The 2011-12 Budget: Overview of the May Revision

The 2011-12 Budget: Overview of the Mac Taylor Legislative Analyst May Revision May 19, 2011 2011-12 BudgeT 2 Legislative Analyst’s Office www.lao.ca.gov 2011-12 BudgeT ExEcutivE Summary administration identifies remaining Budget Problem of $9.6 Billion Prior Legislative Actions and Improved Tax Collections Reduce Budget Shortfall. In its May Revision estimates, the administration projects that the state’s sizable budget gap for 2010-11 and 2011-12—estimated to be over $25 billion in January—has been shrunk to $9.6 billion. The main reasons for the decline of the projected budget shortfall are (1) over $13 billion of expenditure actions, fund shifts, and other measures already approved by the Legislature earlier this year, and (2) an estimated $6.6 billion improvement in state tax collections, mainly due to higher than expected personal income tax (PIT) collections. These improvements are offset by some higher spending estimates. New Proposal Includes Less Taxes Than in January and Some Additional Spending. The Governor proposes that the state plan for a $1.2 billion General Fund reserve at the end of 2011-12. Accordingly, the administration’s plan includes a net amount of $10.8 billion of budget-balancing actions. The centerpiece of the Governor’s proposal continues to be his proposal for taxes enacted in February 2009 to be adopted for several more years and for part of those taxes to fund a realignment of certain state services to local governments. The May Revision tax proposal, however, is about $3 billion less than the January tax proposal by the Governor, as it omits the proposed 2011 PIT surcharge, drops the proposed elimination of enterprise zones, and includes some new and expanded business tax expenditures (credits and exemptions). The May Revision also reflects a $3 billion increase in the 2011-12 Proposition 98 minimum funding guarantee for schools and community colleges due to (1) estimated improvement in tax collections, (2) an expansion of the administration’s new revenue accrual policy, and (3) two “rebenchings” of Proposition 98. Governor Focuses on Reducing Budgetary Debt Obligations. The May Revision includes a new focus of the Governor on reducing the state’s budgetary debt obligations, beginning with reduc- tions in previously planned borrowing from state special funds and eliminating previously adopted deferrals in scheduled payments to school districts. The Governor proposes further reductions in budgetary debt over the next few years. LaO comments Positive Aspects of the Governor’s Proposal. Our revenue estimates in 2010-11 and 2011-12 are very similar to the administration’s, and generally speaking, we find its budget estimates to be based on reasonable assumptions. (We expect to release a more thorough multiyear budget forecast in the coming days.) While the temporary nature of the Governor’s major tax proposals raises longer-term issues, his plan would achieve the important goal of bringing annual spending and resources much closer in line over the next five years. His focus on reducing budgetary debt obligations would help the state’s bottom line in future years as well. Governor’s Plan Involves Much Uncertainty. School districts, counties, and the state each would face various uncertainties if the Legislature were to opt for the Governor’s apparent plan to www.lao.ca.gov Legislative Analyst’s Office 3 2011-12 BudgeT seek approval for his major tax proposals and realignment plan earlier, rather than later, in 2011-12. At this point, the outcome providing the most certainty would be the Legislature and Governor reaching a budget agreement without going to the voters. If, however, the tax measures are to go before voters, it might be preferable to have the election at the end of the fiscal year so that parties affected by the budget would at least have certainty as to funding levels for the entire fiscal year. Legislature Has More Options Now. The May Revision document states that, “Absent the balanced approach proposed by the Governor, the options are either an ‘all cuts’ budget or a combi- nation of gimmicks and cuts.” Clearly, this is not the case. The Legislature has many options to address the now-reduced budget shortfall, such as adoption of some, but not all, of the Governor’s tax proposals, consideration of other revenue proposals, additional program reductions, and selected fund transfers and internal borrowing. As we did last November, we suggest the Legislature focus on maximizing the amount of ongoing solutions it passes to address the remaining budget problem. Incorporating the Governor’s emphasis on reducing budgetary obligations into a final budget agreement would be very helpful in continuing the process of returning the state to a prudent fiscal position. LaO Bottom Line In past budgets, the state has not been able to make significant inroads into its underlying operating shortfall. The reliance on one-time and short-term solutions has meant that the Legislature and Governor have had to address each year a large budget problem. This year is different. An improved economic and revenue situation, along with significant budgetary solutions already adopted, mean that the state is in a position to dramatically shrink its budget problem. The Governor has offered a serious proposal worthy of legislative consideration. The Legislature, however, has a variety of other tax and spending actions it could take to more closely align state revenues and expenditures now and in the future. 4 Legislative Analyst’s Office www.lao.ca.gov 2011-12 BudgeT thE GOvErnOr’S may rEviSiOn administration Estimates $9.6 Billion Legislature Has Passed $13.4 Billion in Budget Problem remains Budget Solutions. In March 2011, the Legislature passed and the Governor signed budget-related A $26.6 Billion Projected Deficit. In January legislation that enacted $11 billion in General Fund 2011, the administration estimated that the state solutions—cuts, fund shifts, and loans—over the would face a $25.4 billion deficit at the end of 2010-11 and 2011-12 period. The Legislature also 2011-12. This large deficit was due in large part to passed the 2011-12 Budget Bill that contained an the ending of many temporary budget solutions, additional $2.4 billion in expenditure reductions, including the expiration of temporary tax but this has not been sent to the Governor for measures adopted two years ago. In March 2011, signature. Figure 1 shows the expenditure-related the administration announced that it would not solutions that have been passed by the Legislature. pursue a planned sale of state buildings, resulting in additional lost revenue of $1.2 billion and the projected deficit increasing to $26.6 billion. Figure 1 General Fund Benefit of Budget Actions Already Adopted 2010-11 and 2011-12 (In Billions) Enacted Expenditure Reductions and Fund Shiftsa Reduced Medi-Cal spending $1.7 Reduced CalWORKs spending 1.0 Used Proposition 10 reserves to fund children’s programs 1.0 Reduced UC and CSU budgets 1.1 Funded transportation debt costs and loans primarily using weight fees 1.0 Shifted Proposition 63 funds to support community mental health services 0.9 Reduced spending on developmental centers 0.4 Reduced In-Home Supportive Services spending 0.4 Other expenditure reductions and fund shifts 0.6 Subtotal ($8.1) Enacted revenue increases $0.3 Enacted new loans, loan extensions and transfers from special funds, other solutions 2.6 Total, Enacted Budget Actions $11.0 Enrolled Expenditure Reductions and Fund Shiftsb Scored savings from efficiencies in state operations $0.3 Suspended, deferred, or repealed state mandates 0.2 Reduced Receiver’s inmate medical care budget 0.2 Reduced court budget 0.2 Reduced other expenditures 1.0 Subtotal ($2.0) Other Enrolled Budget Actions Borrowed from Disability Insurance Fund for Unemployment Insurance interest payments $0.3 Other actions 0.1 Subtotal ($0.4) Total, Enrolled Budget Solutions $2.4 Total, All Budget Actions $13.4 a Enacted solutions are those contained in the budget-related trailer bills passed by the Legislature and signed by the Governor. b Enrolled solutions are those contained in SB 69 (Leno), passed by the Legislature but not yet sent to the Governor for signature. www.lao.ca.gov Legislative Analyst’s Office 5 2011-12 BudgeT Administration Forecasts Additional Revenue end of 2011-12, resulting in the administration’s of $6.6 Billion. Since the administration produced call for $10.8 billion of additional actions. As its revenue estimates in January, its forecast of we will discuss later in this document, the size General Fund revenues in 2010-11 and 2011-12 of the required solutions is based, in part, on combined has increased by $6.6 billion. This largely the administration’s assumptions regarding the reflects the surprisingly strong PIT trends of recent funding of K-14 education under the Proposition 98 months and assumes these continue into next year. minimum guarantee. (We discuss the revenue forecast in detail later in major Proposals in the may revision this publication.) Additional Costs of $3 Billion Since Figure 3 lists the Governor’s May Revision March. The administration has identified an proposals addressing the remaining problem. In additional $3 billion in General Fund costs total, the Governor proposes $11.2 billion in new since the Legislature passed the budget actions revenues and $2.2 billion in additional expenditure in March 2011. These include additional costs reductions, both of which are partially offset by in the California Department of Corrections additional expenditures for Proposition 98 and and Rehabilitation ($0.4 billion), a net increase paying off special fund borrowing. The Governor in Proposition 98 costs over the 2009-10 continues with the plan to end redevelopment through 2011-12 period ($1.6 billion), and the agencies and use some portion of their funding administration’s decision not to include the General to support Medi-Cal programs and the courts. Fund savings from using Proposition 10 funds for Overall, the Governor uses the revenue growth children’s health programs. (The administration described above to (1) scale back some of the new has stated its intent to defend the use of these funds revenue proposals, (2) increase education funding, in the legal challenges brought against the state and (3) reduce some budgetary borrowing. but has decided not to score the savings due to Figure 2 its assessment of the legal Remaining Solutions Needed to Address the Deficit risks.) 2010-11 and 2011-12 Combined (In Billions) Estimate of Required Actions Includes a Estimated June 30, 2012 deficit—January 2011 $25.4 $1.2 Billion Reserve. Loss of sale-leaseback revenue 1.2 Figure 2 shows the Deficit—May 2011 $26.6 administration’s estimate Enacted solutions $11.0 of the actions still needed Enrolled solutions 2.4 Additional current-law revenues 6.6 to balance the 2011-12 Higher state costs (net) -1.4a General Fund budget. In Higher Proposition 98 workload costs -1.6 total, the Governor’s plan Solutions Already Achieved $17.0 projects the need for an Additional Solutions to Close the Deficit $9.6 Governor’s reserve 1.2 additional $9.6 billion Governor’s Estimate of Solutions Needed $10.8 of budget actions. The a Includes the estimated loss of Proposition 10 funds to replace General Fund support for health services Governor also proposes a for children, and estimated deficiencies in the California Department of Corrections and Rehabilitation and the Department of Mental Health. This also includes some baseline adjustments to other $1.2 billion reserve at the department’s costs. 6 Legislative Analyst’s Office www.lao.ca.gov 2011-12 BudgeT Same Basic Framework for Revenue enterprise zones and has replaced this proposal Proposals. The basic framework of the Governor’s with a more modest reform of the program. revenue proposals—the adoption for several more Overall, the total additional revenue in the May years of higher PIT, sales and use tax (SUT), and Revision is $11.2 billion, compared with $14 billion vehicle license fees (VLF) first passed in 2009—is in the January budget proposal. largely unchanged from January. These rates would Governor’s Realignment Proposal Also Largely remain in effect for five years (although the PIT Unchanged. In January, the Governor proposed rates would be in effect for only four years). The to shift responsibility for some program delivery Governor also maintains his proposal to require from the state to local entities (primarily in some multistate companies to apportion profits using criminal justice, mental health, and human services the “single sales factor” method. The Governor, programs). In the May Revision proposal, the however, has dropped his proposal to eliminate Governor makes some adjustments to the programs Figure 3 May Revision Proposals to Close Remaining Gap (In Billions) Impact on Reserve Revenue Solutions General Fund Revenue Solutions Adopt 0.25 percentage point personal income tax surcharge for four more years $1.3 Adopt reduction in dependent exemption credit for five more years 2.2 Adopt 0.1 percentage point vehicle license fee (VLF) increase for five more years 0.3 Make single sales factor mandatory for multistate firms 1.4 Adopt other revenue measures 0.4a Subtotal ($5.6) Local Realignment Revenue Solutions Adopt 0.5 percentage point VLF increase for five more years (0.4 percent goes to $1.1 realignment) Adopt 1 percentage point state sales tax increase for five more years 4.5 Subtotal ($5.6) Total ($11.2) Expenditure-Related Solutions End redevelopment and shift funds to Medi-Cal and trial courts $1.7 Achieve additional state savings from realignment 0.2 Achieve additional health spending reductions 0.2 Achieve additional employee compensation savings 0.1 Achieve other savings 0.1 Total ($2.2) Additional Expenditures Increase Proposition 98 guaranteeb -$1.9 Cancel new loans, loan extensions, and repay other special fund loans early -0.7 Total (-$2.6) Total, All Solutions $10.8 a Includes primarily special fund revenues that benefit the General Fund. b Includes the impact of the tax proposals and of the AB 3632 rebenching of the Proposition 98 minimum guarantee. www.lao.ca.gov Legislative Analyst’s Office 7 2011-12 BudgeT shifted to local entities. The Governor continues entities—be approved by voters. At this stage, the to propose that the programs shifted to local administration has not published a timetable for responsibility be funded through the temporary this election or how these two elements of his plan increases in sales taxes and VLF. However, as the would be implemented prior to the election. estimated cost of the realigned programs is now New Proposals to Restructure Elements of less than the projected revenues from these taxes, State Government. The May Revision includes new the Governor proposes that only a portion of the proposals to change, eliminate, or reorganize some VLF be used to fund programs at the local level, elements of state government (see Figure 4). The with the remainder being available for General administration also proposes to shift all children in Fund purposes. the Health Families Program into Medi-Cal health Governor Still Seeking Voter Approval for coverage. Elements of the Budget Plan. As in January, the Commitment to Pay Off Budgetary Debt. Governor is still proposing that two key elements As part of the May Revision, the administration of the budget proposal—his major tax proposals stated its intent to work towards the repayment of and the shift of some state programs to local “budgetary debt.” Over time, the administration Figure 4 Reorganizations and Eliminations of State Functions in the Governor’s May Revision Estimated Savings (In Millions) 2011-12 General Other Fund Funds Totals Changes Due to Realignmenta Eliminate the Department of Mental Health and the Department of Alcohol — — — and Drug Programs Create a Department of State Hospitals — — — Eliminations and Consolidations Eliminate the Early Learning Advisory Council — $3.6 $3.6 Eliminate the California Anti-Terrorism Information Center $3.2 — 3.2 Eliminate the California Postsecondary Education Commission 0.9 0.2 1.1 Eliminate the Colorado River Board — 0.8 0.8 Accelerate end of American Recovery and Reinvestment Act Task Force 0.4 0.4 0.8 Consolidate the State Personnel Board and the Department of Personnel — — — Administration Adopt other eliminations 1.9 1.1 3.0 Subtotals ($6.4) ($6.1) ($12.5) Program Efficiencies and Reductions Reduce workload in the Office of the Inspector General $6.4 — $6.4 Achieve Department of Parks and Recreation technology savings 4.5 — 4.5 Eliminate the Human Resources Modernization Project 2.3 $3.2 5.5 Adopt other efficiencies and reductions 5.5 1.7 7.2 Subtotals ($18.7) ($4.9) ($23.6) Totalsb $25.1 $11.0 $36.1 a The administration is still developing proposals for these changes, and as such there is no estimate of the estimated savings. b General Fund savings of $250 million in 2011-12 were scored in the January budget action to achieve additional efficiencies in state operations. The savings in this figure would count toward that total. 8 Legislative Analyst’s Office www.lao.ca.gov 2011-12 BudgeT estimates, the state has incurred around $34 billion Governor proposes to repay $744 million of special of debt associated with temporary fixes to General fund loans early (bringing forward repayment Fund deficits such as deferring a portion of annual from 2012-13) as well as reversing an earlier payments to schools or borrowing from special budget decision to defer additional payments to funds. Some of this debt, such as the economic schools. In future years, the Governor proposes to recovery bonds (voter-approved borrowing that further reduce budgetary debt beyond what would was used to fund the state deficit incurred early happen automatically or through existing statute— in the last decade), has a dedicated funding principally, it appears, by ending interyear deferrals source. Others, such as special fund loans, have a of scheduled payments to schools. repayment schedule set in statute. In 2011-12, the thE EcOnOmy and rEvEnuES E conomic o utlook progress but also that much slack remains in labor markets. Seasonally adjusted nonfarm employment, u.S. Economy which peaked at 138 million in January 2008 and Economy Has Been Picking Up Steam Lately. fell to 129 million through February 2010, has now The national recession that began in December risen to 131 million. By historical standards, this 2007—the longest since World War II and the most remains a tepid recovery, as the national economy severe since the Great Depression—ended in June continues to mend and readjust after the severe 2009. The subsequent modest recovery clearly has shocks resulting from the near-collapse of the picked up steam in recent months, aided substan- housing and credit markets. tially by continuing fiscal and monetary economic 2011 Economic Performance Affected by stimulus actions of the federal government. Federal Tax Measures. Figure 5 (see next page) Nonfarm payroll employment has increased by an compares several key national and California average of 233,000 per month over the last three economic variables for 2011 and 2012 in our office’s months compared with an average of 104,000 per February 2011 economic forecast, the administra- month over the entirety of the past year. While tion’s May Revision forecast, and our new May 2011 government payrolls have shrunk—the casualty forecast. Compared to our forecast in February, our of widespread state and local fiscal difficulties— updated forecast shows national economic perfor- gains in private payrolls have been broad-based. mance up by some measures and down by other Economic activity in the manufacturing sector, measures during that period. The projected rate of which has been battered in many recent years, has personal income growth appears to slow in 2012, expanded for 21 consecutive months through April. but this is because of the temporary one-time boost Core inflation—which excludes the sometimes in 2011 resulting from a one-year federal payroll tax volatile components of food and energy—has holiday. Were it not for this one-time effect, 2012 remained low. Business profits have grown, helping likely would show a slightly higher personal income to improve prospects for the labor market. growth rate than 2011. Our updated multiyear Job Market Is Better…But Still a Long Way to national economic forecast—shown in Figure 6 Go. The national unemployment rate has dropped (see page 11)—assumes steady, moderate growth from 9.8 percent in November 2010 to 9.0 percent through 2016. in April 2011—an indication of some economic www.lao.ca.gov Legislative Analyst’s Office 9 2011-12 BudgeT Uncertainties in the Forecast. Like all to approve increases in the federal “debt economic forecasts, ours is subject to uncertainty, limit,” which is key to allowing the both on the upside and the downside. There is United States to continue making its debt certainly a possibility that economic performance payments to investors around the world. could improve above expectations—more closely Should there be substantial disruptions in mirroring the more robust growth trends of past credit markets from the failure to resolve economic recoveries. On the other hand, there are the debt limit issue, severe economic conse- also a number of risks embedded in our forecast, quences may result. For California, such including the following: disruptions in credit markets could hamper the state’s ability to borrow this fall for cash • Oil Prices. Our office’s economic forecast flow purposes. reflects an expectation that recent spikes in fuel prices will be a temporary • Japan’s Recovery. Our forecast assumes phenomenon due to the recent upheaval little or no net economic effect resulting in the Middle East. If prices remain high, from Japan’s efforts to rebuild after its however, near-term economic performance recent earthquake, tsunami, and nuclear could be weakened. disaster. Japan is a leading trade partner, and adverse developments in its recovery • Federal Debt Limit Debate. Our forecast could affect both the United States and also assumes no economic disruption due California. to a failure of Congress and the President Figure 5 Forecasts for Some Economic Indicators Have Improved (Percent Change Unless Otherwise Indicated) 2011 2012 LAO Administration LAO Administration LAO Forecast Forecast LAO Forecast Forecast Forecast Forecast (Feb. 2011) (May 2011) (May 2011) (Feb. 2011) (May 2011) (May 2011) United States Real Gross Domestic 3.2% 2.8% 2.8% 2.9% 2.9% 3.1% Product Personal Income 4.9 5.2 5.3 3.2 3.7 3.6 Wage and Salary 1.4 1.2 1.2 2.1 1.8 1.9 Employment California Personal Incomea 5.0 4.4 5.4 3.3 4.5 3.8 Wage and Salary 1.1 1.3 1.6 1.9 1.9 2.0 Employment Housing Permits 53 55 54 79 87 81 (thousands) a The LAO and administration forecasts appear to differ in 2011 and 2012 based on our respective treatments of the 2011 federal payroll tax holiday. The LAO methodology for forecasting national and California personal income reflects a one-time boost in personal income in 2011 related to the holiday and a drag on personal income growth in 2012 based on the end of the holiday. The administration’s California personal income model appears to omit payroll tax-related changes. Adjusted for these differences, growth over the two-year period would be just slightly higher in the LAO forecast model. It is possible that this forecast difference affects our respective revenue and Proposition 98 forecasts. 10 Legislative Analyst’s Office www.lao.ca.gov 2011-12 BudgeT • Housing Prices. The housing market remains degree to which California suffered more severely fragile, with the most recent California than the nation as a whole during the recent recession. data from February suggesting that prices Like the nation, economic prospects are favorable in continued to fall slowly in San Diego, San much of California’s private-sector economy, except, Francisco, and Los Angeles. Further drops notably, for the construction industry. Nevertheless, in national and California housing prices are like the nation as a whole, California continues to expected to be small, but housing markets have substantial slack in its labor markets. We project are volatile and if the drop is bigger than that the state’s unemployment rate will remain expected, various elements of our economic above 10 percent until early 2013. The number of and revenue forecasts could be affected Californians unemployed for more than six months— adversely, including building permits, currently over 1 million—could remain very high for employment growth, and capital gains. some time. Housing and Construction Remain california Economy Substantial Economic Drags. Housing permits—a key indicator of construction activity—numbered Economic Outlook for State Has Improved about 45,000 in 2010 in California, nearly Somewhat in Recent Months. Figure 5 shows that 80 percent below their pre-recession peak level. our near-term economic outlook for California has While our forecast suggests the number of permits improved somewhat since February. As measured will grow at a fairly good pace (measured in by both personal income and employment growth, percentage growth terms) throughout the forecast California now appears poised to have a somewhat period, there are no prospects for housing permits faster pace of growth than the nation as a whole to return to their pre-recession level. Housing in 2011 and 2012. This is understandable given the Figure 6 The LAO’s Economic Forecast (May 2011) 2009 2010 2011 2012 2013 2014 2015 2016 United States Percent change in: Real Gross Domestic -2.6% 2.9% 2.8% 3.1% 2.9% 2.9% 2.9% 2.7% Product Personal Income -1.7 3.1 5.3 3.6 4.4 5.6 5.2 5.5 Wage and Salary -4.4 -0.7 1.2 1.9 2.0 1.8 1.6 1.3 Employment Consumer Price Index -0.3 1.6 2.6 1.5 2.0 2.3 2.2 2.1 Unemployment Rate (percent) 9.3 9.6 8.7 8.2 7.6 7.1 6.6 6.3 Housing Permits (thousands) 554 585 640 1,065 1,480 1,621 1,732 1,732 California Percent change in: Personal Income -2.3% 2.5% 5.4% 3.8% 5.1% 5.7% 5.6% 5.7% Wage and Salary -6.0 -1.4 1.6 2.0 2.5 2.3 2.1 1.7 Employment Unemployment Rate (percent) 11.4 12.4 12.0 11.1 9.6 8.4 7.5 6.8 Housing Permits (thousands) 36 45 54 81 101 117 127 133 www.lao.ca.gov Legislative Analyst’s Office 11 2011-12 BudgeT prices are poised to remain far below their prior Offsetting the strength in PIT collections peak levels for the foreseeable future. This drag has been weakness in corporation tax (CT) on the state’s economy is one reason why annual receipts compared to the administration’s January personal income growth and employment growth projections. Between January and April, CT should continue to lag those of some past economic collections sagged by $654 million below the recoveries. If there is one brighter spot in the administration’s estimates. Accordingly, the May housing market, it is the multi-unit sector, as Revision lowers the 2010-11 CT baseline forecast by apartment vacancy rates have dropped and permits $1 billion and the 2011-12 forecast by $701 million. have already picked up somewhat. In addition to the $6.3 billion increase in major revenues shown in the May Revision summary, the R EvEnuEs administration also notes that accruals and other administration Forecast revenue estimating adjustments add $300 million in revenue for the 2011-12 budget process. Over $6 Billion Higher Revenue Estimate Accordingly, the administration estimates that Driven by Strong Recent Collection Trends. The the total amount of increased baseline revenues is administration updates its revenue estimates when it $6.6 billion. prepares the May Revision. The revision shows that Budget Problem Definition Also Reflects revenues under the policies described in the 2011-12 Expansion of Administration’s Accrual Policy. As Governor’s Budget from January are estimated to be we described in our January 31, 2011 publication, $6.3 billion higher now—$2.8 billion in 2010-11 and The Administration’s Revenue Accrual Approach, $3.5 billion in 2011-12. the administration incorporated a new, complex The vast majority of this projected revenue approach for accruing (attributing) revenues to increase is in personal income taxes (PIT). Both fiscal years in its January budget package. With PIT withholding and estimated payments have the May Revision, the administration expands this been running very strong. Withholding—a key new approach to apply not just to the Governor’s indicator of current wage and payroll growth in the new tax proposals, but to total personal and economy—has been 5.4 percent above prior-year corporate income tax revenues. This expansion levels since January, despite lower withholding rates of the administration’s January accrual approach due to the expiration at the end of December of results in a $2.5 billion decrease in the state’s higher PIT rates adopted with the February 2009 2009-10 ending General Fund balance—in essence, budget package. Estimated payments in April—a removing revenues from prior years’ books key indicator of capital gains and certain business and moving them to either 2010-11 or 2011-12. activity in the economy—were up by 24 percent Correspondingly, the accrual change increases PIT over collections in the same month of the prior and CT revenues by $900 million in 2010-11 and year. Both the Department of Finance (DOF) and $1.4 billion in 2011-12. Incorporating both the fund our office have had difficulty reconciling these balance adjustment and these changes in 2010-11 robust revenue trends with official economic and 2011-12 revenues, the overall net effect of the data related to wages and other categories of accrual change is a reduction in resources available personal income. Nevertheless, consistent with the for the 2011-12 budget process of $170 million. collection trends, the May Revision increases the administration’s January PIT baseline forecast by $3.7 billion in 2010-11 and $4.4 billion in 2011-12. 12 Legislative Analyst’s Office www.lao.ca.gov 2011-12 BudgeT may revision Proposals modifications to the current program. Specifically, the Governor proposes to Same Basic Framework for Both January reduce the value to employers of the and May Revenue Proposals. The Governor’s May hiring credit portion of the enterprise Revision revenue proposals maintain the same zone program. Under his proposal, a basic framework as those in his January budget business would be eligible for a one-time proposal. Temporary increases in SUT, VLF, and $5,000 credit—claimed on an original PIT originally adopted in February 2009 generally return—for each new full-time equivalent would be adopted for five more years. In addition, employee they hire. This is far less than is the Governor proposes to require multistate generally available now. In addition, the companies to apportion profits to California using administration proposes that no new credit the single sales factor method. vouchers be granted for tax years prior to Governor Changes Some of His Tax Proposals. 2011 if an application was made more than In the May Revision, the Governor changes his 30 days after the hire’s start date. Finally, January revenue proposals—reducing the size enterprise zone hiring credits, including of some tax proposals and proposing new tax those issued in the past, would expire if not expenditures (credit and exemption programs). used within five years after being issued. Specifically, his May proposal reflects the following The new proposal is estimated to increase changes, compared to his January proposal: General Fund revenues by $23 million in • Eliminates PIT Surcharge for 2011. 2010-11, $70 million in 2011-12, and more The Governor has modified his January thereafter. proposal to apply the temporary 0.25 percentage point PIT surcharge to • Adopts Partial Manufacturing Investment tax years 2012 through 2015—therefore Sales Tax Exemption. The Governor omitting the 2011 surcharge included in proposes a four-year partial exemption his January proposal. In January, the 2011 from General Fund SUT for purchases of surcharge had been estimated to result tangible property used in manufacturing. in $725 million of accrued General Fund This exemption would begin in 2012-13. In revenues for 2010-11. general, manufacturers would be eligible for an exemption on paying 1 percentage • Modifies, Rather Than Eliminates, point of the SUT, but start-up firms would Enterprise Zones. The Governor’s January be eligible for a full exemption from the budget proposal included $924 million 5 percentage point General Fund SUT rate. of General Fund revenue over two years The Governor’s proposal would result in a ($343 million accrued to 2010-11 and General Fund revenue decrease estimated $581 million in 2011-12) based on the at $261 million in 2012-13, increasing elimination of the state’s enterprise zones. slightly thereafter through 2015-16. This program seeks to stimulate economic investment and hiring in economically • Changes Existing State New Jobs Credit. depressed areas. In the May Revision, the In 2009, the state adopted a new hiring Governor abandons his enterprise zone credit for certain small businesses. A total of elimination proposal, offering instead $400 million was allocated to the credit, but it www.lao.ca.gov Legislative Analyst’s Office 13 2011-12 BudgeT has not been claimed to the extent expected. $270 million of estimated revenue in 2011-12) to As a result, the administration estimates the General Fund—instead of local realignment that funds would be available for five more funds—for the next five fiscal years. All told, years. With the May Revision, the Governor including various estimating changes, the proposes to increase the hiring credit from administration projects the value of its tax proposals $3,000 to $4,000 per new employee, offer the to be $11.2 billion (of which $5.2 billion is proposed credit to employers with less than for the General Fund) versus about $14 billion 50 employees (as opposed to less than (about $8 billion General Fund) in January. 20 employees under current law), and sunset LaO Forecast the credit at the end of 2012. In addition, Based on our office’s updated national and the administration proposes funding a California economic estimates, we develop our own public awareness effort for the credit. The independent estimate of the near-term and out-year administration estimates these changes effects of both economic conditions and the would decrease General Fund revenues Governor’s proposed tax policies on General Fund by $29 million in 2010-11, $65 million in revenues. The results of our preliminary forecast of 2011-12, and $31 million in 2012-13 and then General Fund revenues under the Governor’s May increase revenues by a few million dollars Revision policies are summarized in Figure 7 and each year thereafter through 2016-17. described below. While the Governor’s VLF proposal is Overall Revenue Estimates Almost Identical unchanged, lower costs of realigned programs to Administration’s in 2010-11 and 2011-12. in his budget package allow him to dedicate Figure 7 shows that, under the Governor’s May 0.1 percentage points of his proposed 0.5 percentage Revision policies, we estimate that 2010-11 General point extension in VLF rates (generating about Fund revenues and transfers would be $95.7 billion Figure 7 LAO Preliminary Revenue Forecast—Reflecting Governor’s May 2011 Proposals General Fund (In Millions) 2009‑10 2010‑11 2011‑12 2012‑13 2013‑14 2014‑15 2015‑16 Actual Projected Projected Projected Projected Projected Projected Personal income tax $44,852 $51,869 $54,191 $56,643 $58,236 $63,051 $64,871 Sales and use tax 26,741 26,770 24,440 26,226 28,077 29,429 30,572 Corporation tax 9,115 9,422 9,944 10,240 10,870 11,673 12,265 Subtotals, “Big Three” ($80,708) ($88,061) ($88,575) ($93,109) ($97,183) ($104,153) ($107,708) General Fund taxes Insurance tax $2,002 $2,009 $1,818 $1,960 $2,189 $2,278 $2,369 Estate taxa — — — 830 1,750 1,850 1,940 Other revenuesb 3,860 3,735 2,936 2,880 2,570 2,697 2,820 Net transfers and loans 476 1,897 391 -292 -1,114 -962 -500 Totals, General Fund $87,046 $95,702 $93,720 $98,487 $102,578 $110,016 $114,337 Revenues and Transfers a Similar to administration’s multiyear forecast, reflects current federal law that restores the ability of states like California to “pick up” a share of federal estate taxes beginning in 2013. There is a substantial likelihood, however, that future federal actions will eliminate the state’s ability to collect any of this revenue. b Includes General Fund’s share of vehicle license fees under current law and Governor’s May Revision proposals. The administration’s forecasts for these revenues appear reasonable and are incorporated into these totals. 14 Legislative Analyst’s Office www.lao.ca.gov 2011-12 BudgeT Figure 8 LAO Forecast Same as Administration’s Now . . . Lower in the Future LAO Preliminary Forecast Minus Administration Forecast (In Millions) 2010‑11 2011‑12 2012‑13 2013‑14 2014‑15 Projected Projected Projected Projected Projected Personal income tax -$76 -$138 -$2,103 -$950 -$1,899 Sales and use tax 30 525 229 10 -286 Corporation tax 14 -216 -232 -1,086 -1,170 Other revenues and transfers -6 -74 -80 -18 10 Differencesa ‑$38 $97 ‑$2,186 ‑$2,044 ‑$3,345 a Negative number means lower LAO forecast. and 2011-12 revenues and transfers would be results this spring with the official economic $93.7 billion. These numbers are virtually identical data. In short, revenues are coming in much to the administration’s, as shown in Figure 8. Over higher than the official labor and other economic the two fiscal years combined, our forecast of data seem to suggest. Administration officials General Fund revenues is $59 million higher than the informed us that their working theory about administration’s. In the out-years, as described more the higher PIT totals centered on an assumption below, our forecasts are $2 billion or more lower than that wage and salary growth for high-income the administration’s estimates in each year. Californians grew substantially in 2010. As shown Some Significant Differences With in Figure 9, the administration assumed that tax Administration on Methodology. While our overall filers with over $200,000 of adjusted gross income General Fund revenue totals for 2010-11 and Figure 9 2011-12 are similar to the 2010 Wage and Salary Estimates Vary Widely administration’s, there Percent Growth Compared to 2009 Totals, California Resident Returns are some significant 20% differences underlying our respective forecasts 15 which are important to understand because they contribute to 10 significant differences in our respective out-year 5 revenue forecasts. Different 0 Assumptions About LAO Administration LAO 2010 Salaries and -5 Wages. Both our office Administration and the DOF have had For tax filers under $200,000 For tax filers over $200,000 difficulty reconciling -10 of adjusted gross income. of adjusted gross income. the very strong PIT www.lao.ca.gov Legislative Analyst’s Office 15 2011-12 BudgeT (AGI) collectively saw their wages and salaries Different Assumptions About 2010 Capital grow by 18.3 percent in 2010. By contrast, the Gains. Our working theory about the higher 2010 administration assumed that tax filers with under tax collections centers on capital gains—typically, $200,000 of AGI saw their wages and salaries a much more volatile revenue source than income decrease by 4.3 percent that year. taxes generated by salaries and wages. As shown While we agree that the data suggest that in Figure 10, we are assuming in our PIT forecast upper-income Californians experienced higher that net capital gains grew from about $29 billion wage growth in 2010, we see nothing in available in 2009 (a very low level due to the 2008 and 2009 economic and tax collection data to support the financial market turmoil) to $65 billion in 2010, a very large growth number the administration level that is equal to about 4 percent of California assumes for upper-income residents and the personal income. By contrast, the administration negative growth number assumed for lower-income assumes only $46 billion of net capital gains in residents. As shown in Figure 9, our forecast 2010. Similarly, we assume higher capital gains than assumes that tax filers with over $200,000 of AGI the administration in 2011 based on these trends saw their salaries and wages grow by 4.2 percent in and recently favorable stock market performance. 2010, versus 0.5 percent growth for tax filers with These higher capital gains assumptions are a key less AGI. reason why our forecast ends up being so similar Data to determine which estimate is more to the administration’s in 2010-11 and 2011-12— accurate will become available gradually over the offsetting our lower assumption for salary and next two years, and have major implications for wage growth in 2010 for higher-income residents. out-year PIT collections. Because the administration Nevertheless, in our forecast model, capital builds such strong 2010 growth for upper-income gains generally remain flat after 2011, with some Californians—those paying taxes at the highest Figure 10 marginal tax rates—into Moderate Forecast for Historically Volatile Capital Gains their wage forecasts and Net Capital Gains as Percent of California Personal Income then grows salaries and 12% wages for this group each year thereafter, its Historical Forecast LAO Forecast forecasts for PIT are 10 Administration Forecast systematically higher than ours for the rest of 8 the forecast period. This difference explains a 6 portion of the $1 billion to $2 billion difference 4 between our PIT forecast and the administration’s 2 beginning in 2012-13. 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 16 Legislative Analyst’s Office www.lao.ca.gov 2011-12 BudgeT variation based on the assumed acceleration of increases by domestic U.S. automakers. Federal capital gains to tax year 2012 due to the scheduled tax policy stimulus—lower payroll taxes in 2011, expiration of federal tax cuts in 2013. Accordingly, as well as two-year extensions of other federal while the higher capital gains help keep us even tax reductions—also are stimulating consumer with the DOF’s forecast in the near term, they do demand. While our forecast is higher than the not provide a similar boost in the out-years. administration’s in the near term, our forecast It should be noted that capital gains are models indicate a somewhat slower rate of taxable virtually impossible to forecast over a multiyear sales growth in the out-years. period. Data to determine which forecast is more Lower CT Forecast in the Out-Years. Our accurate in the out-years will not emerge until well February 2011 CT forecast was considerably lower after PIT collections pour in during April in each than the administration’s. In the May Revision, the year of the forecast. administration has lowered its forecast substantially. Lower Dependent Credit Revenue Our updated forecast is virtually identical to the Assumption. In addition to the differences administration’s new projections in 2010-11 and described above concerning salaries and wages about $200 million less in both 2011-12 and 2012-13. and capital gains, other differences with the In the out-years the administration assumes growth administration also are embedded in our PIT of California taxable business profits that resembles forecasting model. For example, our estimate of the the boom of the early 2000s (see Figure 11). In revenue gain from the proposed reduction of the contrast, we expect corporate profits to grow more dependent exemption credit is $145 million lower slowly beginning in about 2013. This difference in 2010-11 and 2011-12 combined and $100 million in corporate profits largely explains our lower CT to $200 million lower in each fiscal year thereafter. forecasts beginning in 2013-14. Higher SUT Forecast in 2011-12 and 2012-13. Figure 11 Our forecast assumes Future Business Profit Forecasts Vary Widely $525 million more of California Taxable Profits (Real 2011 Dollars in Billions) SUT collections for the General Fund in 2011-12 $250 and $229 million more Historical Forecast in 2012-13. Consumer Administration Forecast 200 (Fiscal Year Basis) confidence clearly is LAO Forecast returning, as retail (same-store) sales trends 150 have experienced months of increases, including 100 impressive increases in April. In recent months, the car sales market—an 50 important component of the SUT base in California—also has 1990 1995 2000 2005 2010 2015 improved, with notable www.lao.ca.gov Legislative Analyst’s Office 17 2011-12 BudgeT Reasonable Revenue Estimates for the we conclude that the overall revenue numbers in 2011-12 Budget Process. As described above, our the Governor’s revised budget plan are reasonable. revenue estimates end up virtually identical to the Revenue prospects clearly have improved administration’s for 2010-11 and 2011-12, despite substantially since January based on robust PIT some differences in methodology. Accordingly, collections trends. PrOPOSitiOn 98—K–14 EducatiOn Governor’s may revision Proposal tax revenues ($57 million). Despite the small increase in total Proposition 98 funding, General Figure 12 shows the Governor’s May Revision Fund costs are notably reduced ($517 million). Proposition 98 funding levels for K-12 education This is because higher-than-expected K-12 local and the California Community Colleges (CCC). property tax revenues ($646 million) reduce the Relative to the budget approved by the Legislature General Fund share of revenue limit costs. (For in March, the May Revision contains only minor CCC, higher-than-expected local property taxes funding increases in the current year but a do not result in an automatic reduction in state $3 billion increase in the budget year. General Fund spending. The additional revenues 2010-11 Funding Up Slightly. For 2010-11, the instead provide an increase to community college Governor’s May Revision continues to assume the apportionments.) Proposition 98 minimum guarantee is suspended. 2011-12 Funding Up $3 Billion. The Governor The May Revision, however, includes an increase of continues to fund at the Proposition 98 minimum $129 million in Proposition 98 funding to recognize guarantee in 2011-12. Due to a number of factors, higher-than-expected K-12 costs ($72 million) and however, the minimum guarantee is $3 billion higher-than-expected community college property Figure 12 Governor’s Proposition 98 Funding Proposal (In Millions) 2010‑11 2011‑12 May May Conference Revision Change Conference Revision Change K‑12 Education General Fund $32,239 $31,722 -$517 $32,494 $34,430 $1,936 Local property tax revenue 11,557 12,147 589 11,406 12,123 717 Subtotals ($43,796) ($43,868) ($72) ($43,900) ($46,553) ($2,653) California Community Colleges General Fund $3,885 $3,885 — $3,542 $3,807 $265 Local property tax revenue 1,892 1,949 $57 1,873 1,949 75 Subtotals ($5,777) ($5,834) ($57) ($5,415) ($5,756) ($340) Other Agencies $85 $85 — $87 $85 -$2 Totals, Proposition 98 $49,658 $49,787 $129 $49,402 $52,394 $2,992 General Fund $36,209 $35,691 -$517 $36,123 $38,322 $2,199 Local property tax revenue 13,449 14,096 646 13,279 14,072 793 18 Legislative Analyst’s Office www.lao.ca.gov 2011-12 BudgeT above the March level. Figure 13 shows the reduce the state’s outstanding Proposition 98 changes from the March to the May estimates of deferrals to $7.6 billion. the minimum guarantee. As the figure shows, the Other Notable Proposals. The May Revision minimum guarantee increases by $2 billion due also contains three major policy proposals: to improvements in the state’s baseline General • Shifts Student Mental Health Services to Fund revenues and changes in the way the state School Districts. In contrast to his January accrues certain General Fund revenues. These proposal, the Governor’s May Revision increases are offset slightly by the Governor’s proposes to make school districts (rather than revised tax proposals, which reduce the minimum counties) responsible for providing students guarantee by $375 million. The guarantee also with educationally necessary mental health increases by $793 million due to higher estimates and residential support services. The May of local property tax revenues in the budget year. Revision contains a total of $389 million to Finally, the Governor makes various adjustments support these services in 2011-12. so that the minimum guarantee is “held harmless” for specific changes in tax policy and shifts in • Undertakes Education Mandate Reform. programmatic responsibilities. These adjust- The May Revision contains an education ments—commonly called rebenching—increase mandate reform package that would the minimum guarantee by a net of $656 million. eliminate 27 K-14 mandates and reduce (Rebenching is discussed in more detail in the box the costs of 13 K-14 mandates—achieving on page 20.) $41 million in associated savings. Additional Funding Designated for Paying Down Deferrals. Figure 13 Whereas the March Summary of Changes in 2011-12 package contained a Proposition 98 Minimum Guarantee new $2.2 billion deferral (In Millions) of K-14 payments in 2011-12 (bringing total K-14 deferrals up General Fund Adjustments: Baseline General Fund increase $1,451 to $10.4 billion), the Accrual/policy changes 573 May Revision provides Tax proposal changes -375 $2.8 billion to eliminate Other minor revenue changes -106 Subtotal—Revenues ($1,543) the new 2011-12 deferrals Property Tax Increase $793a and begin paying down Rebenching: prior-year deferrals. Gas tax shift $630 Specifically, the May AB 3632 mental health shift 222 Change in value of existing LPT shifts/other -196 Revision provides Subtotal—Rebenching ($656) $2.5 billion to reduce K-12 Total Changes $2,992 deferrals and $350 million a In 2011-12, the Proposition 98 minimum guarantee is determined by Test 1, in which a fixed percentage (roughly 41 percent) of state General Fund revenues must be provided to K-14 education. When Test 1 is to reduce CCC deferrals. applicable, any increases in local property tax revenues do not offset state General Fund spending and instead result in additional funding for school districts and community colleges. These payments would LPT = local property tax. www.lao.ca.gov Legislative Analyst’s Office 19 2011-12 BudgeT • Proposes Task Force to Reform State’s longitudinal student and teacher data Testing and Data Systems. In the May systems. Revision, the administration raises several concerns with the state’s existing account- Budget Outlook improved but districts ability system, including excessive testing Still Face uncertainty and timing issues requirements and cumbersome data Despite the proposed $3 billion increase in requirements. The administration proposes Proposition 98 funding, the May Revision does to address these issues by bringing together not reflect a major program expansion from the a group of teachers, scholars, adminis- budget plan adopted in March. This is because trators, and parents to identify ways to the bulk of the additional Proposition 98 funding reduce testing time and eliminate unnec- is associated with paying down deferrals (that essary data collections. The May Revision is, making existing school payments on time) also eliminates funding for the state’s rather than increasing the level of programmatic R R m D i EbEnching aisEs any icEy ssuEs The May Revision contains two rebenching proposals that result in increases in the Proposition 98 minimum guarantee. Specifically, the administration proposes to rebench for: (1) the recent policy change that eliminated the sales tax on gasoline and increased the excise tax and (2) the proposed shift of responsibility for student mental health services from county mental health departments to school districts. As discussed in more detail below, rebenching raises serious legal, policy, and implementation issues. Constitution Makes No Provision for Rebenching. The California Constitution is silent on whether the Proposition 98 minimum guarantee can be adjusted to account for policy changes. Over time, the state has adopted various statutory provisions relating to rebenching, but these provisions tend either to implement only one specific shift or are so general as to raise questions of legal inter- pretation. In the case of program shifts, statute also addresses only shifts to not away from schools. That is, if implemented, rebenching for programmatic shifts would result only in more, never less, funding for schools. Rebenching Can Make Policy Sense but Opens Up Pandora’s Box…To date, rebenching largely has been used to account for shifts in local property tax revenues to or away from schools. In these cases, rebenching can make policy sense because local property tax and General Fund revenues are considered fungible. For example, when the state has redirected local property tax revenues away from schools to other local governments, then General Fund support for schools has been increased to backfill for the loss of local revenue. Though these types of changes seem reasonable, the administration’s rebenching proposals open up a Pandora’s box of other rebenching possibilities. For example, if the state rebenches for the gas tax change (in an effort to hold schools harmless for the loss of sales tax revenue), should it also rebench for the administration’s realignment proposals (in a similar effort to hold schools harmless for the loss of sales tax and vehicle license fee revenue)? Moreover, if the state rebenches for policy decisions that result in the loss of certain General Fund 20 Legislative Analyst’s Office www.lao.ca.gov 2011-12 BudgeT spending. Under the May Revision, per-pupil Increase in Baseline Revenues Significantly programmatic spending goes up only $40—from Improves Districts’ Budget Outlook. School $7,693 to $7,733—with virtually all of the increase districts must have their 2011-12 budgets finalized attributable to including mental health funding by July 1. As a result, without a complete, adopted within Proposition 98. Because of the improvement state budget, school districts often build their in the state’s fiscal condition and the propect of budgets and make their related staffing decisions reduced deferrals, school districts face less budget assuming a “worst-case” scenario. Under these uncertainty today than in March. While uncer- scenarios, school districts prior to the May tainty has been reduced, it has not been eliminated Revision were planning for potential Proposition 98 entirely. As a result, school districts continue to reductions of up to $4.5 billion. School districts face timing issues that likely will result in some of now face an improved budget outlook. As noted them planning for programmatic cuts. above, improvement in state General Fund and rebenching raises many dicey issues (Continued) revenues, then should it also rebench for policy decisions that result in increases in General Fund revenues (such as personal income tax rate increases)? …The Swarm of Questions Continues. Rebenching due to shifts of program responsibility can be almost as problematic as revenue-related rebenchings. For example, given school districts have responsibility for all other special education services, does assuming responsibility for student mental health services reflect a shift of program responsibility? Moreover, should the state rebench only when program responsibilities are shifted between schools and other agencies or should rebenching apply more generally when schools are required to perform any new service? Conversely, should rebenching occur when schools are no longer required to perform existing services (for example, if home-to-school services or after-school programs were eliminated)? Along these lines of thinking, should the state rebench every time a major categorical program is created or eliminated, as most categorical programs are linked to the provision of specific services? Rebenching Fraught With Implementation Issues. Even if one were to set aside these funda- mental legal and policy issues, other implementation issues would remain. One major implemen- tation issue is how exactly to adjust the minimum guarantee. For example, the administration’s May Revision plan uses a different rebenching method than the rebenching method used for previous local property tax shifts. Had the administration used the traditional rebenching method, the effect on the Proposition 98 minimum guarantee would have been significantly smaller. Moreover, for the mental health shift, the administration is rebenching based upon an extremely high estimate of existing program costs. If one of the major reasons these services are being shifted to school districts is because the existing program structure lacks incentives to contain costs, then the Legislature likely would want to reevaluate the amount that should be used for rebenching purposes. Furthermore, depending on the overall state budget situation, the Legislature might want to revisit more generally whether it can afford either of the administration’s rebenching proposals. www.lao.ca.gov Legislative Analyst’s Office 21 2011-12 BudgeT local property tax revenues result in substantial administration’s Proposition 98 Priorities additional Proposition 98 funding. As a result of Generally reasonable and responsible this improvement, cuts as deep as $4.5 billion are We believe the administration’s May much less likely. Proposition 98 plan is generally reasonable and Risk of Tax Proposals Not Passing and Having responsible and recommend the Legislature a Deferral Means Some Districts Still Likely to adopt most of its major components. Specifically, Make Cuts. Unless the state adopts tax proposals if the final state budget package were to contain prior to July 1, many school districts likely will revenues able to support the May Revision level of feel compelled to continue making budget and spending, we recommend the Legislature adopt the staffing decisions assuming no such tax proposals. administration’s plan to rescind previously adopted Nonetheless, a lower level of Proposition 98 funding deferrals. In addition, regardless of the revenue likely would not result in major programmatic situation, we recommend the Legislature adopt the reductions, particularly if the state maintained the Governor’s proposal to shift mental health respon- already adopted payment deferrals. Though districts sibilities to school districts as well as his proposal likely will budget based on this same set of assump- to undertake mandate reform. (We recommend the tions, the effect will vary partly depending on a Legislature reject the administration’s proposal to district’s ability to borrow. If a district believes it defund the state’s student and teacher data systems. will be able to access short-term cash to cover a large Paying Down Deferrals Improves Fiscal deferral, then it will support a higher program- Health. By not creating new programs and instead matic level. In contrast, if a district believes it will paying down deferrals, the May Revision provides be unable to access short-term cash to cover such a benefits to both the state and school districts. From deferral, then it very likely will make corresponding the state’s perspective, outstanding state obliga- cuts rather than budget at the May Revision tions as well as out-year state budget shortfalls are programmatic level. In a survey we conducted reduced. From districts’ perspective, less borrowing earlier this year, approximately 40 percent of is needed, thereby reducing associated transaction districts reported that they would not access cash and interest costs and potentially allowing districts to cover an additional deferral. In short, though to build back some programmatic support and/ no longer planning for the worst-case scenario or replenish their reserves. From both perspec- considered in March, some districts will continue to tives, using additional funds for deferrals is fiscally consider some programmatic cuts due to remaining responsible. concerns over timing and borrowing capacity. OvEraLL aSSESSmEnt OF thE GOvErnOr’S PLan As described above, the Governor’s May Positive aspects of the Proposal Revision proposal generally maintains the same Uses Reasonable Estimates. In putting together framework as his January proposal. As such, it has its revised proposal, the administration had to many of the same positive features and concerns as make a variety of estimates: the problem definition, his original plan. caseload and other spending requirements, revenues, and the value of proposed solutions. 22 Legislative Analyst’s Office www.lao.ca.gov 2011-12 BudgeT Generally speaking, we find their 2010-11 and concerns With the may revision Proposal 2011-12 numbers to be reasonable. As noted earlier, Uncertainties Caused by the Election with regard to the most important variable— Contingency. The Governor continues to updated revenues—our near-term estimates are propose that his major tax proposals and linked very similar to those of the administration. We realignment plan be approved by the voters. While expect to complete a more thorough multiyear the May Revision document does not specify a date, budget forecast in the coming days. the Governor appears to prefer a time earlier in Achieves Operating Balance for Next Several the fiscal year rather than later. The problem with Years. As in January, the proposal not only this plan is that it creates enormous uncertainty for balances in the budget year, but, according to the both the state and local governments. For example, administration’s estimates, would tend to stay in the school districts, which need to make budget-year black over the forecast period. While the temporary staffing and other decisions in the near future, will nature of the major tax proposals raises longer-term not know whether to budget based on the higher issues, the plan would achieve the important goal of Proposition 98 funding level in the May Revision, bringing annual spending and resources much closer the minimum guarantee should no tax proposals in line over the forecast period. be adopted, or some level below that (should Recognizes the “Overhang” of Other rejection of the tax measures require even more Budgetary Obligations. In addressing past significant reductions). budgetary shortfalls, the state has taken actions Counties will face the same types of that have worsened its future fiscal situation. uncertainties. Since the administration’s These actions—primarily spending deferrals of realignment proposal is linked to the tax various types and borrowing—have resulted in an measures, they will be up in the air as to their overhang of debt and obligations that will weigh new responsibilities until the voters have decided. on the Legislature’s budget deliberations for years If the voters reject the measures, they could also to come. Under current law, billions of dollars of face additional state reductions in programs they these obligations are scheduled to be retired in the administer in order to bring the budget back into next few years. The administration, however, has balance. proposed using a portion of the growth in General Finally, the state also faces uncertainty in the case Fund revenues to retire more of these obligations, of a midyear election. As the Treasurer has already as well as committing to further “buy-downs” noted, the risk associated with such an election would in the future. While the exact nature of those make it difficult to obtain the external intrayear commitments—particularly with regard to school- borrowing that is needed to address the state’s cash related payments—is unclear, the administration’s needs. In addition, if the voters rejected the tax attention to these longer-term obligations is measures, the state would have to reconsider various commendable. reductions to state programs in order to bring the Offers Some State Operational Efficiencies. budget back into balance. Through various executive orders and decisions in Issues With the Governor’s Tax Proposals. recent months and numerous proposals in the May Despite the noted improvement in state revenues, Revision, the administration has provided means the Governor has chosen not to change his of achieving some savings and changes in state proposals to extend the higher tax rates on the governmental operations. state’s two major taxes (with the exception of a www.lao.ca.gov Legislative Analyst’s Office 23 2011-12 BudgeT one-year delay in the PIT surcharge). The state’s in our Fiscal Outlook that such a target would be a sales and PIT rates are currently among the productive first step in chipping away at the state’s highest in the country. Keeping these rates as persistent operating shortfall. The state, however, is competitive as possible can contribute to the state’s now in a position to make more significant inroads longer-run economic health. With regard to his into the problem. Whether through revenue other tax proposals, we would rather have seen the or expenditure solutions, we strongly urge the administration stick with its original proposal to Legislature to maximize the amount of ongoing eliminate enterprise zones, and we continue to have solutions in addressing the remaining problem. concerns about the cost-effectiveness and other Prioritize Revenue Increases. In considering features of the hiring credit. As to his proposal proposals that increase revenues, the Legislature to exempt some manufacturing equipment from must always struggle with the trade-off between sales taxes, we think the Governor has raised avoiding undesired program reductions and the legitimate concerns about the taxation of business impact of increased taxes on individuals and intermediate goods. His specific proposal to treat businesses. As such, we think the Legislature start-ups more generously than existing businesses, should carefully prioritize such tax proposals. however, creates unnecessary and distorting In our view, the Legislature should give highest distinctions among businesses. priority to tax provisions which eliminate distortions among taxpayers or for which the h s l ow houlDthE EgislatuRE evidence is not persuasive regarding their a R P ? DDREssthE Emaining RoblEm effectiveness. It is on these bases that we have After accounting for actions taken to date and recommended approval of the Governor’s proposals growth in baseline revenues, the Legislature still to eliminate enterprise zones and require single needs to address a remaining budget-year shortfall sales apportionment for corporations. We would of about $10 billion. Below, we offer our advice to give next priority to proposals which achieve a the Legislature on how to approach this problem. desired tax policy objective. For example, we think Evaluate the Spectrum of Options. The the administration’s VLF proposal accomplishes May Revision document states that, “Absent the the goal of the state taxing property at a similar balanced approach proposed by the Governor, rate. the options are either an ‘all cuts’ budget or a Provide as Much Certainty as Possible. As combination of gimmicks and cuts.” Clearly, this is discussed above, a budget that is based on the not the case. The Legislature has many options to approval of voters for key provisions can create address the remaining shortfall, including: huge uncertainty at the state and local government (1) adoption of some of the administration’s levels. At this point, the outcome providing the revenue proposals, (2) consideration of other most certainty would be the Legislature and revenue proposals, (3) additional program Governor reaching a budget agreement without reductions, and (4) selected fund transfers and going to the voters. If, however, the tax measures internal borrowing. are to go before the voters, it might be preferable to Maximize Ongoing Solutions. Through its have the election at the end of the fiscal year. In this actions and improved revenues, the Legislature case, parties affected by the budget would at least has already addressed about half of its ongoing have certainty as to funding levels for the entire structural shortfall. Last November, we suggested fiscal year. 24 Legislative Analyst’s Office www.lao.ca.gov 2011-12 BudgeT Incorporate the Governor’s Emphasis bond fund expenditures in order to minimize on Budgetary Obligations. Regardless of the the impact of growing debt-service payments. components of a final budget package, we think the Furthermore, as the economy and revenues Legislature should incorporate the Governor’s focus improve, it could specify its priorities for (1) paying on the state’s large fiscal obligations in its budgetary off other obligations (such as special fund loans), deliberations. This could be done in many ways. (2) improving funding of long-term commitments For example, the Legislature could adopt the (such as retiree health benefits), and (3) reversing Governor’s approach of scheduling the repayment the numerous revenue acceleration and accrual of various Proposition 98-related obligations. With policies adopted in recent years in order to enhance regard to infrastructure spending, the Legislature investor and public confidence in the state’s could improve its oversight and prioritization of accounting practices. cOncLuSiOn In recent budgets, the state has not been able adopted, mean that the state is in a position to to make significant inroads into its underlying dramatically shrink its budget problem. The operating shortfall. The reliance on one-time and Governor has offered a serious proposal worthy of short-term solutions has meant that the Legislature legislative consideration. The Legislature, however, and Governor have had to address each year a has a variety of other tax and spending actions it large budget problem. This year is different. An could take to more closely align state revenues and improved economic and revenue situation, along expenditures now and in the future. with significant budgetary solutions already www.lao.ca.gov Legislative Analyst’s Office 25 2011-12 BudgeT 26 Legislative Analyst’s Office www.lao.ca.gov 2011-12 BudgeT www.lao.ca.gov Legislative Analyst’s Office 27 2011-12 BudgeT 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 email 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. 28 Legislative Analyst’s Office www.lao.ca.gov