The 2014-15 Budget: Overview of the May Revision

The 2014-15 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 16, 2014 2014-15 BUDGET 2 Legislative Analyst’s Office www.lao.ca.gov 2014-15 BUDGET EXECUTIVE SUMMARY Governor’s May Revision Proposal. The Governor’s May Revision raises the administration’s January revenue projections. These increased revenues are offset in part by higher spending requirements for schools and community colleges. In addition, the administration estimates higher costs in several program areas, most notably for health and human services programs. Governor’s CalSTRS Plan a Bold Proposal. The Governor proposes a plan to fully pay over about 30 years the $74 billion unfunded liability for teachers’ pensions. Under the Governor’s proposal, school and community college districts would pay about 70 percent of the costs, with the state paying around 20 percent, and teachers the remaining 10 percent. There is no magic formula for determining how these costs should be shared. Thus, the Legislature will have difficult choices to make about the cost sharing and other issues related to the California State Teachers’ Retirement System (CalSTRS). In particular, we think that the state should end its unusual position as a direct contributor to this program over time. Doing so would not necessarily require benefit changes for future teachers, but would result in CalSTRS’ funding structure being like that of virtually all other pension programs for California’s local government employees. LAO’s Higher Revenues Largely Offset by Higher Proposition 98 Obligations. Given the size of the state budget, our $2.5 billion higher revenue forecast—for 2011-12 through 2014-15—is not substantially different from the administration’s. Based on recent economic data, as well as our forecast assumptions concerning stock prices in the coming months, we project that the state will collect significantly more capital gains taxes than the administration does in 2014-15. To the extent that our assumptions are incorrect, state revenues will be higher or lower than we project— potentially by billions of dollars, given the volatility and unpredictability of California’s tax system. It is important to note that our office’s higher revenue and property tax forecasts, if adopted by the Legislature, could result in no more than several hundred million dollars of additional resources for non-Proposition 98 programs, reserves, or state debt payments in 2014-15. That is because the vast majority of our higher General Fund revenues would be taken up by higher required Proposition 98 spending for schools and community colleges. (We have not yet completed reviewing the administration’s non-Proposition 98 expenditure estimates and, as a result, expect to release a full multiyear budget forecast on our website next week.) Reserves and Paying Debts Are Important Priorities. In our November 2013 Fiscal Outlook publication, we recommended that the Legislature prioritize its preparations for the state’s next budget downturn by building reserves and paying down debts, as well as beginning efforts to address the state’s large retirement and other liabilities, especially CalSTRS. The Governor’s budget plan largely aligns with these priorities. Overall, his plan takes a careful approach to state finances, and he deserves much credit for that. Under this approach, the state would improve its chances of managing the next significant state revenue downturn with little in the way of the drastic budget cuts required during the last few recessions. www.lao.ca.gov Legislative Analyst’s Office 3 2014-15 BUDGET 4 Legislative Analyst’s Office www.lao.ca.gov 2014-15 BUDGET GOVERNOR’S MAY REVISION On May 13, 2014, the Governor released requirements under Proposition 98, higher net the 2014-15 May Revision to his annual budget revised cost estimates for programs, and new proposal. The revision includes a higher forecast proposals. The Governor now proposes a $2.1 billion of revenues, offset in part by increased General reserve, down slightly from January. Fund spending requirements under Proposition 98. Differences From January Budget. Figure 2 In addition, the revision includes increased (see next page) displays the major features of the estimates for caseload costs in health and human Governor’s May Revision. The major changes to the services programs, as well as increased costs for budget include the following: state employee pensions. The preeminent new • Lower Revenues for 2012-13 proposal in the May Revision is a plan to fully (-$513 Million). The administration fund California’s teachers’ pension system in about now estimates that personal income tax 30 years. Below, we describe the administration’s (PIT) revenues were $849 million lower latest projection of the General Fund condition and in 2012-13. In addition, the May forecast provide an overview of the major changes since the reflects $321 million in higher estimated January budget proposal. corporation tax (CT) receipts for 2012-13, with no change to the sales and use tax Projected 2014-15 General Fund Condition (SUT) forecast. Overall, the result is Revised Proposed Reserve for End of 2014-15 $513 million in lower estimated revenues Down Slightly From January. Figure 1 displays the for 2012-13. administration’s projected General Fund condition in the May Revision. The Governor’s January • Higher Revenues for 2013-14 ($2 Billion). budget plan proposed a reserve of $2.3 billion, The administration’s forecast of PIT comprised of $1.6 billion revenues for 2013-14 is $2.2 billion above in the Budget Stabilization Figure 1 Account (BSA)—the state’s Governor’s May Revision General Fund Condition rainy-day reserve created Includes Education Protection Account (In Millions) by Proposition 58—and a $693 million reserve in the 2013-14 2014-15 Special Fund for Economic Prior-year fund balance $2,429 $3,903 Revenues and transfers 102,185 106,950a Uncertainties, the state’s Total resources available $104,614 $110,853 traditional reserve. The Expenditures $100,711 $107,766b administration’s latest Ending fund balance $3,903 $3,087 forecast projects higher Encumbrances $955 $955 revenues for 2012-13, Reserve $2,948 $2,132 2013-14, and 2014-15 Budget Stabilization Account — $1,604 Special Fund for Economic Uncertainties $2,948 528 combined, which are a Amount differs from that in the 2014-15 May Revision summary. To improve the comparability with prior- more than offset by year figures, the number listed here includes all revenues, including those transferred to the Budget higher General Fund Stabilization Account, resulting in $1.6 billion higher revenues than shown in administration totals. b Includes $1.6 billion to accelerate the retirement of economic recovery bonds. www.lao.ca.gov Legislative Analyst’s Office 5 2014-15 BUDGET January levels. (The administration’s • Higher Revenues for 2014-15 January forecast had already revised ($843 Million). The May Revision 2013-14 PIT revenues upward by includes a relatively small adjustment to $3.5 billion over 2013 budget projections. the administration’s forecast of General The administration’s PIT forecast is now Fund revenues in 2014-15. Specifically, $5.7 billion above totals incorporated the administration projects higher PIT into the 2013-14 Budget Act.) The revenues ($474 million), higher CT administration estimates that CT revenues revenues ($228 million), and lower SUT in 2013-14 are up $136 million and SUT revenues ($248 million). After other revenues are down $161 million from the changes, the administration’s forecast for January figures. Combined with other 2014-15 is up $843 million. changes, the administration’s forecast for 2013-14 is up $2 billion. Figure 2 Major Features of the Governor’s May Revision 2012‑13, 2013‑14, and 2014‑15 Combined (General Fund Dollars in Millions) Impact on Reserve Governor’s January Budget Proposed Reserve for End of 2014-15 $2,284a Higher Net Revenue Forecast Lower 2012-13 revenues -$513 Higher 2013-14 revenues 2,038 Higher 2014-15 revenues 843 Subtotal ($2,368) Change in Proposition 98 Guarantee Higher revenue forecast increases General Fund spending -$659 Changes to Other Cost or Savings Estimates Debt-service savings $194 Higher firefighting costs in 2013-14 -90 Increased CalPERS costs -343 Net cost increases in health and human services programs -1,368 Subtotal (-$1,606) Proposals to Pay Down Liabilities Fully fund CalSTRS over about 30 years -$59b Pay down a portion of pre-2004 mandate obligation -100 Subtotal (-$159) Other Spending Proposals Additional proposals to mitigate effects of drought -$116 Increase trial court augmentation relative to January proposal -60 Subtotal (-$176) Net Other Changes $80 Governor’s May Revision Proposed Reserve for End of 2014-15 $2,132c a Consisted of $1.6 billion in the Budget Stabilization Account and $693 million in the Special Fund for Economic Uncertainties. b The Governor’s May Revision proposes to increase the state’s contribution to CalSTRS by $73 million in 2014-15. The number listed above reflects a technical adjustment identified by the administration subsequent to the release of the May Revision. c Consists of $1.6 billion in the Budget Stabilization Account and $528 million in the Special Fund for Economic Uncertainties. 6 Legislative Analyst’s Office www.lao.ca.gov 2014-15 BUDGET • Higher General Fund Requirements Retirement System (CalPERS) board. These Under Proposition 98 ($659 Million). The amounts are offset by a nearly $200 million administration’s lower revenue forecast for savings in the state’s debt-service costs. 2012-13 produces a greater than dollar-for- • New Proposals to Pay Down Liabilities dollar decrease in General Fund spending ($159 Million). Perhaps the most under Proposition 98. Specifically, General significant proposal in the May Revision Fund spending is down $524 million. The is a plan to fully fund CalSTRS over a administration’s higher 2013-14 revenue period of about 30 years. (This plan is forecast produces $1.8 billion in higher discussed in detail later in this report.) General Fund spending for Proposition 98 Under the proposal, the state’s contribution in that year. Despite the administration’s to CalSTRS would increase by $59 million higher revenue forecast for 2014-15, the in 2014-15. In addition, the Governor lower year-to-year change in General proposes to pay down $100 million of the Fund revenues results in $600 million less mandate obligation owed to cities, counties, General Fund spending on Proposition and special districts. 98. Across the period, General Fund requirements under Proposition 98 are up • Other Spending Proposals ($176 Million). $659 million relative to the January budget Senate Bill 103 (Chapter 2, Statutes of proposal. 2014) appropriated $687 million for drought assistance activities. Most of the • Higher Net Estimates of Costs expenditures in that package accelerated ($1.6 Billion). The Governor’s May bond spending for water infrastructure. proposal includes several significant The May Revision proposes an additional revisions to the January budget. Higher $116 million in General Fund spending for caseload costs, lower savings related to 1991 drought assistance, including additional realignment, and various other adjustments firefighter capacity and resources increased health and human services programs. The administration also costs by about $1.4 billion. Costs for state proposes to increase the $100 million employee pensions are up $343 million General Fund augmentation proposed in under recent annual valuation approved January for trial courts by $60 million. by the California Public Employees’ REVENUES Figure 3 (see next page) displays our office’s revenue projections through 2017-18, and Figure 5 projections of General Fund revenue through (see page 9) compares recent revenue forecasts 2019-20, based on our office’s newly revised U.S. of our office and the administration for 2013-14 and California economic forecasts. (For tables and 2014-15. summarizing our economic forecasts, refer to the LAO Revenue Forecast Somewhat Higher Appendix of this publication.) Figure 4 (see next Than Administration’s. Across the four fiscal page) displays the administration’s General Fund years (2011-12 through 2014-15), our General www.lao.ca.gov Legislative Analyst’s Office 7 2014-15 BUDGET Fund revenue forecast is $2.5 billion higher than Thereafter, our forecast and the administration’s the administration’s. Our forecast is slightly drift closer together, and by 2017-18 (the last lower than the administration’s for 2012-13, but year of the administration’s forecast) our office higher by larger and varying amounts in later forecasts just $865 million more in revenue than years. In 2013-14, we forecast $542 million more the administration. The routine variability of General Fund revenues than the administration. California’s General Fund revenues means that For 2014-15—reflecting our office’s economic the $2.2 billion difference between our revenue forecast, including our assumptions concerning forecast and the administration’s for 2014-15 is not the stock market—we project $2.2 billion more in that large in the whole scheme of things. While General Fund revenues than the administration. our best estimates right now are for General Fund Figure 3 LAO Revenue Forecast General Fund and Education Protection Account Revenues and Transfers (In Millions) 2012‑13 2013‑14 2014‑15 2015‑16 2016‑17 2017‑18 2018‑19 2019‑20 Personal income tax $64,154 $66,967 $73,012 $76,957 $80,477 $83,739 $83,014 $84,041 Sales and use tax 20,482 22,581 23,222 24,698 25,253 25,639 26,834 28,030 Corporation tax 8,070 8,398 8,980 9,553 10,113 10,604 11,069 11,566 “Big Three” Taxes ($92,706) ($97,945) ($105,214) ($111,208) ($115,843) ($119,982) ($120,918) ($123,638) Insurance tax $2,222 $2,271 $2,368 $2,490 $2,580 $2,668 $2,756 $2,832 Other revenues 2,617 2,164 2,414 2,105 2,057 2,081 2,059 2,038 Transfers and loans 1,813 347 -803 -1,124 -832 -261 239 239 Totals $99,357 $102,727 $109,193 $114,679 $119,648 $124,470 $125,972 $128,747 Unlike administration’s revenue displays, figure does not reflect transfer of revenues from General Fund to Budget Stabilization Account to improve comparability of totals with those of prior years and to show all revenues received. See Figure 4 for discussion of the administration’s assumptions concerning the General Fund’s entering fund balance. Our office has lower assumptions for 2012 Proposition 30 revenues and, therefore, we assume the 2013-14 entering fund balance was $268 million less than the administration now assumes. Transfers and loans forecast may change slightly in LAO’s full multiyear forecast, to be released during the week of May 19. Figure 4 Administration Revenue Forecast General Fund and Education Protection Account Revenues and Transfers (In Millions) 2012‑13 2013‑14 2014‑15 2015‑16 2016‑17 2017‑18 Personal income tax $64,484 $66,522 $70,238 $74,444 $78,082 $82,029 Sales and use tax 20,482 22,759 23,823 25,686 26,267 26,775 Corporation tax 7,783 8,107 8,910 9,644 10,034 10,292 “Big Three” Taxes ($92,749) ($97,388) ($102,971) ($109,774) ($114,383) ($119,096) Insurance tax $2,221 $2,287 $2,382 $2,499 $2,584 $2,672 Other revenues 2,619 2,163 2,400 2,076 2,034 2,098 Transfers and loans 1,813 347 -803 -1,124 -832 -261 Totals $99,402 $102,185 $106,950 $113,224 $118,169 $123,605 Difference From LAO Forecast $44 ‑$542 ‑$2,242 ‑$1,454 ‑$1,479 ‑$865 Unlike administration’s revenue displays, figure does not reflect transfer of revenues from General Fund to Budget Stabilization Account to improve comparability of totals with those of prior years and to show all revenues received. In addition to the fiscal years shown, the administration assumes $152 million more for the General Fund’s entering fund balance—compared to the level assumed in the 2014-15 Governor’s Budget in January—due to updated assumptions concerning 2012 Proposition 30 revenues accrued back to the 2011-12 fiscal year. 8 Legislative Analyst’s Office www.lao.ca.gov 2014-15 BUDGET revenues to be over $2 billion higher than the 10, 2015, that would be about 925 days after the administration’s projections in 2014-15, changes in 2011-12 fiscal year ended.) asset markets and the economy could materialize For 2012-13, the administration has reduced that would result in less or more tax collections its General Fund PIT estimate by $849 million than our office now projects. since January. The primary reason for this change was a reduction in a specific category of Personal Income Taxes accruals, largely separate from the Proposition 30 2011-12 and 2012-13 Revenues: Accruals Still accruals mentioned above. Proposition 30 accrual Changing. Both the administration’s projections changes also contributed to the lowering of the and our own continue to make budgetary administration’s General Fund PIT estimate for accounting adjustments related to revenues 2012-13. Our office has reduced its 2012-13 PIT for the 2011-12 and 2012-13 fiscal years. These estimates for similar reasons, as we attempt to relate largely to the state’s complex, obscure incorporate these technical accrual practices into revenue accrual practices, which take revenue our own revenue estimates. As we have noted in collected in one fiscal year and move it back to the past, changes in accruals can cause revenue prior fiscal years. (We have discussed accruals estimates to be off by hundreds of millions or even in several prior publications.) For 2011-12, our billions of dollars. The reduction in 2012-13 PIT lower Proposition 30 accrual estimates result in revenues is a good example of this. $268 million of a lower entering fund balance for 2013-14 Revenues: June Collections Loom. June the General Fund than the administration. (We is a major month for PIT collections, as high-income suspect that these 2011-12 Proposition 30 accrual taxpayers and others make their second quarterly adjustments may continue through at least the “estimated payments,” principally on capital gains presentation of the Governor’s 2015-16 budget and business income. These payments are due on plan in January 2015 as the Franchise Tax Board June 15 and typically flow in a few days thereafter (FTB) continues to analyze 2012 collection data. If in large amounts—a few days after the Legislature’s these 2011-12 adjustments are finalized on January constitutional deadline for passing a 2014-15 state Figure 5 Comparing LAO and Administration Revenue Forecasts for 2013‑14 and 2014‑15 General Fund and Education Protection Account Revenues and Transfers (In Millions) 2013‑14 2014‑15 LAO DOF DOF LAO LAO DOF DOF LAO Nov. 2013 Jan. 2014 May 2014 May 2014 Nov. 2013 Jan. 2014 May 2014 May 2014 Personal income tax $66,002 $64,287 $66,522 $66,967 $71,363 $69,764 $70,238 $73,012 Sales and use tax 22,809 22,920 22,759 22,581 23,561 24,071 23,823 23,222 Corporation tax 8,278 7,971 8,107 8,398 8,851 8,682 8,910 8,980 “Big Three” Taxes ($97,089) ($95,178) ($97,388) ($97,945) ($103,775) ($102,517) ($102,971) ($105,214) Insurance tax $2,163 $2,143 $2,287 $2,271 $2,343 $2,297 $2,382 $2,368 Other revenues 2,254 2,480 2,163 2,164 1,874 2,046 2,400 2,414 Transfers and loans 342 346 347 347 -375 -765 -803 -803 Totals $101,847 $100,147 $102,185 $102,727 $107,617 $106,094 $106,950 $109,193 Unlike administration’s revenue displays, figure does not reflect transfer of revenues from General Fund to Budget Stabilization Account to improve comparability of totals with those of prior years and to show all revenues received. DOF = Department of Finance. www.lao.ca.gov Legislative Analyst’s Office 9 2014-15 BUDGET budget plan. The administration assumes that June our wage and salary projection generates around 2014 net PIT collections (for all state funds) total $1 billion of a revenue difference between our office $8.9 billion—mostly from estimated payments. Our and the administration in 2014-15. In some other office assumes that June 2014 net PIT collections revenue categories, such as other investment income total around $9.5 billion. This difference—along and certain business income taxed through the PIT, with accrual and other differences—largely accounts the administration has higher revenue projections for our office’s $445 million higher PIT forecast than our office, resulting in the overall net revenue for 2013-14. For this year’s first estimated payment difference of $2.8 billion for the fiscal year. month—April 2014—quarterly estimated payments In the coming months, it will be important to were $2.3 billion, or 14 percent, above those remember that 2013 capital gains and certain other collections in April 2013. Our forecast assumes that income categories were depressed as taxpayers June 2014 estimated payments are about 20 percent “accelerated” realizations of large amounts of above June 2013 levels, which seems reasonable to income to 2012 to avoid higher federal taxes that us based on continued strength in stock and house took effect in 2013. Many taxpayers are able to Graphic Sign Off prices. make estimated payments during the course of the 2014-15 Revenues: Higher LAO Capital year based on their taxes for the prior year. As a Secretary Gains and Wage Assumptions. Our forecast of result, there appears to us a strong possibility that Analyst 2014-15 General Fund PIT revenues is $2.8 billion many taxpayers will make estimated payments in MPA above the administration’s. Based on our office’s 2014 based on their smaller tax liabilities in 2013, Deputy economic forecast assumptions—including which could result in an unusually large amount of assumptions about near-term trends in stock “settle up” by estimated payment filers when they and home prices—we forecast notably higher net make estimated, final, or extension payments in capital gains realizations by California resident taxpayers in 2014-15. Specifically, our Figure 6 office assumes realizations Projections of Taxable Wage and Salary Growth of $136 billion of these net Change From Prior Year capital gains in 2014, dropping 8% to $123 billion in 2015. The administration, by contrast, 7 LAO Forecast assumes $105 billion in 2014, 6 dropping to $89 billion in 2015. These differences alone 5 Administration Forecast result in about $3 billion 4 more in 2014-15 capital gains 3 taxes in our office’s forecast. Our office also assumes faster 2 growth in taxable wages and 1 salaries—the largest category of taxable income—as shown 2012 2013 2014 2015 2016 in Figure 6. The difference in 10 Legislative Analyst’s Office www.lao.ca.gov Template_LAOReport_mid.ait ARTWORK #140292 2014-15 BUDGET early 2015. For example, January and April 2015 7.2 percent of personal income. Other measures, could be unusually large PIT collection months. however, indicate that certain components of the If this is the case, trends on 2014-15 revenue stock market and housing prices in some areas collections may not become clear until the second of California may be overvalued or close to it. In half of the fiscal year. In fact, if more taxpayers wait any event, no economic or budget forecaster can until early April 2015 to settle up, there is a greater reliably predict when stock and other asset prices chance that monthly revenue collections will fall will fall substantially. short of some months’ estimates during the first Yet, every California budget forecast must several months of 2014-15. make assumptions and projections related to Estimating Capital Gains Requires Making capital gains. We base ours on historical data Assumptions About Asset Prices. The chart about capital gains and assumptions concerning frequently displayed by the Governor that shows the future trend of stock and house prices. With the wildly fluctuating levels of taxable capital regard to the stock market, our office currently gains tells an important cautionary tale about assumes that the S&P 500 stock index will remain Graphic Sign Off California budgeting. Elevated levels of capital fairly flat at between 1,850 and 1,900 through the gains and other volatile state revenue sources end of 2014 and grow slowly thereafter in line Secretary have produced spikes in state revenues that have with the general economy. We assume the Nasdaq Analyst not lasted long, and the state’s budget has been stock index—important for technology firms in MPA left deeply out of balance after several prior California and elsewhere—will stagnate between Deputy revenue spikes ended. While stock and house 4,050 and 4,100 through the rest of 2014. Despite prices have both exceeded our office’s prior these modest near-term stock price forecasts, projections recently, asset markets are not nearly stock prices this year are elevated substantially as “overvalued” as they were in past bubbles by some measures. Figure 7, for Figure 7 instance, shows historical Capital Gains as Percent of California Personal Income and projected capital gains (from both our office and 12% LAO Assumption the administration) as a Administration Assumption percentage of California 10 personal income. The 8 projected levels are both currently well below the 6 levels of the “dot-com” bubble. Figure 7 shows that, 4 as compared to the size of the California economy, 2 capital gains are below peaks reached in prior 1990 1995 2000 2005 2010 2015 bubbles. Our 2014 capital gains projection reaches www.lao.ca.gov Legislative Analyst’s Office 11 Template_LAOReport_mid.ait ARTWORK #140292 2014-15 BUDGET above levels of just one year ago. On May 15, for These Assumptions Can Prove to Be Wrong. example, the S&P 500 was 13 percent above its While we believe our near-term capital gains levels of one year prior. This means that, even forecast assumptions are consistent with recent if markets are flat or they decline somewhat in economic and tax collection data, it is important the coming months, California investors selling for policy makers and the public to understand stocks they bought a year or more ago often that the assumptions underlying any such capital will realize substantial gains, which, in turn, gains forecast are subject to great uncertainty. will generate tax liabilities due to the state. The For example, we developed one scenario in which administration’s economic forecast—which stock prices decline 15 percent over the next year. is posted online—lists identical assumptions In this scenario, our PIT projections dropped about S&P 500 performance through 2016 (both by $1.4 billion for 2014-15 and $4.2 billion for the administration and our office use the same 2015-16 due to reduced capital gains alone (other national economic firm, which provides certain taxable income sources also would decline in U.S. economic data and analysis). such a scenario). Conversely, a scenario in which In Near Term, LAO Capital Gains stock prices climbed 15 percent over the next year Assumptions Consistent With Recent Data. produced similar amounts of increased revenue We believe that our office’s revenue forecast from capital gains relative to our current forecast. better accounts for the fact that asset prices, More broadly, the nation is now five years into an such as stock prices, are substantially higher economic expansion, which is about the average than they were one year ago. Our capital gains length of such an expansion in the post-World forecast—like the administration’s and those War II era. This fact, our downside stock market of some other forecasters—now starts with an scenario, and the various charts showing the ebbs assumption about what capital gains would have and flows of capital gains over time all emphasize been but for the changes in federal tax law at the the importance of an important state budgeting beginning of 2013. (Following development of goal: setting aside reserves when revenues or this “baseline” capital gains forecast, forecasters capital gains climb sharply, as seems to be then “accelerate” some capital gains realizations happening now. that would have occurred in 2013 to 2012 to Other Major Taxes match the actions of investors in response to the changed federal tax laws.) In its baseline capital Lower LAO Sales Tax Forecast. Our General gains forecast, the administration assumes that Fund sales tax revenue forecast is $178 million capital gains in 2014 are equal to those that would lower than the administration’s for 2013-14 and have been realized in 2013 but for the federal $601 million lower than the administration’s changes, despite recent gains in asset prices. for 2014-15. The difference between our sales In our view, such stagnation is unlikely under tax forecast and the administration’s partly the stock market assumptions in both of our reflects differences in our forecasts for residential economic forecasts. Our office’s baseline capital construction. Residential construction generates gains forecast for 2014 is 14 percent above 2013 some taxable sales directly (through purchases of levels, consistent with our economic forecast, as construction materials and other goods), but it well as recent trends in asset prices and estimated also serves as a proxy for consumer confidence, payments. which is difficult to measure directly. Our 12 Legislative Analyst’s Office www.lao.ca.gov 2014-15 BUDGET short-term construction forecast is lower than accrual policies, our lower level of projected the administration’s because construction has 2013-14 refunds has a positive effect on CT underperformed our expectations in recent revenues booked to 2012-13. We acknowledge forecasts. Our long-term forecast is lower due the possibility that refunds in May and June 2014 to underlying demographic trends, including could either be closer to the administration’s population growth, household formation, and estimates or below our estimates. average household size, that dictate how many Forecasting CT revenue continues to be new housing units are built each year. As a result, challenging. The FTB analyzes data that it, the our forecast for total residential building permits administration, and our office all use to estimate is 12 percent lower than the administration’s in the revenue effects of recent CT policy changes 2014 and remains lower throughout the forecast adopted by the state, including the adoption of period, plateauing at around 130,000 permits per a mandatory single sales apportionment factor year in 2017. with passage of Proposition 39 (2012) and the end CT Remains Difficult to Project. The of the suspension in the use of net-loss carryover CT revenue collections in 2013-14 have been deductions. In addition, changes in corporate somewhat higher than the administration income taxable in California was historically projected in January because refunds have been highly related to trends in national corporate substantially lower than the administration income. Over the past five years, however, this estimated at that time. Both our forecast and relationship has significantly weakened to the the administration’s take this into account. point at which estimates of national corporate However, the administration expects about income (a key variable in both our revenue $550 million in refunds to be paid in May and forecasting model and the administration’s) have June of 2014. During this period last year, less become less useful for this purpose. It is unclear than $150 million was refunded to taxpayers. Our whether this is due to state-level policy changes forecast for CT “agency cash” revenue collections or other factors. As we have noted in prior in 2013-14 is a few hundred million dollars higher publications, it will take several years before data than the administration because we assume that is available to help us address these forecasting much less will actually be refunded over the next uncertainties. two months. Because of the state’s complicated PROPOSITION 98—K-14 EDUCATION Funding for schools is largely governed guarantee is funded by state General Fund and by a set of constitutional formulas established local property tax revenues. Funding for schools, by Proposition 98, approved by voters in 1988. the California Community Colleges (CCC), state- Most importantly, Proposition 98 established a subsidized preschool programs, and various other funding requirement commonly referred to as the state education programs count toward meeting minimum guarantee. The minimum guarantee is the guarantee. Below, we provide an overview and determined by various factors, including General assessment of the May Revision Proposition 98 Fund revenues, per capita personal income, package. and K-12 average daily attendance (ADA). The www.lao.ca.gov Legislative Analyst’s Office 13 2014-15 BUDGET Overview of May Revision 2013-14. In 2013-14, these costs are up $1.8 billion Proposition 98 Package due to the combined effect of the increase in the minimum guarantee and lower anticipated growth Proposition 98 Spending Increases in local property tax revenues for that year. $242 Million Over Three-Year Period. As Figure 8 Estimates of Local Property Taxes Down shows, the May Revision lowers Proposition 98 $417 Million Over Three-Year Period. Estimates spending by $547 million in 2012-13 and of local property tax revenue growth are down $700 million in 2014-15 but increases spending over the period for various reasons. In 2012-13, the by $1.5 billion in 2013-14—for a net increase in small drop in local property tax revenue growth spending of $242 million over the period. Funding is due primarily to an upward revision in “excess for both schools ($229 million) and community tax revenues,” which in turn reduces the amount colleges ($13 million) increases over the period. As of local revenue that offsets Proposition 98 costs. shown in the figure, Proposition 98 General Fund (Excess tax revenues reflect local revenues that costs are down in 2012-13 and 2014-15 but up in some school districts, county offices of education, and community Figure 8 colleges receive beyond Changes in Proposition 98 Funding their general purpose (In Millions) funding levels set by January May Change the state. These excess 2012-13 Minimum Guarantee $58,342 $57,795 -$547 revenues are excluded By Segment: from the calculation Schools $51,634 $51,119 -$515 of Proposition 98.) In Community colleges 6,149 6,117 -32 2013-14, property tax Othera 559 559 — revenues are $294 million By Fund Source: lower due to higher General Fund $42,207 $41,682 -$524 Local property taxes 16,135 16,112 -23 estimates of excess taxes 2013-14 Minimum Guarantee $56,813 $58,302 $1,489 together with a slightly By Segment: lower rate of growth in Schools $49,995 $51,363 $1,368 local property values. In Community colleges 6,233 6,355 121 2014-15, local property Othera 585 585 — tax estimates decrease by By Fund Source: $100 million primarily General Fund $40,948 $42,731 $1,783 Local property taxes 15,866 15,572 -294 due to an increase in the 2014-15 Minimum Guarantee $61,559 $60,859 -$700 estimated amount of By Segment: local property taxes that Schools $54,250 $53,626 -$624 schools and community Community colleges 6,723 6,646 -76 colleges must transfer to Othera 587 587 — cities and counties under By Fund Source: current law. General Fund $45,062 $44,462 -$600 Local property taxes 16,497 16,397 -100 a Includes funding for state preschool programs and state agencies providing direct instructional services. 14 Legislative Analyst’s Office www.lao.ca.gov 2014-15 BUDGET 2012-13 Minimum Guarantee Down from the January level. The drop in the minimum $547 Million. The Governor’s May Revision guarantee is primarily due to a smaller required estimate of the 2012-13 minimum guarantee is maintenance factor payment, which, in turn, $57.8 billion. Of the $547 million decrease in the results from smaller year-to-year growth in minimum guarantee from the January estimate, General Fund revenues (due to General Fund $533 million is due to General Fund revenues revenues under the May Revision increasing more being lower than in January. The minimum in 2013-14 than 2014-15). As in 2012-13, Test 1 is guarantee decreases more than the decrease in operative in 2014-15 and the maintenance factor General Fund revenues as a result of Test 1 being payment is highly sensitive to changes in General operative in 2012-13 and the state having a large Fund revenues. required maintenance factor payment (as is also Continues to Pay Down All Outstanding the case in 2014-15). The small remaining drop Deferrals, but Changes Timing. All of the changes in the 2012-13 minimum guarantee is the net noted above result in little new Proposition 98 effect of various adjustments, including the small spending over the period. The largest change in reduction in property tax revenues noted above. the Proposition 98 package relates to the scoring 2013-14 Guarantee Up $1.5 Billion. The of school and community college deferrals. As in Governor’s revised estimate of the 2013-14 the Governor’s budget, the May Revision provides minimum guarantee is $58.3 billion. The a total of $6.4 billion to eliminate all school $1.5 billion increase from the January estimate is and community college deferrals by the end of due primarily to higher General Fund revenues 2014-15, but the May Revision attributes smaller coupled with a higher year-to-year growth rate deferral paydowns to 2012-13 and 2014-15 and a (partly due to the downward revision to prior-year larger paydown to 2013-14 (see Figure 9). General Fund revenues). The guarantee also Slight Increase in LCFF Costs Due to Higher- increases slightly due to an upward revision to the Than-Anticipated ADA. As shown in Figure 10 K-12 ADA estimate (described below). Because (see next page), the May Revision maintains the Test 3 is operative in 2013-14, the minimum Figure 9 guarantee is sensitive to Changes to Governor’s Deferral Paydown Plan changes in both General (In Millions) Fund revenues and K-12 January May Change ADA. 2012-13 2014-15 Guarantee Schools $1,813 $1,295 -$518 Community colleges 194 139 -55 Down $700 Million. Subtotals ($2,007) ($1,433) (-$574) Although the Governor’s 2013-14 estimates of 2014-15 Schools $1,520 $2,781 $1,260 General Fund revenues Community colleges 163 296 134 Subtotals ($1,683) ($3,077) ($1,394) are higher than in 2014-15 January, his revised Schools $2,238 $1,496 -$742 estimate of the minimum Community colleges 236 158 -78 guarantee ($60.9 billion) Subtotals ($2,474) ($1,653) (-$820) Total Proposed Deferral Paydown $6,164 $6,164 — is down $700 million www.lao.ca.gov Legislative Analyst’s Office 15 2014-15 BUDGET proposed $4.5 billion augmentation for second-year community colleges. The May Revision rescinds implementation of the Local Control Funding the January proposal to provide $87.5 million Formula (LCFF). The May Revision also updates (one-time) for instructional equipment but underlying ADA estimates, which in turn affect provides an additional $60.5 million (one-time) for total LCFF costs. Specifically, the May Revision maintenance projects at community colleges. In estimates ADA will grow 0.33 percent rather addition, the May Revision provides $50 million than 0.01 percent in 2013-14 (reflecting about (one-time) for the community colleges to undertake 19,000 additional ADA) and assumes the higher certain activities relating to career technical associated ADA count moving forward. The May education (CTE) and $6 million ($4.6 million Revision estimates ADA in 2014-15 will decrease ongoing, $1.4 million one-time) for Internet 0.11 percent (compared to a decline of 0.12 percent connectivity and networking equipment. The assumed in January). These revised ADA estimates May Revision reduces CCC enrollment growth increase LCFF costs by $103 million in 2013-14 and from 3 percent to 2.75 percent and recognizes $121 million in 2014-15. the updated K-14 cost-of-living adjustment of Other Notable Spending Changes. The 0.85 percent (down slightly from 0.86 percent May Revision contains a few other notable assumed in January). The May Revision also Proposition 98 spending changes—mostly for reappropriates $27 million in unspent prior-year Proposition 98 funds for one-time grants to Figure 10 improve K-12 Internet Changes in 2014-15 Proposition 98 Spending connectivity. (In Millions) Per-Pupil January May Change Programmatic Funding Crosscutting K-14 Adjustments Is Virtually Unchanged Deferral paydown $2,474 $1,653 -$820 From January. Because K-14 COLA 82 80 -1 Prior-year adjustments -2,784 -2,784 — the May Revision makes Proposition 39 adjustments -101 -112 -11 few programmatic Other changes — -18 -18 adjustments from the K-12 Education Governor’s January LCFF implementation 4,498 4,498 — K-12 pupil testing 56 54 -2 budget, K-12 per-pupil LCFF attendance growth 7 128 121 funding is virtually FCMAT — 1 1 unchanged. Almost Attendance growth for categorical programs -18 -1 17 California Community Colleges identical to the January Student Success and Support 200 200 — budget, K-12 per-pupil Enrollment growth 155 140 -15 funding under the May Deferred maintenance (one-time) 88 148 61 Revision goes up from Instructional equipment (one-time) 88 — -88 Community college technical assistance teams 3 3 — $7,933 in 2013-14 to CTE funding (one-time) — 50 50 $8,717 in 2014-15—a Internet equipment (one-time) and connectivity — 6 6 year-to-year increase of Total Changes $4,746 $4,046 -$700 $784 (10 percent). Because COLA = cost-of-living adjustment; LCFF = Local Control Funding Formula; FCMAT = Fiscal Crisis and Management Assistance Team; and CTE = career technical education. the bulk of May Revision 16 Legislative Analyst’s Office www.lao.ca.gov 2014-15 BUDGET spending changes for the community colleges duplicative of several other existing CTE programs. are one-time, per-student ongoing programmatic In addition, the administration has not been able to funding also remains virtually unchanged from provide adequate detail and justification for its new January. Under the May Revision, per-student CCC and K-12 Internet connectivity proposals. funding at CCC increases from $5,636 in 2013-14 to Notable Differences in Estimates of General $5,828 in 2014-15—a year-to-year increase of $192 Fund Revenues and Proposition 98 Minimum (3.4 percent). Guarantee. Though the May Revision spending package is reasonable within the context of the Assessment of May Proposition 98 Package administration’s estimates of revenues and the Overall Approach Continues to Be Sound. If minimum guarantee, we have notably different the Legislature were to adopt the administration’s estimates. As discussed earlier in this report, our May Revision estimates of the minimum guarantee, estimates of General Fund revenues are higher we believe the Governor’s overall Proposition 98 than the administration’s in 2013-14 and 2014-15. spending package—with a balance of one-time and Largely due to these differences, our estimate of ongoing proposals—is sound. Most notably, we the Proposition 98 minimum guarantee is higher believe the Governor’s basic packaging approach— than the administration’s in both years (see maintaining a large ongoing augmentation for Figure 11, next page). Though the difference in the LCFF and adjusting deferral paydowns across the minimum guarantee is relatively small for 2013-14 three-year period to align with revised estimates ($313 million), the difference is notable for 2014-15 of the minimum guarantee—is reasonable. In ($2.2 billion). addition, we believe the Governor’s decision to Local Property Tax Estimates Also Vary devote additional funding to deferred maintenance Notably. In addition to having different General projects at the community colleges is appropriate. Fund revenue estimates for 2013-14 and 2014-15, In both of these cases, the May Revision largely we have notably different local property tax builds off of earlier January proposals. Though estimates than the administration. Our local we have some concerns with the Governor’s new property tax revenues are a total of $658 million spending proposals (as discussed in more detail higher than the administration’s estimates across below), we believe using some of the additional the two years ($218 million higher in 2013-14 and May Revision Proposition 98 funds for one-time $440 million higher in 2014-15). As discussed in purposes is prudent. By reserving these funds for more detail below, the differences in our estimates one-time purposes, the state would minimize the of excess local property tax revenues and revenues potential disruption to schools and community redirected from redevelopment agencies (RDAs) colleges were revenues ultimately to come in lower are particularly significant. (We do not have major (due either to typical volatility or an earlier-than- differences in our baseline property tax forecast. expected economic slowdown). The administration forecasts assessed property Some New Proposition 98 Spending Proposals value will grow 4.2 percent in 2013-14 and 7 percent Appear Either Unnecessary or Premature. Though in 2014-15, similar to our estimates of assessed the May Revision contains little new Proposition 98 value for these years.) spending, we have concerns with some of the Excess Property Tax Estimates Vary Due to Governor’s new proposals. Most notably, we believe Differences in Estimation Methods. Whereas the the proposed $50 million for CCC CTE activities is administration’s estimate of excess property taxes www.lao.ca.gov Legislative Analyst’s Office 17 2014-15 BUDGET does not account for recent changes in school the amount of Proposition 98 local property tax finance, our estimates do reflect these changes. revenues available to offset General Fund costs. The Prior to 2013-14, excess taxes were calculated administration’s estimates, however, do not account relative to a school district’s revenue limit funding. for these changes in school funding and are instead If a district’s property tax revenues were greater calculated based on the prior school finance model. than their revenue limit requirement, the revenues As a result, we believe the administration overstates received above the revenue limit requirement were General Fund costs by $229 million in 2013-14. considered excess taxes. (As discussed above, excess Despite the fundamental difference in estimation tax revenues are excluded from the Proposition 98 method, 2014-15 estimates are much closer, with calculation.) In 2013-14, the state combined funding the administration’s estimate of General Fund costs for revenue limits and more than 30 categorical only $26 million higher than our estimate. programs into the LCFF. Beginning in 2013-14, RDA Revenue Estimates Also Vary. Our excess tax revenues will be calculated based on estimate of 2014-15 RDA revenues flowing to a district’s LCFF entitlement. Because a school schools and community colleges is $198 million district’s LCFF funding will be significantly higher than the May Revision estimate. The higher than its 2012-13 revenue limit funding, the administration’s estimate assumes RDA revenues amount of excess tax revenues should decrease in for schools and community colleges is lower year 2013-14, resulting in a corresponding increase in over year because of an anticipated increase in the amount of outstanding RDA obligations as Figure 11 well as delays in the Comparing Administration and LAO Estimates of distribution of RDA assets Minimum Guarantee due to pending litigation. (In Millions) Although these factors 2013-14 2014-15 likely will reduce RDA Governor’s May Revision $58,302 $60,859 revenues in 2014-15, we General Fund 42,731 44,462 Local property taxes 15,572 16,397 forecast a much smaller Base property taxesa (15,293) (16,245) year-to-year reduction RDA revenue (1,095) (811) in the amount of RDA Excess taxes (-817) (-659) revenues that schools and LAO May Estimates $58,615 $63,097 community colleges would General Fund 42,825 46,259 Local property taxes 15,790 16,837 receive. Base property taxesa (15,307) (16,462) Spending Options RDA revenue (1,071) (1,008) Linked With Different Excess taxes (-588) (-633) Levels of Budget Risk. Difference $313 $2,237 Were the Legislature to General Fund 95 1,797 Local property taxes 218 440 adopt our higher General Base property taxesa (14) (216) Fund and local property RDA revenue (-25) (198) tax revenue estimates Excess taxes (229) (26) a Includes education revenue augmentation fund. and recognize the higher RDA = redevelopment agency. 18 Legislative Analyst’s Office www.lao.ca.gov 2014-15 BUDGET resulting Proposition 98 minimum guarantee revenue conditions have been met. For example, across the period, it would have corresponding the Legislature could specify that it intends to decisions to make regarding how to adjust its distribute a portion of higher Proposition 98 Proposition 98 spending package. The Legislature funds on an ADA basis, with retiring unpaid has various Proposition 98 options to consider. mandate claims having first call on the funds The option associated with the least amount of and implementing the new academic standards downside risk would be to set aside the entire and assessments having second call on the funds amount associated with our higher estimates of (with any one-time educational purpose allowable the minimum guarantee. Later in the fiscal year, if for remaining funds). Under this option, the updated revenue estimates indicated the guarantee Legislature would signal to schools how revenues was higher, then the Legislature at that time could were to be used if they materialized, but the funds settle up the minimum guarantee by appropriating would be allocated to districts only after updated available funds for any high-priority one-time revenue estimates showed the expenditures could purpose (such as paying down the mandate be supported. Compared to these two low-risk backlog). A slightly different approach that still strategies, a somewhat riskier approach would be to has little risk would be to declare the Legislature’s allocate at least some one-time funding to schools intent to use the funds in a specified way but and community colleges now. wait to allocate the funds until certain stated CALSTRS Established in 1913, the California State much the assets will grow with future investment Teachers’ Retirement System (CalSTRS) returns. Typically, pension systems set employer administers pension programs for 868,000 and, in some cases, employee pension contributions members—equivalent to about 2 percent of to ensure that 100 percent funding is achieved or California’s population. CalSTRS members retained over the long term. CalSTRS, however, are current, former, and retired teachers and was 100 percent funded for just a brief period in the administrators of school and community late 1990s. Around that time, the state increased college districts, as well as their beneficiaries. As member benefits and reduced its contributions to discussed in our recent publication, Addressing CalSTRS. These actions—combined with major California’s Key Liabilities, CalSTRS has not been investment losses during some recent periods appropriately funded for most of its 101-year and other factors—contributed to the unfunded history. As a result, the system has considerable liability estimated by CalSTRS to total $74 billion unfunded liabilities. at the end of 2012-13. This means that the system Large Unfunded Liabilities. “Fully funding” is only 67 percent funded. (These estimates reflect a pension system means that the future benefits CalSTRS’ current actuarial assumptions, including already earned by members are 100 percent funded an assumed average annual investment return of by assets on hand. Actuaries make assumptions 7.5 percent over the long term. If lower investment about how long members will live and work, how returns were assumed, the unfunded liabilities much their pay will rise in the future, and how would be much greater.) www.lao.ca.gov Legislative Analyst’s Office 19 2014-15 BUDGET State Action Required. State law provides contribution increases from the state, districts, and that CalSTRS members are entitled to a teachers would begin July 1, 2014, and ramp up in financially sound pension system. Unlike other the coming years. Contributions by the state and pension systems, however, CalSTRS itself has teachers would ramp up over three fiscal years, and no authority to change contribution rates of its district contributions would increase over the next employers or others. Under existing law, only the seven years. The plan aims to fully fund CalSTRS Legislature can increase contributions of school within about 30 years. districts, teachers, and/or the state in order to Districts Would Pay About 70 Percent of address the system’s liabilities. Added Costs. Figure 12 displays the proposed Existing Law Provides No Clear Answers. contribution rate increases under the Governor’s There have been many varied legal opinions plan, including estimates from CalSTRS on the about CalSTRS over time. In the May Revision, dollar amounts that would be generated by these the administration asserts that one statute in contribution rate increases. (The figure reflects, for the Education Code means the state “is not example, CalSTRS’ assumptions concerning future responsible” for much or most of CalSTRS’ school district payroll increases.) Over the next unfunded liabilities—those created by the state’s seven fiscal years, school and community college own actions on benefits and contributions about district contribution rates would more than double 15 years ago. Recent legislative hearings also have from their current level, which is 8.25 percent considered conflicting legal positions of the state’s of teacher payroll. The 10.85 percentage point top lawyers concerning required Proposition 98 contribution increase shown in Figure 12 school funding levels under a future CalSTRS would result in total district contributions of financing plan. 19.1 percent of payroll. By 2020-21, when the plan Based on our years of analysis of CalSTRS, is fully phased in, additional contributions by we conclude that state laws are unclear on all districts would total about $3.8 billion. Over the of these points. That has been the big problem 32-year life of the funding plan, districts would with CalSTRS all along. No law clearly assigns pay an estimated 70 percent of the total added responsibility for CalSTRS’ unfunded liabilities. contributions under the proposal. The Governor No law clearly tells the state how to fund a proposes no adjustments to Proposition 98 CalSTRS financing plan under Proposition 98. specifically related to this additional funding No law says how much of the future funding plan responsibility. The higher contributions to CalSTRS should be paid for by teachers, districts, or the would consume a noticeable portion of the non-education part of the state budget. No law additional funding districts expect to receive over provides CalSTRS with tools to ensure the system the next few years. reaches and remains at 100 percent funding State Would Pay Around 20 Percent of Added over the long term. Today’s legislators face the Costs. Under the Governor’s plan, additional state daunting task of developing—and funding—such contributions to CalSTRS would be phased in over a law. three years. By 2016-17, the state’s contributions to the defined benefit program of CalSTRS The Governor’s Proposal would grow by about 80 percent from what they Fully Funding CalSTRS in About 30 Years. otherwise would be—from 3.5 percent of payroll Under the Governor’s May Revision proposal, to 6.3 percent. (In addition, the state already 20 Legislative Analyst’s Office www.lao.ca.gov 2014-15 BUDGET makes annual payments to another program— Teachers Would Pay About 10 Percent of which shields CalSTRS pension benefits from the Added Costs. Longstanding case law in California effects of inflation—equal to about 2.5 percent limits the ability of the state to change benefits of teacher payroll.) Like all of the state’s current or contribution rates for existing members direct contributions to CalSTRS, the additional of CalSTRS. Consistent with this law, the payments would be funded from the non-education administration advances a proposal—already (“non-Proposition 98”) part of the state budget, discussed in legislative hearings—to guarantee thereby reducing the amount of funds otherwise for the first time an existing benefit that adjusts available to fund other state priorities. teachers’ pensions by a simple 2 percent per Figure 12 CalSTRS Contributions Under Governor’s Plan (Dollars in Millions) 2014-15 2015-16 2016-17 2017-18 2018-19 2019-20 2020-21 Districts Current law rate 8.25% 8.25% 8.25% 8.25% 8.25% 8.25% 8.25% Proposed increase 1.25 2.85 4.45 6.05 7.65 9.25 10.85 New Rate 9.50% 11.10% 12.70% 14.30% 15.90% 17.50% 19.10% Projected Contribution $347 $821 $1,329 $1,874 $2,458 $3,083 $3,751 State Current law rate 3.29% 3.52% 3.52% 3.52% 3.52% 3.52% 3.52% Proposed increase 0.16 1.37 2.81 2.81 2.81 2.81 2.81 New Rate 3.45% 4.89% 6.33% 6.33% 6.33% 6.33% 6.33% Projected Contributiona $59b $384 $772 $812 $842 $874 $906 Teachers Hired Prior to January 1, 2013 Current law rate 8.00% 8.00% 8.00% 8.00% 8.00% 8.00% 8.00% Proposed increase 0.15 1.20 2.25 2.25 2.25 2.25 2.25 New Rate 8.15% 9.20% 10.25% 10.25% 10.25% 10.25% 10.25% Projected Contribution $39 $314 $592 $594 $595 $595 $594 Teachers Hired After January 1, 2013 Current law rate 8.00% 8.00% 8.00% 8.00% 8.00% 8.00% 8.00% Proposed increase 0.08 0.56 1.21 1.21 1.21 1.21 1.21 New Rate 8.08% 8.56% 9.21% 9.21% 9.21% 9.21% 9.21% Projected Contribution $1 $15 $43 $55 $69 $83 $98 Grand Total, Projected $446 $1,534 $2,736 $3,335 $3,964 $4,635 $5,349 Contributions a Includes administration’s proposal to accelerate part of the state’s existing contributions by one-quarter. b The Governor’s May Revision proposes to increase the state’s contribution to CalSTRS by $73 million. The number listed above reflects a technical adjustment identified by the administration subsequent to the release of the May Revision. Note: Based on CalSTRS’ estimates. Amounts paid in the future will vary from estimates depending on teacher compensation. www.lao.ca.gov Legislative Analyst’s Office 21 2014-15 BUDGET year in retirement. In exchange for this new not providing additional funding for these teacher guarantee, the state would increase teachers’ compensation costs, the state benefited by having required contributions to CalSTRS. Because more money to fund various priorities. Because all pension benefits for teachers hired after January 1, three groups benefited, we think it is reasonable 2013 were lowered by the Legislature below for each group to share in the costs to address those of previously hired teachers, the amount CalSTRS’ existing unfunded liabilities. by which the state would increase contributions No One Right Way to Share These Costs. There of post-2013 hires is lower under the Governor’s is no magic formula for determining what portion plan. Specifically, the Governor’s plan increases of the unfunded liability should be paid by the contributions for teachers hired before 2013 state, districts, or teachers. Instead, allocating these by 28 percent—from 8 percent of payroll to costs is one of the key choices the Legislature and 10.25 percent. For teachers hired after 2013, the the Governor need to make. After the state’s leaders increase would be 15 percent—from 8 percent of reach a basic agreement on how costs should be payroll to 9.21 percent. shared, the specific allocation of costs to teachers, districts, and the state’s non-education budget— LAO Comments and any desired Proposition 98 adjustments—can Bold Proposal to Address Huge Problem. In be adopted as statutory law. 2012, the Legislature adopted a resolution declaring Critical to Avoid Future Unfunded Liabilities. its intent to approve legislation to address CalSTRS’ Pension liabilities are paid over an extraordinarily long-term funding needs by the end of the 2014 long time horizon. Moreover, in California public legislative session. Both houses have held hearings employees have strong contractual protections over the last two years that developed some of the that often limit changes to pension benefit and ideas now reflected in the Governor’s proposal. contributions once they are hired and continuing The Governor deserves considerable credit for throughout their lifetimes. For these reasons, if this bold proposal that advances an important the Legislature wishes to change how CalSTRS is discussion. We recommend that the Legislature use funded and administered 50 years in the future, the Governor’s plan as a starting point and adopt decisions have to be made now. By taking such a comprehensive, long-term funding program actions, the state can put CalSTRS on a course to be for CalSTRS this year. As we have pointed out consistently and fully funded—reliably providing in legislative testimony, the costs to address this teachers with benefits they have earned. difficult problem only grow the longer the state We recommend that the Legislature adopt a waits. CalSTRS funding plan that achieves this goal by: Sharing These Unfunded Liability Costs Is • Aiming for Full Funding in About Reasonable. Districts, teachers, and the state each 30 Years. As the American Academy of benefited from the underfunding of teachers’ Actuaries pointed out in a 2012 brief, pension benefits over time. Districts benefited there is a myth that pension finances by offering a valuable compensation benefit at a are healthy if the systems are 80 percent lower cost. Teachers benefited from receiving that funded. In fact, 80 percent funding means compensation at a lower cost, as there was more that 20 percent of previous benefit costs funding in district budgets for other purposes— are shifted to future taxpayers—and in including pay and benefit increases. Finally, by some cases, employees—with high interest 22 Legislative Analyst’s Office www.lao.ca.gov 2014-15 BUDGET costs accruing over time. Pension systems the bargaining table—except for CalSTRS generally aim to reach and maintain pensions. Districts pay their employees 100 percent funding over the long term. and most of their benefits, but the state The Governor correctly proposes this makes an unusual direct contribution to sound funding goal. fund part of the CalSTRS benefits. We believe the state should clarify funding • Preserving Full Funding Once It Is responsibilities for newly hired teachers Achieved. One of the key flaws with in the future. Specifically, we recommend CalSTRS’ historical setup has been that teachers and districts be responsible the inability of the system to adjust for all pension costs—including any future contribution rates based on changing rate changes needed to keep the system actuarial conditions—investment returns, fully funded over time. This would result in system demographics, and changing teachers being treated similarly to virtually benefit structures. To avoid new unfunded all other local government employees, liabilities in the future, CalSTRS would whose pension benefits are funded need to be given authority to adjust from employee and local government contribution rates for employers and/or contributions. This would also ensure future employees—similar to the authority that the state—particularly after paying of CalPERS and other pension systems. billions of dollars to help retire the existing unfunded liability of the system—was • Ending the State’s Unusual Position no longer on the hook for any future in CalSTRS Over Time. The state is unfunded liabilities. This does not mean, responsible for California’s public however, that future teacher benefits would education system, but local districts are the have to be changed. It merely means that employers of teachers and administrators the system would be funded entirely from covered by CalSTRS, and those local teacher and district contributions and districts set most teacher compensation at resulting investment earnings. HEALTH AND HUMAN SERVICES Two-Year Spending Increases by $1.4 Billion. of $919 million ($417 million in 2013-14 and The Governor’s May Revision includes increased $502 million in 2014-15) accounts for the bulk of General Fund spending for health and human the growth in health spending, with the remainder services programs of almost $1.4 billion spread across other health programs. Most of the ($528 million in 2013-14 and $840 million in growth in human services spending is concentrated 2014-15) above the spending levels proposed in the in two programs—California Work Opportunity January 10 budget plan. Of the $1.4 billion increase, and Responsibility to Kids (CalWORKs) and about $400 million is for human services programs In-Home Supportive Services (IHSS). and almost $1 billion is for health programs. An Spending Increases Are Largely Caseload- increase in spending for the Medi-Cal Program Driven, Reflecting Implementation of Federal www.lao.ca.gov Legislative Analyst’s Office 23 2014-15 BUDGET Health Care Reform. As shown in Figure 13, most ACA-related. (The Governor’s May Revision major changes in estimated and proposed health estimates that more households eligible for and human services spending are due to caseload CalFresh will enroll in the program as a result increases. Two of the major caseload changes—the of outreach efforts conducted as part of ACA Governor’s updated caseload estimates for the implementation.) so-called mandatory and optional Medi-Cal Fiscal Uncertainty of ACA Implementation. expansions—are related to the implementation of Given the significant uncertainty surrounding the the Patient Protection and Affordable Care Act fiscal effects of ACA implementation when the (ACA), also known as federal health care reform. Governor prepared the January 10 budget plan— Specifically, the Governor’s caseload estimate for some major ACA provisions affecting Medi-Cal the mandatory Medi-Cal expansion in 2014-15 and other state and local government programs increased from 509,000 beneficiaries to 815,000 went into effect on January 1, 2014—it is not beneficiaries between the January 10 budget and surprising that the May Revision makes significant the May Revision—an increase of about 60 percent. adjustments that reflect the first few months of As shown, the net cost of the estimated increase available data. However, ACA implementation is in Medi-Cal enrollment over 2013-14 and 2014-15 still in its initial phases, and estimates of its impact is $410 million. While Figure 13 shows major on state programs are still subject to significant ACA-related caseload changes, we note that there uncertainty and in many cases are based upon are many other smaller ACA-related impacts limited data and key assumptions. We will review in Medi-Cal and other programs. For example, the Governor’s estimates of ACA-related caseload the Governor proposes a $20 million General adjustments and report to the Legislature at budget Fund increase in the CalFresh program that is hearings on our findings. Figure 13 Major Changes in Estimated Health and Human Services (HHS) Spendinga General Fund (In Millions) Combined 2013‑14 2014‑15 Two‑Year Difference Medi‑Cal Caseload Increases Mandatory Medi-Cal expansion caseload increaseb $92.9 $513.2 $606.1 Optional Medi-Cal expansion caseload increasec -7.2 -189.3 -196.5 Subtotals ($85.7) ($323.9) ($409.6) Other HHS Program Caseload Increases CalWORKs caseload increase $35.0 $95.0 $130.0 In-Home Supportive Services caseload-related cost increases 102.3 137.8 240.1 Subtotals ($137.3) ($232.8) ($370.1) Lower Savings Related to Changes to 1991 Health Realignmentd — $175.1 $175.1 Various Other Changes (Net) $305.0 $108.0 $413.0 Net Increased Costs $528.0 $839.8 $1,367.8 a Relative to the Governor’s January 10 budget. b The Affordable Care Act is expected to result in additional enrollment among populations that were previously eligible for the program—also referred to as the mandatory Medi- Cal expansion. The stated cost increases are net of a related increase in General Fund offsets (savings) from the tax on Medi-Cal managed care plans. c Additional enrollment in the federally funded optional Medi-Cal expansion generates an increase in General Fund offsets (savings) from the tax on Medi-Cal managed care plans. d Reduced savings are reflected in increased General Fund support in CalWORKs. 24 Legislative Analyst’s Office www.lao.ca.gov 2014-15 BUDGET IHSS Spending Increases. The administration increase CalWORKs costs in 2013-14 and 2014-15 now estimates that IHSS General Fund program by a combined total of $130 million. Additionally, costs in 2013-14 and 2014-15 will be a combined the administration has also revised downward total of $240 million above the Governor’s its estimate of county health program savings proposed budget in January. The administration expected to result from ACA implementation, estimates that this increase is mostly due to as many low-income uninsured individuals who expected caseload growth, higher costs per would previously have been served by county hour, and increased hours per consumer. We are indigent care programs are transitioned into evaluating the administration’s caseload, cost, and Medi-Cal. Chapter 24, Statutes of 2013 (AB 85, utilization assumptions, and will report at budget Assembly Committee on Budget), revised the hearings on our findings. 1991 health realignment to redirect these county CalWORKs Spending Increases. The savings to pay for an increased share of CalWORKs administration has revised upward its caseload grant costs, directly offsetting General Fund estimates for the CalWORKs program in light expenditures. Expected savings in 2014-15 have of recent actual data that show the caseload been reduced from $900 million (as estimated in declining at a slower rate than was previously the Governor’s January budget) to $725 million, expected. Higher caseloads are estimated to resulting in additional General Fund costs in CalWORKs of $175 million. EMERGENCY DROUGHT RESPONSE Governor’s Proposals. In February 2014, General Fund) in 2014-15 to continue and expand the Legislature passed legislation providing upon those activities in the budget year. As shown $687 million in 2013-14 for various activities in Figure 14, this funding would support a range related to responding to the current drought in of activities in seven departments. Almost half of California. The Governor’s May Revision proposes the funding ($66 million) would be available to an additional $142 million ($116 million from the the Department of Forestry and Fire Protection to Figure 14 May Revision Proposes Additional Drought Funding for Seven Departments 2014-15 (In Millions) General Other Department Purpose Fund Funds Totals Forestry and Fire Protectiona Increased fire suppression and prevention $53.8 $12.2 $66.0 Fish and Wildlife Monitoring and habitat improvements 30.3 8.5 38.8 Water Resources Emergency water supply activities 18.1 — 18.1 Social Services Food assistance to drought-affected areas 5.0 — 5.0 Office of Emergency Services Drought response coordination and guidance 4.4 — 4.4 State Water Resources Control Board Enforcement of limits on water diversions 4.3 — 4.3 General Services Water conservation in state facilities — 5.4 5.4 Totals $115.9 $26.1 $142.0 a The administration projects spending an additional $90 million for emergency fire suppression in 2013-14. www.lao.ca.gov Legislative Analyst’s Office 25 2014-15 BUDGET expand fire suppression and prevention activities, drought; (2) whether the proposed activities are including funding for additional firefighters for cost-effective means of addressing those problems; what is expected to be an extended fire season. The and (3) whether there are alternative funding total also includes $39 million for the Department sources that could be used to support the activities, of Fish and Wildlife to monitor impacts of the such as charges on beneficiaries or polluters. drought on fish populations, as well as to improve We will provide additional comments on these fish and wildlife habitat throughout the state. In proposals in the course of budget hearings. addition, it includes $18 million for the Department Modest Statewide Economic Effects From of Water Resources (DWR) for various emergency Drought. We note that we are often asked about water supply activities, such as coordinating the the potential effect of the drought on California’s state’s response to the drought, monitoring water economy and tax revenues. There is no doubt that conditions, and increasing the availability of the drought presents substantial economic burdens water to communities. (In addition to the total for some local communities, particularly those cited above, the May Revision proposes to redirect dependent on agriculture and those experiencing $28 million in previously appropriated bond funds severe water supply issues. To address these to install temporary barriers to prevent salt water concerns, the previous drought legislation and the from intruding into the Sacramento-San Joaquin May Revision include a total of $53 million for Delta. It also includes provisional language that food, employment, and rental housing assistance would allow the Director of Finance to augment for communities most affected by the drought. On DWR’s General Fund budget by up to $19.3 million a statewide basis, however, the net effects of the to operate, maintain, and remove those barriers.) drought on economic activity likely will be very Considerations When Reviewing Drought modest in the near term. Should the drought persist Proposals. In reviewing the administration’s or intensify, its effects could increase somewhat, drought-related proposals, the Legislature may including the effects of longer-term changes in wish to consider several questions. These include agriculture and other parts of the economy. Our (1) the degree to which the proposals address the office will continue to monitor the economic effects most critical problems associated with the current of the drought. LAO COMMENTS Governor Prioritizes Reserves and services expenditures are increasing in 2014-15, Debt Repayment particularly higher Medi-Cal costs related to ACA implementation. Even after accounting for such The improvement in the state’s fiscal baseline spending increases, there remain several condition—driven largely by continued economic billion dollars to be allocated. The Governor’s key growth and rapid increases in financial and choices for what to do with these funds are to: housing markets—has resulted in large increases in the revenue available to the state in recent • Use his authority under Proposition 58 years. This year, under current law, a significant to allow the full deposit to the BSA to portion of these new revenues is required to be be made in 2014-15. This results in a spent on schools. In addition, health and human $1.6 billion BSA deposit and the paying 26 Legislative Analyst’s Office www.lao.ca.gov 2014-15 BUDGET down of the state’s past deficit bonds Proposition 98 and the (economic recovery bonds, or ERBs) one Higher LAO Revenue Estimates year early with a $1.6 billion payment. (This Higher LAO General Fund Revenue and payment means that the state General Fund Property Tax Estimates ($3.2 Billion). Our office’s will receive a roughly $1.6 billion budget projections of General Fund revenues from 2011-12 benefit in 2015-16 due to the end of the through 2014-15 are nearly $2.5 billion higher ERBs’ “triple flip” repayment mechanism.) than the administration’s estimates of revenues. As we discuss in the “Revenues” section of this • Propose spending over $150 million more report, this multiyear difference in projected in 2014-15 for payments on local mandate revenues is not particularly large, given the size and teacher pension debts. of the state’s $100 billion annual General Fund • Propose several hundred million dollars budget and its significant tax revenue volatility and more of spending on higher education, unpredictability. In addition to our office’s higher judicial, drought-related, and other General Fund revenue projections, we project programs. over $700 million more in local property taxes for school districts through 2014-15, which serves to Building Reserves and Paying Debts Are reduce what otherwise would be General Fund Important Priorities. In our November 2013 Fiscal spending under Proposition 98. Our office’s higher Outlook publication, we recommended that the revenue and property tax estimates combined are Legislature prioritize its preparations for the state’s $3.2 billion above the administration’s through next budget downturn by building reserves and 2014-15. paying down debts, as well as beginning efforts Higher Estimates of Proposition 98 Guarantee to address the state’s large retirement and other ($2.7 Billion). If the Legislature were to adopt our liabilities, especially CalSTRS. The Governor’s office’s higher General Fund revenue and local budget plan largely aligns with those priorities. property tax estimates, the Proposition 98 funding Overall, the Governor’s plan takes a careful requirements over the period would be a total approach to state finances, and he deserves much of $2.7 billion higher than the administration’s credit for that. The state’s volatile tax revenue estimates. That is, the vast majority of the higher system, uncertainty about future stock and revenues would be required to go to schools and other asset prices, and the likelihood—based on community colleges. The guarantee is particularly historical trends—of another recession within sensitive to higher General Fund revenues a few years all emphasize the importance of in 2014-15, with revenue increases primarily building reserves and reducing state debt. Under benefiting schools. the Governor’s approach, the state would improve Still Evaluating Administration’s its chances of managing the next significant Non-Proposition 98 Budget Estimates. Given the state revenue downturn with little in the way of figures described above, our initial conclusion the drastic budget cuts required during the last is that if the Legislature adopted our higher few recessions. Should the economic expansion General Fund revenue and property tax estimates continue a few more years, the Governor’s 2014-15 and adjusted the state’s Proposition 98 costs budget could pave the way for even larger General accordingly, perhaps around $500 million would be Fund budgetary surpluses in the future. available—above amounts in the May Revision—for www.lao.ca.gov Legislative Analyst’s Office 27 2014-15 BUDGET building reserves, paying down more debts, and/ deliberations. Perhaps the most important issue for or other state priorities. This, however, assumes the Legislature is how it responds to the Governor’s that all of the administration’s non-Proposition 98 proposal to address CalSTRS’ massive unfunded spending estimates are accurate. (We have liabilities. Any legislative action on this matter not finished reviewing the administration’s likely will have major long-term fiscal implications non-Proposition 98 expenditure estimates. We for the state, school districts, and teachers. Should plan to release a full multiyear budget forecast, the Legislature adopt our office’s higher revenue including the results of our quick review of the estimates, it will also have important decisions administration’s expenditure estimates, next week.) to make regarding increased Proposition 98 obligations (which would take up the vast majority CalSTRS a Key Issue for the Legislature of the additional revenues) and how to allocate the The Governor’s May Revision proposal remaining funds. sets the stage for the Legislature’s final budget 28 Legislative Analyst’s Office www.lao.ca.gov 2014-15 BUDGET APPENDIX Appendix Figure 1 LAO Economic Forecast Summary Percent Change Unless Otherwise Indicated United States 2013 2014 2015 2016 2017 2018 2019 2020 Real gross domestic product 1.9 2.4 3.0 3.4 3.2 2.8 2.7 2.6 Personal income 2.8 3.6 5.1 5.4 5.6 5.1 4.8 4.6 Wage and salary employment 1.7 1.6 1.9 2.1 1.8 1.2 0.8 0.7 Unemployment rate (percent) 7.3 6.5 6.1 5.6 5.3 5.1 5.0 5.0 Consumer price index 1.5 1.8 1.6 1.5 1.9 2.2 2.0 1.9 Housing starts (thousands) 929 1,045 1,389 1,582 1,603 1,602 1,627 1,616 Target federal funds rate (percent) 0.1 0.1 0.4 2.2 3.8 4.0 4.0 4.0 S&P 500 average (stock index) 1,643 1,868 1,946 2,030 2,096 2,162 2,238 2,317 California 2013 2014 2015 2016 2017 2018 2019 2020 Personal income 2.8 4.6 5.6 5.6 5.8 5.5 5.4 5.2 Wage and salary employment 3.0 2.2 2.4 2.2 1.9 1.5 1.6 1.6 Unemployment rate (percent) 8.9 7.6 6.7 6.0 5.5 5.3 5.1 5.1 Consumer price index 1.5 1.8 1.6 1.5 1.9 2.2 2.0 1.9 Housing permits (thousands) 83 93 110 120 126 129 131 130 Single unit permits (thousands) 36 40 44 50 54 55 54 52 Multiunit permits (thousands) 46 54 66 71 73 74 76 78 State population growth 0.9 1.0 0.9 0.7 0.7 0.6 0.6 0.6 Appendix Figure 2 Comparing Recent Economic Forecasts 2013 2014 2015 DOF DOF LAO DOF DOF LAO DOF DOF LAO January May May January May May January May May 2014 2014 2014 2014 2014 2014 2014 2014 2014 United States Percent change in: Real gross domestic product 1.7% 1.9% 1.9% 2.5% 2.4% 2.4% 3.1% 3.0% 3.0% Personal income 2.8 2.8 2.8 4.6 3.6 3.6 4.8 5.1 5.1 Wage and salary employment 1.6 1.7 1.7 1.6 1.6 1.6 1.8 1.9 1.9 California Percent change in: Personal income 2.6% 2.8% 2.8% 4.6% 4.6% 4.6% 5.0% 5.1% 5.6% Wage and salary employment 2.1 3.0 3.0 2.3 2.5 2.2 2.3 2.5 2.4 Unemployment rate 8.9 8.9 8.9 7.9 7.6 7.6 7.3 6.9 6.7 Housing permits (thousands) 87 84 83 114 106 93 134 123 110 www.lao.ca.gov Legislative Analyst’s Office 29 2014-15 BUDGET 30 Legislative Analyst’s Office www.lao.ca.gov 2014-15 BUDGET www.lao.ca.gov Legislative Analyst’s Office 31 2014-15 BUDGET LAO Publications The development of this report was coordinated by Ryan Miller. 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. 32 Legislative Analyst’s Office www.lao.ca.gov