The 2012-13 Budget: California’s Fiscal Outlook

The 2012-13 Budget: California’s mac Taylor Legislative Analyst Fiscal Outlook November 2011 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 Executive Summary ...................................................1 Chapter 1 The Budget Outlook ...................................................3 Chapter 2 Economy, Revenues, and Demographics ............... 11 Chapter 3 Expenditure Projections ..........................................25 Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook www.lao.ca.gov Legislative Analyst’s Office Executive Summary This report provides our projections of current-law state General Fund revenues and expenditures for 2011-12 through 2016-17. Economic Recovery Even Slower Than Expected One year ago, we wrote that the U.S. economic recovery was progressing more slowly than previously expected. Once again, we have to make the same observation. While the economy has some bright spots, including export growth and strength in technology-related service sectors (which are important to California), weakness in the housing market continues to affect both the construction industry and the financial services sector. The end of the federal fiscal stimulus program and declining governmental employment also are limiting economic growth. In this forecast, we project continuation of this slow, arduous recovery, with California’s unemployment rate remaining above 10 percent through mid-2014 and above 8 percent through the end of 2017. LAO Revenue Forecast Would Translate Into $2 Billion of “Trigger Cuts” Our updated assessment of California’s economy and revenues indicate that General Fund revenues and transfers in 2011-12 will be $3.7 billion below the level assumed in the 2011-12 budget package passed in June. Under provisions of the 2011-12 budget package, this revenue shortfall would translate into $2 billion of trigger cuts to various state programs. (This includes all of the “Tier 1” trigger cuts and about three-fourths of the “Tier 2” trigger cuts.) The Director of Finance will determine the actual amount of trigger cuts to K-14 education and several other programs next month based on the higher of this 2011-12 revenue forecast and the forecast of the administration. Our expenditure forecast assumes that this amount of trigger cuts is implemented in 2011-12 and maintained throughout the forecast period. Estimated 2012-13 Budget Problem of $13 Billion $3 Billion Deficit at End of 2011-12. The net effect of (1) the lower projected revenues for 2011-12, (2) the trigger cuts, and (3) the expected inability of the state to achieve about $1.2 billion of other budget actions—as well as a few other minor changes—would leave the General Fund with a $3 billion deficit at the end of 2011-12. Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook $10 Billion Operating Shortfall for 2012-13. In 2012-13, the state will face increased costs due, in part, to the expiration of a number of temporary budget measures adopted in recent years. Most notably, under our forecast methodology (which does not incorporate any effects from a possible November 2012 ballot measure concerning taxes), General Fund Proposition 98 costs—as well as “settle-up” payments to schools—are projected to rise by $6 billion in 2012-13. Moreover, in 2012-13, the state must repay the $2 billion Proposition 1A property tax loan that was used to help balance the budget in 2009. We forecast that the General Fund’s 2012-13 operating shortfall (the difference between annual General Fund revenues and expenditures) will be $9.8 billion. $13 Billion Budget Problem to Solve in 2012. Accordingly, we project that the Legislature and the Governor will need to address a $12.8 billion budget problem between now and the time that the state adopts a 2012-13 budget plan. Projected Out-Year Imbalances Gradually Decline One year ago, the state faced ongoing budget imbalances of around $20 billion per year. Now, we forecast that the General Fund’s operating shortfalls will be between $8 billion and $9 billion per year in 2013-14 and 2014-15 and then decline gradually to about $5 billion in 2016-17. By making very difficult budgetary decisions—including the trigger cuts—the Legislature and the Governor have strengthened the state’s fiscal condition considerably. Big Challenges to Face…Even With a Lower Deficit Forecast Our forecast assumes no inflation increases for many state programs and assumes that the trigger cuts and most other recent program reductions remain in place in future years. Even under this modest budget scenario, the state faces an ongoing, multibillion dollar annual deficit, even as state revenues expand. Our forecast assumes that many billions of dollars of state budgetary and retirement obligations remain unpaid through at last 2017. Conclusion The Legislature now faces a much smaller budget problem than projected one year ago and the smallest projected out-year deficits since before the 2007-2009 recession. Unfortunately, there are few easy options left for balancing California’s budget. Difficult program reductions already have been passed, and significant one-time budget actions may be more elusive than in prior years. Accordingly, the remaining work of eliminating the state’s persistent, annual deficit will require more difficult cuts in expenditures and/or increases in revenues. If, however, the Legislature and the Governor were to eliminate the state’s ongoing annual budget deficit this year or over the course of the next few years, the focus of their efforts could finally shift away from short-term budget problems and turn to the serious long-term fiscal issues of the state’s accumulated budgetary obligations and unfunded retirement liabilities. 2 www.lao.ca.gov Legislative Analyst’s Office Chapter 1 The Budget Outlook This report provides our projections of the discuss in more detail below, our forecast assumes state’s General Fund revenues and expenditures that most of the trigger cuts are implemented in for 2011-12 through 2016-17. Our projections 2011-12 and remain in effect through the rest of primarily reflect current-law spending require- our forecast period. ments and state tax provisions, while relying on our independent assessment of the outlook for The 2011-12 budget package assumed a California’s economy, demographics, revenues, year-end reserve of about $500 million. We now and expenditures. This report aims to assist the estimate that the General Fund will close the fiscal Legislature with its fiscal planning as it begins year with a $3 billion deficit. (Contributing to this to consider the 2012-13 budget. The basis of our deficit is an estimated $500 million drop in 2010-11 estimates is described in the nearby box (see next revenues compared with the level assumed in the page). budget package.) In 2012-13, expenditures are projected to exceed revenues by $10 billion. This Chapter 41, Statutes of 2011 (AB 121, Committee would leave the state with a year-end deficit of on Budget), specifies that the Department about $13 billion, absent any additional budgetary of Finance (DOF) will compare the Legislative Analyst’s Office’s (LAO’s) Figure 1 November 2011 revenue LAO Projections of General Fund Condition forecast with its December If No Corrective Actions Are Taken 2011 revenue forecast to (In Millions) determine the extent to 2010-11 2011-12 2012-13 which midyear expen- diture reductions (referred Prior-year fund balances -$4,507 -$1,695 -$2,239 to as the “trigger cuts”) will Revenues and transfers 94,292 84,764 86,038 Expendituresa 91,480 85,308 95,787 be put in place. Figure 1 Ending fund balance -$1,695 -$2,239 -$11,988 shows our estimate of the Encumbrances 770 770 770 condition of the General Reserveb -$2,465 -$3,009 -$12,758 Fund through the end a Under the LAO November 2011 revenue forecast, a total of $2.04 billion of expenditure trigger reductions of 2012-13 assuming no would be implemented, as revenues are $3.7 billion below the amount assumed in the 2011-12 Budget Act. additional corrective This represents all of the first tier of trigger cuts and around three-quarters of the second-tier trigger cuts. b Special Fund for Economic Uncertainties. Assumes no transfer to the state’s Budget Stabilization budgetary actions. As we Account. Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook 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 current state tax policies. 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. Impact of Future Ballot Measures Not Considered. Because our forecast is based primarily on current law, our projections do not consider the future effects of ballot measures scheduled or proposed for future statewide elections. For example, we have not assumed passage of a November 2012 measure increasing General Fund revenues, as referenced in the budget package. As described in the “Proposition 98” section of Chapter 3, this results in the creation of additional Proposition 98 payment obligations during the forecast period. No COLAs or Inflation Adjustments Assumed. Consistent with the state’s policies in recent years, we generally have not assumed annual cost-of-living adjustments (COLAs) or price increases over the forecast period. There are, however some exceptions. For example, the state is required to maintain specific benefits in its health programs, which include inflationary increases. If, by contrast, our forecast included COLAs and price increases for all programs, General Fund costs would be higher by around $3 billion by 2016-17. Assumption That State Prevails in Court Cases. Any multiyear state budget forecast involves various legal uncertainties. Our forecast generally assumes that the state prevails in active, budget- related court cases. The state faces an array of active cases, including ones related to redevelopment agencies, health and social services reductions, and the exclusion of sales tax revenues from Proposition 98 calculations. Our projections, however, do not reflect a transfer of $1 billion from Proposition 10 early childhood education programs to reduce General Fund spending, to be consistent with the treatment of these funds in the 2011-12 budget package. Trigger Cuts Ongoing. Our projections include the impact of the trigger cuts beginning in 2011-12 and continuing through the forecast period. Federal Tax and Spending Policies Uncertain. The activities of the congressional “super committee” charged with developing a deficit reduction plan—as well as various soon-to-expire temporary federal tax policies—mean that there is an unusually large element of uncertainty about future federal policies. As described in “Chapter 2,” we therefore must make a number of assumptions about these matters. In general, our expenditure forecasts assume continuation of current federal policies. Future federal actions that are contrary to these assumptions could affect various elements of our forecast positively or negatively. 4 www.lao.ca.gov Legislative Analyst’s Office California’s Fiscal Outlook corrections. Accordingly, the Legislature and the forecast to be $2 billion or more below. The second Governor will have to address this magnitude of tier of cuts—all of which affect K-14 education—is problem between now and the time a 2012-13 state prorated depending upon how much revenues are budget plan is approved. below the budget level. All the trigger cuts may be put in place if revenues are $4 billion or more below the level assumed in the budget. ThE BuDGET FORECAST Under Our Forecast, Most Trigger Cuts Assumed to Be Put in Place. We forecast that Projected 2011-12 Year-End Deficit of revenues will be $3.7 billion below the budget act $3 Billion amount in 2011-12. As such, under our forecast, Provision for Midyear Expenditure Reductions a total of $2 billion of midyear expenditure in the Enacted Budget. The 2011-12 budget package reductions is assumed to be implemented by the assumed a total of $88.5 billion of General Fund Governor on January 1, 2012 (see Figure 2). This revenues and transfers. The budget also contained represents all of the “Tier 1” trigger cuts and three- trigger cuts that would take effect if revenues for fourths of the “Tier 2” trigger cuts. The assumed 2011-12 were forecast to be less than the amount future effects of the trigger cuts are also shown in assumed in the budget package by $1 billion or Figure 2. The ultimate magnitude of the trigger more. There are two tiers of potential trigger cuts: cuts will be determined by the administration first, if revenues are forecast to be $1 billion or more after it compares our revenue forecast with its below the budget level, and second, if revenues are December forecast. The higher of the two forecasts Figure 2 Trigger Reductions to General Fund Expenditures by Program Area (In Millions) 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 Tier 1 Trigger Cuts Reduce University of California budget $100 $100 $100 $100 $100 $100 Reduce California State University budget 100 100 100 100 100 100 Reduce funding developmental services 100 100 100 100 100 100 Reduce service hours in IHSS by 20 percent and anti- 110 210 210 210 210 210 fraud efforts Increase charges to counties for youthful offenders sent to 99 166 159 154 152 151 CDCR facilities and reduce CDCR budget Reduce community college apportionmentsa 30 — — — — — Reduce child care funding 17 17 17 17 18 19 Eliminate state grants for local libraries 16 16 16 16 16 16 Eliminate vertical prosecution grants 15 15 15 15 15 15 Extend Medi-Cal provider cuts and copayments to all 15 15 15 15 15 15 managed care plans Reduce preschool fundinga 6 — — — — — Total Tier 1 Trigger Cuts ($608) ($739) ($732) ($727) ($726) ($726) Tier 2 Trigger Cuts Proposition 98 reductionsa $1,436 — — — — — Total Trigger Reductions $2,044 $739 $732 $727 $726 $726 a Ongoing cuts to Proposition 98 funding are reflected in the lower base used to calculate the 2012-13 minimum guarantee. 5 Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook will be used to determine the level of reductions. Continuing Budget Problem in 2012-13 (The administration may implement less than the Proposition 98 and Other Costs Contribute to maximum amount of trigger cuts. Our forecast, Estimated $13 Billion Budget Problem. In 2012-13, however, assumes the maximum amount of trigger the state will face increased costs due, in part, to cuts based on our forecasted revenue levels.) the expiration of a number of temporary budget measures enacted in recent years. Most notably, As a result of our lower 2011-12 revenue forecast under our forecast methodology (which does not ($3.7 billon lower than the budget package) and incorporate any effects from a possible November the offsetting level of trigger cuts we assume 2012 ballot measure concerning taxes), General ($2 billion), the net deterioration in the General Fund Proposition 98 costs are projected to rise Fund condition in the current year due to our lower by $5.6 billion due to growth in the minimum revenue estimate is $1.7 billion. guarantee, very weak property tax growth, and the loss of one-time funding for schools from the 2011 Other Budget Actions at Risk. In our forecast, redevelopment legislation. In addition, the state we assume that the state will be unable to achieve will owe an additional $400 million in “settle-up” $1.2 billion in planned 2011-12 budget solutions. payments to schools. At the same time, in 2012-13 Some of the major issues are: the state must repay the $2 billion Proposition 1A loan (which was used to help balance the budget • Medi-Cal. Higher Medi-Cal costs of in 2009). We also assume that the state repays around $400 million seem likely due, in $1 billion of loans to special funds. With the large part, to delayed federal approval for General Fund pressured by all of these factors, cost-cutting measures. the state will be left with a 2012-13 operating shortfall (the difference between annual General • Redevelopment. Our forecast assumes that Fund revenues and expenditures) of $9.8 billion. the state will not be able to realize the full Accordingly—when combined with the projected amount of the budgeted savings from this “carry-in” deficit of $3 billion—the total budget year’s redevelopment agency legislation. We problem that the state will need to address between estimate that the state will only be able to now and the passage of the 2012-13 budget is achieve $1.4 billion in savings—$300 million estimated to be $12.8 billion, as shown Figure 1. less than was budgeted. Projected Out-Year Imbalances • Savings From State Operational Gradually Decline Efficiencies. The budget package assumed Structural Deficit Significantly Reduced. In that the administration would reduce our report last November, we were projecting General Fund departmental costs by a structural deficit of $20 billion that persisted $250 million through efficiencies in depart- over the forecast period. As a result of ongoing mental operations and other cost-reduction spending reductions adopted in the 2011-12 budget measures. Our forecast assumes that much package and improvement in the state’s revenue of this savings is unachievable. situation since last November, we are forecasting $3 Billion General Fund Deficit Forecast for significantly lower operating shortfalls. As shown 2011-12. As shown in Figure 1, given these various in Figure 3, our forecast shows an annual budget issues, we forecast that 2011-12 will end with a problem of over $8 billion in 2013-14 and 2014-15, General Fund deficit of $3 billion. declining gradually to about $5 billion in 2016-17. While these numbers are markedly improved from 6 www.lao.ca.gov Legislative Analyst’s Office California’s Fiscal Outlook recent years, the state still faces daunting fiscal the 2012-13 Proposition 98 minimum guarantee is challenges. $4 billion higher than the revised 2011-12 spending level. With the loss of one-time funds related to the 2011 redevelopment legislation, General Fund Proposition 98 costs are projected to rise by LAO COmmEnTS $5.6 billion in 2012-13 under our forecast. Given the size of this projected increase, together with Tough Decisions have Reduced the other budget pressures facing the state, the California’s Chronic Deficits Legislature will need to consider whether it can The reduction in the ongoing deficit required fund the minimum guarantee in 2012-13. If the difficult decisions by the Legislature and the Legislature determines it needs to suspend the Governor in developing the 2011-12 budget. Those guarantee, then it will need to decide how to reduce included ongoing provider rate and service reduc- Proposition 98 spending. Over the last several years, tions in Medi-Cal, substantial grant reductions in the state has relied heavily on deferring school income maintenance programs, a variety of cost- payments as a means of lowering Proposition 98 containment measures for community services Graphic Sign Off spending. Additional deferrals in 2012-13, however, for the developmentally disabled, and cuts to the could be unworkable for many districts giveSn ethcer etary budgets of the University of California (UC) and magnitude of the existing deferrals (with 20 percent California State University (CSU), in addition to Analyst of Proposition 98 payments already made late). the trigger cuts. Director State May Have to Reconsider RestoratiDone pofu ty In addition, the Legislature enacted two major Prior-Year Cuts. In recent years, the state put into pieces of legislation that changed the structure place a number of temporary reductions to health of California government: a measure related to redevel- opment agencies (described Figure 3 in “Chapter 3”) and measures Operating Shortfalls Decline Gradually that shifted various program Over the Forecast Period responsibilities from the state General Fund (In Billions) to local agencies (described in the nearby box, see next page). $0 Both of these measures had a significant positive impact -2 on the state’s General Fund -4 budget in 2011-12, but—as currently structured—offer -6 little direct state fiscal relief in future years. In addition, -8 both of these measures are the subject of court challenges. -10 Annual Operating Shortfall Carry-In Deficit From 2011-12 more Tough Decisions -12 Ahead -14 Funding the Proposition 98 2012-13 2013-14 2014-15 2015-16 2016-17 Minimum Guarantee Will Be Difficult. Under our forecast, 7 Legislative Analyst’s Office www.lao.ca.gov 110619\Chapter 1_Figure 3_Operating Shortfalls Decline Gradually.ai California’s Fiscal Outlook and social services spending that expire in the programs and reconsider various proposals from 2012-13 fiscal year. For example, in California Work last year, such as modifications to enterprise zone Opportunity and Responsibility to Kids, there is programs and passage of a mandatory (rather than over a $400 million restoration of prior-year cuts. the current optional) single sales factor of corporate Given the state’s ongoing fiscal situation, the state profit apportionment. may have to revisit these restorations in 2012-13. Big Challenges to Face… Revenue Increases Also an Option. Given the Even With This Lower Deficit Forecast potential consequences from the types of expen- As noted above, our budget assumes no cost-of- diture reductions discussed above, the Legislature living adjustments or price increases for many state will also want to consider revenue increases. For programs. The impact of not adjusting for inflation instance, the Governor has stated his desire to have means that the purchasing power of current state certain increases in as yet unspecified taxes on the expenditures will be eroded by inflation over the November 2012 ballot. We would recommend that forecast period, and the state will not be able to the Legislature continue to review tax expenditure maintain the current level of services for many Realignment Background. As part of the 2011-12 budget plan, the Legislature enacted a major shift—or “realignment”—of state program responsibilities and revenues to local governments. In total, the realignment plan was intended to provide $6.3 billion to local governments (primarily counties) to fund various criminal justice, mental health, and social services programs in 2011-12, and increasing funding for these programs thereafter. The budget provides ongoing funding from three sources: (1) an ongoing shift of 1.0625 cents of the state sales tax rate, (2) an ongoing shift of vehicle license fee revenues that previously were allocated to the Department of Motor Vehicles and to cities and Orange County, and (3) a one-time shift of funds from the Mental Health Services Fund (established by Proposition 63 in November 2004). Most of the state fiscal benefit from realignment in 2011-12 comes from Proposition 98 savings. Specifically, the budget assumes that, by depositing the sales tax revenue into a special fund for use by local governments for realignment, these funds are not available for the Legislature to spend for education purposes and thus are not counted as state revenue for purposes of calculating the Proposition 98 minimum funding guarantee. This action is estimated to reduce the Proposition 98 minimum funding guarantee by about $2 billion in 2011-12. Realignment Revenues Could Outpace Program Costs. We project that the revenues dedicated to realignment in 2011-12 will total $6.3 billion, roughly equal to the administration’s estimate of program costs for the realigned programs. Over the longer term, the relationship between realignment revenues and realigned program costs is not certain and will depend on many factors, including actual local costs to supervise the offenders transferred to their responsibility. Based on (1) the administration’s estimates of costs to implement the realigned programs and (2) our estimates of growth in program caseload and program costs, we project that the growth in revenues dedicated to realignment could exceed local costs—potentially by hundreds of millions of dollars annually. 8 www.lao.ca.gov Legislative Analyst’s Office California’s Fiscal Outlook programs. Under this scenario, by 2016-17 many We estimate that the state will have accrued major state employees will have received no net general budgetary obligations at the end of the forecast salary increase (considering the net effect of both period, including: (1) $10 billion in interyear scheduled pay increases and recent pension contri- deferrals of payments to schools, (2) $10 billion of bution increases) for about a decade. Our forecast maintenance factor in Proposition 98, and (3) over also assumes no restoration of recent budget reduc- $800 million in loans from special funds to the tions and trigger reductions. In other words, even General Fund. with these modest funding assumptions, the state faces ongoing, multibillion dollar annual deficits, Solving the Ongoing Budget Deficit Would Not even as state revenues expand. Address Massive Liabilities. Our forecast only includes current-law pension and retiree health Forecast Does Not Account for Repayment of payments by the state. It does not include added Most Budgetary Obligation. In recent years, the state payments to curb the massive (and growing) Legislature and Governor have used a number of liabilities for retiree health benefits for state and CSU different methods as part of balancing the budget. employees, teachers’ pensions, and UC retirement The extent to which realignment revenue growth outpaces program costs, however, is subject to significant uncertainty. Actual program caseloads and other costs could be higher than we estimate, depending in part on how local governments implement realigned programs and their success in containing costs. Also, the realignment legislation established allocation formulas to distribute the revenues among the affected programs and across counties. These formulas, however, were established only for 2011-12. Therefore, there is uncertainty as to whether the allocations provided to specific programs or individual counties will be sufficient to keep up with program costs in the future. Risks to Achieving State Savings Estimate. Budget trailer bill language adopted by the Legislature specifies that the exclusion of the sales tax revenues from the calculation of the Proposition 98 minimum guarantee is contingent upon voter approval of a ballot measure in November 2012 providing additional funding for school districts and community colleges. If no ballot measure is adopted satisfying these requirements, (1) the state must repay K-14 education for the loss of about $2 billion for the 2011-12 year over a five-year period, and (2) the sales tax revenues dedicated to 2011 realignment would be included in the Proposition 98 calculation in future years. In addition, the assumption that the realignment revenues are excluded from the minimum funding guarantee is subject to some dispute. We note, for example, that a lawsuit has been filed by some school districts and education associations challenging the legality of the exclusion. Legislative Implications. As we describe in our publication, 2011 Realignment: Addressing Issues to Promote Its Long-Term Success, there are several issues the Legislature should address before the end of the current fiscal year to increase the likelihood that realignment is implemented effectively and achieves the Legislature’s objectives over the longer term. These include: establishing ongoing funding allocation formulas that are responsive to changes in program caseloads and costs over time, providing local governments with appropriate programmatic and financial flexibility to manage these new resources, and creating the right fiscal incentives to promote good program outcomes. 9 Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook benefits. Addressing the unfunded liabilities of just state’s persistent, annual deficit will require more the teacher’s retirement fund probably will require difficult cuts in expenditures and/or increases in billions of dollars of additional payments annually revenues. over the coming decades. It is important to note that our forecast does not Conclusion include funding to address some of the state’s key The Legislature now faces a much smaller budget long-term fiscal and policy problems. If, however, problem than projected one year ago, as well as the the Legislature and the Governor were to eliminate smallest projected out-year deficits since before the structural deficit this year or over the course of the 2007-2009 recession. Unfortunately, there are the next few years, the focus of their efforts could few easy options left for balancing California’s finally shift away from short-term budget problems budget. Difficult program reductions already have and turn to the serious long-term fiscal issues of been passed, and significant one-time budget the state’s accumulated budgetary obligations and actions may be more elusive than in prior years. unfunded retirement liabilities. Accordingly, the remaining work of eliminating the 10 www.lao.ca.gov Legislative Analyst’s Office Chapter 2 Economy, Revenues, And Demographics ThE ECOnOmIC OuTLOOk for over two years now. Over one million jobs have disappeared from the state’s economy since early California and the nation are recovering from 2008. the longest and most severe economic downturn since the Great Depression. The 2007-2009 The latest evidence suggests that the state and recession was precipitated by the implosion of national economies continue a slow, arduous overheated housing and financial markets in recovery from this staggering economic drop-off. California and throughout the United States, the Our economic forecast is summarized in Figure 1 resulting balance sheet deterioration of financial and described in more detail below. Our forecast firms and households, and the near collapse of is that California’s unemployment rate will remain world credit markets. above 10 percent through mid-2014 and remain above 8 percent through at least the end of 2017. Unemployment in California—under 5 percent as recently as 2006—has remained above 11 percent Figure 1 The LAO’s Economic Forecast (November 2011) 2010 2011 2012 2013 2014 2015 2016 2017 United States Percent change in: Real Gross Domestic Product 3.0% 1.8% 2.1% 2.8% 3.6% 3.4% 2.9% 2.6% Personal Income 3.7 5.2 4.0 3.9 5.4 5.3 5.0 4.4 Wage and Salary Employment -0.7 0.9 1.0 1.7 2.1 2.0 1.7 1.1 Consumer Price Index 1.6 3.1 1.5 1.9 2.1 1.9 1.7 1.6 Unemployment Rate (percent) 9.6 9.1 9.0 8.5 7.8 7.0 6.5 6.3 Housing Permits (thousands) 585 596 758 1,085 1,417 1,687 1,811 1,841 California Percent change in: Personal Income 4.0% 6.0% 4.1% 4.5% 5.6% 5.5% 5.0% 4.7% Wage and Salary Employment -1.4 1.2 1.3 2.1 2.2 1.9 1.6 1.4 Unemployment Rate (percent) 12.4 12.0 11.8 11.2 10.3 9.6 9.0 8.5 Housing Permits (thousands) 45 46 61 77 91 104 114 124 Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook The united States Economy growth estimates included in our forecast are lower. Recovery Even Slower Than Previously There were some dismal job reports during the Expected. In November 2010, we wrote that the summer. The initial federal report of employment U.S. recovery was progressing more slowly than for August, for instance, said that there had been previously expected. Once again, we have to make no net job growth for the nation during that month. the same observation. Figure 2 compares several Subsequently, however, this figure has been revised key variables of the May 2011 economic forecasts of upward to 104,000. the administration and of our office to our updated November 2011 economic forecast. In 2011 and What Parts of the Economy Are Doing Well? 2012, we forecast that the U.S. economy will grow Over the last year, U.S. employment has grown most more slowly than previously expected. In 2011, the notably in the health services, leisure and hospi- lower-than-expected real gross domestic product tality, mining, trade, transportation/warehousing, (GDP) growth results largely from major downward and professional and technical services sectors. revisions in July in estimates of GDP growth for The latter sector (including technology and other the first quarter of the year. At the time of our services important to California’s economy) has May forecast, federal data estimated that real GDP been among the strongest job producers—up in that quarter had grown at a 1.8 percent annual 264,000 nationally over the past year. The manufac- rate. In July, this estimate was revised downward to turing sector has gained 220,000 jobs over the last 0.4 percent. Subsequent quarters have seen higher 12 months, buoyed, it appears, by healthy export reported GDP growth, but the effects of this first growth, strong levels of equipment investment, quarter weakness drag down our annual estimate. and a revived domestic automobile market. Similarly, consensus estimates for real GDP growth Temporary help jobs are up 169,000 over the past in 2012 are lower than they were earlier in the year. year, including the past three months of 15,000 or greater growth—potentially a very good sign for the The employment outlook is somewhat weaker economy, as employers frequently convert many of than we expected in May, and U.S. employment these to permanent jobs. Figure 2 Comparison of May and November Economic Forecasts (Percent Change From Previous Year Unless Otherwise Indicated) 2011 2012 Administration LAO LAO Administration LAO Forecast Forecast Forecast Forecast Forecast LAO Forecast (May 2011) (May 2011) (November 2011) (May 2011) (May 2011) (November 2011) United States Real gross domestic 2.8% 2.8% 1.8% 2.9% 3.1% 2.1% product Employment 1.2 1.2 0.9 1.8 1.9 1.0 California Personal incomea 4.4 5.4 6.0 4.5 3.8 4.1 Employment 1.3 1.6 1.2 1.9 2.0 1.3 Housing permits 55 54 46 87 81 61 (thousands) a The LAO and administration forecasts of California personal income differed at May Revision based on our respective treatments of the 2011 federal payroll tax holiday, as described in our report The 2011-12 Budget: Overview of the May Revision. Unlike the May 2011 LAO forecast, the November 2011 LAO forecast assumes the federal payroll tax holiday is extended into 2012. This results in personal income in 2012 being higher than it would be without such an assumption. 12 www.lao.ca.gov Legislative Analyst’s Office California’s Fiscal Outlook What Parts of the Economy Are Not Doing 2012—both down from prior forecasts. Housing Well? The U.S. and California economies continue permits—a key indicator for the state’s very weak to be dragged down by the construction sector. The construction sector—are now forecast to be even weakness in the housing market continues to affect lower than in our May forecast. State and local other sectors too, including the financial activities employment contraction also is expected to sector, which has seen weak job growth over the contribute to the weak labor market in the state. past year. Consumers are still showing signs of significant stress, with consumption pulled down Personal Income Surprisingly Strong Despite sharply by their need to reduce debt and their Weak Job Growth. Despite the state’s weak job difficulty in obtaining credit. Moreover, while the growth, personal income growth in California in Federal Reserve continues to rely on aggressive 2010 and 2011 has proven to be fairly strong. This monetary policy—with a multiyear commitment forecast incorporates somewhat stronger personal to near-zero interest rates—the effects of the 2009 income estimates for the state in 2010 and a higher federal fiscal stimulus now are wearing off, with forecast for 2011, as shown in Figure 2. For 2012, real federal government purchases of goods and this forecast for personal income growth in the services declining from 2010 levels. The end of the state is higher than it otherwise would be due to federal fiscal stimulus and budgetary woes also are our assumption that the federal employee payroll affecting the nation’s local and state governments, tax cut is extended to 2012. We made no such among which employment has declined recently. assumption in May. (Assumptions about federal Federal government employment also has been policy are discussed further below.) declining over the past year. Forecast Risks and uncertainties Slow Recovery Expected Throughout Our Federal Policy Is a Key Uncertainty in the Forecast Period. Following the deep 1981-82 Economic Forecast. Like other state revenue recession, the U.S. economy bounced back forecasters, we rely on national economic data quickly—with real GDP growth of 4.5 percent provided to us by a major economic forecasting in 1983 and 7.2 percent in 1984. As shown in company. The data incorporate numerous assump- Figure 1, however, no such bounce back appears tions about federal fiscal, monetary, regulatory, to be in store for the U.S. economy. We forecast a tax, and other policies. We use this information to slow, steady recovery through 2017 with annual inform many parts of our economic and revenue real GDP growth ranging between 2.1 percent and forecasts—utilizing our own judgment when 3.6 percent. Unemployment is expected to gradually appropriate. decline for the U.S., reaching about 6 percent by the end of 2017. Housing permit activity is expected For this forecast, however, there is considerable to grow—welcome news for the construction and uncertainty about short-term and medium-term other related sectors—even though the 1.8 million federal fiscal and tax policies. This uncertainty housing permits we forecast for the nation in 2017 arises due to the activities of the congressional remains 15 percent below the peak levels of 2005. “supercommittee” charged with recommending substantial deficit-reduction measures in the coming The California Economy weeks, the scheduled expiration of the 2011 employee Weaker Job Growth Than Previously Expected. payroll tax reduction and emergency unemployment As shown in Figure 2, we have downgraded our insurance benefits, and the scheduled expiration forecast for California employment growth since of various tax cuts enacted under the prior federal May. We now forecast 1.2 percent employment administration (and extended under the current growth in the state in 2011 and 1.3 percent in administration) at the end of 2012. Accordingly, 13 Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook current national economic forecasts must make federal domestic and defense spending take effect many assumptions about what federal policy will through the sequestration process). be a few months and a few years from now. Our economic and revenue forecasts generally incor- No Estate Tax Receipts Assumed for the State. porate the following assumptions: In 2001, as a part of the tax reductions enacted during the prior federal administration, the federal • The employee payroll tax cut and emergency government adopted reductions over several years unemployment insurance benefits will be to its estate tax and eliminated a tax code provision extended for 2012 and then phased out over known as the “credit for state death taxes.” The several years. state credit was eliminated entirely for estates of those dying after December 31, 2004. In 2010, • There will be no sequestration (automatic Congress and the President agreed to extend the federal spending cuts beginning in 2013) temporary 2001 estate tax legislation—including resulting from the failure of Congress to elimination of the state death tax credit—until the enact deficit-reduction measures now being end of 2012. Under current federal law, therefore, considered by the supercommittee. Instead, the pre-2001 estate tax regime will resume at the Congress and the President will enact a beginning of 2013, including the state death tax package of deficit-reduction measures to credit. Nevertheless, most observers believe that, no replace sequestration that will begin to take matter what Congress does to the estate tax in 2012, effect in 2014. These measures are assumed there will no longer be a credit for state-level estate to stabilize, but not reduce, the federal debt- taxes. Our forecast assumes that this consensus to-GDP ratio. is correct. Pursuant to Proposition 6 (1982), the state may only collect estate taxes equal to the state • The various federal tax cuts originally death tax credit in federal law. Accordingly, our enacted during the prior federal adminis- forecast assumes that the state receives no estate tration will be extended an additional year taxes during this forecast period. We advise the to 2013. (This produces changes in state Legislature to assume no such revenues during revenue estimates since, in prior forecasts, we its 2012-13 budget process unless there is a clear assumed these tax cuts’ expiration at the end indication from Congress that a state death tax of 2012 caused some taxpayers to accelerate credit will be adopted. recognition of capital gains from 2013 to 2012. Instead, in this forecast, we assume If our assumption proves to be incorrect and that acceleration occurs from 2014 to 2013.) Congress allows the state death tax credit to resume, the amount of revenues the state would Clearly, many of these assumptions may receive beginning in 2012-13 is highly uncertain. not come to pass, but they do seem to reflect The level of revenues in this scenario would depend, a consensus of economists about a reasonable for example, on how many and how large the approach for forecasting the U.S. economy in the estates are that are subject to taxation. This could coming years. Compared to these assumptions, total several hundred million additional dollars actual federal actions in the coming months could for the General Fund in 2012-13 and perhaps over either produce additional short-term benefit for $1 billion per year thereafter. (These additional the economy (for example, by extending payroll revenues, if they were to be received, also would tax reductions for the next few years to employers, increase the state’s Proposition 98 minimum as well as employees) or result in an additional guarantee by an amount equal to around one-half short-term drag (for example, if the payroll tax of the revenue increase.) reduction is not extended or sharp decreases in 14 www.lao.ca.gov Legislative Analyst’s Office California’s Fiscal Outlook Europe and the Financial Markets. Europe’s The next FTB exhibit package likely will include woes—principally the feared default of Greece, some of the first solid data on 2010 California Italy, Spain, and other nations on their national wages and salaries, capital gains, and other income debt—have rattled investors in recent months. tax information. By the time the administration Recently, European leaders have taken actions completes its December revenue forecast, it may intended to help stabilize the debt problems of have the benefit of reviewing this or other FTB heavily leveraged national governments there. data that were not available for use in this forecast. Should the efforts of European leaders fail, some fear Such FTB data could result in the administration’s that the negative effects of national bond defaults revenue forecasts being somewhat higher or lower could imperil European banks, thereby threatening than ours. credit markets and financial firms tied to those banks around the world. At the present time, we In addition, we note that since we prepared this doubt that these issues will have a substantial effect economic forecast, federal job growth data has been on the U.S. economy. In California, for instance, revised upward for both August and September— European trade is a relatively small part of the by a total of 102,000 jobs over the two months. state’s imports and exports. Moreover, banks and These upward adjustments (not reflected in our other firms around the world now have had months economic forecast) would have improved the 2011 to prepare themselves for European debt defaults. employment levels assumed in our forecast—as well as state revenues—slightly. A “Double-Dip” Recession? Probably Not. A double-dip recession in the U.S. now appears unlikely. Our forecast assumes that the economy ThE REvEnuE OuTLOOk grows slowly, but steadily, in the coming years. It is possible, however, that certain negative events in California’s General Fund is supported by the coming months could precipitate one or more revenues from a variety of taxes, fees, licenses, quarters of economic contraction not assumed in interest earnings, loans, and transfers from other this forecast. For example, additional turmoil in the state funds. Over 90 percent of the total, however, financial markets could cause such contraction. In currently is derived from the state’s “big three” addition, the effects of federal sequestration cuts taxes—the personal income tax (PIT), the sales or any major decline of consumer and business and use tax (SUT), and the corporate income and confidence due to failure of Congress and the franchise tax (CT). A summary of our revenue President to agree on deficit reduction goals could projections is shown in Figure 3 (see next page). affect the economy negatively. (Note that, beginning in 2011-12, this figure does not include SUT funds—estimated to total Data Limitations. It takes time for the state’s $5.1 billion in 2011-12—redirected from the tax agencies to compile data from tax returns that General Fund to the Local Revenue Fund 2011 to is used by revenue forecasters. For our personal pay for specified local programs.) and corporate income tax forecasts, for example, we rely significantly on data compiled by the Figure 4 (see page 17) shows the differences Franchise Tax Board (FTB) and presented on a between our forecasts of 2010-11 and 2011-12 routine biannual schedule to both our office and the revenues, as compared with those assumed in administration—with the first set of data generally the 2011-12 budget package. For 2010-11, after submitted each year in late April or May and the including the most recent information available second set in late November or December. (The FTB to us on accruals and other adjustments, General also posts these “exhibit packages” on its website.) Fund revenues were approximately $500 million 15 Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook below budget act expectations, spread across all PIT Holding Up Well Despite Weak Economic, of the Big Three revenue sources. For 2011-12, our Financial Market News. Our PIT forecast for forecasted revenues are $3.7 billion less than those 2011-12 is higher than assumed in the budget assumed in the budget package. act (excluding the $4 billion unallocated revenue assumption) despite the weaker outlook for the Under current law, our estimate of 2011-12 economy and financial markets. Income tax revenues will be compared with the coming withholding and estimated payments have held December estimate of the Department of Finance up well since May, and overall revenue attributable (DOF). The higher of the two estimates will be used to tax year 2010 appears to have been surprisingly to determine the amount of any “trigger” reduc- high given the slow reported growth in personal tions (as discussed in “Chapter 1”). income. We attribute this mainly to stronger growth in capital gains and some other categories Personal Income Tax of taxable income than we would typically expect At the end of 2010, temporary PIT rate increases based on the performance of asset markets and and reductions in the dependent exemption credit reported personal income growth. Specifically, expired. This is a major reason why PIT revenue is some recent initial public offering (IPO) activity forecast to grow between 2010-11 and 2011-12 by in the technology sector and extraordinary bonus only about 2 percent. (If, by contrast, there had been income for some high-income earners may account no such temporary PIT increases in 2010, the growth for this unexpected strength. of the PIT would be about 7 percent between 2010-11 and 2011-12.) Our forecast assumes that PIT revenues Capital Gains Bounced Back From 2009 Low, grow by 5.2 percent per year between 2011-12 and but Slower Growth Forecast Ahead. Capital gains 2016-17. income consists of gains from sales of assets, such as stocks, bonds, and real estate. Taxable capital gains Figure 3 LAO General Fund Revenue Forecast (Dollars in Millions) Revenue Source 2010-11 2011-12a 2012-13 2013-14 2014-15 2015-16 2016-17 Personal income tax $49,779 $50,812 $53,134 $55,692 $57,682 $61,811 $65,625 Sales and use tax 26,983 18,531 19,980 21,573 23,220 24,483 25,856 Corporation tax 9,838 9,483 9,432 9,958 10,806 11,316 11,492 Subtotals, “Big Three” ($86,600) ($78,826) ($82,546) ($87,223) ($91,708) ($97,610) ($102,973) Percent change 7.3% -9.0% 4.7% 5.7% 5.1% 6.4% 5.5% Insurance tax $2,070 $1,895 $1,989 $2,210 $2,326 $2,434 $2,536 Vehicle license fee 1,330 80 5 — — — — Other revenuesb 2,395 2,511 2,546 2,148 2,314 2,530 2,479 Net transfers and loans 1,897 1,451 -1,048 -1,126 -966 -235 -162 Total Revenues and $94,292 $84,764 $86,038 $90,455 $95,382 $102,339 $107,826 Transfers Percent change 8.3% -10.1% 1.5% 5.1% 5.4% 7.3% 5.4% a Beginning in 2011-12, does not include funds redirected from the General Fund to the Local Revenue Fund (LRF) 2011. Sales and use tax funds deposited into the LRF in 2011-12 are estimated to total $5.1 billion. Also, 2011-12 revenues are lower due to the expiration of temporary tax increases passed in 2009. b Does not include the resumption of estate tax revenues in 2012-13 and beyond. 16 www.lao.ca.gov Legislative Analyst’s Office California’s Fiscal Outlook income is a very volatile part of PIT revenues—one California taxpayers will total $69 billion in that is virtually impossible to predict well, but can 2011—down just 6 percent from our May forecast. influence PIT receipts upward or downward by This reduction is relatively small since we have billions of dollars per fiscal year. Overall, as shown incorporated in this forecast a positive adjustment in Figure 5 (see next page), we are assuming that to account for the healthy estimated PIT payments taxable capital income (as a percent of personal the state has received recently and current IPO income) has bounced back from its 2009 low— activity in the technology sector. buoyed by strong investment markets in 2010—but will grow at a slower rate going forward. While the factors described above have helped the recent rebound of capital gains, we do not Since May, two factors have placed downward forecast that California capital gains will rise to pressure on our capital gains forecast for 2011. prerecession levels during the forecast period. As First, our outlook for California real estate prices noted above and illustrated in Figure 5, capital is even weaker now than it was in May. Second, gains generally are slightly lower over the forecast this past summer’s stock market slump caused period than our May projections. stock prices—as measured by the Standard and Poor’s 500 stock index—to be roughly 9 percent Capital gains forecasts—difficult as they are to lower for the third quarter of 2011 than assumed in forecast—can shift materially during the course of our May forecast. While we generally assume that any fiscal year. Accordingly, it is possible that higher stock prices will rise in the future, the effects of this capital gains than we forecast could lead to PIT summer slump result in our current assumptions revenues being billions of dollars higher or lower than of stock prices being lower throughout the forecast our forecast in 2011-12 or any future year. period than assumed in our May forecast. Wages and Salaries—More Growth for Despite these dual downward pressures, our High-Income Earners. In our report The 2011-12 forecast assumes that capital gains income for Budget: Overview of the May Revision, we noted Figure 4 November 2011 LAO Revenue Estimates Compared With 2011-12 Budget Package General Fund (In Millions) 2010-11 2011-12 LAO LAO November 2011 Budget November 2011 Budget Revenue Source Forecast Package Difference Forecast Package Difference Personal income tax $49,779 $50,027 -$248 $50,812 $50,408 $404 Sales and use tax 26,983 27,140 -157 18,531 19,009 -478 Corporation tax 9,838 9,963 -125 9,483 9,012 471 Subtotals, “Big Three” ($86,600) ($87,130) (-$530) ($78,826) ($78,429) ($397) Other revenuesa $5,795 $5,754 $41 $4,486 $8,561 -$4,075 Net transfers and loans 1,897 1,897 — 1,451 1,465 -14 Total Revenues and $94,292 $94,781 -$489 $84,764 $88,456 -$3,692 Transfers a The 2011-12 budget package assumed a $4 billion “unallocated revenue assumption” as miscellaneous revenue in 2011-12. The $4 billion is included as “other revenues” for the budget package columns in this figure. 17 Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook a significant PIT forecasting difference between Since we lack hard data from PIT returns for our office and the administration related to high- 2010, we still must make a rough estimate of wage income tax filers. Forecast differences for this group and salary growth for that income year. In this are important because of the higher marginal tax forecast, we assume higher 2010 wage and salary rates on their income. Specifically, prior to passage growth than we did in May for both higher-income of the 2011-12 budget package, both our office and and lower-income groups. Specifically, we assume DOF had difficulty reconciling the very strong PIT that those with over $200,000 of AGI saw their results from last spring with the official economic wages and salaries grow by 7.5 percent in 2010, data. Revenues were coming in much higher than while those with under $200,000 of AGI saw their the official labor and other economic data seemed wages and salaries grow by 2.5 percent. In our to support. In the Governor’s May Revision forecast, higher-income earners’ wage and salary forecast, the administration assumed that higher growth outpaces that of lower-income earners PIT totals resulted in large part from huge growth throughout the forecast period. in 2010 of salaries and wages for high-income wage and salary earners—those tax filers with Sales and use Taxes over $200,000 of adjusted gross income (AGI). At We estimate that General Fund SUT revenues Graphic Sign Off the same time, the administration assumed that will total $18.5 billion in 2011-12, which is tax filers with less than $200,000 of AGI saw their 2.5 percent, Sore $c4re78ta mryillion, lower than the level wages and salaries fall by several percentage points. assumed in the 2011-12 Budget Act. A large part Analyst In our May forecast, we also assumed some higher of the decline is due to the so-called “Amazon MPA growth for high-income wage earners—though not compromise” that delays taxation of certain online as much as the administration assumed—and small purchases toD 2e01p2u-1ty3. growth in wages for lower-income groups. In 2012-13, we estimate that SUT will grow strongly to $20 billion, a 7.8 percent increase from Figure 5 2011-12. Over the first three years of the forecast period, Capital Gains Forecast Slightly Lower Than in May SUT revenues are expected Capital Gains as a Percent of Personal Income to grow at an average rate of 7.8 percent—somewhat faster 12% LAO Forecast than personal income—before May 2011 Forecast dropping to more modest November 2011 10 growth during the remainder of the forecast period. 8 Recent Policy Changes Reduce General Fund 6 SUT Revenues. In 2011-12, General Fund SUT revenues 4 are projected to fall signifi- cantly from 2010-11 levels, 2 reflecting the net effect of: (1) the “fuel tax swap” passed by the Legislature in 2010, 1985 1990 1995 2000 2005 2010 2015 18 www.lao.ca.gov Legislative Analyst’s Office California’s Fiscal Outlook under which the state no longer collects sales new vehicles, and business machinery; (2) increased tax on gasoline, (2) the realignment of some household savings rates; and (3) the long-term state responsibilities to local government (which trend toward greater consumption of nontaxable redirects $5.1 billion in state SUT receipts to cities goods (services and other products, such as those and counties), (3) the expiration of the temporary purchased online, for which the collection of SUT 1 percent SUT rate increase adopted in 2009, and has been limited). (4) projected growth in the SUT base of nearly 7 percent. Policy changes and underlying growth, Taxable Sales Now Making Up Lost Ground. taken together, reduce state General Fund SUT Since the start of the modest recovery, taxable sales revenue from $27 billion in 2010-11 to an estimated have increased somewhat faster than personal $18.5 billion in 2011-12. Our forecast assumes that income, signaling a correction to the decline in the 2011-12 SUT policies outlined above continue taxable sales discussed above. We expect this trend through the remainder of the forecast period. to continue through the first three years of our forecast, as illustrated in Figure 6 in the upwGGarrraad-pphhiicc SSiiggnn OOffff Factors Affecting Forecast. The main deter- sloping line beginning in 2011. We expect that minant of SUT receipts is taxable sales. About consumers and businesses will gradually reSStueerccnrr eettaarryy two-thirds of taxable sales result from retail to more normal levels of taxable spending relAAatnnivaaellyy sstt spending by consumers, including a significant to income during this period. Taxable sales in the DDiirreeccttoorr portion on personal vehicles and large household final two years of the forecast grow approximately DDeeppuuttyy purchases, both of which declined sharply during 5.5 percent annually as growth levels off over the the recession. Other important categories of taxable remainder of the forecast period. sales are the purchase of building materials involved in new construction as well as business- to-business taxable Figure 6 transactions, where the purchasing business is Taxable Sales Forecast to Rebound the final consumer of the Taxable Sales as a Percent of Personal Income sold item. 38% Taxable Sales Fell Forecast Disproportionately 36 During the Recession. From 2007 to 2009, taxable 34 sales fell approximately 19 percent while personal income declined by just 32 2 percent. The reduction in taxable sales relative 30 to income—illustrated in Figure 6—was the result 28 of: (1) consumers and businesses curtailing costly purchases such as 26 household appliances, 1992 1995 1998 2001 2004 2007 2010 2013 2016 19 Legislative Analyst’s Office www.lao.ca.gov ARTWORK# 110619 Fiscal Forecast California’s Fiscal Outlook Uncertainties in the SUT Forecast Could particular, we are concerned that possible Impact Actual Revenues. Taxable sales typically congressional deadlock over the supercom- are influenced by (1) employment and income mittee’s deficit reduction package could growth, (2) household savings rates, (3) the affect consumer behavior during the holiday availability of consumer and business credit, and spending season. Congressional deadlock (4) overall confidence in the economy. These factors could impair business confidence as well, could differ substantially from our underlying which could lead businesses to postpone assumptions in the following ways: taxable investments—on machinery and other equipment, for instance. • Household Savings Rates, Incomes, and Employment Affect Spending Patterns. In Corporation Tax recent months, national household savings Likely to Bottom Out in 2011-12 or 2012-13 rates have fallen to prerecession levels Before Rebounding. Corporation tax revenues for (savings tend to increase during recessions 2010-11 are estimated to have totaled $9.8 billion, as consumers curb spending and pay down slightly higher than the previous fiscal year. We debt), likely indicating that savings built project CT receipts will be slightly lower in 2011-12 up over the past few years have supported and 2012-13, but then grow steadily to $11.5 billion recent growth in taxable sales. Should by the end of the forecast period. employment, income, or savings rates vary significantly relative to our expectations, Profits Forecast Stronger… Corporate profits— actual taxable sales could differ substan- the main driver of our CT revenue forecast—now tially from our forecast. are projected to be higher than indicated in our last forecast in May 2011. Specifically, we now assume • Consumer Credit Availability Influences that before-tax national corporate profits will Spending Decisions. The availability of be $2 trillion in 2011, which is 15 percent higher consumer credit in the next few years than the value used in our previous forecast. The (presently at historically low levels) weak labor market, productivity growth, export is also significant, as credit generally expansion for certain U.S. products, and growing allows consumers to finance large taxable consumer demand all appear to be contributing to purchases—such as vehicles, appli- the strength in corporate profits. ances, personal electronics, and home improvements. …But Tax Credits Dampen Benefits of Profit Growth on CT Revenues. As profits increase, • Consumer and Business Confidence however, businesses will be more able to use new or May Affect Future Spending. National previously earned state tax credits (such as research consumer confidence indicators are at and development or enterprise zone credits) to their lowest levels since the end of the reduce taxes owed. recession. Weak confidence about the economy, however, does not seem to have Net Impact of Recent Policy Changes Now affected consumer spending—as evidenced Reducing Revenues. In addition to tax credits, by steady vehicle and retail sales in recent various major CT policy changes of recent months. If current low consumer confidence years affect the revenue outlook. In 2009-10 and about the economy drives Californians to 2010-11, these policy changes had the net impact spend less on taxable goods over the next of increasing CT revenues. The expected net several months, SUT receipts would grow effect of these recent changes to CT policies will more slowly than our forecast projects. In be to lower revenues by around $700 million in 20 www.lao.ca.gov Legislative Analyst’s Office California’s Fiscal Outlook 2011-12, compared to estimates of what revenues collections. This occurs as businesses try would have been had these policies not changed. to avoid the penalties by paying upfront This net negative effect is expected to grow, likely some of the tax they might have paid later to over $1 billion annually for the remainder of following an audit. our forecast period. This is shown in Figure 7. The recent major policy changes affecting the CT • Expanded Credit Use. Recent legis- forecast are: lation also affected the use of tax credits. The single largest change is that credits • Changes in Multistate Business Taxation. are now easier to use due to a law that The elective single sales factor—the new allows transfers of certain credits between option for businesses to annually choose companies that are treated as parts of a which method is used to determine their single business group for tax purposes. California taxable income—and associated tax law changes are estimated to reduce CT Uncertainties in the CT Forecast. ForecasGtinrag phic Sign Off revenues by around $1 billion per year. CT revenues is very difficult. Several factors could result in our forecast being too high or tooS loewc retary • Major Revenue Accelerations. The by large margins in any given fiscal year. BesAidneas lyst Legislature has enacted several measures the usual uncertainties in forecasting corporate Director over the last few years that have accelerated profits, there are some particularly difficult issues Deputy revenue collections and delayed the use now for CT forecasting. of tax deductions or credits. The actions include the suspension, for 2008 through • Lags in Getting Certain Data. As there 2011, of larger are long lags in getting certain data, businesses’ use of net operating Figure 7 loss deductions. Estimated Effects of This increased CT Recent Policy Changes on CT Revenues revenues. Since Changes From Revenues Otherwise Expected (General Fund, In Billions) 2008, however, business losses have $2 accumulated and will be deductible against income 1 again starting in tax year 2012. Net Gains Recently enacted— and modified— 0 penalties on c o r p o r a t e Net Losses taxpayers who -1 are found to have significantly underpaid their -2 taxes also serve to accelerate CT 08-09 09-10 10-11 11-12 12-13 13-14 14-15 15-16 16-17 21 Legislative Analyst’s Office www.lao.ca.gov ARTWORK # 110619 Fiscal Forecast California’s Fiscal Outlook developing our forecast requires us to forecast for 2010 through 2017 is summarized in estimate data associated with prior years. Figure 8. For example, the latest year for which we have firm data from FTB on California Population Growth Slowed Considerably in taxable profits is 2009. For CT revenues, the Late 2000s. Population estimates for years this significantly impairs our ability to between Censuses typically are subject to some know how recent policy changes already uncertainty, but it now appears that California’s have affected revenues. As described earlier, population growth slowed considerably in the the administration may receive additional second half of the 2000s. Growth seems to have information on 2010 CT returns from FTB been especially low in 2005 and 2006 at the height prior to releasing its December forecast. of the housing bubble, as high housing prices may have discouraged new people from moving to the • Recent Policy Changes Reduce the state and encouraged some outmigration. It also Reliability of Forecasts in the Near Term. appears that large numbers of undocumented Our forecast involves identifying patterns immigrants may have left the state at the end of the among economic variables and assuming decade in response to the lack of job opportunities. these patterns will persist. In the past, for example, the ratio between California Population Growth Forecast to Pick Up Slightly taxable profits and national profits has in Future Years. We expect population growth tended to return to a stable level after to return to around 1 percent a year by 2013. occasional increases or decreases. Due to Combined domestic and foreign net migration recent CT policy changes in California, appears to have been negative from 2005 to 2010, however, this ratio may be a much less useful but we expect it to turn positive beginning in 2012 guide for forecasting California profits. due to lower housing prices and slowly expanding Accordingly, these policy changes—as job growth in the state. We project California’s well as the recent volatility of the economy population will reach 40 million in 2017. during the recession and the current slow Most of the state’s population growth will recovery—make it less likely that historical come from natural increase. The state still has a patterns will reemerge in the near term. relatively young population, and births consis- This results in a need to incorporate a tently outnumber deaths by about 300,000 per significant degree of judgment into our year. Birth rates have been falling and should forecasts. remain fairly low even as the job market improves. Demographics Death rates, meanwhile, are falling sharply, Our forecasting process also involves exami- and we expect this to continue. This means that nation of population and other demographic trends California’s population—like the nation’s—will in the California economy. This is our first forecast become proportionately older in the coming years, to incorporate 2010 Census results. Future forecasts presenting federal, state, and local governments will incorporate them more, as we have time to with new challenges in service delivery and the examine additional Census data. Our demographic funding of health, social services, social insurance, and pension programs. 22 www.lao.ca.gov Legislative Analyst’s Office California’s Fiscal Outlook Figure 8 The LAO’s Demographic Forecast (In Thousands) Estimated Forecast 2010 2011 2012 2013 2014 2015 2016 2017 Totals (July 1st) 37,345 37,619 37,964 38,373 38,793 39,217 39,626 40,051 Change 268 274 345 408 421 424 409 425 Percent change 0.72% 0.73% 0.92% 1.08% 1.10% 1.09% 1.04% 1.07% Births 512 511 513 528 544 561 576 579 Deaths 242 242 244 246 247 250 253 255 Net domestic migration -88 -169 -93 -49 -51 -57 -79 -69 Net foreign migration 86 174 169 180 182 176 170 170 23 Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook 24 www.lao.ca.gov Legislative Analyst’s Office Chapter 3 Expenditure Projections In this chapter, we discuss our General Fund in 2014-15 and in 2015-16, and 4.1 percent in expenditure estimates for 2010-11 and 2011-12, as 2016-17. As shown in Figure 1, this equates to an well as our projections for 2012-13 through 2016-17. average annual growth rate of 5.8 percent between Figure 1 (see next page) shows our forecast for major 2011-12 and 2016-17. The period is characterized General Fund spending categories for all of these by consistently high growth rates in two areas that years. Below, we first discuss general budgetary represent over half of the General Fund budget trends and then discuss in more detail our expen- in 2016-17: (1) Proposition 98 spending for K-14 diture projections for major program areas. education and (2) Medi-Cal. The remainder of the budget is projected to grow at a modest 3.5 percent 2011-12 Outlook annually over the forecast period. This modest General Fund expenditures in 2011-12 are growth is due in part to the stated legislative policy 6.7 percent below their 2010-11 levels, due for of having no automatic inflation adjustments for the most part to the shift of some $5.5 billion of many programs (as discussed in “Chapter 1”). For expenditures from the General Fund to the Local instance, our forecast assumes no growth in the Revenue Fund 2011 (as part of the realignment of General Fund appropriations to the universities state programs to local responsibility). In total, or the courts after 2012-13. General Fund expenditures are forecast to be slightly (1 percent) lower than the budgeted amount due to the net effect of the trigger cuts and increased PROPOSITIOn 98 costs in some program areas. State budgeting for public education below Expenditure Growth During the the university level is governed largely by Forecast Period Proposition 98, passed by voters in 1988. The Sharp Growth in 2012-13. In 2012-13, our measure, modified by Proposition 111 in 1990, forecast shows General Fund spending climbing establishes a minimum funding requirement, by 12 percent. A large component of this is the commonly referred to as the “minimum guarantee.” additional $5.6 billion in Proposition 98 expen- Both state General Fund and local property tax diture combined with the $2 billion Proposition 1A revenues apply toward meeting the minimum property tax loan that the state must repay. guarantee. Proposition 98 monies support K-12 education and the California Community Colleges Lower Growth Projected After 2012-13. Our (CCC), constituting about 70 percent of funding forecast shows overall General Fund spending for these programs. These programs also receive growing by 3.6 percent in 2013-14, 4.7 percent Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook support from the federal government, other state and per capita General Fund revenue. Though sources, and various local sources. Proposition 98 the calculation of the minimum guarantee is monies also subsidize preschool for low-income formula-driven, a supermajority of the Legislature families. can vote to suspend the formulas and provide less funding than the formulas require. This happened Calculating the Minimum Guarantee. The in 2004-05 and 2010-11. As a result of a suspension Proposition 98 minimum guarantee is deter- or a “Test 3” year (when the Proposition 98 mined by one of three tests set forth in the State guarantee grows more slowly than per capita Constitution. These tests are based on several personal income), the state creates an out-year inputs, including changes in K-12 average daily obligation referred to as a “maintenance factor.” attendance (ADA), per capita personal income, When growth in state General Fund revenues is Figure 1 Projected General Fund Spending for Major Programsa (Dollars in Millions) Average Annual Growth Estimates Forecast From 2011-12 to 2010-11 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 2016-17 Education K-14—Proposition 98 $35,691 $31,664 $37,240 $39,649 $41,810 $44,556 $46,451 8.0% Other Proposition 98 obligationsb — — 841 841 573 391 391 — Child care — 1,064 1,008 1,019 1,114 1,209 1,361 5.2 CSU 2,542 1,976 1,976 1,976 1,976 1,976 1,976 — UC 2,711 2,072 2,071 2,070 2,069 2,068 2,067 — Student Aid Commission 1,257 1,403 1,570 1,720 1,954 2,128 2,308 10.5 Health and Social Services Medi-Cal 12,437 15,140 15,611 16,734 18,245 19,567 21,036 6.8 CalWORKs 2,079 1,065 1,448 1,468 1,360 1,250 1,234 3.0 SSI/SSP 2,861 2,752 2,815 2,888 2,968 3,055 3,151 2.7 IHSS 1,436 1,530 1,281 1,328 1,377 1,438 1,504 -0.3 Developmental Services 2,437 2,526 2,733 2,843 2,966 3,095 3,231 5.0 Mental Health 1,794 1,252 1,273 1,319 1,345 1,351 1,357 1.6 Other major programs 3,136 1,890 2,088 1,985 1,990 1,886 1,874 -0.2 Corrections and Rehabilitation 9,217 7,749 8,311 8,139 8,222 8,344 8,569 2.0 Judiciary 1,657 1,214 1,213 1,228 1,227 1,227 1,227 0.2 Proposition 1A Loan Costs 91 91 1,986 — — — — Infrastructure Debt Servicec 5,344 5,345 5,216 6,317 6,809 7,114 7,295 6.4 Other Programs/Costs 6,790 6,576 7,107 7,683 7,906 8,106 8,220 4.6 Totals $91,480 $85,308 $95,787 $99,205 $103,909 $108,761 $113,253 5.8% Percent Change -6.7% 12.3% 3.6% 4.7% 4.7% 4.1% a Under the LAO November 2011 revenue forecast, a total of $2.04 billion of expenditure trigger reductions would be implemented, as revenues are $3.7 billion below the amount assumed in the 2011-12 Budget Act. This represents all of the first tier of trigger cuts and around three-quarters of the second-tier trigger cuts. b Includes Quality Education Investment Act payments as well as 2011-12 settle-up payments. c Does not include General Fund debt-service costs of lease-revenue bonds funded through the California Community College portion of Proposition 98 funding. 26 www.lao.ca.gov Legislative Analyst’s Office California’s Fiscal Outlook healthier (as determined by a specific formula also (with an additional $17 million non-Proposition 98 set forth in the Constitution), the state is required General Fund being cut from other child care to make a maintenance factor payment, thereby programs). Additionally, almost all of the Tier II accelerating growth in K-14 funding. Another reductions would be enacted—resulting in the type of Proposition 98 obligation is created when elimination of the Home-to-School Transportation the finalized estimate of the minimum guarantee program (for half-year savings of $248 million), for a particular year ends up being higher than the an additional $72 million cut to CCC apportion- Proposition 98 appropriation for that year. When ments, and a $1.1 billion reduction to K-12 revenue this happens, the state needs to make a “settle-up limits. Whereas budget legislation authorizes a payment” (or series of payments) to ensure the revenue limit reduction of $1.5 billion, we estimate guarantee is met. a somewhat smaller reduction given our estimates of General Fund revenues and the Proposition 98 Current-Year Proposition 98 Adjustments minimum guarantee. The reductions would be Figure 2 shows the major current-year effective beginning January 1, 2012, except foGr rtahep hic Sign Off Proposition 98 adjustments resulting from our revenue limit reduction, which would take effect forecast. Based upon updated 2011-12 information, February 1, 2012. Secretary the Proposition 98 calculations have changed in Analyst three ways, each of which is described below. Assume Higher Base and Large Settle-Up MPA Obligation Moving Forward. The 2011-12 budget Deputy Unmet 2011-12 Revenue Projections Result package proposed that a ballot measure be in Proposition 98 Trigger Cuts of $1.5 Billion. approved to raise additional revenue for schools The 2011-12 Budget Act appropriated $48.7 billion and community colleges. The budget package, in Proposition 98 funding. Under our revised current-year General Fund forecast, revenues Figure 2 are $3.7 billion below 2011-12 Proposition 98 Estimates 2011-12 budget assump- (In Billions) tions, which would trigger $1.5 billion $49.5 $49.1 in corresponding Proposition 98 cuts. As 49.0 $48.7 a result, revised 2011-12 48.5 Proposition 98 spending would be reduced to 48.0 $47.2 billion. Specifically, all the Proposition 98 47.5 Tier I reductions would $47.2 be enacted—resulting 47.0 in a $30 million cut to CCC apportionments 46.5 (accompanied by a fee increase beginning in 46.0 Budget Act Spending Level Estimate of summer 2012) as well as Spending Level After Making Minimum Guaranteea a $6 million cut to the Trigger Cuts State Preschool program a Assumes no ballot measure. All sales tax revenues are included in Proposition 98 calculations. Difference between spending level and guarantee would become new settle-up obligation. 27 Legislative Analyst’s Office www.lao.ca.gov #110619\Chapter 3_Figure 2_CY Prop 98 Spending.ai California’s Fiscal Outlook however, also contained a provision specifying that Revisions in Redevelopment Savings Result in if no such ballot measure passed, the state would Higher General Fund Costs. The 2011-12 budget be required to provide an additional $2 billion in package also assumed the state would receive settle-up payments for K-14 education, reflecting $1.7 billion in General Fund savings as a result the increase in the 2011-12 minimum guarantee if of redevelopment agencies making “remittance certain sales tax revenues had been included in the payments” to school districts. As discussed in more Proposition 98 calculations. To date, no such ballot detail later in this chapter, our forecast assumes measure has been adopted. Therefore, in calculating the state will receive $300 million less than the the minimum guarantee for 2012-13, our forecast initial estimate. As a result, the General Fund assumes that all sales tax revenues are included share of Proposition 98 costs for 2011-12 is up by in the Proposition 98 calculation, increasing the about $300 million. (As specified in current law, 2011-12 spending base by $2 billion. That is, even we assume any increase in local redevelopment- though the spending level with the trigger cuts related revenue for school districts would provide would be $47.2 billion, we calculate the 2012-13 no General Fund benefit after 2011-12.) guarantee assuming a 2011-12 base of $49.1 billion. The budget package specifies that this settle-up Proposition 98 Forecast obligation is to be paid in equal installments over a Steady Increases in Proposition 98 Minimum five-year period, beginning in 2012-13. We estimate Guarantee Throughout Period. The top part of annual payments of almost $400 million to satisfy Figure 3 shows our projections of the Proposition 98 this obligation. minimum guarantee throughout the forecast Figure 3 Proposition 98 Forecast (Dollars in Millions) 2012-13 2013-14 2014-15 2015-16 2016-17 Minimum Guarantee General Fund $37,240 $39,649 $41,810 $44,556 $46,451 Local property tax 14,023 14,159 14,295 14,459 15,067a Totals $51,263 $53,808 $56,105 $59,015 $61,518 Percent change 4.3% 5.0% 4.3% 5.2% 4.2% Proposition 98 “Test” 2 1 1 2 2 Key Factors K-12 average daily attendance 0.08% -0.07% -0.24% -0.13% 0.01% Per capita personal income (Test 2) 4.04 3.41 3.61 4.74 4.10 Per capita General Fund (Test 3) 4.28 5.29 4.81 5.85 4.74 Preschool through community colleges (P-14) 3.09 1.75 2.16 2.41 2.51 cost-of-living adjustment Year-to-Year Change in Guarantee $2,127 $2,545 $2,297 $2,910 $2,503 Baseline Costs P-14 attendance $82 $18 -$54 $1 $71 P-14 COLA 873 669 888 1,146 1,249 Backfill of one-time actions 2,283 — — — — Totals $3,238 $687 $834 $1,147 $1,320 Funds Available/Shortfall (+/-) -$1,111 $1,858 $1,463 $1,763 $1,183 a Our forecast assumes the state will have fully repaid the Economic Recovery Bonds by the end of fall 2016, with the “triple flip” ending in spring 2017 and related local property tax revenues thereafter flowing back to schools and community colleges. 28 www.lao.ca.gov Legislative Analyst’s Office California’s Fiscal Outlook period. For 2012-13, we project the minimum major Proposition 98 Issues guarantee will be $51.3 billion, or 4.3 percent, higher We believe the Legislature should be mindful than the revised prior-year level (of $49.1 billion). of several major issues as it begins to craft a Thereafter, we project year-to-year increases in the Proposition 98 budget for the coming fiscal year. minimum guarantee ranging from $2.3 billion to $2.9 billion, reflecting 4 percent to 5 percent Effect of Current-Year Trigger Cuts on School annual increases. Although not reflected in the Districts Will Vary. Unsurprisingly, given the figure, the state’s outstanding maintenance factor diversity among California’s school and community obligation would remain more than $10 billion college districts, the Proposition 98 trigger throughout the forecast period. Also not shown in reductions will affect different types of districts the figure, we assume the state continues to carry differently. Understanding these impacts can help a $1.5 billion settle-up obligation from 2009-10 inform the Legislature’s 2012-13 budget decisions. but makes no associated payments throughout the • Some Districts Already Have Planned period. We also assume the state continues to make $450 million payments associated with the Quality for Reductions. The districts that would Education Investment Act in 2012-13 and 2013-14 be affected the least adversely by trigger and then makes a smaller final payment to retire cuts are those that built their 2011-12 the obligation the following year. budgets assuming some reduction in Proposition 98 per-pupil spending. These Except for 2012-13, Year-to-Year Growth districts likely budgeted cautiously given in Guarantee to Exceed Growth in Baseline the continued uncertainty regarding a Costs. The middle part of Figure 3 shows some tax package, concerns with the reliability of the key factors that underlie the forecast and/ of the $4 billion in additional revenue or drive education costs. As shown, K-12 ADA assumed late in budget negotiations, and is projected to be virtually flat throughout the the borrowing constraints they faced due period. Projected growth in per capita General to the new 2011-12 deferral of $2.1 billion. Fund ranges from 4 percent to 6 percent whereas As a result of already making program- growth in per capita personal income is slightly less, matic reductions, many of these districts ranging from 3 percent to 5 percent. The cost-of- are carrying relatively solid reserves. Thus, living adjustment (COLA) for preschool through these districts likely will respond to trigger community colleges (P-14) hovers around 2 percent cuts by drawing down their reserves but throughout the period. The bottom part of Figure 3 make few, if any, midyear reductions. compares our projection of the year-to-year change in the Proposition 98 minimum guarantee with • Other Districts Significantly Affected. In the amount needed to fund annual increases in contrast, the districts likely to be the most baseline costs. As shown in the figure, except for affected by the trigger reductions are those 2012-13, the minimum guarantee would grow by that made few initial reductions in their more than is needed for the state to fund changes 2011-12 programs. Instead, these districts in enrollment and inflation. Over the last four years were more optimistic in their budget of the period, the guarantee would grow by a total assumptions—both assuming additional of $6.2 billion more than needed to cover baseline state revenue would materialize in 2011-12 costs. Nonetheless, as discussed in more detail and increasing their borrowing to sustain below, the state still would face notable budget prior-year program levels. These districts challenges. will tend to be carrying less robust reserves. As a result of all these local decisions, these 29 Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook districts will face much more difficult make programmatic reductions in 2012-13 under options in response to the trigger cuts. either of these scenarios. They, like the districts described above, likely will first draw down their reserves. If Remainder of Forecast More Robust but Not their reserve levels, however, reflect only the Enough to Retire Existing Obligations. As shown minimum levels required by state law, they toward the bottom of Figure 3, we project the would not be adequate to absorb the entire minimum guarantee will increase by an average cut. School districts also will face challenges of $2.5 billion a year—or $10 billion cumula- given that collective bargaining and impasse tively—from 2013-14 through 2016-17. Even this processes likely will make negotiating notable growth, however, does not appear suffi- additional furlough days difficult, despite cient to allow the state to retire all of its existing being authorized in state law. Given school Proposition 98-related obligations. For example, districts also cannot impose teacher layoffs even if the state dedicated this entire amount midyear, these districts could need to make toward funding revenue limit COLAs and paying significant reductions in classified staff and/ down the existing revenue limit deficit factor, it or service programs that rely on temporary still would end the period with almost $1 billion teachers. Under a worst-case scenario, in outstanding revenue limit obligations. Over the these districts could run out of cash the last course of this period, the state would have foregone few months of the year, be unable to make COLAs for all other Proposition 98 programs, payroll, and require an emergency state loan and it would have continued to make more than (for which the district pays all associated $10 billion in late Proposition 98 payments each costs and loses local control for a period of year. Moreover, by the end of the period, the up to 20 years). state still is projected to be carrying a more than $10 billion maintenance factor obligation and a Given Size of Budget Problem, Legislature Needs $1.5 billion settle-up obligation. to Consider Whether It Can Fund the Minimum Guarantee in 2012-13. Based upon our forecast, the Maintenance Factor Issues Remain. In recent 2012-13 minimum guarantee would be more than years, disagreements have emerged regarding how $4 billion higher than the revised 2011-12 spending to run the Proposition 98 calculations in certain level (after making the trigger cuts). With a projected situations, with differences in interpretation 2012-13 overall state budget shortfall of $13 billion, leading to results that can differ by billions of the state will need to consider whether it can provide dollars. The main disagreements relate to when that large of an augmentation to school districts and maintenance factor is created and paid. For community colleges. If the Legislature determined example, in 2011-12, depending upon one’s inter- that such a sizeable Proposition 98 augmentation pretation of the State Constitution and associated would make balancing the overall state budget statutory provisions, either no maintenance too difficult, it could consider suspending the factor was created or $2.5 billion in maintenance Proposition 98 minimum guarantee and providing factor was created. Moreover, the issue of how to either no or less growth in Proposition 98 funding. pay maintenance factor can affect the long-term Retaining the revised 2011-12 spending level or Proposition 98 funding level. Depending on one’s providing a smaller-than-$4 billion augmentation interpretation of how to pay maintenance factor, would affect districts differently. As discussed above, differences of hundreds of millions to billions of some districts would be either keeping program- dollars are at stake. To make matters even more matic support flat or making slight programmatic complicated, different combinations of perspectives increases. In contrast, other districts would have to on maintenance factor creation and payment can lead to even greater differences in results. Unless 30 www.lao.ca.gov Legislative Analyst’s Office California’s Fiscal Outlook the Legislature (or voters) resolve these disagree- CalWORKs Stage 1 child care (funded through the ments, calculating the Proposition 98 minimum Department of Social Services) has decreased by guarantee will become increasingly problematic nearly 30 percent since 2008-09 due to temporary moving forward. exemptions that allowed certain families to receive cash grants without meeting work participation Child Care and Development (CCD) requirements. We assume that this reduction in Traditionally, CCD programs have been funded Stage 1 caseload will subsequently lead to reduced through a combination of state Proposition 98 Stage 2 and Stage 3 caseload over the next several General Fund and federal funds. The 2011-12 years, thereby curbing the state’s child care costs. Budget Act departed from this practice and instead We project costs will increase more rapidly used non-Proposition 98 General Fund for the (average of 10 percent) in the latter three years state’s share of all CCD programs except for State of our forecast, when we expect normal child Preschool. Thus, we include State Preschool within care usage patterns will resume and increases in our Proposition 98 forecast but run a separate overall CalWORKs caseload will have resulted in forecast for the remaining CCD programs. more child care enrollments. For non-CalWORKs CCD programs (General Child Care, Alternative Current-Year Adjustments for CCD Programs. Payment, and migrant programs), we assume costs The 2011-12 Budget Act provided $374 million in increase gradually over the forecast period, with Proposition 98 General Fund monies for State year-to-year changes growing from 1 percent in Preschool and $1.1 billion in non-Proposition 98 2012-13 to 5 percent by 2016-17. This trend reflects General Fund for all other CCD programs. The declines and then slow growth in the population trigger cuts would result in a $23 million reduction of children under age four, together with annual to these programs ($6 million in State Preschool COLA rates of roughly 2 percent. and $17 million in reductions to all other CCD programs). We expect most programs will realize these savings by disenrolling some children who hIGhER EDuCATIOn are currently being served. (Current law generally requires programs to disenroll children from In addition to the community colleges (which families earning the highest incomes first.) More are discussed above as part of the Proposition 98 than offsetting the drop in non-Proposition 98 forecast), the state’s public higher education spending, we estimate 2011-12 General Fund child entities include the University of California (UC), care costs have increased by $26 million due to the California State University (CSU), and the higher-than-expected Stage 2 caseload. California Student Aid Commission (CSAC). Future CCD Costs Reflect Ripple Effects of uC and CSu Temporary CalWORKs Policy Changes. Moving Current-Year Trigger Cuts for Universities. forward, we project overall CCD costs (excluding Based on our revenue forecast, we have assumed State Preschool) will decline slightly in 2012-13, $100 million in trigger cuts each for UC and CSU. then grow to almost $1.4 billion by 2016-17. For Cuts of this magnitude amount to about 4.5 percent California Work Opportunity and Responsibility to of the universities’ General Fund support. However, Kids (CalWORKs) child care, we project a decline given that the universities’ core funding also and then slow growth in costs over the early years includes a significant amount of tuition revenue, of the period, largely resulting from temporary the programmatic reduction experienced by the CalWORKs policies that were in effect for 2009-10 universities would be about 2 percent at UC and through 2011-12. Specifically, participation in 3 percent at CSU. The universities have limited 31 Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook options for accommodating midyear reduc- cost obligations. This is no longer the case, with tions, as most decisions affecting workload for UC recently reinstituting employee payroll the remainder of the academic year (admissions contributions and UC employer contributions and course scheduling for example) were made toward UCRP. These contributions, however, are months earlier. Unless the universities find insufficient to cover all of UC’s projected retirement sources of replacement revenue (such as through a costs. Though UC recently has begun requesting midyear tuition increase), they will have to accom- increased state General Fund support to help close modate the reductions with some combination of this gap, the state has yet to appropriate funds for drawing down reserves, borrowing, and reducing this purpose. per-student costs. California Student Aid Commission Overall University Costs Projected to Be Flat Cal Grant Programs. Most of the state’s direct Throughout Forecast. Our forecast assumes the General Fund support for student financial aid is universities’ annual General Fund operating costs provided through the CSAC’s Cal Grant programs, will be roughly $4 billion over the course of the which offer tuition coverage and subsistence grants forecast period. This reflects our overall forecast to eligible students. These costs are affected both approach of not providing automatic COLAs, by the number of students participating in the as well as an absence of college-age population programs and the universities’ tuition charges. As growth. discussed above, we do not anticipate significant changes in enrollment levels. However, recent Enrollment Projected to Be Flat. Enrollment at trends in tuition increases, coupled with statements the universities is affected by demographic changes by the universities, suggest that UC and CSU tuition in the student population as well as demand among will continue to increase. As a result, we project that eligible individuals. we project that demographic Cal Grant costs will increase from $1.4 billion in growth in the student population will slow and then 2011-12 to $2.3 billion at the end of the forecast become negative by the end of the forecast period. period. Our forecast also takes into account costs Though enrollment demand at the universities is associated with passage of the California Dream difficult to project, as it depends on many different Act of 2010. Among other provisions in the act, economic and social forces, we assume a modest Chapter 604, Statutes of 2010 (AB 131, Cedillo), increase in demand would generally be canceled makes some nonresident students eligible to receive out by the projected demographic declines. state financial aid beginning in 2013. We therefore assume no increase in university enrollment during the forecast period. key Issues Given that state General Fund resources are UC Retirement Program Costs Not Included in likely to continue to be severely constrained for the Forecast. Because no statutory formula or plan has next several years, the Legislature faces several key been adopted governing state support for the UC questions with regard to the higher education budget. Retirement Program (UCRP), we did not include General Fund costs for UCRP in our forecast. Based • How Much Should Students Pay? As on discussions with UC, however, we estimate that noted above, the universities have signaled UC could request state General Fund contribu- that they could continue to increase tuition tions exceeding $400 million annually by the significantly for at least the next several end of the forecast period. Beginning in the early years. The Legislature may wish to provide 1990s, neither the state nor UC employees made direction to the universities with regard to contributions to UCRP. This was because UCRP the share of education cost that non-needy investments were sufficient to cover retirement students should be expected to pay. 32 www.lao.ca.gov Legislative Analyst’s Office California’s Fiscal Outlook • How Can Cal Grant Costs Be Managed? hEALTh AnD Because state law currently provides for humAn SERvICES a corresponding increase in Cal Grant payments when UC and CSU raise their Overview of Services Provided. California’s tuition, state General Fund costs are driven major health programs provide health coverage in part by independent actions by the univer- and additional services for various groups of sities’ governing boards. In some cases, the eligible persons—primarily poor families and universities’ decisions to increase tuition children as well as seniors and persons with are made after passage of the state budget. disabilities. The federal Medicaid program, known The Legislature may wish to explore ways to as Medi–Cal in California, is the largest state health better manage its own expectations for Cal program both in terms of the amount of funding Grant costs at the time of budget passage. and number of persons served. In addition, the • How Should the Universities Reduce state supports various public health programs, Operating Costs? Since the onset of the community services, state-operated facilities for the mentally ill and developmentally disabled, current recession, General Fund support and health care insurance for children through for UC and CSU has declined by about a the Healthy Families Program. Beyond these quarter. Much of this reduction has been health programs, the state provides a variety of backfilled with revenue from student human services and benefits to its citizens. These tuition increases. Given the likelihood of include income maintenance for the aged, blind, continuing state budget constraints for or disabled; cash assistance and welfare-to-work the next several years, it may be necessary services for low-income families with children; for the universities to further reduce their protection of children from abuse and neglect; and overall costs. The Legislature may wish the provision of home-care workers who assist the to express expectations with regard to aged and disabled in remaining in their own homes. cost-saving opportunities related to factors Although various state departments oversee the such as faculty teaching and research management of these programs, the actual delivery expectations, student remediation rates, of many services is carried out by county welfare articulation of course sequences, student and child support offices, and other local entities. assessment and placement, and expansion Health programs are largely federally and state of distance education and other alternative funded, while most human services programs have modes of instruction. a mixture of federal, state, and county funding. • How Should the State Address UCRP Costs? As noted above, UC’s current efforts Overall Spending Trends. The 2011-12 budget provided $25.2 billion in General Fund spending to restart UCRP contributions envision a for health and human services (HHS) programs. corresponding increase in General Fund These costs would have been significantly higher, support, reaching several hundred million but the realignment package discussed earlier dollars per year by the end of the forecast shifted $3.5 billion of state costs to counties. We period. Besides the magnitude of any now estimate that these General Fund costs will augmentation, the Legislature also will be about $25.9 billion in 2011-12, primarily due have to consider how state support would be to higher-than-anticipated costs in Medi-Cal and adjusted in future years, including potential In-Home Supportive Services (IHSS). Based on increases or decreases in UCRP normal current law requirements, we project that General costs and unfunded liabilities. Fund spending for HHS programs will increase 33 Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook to about $27.2 billion in 2012-13 and $28.6 billion Some key provisions will not take effect until 2014. in 2013-14. Over the final three years of the The scope of ACA is so broad that it will be years forecast, we project that spending will increase by before all of its provisions will be fully implemented about $1.6 billion each year, eventually reaching and its overall ramifications fully understood. Our $33.4 billion. All of our estimates include annual fiscal forecast includes some significant budgetary savings of about $325 million pursuant to the adjustments to account for the implementation trigger reductions for Medi-Cal programs operated of ACA. Some of these adjustments result in cost by the Department of Developmental Services and increases for the state while others result in savings. IHSS. medi-Cal Although the average annual increase in HHS Overall Spending Trends. We estimate that spending is 5 percent during the forecast period, in the current year General Fund spending for there is substantial variation in spending growth Medi–Cal local assistance administered by the rates by program. General Fund spending for the Department of Health Care Services will amount state’s largest HHS program, Medi-Cal, averages to $15.1 billion. This is about $450 million, or 6.8 percent per year during the forecast period. 3.1 percent, more than appropriated in the 2011-12 Conversely, the Supplemental Security Income/ Budget Act. We project that General Fund support State Supplementary Program (SSI/SSP) and will grow to $15.6 billion in 2012-13, a 3.2 percent CalWORKs programs are both projected to have increase from current-year expenditures. The average annual growth of around 3 percent. largest factors contributing to this year-over-year spending growth are: (1) increases in caseload, Anticipated Lower Caseload Growth Reduces utilization of services, and rising costs for those Cost Pressures. The recent recession raised services; (2) costs for replacing one-time savings unemployment and reduced income, resulting from a budget maneuver that accelerated provider in historically high numbers of Californians payments and reduced expenditures in the 2011-12 enrolling in state HHS programs. As a result, budget; and (3) full-year savings in 2012-13 from caseload growth for many HHS programs from various cost-containment measures implemented 2008-09 through 2011-12 was well above historical in part of 2011-12. After 2012-13, we project that trends. Our economic forecast assumes modest General Fund spending will increase by about but sustained employment growth over the next 8 percent each year, reaching a total of $21 billion five years. Accordingly, our caseload projections by 2016-17. for many HHS programs reflect substantially lower growth rates compared to the experience of Key Program Cost-Drivers. We assume that the recent years. This in turn reduces cost pressures. cost per person for Medi-Cal health services will Below, we discuss spending trends in the major grow at an average annual rate of 5.4 percent over HHS programs. the entire forecast period. We also project that the number of individuals enrolled in Medi-Cal under Impact of Federal Affordable Care Act (ACA). current eligibility rules will grow at an average rate The ACA, also referred to as federal health care of only 0.8 percent per year. However, the overall reform, is far-reaching legislation that will change Medi-Cal caseload will grow more than 6 percent how millions of Californians access health care annually due to factors related to the ACA, most coverage. Among many other provisions, the new notably expanded eligibility beginning in January federal law expands federal funding and eligibility 2014. The impact of the ACA on our Medi-Cal for the Medi-Cal Program and mandates that spending forecast is discussed below. individuals obtain private or public health coverage. 34 www.lao.ca.gov Legislative Analyst’s Office California’s Fiscal Outlook Key Assumptions Related to Cost-Containment Current-Year Impacts. As shown earlier Measures. The 2011-12 budget assumed savings in Figure 1, General Fund spending for DMH from a variety of cost-containment measures, such programs decreased from almost $1.8 billion as copayments and utilization limits, for which the in 2010-11 to $1.3 billion in 2011-12. This net state is still awaiting federal approval. Our forecast decrease of $540 million can be attributed to two assumes the implementation of these measures will main factors: (1) realignment-related state savings be delayed several months, resulting in an erosion of $762 million from replacing General Fund of 2011-12 budget savings. We assume, however, expenditures for the Early and Periodic Screening, a full year of savings from the cost-containment Diagnosis, and Treatment Program and Mental measures in 2012-13. We also assume the state Health Managed Care with Proposition 63 funds; will implement provider rate reductions recently and (2) partially offsetting cost increases (including approved by the federal government, despite additional General Fund expenditures to replace ongoing legal challenges. expiring enhanced federal matching funds that were available in the prior year). ACA Impacts. Implementation of ACA will have a series of impacts on the Medi-Cal Program Developmental Services over the forecast period. For example, the federal We estimate that the General Fund spending government will initially cover the health service for developmental services in 2011-12 will total costs for individuals who become eligible for $2.5 billion, assuming that the “revenue” trigger Medi-Cal in 2014 under the expanded eligibility discussed earlier is pulled to achieve $100 million categories required in the ACA. Our spending in ongoing savings. We project that General Fund forecast captures a partial-year effect in 2017, support will grow to more than $2.7 billion in when the state will pay for a small proportion 2012-13, an increase of more than 8 percent from of costs associated with the expanded eligibility current-year expenditures. This year-over-year categories. The state will also share costs for any projected growth is largely due to increased increase in caseload in existing eligibility categories caseload, utilization of services, and rising costs for that results from persons enrolling in Medi-Cal community services provided by regional centers. It in response to the individual coverage mandate is also due to the expiration of temporary provider created under ACA. We note that, due to ACA, payment reductions that were implemented as a our estimates related to caseload growth and other cost-cutting measure. factors impacting program expenditures contain a significantly greater degree of uncertainty. We project that General Fund support will grow to $3.2 billion by the end of the forecast period mental health in 2016-17. This projected growth is largely due We estimate that General Fund spending for the to increased caseload, utilization of services, and Department of Mental Health (DMH) in 2011-12 rising costs for community services. Our forecast will be about $1.3 billion and will grow very slowly, assumes that regional center caseloads will grow approaching $1.4 billion by 2016-17. General at an annual average rate of 3 percent, and that Fund spending would have remained virtually costs overall will grow at an average annual rate unchanged during the forecast but for an almost of about 5 percent. $80 million increase in DMH staff costs to provide treatment services for mentally ill inmates at a new CalWORks prison facility in Stockton. Overall Spending Trends. For 2011-12, the state budget provided $1 billion from the General Fund for CalWORKs. This amount reflects the 35 Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook impact of the 2011 realignment legislation, which during previous periods of employment growth, shifted about $1.1 billion in CalWORKs grant costs the CalWORKs caseload grew at a slower rate or to the counties. We project that General Fund declined. Our forecast of CalWORKs caseload spending for CalWORKs will be about $1.1 billion reflects this empirical relationship between in 2011-12 or approximately $75 million above the caseload and employment. The budget forecasts 2011-12 Budget Act appropriation, due to higher- caseload growth of 1.2 percent in 2011-12. Based than-projected caseload. From this current-year on recent caseload data, we estimate slightly base, we project spending will increase by about higher caseload growth of 2.5 percent, resulting in $400 million in 2012-13, stay fairly flat in 2013-14, additional costs of about $75 million. In 2012-13, as and then decline in each of the next three years employment growth begins to increase, we project to around $1.2 billion in 2016-17. The increase caseload will grow by only 0.6 percent. Beginning in CalWORKs costs over the next two years is in 2013-14, we expect the caseload to gradually primarily the result of (1) the restoration of short- decline over the remainder of the forecast period. term reductions, (2) caseload growth, and (3) the state’s fixed federal Temporary Assistance for SSI/SSP Needy Families (TANF) block grant, which does State expenditures for SSI/SSP are estimated to not adjust for caseload changes. Long-term cost be $2.8 billion in 2011-12 and 2012-13. Beginning in declines are primarily driven by projected declines 2013-14, we project that General Fund support for in caseload levels. SSI/SSP will increase by an average of $80 million per year, reaching $3.2 billion by 2016-17. The Cost of Restoring Short-Term Policy Changes. projected spending increases are primarily due to For 2011-12, the Legislature achieved major average annual caseload growth of about 2 percent ongoing CalWORKs savings through grant and with somewhat higher growth rates in the later eligibility reductions and additional short-term years to reflect the aging of the population. savings of over $400 million. The short-term savings included (1) extending certain exemptions IhSS from work participation requirements with a corre- For 2011-12, we estimate that General Fund sponding $375 million reduction in county block spending for IHSS will exceed the budget act grants for employment services and child care and appropriation by roughly $300 million, resulting (2) suspending the case management portion of the in total costs of about $1.5 billion. We then project Cal-Learn program for teen parents who remain in that costs will decrease to around $1.3 billion in school, for a General Fund savings of $44 million. 2012-13. These amounts reflect implementation of Our forecast reflects the complete restoration of revenue triggers mentioned earlier and a specific these reductions beginning in 2012-13. (We note IHSS trigger discussed below which will result that the state General Fund bears 100 percent of in combined savings of $110 million in 2011-12 these costs because the federal TANF block grant and $350 million annually thereafter. Finally, we and county realignment funds do not adjust for project only modest growth in program cost in caseload or policy changes.) the out-years. Caseload Levels Driven Mainly by Economic Budget Solutions and Unrealized Savings. Conditions. Historically, changes in employment The 2011-12 budget reflects a package of solutions levels have significantly affected CalWORKs including (1) receipt of additional federal funds caseload growth. During the recent economic due to a provider tax and implementation of the downturn, the growth rate of the CalWORKs Community First Choice option under the federal caseload increased significantly. Conversely, ACA, (2) elimination of services for recipients 36 www.lao.ca.gov Legislative Analyst’s Office California’s Fiscal Outlook whose need for services has not been certified by JuDICIARY AnD a medical professional, (3) a medication dispenser CRImInAL JuSTICE initiative, and (4) program integrity activities. Altogether, the budget assumed these initiatives The major state judiciary and criminal justice would result in about $600 million in program programs include support for two departments in savings in 2011-12. However, we estimate that this the executive branch—the California Department package will only save about $200 million in that of Corrections and Rehabilitation (CDCR) and the year. Most of the unrealized savings in 2011-12 Department of Justice—as well as expenditures for are related to delays in the implementation of the the state court system. medication dispenser initiative and the Community First Choice option, along with overestimation of CDCR savings from other solutions. We estimate that General Fund spending for the support of CDCR operations in the current year Medication Dispenser Initiative and Budget will be about $7.7 billion, which is $1.5 billion, or Trigger. As part of the 2011-12 budget, the Legislature 16 percent, less than the 2010-11 level of spending. established a medication dispensing pilot program This primarily reflects the estimated savings from intended to improve medication compliance among (1) the realignment of certain lower-level offenders, Medicaid recipients, estimated to result in annual parole violators, and parolees to counties beginning net cost avoidance of $140 million from reduced October 1, 2011 and (2) use of realignment revenues nursing home placement and hospital admissions. in the current year to reimburse CDCR for lower- Budget legislation requires the Department of level offenders in state prison who were sentenced Finance (DOF) to report to the Legislature by April prior to October 1. Our estimate of current-year 10, 2012 on how much savings the pilot is likely spending is also lower because of assumed trigger to achieve. At that time, the Legislature will have reductions. Counties would be required to pay until July 1, 2012 to enact alternative legislation to $125,000 per year to the state for each juvenile achieve a total of $140 million in ongoing savings offender committed to the Division of Juvenile from the medication pilot and/or new initiatives. Facilities, resulting in an estimated savings of If the DOF determines that these legislative $79 million in the General Fund cost of operating actions are insufficient to achieve $140 million in state youth correctional facilities in 2011-12. In savings, an across-the-board reduction in IHSS addition, there would be a $20 million unallocated hours sufficient to meet this savings target will reduction to CDCR’s budget. be implemented in 2012-13. Our forecast assumes that no savings from the medication dispensing Our forecast projects that General Fund pilot will be achieved in 2011-12, but that the full spending on corrections will increase to about $140 million target will be achieved beginning in $8.6 billion in 2016-17. As indicated above, the 2012-13. 2011-12 realignment package assumed that the Local Revenue Fund 2011 (realignment revenues) Caseload Growth. Our forecast assumes would reimburse CDCR about $1.2 billion for costs that IHSS caseload will grow 3 percent per year incurred in 2011-12 for lower-level offenders in state throughout the forecast period. Our forecast is prison who were sentenced prior to October 1, 2011. higher than the trend observed in 2009 and 2010, Our forecast assumes that the General Fund will but below the rapid caseload growth that occurred replace the $1.2 billion in 2012-13 and future years. prior to those years. In addition, as discussed in more detail below, our projections also reflect actions to reduce the state’s inmate population as well as additional costs that 37 Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook CDCR will incur to staff and operate new prison construction of tens of thousands of additional facilities expected to be constructed during the prison beds. Our projections assume that about forecast period. 15,300 additional beds will be constructed pursuant to AB 900 during the forecast period, resulting in Projected Savings From Reduced Inmate an estimated $800 million in additional General Population... Our forecast assumes that the Fund expenditures annually to staff and operate realignment of certain criminal offenders from the new facilities. As the new facilities are built, the the state to the counties will reduce CDCR expen- Legislature will need to make policy and budgetary ditures by $1.5 billion annually upon full imple- decisions regarding the level of programming and mentation in 2014-15. Although this realignment staffing to be provided at these facilities, which of services would significantly reduce the state’s will determine the actual increase in operational inmate population, and go a long way towards costs. Given the likely magnitude of these eventual complying with a federal court order to reduce costs, as well as the significant reduction in the prison overcrowding, it may fall short in meeting state’s inmate population resulting from the federal the requirements within the deadlines established court ruling to reduce prison overcrowding, the by the court. (Please see nearby box for more Legislature may want to hold off from moving detailed information about the federal court order.) forward with some of the projects authorized under Thus, our forecast assumes annual savings of over AB 900. $100 million beginning in 2012-13 from additional inmate population reduction measures that would Judicial Branch likely need to be adopted to comply with the court We estimate that General Fund spending for order. However, the actual savings achieved would the support of the judicial branch in the current largely depend on the specific actions taken to year will be about $1.2 billion, which is roughly further reduce prison overcrowding. $500 million lower than the amount appropriated in the 2011-12 Budget Act. This estimate primarily …But Increased Costs to Operate Planned AB reflects the estimated General Fund savings from 900 Facilities. In 2007, the Legislature enacted the realignment of court security to county sheriffs. Chapter 7, Statutes of 2007 (AB 900, Solorio), Our forecast assumes that state spending on the in order to relieve the significant overcrowding judicial branch will remain roughly flat from problems facing state prisons and improve 2011-12 through 2016-17. rehabilitation. Specifically, AB 900 authorizes the Federal Court Order to Reduce Prison Overcrowding On May 23, 2011, the U.S. Supreme Court issued a ruling in a lawsuit against the state involving prison overcrowding. Specifically, the court upheld the ruling of a federal three-judge panel requiring the state to reduce overcrowding in its prisons to 137.5 percent of the system’s overall “design capacity” within two years. Currently, the state prison system is operating at roughly 180 percent of design capacity—or about 32,000 inmates more than the limit established by the three-judge panel. The ruling, however, did not specify the particular measures that the state must implement to comply. On June 7, 2011 and July 21, 2011 the administration submitted reports to the three-judge panel describing specific measures that were recently taken, as well as those in the process of being implemented, to reduce overcrowding in California prisons. For more detailed information, see our recent publication, A Status Report: Reducing Prison Overcrowding in California (August 2011). 38 www.lao.ca.gov Legislative Analyst’s Office California’s Fiscal Outlook OThER PROGRAmS “basic aid districts”). These funds, therefore, will not offset state school costs. Redevelopment The 2011-12 budget package included two On November 10, 2011, the California Supreme measures designed to generate (1) $1.7 billion in Court heard a case challenging the constitutionality state education savings in the current year and of the redevelopment bills. A decision is expected (2) about $400 million in increased resources by January 15, 2012. for school districts annually thereafter. Under Employee Compensation these measures, each city or county with a During 2010-11, the Legislature ratified new redevelopment agency must choose whether to memoranda of understanding (MOUs) with each retain its redevelopment agency and make annual of the state’s 21 collective bargaining units. These remittance payments to local school districts or MOUs reduced state employee compensation costs allow its agency to be eliminated. Under either through (1) the Personal Leave Program (PLP), scenario, school districts receive additional local which decreased most employees’ pay by about funding, either from remittance payments or 5 percent for the first 12 months of the new MOU’s, property tax revenues redirected from the expired and (2) increased employee pension contributions. redevelopment agencies. In 2011-12, the remittance The 2011-12 Budget Act also directed the California payments are intended to offset state funding Public Employees’ Retirement System (CalPERS) to obligations for schools. In 2012-13 and future reduce employee health benefit costs by $80 million years, the ongoing remittance payments (about (General Fund). $400 million annually) are intended to supplement the resources the state provides to schools. Net Costs Beginning in 2012-13. Our forecast assumes that the state will achieve all of the Our forecast estimates that state education MOU-related employee compensation savings savings in the current year will be about $1.4 billion, anticipated in the 2011-12 Budget Act ($135 million about $300 million less than the amount assumed General Fund), but only $47 million of the antici- in the budget because: pated savings in health benefits costs. Beginning • As permitted by law, DOF reduced the remit- 2012-13, our forecast assumes that employee tance payment obligations for certain local compensation costs grow because: governments that experienced increases in • The temporary salary reductions associated their redevelopment debt obligations. with the PLP end in 2011-12. • Some cities and counties are expected • Employees at the top step of the salary range to allow their redevelopment agencies to will receive pay increases as provided by expire and that the amount of property the MOUs. taxes redirected from the expired agencies will be less than the local governments’ • Employee health care costs increase at an remittance payments. average annual rate of 7.6 percent. • Some of the remittance payments and By 2016-17, we forecast employee compen- property tax revenues will be allocated to sation costs (nonretirement) will be more than school districts that do not receive state $550 million higher than in 2011-12, principally funding for apportionments (so-called due to higher health care costs. 39 Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook Public Employee Retirement Costs in 2016-17.) This assumes that CalPERS does not Our forecast reflects current-law increases in the change its current actuarial rate-setting practices state’s annual payments to (1) pension programs for (including rate “smoothing”) and that in 2012-13 state and CSU employees, (2) teachers’ pensions, and beyond, CalPERS investment returns hit the (3) state and CSU retiree health benefit programs, system’s assumed investment target of 7.75 percent and (4) pension programs for judges. (The teachers’ per year. Moreover, it assumes only the pay pension program is administered by the California increases for state workers that are included in State Teachers’ Retirement System [CalSTRS], and current MOUs—for most, a single 3 percent or the other three programs are administered by 4 percent pay increase during the entire five-year CalPERS.) Figure 4 shows the recent history and forecast period. The forecast assumes that state forecasted trend for General Fund budgetary costs workers continue to pay more in contributions to related to these retirement programs. CalPERS throughout the forecast period, as agreed in collective bargaining agreements that were CalPERS Contributions Driven by Pay Raises, approved during the past year. Graphic Sign Off Investments, and Actuarial Methods. Our forecast assumes that the state’s required contribution to These variouSs efocrreectaasrty assumptions limit the CalPERS for state and CSU pensions rises from growth of the state’s CalPERS contribution rates Analyst $3.6 billion (all funds) in 2011-12 to $3.8 billion in our model. If, by contrast, pay raises were to Director in 2016-17. (Of the $3.6 billion to be contributed rise faster than we assume, investment returns in 2011-12, about $2.1 billion is expected to be were to be signDifeicpauntytly less, and/or actuarial paid from the General Fund. This General Fund methods of CalPERS were to change, the state’s contribution grows to $2.2 billion in our forecast required payments to CalPERS could be hundreds of millions of dollars more than we forecast in 2016-17. CalSTRS Contribution Figure 4 Driven by Rates Set in Current-Law State Retirement Costs to Keep Growing Statute and Teacher Salary General Fund (In Billions) Growth. The forecast $7 assumes that the state’s contributions to CalSTRS CalSTRS 6 CalPERS Retirement Programsa grow from $1.3 billion in CalPERS Retiree Health Programb 2011-12 to $1.5 billion in Other 5 2016-17. State contribu- tions in 2011-12 are based 4 on a 2009-10 payroll level for K-12 and community 3 college teaching and 2 administrative personnel of $27.1 billion. The prelim- 1 inary estimate for 2010-11 upon which the state’s 2012-13 contributions will 1990-91 1993-94 1996-97 1999-00 2002-03 2005-06 2008-09 2011-12 2014-15 be based is $26.2 billion aAmount for 1997-98 includes an over $1 billion state payment related to a major court case involving CalPERS. bIncludes the budget item for these costs and LAO estimate of the General Fund share of the implicit subsidy for annuitant (down 3.2 percent from benefits that is paid along with employees' health premiums. 40 www.lao.ca.gov Legislative Analyst’s Office 110619\Chapter 3_Figure 4_Current-Law State Retirement Costs To Keep Growing.ai California’s Fiscal Outlook 2009-10). We assume that statewide payroll remains required under current law to contribute additional fairly flat through the forecast period. funds to UC to address its unfunded pension and retiree health liabilities, the forecast includes no Typically, the state pays about 4.5 percent of General Fund resources to assist UC for these prior-year teacher payroll to CalSTRS, as required purposes. It also includes virtually no General in contractual commitments that are outlined Fund support to begin paying down large unfunded in the Education Code. The system also receives retiree health liabilities for current and past state payments from school districts and teachers to and CSU employees. If the state does not take action cover pension program costs, which also are fixed concerning these liabilities soon, the extra costs in the Education Code. Pursuant to its contractual needed to retire these unfunded liabilities over the obligations, the state must contribute additional next few decades will increase dramatically. funds each year when certain unfunded liabilities emerge, as they did after the decline of world Debt Service on Infrastructure Bonds financial markets in 2008. In our forecast, these The state uses General Fund revenues to added contributions total $106 million in 2011-12 pay debt-service costs for principal and interest and grow to $394 million by 2016-17. (These added payments on two types of bonds used primarily contributions are very small compared to the to fund infrastructure—voter-approved general billions of dollars of additional funding per year obligation bonds and lease-revenue bonds approved that CalSTRS will require to remain solvent and by the Legislature. We estimate that General eliminate its unfunded liabilities over the next few Fund costs for debt service on these bonds will be decades.) $5.2 billion in 2012-13, which is roughly equal to the state’s General Fund debt-service costs every Retiree Health Costs to Continue Increasing. year since 2009-10. General Fund debt-service costs The forecast assumes continued pay-as-you-go have not increased significantly over this period for payments for the vast majority of state and CSU a few reasons. Most notably, the Legislature and retiree health costs. These are forecast to grow from Governor enacted legislation to offset some General $1.5 billion in 2011-12 to $2.3 billion in 2016-17. Fund debt-service costs with transportation funds. This represents an average 9.4 percent annual Additionally, the administration slowed the pace growth rate during the forecast period. This growth of bond sales over the last 18 months, including is driven by two elements: (1) projected annual the cancellation of state bond sales during the first growth in state employee and retiree health plan half of 2011. premiums and (2) a rising population of state and CSU retirees. Over the forecast period, however, debt service is projected to grow 6.4 percent annually Unfunded Liabilities Persist. The state’s over the period, reaching $7.3 billion by 2016-17. retirement programs are projected to have Projections of debt-service costs depend primarily significant—and growing—unfunded liabilities on the volume of past and future bond sales, their through the forecast period. Because our forecast interest rates, and their maturity structures. The includes only current-law pension contribution exact timing of bond sales depends upon when requirements, it does not include funding sufficient various bond-related programs will be in need of to begin to reduce CalSTRS’ unfunded liabilities funds and the accessibility of financial and credit (currently estimated to be around $4 billion per markets. In general, our forecast assumes that year beginning immediately to eliminate the the slower pace of bond sales continues for many liabilities over the next 30 years, assuming that programs because they currently have sufficient CalSTRS achieves its investment targets over the bond proceeds to cover their spending needs for long term). Moreover, because the state is not 41 Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook the initial portion of the forecast. Nonetheless, over Fund revenues, as well as the continued sale of the the entire forecast period, we assume that a total large bonds approved since 2006. To the extent of about $36 billion of already authorized general additional bonds are authorized and sold in future obligation and lease-revenue bonds will be sold as years beyond those already approved, the state’s currently approved projects move forward. A large debt-service costs and DSR would be higher than share of this—about $24 billion—is from the nearly projected in Figure 5. $54 billion in infrastructure bonds authorized by voters in 2006 and 2008. It also reflects the growing State-mandated Local Programs issuance of lease-revenue bonds for the prison (non-Education) system authorized by the Legislature in 2007. We Over the last several years, the Legislature also expect that transportation debt-service costs has taken various actions to reduce or defer will exceed available transportation funds during costs for state mandates on local governments the forecast period and the General Fund will (cities, counties, and special districts). These resume paying a portion of these costs. Our forecast actions include permanently repealing mandates, is based on the expected sale of bonds that have suspending statutory requirements to implement Graphic Sign Off already been authorized, but does not include any mandates, and deferring payments towards Secretary proposed bonds (such as the water bond scheduled retiring the state’s backlog of mandate claims (over for the 2012 ballot). $1 billion). The 2011-12 budget shifted the respon- Analyst sibility and funding for providing certain mental Director Debt-Service Ratio (DSR) Expected to Rise. health services to K-12 students from counties Deputy The DSR for general obligation and lease-revenue to schools (commonly referred to as “AB 3632” bonds—that is, the ratio of annual General Fund program). This action eliminates the need for debt-service costs to annual General Fund revenues ongoing mandate payments to counties for this and transfers—is often used as one indicator program. Our forecast assumes that the Legislature of the state’s debt burden. There is no one “right” level for the DSR. The higher it Figure 5 is and more rapidly it rises, Projected Debt-Service Ratioa however, the more closely bond raters, financial analysts, and 8% investors tend to look at the Authorized, but Unsold state’s debt practices and the 7 more debt-service expenses 6 limit the use of revenues for other programs. Figure 5 5 shows what California’s DSR 4 has been in the recent past and our DSR projections for the 3 forecast period. 2 Previously Sold The DSR we are 1 projecting—over 7 percent at its peak—is higher than it has 1986-87 1991-92 1996-97 2001-02 2006-07 2011-12 2016-17 been in the past. In part, this reflects declines in General Forecast a Ratio of annual General Fund debt-service payments to General Fund revenues and transfers. 42 www.lao.ca.gov Legislative Analyst’s Office 110619/Chapter 3_Figure 5_Projected Debt-Service Ratio.ai California’s Fiscal Outlook continues to suspend all mandates it suspended in these assumptions, state costs for mandates would 2011-12. Our forecast also assumes that the state increase from $48 million in 2011-12 to roughly makes annual payments to retire the backlog of $200 million annually throughout the forecast mandate claims, as specified in current law. Under period. 43 Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook Legislative Analyst’s Office Legislative Analyst Mac Taylor .......................................................................................................................445-4656 Deputy Legislative Analyst Daniel C. Carson .............................................................................................................319-8303 Corrections, Transportation, and Environment Deputy: Anthony Simbol ...............................................................................................319-8350 Managing Principal Analysts: Farra Bracht, Transportation ...................................................................................319-8355 Mark C. Newton, Environment ...............................................................................319-8323 Education Deputy: Jennifer Kuhn ...................................................................................................319-8332 Managing Principal Analyst: Steve Boilard, Higher Education..............................................................................319-8331 Health and Human Services Deputy: Todd Bland ........................................................................................................319-8353 Managing Principal Analyst: Shawn Martin, Health ...............................................................................................319-8362 State and Local Finance Deputy: Jason Sisney.......................................................................................................319-8361 Managing Principal Analyst: Marianne O’Malley, General Government ............................................................319-8315 44 www.lao.ca.gov Legislative Analyst’s Office California’s Fiscal Outlook 45 Legislative Analyst’s Office www.lao.ca.gov California’s Fiscal Outlook 46 www.lao.ca.gov Legislative Analyst’s Office The 2012-13 Budget: California’s mac Taylor Legislative Analyst Fiscal Outlook November 2011 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.