The 2013-14 Budget: Overview of the May Revision

The 2013-14 Budget: Overview of the May Revision MAC TAylor • l e g i s l A T i v e A n A l y s T • MAy 17, 2013 2013-14 Budget 2 Legislative Analyst’s Office www.lao.ca.gov 2013-14 Budget ExEcuTivE SuMMaRy Governor’s May Revision Revenue Forecast Up Slightly. The administration’s May Revision forecast projects that weaker tax collections in the coming months will erode the vast majority of the $4.5 billion of unexpected tax revenues collected since January. For 2011-12, 2012-13, and 2013-14 combined, the administration’s updated forecast anticipates that revenues will be only $749 million higher than indicated in its January estimates (not counting a new $500 million loan proposal in the May Revision, which is booked to the revenue side of the budget). Proposition 98 Guarantee Up in 2012-13. Because the administration’s forecast reflects much of the $4.5 billion of unanticipated tax collections as higher 2012-13 revenues, the Proposition 98 minimum guarantee for the current fiscal year rises to $56.5 billion—almost $3 billion higher than in the January budget proposal. Whereas the guarantee in 2012-13 is notably higher, the guarantee in 2013-14 is notably lower—$55.3 billion, down almost $1 billion from the January level. New Realignment Proposal and State-Based Medi-Cal Expansion. Another significant element of the May Revision is the Governor’s proposal to use a state-based approach for implementing the optional Medi-Cal expansion under the federal Patient Protection and Affordable Care Act. Related to this decision, the administration proposes to achieve $300 million in General Fund savings in 2013-14 by realigning some responsibilities for California Work Opportunity and Responsibility to Kids (CalWORKs), CalWORKs-related child care, and CalFresh to counties. The administration’s budget plan projects this $300 million of savings to grow to $1.3 billion in 2015-16. This report discusses our concerns about this proposal and offers an alternative for the Legislature’s consideration. LaO comments Administration’s View of the Economy and Revenues Seems Too Pessimistic. We do not agree with the administration’s view that there has been a significant dimming of the state’s near-term economic prospects. In addition, we observe that the administration’s new revenue forecast does not seem to reflect some recent economic improvements—most notably, a sharp increase in stock prices. As a result, our forecast now is $3.2 billion higher than the administration’s May Revision total for 2011-12, 2012-13, and 2013-14 combined. Given the significance of capital gains-related tax revenue to state finances, all state budget forecasts include an explicit or implicit assumption about future stock price trends. Our forecast, for example, assumes that stocks will remain fairly flat through the rest of 2013. Even in that scenario, the significant stock gains of recent months would provide a boost to state revenue collections in the coming months. The administration’s forecast does not take account of this trend. (Our report includes a multiyear projection of state revenues and expenditures under the Governor’s May Revision policies and discusses various risks to the improved state fiscal outlook.) www.lao.ca.gov Legislative Analyst’s Office 3 2013-14 Budget Many Reasons for Legislature to Adopt a Cautious Approach. While the state’s fiscal condition has improved, there remain many good reasons for the Legislature to adopt a cautious budgetary posture. After years of “boom and bust” budgeting, California’s leaders now have the opportunity to build a budget for future years that gives the state more choices about how to build reserves in times of healthy revenue growth, prioritize future state spending, and pay off past debts. There is a risk that our outlook will prove wrong in the near term because capital gains are volatile and stock trends are impossible to predict. In that case, the Governor’s cautious approach to budgeting potentially would allow the state to deal with any economic downturn with less need for urgent budget cuts. On the other hand, if the state adopts a cautious budgetary outlook and revenues are closer to our estimates, the Legislature would have much more flexibility to prioritize state spending within the next year or two. Maintenance Factor Policy Means Higher Revenues Help Rest of Budget Little. Another reason to take a cautious approach is that, under our initial calculations, there is surprisingly little benefit to the state’s “bottom line” from adopting our higher revenue calculations. That is because the state’s current policy for how to make Proposition 98 maintenance factor payments requires a very large portion of our office’s higher projected revenues to be allocated to schools and community colleges. Our initial estimates show that adopting our higher revenue estimates—while keeping the current maintenance factor approach—would allow, at most, several hundred million dollars to be available for allocation to reserves, paying down debts, or restoring cuts to non-school programs. Our report also discusses an option for legislative consideration—changing the state’s current approach to maintenance factor repayment, which would greatly enhance legislative flexibility over new revenues. Time for Legislature to Take Charge of State’s Future Fiscal Plans. Given the improved fiscal forecast, we believe this is an ideal time for the Legislature to begin addressing its huge budgetary and retirement liabilities, including the funding problems of the California State Teachers’ Retirement System. In addition, given the presence of various risks to the economic outlook and the state’s budgetary volatility, building larger state budget reserves in the coming years is an important state priority. Building reserves when the economy is strong means that there will be less necessity during future downturns to cut public spending, as occurred in recent years. 4 Legislative Analyst’s Office www.lao.ca.gov 2013-14 Budget GOvERNOR’S May REviSiON Projected 2013-14 General Fund condition close of the fiscal year. The May Revision decreases revenue estimates for 2011-12 Revised Budget Proposal Would End 2013-14 by a net $285 million. This consists With a $1.1 Billion Reserve. In January, the primarily of a $425 million increase in Governor proposed a spending plan for 2013-14 estimated personal income tax (PIT) that reflected a significant improvement in collections—essentially, a part of the the state’s finances. As shown in Figure 1, the $4.5 billion unexpected revenue surge since revised spending plan projects General Fund January—and a $716 million reduction in and Education Protection Account revenues of corporation tax (CT) revenues. $97.2 billion in 2013-14, down about $1.3 billion from January. The May Revision also assumes • Higher Revenues in 2012-13 about $1.3 billion in lower spending. After ($2.8 Billion). The administration’s May accounting for these changes and others, the revenue forecast increases by $3.3 billion May Revision anticipates that the state would the estimated amount of PIT revenues for end 2013-14 with a $1.1 billion reserve (slightly the 2012-13 fiscal year. (This is another higher than the reserve level in the January budget part of the $4.5 billion revenue surge since proposal). January.) The higher PIT revenues are offset Differences From Governor’s January Budget. by $545 million in lower projections for The May Revision projects higher net revenues for sales and use tax (SUT) and CT revenues, 2011-12, 2012-13, and 2013-14 combined that are compared to the January forecast. more than offset by required state expenditures on school and community college districts. The major • Lower Revenues in 2013-14 changes to the General Fund condition include the (-$1.3 Billion). The Governor’s budget following: • Lower Revenues Figure 1 in 2011-12 governor’s May revision (-$0.3 Billion). general Fund Condition Because of General Fund and Education Protection Account Combined (In Millions) recent decisions Proposed for 2013-14 to change Proposed Percent 2012-13 Amount Change revenue accruals (discussed later Prior-year fund balance -$1,658 $850 Revenues and transfers 98,195 97,235 -1.0% in this report), Total resources available $96,537 $98,085 beginning with Expenditures $95,687 $96,353 0.7% the 2011-12 fiscal Ending fund balance $850 $1,732 year revenues are Encumbrances $618 $618 reservea $232 $1,114 no longer final a until about two Reflects the administration’s projection of the balance in the Special Fund for Economic Uncertainties. (The Governor’s 2013-14 budget plan proposes to continue suspending transfers to the Budget years after the Stabilization Account.) www.lao.ca.gov Legislative Analyst’s Office 5 2013-14 Budget reflects a cautious forecast for state and 2013-14 combined. These amounts revenues in 2013-14. Accordingly, the include greater savings associated with May Revision forecast projects that the dissolution of redevelopment agencies. all three of the state’s major taxes will (Because property tax revenues help satisfy produce less revenue than anticipated in the Proposition 98 minimum guarantee, the administration’s January forecast. In these higher projections offset General Fund total, administration revenue forecasts for Proposition 98 costs.) 2013-14 have been lowered $1.8 billion since • Some Different Programmatic Cost January, including a $920 million reduction Estimates. The May Revision includes a in the PIT forecast. To offset this drop, the number of changes to “baseline” estimates, May Revision includes a $500 million new some of which are summarized in Figure 2. proposed loan to the General Fund from These include changes in caseload and cap-and-trade auction revenues, which population assumptions, costs or savings is booked on the revenue side of the state related to actions outside of the state’s budget. In total, May Revision revenues control (such as decisions by the federal for 2013-14 are $1.3 billion below the government or the courts), assumed interest figure that the administration projected in rates that affect debt-service costs, and other January. methodological changes to programmatic • Higher General Fund Proposition 98 spending. Costs (-$1.9 Billion). The May Revision reflects significantly higher costs required Governor’s May Revision Proposals by the Proposition 98 minimum funding Fewer Significant May Policy Proposals Than in guarantee for schools and community Recent Years. In recent years, the May Revision has colleges. These higher costs result primarily typically included numerous proposals to mitigate the from recent decisions regarding how to state’s significant budget problems. This year’s May make Proposition 98 “maintenance factor” Revision contains just a few such proposals. payments in 2012-13. Figure 2 • Higher Forecast Major Changes to Programmatic Cost estimates of Property outside of Proposition 98a Tax Revenues 2012‑13 and 2013‑14 General Fund (In Millions) ($0.7 Billion). impact on reserve The May Revision includes Lower costs for bond debt service and short-term cash borrowing $484 Higher Medi-Cal costs -467 $736 million in Lower caseload for CalWORKs and SSI/SSP 221 projected higher Higher caseload for In-Home Supportive Services -200 Proposition 98 Lower caseload and increased SLOF funds for Cal Grants 85 Higher costs for CalFIRE fire suppression efforts -51 property tax a Relative to Governor’s January budget estimates. Reflects administration’s estimates. Excludes revenues over Proposition 98 changes. SLOF = Student Loan Operating Fund. 2011-12, 2012-13, 6 Legislative Analyst’s Office www.lao.ca.gov 2013-14 Budget Additional Deferral Payments, Funding for policy changes in the May Revision. Related to Common Core, K-12 Formula. With the higher his decision to use the state-based approach for projected revenues in 2012-13 and the resulting implementing federal health care reform, the increase in the Proposition 98 minimum guarantee, Governor proposes to achieve $300 million in the May Revision proposes to provide additional General Fund savings in 2013-14 by realigning some Proposition 98 funds in 2012-13 to retire payment responsibilities for California Work Opportunity and deferrals to schools and community colleges. Responsibility to Kids (CalWORKs), CalWORKs- This amount is partially offset by lower proposed related child care, and CalFresh to counties. This deferral payments in 2013-14, for a net increase of proposal is discussed later in the report. The $760 million in higher deferral payments across the Governor also proposes to loan $500 million from two years. The Governor’s May Revision also includes the Greenhouse Gas Reduction Fund to the General $1 billion for a new initiative to help school districts Fund. Under the administration’s multiyear budget implement the Common Core State Standards plan, this loan would not be repaid until after (CCSS) and $240 million in additional funding for 2016-17. Because the Governor’s January budget implementing the Local Control Funding Formula previously proposed to use cap-and-trade revenues to (LCFF). offset General Fund costs, the net incremental effect New Realignment Proposal, Cap-and-Trade in the May Revision is zero. Loan. Figure 3 displays major non-Proposition 98 Figure 3 Major Policy Changes in the May revision outside of Proposition 98a 2012‑13 and 2013‑14 General Fund (In Millions) Proposed Policy Changes impact on reserve Realign to counties some responsibilities for CalWORKs, CalWORKs-related child care, $300 and CalFresh Drop January proposal to implement managed care efficiencies -135 Increase taxes on Medi-Cal managed care plansb 107 Increase funding for counties to reduce the number of felony probation violations -72 Augment CalWORKs employment services -48 Loan cap-and-trade revenues to the General Fundc — a Relative to Governor’s January budget estimates. Reflects administration’s estimates. b Changes Governor’s January proposal from a gross premiums tax to a sales tax on managed care plans beginning in 2013-14. Total General Fund savings in the May Revision are $471 million in 2012-13 and 2013-14 combined. c Governor’s January budget proposed to use these revenues to offset General Fund costs. The net effect in the May Revision is zero. EcONOMic OuTLOOk Each May, our office releases an updated our forecast and the Department of Finance (DOF) forecast of trends in the U.S. and California May Revision forecast. Figure 5 compares these economies. Our forecast is summarized in indicators to those in prior forecasts from both Figure 4 (see next page). Figure 5 (see next page) DOF and the University of California, Los Angeles’ summarizes the major economic indicators in both Anderson School of Management. www.lao.ca.gov Legislative Analyst’s Office 7 2013-14 Budget Figure 4 LAO Economic Forecast Summary United States 2012 2013 2014 2015 2016 2017 2018 Unemployment rate 8.1% 7.7% 7.3% 6.7% 6.3% 6.0% 5.8% Percent change in: Real gross domestic product 2.2% 2.0% 2.8% 3.2% 2.8% 2.9% 2.6% Personal income 3.6 2.8 5.1 4.7 4.7 4.9 4.7 Wage and salary employment 1.7 1.5 1.6 1.8 1.7 1.3 0.9 Consumer price index 2.1 1.4 1.6 1.6 1.7 1.8 1.9 Housing starts (thousands) 782 970 1,265 1,567 1,609 1,582 1,589 Percent change from prior year 27.8% 24.1% 30.4% 23.8% 2.7% -1.7% 0.5% S&P 500 average monthly level 1,380 1,606 1,690 1,751 1,816 1,882 1,948 Percent change from prior year 8.7% 16.4% 5.2% 3.7% 3.7% 3.6% 3.5% Average target federal funds rate 0.14 0.16 0.16 0.19 1.64 3.57 4.00 California 2012 2013 2014 2015 2016 2017 2018 Unemployment rate 10.5% 9.3% 8.3% 7.5% 6.9% 6.5% 6.1% Percent change in: Personal income 4.0 3.3 5.9 5.4 5.2 5.3 4.7 Wage and salary employment 2.1 2.0 2.5 2.4 2.0 1.5 1.2 Consumer price index 2.2 1.4 1.6 1.6 1.7 1.8 1.9 Housing permits (thousands) 59 91 123 152 165 173 178 Percent change from prior year 23.4% 55.6% 35.5% 23.4% 8.6% 4.4% 3.1% Single-unit permits (thousands) 27 45 65 84 91 94 96 Multi-unit permits (thousands) 31 46 58 68 75 79 82 Figure 5 Comparing Current Economic Forecasts With Recent Forecasts 2013 2014 DOF UCLA DOF LAO DOF UCLA DOF LAO January March May May January March May May 2013 2013 2013 2013 2013 2013 2013 2013 United States Percent change in: Real gross domestic product 1.8% 1.9% 2.0% 2.0% 2.8% 2.8% 2.8% 2.8% Personal incomea 3.8 2.6 2.8 2.8 4.8 5.4 5.1 5.1 Wage and salary employment 1.5 1.5 1.5 1.5 1.6 1.8 1.6 1.6 Consumer price index 1.9 1.6 1.8 1.4 2.0 2.2 1.9 1.6 California Percent change in: Personal income 4.3% 2.9% 2.2%a 3.3% 5.5% 5.8% 5.7% 5.9% Wage and salary employment 2.1 1.4 2.1 2.0 2.4 2.1 2.4 2.5 Unemployment rate 9.6 9.6 9.4 9.3 8.7 8.4 8.6 8.3 Housing permits (in thousands) 81 69 82 91 123 100 121 123 a The January 2013 forecast assumed continuation of the payroll tax cut, which increased personal income. Later forecasts reflect congressional actions to end the payroll tax cut. The DOF and LAO May 2013 forecasts assume a virtually identical level of 2013 California personal income, but the administration’s personal income growth rate is smaller due at least in part to its usage of alternative data sources for prior years, as opposed to the most recent BEA data on 2012 personal income. DOF = Department of Finance; UCLA = University of California, Los Angeles’ Anderson School of Management Forecast; and BEA = Federal Bureau of Economic Analysis. 8 Legislative Analyst’s Office www.lao.ca.gov 2013-14 Budget key Points likely will benefit California’s budgetary outlook in the near term. The May Revision does not Administration’s Economic Viewpoints reflect some of these positive economic trends. Seem Too Pessimistic. The administration’s Below, we summarize key points from our economic forecast data generally reflects the office’s economic forecast. continuing recovery of California’s economy—a recovery that seems to have taken hold in recent u.S. and Global Economies months. For example, the administration’s Despite Federal Sequestration, Acceleration forecast for growth in wages and salaries in in U.S. Growth Expected. Our office’s forecast California in 2013 is slightly more optimistic projects 2.0 percent real growth in U.S. gross than our own. domestic product (GDP) in 2013 and 2.8 percent Yet, the administration’s description of the growth in 2014. We expect that the federal state’s economy in the May Revision summary spending sequester will moderate real GDP seems unduly pessimistic. We think that the state growth through mid-2013, but that overall and national economic outlooks have remained, growth of the nation’s economy will accelerate at worst, steady since January. While the federal in the second half of the year. (In total, federal government has implemented sequestration cuts, sequestration is assumed to reduce 2013 GDP these cuts have not yet precipitated a substantial growth by around half a percentage point pullback in consumer or business activity. The compared to what it would be otherwise.) We expiration of the payroll tax cut reduces personal expect capital equipment spending to be a income growth by less than 1 percentage point driver of GDP growth this year, with additional in 2013 and affects both of our offices’ outlooks growth in 2014. Nationally, oil and gas drilling for California taxable sales. Still, it is important activity is growing in economic significance. to note that the slowing of taxable sales growth— Rising demand and an increase in the rate of following recent, rapid increases that exceeded household formation are propelling the recovery the rate of personal income growth—was of the housing sector. The data in the DOF inevitable, even if it occurred a bit earlier than economic forecast seems to reflect very similar we were expecting. assumptions about the growth of the U.S. In general, our office’s view on the economy economy. remains similar to what it was in January when Growth in Private Sector Jobs Offsetting we released our Overview of the Governor’s Employment Weakness in Public Sector. The Budget. There are always economic risks, and latest national jobs report from the federal unemployment remains elevated. Yet, the Bureau of Labor Statistics showed that April economy is expanding, more or less as expected. payroll jobs increased by 165,000, and this report In addition, the Governor’s own economic also revised estimates for previous months forecast reflects a view that asset markets upward. Over the past 12 months, in percentage (principally stocks) generated considerably terms, the fastest-growing major job category more capital gains for Californians than the has been temporary help (up 7.4 percent from administration previously expected in 2012. 12 months ago), which is likely a sign of future Importantly, stock prices also have risen hiring growth. In addition, both professional markedly since the beginning of 2013. Barring a and technical services, as well as leisure and major stock price correction in 2013, these trends www.lao.ca.gov Legislative Analyst’s Office 9 2013-14 Budget hospitality jobs, have performed well over the last federal leaders concerning the debt ceiling— year. Federal government employment, however, specifically, raising the possibility of the U.S. has declined, and the federal spending sequester defaulting on its sovereign debt—could reduce may also slow job growth in private industries economic activity below the level assumed in our that contract with the U.S. government. forecast, just as occurred during the 2011 debt Declining defense spending, for example, has ceiling debate. dragged down GDP growth recently and could california’s Economy continue to affect private hiring (including in regions of California with a large military House Price and Construction Outlooks presence, such as San Diego). As spending at the Brightening. The recovery of house prices is now federal level has slowed, we expect continuing well underway in both California and the rest gains in the private economy and state and local of the nation. Our forecast assumes that house government spending to be key drivers of 2013 prices in California continue to recover from growth. their recession lows. Nevertheless, after several Federal Deficit Narrowing, but Washington years of growth, we forecast that major indices of Remains an Economic Wild Card. The federal California house prices in 2018 will remain well budget deficit has declined due to recent tax under their prerecession peak levels. The growth increases (including the end to the payroll tax rates for house prices in coastal, urban areas of cut and higher taxes for high-income individuals the state likely will outpace growth elsewhere, as adopted as part of the “fiscal cliff” agreement many other areas continue to struggle with the in January), spending reductions, economic lingering effects of the housing downturn. growth, and recent growth in the stock market Our forecast assumes steady growth in (which affects federal capital gains taxes). The housing construction in California, which, in federal deficit equaled 8.7 percent of GDP in turn, should help improve job growth in the 2011 and declined in 2012. Our forecast assumes state’s construction industries and contribute the deficit will decline to around 5 percent to annual growth in taxable sales. We also of GDP in 2013. (The Congressional Budget forecast that between 2013 and 2018, growth in Office announced this week that it projects construction jobs will outpace that in nearly all an even larger decline—to 4 percent of GDP.) other major employment categories, growing at Nevertheless, Congress and the President will about 5 percent per year. By 2018, under these need to come to agreement on avoiding another assumptions, the number of construction jobs in threat of a federal government “shutdown” California would still be about 10 percent below later this year and on increasing further the its prerecession peak. debt ceiling (the statutory limitation on U.S. State and Local Governmental Employment government debt). The next deadline for and Health Jobs Likely to Increase. Among increasing the debt ceiling has moved to later the two largest employment categories in both this year—likely to this fall—due to improving California and the rest of the nation are state and federal budgetary trends. To date in 2013, federal local government employment and health care. leaders have avoided another damaging debt In recent years, budget cuts have led to ceiling debate. As in our recent forecasts, we declines in state and local employment. For observe that a resumption of brinksmanship by the U.S as a whole, state and local governments 10 Legislative Analyst’s Office www.lao.ca.gov 2013-14 Budget employ about 14 percent of all nonfarm workers, work. As of March 2013, the state’s unemployment and employment by these governments has rate was 9.4 percent. Our forecast projects that the declined by about 750,000 (down 3.8 percent) number of unemployed individuals in California since 2008. In California, state and local will fall to around 1.2 million by 2018. At that governments employ 14.6 percent of nonfarm time, the state’s unemployment rate would be workers, and employment by these governments around 6.1 percent (which is 1.3 percentage points has declined by around 150,000 (down above the state’s unemployment rate at the time of 6.7 percent) since 2008. Consistent with the the prerecession peak). recent improvement in state and local revenues, The labor markets in California have improved our forecast assumes that employment by these recently. In recent months, the number of governments will begin to expand again this year. Californians classified as unemployed for long Nearly 80 percent of state and local workers in periods also has declined. Those unemployed for California are employed by local governments, over 26 weeks fell from 955,000 in March 2012 and of these, more than half work for school and to 820,000 in March 2013 (as measured by a community college districts. Recent increases 12-month moving average). The sharpest decline in Proposition 98 funding should lead to more was among those classified as unemployed hiring by those districts. Our forecast projects for 52 weeks or more—down from 726,000 in that California state and local government March 2012 to 600,000 in March 2013. Those employment returns to prerecession levels in unemployed 52 weeks or more still make up about 2018. During the same period, federal government one-third of California’s unemployed—a figure employment in the state—a much smaller part of that remains troublingly high. California’s employment picture—is projected to In recent years, labor force participation decline by 7 percent due to lower federal spending. rates—the percentage of the population working The trend in federal employment is expected to or seeking work—have been falling in both be the worst of any major employment sector in California and the rest of the country. Currently, California through 2018. California’s labor force participation rate is In contrast, health care jobs in California 63 percent—about the same for the nation (about 11 percent of all nonfarm workers) as a whole—but this level is down from the generally increased through the recession at a participation rate before the recession (66 percent). fairly steady pace. Our forecast assumes that To a certain extent, this decline results from an health employment in California will increase aging population, but there are other reasons for by an average of over 2 percent per year through this trend. Currently, for example, Employment 2018—producing around 200,000 additional jobs. Development Department data indicates that Additional job gains are possible as governments the number of Californians not in the labor and the health care industry implement the federal force (meaning they are not actively searching Patient Protection and Affordable Care Act (ACA). for work), but still interested in a job, is about Long-Term Unemployment Falling, but one million—up 5 percent from one year ago. Remains a Concern. About 1.75 million Some of these individuals may have been classified Californians currently are classified as as unemployed in the past (meaning they were unemployed—not working, but actively seeking then actively searching for work). www.lao.ca.gov Legislative Analyst’s Office 11 2013-14 Budget REvENuE OuTLOOk Figure 6 summarizes General Fund and Administration’s Forecast Raises January Education Protection Account revenues that Revenue Estimates by $749 Million. Due to the are projected in the administration’s revised state’s new revenue accrual policies, the May May 2013 forecast. Figure 7 displays our office’s Revision forecast now needs to reflect changes not revenue forecast, assuming implementation of the only to current-year (2012-13) and budget-year Governor’s proposed May Revision budget policies. (2013-14) revenue projections, but also projections for the prior year (2011-12). Across these three key Points fiscal years, compared to the Governor’s budget Figure 8 compares the administration’s May forecast from January, the administration’s May Revision forecast and our updated forecast to forecast projects higher revenues and transfers the forecast that the administration released in of $749 million. This $749 million consists of January. a $285 million lower forecast for 2011-12, a $2.8 billion higher forecast for 2012-13, and Figure 6 Administration Revenue Forecast Summary General Fund and Education Protection Account Combined (In Millions) 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 Personal income tax $54,261 $63,901 $60,827 $67,132 $71,762 $74,985 Sales and use tax 18,658 20,240 22,983 24,702 26,327 26,962 Corporation tax 7,233 7,509 8,508 9,095 9,639 10,074 Subtotals, “Big Three” Taxes ($80,152) ($91,650) ($92,318) ($100,929) ($107,728) ($112,021) Insurance tax $2,165 $2,156 $2,200 $2,265 $2,481 $2,551 Other revenues 2,959 2,641 2,249 1,858 1,840 1,827 Net transfers and loans 1,509 1,748 468 -520 -1,892 -299 Total Revenues and Transfers $86,786 $98,195 $97,235 $104,532 $110,158 $116,100 Differences From LAO Forecast $322 -$690 -$2,794 -$2,459 -$2,118 -$2,838 Figure 7 LAO Revenue Forecast Summary General Fund and Education Protection Account Combined (In Millions) 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 2017-18 Personal income tax $53,889 $64,453 $64,320 $70,354 $74,676 $78,606 $82,909 Sales and use tax 18,658 20,394 22,194 23,735 25,348 26,032 26,495 Corporation tax 7,283 7,500 8,600 9,300 9,800 10,200 10,600 Subtotals, “Big Three” Taxes ($79,830) ($92,347) ($95,114) ($103,389) ($109,824) ($114,838) ($120,004) Insurance tax $2,165 $2,150 $2,200 $2,260 $2,490 $2,570 $2,670 Other revenues 2,959 2,640 2,246 1,861 1,853 1,829 1,832 Net transfers and loans 1,509 1,748 468 -520 -1,892 -299 282 Total Revenues and Transfers $86,463 $98,884 $100,028 $106,991 $112,276 $118,938 $124,788 12 Legislative Analyst’s Office www.lao.ca.gov 2013-14 Budget Figure 8 Comparisons With Prior Revenue Forecastsa General Fund and Education Protection Account Combined (In Millions) 2012-13 2013-14 DOF DOF LAO DOF DOF LAO Jan. 2013 May 2013 May 2013 Jan. 2013 May 2013 May 2013 Personal income tax $60,647 $63,901 $64,453 $61,747 $60,827 $64,320 Sales and use tax 20,714 20,240 20,394 23,264 22,983 22,194 Corporation tax 7,580 7,509 7,500 9,130 8,508 8,600 Subtotals, “Big Three” Taxes ($88,941) ($91,650) ($92,347) ($94,141) ($92,318) ($95,114) Insurance tax $2,022 $2,156 $2,150 $2,198 $2,200 $2,200 Other revenues 2,631 2,641 2,640 2,185 2,249 2,246 Net transfers and loans 1,800 1,748 1,748 -23 468 468 Total Revenues and Transfers $95,394 $98,195 $98,884 $98,501 $97,235 $100,028 a In addition, the Department of Finance (DOF) May 2013 forecast updated revenues to 2011-12—reducing them, compared to the January forecast by $285 million. Our 2011-12 revised forecast is lower than DOF’s May forecast by an additional $322 million. a $1.8 billion lower forecast for 2013-14 (not from 2013 to 2012 related to the lower federal including the administration’s new proposal to loan tax rates that were then in effect, but also by the $500 million of cap-and-trade auction revenues to administration’s lowered capital gains forecasts for the General Fund, which is booked on the revenue 2013. side of the budget). LAO Revenues $3.9 Billion Higher The recent $4.5 billion surge of General Than January Estimates. Compared to the Fund and Education Protection Account PIT administration’s January revenue estimates, our revenues affects the state’s budgetary revenue office’s revised forecast projects that General totals primarily in 2012-13, with a part of the Fund and Education Protection Account revenue influx “accrued back” (attributed for revenues will be $3.9 billion higher for 2011-12, state budget accounting purposes) to 2011-12. 2012-13, and 2013-14 combined (again, without The administration’s forecast for PIT revenues counting the administration’s new cap-and-trade in 2011-12 and 2012-13 combined is $3.7 billion loan proposal). Specifically, compared to the higher, which suggests that May and June revenue administration’s January estimates, our 2011-12 collections—as well as PIT accruals—will, in the forecast is $608 million lower, our 2012-13 forecast aggregate, be around $800 million weaker than is $3.5 billion higher, and our 2013-14 forecast assumed in January, thereby eroding a portion is $1 billion higher. The two major differences of the revenue gain. In 2011-12 and 2012-13, the between our office’s updated forecast and the May forecast also lowers previous projections for CT and Revision forecast are (1) our office’s significantly SUT collections. Compared to the January forecast, higher assumed level of capital gains and resulting the administration has lowered its projections for PIT revenues in 2013-14 and (2) our office’s lower all three of the state’s major taxes in 2013-14. The projected level of SUT collections in 2013-14. Our forecast assumes that total PIT revenues will be forecast takes into account the recent, sharp increase over $3 billion lower in 2013-14 than in 2012-13. in stock prices, which likely will boost 2013-14 This drop is explained partly by the significant revenues. We do not believe the administration’s amount of assumed capital gains “accelerations” forecast takes account of this trend. www.lao.ca.gov Legislative Analyst’s Office 13 2013-14 Budget While there are other revenue changes in our generally can predict neither asset bubbles nor forecast, we project that PIT collections in 2011-12 the typical month-by-month volatility in stock and 2012-13 combined are $3.9 billion higher than prices. Given this fact, the standard approach we the administration forecast in January. Therefore, have used in recent years to forecast California like the administration, we assume that May and tax revenue from capital gains has assumed that June revenue collections—as well as PIT accruals— asset prices rise in the future at a fairly steady rate will, in the aggregate, erode a portion of the recent approximating the assumed growth of the nation’s $4.5 billion revenue surge. economy. This approach implicitly assumes that investors currently are paying reasonable prices Personal income Tax for stocks based largely on the future income that The largest differences between the two May companies are likely to generate. Revision revenue forecasts concern PIT revenues. Recently, large increases in stock and some Wages and salaries account for the majority of other asset prices have given rise to concerns Californians’ taxable income, and our offices’ that new asset bubbles are being created now. forecasts for this category of taxable income (Figure 9 shows the recent, upward trend of the differ by under 1 percent per year through 2015. Standard and Poor’s [S&P] 500 stock index.) Substantial differences, however, are apparent in Recent corporate profit growth trends—which our respective forecasts’ assumptions about net have helped facilitate the stock market rise—are realizations of capital gains (resulting from sales unlikely to continue (a projection embedded of stock and other assets) in 2013 and beyond. in our own forecast model), and particularly if This section describes our current perspectives on corporate profits enter a weak period, a stock asset markets (including the stock market) and market “correction” could occur. As they set the capital gains taxation. state’s future budgetary plans, California’s elected Currently, Limited Evidence of Asset Price leaders should be aware of the concerns about “Bubbles.” It has proved very difficult over time asset bubbles and their potential effects on tax for economic forecasters—including both our revenues. office and DOF—to spot bubbles in the prices of That being said, there is limited evidence to assets, such as prices of stocks and homes, before suggest that bubbles currently are widespread in the bubbles “burst” and prices decline. This is asset markets. Corporate earnings have grown important because the creation and bursting strongly in recent years and have appropriately of asset bubbles have been major contributors pushed stock prices upward. As of May 14, for to California’s revenue volatility. Bubbles cause example, the price-to-earnings ratio of the S&P increases (and, following their bursting, rapid 500 stock index was about 19-to-1. By contrast, decreases) in capital gains realized by high-income the ratio rose to 34-to-1 in 1999 during the taxpayers, who are taxed at the highest marginal “dot-com” bubble, and the mean ratio over a long rates in California’s progressive income tax rate period has been about 15.5-to-1. The S&P 500 structure. (The tax structure has become even price-to-“book value” ratio was about 2.5-to-1, more progressive since November 2012, when which is comparable to historical averages voters passed a temporary increase in marginal and well below the comparable ratio in 2000 income tax rates affecting the top 1 percent of (during the dot-com bubble). Potential bubbles taxpayers as part of Proposition 30.) Forecasters in commodities such as silver and gold recently 14 Legislative Analyst’s Office www.lao.ca.gov 2013-14 Budget have burst, with little apparent economic impact. the relationship between stock prices and this House prices are rising, but only after they fell important state revenue source, every California sharply in many regions several years ago. To state budget forecast explicitly or implicitly some extent, the recent rise in stock prices may reflects some assumption about the future be influenced by bond yields that have been kept direction of the stock market. low by accommodative monetary policy, but as Role of Capital Gains in California’s Budget. a consequence of the various weaknesses in the Capital gains are a significant, but volatile, economy described above, this monetary policy is component of California’s PIT revenues. In likely to continue at least into 2014 and thereafter most recent years, 40 percent to 50 percent of be altered only gradually. PIT revenues have been paid by the 1 percent of These facts suggest limited evidence of a California tax filers with the most income (as of Graphic Sign Off significant, current bubble in stock and other 2011, those tax returns with over $1.4 million of asset markets. Accordingly, we are utilizing adjusted gross income). Capital gains are a large Secretary assumptions for future stock market growth in portion of these taxpayers’ income, and their Analyst this forecast that are consistent with those used in income tax liabilities attributable to capital gains Director prior LAO revenue forecasts. As discussed below, vary widely from year to year, principally based Deputy capital gains driven largely by stock market trends on trends in prices of stocks and property. In the are a major factor in forecasting California’s last decade, income taxes paid by individuals revenues. In fact, our statistical models indicate on their capital gains have totaled as little as that changes in stock and property prices have $2.6 billion in 2009 (about 3 percent of all General accounted for about 80 percent of the annual Fund revenues) and as much as $12 billion in 2007 changes in capital gains. Due to the strength of (about 12 percent of General Fund revenues). Figure 9 S&P 500 Index Has Risen Markedly in Recent Months (Through May 14, 2013) 1700 1650 1600 1550 1500 1450 1400 1350 1300 January 2013 February 2013 March 2013 April 2013 May 2013 ARTWORKw#w1w30.l2ao8.4c_a.Mgoavy RLeegviisslaitoivne Analyst’s Office 15 2013-14 Budget While Accelerations Were a Factor, Other that around $2.9 billion of total acceleration Causes for Revenue Surge Remain Unclear. The tax payments were received, which is about role of capital gains in the state budget recently $1.2 billion above the level already assumed in the was highlighted by the influx of $4.5 billion of January administration forecast. In short, both unanticipated revenues between January and April. of our forecasts suggest that higher capital gains While accelerations of capital gains from 2013 to accelerations caused only a part of the $4.5 billion 2012 certainly were one factor behind the revenue revenue surge of recent months. surge, the reasons for the bulk of the tax surge Our forecasts’ capital gains assumptions for remain unclear. Solid data on capital gains and this year are based on limited data. Similarly, data other income reported on 2012 tax returns will take is not yet available to explain the reason for most months to compile, which means that forecasters of the rest of the revenue surge in 2012-13. Such currently have to make various assumptions based unexplained variances in state tax collections are on limited data. common. Forecasting revenues in a state with an Prior forecasts of both our office and DOF economy as complex—and a tax system as volatile— already assumed significant accelerations of capital as California’s requires making assumptions each gains realizations from 2013 to 2012. In our prior year despite these uncertainties. We attempt to forecasts, both the LAO and DOF assumed that make reasonable assumptions based on the often 20 percent of net capital gains realizations that limited data available. In this forecast, for example, otherwise would have occurred in 2013 would occur we assume some revenue collections related to instead in 2012 due to the federal tax changes. In tax year 2012 will not recur in later years. The our respective May forecast updates, both of our PIT revenues generated by one-time transactions offices have increased this acceleration assumption. related to Facebook’s initial public offering (which The DOF forecast now assumes that 25 percent of we think may have been higher than assumed 2013 capital gains realizations were accelerated, in the November 2012 and January 2013 budget and our forecast now assumes that 28 percent were forecasts) are an example of revenues that will not accelerated. These accelerations have the effect of recur. While Facebook’s initial public offering was increasing near-term revenue collections, while definitely a one-time event, other portions of the eroding future revenue collections. unanticipated 2012 tax year revenue may actually Nevertheless, neither of our updated forecasts prove to be recurring. Thus, while it is possible our seems to adopt the thesis that a large portion of PIT assumptions will prove to be too optimistic, it is the $4.5 billion tax surge was related to increased also possible they will prove to be too cautious. accelerations. By increasing the acceleration factor Assumptions for Future Stock Performance in its forecast from 20 percent to 25 percent, we in Our Forecast. As of May 14, the S&P 500 index can make a rough estimate that DOF implicitly closed at the level of 1650—up from 1426 at the assumes that around $2 billion of total accelerated end of 2012. Our capital gains forecast model is tax payments were received, which is only about built around an assumption for the average daily $400 million more than the accelerations already close of the S&P 500 in each quarter. Our model reflected in the Governor’s budget forecast in assumes that these quarterly averages remain close January. Our office’s forecast—with its higher to the May 14 level of the S&P 500 index through overall capital gains assumptions and a change the rest of 2013. Thereafter, we assume that the in the acceleration factor to 28 percent—assumes average S&P 500 close in each quarter increases 16 Legislative Analyst’s Office www.lao.ca.gov 2013-14 Budget about 0.9 percent—slower than the growth rate realizations than we do in 2013 and beyond— for personal income in our forecast. This sort of slightly less than the administration’s own forecast assumption has been typical in our recent forecasts. assumed in January 2013 and considerably less than Even accounting for the recent growth in the the administration’s forecast in January 2012 (a stock market, our forecast for 2013-14 PIT revenues capital gains forecast that, in retrospect, seems to is $133 million (0.2 percent) less than our PIT have been reasonably accurate last year). We find the forecast for 2012-13. While accelerations may not administration’s pessimism surprising given that (1) explain a large portion of the recent tax revenue the administration’s own estimates of 2012 capital surge, they remain substantial and are a major gains are stronger than they were a few months cause of this projected, but small, year-over-year ago (both with and without assumptions regarding net decline in PIT revenue. (The administration’s capital gains accelerations) and (2) the stock market Graphic Sign Off 2013-14 PIT revenue forecast reflects an even greater is much higher than it was in January. drop from 2012-13—down 4.8 percent—due in part Our capital gains assumptions seem consistent Secretary to its lower assumptions for capital gains in 2013.) with historical averages for this very volatile part Analyst Assumed Capital Gains in Our Forecast of the taxable income base. Figure 10 shows capital Director Compared to Historical Levels. Our forecast gains as a percentage of California personal income Deputy assumes that net capital gains realizations by since 1994. From 1994 through 2011, Californians’ Californians totaled $105 billion in 2012 (virtually capital gains have averaged 5.2 percent of personal identical to DOF’s current assumption). In 2013, income. On average, our forecast assumes that we assume that the accelerations reduce net capital capital gains equal 5.1 percent of personal income gains to $74 billion ($15 billion above DOF’s between 2012 and 2018 (compared to 4.5 percent assumption). In 2014, when the accelerations Figure 10 no longer have a Capital Gains Forecast Assumptions: As Percent of Personal Income significant influence on our model, net capital 12% gains rise to $103 billion Forecast ($20 billion above Assumptions 10 DOF’s assumption). This roughly $20 billion 8 difference persists through the remainder of our forecast period, 6 LAO accounting for the largest share of the 4 DOF difference between our respective PIT 2 revenue forecasts. Our best assessment is that DOF simply assumes 1995 2000 2005 2010 2015 lower capital gains DOF = Department of Finance wAwRwT.lWaoO.caR.gKo#v1 3 L0e2g8is4la_tiMvea Ay nRaleyvsti’ssi oOnffice 17 2013-14 Budget in DOF’s forecast). The administration’s economic will end up considerably lower than projected. forecasters also compare capital gains to California (Obviously, there is a greater risk of this if the state GDP. From 1994 through 2011, capital gains have uses our office’s higher revenue projections for averaged 4.4 percent of California GDP. On average, the 2013-14 budget plan.) There is also a chance our forecast assumes that capital gains equal that revenues will end up higher than expected, 4.3 percent of California GDP between 2012 and even compared to our office’s forecast. In the 2018 (compared to 3.8 percent in DOF’s forecast). end, revenues will differ from estimates one Capital Gains and Stock Market Will Be way or another—perhaps by billions of dollars. Volatile and Make Budgeting More Difficult. Our Our office attempts to take our “best shot” at model assumes a fairly modest, “straight-line” making a projection with the release of each state growth rate for stock prices and annual capital revenue forecast. With regard to capital gains, our gains totals in line with historical averages. We projections seem to us to be neither too cautious acknowledge, however, that capital gains and nor too optimistic based on the recent status of the resulting PIT revenues will not exhibit a financial markets. straight-line trend in the future. Instead, capital Other Revenue issues gains and these tax revenues will be volatile. That is, it is likely that capital gains-related taxes will Lower Sales Tax Forecast in 2013-14. Our exceed our forecasts in some years and fall short in forecast assumes slightly higher General Fund SUT other years—sometimes by billions of dollars. This collections than the administration in 2012-13 complicates the work of the state’s elected leaders in but is $789 million lower than the administration a number of ways. First, it means that each annual for 2013-14. Taxable sales in California—the budget has to be passed without knowing whether main determinant of SUT revenue—declined the subsequent year will be a “good” capital gains substantially during the recession as consumers year or a “bad” one. In the latter circumstance, the and businesses delayed major purchases, especially fiscal year can close with a shortfall, necessitating of vehicles, industrial equipment, and household budget cuts or other budget actions in the ensuing appliances. Since that time, taxable sales have year. Second, the volatility of capital gains makes grown briskly from their historically depressed it very difficult to plan for the state’s annual level levels—with taxable sales growth rates exceeding of required school spending under Proposition 98, the growth of personal income in the state, as given that Proposition 98 is affected significantly shown in Figure 11 (see page 20). In prior forecasts, by the year-over-year growth rate in state our office has noted that the annual growth in General Fund revenues. These challenges are only taxable sales should revert to more normal levels increasing due to Proposition 30, recent decisions over time as consumers and businesses return to about how to make Proposition 98 maintenance typical consumption patterns. In recent months, factor payments, and the state’s recently adopted actual taxable sales growth has been markedly revenue accrual policies. (The nearby box discusses slower than our most recent estimates, leading those accrual policies.) both our office and the administration to revise Caution Is Appropriate Concerning Capital downward 2012-13 General Fund SUT estimates. Gains. Caution is in order for the state’s elected The administration essentially projects that this leaders. No matter which revenue assumptions are downward trend will reverse itself for a time used in the budget, there is a risk that revenues (DOF projects taxable sales to grow by more than 18 Legislative Analyst’s Office www.lao.ca.gov 2013-14 Budget accrual Policy complicates Budgeting and Diminishes Legislative authority 2011-12 Revenues Will Continue to Evolve. The state’s 2011-12 fiscal year “ended” over ten months ago, but the May Revision decreases the estimates of state revenues for that fiscal year by $285 million. Under the state’s new revenue accrual approach for Proposition 30 and Proposition 39 revenues, a portion of collections for 2012 were “accrued back” to 2011-12. The 2011-12 revenue amount will continue to change until 2014 or even longer because solid data on what the state collected in 2012 tax revenues will take many months to compile. This practice is slated to continue in the administration’s budget plan. More 2013 tax collections than are actually collected prior to June 30, 2013 will be accrued back to the current fiscal year, and so on, for each year that the policy remains in place. These accruals are difficult for revenue forecasters to predict and add to the already substantial possibility of error in state budget revenue forecasts. Not Knowing Last Year’s Revenues Complicates Budgeting. As anyone who reads this publication’s Proposition 98 description will see, the amount of revenues in each specific year determines not only how much money is available for state spending, but also how much must be spent on schools. It is becoming increasingly unmanageable for policymakers to set each year’s state budget plan without a clear idea of how both the current and prior fiscal years ended. Current Accrual Policies Diminish Legislative Authority. The current accrual process—for all revenues, including Propositions 30 and 39—lacks transparency. Executive branch officials seem to have broad flexibility concerning the fiscal year to which each revenue dollar is assigned. This, in turn, could allow a Governor to increase or decrease the Proposition 98 guarantee as he or she sees fit. Moreover, in the rare fiscal year like this one (in which the current method for paying Proposition 98 maintenance factor is absorbing more than every dollar of increased revenue), continuing to accrue next fiscal year’s cash into the current fiscal year results in the Legislature having less flexibility to set its own budgetary priorities. Recommend Transitioning to Simpler Accrual Policy. Returning state budgetary revenue accounting to something approximating a cash basis—counting revenues in the fiscal year in which they are collected—would correct these problems. A multiyear transition plan is required, which, by its nature, will result in the Proposition 98 minimum guarantee being more or less in the years during the transition. We recommend that the Legislature direct the administration to submit a multiyear plan for a return to a transparent, logical, and simpler budgetary revenue accrual policy. 8 percent in 2013-14), whereas we think that taxable dollars less in CT revenues in 2013-14 compared sales growth has begun to normalize, resulting to the January 2013 administration forecast. in our lower (5 percent annual growth) growth Nevertheless, we caution, as we have for some expectation for 2013-14. time now, that this tax remains very difficult to Corporate Income Taxes Remain Difficult to predict, given the wide array of recent CT policy Project. Currently, our forecast for CT revenues changes adopted by the state (the estimated is similar to that of the administration. Both of effects of which remain somewhat unclear) and our forecasts anticipate hundreds of millions of other recent developments. Among those recent www.lao.ca.gov Legislative Analyst’s Office 19 Graphic Sign Off Secretary Analyst Director Deputy 2013-14 Budget during the budget crisis. Figure 11 Higher or lower levels Taxable Sales Growth Forecast to Normalize of these deductions in Percent Change From Same Quarter Prior Year 2012 could affect future 15% Taxable Sales forecasts by hundreds of Forecast California Personal Income millions of dollars per 10 year. Administration’s 5 Business Tax Proposal. The administration’s May Revision -5 submissions to the Legislature include a -10 proposal—described by the administration as -15 “revenue neutral”—to change certain business -20 2008 2009 2010 2011 2012 2013 2014 tax provisions. The proposal lacks some developments has been a marked increase in CT key details, but seems ARTWORK#130284_May Revision refunds in 2012-13—up 51 percent from the prior to be focused on shrinking over time the scale fiscal year through April. We understand that a of parts of California’s existing enterprise zone portion of this higher refund activity relates to the tax program. The proposal, as we understand resolution of certain large business tax disputes by it, also would eliminate the state General Fund the Franchise Tax Board, and this refund activity portion of the sales tax on certain manufacturing in turn has resulted in a larger amount of CT and biotechnology equipment, change a state refunds accrued to the prior fiscal year (2011-12). hiring tax credit (which was little used during These accrual developments are responsible for a the recession), and establish a “recruitment and part of the administration’s $716 million reduction retention” fund that the Governor’s Office of of its 2011-12 CT forecast. Our forecast assumes Business and Economic Development would that further such refund activity continues in the administer to grant tax credits to businesses that coming months. Moreover, our forecast reflects meet certain jobs-related criteria. Our revenue some degree of caution due to the weak results for forecast assumes, based on the administration’s April 2013 estimated payments by corporations, stated goals, that the plan, if adopted, would be which were 1 percent below those of April 2012. revenue neutral through at least 2017-18. In reality, In the coming months, a particularly important it will be very difficult for the administration new set of data we will have to consider will be to design an approach that is precisely revenue the level of net operating loss deductions claimed neutral in future years. by larger California businesses in 2012, the first Our initial impression is that there are some year they can use these deductions after they were positive parts of this proposal—specifically, as prevented from claiming them for a few years we understand it, scaling back the ineffective 20 Legislative Analyst’s Office www.lao.ca.gov 2013-14 Budget enterprise zone program and reducing certain providing windfall gains to businesses for decisions manufacturing sales taxes. (Such taxes are one of they would have made even without the tax a number of state tax provisions that create “tax incentives. In general, we advise the Legislature to pyramiding”—an economically distortionary move toward state tax changes that spread the cost phenomenon whereby businesses pay sales tax of public services over the broadest base possible, on their equipment and their customers then pay with fewer tax expenditures focused on select additional sales tax on the final product itself.) segments of the economy. By doing this, the state On the other hand, we are skeptical that the would have the option of lowering certain marginal hiring credit and incentive fund can be designed tax rates and yet be able to collect approximately in ways that achieve their stated goals without the same amount of tax revenue. PROPOSiTiON 98—k-14 EDucaTiON Approved by voters in 1988, Proposition 98 updated 2012-13 local property tax estimates established a set of rules relating to education almost identical to the January estimates. Whereas funding. Most importantly, Proposition 98 the guarantee in 2012-13 is notably higher, the established a funding requirement commonly guarantee in 2013-14 is notably lower. The 2013-14 referred to as the minimum guarantee. The minimum guarantee under the May Revision minimum guarantee is determined by various is $55.3 billion—down almost $1 billion from inputs (including General Fund revenues and K-12 the January level. Because the updated 2013-14 average daily attendance) and formulas (including local property tax estimate is significantly higher calculations that compare growth in per capita than the January estimate (up $579 million), the General Fund revenues with growth in per capita General Fund Proposition 98 cost for 2013-14 is personal income). The guarantee is funded with estimated to be $1.5 billion lower than the January state General Fund revenues and local property estimate. As discussed in more detail later in this tax revenues. Funding provided for schools, the section, almost the entire change in the guarantee California Community Colleges (CCC), preschool for these two fiscal years is driven by changes in programs, and various other state education state revenues, with updated estimates of student programs count toward meeting the guarantee. attendance in 2012-13 and 2013-14 up only slightly This section of the report describes and assesses from the January estimates. the Governor’s May Revision Proposition 98 Changes in Guarantee Linked With Notable proposals. Changes in Proposition 98 Spending. Figure 13 (see next page) shows the May Revision changes Overview of Governor’s May Revision Proposal in Proposition 98 spending. Of the $2.9 billion Proposition 98 Funding Changes Significantly increase in the 2012-13 guarantee, the Governor in May Revision. Shown in Figure 12 (see next designates $1.8 billion for paying down additional page), the 2012-13 minimum guarantee under the deferrals, $1 billion for a new initiative to help May Revision is $56.5 billion—almost $3 billion school districts implement the Common Core higher than the January level. Virtually the entire State Standards (CCSS), and the remainder for increase reflects higher General Fund costs, with various relatively small baseline adjustments mostly www.lao.ca.gov Legislative Analyst’s Office 21 2013-14 Budget Figure 12 Proposition 98 Funding (In Millions) 2012-13 2013-14 May May January Revision Change January Revision Change Preschool $481 $481 — $481 $482 — K-12 Education General Fund $33,406 $36,196 $2,790 $36,084 $35,028 -$1,057 Local property tax revenue 13,777 13,773 -5 13,160 13,668 508 Subtotals ($47,183) ($49,968) ($2,786) ($49,244) ($48,696) (-$548) California Community Colleges General Fund $3,543 $3,699 $157 $4,226 $3,761 -$464 Local property tax revenue 2,256 2,253 -3 2,171 2,242 71 Subtotals ($5,799) ($5,953) ($153) ($6,397) ($6,003) (-$393) Other Agencies $78 $78 — $79 $78 -$1 Totals $53,541 $56,480 $2,939 $56,200 $55,259 -$941 General Fund $37,507 $40,454 $2,947 $40,870 $39,349 -$1,521 Local property tax revenue 16,034 16,026 -8 15,331 15,910 579 associated with changes in revenue limit costs. Of college proposals. These actions reduce spending the $941 million decrease in the 2013-14 guarantee, by a total of $1.5 billion, thereby freeing up about the Governor reduces the amount of deferral pay $600 million for other Proposition 98 purposes. The downs and rescinds most of his January community Governor directs the bulk of the $600 million to the Local Control Funding Figure 13 Formula (LCFF), various Proposition 98 May revision spending Changes new community college proposals, and backfilling 2012-13 Changes: the federal sequestration Pay down additional deferrals $1,783 cut to special education. Fund one-time Common Core implementation initiative 1,000 The May Revision Make technical adjustments 156 Total $2,939 also includes a revised 2013-14 Changes: estimate of Proposition 39 Reduce deferral paydown -$1,024 corporate tax revenues, Rescind January adult education proposal -300 resulting in a small Rescind January CCC unallocated base augmentation -197 increase ($14 million) in Swap additional one-time funds -22 Provide additional funds for Local Control Funding Formula 240 energy-related funding for Fund CCC enrollment growth 89 schools and community Provide cost-of-living adjustment to CCC apportionments 88 colleges. We discuss Backfill special education sequestration cut 61 Fund CCC student-support program 50 several of these spending Make technical adjustments 31 proposals in more detail Fund adult education planning grants 30 later in this section. Increase funds for Proposition 39 energy projects 14 Total -$941 22 Legislative Analyst’s Office www.lao.ca.gov 2013-14 Budget Changes in Programmatic Per-Pupil Funding factor payment ($4.4 billion, an increase Offer Different Perspective. Under the May of $1.8 billion from the January estimate). Revision, K-12 programmatic per-pupil funding is Taken together, these two factors explain the $7,588 in 2012-13—roughly the same as under the $2.9 billion increase in the 2012-13 minimum January plan and flat from the prior year. Because guarantee under the May Revision. the increase in 2012-13 spending under the May Revenue Estimates Result in Notable Revision is designated for paying down deferrals Drop in 2013-14 Proposition 98 Minimum and the new CCSS initiative to be implemented Guarantee. The May Revision estimate of in subsequent years, the programmatic impact in General Fund revenues that count toward the the current year is assumed to be negligible. In guarantee in 2013-14 is $1.8 billion lower than 2013-14, programmatic per-pupil funding under the January estimate. Given the notable increase the May Revision is $8,081—$152 higher than the in 2012-13 revenues and the decline in 2013-14 January level and $493 (6 percent) higher than the revenues, the year-to-year growth rate drops current year. This increase is largely associated significantly. This drop in year-to-year revenue with the additional funding provided for the LCFF. growth results in a $1 billion reduction in the Our estimates also assume that schools would minimum guarantee. This reduction is offset by spend half of the CCSS funding for programmatic a small increase ($106 million) due to updating purposes in 2013-14 (with the remainder spent various other inputs, including K-12 attendance in 2014-15). At CCC, programmatic funding per (projected to grow by 0.20 percent, up from full-time equivalent (FTE) student increases under 0.10 percent in January). Combined, these the May Revision by 4 percent, from $5,418 in changes explain the net $941 million decrease 2012-13 to $5,638 in the 2013-14 in the 2013-14 minimum guarantee under the May Revision. changes in Revenue Estimates “Spike Protection” Provision Dampens and Minimum Guarantee the Ongoing Effect of Large Current-Year Revenue Estimates Result in Significant Increase in Minimum Guarantee. Under the Increase in 2012-13 Proposition 98 Minimum May Revision, General Fund revenues that count Guarantee. The May Revision estimates of toward the guarantee in 2013-14 ($95.2 billion) are General Fund revenues that count toward the somewhat higher than 2012-13 ($94.6 billion). The minimum guarantee are roughly $300 million minimum guarantee, however, is lower in 2013-14 lower in 2011-12 and $2.9 billion higher in ($55.3 billion) than 2012-13 ($56.5 billion). This 2012-13 relative to the January estimates. The rare situation is due to the spike protection current-year minimum guarantee increases provision of Proposition 98. (2013-14 would roughly $1.1 billion as a result of higher total be the first time this provision has ever taken 2012-13 General Fund revenues. The minimum effect.) In a year when the minimum guarantee guarantee also increases because of the change increases at a much faster rate than per capita in the year-to-year growth in revenues. The personal income, the spike protection provision combination of a decrease in 2011-12 and an excludes a portion of Proposition 98 funding increase in 2012-13 significantly increases from the minimum guarantee calculation in the year-to-year General Fund growth and results subsequent year. In the May Revision, the spike in a larger 2012-13 Proposition 98 maintenance protection provision excludes $1.5 billion in www.lao.ca.gov Legislative Analyst’s Office 23 2013-14 Budget 2012-13 Proposition 98 funding from the 2013-14 2014-15). The CCSS spending would be subject to Proposition 98 calculations, reducing the 2013-14 the annual funding and compliance audit. minimum guarantee by a like amount. Although Increases Deferral Paydowns Over Two-Year the spike protection provision also was applied Period. Figure 14 shows the changes in the in the Governor’s January budget, the effect was Governor’s proposal to reduce the amount of much smaller ($279 million). outstanding K-14 payment deferrals. The May Estimates of Proposition 98 Local Property Revision provides an additional $1.8 billion to Tax Revenues Up Notably. Estimates of retire existing deferrals in 2012-13—for a total Proposition 98 local property tax revenues are current-year paydown of $4 billion. As a result of up a total $736 million across the three-year the decline in the minimum guarantee in 2013-14, period under the May Revision (up $165 million the Governor reduces his proposed 2013-14 in 2011-12, down $8 million in 2012-13, and paydown by almost $1 billion (to $920 million). up $579 million in 2013-14). The increase in Compared to the January proposal, the May 2011-12 is primarily due to increases in base Revision retires an additional $760 million property tax revenues. In 2013-14, property tax in deferrals over the two-year period, leaving revenues are up mostly due to higher estimates $5.5 billion in outstanding deferrals at the end of of redevelopment agency revenues that will be 2013-14. redirected to schools and community colleges. Makes Some Modifications to LCFF, The higher property tax estimates for schools Increases Year-One Funding. In January, the and community colleges generally result in a Governor proposed to replace the state’s existing dollar-for-dollar reduction in state General Fund system for allocating funding to school districts Proposition 98 costs. and charter schools with a new student-based funding formula. The May Revision proposes an changes in Proposition 98 Spending additional $236 million for implementing this One-Time Funding for Implementing CCSS. formula (bringing total 2013-14 funding for LCFF California adopted the nationally developed implementation up to $1.9 billion). The Governor CCSS in 2010 and, pursuant to federal direction, also makes various modifications mostly relating is planning to begin implementing the new to the proposed funding supplement for English standards in the 2014-15 school year. One way learners and low-income (EL/LI) students, including: the May Revision responds to the large increase (1) basing EL/LI counts on a three-year rolling in the current-year guarantee is by providing average, (2) allowing EL students to generate $1 billion to school districts on a one-time supplemental funding for seven (rather than five) basis for implementing the CCSS. The May years, and, (3) requiring districts to allocate EL/ Revision proposes to allocate this funding on LI funding to school sites in proportion to their a per-student basis (equating to about $170 per enrollment of EL/LI students. Additionally, student). School districts would be required the Governor proposes to strengthen academic to use the funds for instructional materials, accountability by developing a tiered intervention professional development, or technology related system through which county superintendents, the to CCSS implementation. Districts would need Fiscal Crisis and Management Assistance Team to develop a related expenditure plan and spend (FCMAT), and Superintendent of Public Instruction the funds over the next two years (2013-14 and (SPI) could intervene in districts failing to meet 24 Legislative Analyst’s Office www.lao.ca.gov 2013-14 Budget academic performance targets. (The May Revision districts (as well as community colleges) to maintain makes no major modifications to the proposed LCFF existing levels of support for adult education over the for county offices of education [COEs] but provides next two years (2013-14 and 2014-15), the Governor an additional $4 million in funding—on top of the proposes to earmark two-thirds of the proposed $28 million proposed in January.) $500 million augmentation in 2015-16 for providers Introduces New Proposal for Adult Education. that meet this criterion. The Governor rescinds his January proposal that Substitutes Unallocated Base CCC Increases would have provided CCC with $300 million in for Targeted Augmentations. The Governor base funding for adult education. Instead, the May also rescinds his January proposal to provide an Revision proposes to provide $30 million in the unallocated base increase to CCC of $197 million. budget year for community colleges and school Instead, the May Revision provides a total of Graphic Sign Off districts (through their adult schools) to create $227 million to CCC for three specific purposes: Secretary joint plans for serving adult learners in their area. (1) funding 1.63 percent enrollment growth Analyst Providers would have two years to form regional ($89 million), (2) providing a 1.57 percent cost-of- Director consortia and develop plans for coordinating and living adjustment (COLA) for apportionments Deputy integrating services. Beginning in 2015-16, the ($88 million), and (3) augmenting the Student administration proposes to provide $500 million Success and Support categorical program (formerly to the regional consortia to deliver adult education. known as Matriculation), which funds services such Under the administration’s plan, each consortium as orientation and counseling ($50 million). would submit an application to the California Department of Education (CDE) and Figure 14 CCC Chancellor’s May Revision Makes Larger Deferral Office, which would Reductions Over Two-Year Period jointly review the (In Billions) applications and Amount Paid allocate the funding. $12 Amount Outstanding Funding would be 10 limited to core adult $2.2 education programs $4.0 8 (such as English as $1.9 a second language 6 $0.9 and vocational instruction) and 4 $8.2 all providers would $6.3 $6.4 $5.5 receive the same 2 enhanced noncredit funding rate that community colleges 2012-13 2013-14 2012-13 2013-14 receive. To create an Governor’s January May Revision Budget Proposal incentive for school ARTWORK#130284_May Revision www.lao.ca.gov Legislative Analyst’s Office 25 2013-14 Budget Allocates $61 Million to Backfill Federal of maintenance factor—one akin to the past Sequestration Cut to Special Education. California’s interpretation in which about 50 percent to federal Individuals with Disabilities Education Act 55 percent of revenue growth went to K-14 (IDEA) grant is projected to be cut $61 million education—the budget situation facing the state as a result of sequestration. In contrast to the would be quite different. Using this alternative other education sequestration cuts (including an application, the minimum guarantee in 2012-13 $84 million drop in Title I support for students would be $53.6 billion. This is $2.9 billion below the from low-income families), the May Revision would May Revision estimate but almost identical to the backfill this loss with ongoing Proposition 98 funds. Governor’s January estimate, meaning that the state Most of the proposed backfill would be distributed could keep the existing current-year spending plan. based on the state’s “AB 602” allocation formula. (A In 2013-14, the minimum guarantee ($53.8 billion) small amount—$2.1 million—would be dedicated would be lower than the January and May Revision to special education infant/toddler and preschool levels, but the Legislature could provide more than services.) The $61 million equates to about 1 percent the minimum guarantee and fund at whatever of total special education categorical funding. level it chose. If the Legislature chose to spend at the 2013-14 May Revision Proposition 98 level, it LaO assessment of changes in still would have $2.9 billion available—funds that Revenues and Guarantee could be used to build up the budget reserve, pay off Most New Revenue Dedicated to Proposition 98 debts, or spend on non-Proposition 98 programs. Because of Maintenance Factor Application. Alternatively, if the Legislature chose to spend at the The changes in the Proposition 98 minimum higher January Proposition 98 level, it would have guarantee stemming from updated General Fund $1.9 billion available. The Legislature could choose revenue estimates have resulted in highly unusual to fund Proposition 98 even higher than the January outcomes whereby schools and community level, determining how much of the $1.9 billion to colleges have disproportionately benefited from leave for other priorities. Such an approach offers the improvements in General Fund revenues. These Legislature considerably more flexibility in building outcomes are driven by the Governor’s approach to the 2013-14 state budget. calculating maintenance factor payments in Test LaO assessment of Spending Proposals 1 years (2012-13 is a Test 1 year). The Governor’s maintenance factor treatment ratchets up the Mix of One-Time and Ongoing Spending minimum guarantee, such that the $2.8 billion Reasonable. We believe the May Revision approach increase in 2012-13 General Fund revenues in the of using new one-time 2012-13 funds for one-time May Revision results in a $2.9 billion increase in the initiatives (including the acceleration of deferral pay minimum guarantee. This result essentially requires downs) is prudent. We also think the May Revision the state to make budget reductions in other areas to 2013-14 approach of dedicating about one-quarter pay for additional Proposition 98 costs. We question of new resources to paying down deferrals and the the reasonableness of an approach that results in remainder to building up ongoing programmatic the rest of the budget under certain situations not spending is reasonable. Although the Governor benefitting at all from revenue growth. dedicates a smaller share of new resources in LAO Option Frees Up Almost $3 Billion. If 2013-14 to paying down existing obligations under the state were to use an alternative interpretation the May Revision compared to the January plan, 26 Legislative Analyst’s Office www.lao.ca.gov 2013-14 Budget the May Revision pays down more deferrals across to school-site expenditures), we are concerned the two-year period. Though the state will face a that the modifications in the May Revision somewhat greater challenge in 2014-15 in finding could limit districts’ flexibility and increase available resources to continue paying down their administrative burden. The Governor’s deferrals given this approach, the amount of total May Revision proposal relating to academic outstanding deferrals will be lower by $760 million accountability under the LCFF seems generally moving into 2014-15. reasonable in that it attempts to outline certain One-Time Common Core Implementation steps county superintendents, FCMAT, and the Initiative Raises Important Issues to Consider. SPI can take to intervene in struggling districts. The Legislature has several important issues to This proposal somewhat parallels existing consider regarding how best to spend an additional practices for holding districts fiscally accountable. $1 billion in one-time funding. The Legislature faces We have some concerns, however, regarding the significant trade-offs in deciding whether to use the current capacity of the county superintendents, funding for CCSS implementation or other existing FCMAT, and the SPI to perform these duties one-time obligations. For example, the Legislature effectively. As the Governor proposes to begin could use the funds to pay down additional implementing the new system in 2015-16, we deferrals, pay outstanding mandate claims, retire think the Legislature could take some more time more of the Emergency Repair Program obligation to consider the specific roles of each identified (an obligation relating to a legal settlement), or agency and then accordingly build their capacity fund other activities, such as facility maintenance, to advise, support, and intervene in struggling that have been reduced significantly over the past districts. several years. Were the Legislature to deem CCSS Recommend Governor’s COE Proposal implementation the highest of these priorities, it Be Postponed One Year. As described in our then would want to consider both how much to January report, we have serious concerns with the provide and what requirements, if any, to link with Governor’s proposal for COEs. Specifically, the the funding. As part of this decision making, the proposal: (1) increases funding for regional services Legislature would want to consider the amount of while reducing the responsibilities of COEs, existing local, state, and federal resources that can be (2) compounds the existing lack of accountability used to cover CCSS implementation costs, such that over how COEs spend regional funding, and the additional amount of state resources provided (3) increases alternative education funding by up could cover otherwise unaddressed implementation to $7,000 per student without clear justification. costs. Given these concerns and the short amount of time Overall LCFF Framework Remains Sound. remaining this budget season to address them, We continue to believe that the overarching we recommend the Legislature retain the existing structure of the Governor’s LCFF proposal is COE funding formulas in 2013-14 and refine the sound and recommend the Legislature adopt some Governor’s proposal during the upcoming year. variant of it. We believe most of the specific LCFF This alternative would allow the state additional modifications proposed in the May Revision are time to consider carefully what activities should be reasonable but likely would have only a minor required of all COEs and develop an appropriate effect on districts and their funding allotments. In funding rate for those activities beginning in a few cases (such as the new requirements related 2014-15. If the Legislature were to adopt this www.lao.ca.gov Legislative Analyst’s Office 27 2013-14 Budget recommendation, $32 million would be freed up for Special Education Backfill Proposal Is other Proposition 98 purposes in 2013-14. Reasonable. We believe the Governor’s proposal to Promising Plan for Adult Education. We believe increase Proposition 98 spending for special education the May Revision adult education proposal is much is reasonable. Though the state is not obligated to better than the Governor’s January proposal. By backfill this cut in federal funding, school districts are proposing a regional delivery model, the new plan required by federal law to provide special education would create a strong incentive for adult-education services and a reduction in federal funding likely providers to leverage their relative strengths and would lead to an increase in the amount of local improve collaboration. By conditioning the bulk of general purpose funds school districts would have new base funding on providers maintaining at least to dedicate for these services. This likely would their current level of service, the May Revision also exacerbate a recent trend in which school districts would create an incentive for providers to continue appear to be bearing a greater share of special offering adult education programs in 2013-14 and education costs, as growth in state categorical and 2014-15. We think the two-year planning time federal IDEA funds have not been keeping pace with frame is reasonable. During this preparation period, growth in special education costs over the last several providers would have an opportunity to identify years. program needs and create aligned curricula. At General Fund Proposition 98 Costs Higher the same time, the Legislature, CDE, and the CCC Than Estimated in May Revision. The Governor’s Chancellor’s Office could be addressing state-level May Revision fails to recognize additional General issues in support of the regional consortia, such as Fund Proposition 98 costs related to the allocation developing a common course numbering system of Education Protection Account (EPA) funds. for adult education and deciding on the amount Proposition 30 requires that each school district of funds each region would be eligible to apply for receive at least $200 in EPA funds per student and beginning in 2015-16. While we agree with the overall each community college district receive at least $100 approach proposed by the Governor, we recommend per FTE student. For most districts, EPA funds will be the Legislature provide more flexibility for providers used to pay for costs that otherwise would have been to organize themselves (for example, by allowing the paid with state General Fund dollars. As a result, those Chancellor’s Office to pass through funds to school EPA allocations will not increase state costs. Some districts if they are interested in being a consortium’s districts, however, do not receive base state funding fiscal agent). because associated costs can be met entirely with Proposed CCC Base Augmentations Have their local property tax revenues. For these districts— Merit. In our analysis of the Governor’s January known as basic aid districts—EPA allocations will proposal to provide an unallocated increase to CCC, result in higher state costs. The May Revision does not we voiced serious concern that such an approach account for these costs. We estimate the annual cost would provide no assurance that the Legislature’s in 2012-13 and 2013-14 at $68 million ($62 million for priorities would be met. The May Revision addresses school districts and $6 million for community college this concern by funding specific and high legislative districts). We recommend the Legislature include these priorities such as access (enrollment) and student costs in building its Proposition 98 budget package and support services. As such, we recommend the reduce spending in other Proposition 98 programs to Legislature approve the administration’s May maintain spending at the minimum guarantee in both Revision proposal. 2012-13 and 2013-14. 28 Legislative Analyst’s Office www.lao.ca.gov 2013-14 Budget MEDi-caL ExPaNSiON Under the ACA, also known as federal health Redirects County Indigent Health Funding. care reform, the state has the option to expand its Under the proposal, the responsibility for providing Medicaid Program (known as Medi-Cal) to cover health care to the expansion population would shift over one million low-income adults who are currently from counties to the state—resulting in significant ineligible. For three years, beginning January 1, savings for counties. The May Revision proposes to 2014, the federal government will pay almost all redirect certain funding provided to counties for the costs associated with the expansion. Beginning indigent health care under the 1991 state-county January 1, 2017, the federal share of costs associated realignment plan in order to help cover increased with the expansion would be decreased over a state costs due to the optional expansion and three-year period until the state pays for 10 percent of the ACA. (Under the 1991 realignment, the state the expansion and the federal government pays the transferred to counties certain health and human remaining 90 percent. Currently, the counties have services program responsibilities and offset counties’ the fiscal and programmatic responsibility for health expanded fiscal responsibilities with increased sales care for the low-income adult population that would tax and vehicle license fee revenues.) be covered by the expansion (hereafter referred to as The May Revision proposes to establish a the expansion population). mechanism (hereinafter referred to as the “formula”) to calculate annual county health care savings Governor’s Proposal available for redirection. Based on initial discussions Adopts the Optional Medi-Cal Expansion with the administration, county health care savings Using a State-Based Approach. In January, as we under this formula would be defined as the difference discussed further in our report, The 2013-14 Budget: between (1) county health care revenue and Examining the State and County Roles in the Medi-Cal (2) county costs for providing services to Medi-Cal Expansion, the Governor proposed to adopt the beneficiaries (the expansion population and current optional Medi-Cal expansion and proposed two enrollees) and uninsured patients. The formula options to implement the expansion: (1) a county- includes some adjustments, presumably intended based approach or (2) a state-based approach. The to (1) safeguard resources for county mental health Governor’s May Revision proposes to adopt a state- and substance use programs and (2) ensure that the based approach under which the state would expand calculation of county savings is not affected by future its existing state-administered Medi-Cal Program county actions to redirect health care resources to cover the expansion population. The expansion or greatly increase health care spending. These population would receive the same set of benefits adjustments include: currently provided by Medi-Cal—including long-term • County Mental Health and Substance Use care services if the federal government allows the state Disorder Services Resources Would Be to restrict these services to individuals with limited Excluded. The formula excludes resources financial assets. Counties would have the option to for mental health and substance use disorder provide enhanced substance use disorder services to services from its calculations of county both new and existing enrollees. health care revenue and spending. www.lao.ca.gov Legislative Analyst’s Office 29 2013-14 Budget • County Health Care Revenue Estimates package is intended to increase county costs by an Would Be Based Partly on Historic amount equal to county indigent health savings Factors. The formula would include actual and decrease state General Fund spending by a federal funds and patient payments provided corresponding amount. to counties. The amount of county health LaO comments care funds attributable to 1991 realignment and local sources, in contrast, would be State-Based Expansion Makes Sense. In our based on county prior use of these resources February report examining Medi-Cal expansion, for health care purposes. we recommended the Legislature adopt a state- based expansion. The Governor’s proposal is • High Growth in County Health Care consistent with our recommendation. We believe Costs Would Be Excluded From the the state is in a better position than the counties to Formula. The formula would include effectively organize and coordinate the delivery of actual costs experienced by counties during health services to the newly eligible population— each year of ACA implementation, up to a potentially resulting in improved health outcomes specified cap based on historical spending and administrative efficiencies. As a practical levels. Actual county expenditures above matter, we also believe the state is better positioned the cap would not be incorporated into the than the counties to successfully implement an formula. expansion by January 1, 2014. The May Revision estimates that county New Realignment Presents Significant Issues. health care savings under this approach would be The Governor’s realignment proposal raises two $300 million in 2013-14, $900 million in 2014-15, primary concerns. First, the new realignment and $1.3 billion 2015-16. proposal adds complexity to the already Realigns State and County Responsibilities complicated issue of implementing the optional for Health and Social Services Programs. The expansion. Evaluating programs as to their administration proposes to redirect these county suitability for state-county realignment is complex healthcare savings to pay for increased county and only should be implemented after thorough costs resulting from a new state-county program deliberation by the Legislature and discussions realignment. Under the new realignment, counties with the administration, counties, and program would assume increased fiscal responsibility for stakeholders. For example, in considering the CalWORKs, CalWORKs-related child care, and realignment of CalWORKs, the Legislature would CalFresh administration—decreasing state General need to assess whether it is willing to relinquish Fund spending in these programs dollar-for-dollar. some policy making authority over the program The state would maintain its current policy making and allow variation in treatment of recipients and oversight responsibilities for these programs. across counties. Given the multitude of issues the Additionally, county fiscal responsibility for Legislature will face in implementing the optional California Children’s Services would be shifted expansion, we suggest the Legislature avoid to the state. Pending future developments (which introducing additional issues—such as complicated the administration has not yet defined), county shifts of authority over unrelated programs—into costs for In-Home Supportive Services also might discussions of the optional expansion. Second, be shifted to the state. In total, the realignment the realignment proposal raises concerns about 30 Legislative Analyst’s Office www.lao.ca.gov 2013-14 Budget potential increased county costs and state formerly indigent. Furthermore, the state’s claim mandates. Specifically, under the proposed to all county health care funds in excess of the realignment plan, counties would have increased formula’s calculations of their health care costs fiscal responsibility for human services programs. may limit incentives and resources for counties to The California Constitution generally requires the reinvest in county public hospitals and clinics. state to reimburse local governments if it mandates Basis for County Savings Estimates Is that local governments provide a new program, pay Unclear. At the time this report was written, an increased share of a program’s cost, or provide the methodology and assumptions used by a higher level of service. Forecasting future costs the administration to estimate county savings for caseload-driven programs such as CalWORKs, were unclear. Additionally, as we discussed in child care, and CalFresh is very difficult. For our February report, data on county indigent this reason, in future years it would be difficult health expenditures are limited. According to to ensure that the redirected realignment funds the administration, information about county were sufficient to cover the costs of new county indigent health costs submitted to the state as part responsibilities. If funding fell short of what is of the Medi-Cal Section 1115 waiver—including required to fund the counties’ new responsibilities, Low-Income Health Program cost information— counties could experience fiscal pressure and was a primary source of information used to the state could be liable for claims for mandate estimate county savings. While we believe this cost reimbursements. information could be useful in estimating county Proposed Formula Appears to Diverge savings, the information has some significant From Stated Goals of Financing Expansion. limitations—such as the fact that not all counties The administration has articulated two major operate a Low-Income Health Program. goals in its proposal for financing the optional LaO alternative expansion: (1) to ensure the state no longer funds counties to provide health care to patients who The Governor’s proposal raises concerns in gain Medi-Cal and private coverage under ACA, that it: (1) unnecessarily ties implementation of and (2) to preserve access to county-operated the optional expansion to a complicated new state- hospitals and clinics for Medi-Cal beneficiaries county realignment and (2) appears to rely on a and the remaining uninsured. While we find the formula for calculating expansion-related savings administration’s goals to be reasonable, we note that does not square with the administration’s that the formula for determining county savings— stated principles. Below, we discuss an alternative as described to us by the administration—appears that attempts to address these concerns. to diverge from these stated objectives. Specifically, Redirect Realignment Funds Historically by incorporating in the formula revenues and costs Related to Expansion Population. Under our related to all Medi-Cal patients, including currently alternative, the Legislature would redirect eligible enrollees, the mechanism would define the share of 1991 health realignment funds county healthcare savings to encompass a broader historically associated with providing services patient population than the formerly indigent. In to the expansion population—about 46 percent our view, redirecting net county savings from all of total health realignment funds. (We discuss payer sources is a distinct concept from preventing the policy basis for this redirection in our overpayments from realignment funds for the February report.) Accounting for the partial-year www.lao.ca.gov Legislative Analyst’s Office 31 2013-14 Budget implementation of the optional expansion in Legislature and used to adjust the amount of 2013-14, this approach would suggest redirecting redirected realignment funding in future years. about $325 million in that fiscal year. However, Use Indigent Health Realignment Funds to in light of the uncertainty surrounding the Pay Some CalWORKs Costs. Instead of making implementation of the optional expansion and major changes to county fiscal and program the potential administrative difficulties that responsibilities as proposed by the Governor, may arise, the Legislature may want to consider the Legislature could build upon an existing redirecting a somewhat lesser amount—perhaps arrangement created under the 2011 realignment $300 million, as suggested by the Governor—in plan (a recent state-county realignment that, 2013-14. In 2014-15 and 2015-16, the amount among other changes, transferred responsibility redirected under this approach would be around for certain criminal offenders from the state $700 million. to counties) that uses county funding to offset Establish a Review Process to Protect state General Fund costs for CalWORKs grants. Solvency of Public Hospitals and Clinics. The Under this approach, redirected indigent health Legislature could create a process to formally realignment funds would be placed in an account review the solvency of public hospitals and within the 1991 realignment structure to help pay clinics to ensure the above described shift of for CalWORKs grant costs—creating dollar-for- 1991 realignment funds does not threaten the dollar state General Fund savings. This approach financial viability of safety-net providers. This does not fundamentally increase county financial process would involve various state and county responsibility for supporting CalWORKs and stakeholders and review data on actual county does not change the state’s authority over or funding and costs for the operation of public programmatic responsibility for CalWORKs. As hospitals and clinics as it becomes available. The a result, it would be a much simpler approach to findings of this review could be presented to the implement—particularly in the near term. LaO MuLTiyEaR FOREcaST Consistent with our practice following the redevelopment agencies—a forecast that is similar release of the May Revision in most years, our to that of the administration.) office has completed a quick forecast of the state’s Figure 15 summarizes our multiyear budget future fiscal condition. This forecast—consistent forecast, showing the projected ending 2013-14 state with our standard approach for May Revision fund balance under our higher revenue estimates, forecasts—generally assumes that the Governor is as well as the projected operating surpluses (the successful in implementing his policies as of the differences between our annual revenue forecast May Revision, but is based on our own revenue and a forecast of expenditures under the Governor’s forecast, our independent assessment of the future policies) through 2016-17. Our forecast also reflects growth of caseload and costs for major state-funded the Governor’s plan for paying down much of the programs, and our property tax forecast. (Our “wall of debt” through 2016-17, a significant portion property tax forecast reflects our office’s current of which is paid from within the Proposition 98 assessment of revenues related to the dissolution of minimum guarantee. 32 Legislative Analyst’s Office www.lao.ca.gov 2013-14 Budget Higher Reserve at End of 2013-14 in 2016-17. Broadly speaking, the year-over-year change in operating surpluses under our forecast Higher Revenue Forecast Increases Projected is caused by our estimates of revenue growth Reserve. Our forecast indicates that the state would outpacing projected expenditure growth. end 2013-14 with a reserve that is several hundred By 2016-17, Our Forecast Shows Notably million dollars higher than that reflected in the Less Spending Than Administration’s Forecast. administration’s estimates. This difference results In general, our May forecast projects higher almost entirely from our forecast’s higher revenues revenues and lower expenditures than does ($3.2 billion more than the DOF forecast through the administration in its multiyear forecast. In 2013-14), offset by correspondingly higher General 2014-15, for example, our revenue forecast is about Fund Proposition 98 spending ($2.4 billion more $2.5 billion higher than the administration’s, while than the DOF forecast for 2012-13 and 2013-14 Graphic Sign Off our expenditure forecast is about $600 million combined). Our estimate assumes that property taxes offsetting state Proposition 98 spending lower. In 2014-15 we project an operating Secretary surplus that is about $3.1 billion higher than are $120 million higher than DOF projections in Analyst the administration’s projections. By 2016-17, the 2012-13 and 2013-14 combined (due in part to our Director differences become even more apparent, with office’s slightly higher projected assessed valuation Deputy the administration projecting notably more growth). expenditure growth than we expect under our State Revenues Projected to Exceed forecast. Specifically, while we estimate that Expenditures Through 2016-17 2016-17 revenues will be about $2.8 billion higher than the administration, our expenditure forecast Revenues Forecasted to Grow Faster Than projects over $3.7 billion in lower expenditures. Expenditures. Consistent with our multiyear budget forecasts that Figure 15 were released in May LAO May Revision Forecast and November 2012, we project growing General Fund and Education Protection Account Combined (In Millions) operating surpluses $8,000 beginning in 2014-15 Reserve for 2013-14 and continuing 7,000 Annual Operating Surpluses throughout the forecast 6,000 period (which ends in 2016-17) under 5,000 the Governor’s May 4,000 Revision policies. As indicated in Figure 15, 3,000 our forecast shows that there could be an over 2,000 $3 billion operating 1,000 surplus in 2014-15, growing thereafter to 2013-14 2014-15 2015-16 2016-17 a $6.9 billion surplus wwAwR.TlaWo.cOaR.gKov# 1 3Le0g2is8la4t_ivMe aAyn aRlyesvt’iss iOofnfice 33 2013-14 Budget This results in our forecast of the operating surplus Lower Revenues Would Result in Smaller for that year being $6.6 billion higher. Nearly half Surpluses. The LAO revenue forecast assumes of the difference in the expenditure forecast is a considerably higher level of capital gains explained by the administration’s higher projection realizations by Californians than the DOF forecast for Proposition 98 General Fund spending. The does. This and other forecast differences result in vast majority of this difference results from the our revenue forecast being over $2.8 billion higher administration’s considerably weaker forecast of than DOF’s by 2016-17. Our respective revenue property tax revenues, which increases the amount forecasts also affect the level of Proposition 98 of required General Fund Proposition 98 spending. funding each year, with a higher revenue total Specifically, in 2016-17, we forecast that property generally resulting in a higher Proposition 98 tax revenues provided to schools (that offset minimum guarantee. For illustrative purposes, Proposition 98 state costs) will be $1.9 billion more Figure 16 shows that the net effect of a $3 billion than reflected in the administration’s forecast. drop from our revenue estimates in a future fiscal In our view, the administration’s property year could worsen the General Fund’s bottom line tax forecast—assuming 2.5 percent assessed by about $1.5 billion (thus assuming a $1.5 billion valuation growth per year—is inconsistent with the decline in the Proposition 98 guarantee for that administration’s economic forecast. The economic year). In a recession, the revenue drop could be forecast, according to the May Revision summary, considerably worse than illustrated in Figure 16. is premised on a transition of the housing market Health and Human Services Costs Could back to a more normal rate of buying and selling, Increase More Rapidly. For 2013-14, our including a rising number of housing permits. Such estimate of state expenditures in the health a housing market should facilitate higher assessed and human services area is slightly under valuation growth in the coming years, consistent that of the administration. While we forecast with past patterns and as reflected in our forecast. significant spending growth in health and human services programs, by 2016-17 it seems that the Reasons Future Surpluses May Not Materialize administration’s estimates of these costs are still Several Assumptions Key to Achieving Future somewhat higher than those of our office. The Surpluses. The forecast reflects our standard Governor, for example, has expressed concern that forecast assumptions, including an assumption the federal government may shift certain health of continued, moderate economic growth and, and human services costs to the state in future as noted above, a general assumption that the years, and there are various uncertainties about administration will be able to implement its how implementation of the ACA will affect future budgetary proposals successfully in most cases. growth of health care expenditures by the state and The forecast therefore depends on a number of other governments. If health and human services economic, policy, and budgetary assumptions that, costs ended up growing much faster than we if changed, could result in dramatically different expect, operating surpluses could end up being a outcomes. As summarized in Figure 16, a variety few billion dollars weaker by 2016-17, as illustrated of alternate scenarios would result in much smaller in Figure 16. future operating surpluses or possibly operating Forecast Assumes No COLAs or Inflation deficits. Adjustments. Consistent with existing state law specifying that inflation adjustments to many state 34 Legislative Analyst’s Office www.lao.ca.gov 2013-14 Budget programs are not “automatic,” the Governor’s May state’s costs for CalSTRS would be phased in Revision plan includes no COLAs or inflation over several years, with state costs increasing by adjustments for state operations (including, in roughly $800 million each year over a few years. general, no future raises for state employees other (This assumes that the state pays the entire amount than those already included in state collective of these additional funding costs. Teachers and/ bargaining agreements). As shown in Figure 16, or school districts also may be required to make if we included such COLAs and price increases higher payments to CalSTRS, which would reduce beginning in 2014-15 (based on the projected rate the amount the state has to provide.) By 2016-17, of inflation), operating surpluses would be around increased contributions to CalSTRS in this $800 million lower by 2016-17. scenario would reduce the operating surplus by Forecast Assumes No Additional about $2.6 billion. Contributions to CalSTRS. As of June 30, 2012, Forecasts Assumes No Additional the California State Teachers’ Retirement System’s Contributions to Address Retiree Health (CalSTRS) actuary estimated that the defined Liabilities. Current state law does not require the benefit pension program had an unfunded liability state to “pre-fund” liabilities for retiree health of about $71 billion. Last year, the Legislature benefits of state and California State University passed a resolution stating its intent to adopt a plan employees. Because the state does not pre-fund during the current two-year legislative session to these liabilities, it pays for statutorily set retiree address the unfunded liability. If the Legislature health benefits on a “pay-as-you-go” basis. Paying adopted the plan described by CalSTRS as the for retirement benefits, such as these, on a pay-as- “definitive approach” to retiring the system’s you-go basis is a poor governmental fiscal practice, unfunded liabilities within about 30 years, the as it results in future taxpayers paying the costs Figure 16 Reasons That Sizable Operating Surpluses May Not Materialize (In Billions) 2014-15 2015-16 2016-17 LAO Budget Forecast Revenues and transfers $107.0 $112.3 $118.9 Expenditures 103.6 107.9 112.1 LAO Operating Surpluses $3.4 $4.3 $6.9 Alternate Scenarios Net effect of $3 billion less in revenuesa -$1.5 -$1.5 -$1.5 Higher health and human services costs -0.7 -1.3 -2.0 Inflation increases for state operations (including courts and state worker pay) -0.2 -0.5 -0.8 Operating Surpluses Under These Scenarios $1.0 $1.0 $2.6 Scenarios for Unfunded Retirement Liabilities State addresses CalSTRS’ unfunded liability in 30 yearsb -$0.8 -$1.7 -$2.6 Higher state payments to “pre-fund” retiree health liabilities -1.0 -1.0 -1.0 Operating Deficits (Including All Scenarios Above) -$0.8 -$1.7 -$1.0 a Assuming that, in a given fiscal year, a $3 billion lower revenue total would reduce the Proposition 98 minimum guarantee by $1.5 billion in that year—resulting in a net budget deterioration of $1.5 billion. Actual results will vary. In the event of a recession or stock market downturn, the revenue decline could be much greater. b Rough estimate, assuming implementation of the California State Teachers’ Retirement System’s (CalSTRS) recently identified “definitive approach” to addressing system unfunded liabilities within about 30 years. Assumes that neither teachers nor districts pay any part of the higher contributions. www.lao.ca.gov Legislative Analyst’s Office 35 2013-14 Budget of services provided in the past by public workers. the expiration of Proposition 30. (The exact effects Significant unfunded liabilities for retiree health would depend on economic and Proposition 98 benefits result from pay-as-you-go funding, and funding trends around the time the taxes expire.) the state forgoes the ability to generate investment The Legislature should be mindful of this issue earnings from pre-funding deposits (which, over when considering the state’s spending plans in the time, reduce taxpayer costs of providing the coming years. benefits). If the state were to begin pre-funding Also Possible That Larger Surpluses Could these benefits for all employees, added General Materialize in Some Years. While there are Fund costs could total around $1 billion more per various risks to the state’s budgetary outlook, we year, as shown in Figure 16. note that our revenue projections are based on Some of Proposition 30 Tax Increases Expire statistical models that consider historical economic After Forecast Window. Proposition 30, passed and tax collection trends. Just as revenues (and by the voters in November 2012, increased PIT other budgetary totals) could end up weaker than rates on higher-income individuals through 2018 we project in some years, the economy and state and SUT rates through 2016. Because the bulk of revenues likely will grow more rapidly than our additional revenue attributable to Proposition 30 projections in other years. Therefore, in some years, is expected to be generated from the PIT rate the state’s fiscal condition could be better than increase, the budget could be several billion dollars summarized in Figure 15. worse off shortly after the end of our forecast due to LaO cOMMENTS Many Reasons to adopt cautious approach growth, Proposition 30, and the savings from past budget reductions have put the state in a much Governor Clearly Wants to Ensure That improved budgetary situation, the Governor seems Recent Budget Improvements Hold. In introducing determined to consolidate these budgetary gains the May Revision, the Governor openly described and reject additional spending options that could his administration’s aim to adopt a cautious put the budget at risk in the future. budgetary approach—one that focuses on Significant Reasons for the Legislature to avoiding the budgetary erosions that would Adopt Such an Approach. In our view, there is result from potential economic setbacks, putting good reason for the Legislature to adopt a cautious a reasonable portion of new school spending budgetary posture. After years of “boom and bust” into one-time spending efforts, and rejecting budgeting, California’s state government now has most proposals to restore programmatic cuts the opportunity to build a budget for future years that were adopted during the recession, such as that gives lawmakers more choices about how to those in health and social services programs. The build reserves in times of healthy revenue growth, Governor also aims to reduce the state’s future prioritize future state spending, and pay off many budgetary exposure to costs resulting from the accumulated bills that were incurred during the expansion of Medi-Cal under the ACA, and recent budget turmoil. While we believe that the as we described, his administration’s revenue economic outlook is considerably more promising estimates are quite cautious. Now that economic 36 Legislative Analyst’s Office www.lao.ca.gov 2013-14 Budget than the administration seems to think, there is fiscal year, providing $2.9 billion of General Fund certainly a risk that our outlook will prove wrong savings compared to the May Revision. As a result, in the near term. If that risk materializes, then the increase in required school payments would not the Governor’s cautious approach to budgeting be greater than the increase in revenues, allowing potentially would allow the state to deal with any the state to actually save additional funds by adding economic downturn with less need for urgent to the reserve—in our view, a key goal during budget cuts or other public policy changes than this economic recovery period, when the state otherwise would be the case. On the other hand, if budget is benefiting from the temporary taxes of the state adopts a cautious budgetary outlook and Proposition 30. For example, even if the Legislature revenues are closer to our estimates, the Legislature adopted the Governor’s revenue estimates and his would have much more flexibility to prioritize state 2013-14 Proposition 98 spending level, there would spending within the next year or two. Put another still be enough money to: way, if the Legislature adopts the Governor’s • Roughly triple the size of the Governor’s plan and revenue estimates, but the economy proposed budget reserve (to $3 billion). and revenues end up performing in line with our office’s expectations, substantial state money will • Avoid adding to the wall of debt by not be available for state reserves, paying accumulated borrowing cap-and-trade auction revenues. state liabilities, restoring prior cuts, and additional • Make targeted program augmentations of a school funding increases within the next few years. few hundred million dollars. Maintenance Factor Policy Means Higher Revenues Help Rest of Budget Little. Another Cautious Approach Involves Tradeoffs, reason to take a cautious approach is that, under Particularly in Restoring Prior Cuts. Since our initial calculations, there is surprisingly little Proposition 98 fares well even under the benefit to the state’s “bottom line” from adopting Governor’s cautious budget plan, a key reason our higher revenue calculations. This is because that the Legislature might want to adopt a less the current maintenance factor approach would cautious budgetary approach is to restore prior require a very large portion of the higher projected cuts in non-Proposition 98 programs. Using the revenues to be allocated to Proposition 98. Our Governor’s maintenance factor policy, but adopting initial estimates show that adopting our higher our office’s revenue estimates, for example, could revenue estimates—while keeping the current give the Legislature some flexibility to use up maintenance factor approach—would allow, at to several hundred million dollars of revenues most, several hundred million more dollars to be to augment non-school programs, while the available for allocation to reserves, paying down rest of our higher revenues would be required debts, or restoring cuts to non-school programs. to be provided to schools. We acknowledge that Alternative Maintenance Factor Approach legislators reasonably might want to restore a few, Would Greatly Enhance Legislative Flexibility. very targeted prior budget cuts and that such an If the Legislature adopted our approach on approach could be consistent with maintaining a maintenance factor repayment, it would have much sound General Fund budgetary condition. If the more control over the use of new revenues. Such Legislature were to take this approach and adopt an approach would not require the state to make our revenue estimates, we would advise it to budget additional Proposition 98 payments in the current the incremental increases in school funds very www.lao.ca.gov Legislative Analyst’s Office 37 2013-14 Budget cautiously, given the significant influx of money Legislature passed a resolution stating its intent already expected under the Governor’s plan and to adopt a plan to address CalSTRS’ unfunded the possibility that revenues will end 2013-14 liabilities during the current, two-year legislative below our forecast levels. If that possibility were to session, and CalSTRS submitted a set of funding materialize, the Legislature would want to preserve options for legislative consideration earlier this options to bring school spending back down to a year. While the Governor addresses comparatively lower minimum guarantee next spring without smaller and less risky items on his wall of debt, he having to make midyear programmatic cuts. has not placed a priority on addressing the more worrisome CalSTRS funding problem. We believe Time for Legislature to Take charge it is time for the Legislature to establish a plan of State’s Future Fiscal Plans addressing CalSTRS’ unfunded liabilities fully Brightened Fiscal Outlook Means Big within the next few decades, as we recommended Choices Ahead. California’s fiscal outlook has earlier this year. This plan will be expensive, but sharply improved in recent months. As indicated there is no option to avoid much higher payments in our forecast, if the economy continues to to the system to address the costs of benefits grow, considerably more budgetary improvement already provided to system members. The longer is possible, particularly if the state continues that a funding solution is delayed, the more costly to carefully limit new or restored spending it will prove to be for future taxpayers. We believe commitments. This year is the time for the the next step for the Legislature should be asking Legislature to begin laying the groundwork for the CalSTRS board directly what a funding plan future budgetary progress by planning how to would have to look like—in its view and that of its address the mammoth set of bills due in part actuaries—to fulfill the contractual commitment because of actions taken during times of recent provided to teachers for a financially sound pension budget turmoil. The state’s debts include not only plan. The Legislature then could evaluate that reply the collection of liabilities the Governor calls and begin the difficult task of figuring out how the wall of debt (substantial repayment of which much more should be paid in the future by the is assumed in our forecast of the state’s budget state, school districts, and teachers, respectively. situation under the Governor’s policies), but also We note that there may be a strong argument to the state’s much larger set of retirement liabilities. prioritize addressing CalSTRS’ liabilities over some In the short term, recent stock market gains will items in the Governor’s wall of debt, given the high improve—at least temporarily—the actuarial effective interest rate of deferring payments on health of public pension funds, but in the long run unfunded pension liabilities. governments will be increasing their payments to Building Reserves Needs to Be a Priority for these entities. Our forecast, for example, reflects Future Surpluses. To the extent that surpluses hundreds of millions of dollars in added costs arise, increasing state reserves needs to be a key in the coming years resulting in part from the funding priority. The Governor’s May Revision California Public Employees’ Retirement System assumes continued, annual suspension of the state’s decision to increase governmental payments and future deposits to the Budget Stabilization Account reduce the risk of future pension funding shortfalls. established by Proposition 58. We recommend CalSTRS Liabilities a Major Fiscal Problem, that the Legislature increase the size of the state’s But Ignored in May Revision. Last year, the reserves over the next few years to the extent 38 Legislative Analyst’s Office www.lao.ca.gov 2013-14 Budget possible. This is important in order for the state could occur with surprising speed). Building to prepare for the expiration of the Proposition 30 reserves means that there will be less necessity taxes within a few years, as well as the inevitable during future downturns to slash public spending, next economic or stock market downturn (which as has occurred in recent years. www.lao.ca.gov Legislative Analyst’s Office 39 2013-14 Budget LAO Publications 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 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. 40 Legislative Analyst’s Office www.lao.ca.gov