed federal funds will not be following years averages 6 percent annual growth secured. In addition, we project that several major as the economy continues its expected recovery. programs—such as the prison system, In‑Home The largest growth in our forecast (8 percent) Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook occurs in Medi‑Cal due to growth in caseload and PROPOSITION 98— health care costs and, in the last two years of the K‑14 EDUCATION forecast, the impact of federal health care reform. The remainder of the budget is forecast to grow at State budgeting for K‑14 education is a modest 3.5 percent over the forecast period. This governed largely by Proposition 98, passed by the modest growth is due in part to the stated legislative voters in 1988. The measure, later modified by policy of having no automatic cost‑of‑living Proposition 111 in 1990, establishes a minimum adjustments (COLAs) or inflation adjustment for funding requirement, commonly referred to as programs (as discussed in Chapter 1). For instance, the “minimum guarantee,” for K‑14 education. our forecast shows no growth in General Fund Both state General Fund and local property tax appropriations to the universities or the courts revenues apply toward meeting the minimum after 2011‑12. guarantee. Proposition 98 monies support child Figure 1 Projected General Fund Spending for Major Programs (Dollars in Millions) Average Annual Growth Estimates Forecast From 2011‑12 to 2009‑10 2010‑11 2011‑12 2012‑13 2013‑14 2014‑15 2015‑16 2015‑16 Education K-14–Proposition 98 $35,669 $36,209 $34,184 $36,733 $38,847 $41,058 $43,270 6.1% Proposition 98 QEIA and Settle-Up 300a —a 750 750 750 750 472 -10.9 CSU 2,288 2,433 2,646 2,646 2,646 2,646 2,646 — UC 2,449 2,711 2,815 2,815 2,815 2,815 2,815 — Student Aid Commission 1,019 1,079 1,258 1,334 1,413 1,499 1,609 6.4 Health and Social Services Medi-Cal 10,136 12,595 17,642 18,831 20,291 22,101 23,976 8.0 CalWORKs 1,995 2,143 3,041 3,140 3,130 2,960 2,676 -3.1 SSI/SSP 2,951 2,954 3,033 3,116 3,200 3,287 3,379 2.7 IHSS 1,488 1,419 1,732 1,835 1,903 1,973 2,045 4.2 Developmental Services 2,420 2,541 3,124 3,292 3,473 3,671 3,885 5.6 Mental Health 1,666 1,837 2,142 2,193 2,247 2,305 2,367 2.5 Other major programsb 3,185 2,823 3,327 3,460 3,518 3,457 3,751 3.1 Corrections and Rehabilitation 7,718 9,281 9,034 9,124 9,371 9,546 9,792 2.0 Judiciary 419 1,649 2,016 2,013 2,012 2,012 2,012 — Proposition 1A Loan Costs 15 91 91 1,986 — — — — Infrastructure Debt Servicec 5,383 5,752 6,926 7,239 8,378 8,848 8,705 5.9 Other Programs/Costs 7,934 6,988 8,995 10,658 11,155 11,755 12,230 8.0 Totals $87,037 $92,505 $102,756 $111,167 $115,149 $120,683 $125,631 5.2% Percent Change 6.3% 11.1% 8.2% 3.6% 4.8% 4.1% a Consistent with the administration’s accounting, Quality Education Investment Act (QEIA) payments are reflected as a prior-year adjustment for 2009-10 and 2010-11. b Assumes $500 million annually through 2014-15 in General Fund savings from Medi-Cal 1115 Demonstration waiver. However, actual savings to the state could be less. Allocation of savings between program areas will be determined during the implementation of the waiver. c Includes transportation and transit debt-service offsets in 2009-10 and 2010-11. Excludes debt service funded within Propostion 98 and other minor payments included in other departmental budgets. 24 www.lao.ca.gov Legislative Analyst’s Office California’s Fiscal Outlook care, preschool, K‑12 education, and the California Legislature suspending Proposition 98 and Community Colleges—accounting for about providing less funding than otherwise required. 70 percent of total funding for these programs. As a result of the suspension, the state created (K‑14 education funding also comes from the an out‑year Proposition 98 obligation referred to federal government, other state sources, and as a “maintenance factor.” When growth in state various local sources.) General Fund revenues is healthier (as determined by a specific formula set forth in the Constitution), Calculating the Minimum Guarantee. The the state is required to provide additional funding Proposition 98 minimum guarantee is determined (make a maintenance factor payment) to build by one of three tests set forth in the Constitution. up K‑14 funding to the level it otherwise would These tests are based on several inputs, including have been absent the earlier reduction. In essence, changes in K‑12 average daily attendance, per capita the maintenance factor allows the state to attain personal income, and per capita General Fund near‑term savings without affecting the long‑run revenue. Though the calculation of the minimum level of K‑14 support. guarantee is formula driven, a supermajority of the Legislature can override the formulas Proposition 98 Forecast and provide less funding than the formulas Minimum Guarantee Drops in 2011‑12 Before require. This happened in 2010‑11, with the Rebounding. The top part of Figure 2 shows Figure 2 Proposition 98 Forecast (Dollars in Millions) 2010‑11 2011‑12 2012‑13 2013‑14 2014‑15 2015‑16 Minimum Guarantee General Fund $36,465 $34,184 $36,733 $38,847 $41,058 $43,270 Local property tax 13,193 13,272 13,598 14,014 14,559 15,231 Totals $49,658a $47,456 $50,331 $52,861 $55,617 $58,501 Percent change -4.4% 6.1% 5.0% 5.2% 5.2% Proposition 98 “Test” 2 1 2 2 2 1 Proposition 98 Obligations Maintenance Factor Created/Paid (+/-) $475 $3,929 -$1,229 -$463 -$392 -$611 Outstanding Maintenance Factor 9,489 13,749 12,996 13,067 13,259 13,189 Key Factors K-12 average daily attendance -0.12% 0.14% 0.20% 0.17% 0.33% 0.50% CCC full-time equivalent students 1.40 1.00 1.00 1.00 1.00 1.00 Per capita personal income (Test 2) 0.62 3.33 3.26 3.93 4.13 3.57 Per capita General Fund (Test 3) 5.92 -7.31 6.54 5.42 5.42 5.12 K-14 COLA -0.39 1.78 1.34 1.76 2.23 2.37 Year‑to‑Year Change -$1,946 $2,875 $2,530 $2,756 $2,884 Less Baseline Costs K-14 COLA -$864 -$663 -$883 -$1,144 -$1,252 K-14 attendance -101 -124 -116 -206 -305 Backfill of one-time actions -2,272 — — — — Funds Available/Shortfall (+/‑) ‑$5,184 $2,088 $1,531 $1,406 $1,326 a Reflects Proposition 98 funding level specified in Chapter 715, Statutes of 2010 (SB 851, Committee on Budget and Fiscal Review). 25 Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook our projections of the Proposition 98 minimum in the figure, the minimum guarantee would fall guarantee throughout the forecast period. For $5.2 billion short of fully funding baseline K‑14 2011‑12, we project the minimum guarantee will costs in 2011‑12. (This shortfall would be a few be about $2 billion lower than the 2010‑11 spending hundred million dollars higher if the Legislature level due to the expiration of tax increases that chooses to restore the California Work Opportunity temporarily raised tax revenues in 2009‑10 and and Responsibility to Kids [CalWORKs] Stage 3 2010‑11. For the rest of the forecast period, we child care program vetoed by the Governor this project steady increases in the minimum guarantee year.) That is, if the state funded at the minimum of $2 billion to $3 billion each year. Local property guarantee level in 2011‑12, school districts and tax revenues modestly grow each year of the community college districts would face significant forecast period. In the last year of the forecast programmatic reductions. As shown in the figure, period, we project the Proposition 98 minimum this is due to the decline in Proposition 98 funding guarantee and local property tax revenues would in 2011‑12 coupled with the cost of backfilling for finally be higher than their pre‑recession levels. the loss of one‑time 2010‑11 budget solutions. These reductions would occur at the same time as school Maintenance Factor Obligation Grows in districts exhaust one‑time revenues from the federal 2011‑12, Remains Large Throughout Period. American Recovery and Reinvestment Act (ARRA) Figure 2 also shows both how much maintenance of 2009 and the Education Jobs and Medicaid factor is created or paid in each year of the forecast Assistance Act of 2010. In every subsequent year period and the total amount of outstanding of the forecast period, the minimum guarantee maintenance factor. As shown in the figure, funding level would be sufficient to cover growth we estimate the state will have an outstanding and COLA and still have $1 billion to $2 billion to maintenance factor obligation of $9.5 billion at restore prior budget reductions. By 2015‑16, the the end of 2010‑11. Using the same maintenance minimum guarantee would grow to sufficient levels factor assumptions as used to build the last that all growth and COLA costs could be paid and three Proposition 98 budgets, $4 billion in new any reductions made in 2011‑12 could be restored. maintenance factor would be created in 2011‑12— Funding would be insufficient, however, to restore resulting in a total outstanding obligation of reductions made in 2008‑09, 2009‑10, and 2010‑11. about $14 billion. During the remainder of the forecast period, the state would make relatively Settle‑Up Assumed to Be Paid in Installments small maintenance factor payments each year. Throughout Forecast Period. For 2009‑10, the Because maintenance factor obligations grow (akin state provided $1.8 billion less than the minimum to an inflationary adjustment) and the required guarantee—creating a “settle‑up” obligation of payments are small, we project the state would that amount. Additionally, for 2010‑11, we assume end the forecast period still having an outstanding a new $256 million settle‑up obligation is created maintenance factor obligation of more than as a result of the Governor’s veto of Stage 3 child $13 billion. care funding (consistent with the administration’s intent). The 2010‑11 budget contained a $300 million Baseline Costs Much Higher Than Available first payment toward retiring the 2009‑10 settle‑up Resources in 2011‑12, Can Be Covered Thereafter. obligation. Consistent with this action, we assume The bottom part of Figure 2 compares our projection the state continues to make $300 million annual of the year‑to‑year change in the Proposition 98 payments throughout the forecast period—fully minimum guarantee with the amount needed to retiring the settle‑up obligations in the last year fund annual increases in baseline costs. As shown of the forecast. 26 www.lao.ca.gov Legislative Analyst’s Office California’s Fiscal Outlook Major Proposition 98 Issues payment deferrals would translate into K‑14 cuts We believe the Legislature should be mindful almost double the level otherwise needed in of several major issues as it begins to develop a 2011‑12. Given most districts have been cautious Proposition 98 budget strategy for the coming in increasing 2010‑11 program support as a result fiscal year. of the recent deferrals and some districts have been unable to access cash sufficient to support Unresolved Maintenance Factor Issues Quickly new spending paid for by the new deferrals, many Reemerge. As we discussed in our Analysis of the districts would not be significantly impacted 2010‑11 Budget: Proposition 98 and K‑12 Education, in 2010‑11 if the new deferral payments were conflicting interpretations of the constitutional eliminated. In essence, rather than encouraging provisions of Proposition 98 led to uncertainty school districts to hire new staff for half of the over the amount of maintenance factor owed at 2010‑11 school year merely to have the new staff the close of 2008‑09. Specifically, disagreement and even more existing staff laid off next year, existed regarding whether a maintenance factor the state would be encouraging school districts to was created when Test 1 applied and was lower retain their existing staff levels and plan for fewer than Test 2. The 2009‑10 Budget Act resolved layoffs next year. Such action would help minimize the issue by declaring that a maintenance factor the funding cliff that could result next year. obligation was created in 2008‑09. Current law, however, does not clarify how this situation should Relying on More Deferrals Increasingly be addressed in future years. In our forecast, this Problematic. Including the recent deferrals, particular scenario reemerges in 2011‑12, with the 17 percent of K‑14 program support is paid state potentially creating a maintenance factor using funds borrowed from the next fiscal year. obligation of $4 billion in 2011‑12. (As indicated In monetary terms, the first $8.2 billion in above, our forecast assumes a maintenance factor Proposition 98 funds the state provides each year is created.) Differences of opinion also exist with is paying for K‑14 services that local educational regards to how maintenance factor payments agencies already have provided. Though districts should be calculated (either on top of the Test 2 are assumed to front the cash to support programs level or the Test 1 level, if higher). This particular until the state makes payment, some local scenario reemerges in 2012‑13, with an impact of educational agencies (particularly small districts, about $900 million. (Our forecast assumes the districts with negative budget certifications, and lower Proposition 98 estimate, consistent with the charter schools) have had notable difficulty and/ manner in which the minimum guarantee was or have not been able to front the cash. As a calculated in the 2009‑10 and 2010‑11 budgets.) result, for these agencies deferrals increasingly are translating into de facto cuts. For most districts, Potential Reductions on Horizon Suggest big and small, cash management has become an Rethinking Recent Deferrals. Given the potentially increasingly significant issue, with Fiscal Crisis and sizeable drop in the minimum guarantee next year Management Assistance Teams reporting that the (absent legislative action to add new revenues), bulk of its district support is now devoted to cash one action the Legislature could take early in flow management. These issues also are affecting the upcoming budget cycle is eliminating the the number of districts with negative or at‑risk $1.8 billion in K‑14 payments deferred until July budget certifications, with 123 school districts in 2011. (As part of the 2010‑11 budget package, the 2007‑08 identified as having these certifications state authorized 2010‑11 spending using funds compared with 174 districts in 2009‑10. Negative borrowed from 2011‑12.) With the projected drop certifications in particular can make district in the 2011‑12 minimum guarantee, the recent borrowing significantly, if not prohibitively, more 27 Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook expensive. For all these reasons, the Legislature may providing automatic COLAs. This amount is want to avoid adopting new inter‑year deferrals as somewhat higher than state spending in 2010‑11, part of its 2011‑12 budget strategy as well as monitor which takes advantage of one‑time federal stimulus district health to determine if more districts could funds that offset state costs. We discuss the stimulus need an emergency state loan in 2011‑12. funds in more detail below. Help Districts by Maximizing Flexibility and “Tidal Wave II” Is Over. Beginning in the 1990s, Sending Signals Early. Though the state might not sustained growth in the traditional college‑age be able to provide monetary relief to distressed population created ongoing enrollment pressures districts, the Legislature can help school districts in higher education. This demographic bulge has and CCC districts in various ways. Among the most been popularly known as Tidal Wave II (following a notable ways are by retaining existing flexibility larger demographic surge in the 1960s). While there provisions, extending some of those provisions, was some disagreement over the magnitude of Tidal and exploring new types of flexibility. Over the Wave II, by all accounts the demographic growth last couple of years, districts have reported relying has plateaued and the college‑age population will heavily on these flexibility provisions to meet actually be declining in the latter years of the critical local needs and balance their budgets. In forecast. Already the annual number of high school general, these flexibility measure expire at the end graduates has begun to shrink. of 2012‑13; yet, under state law, districts currently need to project costs through 2013‑14 for budgeting Enrollment demand at the universities results purposes. Thus, another way the Legislature could not just from the size of their eligibility pools, but help districts is by beginning to think about what also on the percentage of eligible individuals who flexibility rules it wants in place come 2013‑14. The seek admission. We are unable to project changes Legislature might want to consider fundamental in this latter factor. We assume, however, that the school finance reform that could take a couple shrinking eligibility pool would generally cancel years to develop. Starting these conversations now out the effect of a modest increase in the demand will better position both the state and districts for rate. For this reason, we assume no increase in whatever transition might happen in 2013‑14. university enrollment during the forecast period. Fees Projected to Continue Rising. A significant portion of core operating costs at the universities is HIGHER EDUCATION covered by student fees. The state has no expressed policy for annual adjustments to these fees, which In addition to the community colleges (which are set by the universities’ governing boards. In are discussed above as part of the Proposition 98 recent years, the universities have generally raised forecast), the state’s public higher education entities fees at double‑digit rates in order to compensate include the University of California (UC), the for limited state funding. This pattern, as well as California State University (CSU), the California statements by the universities, suggests that student Student Aid Commission (CSAC), and the fees will continue to increase for the next few years. California Postsecondary Education Commission. Any fee increases could be used to cover new costs— such as inflation and expansion of institution‑based UC and CSU Expenditures financial aid programs—that are not accounted for Our forecast assumes the universities’ annual in our General Fund forecast. Expanded federal, operating costs will be roughly even at about state, and institutional student aid programs will $5.5 billion over the course of the forecast period. offset a significant proportion of fee increases, This reflects our overall forecast approach of not particularly for lower‑income students. 28 www.lao.ca.gov Legislative Analyst’s Office California’s Fiscal Outlook Federal Funds Provided One‑Time Budget • How Much Should Students Pay? As Solution. The Governor’s 2010‑11 budget noted above, the universities are likely to proposal included $305 million in General Fund be increasing student fees at double‑digit augmentations to restore prior‑year cuts of the annual rates for at least the next several years. same amount at UC and CSU. The Legislature Not only does this affect the cost of education instead approved General Fund augmentations for students, it also increases state costs for of $199 million, and appropriated $106.6 million the Cal Grant financial aid programs. The for each university system in one‑time federal Legislature may wish to provide direction stimulus funding. Our forecast assumes that this to the universities with regard to the share federal funding is replaced with base General Fund of education cost that non‑needy students support starting in 2011‑12. should be expected to pay. UC Restarting Contributions to Retirement • How Should the Universities Reduce Program. For close to two decades, neither the state Operating Costs? In a reversal of earlier nor UC employees have made contributions to the budget reductions, the universities in UC Retirement Program (UCRP). This is because, 2010‑11 are receiving more total funding until recently, UCRP investments were sufficient per student than they were before the to cover the retirement cost obligations for UC current recession began. Given the employees. This is no longer the case, and UC likelihood of continuing state budget has re‑instituted employee payroll contributions constraints for the next several years, it may toward the UCRP. Meanwhile, as part of the be necessary for the universities to reduce 2009‑10 budget package, the Legislature adopted their per‑student costs. The Legislature may statutory language declaring its intent that no wish to express expectations with regard new General Fund augmentations would be made to cost‑saving opportunities related to toward UCRP costs. In the 2010‑11 budget package, student‑faculty ratios, student remediation the Legislature deleted that language. A new budget rates, articulation of course sequences, provision directing UC to provide a long‑term plan student assessment and placement, caps on for renewed funding of UCRP, including a proposal the number of course units a student may for state contributions, was vetoed by the Governor. take at subsidized rates, use of summer session, expansion of distance education Because there is no statutory formula or adopted and other alternative modes of instruction, plan governing state support for UCRP, we did not and other considerations. include General Fund costs for UCRP during the forecast period. Based on discussions with UC, • How Should the State Address UCRP however, we estimate that their proposal could call Costs? As discussed above, UC’s current for state General Fund contributions exceeding plans to restart UCRP contributions $400 million annually by the end of the forecast envision a corresponding increase in UC’s period. General Fund support, reaching several hundred million dollars per year by the Key Choices Facing Legislature. Given that end of the forecast period. This constitutes state General Fund resources are likely to continue one of the largest single General Fund to be severely constrained for the next several years, augmentation requests the Legislature is the Legislature faces key questions with regard to likely to be considering in the near future. the higher education budget. Until UC finalizes a detailed plan, we are unable to advise the Legislature on UC’s 29 Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook estimated state contribution. Besides Phase‑Out of Enhanced Federal Match. the magnitude of any augmentation, the One factor that increases state costs for some Legislature will also have to consider health programs over the forecast period is how state support would be adjusted in the phase‑out of the enhanced federal medical future years, including potential increases assistance percentage (FMAP) originally provided or decreases in UCRP normal costs and under ARRA and extended through June of 2011 unfunded liabilities. For example, annual by further congressional actions. Historically, state contributions to UCRP could be tied to the state and federal government share most other public retirement systems (such as the Medi‑Cal costs on a roughly equal basis. However, California Public Employees Retirement ARRA temporarily increased the federal share System [CalPERS]). Alternatively, the for California to almost 62 percent beginning in state’s contribution to UCRP could take the October 2008 and continuing through December form of a base increase to UC’s operating 2010. Between January and June of 2011, the budget. The UC would then be expected enhanced federal match will be phased out and to manage its retirement costs out of its the state’s share of most Medi‑Cal costs will regular General Fund appropriations as it return to a roughly equal basis in July 2011. When does for most other ongoing support costs. the enhanced FMAP ends, it will reduce federal funding for programs in the departments of CSAC Health Care Services, Developmental Services, Cal Grant Programs. Most of the state’s direct and Mental Health, among others. Our forecast General Fund support for student financial aid assumes that the reductions in federal funding will is directed through the Cal Grant programs, be backfilled with General Fund spending. Notably, which provide fee coverage and subsistence grants this has the effect of increasing the year‑over‑year to eligible students. These costs increase with percentage growth in General Fund spending for expanded program participation and fee increases. these programs in 2011‑12 compared to 2010‑11. Based on these factors, we project that Cal Grant costs will increase from $1.1 billion in 2010‑11 to Impact of Federal Affordable Care Act (ACA). $1.6 billion at the end of the forecast period. The ACA, also referred to as federal health care reform, is far‑reaching legislation that will change how millions of Californians access health care coverage. Among many other provisions, the new HEALTH federal law expands federal funding and eligibility for the Medi‑Cal Program and mandates that California’s major health programs provide individuals obtain private or public health coverage. health coverage and additional services for various Some key provisions will not take effect until 2014. groups of eligible persons—primarily poor families The scope of ACA is so broad that it will be years and children as well as seniors and persons with before all of its provisions will be fully implemented disabilities. The federal Medicaid program, and its overall ramifications fully understood. known as Medi‑Cal in California, is the largest Over the next few years, the federal government state health program both in terms of funding will promulgate regulations that will clarify ACA and number of persons served. In addition, the and give more detailed guidance on how many of state supports various public health programs, its provisions are to be implemented. Our fiscal community services and state‑operated facilities forecast includes some significant budgetary for the mentally ill and developmentally disabled, adjustments to account for the implementation of and health care insurance for children through the ACA. However, our estimates of these adjustments Healthy Families Program (HFP). 30 www.lao.ca.gov Legislative Analyst’s Office California’s Fiscal Outlook are preliminary in nature and may change increases in the state population, policy changes, significantly in the future as more details emerge and other underlying trends. Due to the recent regarding ACA implementation. passage of ACA, as described above, Medi‑Cal caseload will increase significantly beginning in Waiver Renewal Approved by Federal January 2014. The federal government will cover Authorities. The Department of Health Care the costs for those individuals who are considered Services (DHCS) submitted a Medi‑Cal waiver newly eligible under ACA during the forecast request to the federal centers for Medicare and period. The state will share costs for any increase Medicaid Services (CMS). At the time this forecast in caseload in existing eligibility categories that was prepared, the waiver application had just results from persons enrolling in Medi‑Cal in been approved by CMS. As a result of an expected response to the individual coverage mandate increase in federal funds of up to $500 million created under ACA. We note that, due to ACA, annually through 2014‑15, we have reduced overall our estimates related to caseload growth and other General Fund spending by comparable amounts. economic factors contain a significantly greater (These savings, which will accrue to various state degree of uncertainty than in the last few years. departments, have not been allocated to specific health programs.) Erosion of Assumed Budget Savings. Due to implementation delays resulting from the passage of a late budget, we estimate that certain budget Medi-Cal solutions will achieve less in savings than assumed Overall Spending Trends. We estimate that in the 2010‑11 spending plan. We also assume the General Fund spending for Medi‑Cal local that none of an unspecified $323 million budget assistance administered by DHCS in the current reduction in Medi‑Cal will be achieved. year will amount to almost $12.6 billion. This is about $396 million, or 3.2 percent, more than Expiration of One‑Time Savings Measures. appropriated in the 2010‑11 Budget Act. We We estimate that Medi‑Cal spending will increase project that General Fund support will grow to significantly in 2011‑12 due to the expiration of $17.6 billion in 2011‑12, a 40 percent increase from several one‑time savings measures included in current‑year expenditures. The biggest factors the 2010‑11 budget plan. These savings include: contributing to this year‑over‑year spending (1) about $3 billion from the receipt of additional growth are: (1) changes in the FMAP discussed federal funds; (2) $560 million in hospital provider above that result in the need for the state to fee funds allocated for children’s health coverage; backfill lost federal funds with General Fund; and (3) about $380 million in payment deferrals for (2) increases in caseload, utilization of services, institutional providers, managed care plans, and and rising costs for those services; (3) erosion of provider repayments to the federal government. budget savings; and (4) expiration of one‑time The forecast assumes that these one‑time savings solutions assumed in the 2010‑11 budget plan. We measures will be backfilled with General Fund project that spending will reach about $24 billion spending in 2011‑12. by the end of the forecast period in 2015‑16. Healthy Families Key Program Cost‑Drivers. A significant We estimate that $123 million from the General forecast factor is our assumption that the cost per Fund will be spent for support of HFP in 2010‑11. person of Medi‑Cal health services will grow at an An expected one‑time contribution of $81 million average annual rate of about 5.5 percent. We also from the California Children and Families project that the overall Medi‑Cal caseload will Commission, $193 million from a temporary grow nearly 4 percent annually commensurate with 31 Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook tax on Medi‑Cal managed care plans, and Developmental Services reimbursements from other sources, is projected to We estimate that the General Fund spending bring total state support for the program in 2010‑11 for developmental services in 2010‑11 will total to $405 million. Due to the expiration of these $2.5 billion. We project that General Fund support one‑time funding sources that offset General Fund will grow to more than $3.1 billion in 2011‑12, a support, we estimate that General Fund spending 23 percent increase from current‑year expenditures. for HFP will grow to $425 million in 2011‑12 This year‑over‑year projected growth is largely and continue growing until 2014‑15, but decline due to the phase out of the enhanced FMAP rate significantly in 2015‑16 due to the impact of ACA. provided under ARRA and the expiration of temporary provider payment reductions that were Recent Caseload Trends Are Flat, but Growth implemented as a cost‑cutting measure. Is Projected to Resume. Ever since enrollment dipped due to a temporary program closure in fall We project that General Fund support will grow 2009, caseload in the HFP has remained relatively to almost $3.9 billion by the end of the forecast flat. We project that caseload will begin climbing period in 2015‑16. This projected growth is largely again in 2011, and will continue to grow throughout due to increased caseload, utilization of services, the forecast period consistent with past annual and rising costs for community services provided in caseload growth rates of approximately 5 percent. regional centers. Our forecast assumes that regional center caseloads will grow at an annual average rate Other Cost‑Drivers. Our forecast assumes of 3.6 percent, and that costs overall will grow at an increased costs for provision of health care due to average annual rate of about 7 percent. general growth in medical costs. In addition, the forecast includes local assistance cost increases associated with program changes required by SOCIAL SERVICES the U.S. Children’s Health Insurance Program Reauthorization Act of 2009 (CHIPRA). The California’s major social services programs state may also incur further costs throughout provide a variety of benefits to its citizens. These the forecast period due to additional CHIPRA include income maintenance for the aged, blind, requirements for substance abuse, mental health, or disabled; cash assistance and welfare–to–work and dental benefits. These costs are not included services for low–income families with children; in the forecast, due to uncertainty at this time protecting children from abuse and neglect; regarding the cost implications of complying with providing home–care workers who assist the aged these requirements. and disabled in remaining in their own homes; and subsidized child care for families with incomes ACA Provision Will Lower General Fund under 75 percent of the state median. Although Costs in Out‑Years. The ACA specifies that the state departments oversee the management of federal matching rate for HFP will increase from these programs, the actual delivery of many 65 percent to 88 percent beginning October 1, services at the local level is carried out by county 2015. If not for this enhanced match, we would welfare and child support departments. Most social project HFP General Fund costs of $570 million services programs are supported by a mix of state, for 2015‑16, the last year of our forecast period. federal, and county funds. (In the nearby box, we Instead, we project that the enhanced federal match also discuss the rising General Fund costs of the in 2015‑16 will reduce HFP General Fund costs to federal–state unemployment insurance program.) $289 million. 32 www.lao.ca.gov Legislative Analyst’s Office California’s Fiscal Outlook Major Current‑Year Adjustments. The 2010‑11 Overall Spending Trends in Social Services. budget provided $8.7 billion from the General Based on current law requirements, we project Fund to support social services programs and that General Fund spending will increase from a departments. We now estimate that General revised $9.3 billion in 2010‑11 to approximately Fund costs for social services will be $9.3 billion. $10.7 billion in 2011‑12 and $11 billion in 2012‑13. Most of this increase is attributable to backfilling For the final year three years of the forecast, we for assumed federal funds which have not been project that spending will remain relatively flat, approved by Congress and anticipated delays in reaching $11.1 billion in 2015‑16. The $1.4 billion realizing savings from certain recently adopted increase in 2011‑12 is mostly attributable to the budget solutions. General Fund cost of backfilling temporary federal General Fund Impact of the Unemployment Insurance Insolvency The Unemployment Insurance (UI) program is a federal–state program that provides weekly UI payments to eligible workers who lose their jobs through no fault of their own. The UI program is financed by unemployment tax contributions paid by employers for each covered worker. Insolvency. As we discussed in our recent report, California’s Other Budget Deficit: The Unemployment Insurance Fund Insolvency, the UI fund is currently insolvent and ended 2009 with a deficit of $6.2 billion. Based on earlier Employment Development Department (EDD) estimates, this report indicated that the deficit could reach $20 billion by the end of 2011. In its most recent fund forecast, EDD estimates that the fund will have a deficit of $10 billion at the end of 2010, rising to $13.4 billion in 2011 and $16 billion by the end of 2012. Federal Loans. Because of the insolvency, EDD obtains federal loans on a quarterly basis to cover projected fund deficits. To date, the state has borrowed about $8.7 billion, permitting California to make benefit payments to UI claimants without interruption. Federal loans lasting more than one year generally will accumulate interest charges of about 5 percent per year on the outstanding balance. Temporary Federal Relief. The federal economic stimulus package enacted in 2009, the American Recovery and Reinvestment Act, relieves states from making interest payments for UI loans through December 31, 2010. After December 2010, the state must resume making interest payments. The EDD estimates that the interest amount due in September 2011, for nine months of interest accruing from January 2011 through September 2011, will be about $360 million. Addressing the Insolvency. To restore solvency, the state must increase employer taxes, reduce benefits, or do some combination of the two. Our report on the insolvency discusses the advantages and disadvantages of potential solutions to this difficult problem. Budget Forecast. Absent corrective action, the UI fund will remain insolvent for the foreseeable future, and interest costs will continue to grow significantly. We estimate that these costs will reach about $700 million by the final year of our forecast, 2015‑16. Under federal law, these interest charges cannot be paid from the UI fund. Our forecast assumes that these interest payments become a General Fund cost beginning in 2011–12. 33 Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook funds from the ARRA (discussed earlier in the attributable to: (1) a General Fund backfill to “Health” section) and the expiration of certain replace a one‑time savings from the accelerated short‑term solutions adopted in the past two receipt of TANF block grant funds in 2010‑11, budget cycles. The relatively slow growth in the (2) caseload growth, (3) the fixed federal TANF out‑years of the forecast is because caseload growth block grant, which does not adjust for caseload in IHSS and Supplemental Security Income/State increases, and (4) backfilling of TANF ECF Supplementary Program (SSI/SSP) is offset by funds. We explain these changes in more detail caseload declines in CalWORKs and Foster Care. below. Last year, the Legislature made additional substantial short– and long–term policy changes Costs of Providing COLAs. Current law in the CalWORKs program, as discussed below. suspends COLAs for social services programs. Their fiscal effects are also reflected in the forecast. If the Legislature elected annually to provide the discretionary California Necessities Index COLAs Replacing One‑Time Savings From Accelerated for social services benefits, however, total General Receipt of Federal Funds. The 2010‑11 budget Fund costs in 2015‑16 would be about $550 million assumes that California will take advantage of higher than we have projected. This approach existing federal rules which allow states to draw would result in additional costs of approximately down an extra 10 percent of their TANF block $350 million in CalWORKs, $160 million in grant during the final quarter of the state fiscal year. SSI/SSP, and $40 million in Foster Care. Similarly, On a one‑time basis, this will result in increased if the Legislature elected to provide the counties, federal funding of $366 million and corresponding which administer most of these programs, with General Fund savings. In 2011‑12, the forecast annual inflationary adjustments, total annual provides a General Fund backfill of $366 million General Fund costs in 2015‑16 would increase by to replace the federal funding. about $410 million. Caseload Costs Affected Mainly by Economic CalWORKs Conditions. The forecast reflects some significant Overall Spending Trends. For 2010‑11, the state assumptions about how the CalWORKs caseload budget provided $1.7 billion from the General Fund and the state’s economy will change during the for CalWORKs. The budget assumed that Congress next five years. During 2008‑09 and 2009‑10, would reauthorize the Temporary Assistance for the caseload increased by about 8 percent and Needy Families (TANF) Emergency Contingency 10 percent, respectively, as the state suffered a severe Fund (ECF) and provide California with about recession. The rate of caseload growth appears to $400 million to offset General Fund costs. However, have peaked toward the end of calendar 2009 and the TANF ECF expired on September 30, 2010. the latest data through July 2010 indicate that the Because Congress has not yet acted to continue caseload has only grown by 2.3 percent over the the program, our forecast assumes a General Fund last seven months. The latest data are consistent backfill of about $400 million. From a revised base with the budget forecast of 4.7 percent caseload of $2.1 billion in 2010‑11, we project that spending growth during 2010‑11. We are forecasting growth will increase by about $900 million in 2011‑12, of 4.5 percent in 2011‑12 and 2.6 percent in 2012‑13. peak at about of $3.1 billion in 2012‑13, and then After that, we expect the caseload to flatten, with decline to about $2.7 billion by the end of the a gradual decline in 2014‑15 as the economy forecast period. improves. Our projection of a $1 billion increase in State, Rather Than Federal Government, Bears spending over the next two years is largely Caseload Costs. Although General Fund support for CalWORKs is only $2.1 billion in 2010‑11, 34 www.lao.ca.gov Legislative Analyst’s Office California’s Fiscal Outlook total program costs, including federal funds, are automatic COLAs for many programs, including approximately $6 billion. Each 1 percent increase in SSI/SSP. Thus, COLA costs are not included in caseload results in state costs of about $60 million this forecast, contributing to the relatively slow per year, because the TANF block grant is fixed. spending growth in SSI/SSP. Additional Backfill for TANF ECF. Because IHSS federal support for CalWORKs from the TANF For 2010‑11, we estimate that General Fund ECF ended in September 2010, the forecast assumes spending for IHSS will be about $1.4 billion, a backfill of about $400 million from the General which is roughly $200 million above the budget Fund in 2010‑11, with an additional $115 million appropriation. For 2011‑12, we estimate General in 2011‑12. Fund costs will reach about $1.7 billion. We project that General Fund support for IHSS will increase to Cost of Restoring Funds for Short‑Term Policy just over $2 billion in 2015‑16. Most of the growth Changes. For 2009‑10 and 2010‑11, the Legislature in spending occurs within the first two years of the (1) exempted families with very young children or forecast period, followed by more modest growth in families with two or more preschool children from the out‑years. The $600 million in spending growth work participation requirements and (2) reduced over the forecast period is primarily due to (1) the associated county block grants for employment General Fund backfill of lost additional federal services and child care by $375 million. Our funds, (2) caseload growth, and (3) the expiration forecast reflects complete restoration of these of a temporary budget reduction. Below, we first reductions in 2011‑12. discuss the changes in 2010‑11, and then turn to a discussion of the major IHSS program cost drivers Savings From Long‑Term Changes. in the out‑years. Commencing in 2011‑12, the Legislature created a system of (1) shortened time limits for most families New Budget Solutions and Estimated Erosion on aid, (2) increased sanctions, and (3) new county in 2010‑11. As noted above, our forecast assumes service obligations for families affected by these that IHSS program costs will be $200 million more new policies. The net impact of these changes is than appropriated in 2010‑11. As part of the 2010‑11 very hard to estimate, but our forecast assumes net budget plan for IHSS, the Legislature adopted savings of about $200 million beginning in 2011‑12 (1) a provider tax and supplemental payment and growing to $250 million in 2012‑13. which will draw down additional federal funds, (2) a 3.6 percent reduction to authorized service SSI/SSP hours, and (3) a caseload savings relative to prior State expenditures for SSI/SSP are estimated estimates. Together, this package of solutions was to be about $3 billion in 2010‑11 and 2011‑12. We estimated to save $300 million in 2010‑11. For project that General Fund support for SSI/SSP will 2010‑11, our review suggests that this package will increase by about $85 million each year, reaching only save about $155 million and that a portion of about $3.4 billion by 2015‑16. the savings ($45 million) from previously enacted anti‑fraud activities will not be achieved. We Costs Primarily Driven by Caseload Growth. discuss these adjustments below. The spending increases that we project in SSI/SSP are primarily due to expected caseload growth • Delayed Implementation. For both the of about 2.3 percent annually. In our forecast, provider tax and the 3.6 percent reduction the primary driver of the caseload increase is in service hours, our forecast assumes the anticipated growth in the aging population. later implementation than was assumed As discussed earlier, the Legislature eliminated 35 Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook in the 2010‑11 budget plan. This delay is Affect Social Services, a federal judge has issued likely because of the time required for injunctions preventing implementation of service recipient notification and automation hours and wage reductions enacted in 2009‑10. system changes. During the time the new 3.6 percent reduction is in place, budget legislation suspends the 2009‑10 • Increased Utilization of Authorized reductions to allow for current court challenges to Hours. In addition to our assumption be resolved. Given the uncertainty of the current related to delayed implementation, our litigation, our forecast assumes no savings from forecast assumes further erosion of the these 2009‑10 reductions. savings associated with the 3.6 percent reduction in authorized service hours. Because not all recipients currently utilize JUDICIARY AND all of their authorized hours, the approved reduction in authorized hours will not CRIMINAL JUSTICE save 3.6 percent of program costs for all recipients. The major state judiciary and criminal justice programs include support for two departments in • Interaction of Savings Estimates for the executive branch—the California Department Caseload and Anti‑Fraud Activities. Due of Corrections and Rehabilitation (CDCR) and the to technical interactions related to the Department of Justice—as well as expenditures for assumed savings from anti‑fraud activities the state court system. and caseload savings, our forecast assumes less combined savings from these two CDCR factors than was included in the 2010‑11 Our forecast assumes that General Fund budget. spending for the support of CDCR operations will increase from $9.3 billion in 2010‑11 to $9.8 billion Backfill for Loss of Federal Funds in 2011‑12. in 2015‑16. This projection reflects additional costs Because federal relief initially provided pursuant to staff and operate new prison facilities that are to the ARRA (discussed above in the “Health” expected to be constructed during the forecast section) ends in June 2011, the forecast provides a period. As discussed below, we estimate that state General Fund backfill of $298 million in 2011‑12. spending on corrections will be almost $1 billion higher than the budgeted amount for 2010‑11, IHSS Caseload Growth. Our forecast assumes primarily due to planned savings that largely will the IHSS caseload will grow at 3.3 percent per year not be realized. throughout the forecast period, which is lower than in past years. This is based on recent data which reflect Policy Changes Needed to Fully Achieve Budget a slowing in the growth of the caseload. This lower Savings. The 2010‑11 budget assumed $820 million caseload growth could be attributed to a combination in savings in the federal Receiver’s inmate medical of factors related to recent program changes. services program by releasing certain infirm inmates early from prison and placing them on Two‑Year 3.6 Percent Service Hour Reduction parole based on their medical status and from and Current Law Suspension. As noted above, other unspecified operational and policy changes. 2010‑11 budget legislation temporarily reduced However, our forecast assumes that most of these authorized hours for IHSS recipients by 3.6 percent savings will not be realized in the current year. This through June 2012. As explained in our January is primarily due to the absence of a complete plan as 2010 report, How the Special Session Actions Would 36 www.lao.ca.gov Legislative Analyst’s Office California’s Fiscal Outlook to how the Receiver will achieve all of the assumed costs, as well as a federal court order to significantly savings. Moreover, our forecast also assumes that a reduce the state’s inmate population (see nearby box separate $219 million population‑related reduction for more detailed information), the Legislature may in the 2010‑11 budget will not be fully achieved as wish to reconsider the need for some of the projects planned, due to the fact that sufficient statutory authorized under AB 900. changes to allow for a significant reduction in Providing Inflationary Adjustments Would correctional populations were not adopted as part Further Increase Spending. As discussed earlier of the budget. in this report, our forecast assumes no price adjustments for CDCR’s operating expenses and Ongoing Operating Costs Projected to Increase. equipment. If the Legislature were to provide Chapter 7, Statutes of 2007 (AB 900, Solorio), such adjustments each year, we estimate that the authorizes the construction of tens of thousands of department’s expenditures would increase by about additional prison beds. Our projections assume that $350 million annually by the end of the forecast about 16,300 additional beds will be constructed period, relative to our baseline projections. (This pursuant to AB 900 during the forecast period, estimate does not include adjustments for employee resulting in an estimated $800 million in additional compensation increases, which are discussed later General Fund expenditures to staff and operate the in this chapter.) new facilities. As the new facilities are built, the Legislature will need to make policy and budgetary Judicial Branch decisions regarding the level of programming and General Fund spending for the support of the staffing to be provided at these facilities, which judicial branch is projected to remain relatively will determine the actual increase in operational flat at roughly $2 billion from 2011‑12 through costs. Given the likely magnitude of these eventual 2015‑16. This amount is, however, higher than the Federal Court Order to Reduce Inmate Population Not Reflected in Projections On January 12, 2010, a federal three‑judge panel issued a ruling requiring the state to reduce the inmate population in its prisons to 137.5 percent of design capacity—a reduction of roughly 40,000 inmates—within two years. However, the court stayed implementation of this court ruling pending the state’s appeal of the decision to the U.S. Supreme Court. The January 12 ruling does not specify the particular inmate population reduction measures that the state must implement. However, the court did require the administration to submit an inmate population reduction plan on November 19, 2009, and indicated in its January 12 ruling that the administration could implement the measures identified in the plan. This plan included certain changes that were adopted as part of the 2009‑10 budget (such as increasing the credits that inmates can earn to reduce their stay in prison), as well as certain changes that the Governor proposed for 2010‑11 but were rejected by the Legislature (such as requiring that certain felons be incarcerated in county jail in lieu of state prison). The U.S. Supreme Court is scheduled to hear the state’s appeal on November 30, 2010. Given that the ruling is still under appeal, our forecast does not reflect the savings that could result from such a massive population reduction. However, if the court were to uphold the three‑judge panel’s ruling and the state inmate population were to be reduced 137.5 percent of design capacity, we estimate that state spending could decline beginning in 2011‑12 in the range of about several hundreds of millions of dollars annually relative to our baseline forecast for the California Department of Corrections and Rehabilitation. 37 Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook amount the state will spend in 2010‑11. As part of for the 15 bargaining units with ratified contracts) the 2010‑11 budget package, a one‑time shift of and (2) employee healthcare premiums (forecast redevelopment funding will offset $350 million to increase by 7.7 percent annually). By the end in General Fund costs for the trial courts in the of the forecast period, these costs will more than current year. Our forecast assumes that the General offset the state’s ongoing savings from the increased Fund will replace the $350 million in 2011‑12 and employee pension contribution rates and workforce future years. cap. In addition, we estimate that state savings from the unpaid leave programs will end by mid‑2011‑12 Providing Inflationary Adjustments Would because the PLP expires after 12 months, and the Further Increase Spending. As discussed earlier administration currently does not have authority in this report, our forecast assumes no inflationary to extend furloughs beyond 2010‑11. Consistent adjustments to the operating budget of trial courts. with current labor agreements and law, our forecast If the Legislature were to provide such adjustments, assumes no other salary increase through 2015‑16, we estimate that operating expenditures for trial other than the ones described above. courts would increase by roughly $540 million annually by the end of the forecast period, relative Uncertainties. Many factors make it difficult to to our baseline projections. project future state employee compensation costs. New labor agreements with employee bargaining units could affect state savings under the unpaid leave programs. Similarly, actions by the Governor OTHER PROGRAMS and/or Legislature to extend the leave programs or make other changes to employee compensation Employee Compensation (beyond the top step pay increases included in the The 2010‑11 Budget Act assumes $1.4 billion current bargaining agreements) could increase in General Fund savings from various actions or decrease annual General Fund costs in the affecting state employee pay and benefit costs, hundreds of millions of dollars each year. including: a 12‑month personal leave program (PLP) and increased employee pension contribution Public Employee Retirement Costs rates for most executive branch employees; a three Our forecast reflects current‑law increases in day per month furlough program for employees in the state’s annual payments to four major public the six bargaining units with expired contracts; and employee retirement programs: pension programs an executive order directing departments to reduce for state and CSU employees, the teachers’ pension workforce costs by 5 percent. program, state and CSU retiree health benefit programs, and pension programs for judges. (The Short‑Term Net Personnel Savings. Our teachers’ pension program is administered by forecast assumes $1 billion in net employee the California State Teachers’ Retirement System compensation savings in 2010‑11. We expect that [CalSTRS], and the other three programs are difficulties associated with the implementation of administered by CalPERS.) The state’s required the workforce cost reduction and other factors will contributions to CalPERS for state and CSU result in over $300 million of the projected budget pensions are forecasted to be about $3.6 billion act savings not being realized. (all funds) in 2010‑11, growing to $3.9 billion in 2015‑16. (This figure reflects estimated savings due No Net Savings in Out‑Years. In our forecast, to recent collective bargaining agreements that we estimate state costs to pay (1) salary increases increase some employees’ pension contributions.) beginning 2012 or 2013 for employees at their top The General Fund pays just under 60 percent step (pursuant to memoranda of understanding 38 www.lao.ca.gov Legislative Analyst’s Office California’s Fiscal Outlook of these costs. The state’s required payments dollars higher than indicated in our forecast by to CalSTRS—paid entirely from the General 2015‑16. Fund—are estimated to be $1.3 billion in 2010‑11 and grow to over $1.5 billion in 2015‑16. The state’s Additional Contributions to CalSTRS “pay‑as‑you‑go” retiree health benefit contributions Assumed. Typically, the state pays about 4.5 percent to CalPERS are forecast to grow from $1.4 billion of prior‑year teacher payroll to CalSTRS. The in 2010‑11 to over $2 billion in 2015‑16. CalSTRS also receives payments from school districts and teachers to cover its pension program State Payroll, Investment Return Assumptions, costs. Under state law, the General Fund must and Stock Values Drive CalPERS Costs. Our contribute additional funds each year when certain forecast includes fairly modest growth projections unfunded liabilities emerge. Our forecast assumes for the state’s CalPERS contributions. This is in that the system’s 2010 actuarial valuation—to be contrast to consistent warnings from the system completed in 2011—will show that such unfunded in recent years that state contribution rates are on liabilities emerge as the system recognizes more of track to increase significantly over time—due to the its investment losses from 2008‑09. In our forecast, need to cover added liabilities resulting from the these added contributions total $106 million in system’s 2008‑09 investment declines and recent 2011‑12 and grow to $392 million by 2012‑13. (These demographic experience of the system. There are added contributions are very small compared to several reasons for our projections: the amount of funding the system would require to eliminate its unfunded liabilities over the next • Our assumption that state employees three decades.) In addition, our forecast assumes receive no salary increases except for the that in 2012‑13 the state will finish paying off its one step increase included in many of court‑ordered payments to compensate CalSTRS the labor agreements recently passed by for the state’s decision to withhold a $500 million the Legislature. (The CalPERS actuarial required contribution in 2003‑04. Currently, the assumptions, by contrast, assume state pays $57 million per year related to the court steady, regular, annual pay growth.) order. • Our assumption that investment Unfunded Liabilities Will Persist. The state’s returns will hit CalPERS’ current retirement programs are projected to have actuarial investment rate target— significant—and growing—unfunded liabilities 7.75 percent per year—each and every through the forecast period. Because our forecast year and that other current actuarial includes only current‑law pension contribution assumptions will be met. requirements, it does not include funding sufficient to begin to reduce CalSTRS’ unfunded liabilities, • Our assumption that the current and it includes no resources to assist UC in actuarial investment rate target will restoring its pension program to a sound funding not change, despite indications from position. It also includes no funding to begin to system officials that it might as soon pay down large unfunded liabilities for state, UC, as next year. and CSU retiree health costs. If the state does not initiate benefit decreases and/or contribution Each of these key assumptions serves to contain increases very soon, the extra costs needed to retire growth of the state’s CalPERS contributions. If these huge unfunded liabilities over the next few one or more of them were changed, the state’s decades will spiral upward. contributions could be hundreds of millions of 39 Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook State-Mandated Local Programs 8.4 percent annually between 2010‑11 and 2015‑16. (Non-Education) Annual General Fund costs are about $1 billion Over the last several years, the Legislature higher each year due to the recent passage of has taken various actions to reduce or defer costs Proposition 22 and 26 which restricted the use for state mandates on local governments (cities, of transportation funds to pay bond costs. The counties, and special districts). These actions include relatively high pace of debt‑service growth is due permanently repealing mandates, suspending in part to the increase in bond sales from the large statutory requirements to implement mandates, general obligation bond authorizations in 2006 and and deferring payments towards retiring the 2008, as well as the growing issuance of AB 900 state’s backlog of mandate claims (over $1 billion). lease‑revenue bonds for the prison system. Our In signing the 2010‑11 budget, the Governor forecast is based on the planned sale of bonds that eliminated funding for two mandates (AB 3632 already have been authorized, but does not include and Background Checks) and asserted that local any proposed bonds—such as the water bonds government responsibility for implementing these now scheduled for the 2012 ballot. Our forecast mandates was suspended for 2010‑11. also assumes a minor reduction in debt‑service costs—approximately 1 percent of total General Mandate Costs Escalate Sharply. Our forecast Fund debt‑service costs over the forecast period— assumes that the Legislature continues to suspend due to the planned sale‑leaseback of 11 state office all mandates that it suspended in 2011‑12. properties. Because the sale proceeds will be used to Because state law does not appear to authorize retire the outstanding debt on those buildings, the the Governor to suspend mandates, we assume scheduled debt‑service payments are eliminated. that local governments continue to implement the (This reduction in General Fund debt‑service costs, AB 3632 and Background Checks mandates during however, is more than offset by the cost of leasing 2010‑11 (and throughout the forecast period) and those facilities back from the new owners.) that the state reimburses local governments for these mandated costs. Our forecast also assumes Debt‑Service Ratio (DSR) Expected to Rise. that the state makes annual payments to retire The DSR for general obligation and lease‑revenue the backlog of mandate claims, as specified in bonds—that is, the ratio of annual General Fund current law. Under these assumptions, state costs debt‑service costs to annual General Fund revenues for mandates would increase from $80 million in and transfers—is often used as one indicator of the 2010‑11 to over $500 million annually throughout state’s debt burden. There is no one “right” level for the forecast period. the DSR. The higher it is and more rapidly it rises, however, the more closely bond raters, financial Debt Service on Infrastructure Bonds analysts, and investors tend to look at the state’s The state uses General Fund revenues to debt practices, and the more debt‑service expenses pay debt‑service costs for principal and interest limit the use of revenues for other programs. payments on two types of bonds primarily used Figure 3 shows what California’s DSR has been in to fund infrastructure—voter‑approved general the recent past and our DSR projections for the obligation bonds and lease‑revenue bonds approved forecast period. by the Legislature. We estimate that General Fund costs for debt service on these bonds will be The DSR we are projecting—slightly above $6 billion in 2010‑11 and $7.2 billion in 2011‑12. 9 percent at its peak—is considerably higher than General Fund debt service is projected to grow at it has been in the past. This reflects the sharp, 40 www.lao.ca.gov Legislative Analyst’s Office California’s Fiscal Outlook recent fall‑off in General Figure 3 Fund revenues, the planned Projected Debt-Service Ratioa sale of the large bonds approved since 2006, and 10% the voters’ recent approval 9 of Propositions 22 and 26. Authorized, but Not Yet Sold To the extent additional 8 bonds are authorized and 7 sold in future years beyond those already approved, the 6 state’s debt‑service costs 5 and DSR would be higher 4 than projected in Figure 3. 3 2 Previously Sold 1 85-86 90-91 95-96 00-01 05-06 10-11 15-16 Forecast aRatio of annual debt-service payments to General Fund revenues and transfers. 41 Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook Legislative Analyst’s Office Legislative Analyst Mac Taylor ......................................................................................................................445–4656 Deputy Legislative Analysts Daniel C. Carson ............................................................................................................319–8303 Michael Cohen................................................................................................................319–8301 State Finance Director: Jason Sisney ..................................................................................................319–8361 General Government Director: Marianne O’Malley ......................................................................................319–8315 Education, K–12 Director: Jennifer Kuhn ...............................................................................................319–8332 Education, Higher Director: Steve Boilard .................................................................................................319–8331 Health Director: Shawn Martin ...............................................................................................319–8362 Social Services Director: Todd R. Bland ...............................................................................................319–8353 Criminal Justice Director: Anthony Simbol ...........................................................................................319–8350 Transportation, Business, and Housing Director: Farra Bracht ..................................................................................................319–8355 Resources and Environmental Protection Director: Mark Newton................................................................................................319–8323 www.lao.ca.gov Legislative Analyst’s Office