Insufficient Eraf: Examining a Recent Issue in Local Government Finance

Insufficient ERAF: Examining A Recent Issue in Local Government Finance MAC TAylor • legislATive AnAlysT • DeCeMber 18, 2012 Summary Over the last two years, a small number of cities and counties did not receive enough local property tax revenue to offset two complex state-local financial transactions: the triple flip and vehicle license fee (VLF) swap. This funding insufficiency, commonly called “insufficient ERAF” (Educational Revenue Augmentation Fund), requires state action if the affected local governments are to receive complete payment. To assist the Legislature in responding to this unanticipated development, this report describes the causes of insufficient ERAF and outlines a framework the Legislature may wish to use in considering remedies. We summarize the highlights of our report below. Insufficient ERAF Probably Is a Limited Issue. To date, insufficient ERAF has affected local governments in only two counties—Amador and San Mateo—and resulted in total VLF swap funding shortfalls of less than $2 million. Insufficient ERAF may grow somewhat over the next few years. In the longer term, however, insufficient ERAF likely will be limited to a small number of cities and counties—or not occur at all in some years. Two Possible Levels of Compensation for Insufficient ERAF Appear Reasonable. As insufficient ERAF is not the product of any particular local government actions, a strong analytical argument can be made that the state should reimburse cities and counties for all triple flip and VLF swap funding shortfalls. This would require increased state expenditures, potentially up to tens of millions of dollars annually. On the other hand, in recognition of the significant fiscal benefits cities and counties receive under the VLF swap, the Legislature may wish to reimburse cities and counties only where necessary to replace actual sales tax and VLF revenue losses. Compensation Mechanisms Are Limited. We see two primary options for compensating local governments experiencing insufficient ERAF: provide the compensation in the annual state budget or through a redirection of certain local education agency property tax revenues. An LAO RepORt 2 Legislative Analyst’s Office www.lao.ca.gov An LAO RepORt IntRoductIon Almost a decade ago, the Legislature 2011-12 and expanded to include local governments adopted two complex financial transactions with in San Mateo County. California’s cities and counties known as the “triple In the 2012-13 state budget, the Legislature flip” and “VLF swap.” Under these transactions, appropriated $1.5 million to fully offset Amador city and county sales tax and VLF revenues are County’s 2010-11 funding shortfall. (Funding reduced, but local revenue shortfalls are offset insufficiencies in Amador and San Mateo in annually by property taxes redirected from (1) a 2011-12 were not known until after the state budget countywide educational account (ERAF) and, in was adopted.) To consider the state’s options for some cases, (2) certain K-12 and community college addressing future claims of insufficient ERAF, the districts. Local education district revenue losses, in Supplemental Report of the 2012‑13 Budget Package turn, are offset by increased state aid. directed the Legislative Analyst’s Office and the Earlier this year, the auditor from Amador Department of Finance (DOF) to submit reports County reported an unanticipated development: (1) addressing the conditions under which local available funding in 2010-11 was not sufficient governments may be compensated in cases where to fully reimburse the second financial trans- there are insufficient local funds to offset fully the action, the VLF swap. The county had insufficient fiscal effect of the triple flip and VLF Swap and ERAF—not enough revenues to fully compensate (2) outlining one or more alternative mechanisms local governments for the triple flip and/or VLF for providing such compensation. This report is swap. More recently, county auditors reported that submitted in fulfillment of our office’s requirement. insufficient ERAF continued in Amador County in BAckGRound In order to better comprehend the complicated special districts, K-12 schools, and community issue of insufficient ERAF, this report begins with college districts). The county auditor is responsible an overview of California’s system of distributing for allocating revenue generated from the 1 percent property taxes amongst local governments. It then rate to local governments pursuant to state law. describes several major statutory measures that are The allocation system commonly is referred to integral to the issue of insufficient ERAF: the 1990s as “AB 8,” after the bill that first implemented ERAF property tax shift, triple flip, VLF swap, and the system—Chapter 282, Statutes of 1979 (AB 8, dissolution of redevelopment. L. Greene). In general, AB 8 provides a share of the total property tax revenue collected within a Property tax Allocations Basics community to each local government that provides Property Taxes Are Shared by Many Local services within the community. Governments. All property tax revenue remains Property Taxes Also Affect the State Budget. within the county in which it is collected to be used Although the state does not receive any property exclusively by local governments (cities, counties, tax revenue directly, the state has a substantial www.lao.ca.gov Legislative Analyst’s Office 3 An LAO RepORt fiscal interest in the distribution of property tax shortfalls, the state permanently redirected revenue because of the state’s education finance almost one-fifth of total statewide property tax system under which the state guarantees each revenue from cities, counties, and special districts school district an overall level of funding. For to K-12 and community college districts. Under K-12 districts, each district receives a comparable the changes in property tax allocation laws, the amount of per-pupil funding—a “revenue limit”— redirected property tax revenue is deposited into a from local property taxes and state resources countywide fund for schools, ERAF. The property combined. Community college districts receive tax revenue from ERAF is distributed to nonbasic apportionment funding from local property taxes, aid schools and community colleges, reducing the student fees, and state resources. If a district’s local state’s funding obligations for K-14 education. property tax revenue (and student fee revenue in “Excess ERAF” Shifted Back. In the late 1990s, the case of community colleges) is not sufficient, some county auditors reported that their ERAF the state provides additional funds. Conversely, accounts had more revenue than necessary to offset if a district’s nonstate resources alone exceed the all state aid to non-basic aid K-12 and community district’s revenue limit or apportionment funding college districts. In response, the Legislature level, the district does not receive general purpose enacted a law requiring that some of these surplus state aid (though they typically receive funding funds be used for countywide special education for various categorical programs). These districts programs and the remaining funds be returned to commonly are referred to as “basic aid” districts cities, counties, and special districts in proportion because historically they have received only the to the amount of property taxes they contributed minimum amount of state aid required by the State to ERAF. The ERAF funds that are returned to Constitution (known as basic aid). noneducational local governments are known as Each year, the state estimates how much each excess ERAF. district will receive in local property tax revenue triple Flip (and student fee revenue in the case of community colleges), then the annual budget act appropriates The Triple Flip Is Reimbursed From ERAF. In state General Fund to “make up the difference” and 2004, state voters approved Proposition 57, a deficit- fund the district’s revenue limit or apportionment financing bond to address the state’s budget shortfall. at the intended level. Frequently, however, the The state enacted a three-step approach—commonly actual property tax revenues allocated to school referred to as the triple flip—that provides a districts may be less than anticipated. The state’s dedicated funding source to repay the deficit bonds: education finance system addresses these short- • Beginning in 2004-05, one-quarter cent falls differently for different types of educational of the local sales tax is used to repay the entities. For K-12 districts, all funding shortfalls deficit-financing bond. are backfilled automatically with additional state aid. In contrast, explicit state action is required to • During the time these bonds are backfill community college funding shortfalls. outstanding, city and county revenue losses from the diverted local sales tax are 1990s ERAF Property tax Shift replaced on a dollar-for-dollar basis with Property Taxes Shifted to Schools. In 1992-93 property taxes shifted from ERAF. and 1993-94, in response to serious budgetary 4 Legislative Analyst’s Office www.lao.ca.gov An LAO RepORt • K-12 and community college district tax reduce VLF collections by 25 percent. Chapter 322 losses from the redirection of ERAF to provided for a series of additional reductions cities and counties, in turn, are offset by beginning in 2001, possibly reaching a maximum increased state aid. 67.5 percent beginning in 2003, if General Fund revenue growth met certain targets. Subsequent Triple Flip Projected to End in 2016‑17. legislation accelerated the pace of these additional Based on current projections, the Proposition 57 effective rate reductions, setting the VLF offset deficit-financing bond will be repaid in 2016-17 at 67.5 percent and reducing VLF collections a and the triple flip will be ended. At that time, commensurate amount. Under this reduction, the $1.7 billion in ERAF monies that otherwise the effective VLF rate paid by vehicle owners was would have been used to fund the triple flip will be 0.65 percent. available for other uses—namely funding the VLF State General Fund Allocations Backfilled swap and offsetting state K-14 expenditures. Local Revenue Losses. These reductions in VLF VLF Swap collections substantially reduced the revenue available for cities and counties. The Legislature, VLF Traditionally Has Been a Local Revenue however, replaced the lost VLF revenues with Source. Established in 1935, the VLF is an annual General Fund allocations to cities and counties tax on the ownership of registered vehicles in on a dollar-for-dollar basis. Funds from the California in place of taxing vehicles as personal General Fund backfill generally were allocated property. The tax is based on the vehicle’s purchase on a per capita basis so that each city and county price and declines in accordance with a statutory received the same amount of revenue as the local depreciation schedule. For most of its years, the government would have received absent the VLF primary use of VLF has been as a general purpose reductions. The backfill was continuously appro- local government revenue source—with all or most priated and, therefore, not subject to annual appro- VLF revenues distributed to cities and counties on priation in the budget bill. a per capita basis. General Fund Resources Found Insufficient State Began Reducing VLF Revenue to Cover Backfill. Chapter 322 included a “trigger” Collections in the Late 1990s. While the VLF provision requiring the effective VLF rate to be rate was 2 percent for over five decades, the state increased during periods in which insufficient began enacting measures in 1999 that reduced the General Fund monies were available to backfill effective VLF rate paid by vehicle owners—thus for city and county revenue losses. In these cases, reducing revenue collections. Most notably, General Fund expenditures for the backfill would Chapter 322, Statutes of 1998 (AB 2797, Cardoza), be reduced, accompanied by a commensurate established an “offset” to the annual VLF paid by increase in VLF payments made by vehicle vehicle owners. Under this legislation, the VLF owners. In June 2003, Governor Davis determined owed by a vehicle owner was initially calculated that there were insufficient funds for the state using the 2 percent tax rate and then the offset was to continue making backfill payments to cities applied, effectively reducing the rate paid by the and counties. As a result, backfill payments were vehicle owner. The amount of the tax reduction suspended in June 2003. For various reasons, was shown as a credit on the vehicle owner’s regis- however, the effective VLF rate was not returned tration bill. Beginning in 1999, this offset acted to to 2 percent until October 2003. Following the www.lao.ca.gov Legislative Analyst’s Office 5 An LAO RepORt recall election, in November 2003 Governor As discussed in our report, The 2012‑13 Budget: Schwarzenegger reversed the determination of Unwinding Redevelopment, by diverting property insufficiency. This restored the effective VLF rate to taxes from K-12 and community college districts, 0.65 percent and resumed payment of the General redevelopment had the overall effect of increasing Fund backfill to cities and counties. The time state costs for K-14 education. Under the dissolution difference between the suspension of the backfill process, the property tax revenue that formerly payments and the increase in the effective VLF rate went to RDAs is used first to pay off redevelopment resulted in revenue losses of $1.3 billion for cities debts and obligations and the remainder is and counties. This amount was deemed to be a loan distributed to local governments, including K-12 from cities and counties to the state, and was repaid and community college districts, in accordance during the 2005-06 budget year. with AB 8. The shift of property taxes to nonbasic VLF Swap Enacted to Replace General Fund aid districts reduces state K-14 expenditures Backfill. In 2004, the state and cities and counties by a similar amount. Over time, as former worked together to develop a new mechanism for redevelopment debts and obligations are retired, reimbursing cities and counties for their reduced state savings from redevelopment dissolution will VLF revenue. This mechanism, known as the VLF grow as school districts receive larger distributions swap, provides an element of increased security for of property taxes. The cash and other liquid assets cities and counties by replacing a state-controlled of former RDAs also will be distributed to local reimbursement with a revenue source that is subject governments in accordance with AB 8. These to greater local control. Specifically, the VLF swap distributions will provide additional one-time replaced the General Fund VLF backfill with increases in revenue for school districts in the property taxes redirected at the county level from current year and over the next few years. (1) ERAF and, if ERAF revenues are not sufficient, No Change in Excess ERAF. In general, an from (2) nonbasic aid K-12 and community college increase in the amount of property tax revenue districts. (All reductions in revenue to K-12 and to school districts decreases (1) the amount of community college districts are offset by additional state funding needed by schools to reach their state aid.) The VLF swap also specified that future revenue limits and (2) the amount of ERAF that growth in these reimbursement property taxes can be used to offset the state’s obligations. As less would not be distributed on a per capita basis (like ERAF funding is needed to offset state education VLF revenues and the VLF General Fund backfill expenditures, more property tax is returned to had been). Instead, the property taxes provided as local governments as excess ERAF. This, in turn, part of the VLF swap would grow each year based leaves fewer resources in ERAF available to make on growth in property values within the entity. payments under the triple flip and VLF swap. In order to maximize the state’s fiscal benefit from Redevelopment dissolution the dissolution of redevelopment, the Legislature Dissolution of Redevelopment Increases enacted Chapter 26, Statutes of 2012 (AB 1484, Property Taxes Distributed to Schools. The Committee on Budget), which directs county 2011-12 budget package included legislation— auditors to exclude revenues provided to schools by Chapter 5 (ABX1 26, Blumenfield)—that resulted the dissolution of RDAs in the calculation of excess in the dissolution of all redevelopment agencies ERAF. (RDAs) in California effective February 2012. 6 Legislative Analyst’s Office www.lao.ca.gov An LAO RepORt AdmInIStERInG thE tRIPLE FLIP And VLF SwAP calculating Payments to cities and counties shortfalls are referred to as insufficient ERAF. The major steps in the process are as follows. Triple Flip Reimbursements Equal to Step 1: Return Excess ERAF. As shown in Projected Annual Reductions in Sales Tax the figure, the first step is for each county auditor Revenue. Each fiscal year, DOF provides county to determine whether the funds deposited into auditors with an estimate of the sales tax revenue the countywide account exceed the amount lost by each local government as a result of the needed by all nonbasic aid K-12 and community triple flip. The DOF’s estimate is based on the college districts in the county, plus a specified actual amount of sales tax revenue distributed to amount for special education. If so, the special each local government in the prior year, adjusted education program receives funding from ERAF for projected growth (as determined by the State and any remaining ERAF is returned to cities, Board of Equalization) in the current year. special districts, and the county in proportion to VLF Swap Payments Pegged to Growth in the amount of property taxes they contributed Local Assessed Property Values. In general, to ERAF. This calculation of excess ERAF was each city and county’s annual VLF payment is recently modified to exclude property taxes equal to its VLF losses related to the state reduc- distributed to K-12 and community college districts tions in 2004-05, grown by the total percentage as a result of redevelopment dissolution. change in the city or county’s assessed value of Step 2: Reimburse Triple Flip. Following the taxable property—or assessed valuation—between calculation and distribution of excess ERAF, state 2004-05 and the current year. For example, if law directs county auditors to reimburse local a city’s VLF revenue losses were $1 million in governments for their revenue losses associated 2004-05 and its assessed valuation increased by with the triple flip. This reimbursement is shown 20 percent between 2004-05 and 2012-13, then in the figure as step two. If the county auditor uses its VLF payment in 2012-13 is $1.2 million. For all available ERAF, but determines that the local the purposes of this calculation, county auditors governments have not been fully reimbursed for are directed to ignore any growth in assessed the triple flip, the county has insufficient ERAF. In valuation due to changes in a city’s boundaries, this situation, additional state action is required if such as an expansion of boundaries through cities and counties are to be fully reimbursed for annexation, that occur after 2004-05. the triple flip. Reimbursement Process Steps 3 and 4: Pay for VLF Swap. After reimbursing the triple flip, the next use of ERAF Figure 1 (see next page) displays the complex is to make payments to local governments for the process county auditors follow to allocate ERAF VLF swap. If the county auditor determines that the and to reimburse cities and counties for the triple remaining ERAF resources alone are not sufficient flip and VLF swap. This figure also shows that, to fully pay cities and the county for the VLF swap, under certain circumstances, it is possible that the the county auditor redirects some property taxes auditor could determine that there are not enough from nonbasic aid K-12 and community college funds to fully compensate cities and the county for districts for this purpose, as shown in step 4. The the triple flip and/or the VLF swap. These funding www.lao.ca.gov Legislative Analyst’s Office 7 An LAO RepORt Figure 1 Process to Distribute ERAF and Reimburse the Triple Flip and VLF Swap County auditors shift property taxes from counties, cities, and special districts to ERAF. YES (1) Return excess Does the amount in ERAF ERAF to counties, exceed the total amount needed cities, and special districts. by K-14 districts? NO (2) Use ERAF to reimburse cities and counties for triple flip. NO Is ERAF sufficient to fully reimburse for triple flip? YES County is experiencing insufficient ERAF. (3) Use remaining ERAF to pay cities and counties for VLF swap. NO NO (4) Negative ERAF: Is ERAF sufficient to fully fro U m s e K p -1 ro 4 p d e i r s t t y r ic ta ts x e th s a t Ar ta e x K e - s 1 s 4 u d ff i i s c t i r e ic n t t p to ro f p u e lly rt y pay for VLF swap? are not basic aid to pay for VLF swap? pay for VLF swap. YES YES (5) Distribute remaining ERAF funds to End. K-14 districts. ERAF = Educational Revenue Augmentation Fund; VLF = vehicle license fee. 8 Legislative Analyst’s Office www.lao.ca.gov An LAO RepORt redirection of school property taxes is commonly Negative ERAF: Los Angeles County. Property referred to as “negative ERAF” because it decreases tax collections in the county totaled about K-12 and community college property taxes rather $10 billion—of which $2.08 billion was deposited in than supplementing them (the original purpose of ERAF. K-12 and community college districts needed ERAF). If ERAF and nonbasic aid school district more than $2.08 billion to satisfy their revenue property taxes combined do not contain enough limits or guaranteed funding levels. Therefore, no resources to make the payments required under the ERAF funds were returned to cities, counties, and VLF swap, then the county has insufficient ERAF. special districts as excess ERAF. The first use of the In this situation, additional state action is required county’s ERAF (before allocating any funds to K-12 for cities and counties to receive the full VLF swap and community college districts) was to provide payment. $302 million in triple flip reimbursements to cities Step 5: Distribute Remaining ERAF to K‑12 and the county. After ERAF funds were distributed and Community College Districts. Any funds for the triple flip, $1.78 billion remained in ERAF to remaining in ERAF after the other uses have been fund VLF swap payments of $1.84 billion—resulting satisfied are distributed to schools and offset state in a shortfall of about $65 million. To cover this education spending. shortfall, Los Angeles’ auditor redirected $65 million of property taxes from nonbasic aid K-12 and Examples of the ERAF distribution Process community college districts to ERAF to make the While the same rules govern the distribution full VLF payment. (The numbers above exclude of ERAF throughout the state, the outcome varies certain revenues related to the county’s policies significantly from county to county. This variation regarding delinquent property taxes.) reflects the large differences among counties in the Excess ERAF: Napa County. Property tax amount of property taxes allocated to K-12 and collections in the county totaled $275 million—of community college districts, the number of students which $34 million was deposited to ERAF. In enrolled in K-14 programs, the level of ERAF total, K-12 and community college districts in resources and sales taxes, and other factors. Below, the county needed only one-fourth of the funds we present four examples using data from 2011-12. deposited into ERAF to meet their funding needs. Simplest Example: Alameda County. Thus, $25 million of the ERAF resources were Property tax collections in the county totaled first used to offset state expenditures in county $2 billion—of which $410 million was deposited in special education programs ($7 million), with the ERAF. Because the county’s K-12 and community remaining funds ($18 million) returned to cities, college districts needed more than $410 million counties, and special districts as excess ERAF. in additional property taxes to meet their revenue Following these distributions, just under $9 million limits or guaranteed funding levels, no ERAF remained in ERAF to fund the triple flip and VLF resources were returned to cities, counties, and swap. These funds were used first to pay triple flip special districts as excess ERAF. Instead, ERAF reimbursements totaling $6 million. The remaining resources were available to make triple flip and $3 million was applied to a VLF swap obligation of VLF swap payments to cities and the county $23 million—resulting in a shortfall of $20 million. ($309 million) and the remainder was distributed to To cover this funding shortfall, Napa’s auditor nonbasic aid K-12 and community college districts redirected $20 million from property taxes of ($101 million). nonbasic aid K-12 and community college districts. www.lao.ca.gov Legislative Analyst’s Office 9 An LAO RepORt Insufficient ERAF: San Mateo County. The remaining $6 million was applied to a VLF Property tax collections in the county totaled swap obligation of $125 million—resulting in a $1.4 billion—of which $187 million was deposited shortfall of $119 million. To cover this funding to ERAF. In total, the county’s K-12 and shortfall, San Mateo’s auditor shifted property taxes community college districts needed $38 million from nonbasic aid K-12 and community college from ERAF to meet their guaranteed funding districts. Because many K-12 and community levels, leaving $149 million to distribute to county college districts in San Mateo are basic aid, special education programs ($18 million) and however, the amount of K-12 and community to cities, counties, and special districts as excess college district property taxes available to be shifted ERAF ($131 million). Following these distributions, was slightly lower ($200,000) than the $119 million $38 million remained in ERAF to fund the triple needed to reimburse city and county for the flip and VLF swap. These funds were used first to VLF swap. Thus, San Mateo County experienced pay triple flip reimbursements totaling $32 million. $200,000 of insufficient ERAF. A REcEnt dEVELoPmEnt: InSuFFIcIEnt ERAF In 2010-11, Amador County found that the flip and VLF swap in two ways. First, if more resources available from ERAF and nonbasic aid K-12 and community college districts are basic K-12 and community college district property taxes aid, there is less capacity to use ERAF to offset were insufficient to fully fund VLF swap payments state education costs and, therefore, more ERAF to cities and counties. This funding shortfall—the is returned to local governments as excess ERAF. first reported case—is known as insufficient ERAF. Monies returned as excess ERAF are not available If insufficient ERAF occurs, state action is required to fund triple flip or VLF swap payments. Second, if cities and counties are to receive full triple flip or because state law does not allow county auditors to VLF swap payments. In the 2011-12, two counties— shift property taxes from basic aid districts to fund Amador and San Mateo—reported having insuf- the VLF swap, an increase in the number of basic ficient ERAF. This section discusses the factors aid districts decreases the pool of resources county leading to insufficient ERAF and explores the auditors can draw from to fund the VLF swap. In possibility of insufficient ERAF extending to other 2011-12, around 10 percent of K-12 and community counties and affecting payments for the triple flip. college districts in the state were basic aid. In contrast, about two-thirds of K-12 and community Factors Leading to Insufficient ERAF college districts in San Mateo County were basic Prevalence of Basic Aid School Districts Is aid and Amador County’s only K-12 district was the Most Significant Cause of Insufficient ERAF. basic aid. In general, counties where a greater proportion of Local Demographics, Property Values, and K-12 and community college districts are basic aid State Policies Drive Basic Aid Status. A wide range are more likely to experience insufficient ERAF. of factors influence whether a K-12 or community The prevalence of basic aid districts can affect the college district is basic aid, including economic amount of resources available to fund the triple and demographic factors, as well as state fiscal 10 Legislative Analyst’s Office www.lao.ca.gov An LAO RepORt and educational policies. In general, basic aid rates in Amador and San Mateo Counties was not districts (1) receive comparatively high property a significant factor contributing to their ERAF tax revenue—because of substantial property insufficiencies. wealth and/or they receive a higher share of the Insufficient ERAF In Future Years property tax (for more information on property tax allocation, see our report, Understanding To date, insufficient ERAF has been a limited California’s Property Taxes) and (2) serve a issue: only a small number of local governments community with a comparatively smaller school- have been affected and the dollar amount of the aged population. In addition, changes in state insufficiencies has been relatively minor. Going policy can also influence whether a district is basic forward, it is difficult to project the magnitude of aid. The number of basic aid districts generally insufficient ERAF in future years. However, based increases when the state decreases K-12 district on our current economic and demographic forecasts revenue limits and community college appor- and our review of county triple flip and VLF swap tionment funding levels, and vice-versa. Changes financial data, in the absence of significant state in revenue limits and apportionment funding educational policy changes, we think it is likely that levels can be caused by state fiscal actions (such as insufficient ERAF (1) will increase over the next a reduction of overall state K-14 expenditure) or few years (potentially to tens of millions of dollars by state policy changes (such as consolidation of in some years), (2) may affect triple flip reimburse- categorical program funding into revenue limits). ments in a small number of counties, and (3) will In addition, state actions that increase the property abate considerably after 2016-17 (following the tax revenue of K-12 and community college end of the triple flip), possibly continuing to affect districts (such as dissolution of redevelopment) can a small number of counties on an ongoing basis. increase the number of basic aid districts. We note that these outcomes could be influenced Slower Growth of ERAF Contributes Modestly by legislative actions to increase general purpose to Insufficient ERAF. Property tax revenues funding levels for K-12 and community college deposited in ERAF are the primary funding districts—such as transitioning to a new K-12 source for VLF swap payments. Historically, weighted student formula—which could substan- ERAF resources have grown slightly slower than tially reduce future growth in basic aid districts VLF payments—by up to about 1 percent a year. and, therefore, insufficient ERAF. Below, we discuss The slower growth of ERAF relative to VLF swap the rationale underlying our insufficient ERAF payments (which grow at the rate of change in projections. assessed valuation) has reduced somewhat the Property Tax Growth Over Next Few Years amount of resources available to fund the VLF Could Create More Basic Aid Districts. In swap, thus contributing to insufficient ERAF. The 2012-13 and over the next few years, many K-12 overall statewide effect of ERAF’s slower growth and community college districts are expected to rate, however, has been small. If ERAF grew at the receive a significant increase in property tax revenue same pace as VLF swap payments, there currently from the distribution of former RDA assets and an would be around $340 million more ERAF to fund anticipated increase in property values. This growth VLF swap payments—an amount equal to 6 percent in property tax revenue is likely to shift tempo- of total VLF payments. We note that the difference rarily some K-12 and community college districts between ERAF and VLF swap payment growth into basic aid status and, in turn, increase the www.lao.ca.gov Legislative Analyst’s Office 11 An LAO RepORt number and dollar amount of ERAF insufficiencies funding shortfall. It is possible such an increase experienced by local governments. The ERAF insuf- in excess ERAF distributions could result from ficiency faced by local governments in San Mateo expected growth in property values in San Mateo County is likely to increase significantly in 2012-13, and Napa counties over the next few years. Because from $200,000 to several million or more. Also, the triple flip is scheduled to end in 2016-17, any at least one additional county—Napa—appears triple flip related insufficient ERAF would be a at risk of having insufficient ERAF in 2012-13 or temporary, short-term issue. the near future. Despite the potential growth of End of Triple Flip Should Decrease ERAF insufficient ERAF over the next few years, the issue Insufficiencies. Any growth in insufficient ERAF is not likely to expand beyond a small number of that occurs over the next few years is likely to be counties because the vast majority of counties have reversed beginning in 2016-17. As mentioned previ- only a small number of K-12 and community college ously, the Proposition 57 deficit-financing bonds districts that are basic aid or are close to becoming are projected to be repaid in 2016-17 and the triple basic aid. flip will end. At that time, there will be roughly Chance of Triple Flip Funding Shortfalls. $1.7 billion (about one-third of statewide VLF swap A few counties—San Mateo and Napa—appear payments) more ERAF funding available statewide somewhat at risk of developing insufficient ERAF to fund the VLF swap—significantly decreasing as a result of ERAF resources being inadequate the likelihood of VLF swap funding shortfalls. to reimburse cities and counties for the triple flip. In addition, state K-14 expenditures are projected This situation can occur if a significant portion to increase consistently between 2013-14 and of a county’s ERAF revenues are distributed to 2017-18, likely leading to growth in revenue limit special education programs and to local govern- entitlements for K-12 districts and apportionment ments as excess ERAF, leaving inadequate funds funding levels for community colleges. To the to reimburse for the triple flip. In 2011-12, over extent growth in revenue limits and apportionment 70 percent of ERAF monies in San Mateo and Napa funding exceeds growth in K-12 and community counties were distributed to special education college district property taxes, the number of basic programs and as excess ERAF, leaving less than aid districts could decrease. The combination of 30 percent of ERAF to fund the triple flip and VLF these factors should reduce the possibility of local swap. Most of the funds remaining in ERAF were governments experiencing insufficient ERAF. As a used to reimburse the triple flip. For this reason, a result, beginning in 2016-17, it is likely that insuf- relatively small increase in excess ERAF distribu- ficient ERAF will be limited to a small number of tions—for example, a 5 percent increase in San counties—or perhaps nonexistent in some years— Mateo County—likely would result in a triple flip for the foreseeable future. AddRESSInG InSuFFIcIEnt ERAF In addressing claims of insufficient ERAF compensation should be provided. In the sections in future years, the Legislature is faced with two that follow, we provide a framework the Legislature primary decisions: how much compensation may wish to use in considering these decisions. cities and counties should receive and how the 12 Legislative Analyst’s Office www.lao.ca.gov An LAO RepORt how much Should cities and counties Be complex system of local finance and not the result compensated for Insufficient ERAF? of any actions by cities and counties. Therefore, there is no clear reason that some local govern- Deciding the amount of compensation to ments should get lower levels of reimbursement provide is difficult and inevitably requires the simply because they are located in a county with Legislature to make trade-offs between providing insufficient ERAF. funding for state versus local government Alternative: Fully Reimburse Actual Local programs—and weighing implicit commitments Government Revenue Losses. While it is clear the made by previous Legislatures. As we discuss Legislature intended for VLF swap payments to below, we think a strong analytical argument can grow with annual changes in assessed valuation, it be made for developing a funding mechanism that is not clear the Legislature could have known this provides full reimbursement for all shortfalls in would result in most cities and counties receiving triple flip and VLF swap reimbursements. However, VLF swap payments significantly in excess of it would also be reasonable for the Legislature their VLF losses. As discussed in the nearby to consider a lower level of reimbursement for box (see next page), VLF swap payments have VLF swap funding shortfalls in recognition of an grown relatively quickly since 2004, significantly additional unforeseen outcome of the VLF swap: surpassing the amount of VLF revenues that local cities and counties have received a significant fiscal governments lost as a result of the VLF swap. Local benefit from the VLF swap due to unexpected governments today are receiving $2 billion more growth in VLF swap payments. Should the annually than they would have received if the VLF Legislature wish to provide a lower level of support, rate had been left at 2 percent. In recognition of we think a reasonable alternative would be to this fact, the Legislature may wish to consider an (1) provide full reimbursement for all triple flip alternative approach to insufficient ERAF which losses and (2) reimburse VLF swap shortfalls to the limits reimbursement to the actual amount of sales extent that a local government did not receive more tax and VLF losses a local government experienced. revenues under the VLF swap than it would have if Under this approach, all triple flip shortfalls would the VLF rate had remained 2 percent. be reimbursed, but the state would reimburse VLF Providing Full Reimbursement. The legislative swap shortfalls only to the extent that the local record is unambiguous that the state intended government had not already received at least the to provide each city and county with (1) dollar- same amount of funding it would have received if for-dollar reimbursement for their local sales tax the swap had not occurred and the VLF rate was losses associated with the triple flip and (2) VLF 2 percent. This limitation on VLF reimbursement swap payments equal to the local government’s would decrease the magnitude of state liabilities— 2004-05 VLF losses, grown by annual change in no additional reimbursement would be required for its assessed value. The Legislature specified that the cases of insufficient ERAF that have occurred the resources to provide this compensation were to date. While the analytical argument for this to be property taxes in ERAF and, if necessary, alternative is less straightforward, it is consistent property taxes redirected from nonbasic aid K-12 with the notion that the state’s goal was to hold and community college districts—a funding system local governments harmless from the fiscal effects that was believed to be sufficient to accomplish the of the VLF rate reduction—not to increase local Legislature’s objective. The funding insufficiency government revenues overall. that has developed is a byproduct of California’s www.lao.ca.gov Legislative Analyst’s Office 13 An LAO RepORt how Should compensation agency property tax revenues. We discuss these Be Provided to cities and counties? alternatives below. Annual State Budget Appropriations. In the After deciding how much compensation to 2012-13 state budget, the Legislature addressed provide to local governments, the next decision for insufficient ERAF by providing the affected local the Legislature is to design a financing mechanism governments with a one-time allocation from to provide the funds. Given the Constitution’s the General Fund. Continuing this approach many provisions limiting state authority over local in future years would allow the Legislature to finance, we see only two primary options: provide weigh the expense of providing insufficient the compensation in the annual state budget or ERAF compensation against other state spending through a redirection of certain local education priorities on an annual basis. On the other hand, A Look at Growth in Vehicle License Fee (VLF) Payments VLF Swap Payments Have Grown Faster Than VLF Revenues. Each year, a city’s or county’s VLF payment increases (or decreases) proportionately to the change in its assessed valuation. After the adoption of the VLF swap, statewide growth in assessed valuation—and, as a result, VLF swap payments—has significantly exceeded growth in VLF revenues. From 2004-05 to 2011-12, VLF swap payments grew by an average of about 5 percent each year, while VLF revenues declined by an average of about 0.5 percent each year. Consequently, annual statewide VLF swap payments now are roughly $2 billion (around 45 percent) greater than the VLF revenues lost by cities and counties. This large fiscal benefit for cities and counties was not foreseen at the time the VLF swap was adopted. Prior to the VLF swap, historical growth in assessed valuation and VLF revenue had been fairly comparable. City and County Fiscal Benefits Vary Significantly. While most cities and counties have benefited from the faster growth of VLF swap payments, some cities and counties with less growth in assessed valuation or more growth in population have received less benefit from the VLF swap than other cities and counties. Our estimates of the benefits (or losses) of individual cities and counties—measured in terms of the percentage gain or loss in VLF swap payments relative to VLF revenue losses—range from losses of a few percent to gains in excess of 80 percent. In terms of the two counties that have insufficient Educational Revenue Augmentation Fund (ERAF) (Amador and San Mateo), our analysis indicates that local governments in these counties have benefited under the VLF swap, but not more than most other cities and counties. Choice to Tie VLF Swap Payments to Assessed Value Was Significant. In enacting the VLF swap, the state departed from its prior policy of replacing city and county VLF revenue losses dollar for dollar and instead linked growth in VLF swap payments to growth in assessed valuation. Had the state adopted a mechanism that provided for reimbursement of city and county actual VLF revenue losses only, annual payments to cities and counties would be about $2 billion less today than under the VLF swap. This would reduce the occurrence of insufficient ERAF, including eliminating Amador and San Mateo’s status as counties with insufficient ERAF. 14 Legislative Analyst’s Office www.lao.ca.gov An LAO RepORt subjecting insufficient ERAF compensation to if the scope of insufficient ERAF is constant or annual review would reduce revenue security for expands. Consequently, if the Legislature wishes cities and counties. We note that the Legislature to provide full reimbursement for all triple flip designed the current triple flip and VLF swap and VLF swap funding shortfalls, supplemental payment mechanism to be controlled at the local General Fund appropriations will be required to level with the objective of giving local government compensate cities and counties. revenue security. The Redirection Option Raises Two Important Redirect Property Taxes From Some Local Considerations. In considering this option, the Educational Entities. Current law allows auditors Legislature should be aware of two important to redirect property taxes from nonbasic aid considerations. First, if the actual amount of K-12 and community college districts to fund property taxes allocated to COEs or special the VLF swap. These districts’ property tax losses education programs in a given year ends up being are backfilled with state aid. Current law does less than was expected at the time the state budget not allow auditors, however, to redirect (1) K-12 was enacted, additional state funding would need or community college district property taxes to be provided if COEs and special education to fund the triple flip or (2) county offices of programs are to reach their specified funding education (COE) and special education program levels. State policies addressing this situation differ property taxes to fund the triple flip or VLF swap. between COEs and special education programs. Expanding county auditor authority to redirect As with K-12 districts, COE funding shortfalls property taxes from all of these educational are backfilled automatically with additional agencies for the triple flip and VLF swap would state aid. On the other hand, an additional provide additional funding that could be used to state appropriation would be needed to backfill avoid ERAF insufficiencies. Similar to K-12 and special education funding shortfalls—similar to community college districts, COE and special community colleges. While the issue of differing education programs receive a particular level of approaches to backfilling local educational annual funding through a combination of local agencies’ property tax revenues extends far beyond revenues and state aid. If the property tax revenues insufficient ERAF and the scope of this report, the received by COEs or special education programs Legislature should be aware that the ramifications decrease, the state typically provides additional of shifting property taxes from local educational state funding to achieve a specified funding agencies to fund the triple flip and VLF swap may level. Therefore, total funding to these entities vary across entities. Second, the Constitution likely would not decrease if county auditors were constrains the Legislature’s ability to alter the permitted to redirect some of their property taxes allocation of property tax revenues—even in cases to fund the triple flip and VLF swap. when the state would be providing cities and Our review indicates that redirecting property counties with increased property taxes. Legislation tax revenues from COEs and special education authorizing property taxes to be shifted from programs would cover most, but not all, of the COE or special education programs may require current costs of insufficient ERAF in Amador approval by two-thirds of both houses of the and San Mateo Counties. Similarly, this funding Legislature. mechanism might not be sufficient in future years www.lao.ca.gov Legislative Analyst’s Office 15 An LAO B R I E F concLuSIon Over the last two years, local governments claims of insufficient ERAF, the Legislature will in two counties—Amador and San Mateo—did be faced with the difficult decisions of how much not receive enough revenue to offset two complex compensation cities and counties should receive state-local financial transactions: the triple flip and and how it should be provided. Ultimately, in VLF swap. It is likely this funding insufficiency, making these decisions, the Legislature to will need commonly called insufficient ERAF, will continue to balance trade-offs between providing funding in future years, requiring state action if the affected for state versus local government programs and local governments are to receive their full triple weigh implicit commitments made by previous flip and VLF swap payments. In addressing future Legislatures. LAO Publications This brief was prepared by Brian Uhler and reviewed by Marianne O’Malley. The Legislative Analyst’s Office (LAO) is a nonpartisan office that provides fiscal and policy information and advice to the Legislature. To request publications call (916) 445-4656. This brief 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. 16 Legislative Analyst’s Office www.lao.ca.gov