The 2015-16 Budget: California's Fiscal Outlook

The 2015-16 Budget: California’s Fiscal Outlook MAC TAYLOR (cid:127) L E G IS L AT I V E A N AL Y ST (cid:127) NOVEMBER 2014 Table of Contents Executive Summary ..................................................................................................1 Chapter 1—G eneral F und T hrouGh 2015-16 ................................3 Factors Affecting the 2015-16 Budget ....................................................................3 LAO Comments .........................................................................................................8 Chapter 2—T he e conomy and r evenues ........................................11 The Economy ...........................................................................................................11 State General Fund Revenues ................................................................................13 Chapter 3—s pendinG o uTlook .....................................................21 Education ................................................................................................................21 Proposition 98 ..............................................................................................................................21 Universities ....................................................................................................................................29 Financial Aid ................................................................................................................................31 Health and Human Services ...................................................................................32 Corrections and Rehabilitation ............................................................................41 Other Programs ......................................................................................................41 Chapter 4—i mplemenTinG p roposiTion 2 .......................................45 Choices About Rules and Calculations ..................................................................45 Strategies for Paying Down Debt .........................................................................50 Chapter 5—T he s TaTe B udGeT a FTer 2015-16 ..............................55 Legislative Analyst’s Office www.lao.ca.gov CALIFORNIA’S FISCAL OUTLOOK Legislative Analyst’s Office Legislative Analyst Mac Taylor State and Local Finance Education Jason Sisney Jennifer Kuhn Marianne O’Malley Edgar Cabral Chas Alamo Carolyn Chu Justin Garosi Natasha Collins Seth Kerstein Jason Constantouros Ryan Millera Rachel Ehlers Nick Schroeder Paul Golaszewski Brian Uhler Judy Heiman Brian Weatherford Kenneth Kapphahn Jameel Naqvi Corrections, Transportation, and Environment Anthony Simbol Health and Human Services Brian Brown Mark C. Newton Drew Soderborg Shawn Martin Ashley Ames Amber Didier Ross Brown Rashi Kesarwani Virginia Early Lourdes Morales Aaron Edwards Ginni Bella-Navarre Anton Favorini-Csorba Felix Su Jeremy Fraysse Ryan Woolsey James Hacker Helen Kerstein Sarah Larson Anita Lee Jessica Peters Administration and Information Services Support Larry Castro Tina McGee Sarah Kleinberg Izet Arriaga Karry Dennis-Fowler Sarah Scanlon Michael Greer Jim Stahley Vu Chu Anthony Lucero Douglas Dixon Sandi Harvey a Fiscal Outlook coordinator. ii Legislative Analyst’s Office www.lao.ca.gov Executive Summary Keys to Understanding This Report. This report estimates the fiscal outlook of the General Fund—the state’s main operating account. The main scenario we use to develop the outlook assumes continued moderate economic growth through 2020. We base our outlook on today’s laws and budget practices, thereby providing state policymakers a sense of the available resources to guide future policy changes. The Current Budget Situation. We estimate that 2014-15 General Fund revenues will be about $2 billion higher than estimated in this year’s budget act. The increase, however, is fully offset by higher General Fund spending on Proposition 98. Our outlook for 2015-16 is characterized by moderate revenue growth, which supports an underlying spending increase of about 4 percent. (While we project 2015-16 expenditures as being similar to 2014-15 spending, there are several large one-time factors that mask the growth rate in ongoing programs.) Under our outlook, the resources available for Proposition 98 priorities in 2015-16 will be significantly higher than the current ongoing spending level, making the near-term outlook for schools and community colleges especially favorable. Absent New Budget Commitments, 2015-16 Ends With $4.2 Billion in Reserves. Under our main scenario, 2015-16 would end with $4.2 billion in total reserves assuming no new budget commitments are made. This total includes an estimated $2 billion deposit in the rainy-day fund in 2015-16 under the new rules passed by voters in Proposition 2. Under Proposition 2, another $2 billion would have to be spent on existing state debts, for a total of $4 billion in Proposition 2 reserve and debt payment requirements. We note that key choices in 2015-16 concerning Proposition 2 implementation will determine the extent of the Legislature’s ability to access the state’s reserves and could alter the total Proposition 2 requirement by around $1 billion or more. State Budget After 2015-16. We consider the future condition of the General Fund in three different economic scenarios. Our main scenario suggests future surpluses and growing budget reserves. Surpluses, however, disappear in a hypothetical scenario involving a large stock market drop and slowdown of economic growth. The budget also would be somewhat more constrained Legislative Analyst’s Office www.lao.ca.gov CALIFORNIA’S FISCAL OUTLOOK if higher revenues materialize in 2014-15, but result largely from a one-time spike in capital gains taxes. In that scenario, higher ongoing school funding requirements could make it more difficult to balance the budget in 2015-16 and beyond. Thus, the state could see the condition of its General Fund worsen in the future if (1) revenues decline sharply or (2) revenues increase sharply, but temporarily, in 2014-15. Opportunities to Further Strengthen California’s Budget. The $4.2 billion reserve we project for the end of 2015-16 would mark significant progress. In addition, a reserve of around this size would stave off the hypothetical slowdown scenario described above for a year or two before the state would face multibillion-dollar budget problems. Maintaining a $4 billion reserve, however, would allow little or no new spending commitments outside of Proposition 98 in 2015-16. Considering that the U.S. economy is six years into the current economic expansion, and given the future risk to the General Fund under scenarios in which revenues are either lower or higher, we advise the Legislature to keep making progress in building budget reserves. Moreover, the Legislature has the opportunity in the coming months to develop a plan for using the $15 billion to $20 billion of future Proposition 2 debt payments. This plan could pay down several persistent state debts and save future taxpayers tens of billions of dollars. 2 Legislative Analyst’s Office www.lao.ca.gov Chapter 1 General Fund Through 2015-16 This report summarizes our office’s assessment our outlook for state spending over the next few of California’s economy and budget condition. years. We discuss various choices the state has in Our main outlook scenario (referred to as our implementing Proposition 2—the budget reserve “main scenario” or “main economic scenario”) and debt payment measure recently approved assumes continued moderate economic growth, by voters—in Chapter 4. Finally, we discuss the though many other scenarios—both stronger and longer-term outlook for the budget condition in weaker—are possible. In this chapter, we present Chapter 5, comparing our main economic scenario our estimates of the near-term budget condition. to alternate sets of assumptions—including a In Chapter 2, we discuss key revenue trends and hypothetical economic slowdown. The box on the our assessment of the economy. Chapter 3 presents next page discusses some key information needed to understand this report. FACTORS AFFECTING THE 2015-16 BUDGET Figure 1 (see page 5) displays our estimate of argument that the Legislature could appropriate the condition of California’s General Fund through pre-Proposition 2 BSA balances with a simple 2015-16 under our main scenario. As shown in the majority vote, whereas the Governor would have to figure, absent changes to current law and practices, declare a budget emergency before the Legislature we estimate that the state would end 2015-16 with could access BSA funds deposited after passage of $4.2 billion in total reserves. This would consist Proposition 2.) of $641 million in the Special Fund for Economic 2014-15 Budget Erosions Uncertainties (SFEU)—the state’s traditional budget reserve—and $3.6 billion in the Budget Stabilization The state’s 2014-15 budget package assumed Account (BSA). We distinguish between amounts that 2014-15 would end with $2.1 billion in total that were deposited in the BSA before and after reserves. This consisted of a $450 million reserve the voters passed Proposition 2 in Figure 1. in the SFEU and a $1.6 billion balance in the BSA. (As discussed in Chapter 4, there is a strong We now estimate a $569 million erosion in the Legislative Analyst’s Office www.lao.ca.gov CALIFORNIA’S FISCAL OUTLOOK SFEU reserve balance, leaving a year-end deficit Proposition 98 minimum guarantee for schools and of $119 million in that account. Combined with community colleges; (4) $170 million in mandate the $1.6 billion balance in the BSA, we estimate reimbursements to cities, counties, and special that total reserves will be $1.5 billion at the end of districts resulting from a “trigger” included in the 2014-15. The decline in the SFEU balance is the net 2014-15 budget; and (5) other small estimating result of (1) our lower estimate of 2013-14’s entering differences. fund balance; (2) higher revenues; (3) higher Revenue Accruals, SUT Correction Reduce General Fund spending necessary to satisfy the Entering Fund Balance (-$243 Million). The Keys to Understanding This Report Outlook Based on Current Laws and Practices. Our outlook is based on the state’s revenue and spending policies currently in place. For example, we assume that the temporary taxes passed by voters in Proposition 30 expire consistent with existing law. We also assume continuation of recent budget practices, such as funding increases for universities and state employee pay, as best we can. (In some programs, different interpretations of how to extend recent budget practices into the future are possible.) Future Resources Will Differ Based on Future Policy Decisions. Our outlook provides state policymakers a sense of future budgetary resources available under a scenario in which no new budget commitments are approved. The state’s leaders can use our estimates along with other information to make decisions about changes in policies which may increase or decrease state spending or revenues. Because the state will make such changes over time, future estimates of revenues and spending will not be directly comparable to those reflected in this report. Our Main Economic Scenario Is One of Many Possible Scenarios. We develop economic scenarios in order to produce our budget outlook. Our main economic scenario—discussed throughout this publication—reflects our best estimate, as of now, of economic trends through 2015-16. After 2015-16, it assumes moderate, ongoing economic growth, consistent with standard practices employed by many economic forecasters. Our main scenario, however, is only one of many possible economic outcomes. Future economic conditions could be stronger or weaker than our main scenario—or even weaker than the hypothetical economic slowdown scenario discussed in Chapter 5. Different Economic Outcomes Will Affect Future State Budgets. As described above, future economic conditions may differ substantially from the scenarios we develop for this report. In particular, it is impossible to predict future stock market trends—an extremely volatile variable that is key to predicting personal income tax collections, Proposition 98, and Proposition 2 requirements. The links between the state budget, the stock market, and the economy mean that the future “bottom line” of the budget—particularly past 2015-16—will likely vary significantly from our outlook. We advise policymakers to consider our main scenario, the hypothetical economic slowdown, and other information discussed in Chapter 5 in making choices about future state policies. 4 Legislative Analyst’s Office www.lao.ca.gov CALIFORNIA’S FISCAL OUTLOOK 2014-15 budget assumed a 2013-14 entering fund from the unclaimed property program to be over balance of $2.4 billion. The state commonly adjusts $100 million lower than budget act estimates for the prior fiscal year’s entering fund balance as part 2013-14 and 2014-15 combined based on recent cash of the budget process to reflect changes in past receipts that fell far short of budget act assumptions. revenue and spending estimates. Under the state’s We also assume no 2014-15 General Fund fine or revenue accrual policies, personal income tax (PIT) penalty payments from the Pacific Gas & Electric and corporation tax (CT) estimates are regularly (PG&E) Company related to the 2010 San Bruno adjusted in this way. We estimate that PIT and pipeline explosion. The 2014-15 budget assumed CT revenue accruals for 2012-13 will increase the that the General Fund would receive a $300 million entering fund balance by a combined $114 million. PG&E payment, but an appeal makes the timing This gain, however, is offset by a $358 million and amount of any such payment highly uncertain. downward adjustment relating to an allocation of It is quite possible that the General Fund will state sales and use tax (SUT) to local governments receive some payments from PG&E in the coming to correct for past accounting issues. All told, these years, and if so, these payments would improve the adjustments result in an entering fund balance of budget’s bottom line. $2.2 billion, or $243 million lower than the budget’s Higher Revenues Offset by Higher assumptions. Given our limited information about Proposition 98 Spending (-$2.1 Billion). prior-year expenditures and the complexity of the Proposition 98 is the state’s constitutional state’s revenue accrual policies, we stress that this minimum funding guarantee for schools and assumption could easily prove hundreds of millions community colleges. Under current practices for of dollars too low or too high. calculating the guarantee, higher state revenues Revenues in 2013-14 and 2014-15 Combined in certain years can result in a dollar-for-dollar Exceed Budget Projections ($2 Billion). We project increase in Proposition 98 requirements. In that General Fund Figure 1 revenues and transfers LAO General Fund Condition Under Main Scenarioa will be higher than the (In Millions) budget’s assumptions by $92 million in 2013-14 2013‑14 2014‑15 2015‑16 and $2 billion in 2014-15. Prior-year fund balance $2,186 $3,680 $836 This is primarily due Revenues and transfers 102,277 107,442 111,397 Expenditures 100,783 110,286 110,638 to the combination of Difference between revenues and $1,494 -$2,843 $760 $2.1 billion in higher PIT expenditures revenues, $984 million in Ending fund balance $3,680 $836 $1,596 higher CT collections, and Encumbrances -955 -955 -955 SFEU balance 2,725 -119 641 $911 million in lower SUT Reserves revenues over those two SFEU balance $2,725 -$119 $641 fiscal years. In addition Pre-Proposition 2 BSA balance — 1,606 1,606 to our revised estimates Proposition 2 BSA balance — — 1,974 for the state’s major Total Reserves $2,725 $1,488 $4,222 a Includes Education Protection Account created by Proposition 30 (2012). taxes, we also estimate SFEU = Special Fund for Economic Uncertainties (the General Fund’s traditional budget reserve) and BSA = Budget Stabilization Account. General Fund revenues www.lao.ca.gov Legislative Analyst’s Office 5 CALIFORNIA’S FISCAL OUTLOOK 2014-15, our higher estimates of General Fund spending items do not continue into 2015-16. proceeds of taxes results in a nearly equal increase The combination of revenue growth and flat in General Fund spending under Proposition 98. General Fund spending results in a $760 million While lower assumptions of unclaimed property increase in our estimated year-end SFEU balance revenues and the PG&E penalty reduce General during 2015-16. In addition, we calculate that Fund revenues, they do not reduce Proposition 98 Proposition 2 will require $4 billion of revenues to requirements because these particular revenues be split between deposits to the BSA reserve and are not proceeds of taxes factored into the payments on existing state debts. Below, we discuss Proposition 98 calculation. This partly explains some of the major trends in 2015-16. the disproportionate increase in General Fund Modest Revenue Growth in 2015-16. We spending under Proposition 98 ($2.1 billion) estimate that total General Fund revenues and compared to the increase in total General Fund transfers will increase from $107 billion in 2014-15 revenues ($2 billion). We discuss Proposition 98 in to $111 billion in 2015-16. This is mostly explained more detail in Chapter 3. by $2.7 billion in higher PIT revenues, $1.2 billion Mandates Trigger Increases Spending in increased SUT collections, and $893 million in (-$170 Million). The 2014-15 budget requires the higher CT revenues. Our PIT estimates assume Director of Finance to determine as of May 2015 somewhat slower wage and salary growth in 2015, whether General Fund proceeds of taxes exceed compared to this year. In addition, we assume that the administration’s May 2014 estimates. If so, the stock market will decline somewhat through after setting aside amounts necessary to satisfy the early 2015, remain flat for the remainder of that Proposition 98 minimum guarantee, any remaining year, and then grow modestly in 2016. Accordingly, proceeds of taxes—up to $800 million—will be our assumed PIT growth of 3.8 percent in 2015-16 allocated to cities, counties, and special districts for is much lower than in some recent years. On the outstanding mandate claims. Under our estimates, other hand, we estimate strong CT growth of this trigger results in $170 million in mandate 9.4 percent in 2015-16, reflecting our assumptions reimbursements. (This trigger calculation does not that corporate income will continue to grow consider some of the budget erosions described through 2015 and that CT refunds will remain earlier.) lower than budget act assumptions. These revenues are offset by required deposits to the BSA under Main Outlook Scenario: Proposition 2 and additional special fund loans $4.2 Billion in Reserves in 2015-16 assumed to be repaid in 2015-16. We estimate that—absent changes to current Growth in Spending Masked by One-Time law and practices—total reserves would grow from Actions. As shown earlier in Figure 1, we estimate $1.5 billion at the end of 2014-15 to $4.2 billion General Fund spending across 2014-15 and at the end of 2015-16. We estimate moderate 2015-16 to be largely flat. Underlying growth in growth in the state’s “big three” revenue sources. programmatic spending, however, is masked by Specifically, we estimate PIT, CT, and SUT various one-time and ongoing changes that offset collections to increase 4.6 percent in 2015-16, from what otherwise would have been a year-to-year $105 billion to $110 billion. General Fund spending increase in General Fund spending. For example, is largely flat between 2014-15 and 2015-16 under the 2014-15 budget included $1.6 billion to our outlook, in part because certain one-time accelerate payment of the state’s prior deficit 6 Legislative Analyst’s Office www.lao.ca.gov CALIFORNIA’S FISCAL OUTLOOK financing bonds—known as economic recovery resulting from passage of the measure. Figure 3 bonds (ERBs). The retirement of the ERBs results in (see next page) displays estimates of Proposition 2 $1.7 billion more in property tax revenue available requirements through 2019-20 under our main to offset General Fund spending in Proposition 98 economic scenario. Because the stock market drives beginning in 2015-16. (Had this ERB payment capital gains taxes that affect Proposition 2 and it not been made in the 2014-15 budget, General is impossible to predict future stock market trends Fund spending would have increased $3.3 billion with precision, future Proposition 2 estimates will year over year.) In addition, we assume that differ from those shown in the figure. Moreover, savings associated with increased federal funding different choices about implementing Proposition 2 of the Children’s Health Insurance Program would also result in future calculations that differ (CHIP) under federal health care reform reduces from those in Figure 3. General Fund spending for Medi-Cal by around No Budget Emergency Available Under $500 million in 2015-16 without affecting the Proposition 2 Fiscal Calculation. Under overall level of spending for CHIP. We also assume Proposition 2, amounts to be deposited in the BSA that various one-time commitments made in the can only be reduced in a budget emergency. The 2014-15 budget are not renewed, including funding Governor may choose to declare a budget emergency for mandates ($270 million), multifamily housing based on conditions specified in the measure. One ($100 million), drought assistance ($115 million), such condition includes a fiscal calculation shown and higher education innovation awards in Figure 4 (see page 9). (A budget emergency could ($50 million). Absent all these items, 2015-16 also be declared in the case of a natural disaster.) To General Fund spending would have been around determine the availability of a budget emergency 4 percent over 2014-15 levels. under this fiscal calculation, the estimated resources About $4 Billion Split Between Reserves for both the current fiscal year (2014-15) and the and Debt Under Proposition 2. Beginning in upcoming fiscal year (2015-16) are compared to the 2015-16, Proposition 2 will change how the state last three enacted budgets, adjusted for inflation saves money in reserves and pays down debt. and population growth. Under our main scenario, Figure 2 summarizes some of the key changes we estimate that resources in both years would be Figure 2 Key Changes Made By Proposition 2 State Debts Requires state to spend minimum amount each year to pay down specified debts.a State Reserves Changes amount of annual Budget Stabilization Account (BSA) deposit.a Increases maximum size of the BSA. Changes rules for when the state can reduce or suspend the BSA deposit. Changes rules for withdrawing funds from the BSA. School Reserves Creates state reserve for schools and community colleges, the Public School System Stabilization Account (PSSSA). Sets maximum reserves that school districts can keep in a year following a deposit into the PSSSA.b a After 15 years, debt spending under Proposition 2 becomes optional. Amounts that otherwise would have been spent on specified debts would instead be deposited in the BSA. b This change results from Chapter 32, Statutes of 2014 (SB 858, Committee on Budget and Fiscal Review). www.lao.ca.gov Legislative Analyst’s Office 7 CALIFORNIA’S FISCAL OUTLOOK sufficient to fund the prior three adjusted budgets. to administer this particular calculation. Different As such, no budget emergency would be available decisions could change how often a budget emergency under this fiscal calculation. As we describe later is able to be declared and could result in near-term in this publication, the state faces choices in how calculations that differ from those in Figure 4. LAO COMMENTS Key Choices in Implementing Proposition 2. $4.2 Billion Reserve Would Be Substantial As we describe in Chapter 4, the state has some Progress. Absent new spending commitments discretion in implementing Proposition 2. Choices above the increases already contained in our the state makes could change the level of budgetary expenditure outlook, we estimate total state resources available for legislative appropriations in budget reserves will be $4.2 billion at the end of 2015-16. For example, there is a strong argument 2015-16. Finalizing a budget with a total reserve that the $1.6 billion deposited in the BSA in 2014-15 of this size would mark significant progress. A is not governed by the Proposition 2 rules, meaning $4.2 billion total reserve would also be a good that the Legislature would have greater control over start to building the roughly $11 billion reserve these funds than it will over Proposition 2 BSA envisioned by Proposition 2. As we illustrate deposits. in Chapter 5, a $4.2 billion reserve would stave Figure 3 Proposition 2 Summary Under Main Scenario (In Millions) 2015‑16 2016‑17 2017‑18 2018‑19 2019‑20 BSA and Debt Payment Calculationsa 1.5 Percent of General Fund $1,701 $1,760 $1,833 $1,879 $1,926 Revenues and Transfers Excess Capital Gains Revenues Capital gains revenues over 8 percent 2,393 1,613 810 — — of General Fund taxes Less amount by which these revenues -145 -798 -400 — — increase Proposition 98 guarantee Amounts $2,248 $815 $411 — — Totals $3,949 $2,575 $2,244 $1,879 $1,926 Deposit Into BSA Reserve $1,974 $1,288 $1,122 $940 $963 Debt Payments 1,974 1,288 1,122 940 963 Debt Payments Assumed special fund loan repayments $1,280 $996 $99 $113 — Unallocated debt paymentsb 695 292 1,023 827 $963 Total, Debt Payments $1,974 $1,288 $1,122 $940 $963 a Due largely to difficulty in estimating future capital gains, actual results will vary. b Reflects amounts that the Legislature must spend on debt under Proposition 2 but that are not assumed to be spent elsewhere in our main scenario. Possible uses for unallocated funds include additional special fund loan repayments; previous Proposition 98 obligations; amounts owed to cities, counties, and special districts for pre-2004 mandate claims; and payments for unfunded liabilities for pensions and retiree health benefits in excess of current-law requirements. BSA = Budget Stabilization Account. 8 Legislative Analyst’s Office www.lao.ca.gov CALIFORNIA’S FISCAL OUTLOOK off one hypothetical downturn scenario for a stock market and other trends. While the current year or two before the state would again face level of the stock market suggests that capital budget problems (albeit modest budget problems gains revenues may wind up higher in 2014 than compared to those of the 2000s). Considering what we have assumed in our outlook, we have that the U.S. economy is in the sixth year of tried to peg our 2014-15 PIT estimates closer to the current economic expansion, we advise the more modest cash flow trends received to date the Legislature to keep making progress in in 2014. Nevertheless, even if PIT revenues wind accumulating state budget reserves. However, up higher than what we now display for 2014-15, in order to maintain approximately $4 billion there would be little bottom line benefit for the in total reserves in 2015-16, there would be little General Fund, as virtually all of these higher or no capacity for added non-Proposition 98 revenues likely would be required to be given to spending commitments in the next year under our schools and community colleges. In addition, estimates. increases in 2014-15 revenues could permanently Even Higher Revenues in 2014-15 Would ratchet up the Proposition 98 minimum Almost All Go to Schools. As described in guarantee, making it somewhat harder to fund Chapter 2, our estimates for PIT revenues in non-Proposition 98 programs in the future. 2014-15 may prove to be too cautious given recent We discuss choices the state faces in budgeting required increases in school funding in Chapter 3. Figure 4 Proposition 2 Budget Emergency Fiscal Calculation (Dollars in Millions) 2014‑15 Calculation Estimated Resources for 2014‑15a $111,773 Budget emergency available?b No 2012‑13 2013‑14 2014‑15 Enacted budget spending $91,338 $96,281 $107,987 Change in California CPI 3.6% 1.4% — Change in population 1.5 0.8 — Adjusted Budget Spending $96,042 $98,442 $107,987 2015‑16 Calculation Estimated Resources for 2015‑16a $112,885 Budget emergency available?b No 2012‑13 2013‑14 2014‑15 Enacted budget spending $91,338 $96,281 $107,987 Change in California CPI 5.3% 3.1% 1.6% Change in population 2.5 1.8 1.0 Adjusted Budget Spending $98,538 $101,001 $110,794 a Includes $1.6 billion deposited in the Budget Stabilization Account (BSA) under Proposition 58 and subtracts the estimated value of encumbrances. b If adjusted budget spending for any of the last three fiscal years exceeds estimated resources for the current fiscal year or the budget year, a budget emergency may be declared by the Governor and the Legislature can pass a bill reducing or suspending the deposit into the BSA. A budget emergency may also be declared due to a natural disaster. CPI = consumer price index. www.lao.ca.gov Legislative Analyst’s Office 9 CALIFORNIA’S FISCAL OUTLOOK 10 Legislative Analyst’s Office www.lao.ca.gov Chapter 2 The Economy and Revenues THE ECONOMY Positive Trends for U.S. and California. The and (2) a general assumption that growth will U.S. economy began its recovery from the last continue—and in some respects, accelerate—over recession in June 2009. Now well into its sixth the next few years. (In Chapter 5, we discuss year of expansion, the U.S. economy—as well hypothetical alternate scenarios—including one as California’s—appears to be on solid footing involving a stock market downturn and economic based on various measures. The U.S. is leading slowdown, in order to illustrate such a slowdown’s global growth as Europe and China struggle effect on state finances.) Figure 2 (see next page) somewhat. Strengthening demand is driving compares some key assumptions in the main the current U.S. expansion, and this has positive scenario to ones in recent state budget outlooks. implications for state and local budgets. House Housing Trends a Big Question Mark prices have strengthened considerably. Stock prices have soared over much of the past year. In last November’s Fiscal Outlook, we The unemployment rate has fallen, even though discussed various unusual features of the housing long-term unemployment (those unemployed for recovery, including then-unsustainable price gains 27 weeks or more) remains elevated. and limited increases in housing construction. We LAO’s Main Economic Scenario Assumptions. cautioned that “given the sizable shifts taking place The positive trends discussed above are reflected in today’s housing market…actual price gains and in the main economic and budget scenario we construction activity in the coming years could discuss throughout this publication. The major vary widely—either above or below—our office’s economic assumptions underlying our main forecast over the next few years.” Our caution was scenario are listed in Figure 1 (see next page). It is well founded. We have been surprised by some important to note that no such set of assumptions recent trends in California’s housing markets. will prove completely accurate over time. The main Prices Have Been Rising Rapidly. As shown scenario, however, reflects (1) our best estimate, in Figure 3 (see page 13), the median house as of now, of near-term economic conditions price in California—as tracked by the online Legislative Analyst’s Office www.lao.ca.gov CALIFORNIA’S FISCAL OUTLOOK real estate company Zillow—has risen sharply from one year prior. Despite these substantial since 2012. Over the 12 months ending in May price increases, residential building permits in 2014, the median price increased over 15 percent. California this year are far fewer than what we Year-over-year growth slowed a bit thereafter, but assumed a year ago. In fact, it appears possible that has remained strong. As of September 2014, the California residential construction activity in 2014, median price was about $431,000, up 10 percent as measured by the number of residential building permits, will be below the 2013 level. Figure 1 LAO Economic Assumptions: November 2014 Main Scenario Percent Change Unless Otherwise Indicated United States 2014 2015 2016 2017 2018 2019 2020 Real gross domestic product 2.3% 2.7% 2.9% 3.1% 2.8% 2.7% 2.6% Personal income 4.2 4.6 5.1 5.7 5.2 5.0 4.9 Wage and salary employment 1.8 1.8 1.5 1.3 1.0 0.9 0.9 Unemployment rate (percent) 6.2 5.7 5.5 5.3 5.2 5.1 5.0 Consumer price index 1.8 1.4 1.6 2.0 2.1 2.1 2.2 Housing starts (thousands) 994 1,194 1,356 1,492 1,522 1,548 1,566 Federal funds rate 0.1% 0.4% 1.6% 3.3% 3.8% 3.8% 3.8% S&P 500 annual average 1,914 1,929 1,979 2,041 2,104 2,176 2,250 California 2014 2015 2016 2017 2018 2019 2020 Personal income 4.9% 4.8% 5.4% 6.2% 5.7% 5.6% 5.5% Wage and salary employment 2.2 2.1 1.8 1.9 1.6 1.7 1.8 Unemployment rate (percent) 7.5 6.6 5.9 5.4 5.3 5.2 5.1 Consumer price index 1.8 1.4 1.6 2.0 2.1 2.1 2.2 Housing permits (thousands) 83.4 94.2 110.5 132.4 142.3 144.4 145.1 Single-unit permits 36.7 37.4 46.9 62.2 68.5 68.3 66.9 Multifamily permits 46.7 56.8 63.6 70.2 73.8 76.1 78.3 Population growth 0.8% 0.7% 0.5% 0.5% 0.5% 0.5% 0.4% Figure 2 Comparing Recent Economic Outlooks 2014 2015 2016 DOF LAO LAO DOF LAO LAO DOF LAO LAO May May Nov. May May Nov. May May Nov. 2014 2014 2014 2014 2014 2014 2014 2014 2014 United States Percent change in: Real gross domestic product 2.4% 2.4% 2.3% 3.0% 3.0% 2.7% 3.4% 3.4% 2.9% Personal income 3.6 3.6 4.2 5.1 5.1 4.6 5.4 5.4 5.1 Wage and salary employment 1.6 1.6 1.8 1.9 1.9 1.8 2.1 2.1 1.5 California Percent change in: Personal income 4.6% 4.6% 4.9% 5.1% 5.6% 4.8% 5.4% 5.6% 5.4% Wage and salary employment 2.5 2.2 2.2 2.5 2.4 2.1 2.4 2.2 1.8 Unemployment rate 7.6 7.6 7.5 6.9 6.7 6.6 6.5 6.0 5.9 Housing permits (thousands) 106 93 83 123 110 94 141 120 110 12 Legislative Analyst’s Office www.lao.ca.gov Graphic Sign Off Secretary Analyst MPA Deputy CALIFORNIA’S FISCAL OUTLOOK Building Permits Not Figure 3 Responding in Kind. Our California House Prices Have Been Rising main economic scenario— summarized in Figure 1— Zillow Statewide Median House Price (In Thousands) continues to assume that $600 California residential building permits return 500 over the next several years to levels one would expect 400 based on population growth 300 and historical household formation trends. Yet, it 200 is possible that residential building will not return to 100 these levels or will take much longer to do so than we have 2002 2004 2006 2008 2010 2012 2014 assumed. Data suggests that the number of household formations—for example, when younger people move fundamentally their economic, lifestyle, and related out of parents’ homes—has fallen considerably. choicesA cRonTcWernOinRgK h o#m1e4s0. I5f3 th6ese trends continue, There are several possible explanations for this they could result in meaningful changes in the Template_LAOReport_mid.ait trend. One is that first-time homebuyers are California economy—some negative and some finding it more difficult to purchase homes at positive—affecting construction employment, sales current prices. It is also possible that, despite taxes, property taxes, income taxes, population strong demand and rising prices, various factors growth, and housing affordability. Our office are preventing developers from increasing anticipates releasing additional analyses of issues production of new housing. These factors may concerning housing supply, demand, and prices in include heightened caution among developers and publications over the next year or so. It is possible local government resistance to additional building. that future outlooks concerning California’s Alternatively, Californians may be altering housing market will be quite different from the one in this publication. STATE GENERAL FUND REVENUES Figure 4 (see next page) summarizes state office and the administration released in May 2014 General Fund revenues and transfers under our for 2013-14 and 2014-15. (The administration’s May main economic scenario. Figure 5 (see next page) revenue outlook was used by the Governor and the compares this revenue outlook to ones that our Legislature as the basis for the 2014-15 Budget Act in June 2014.) www.lao.ca.gov Legislative Analyst’s Office 13 CALIFORNIA’S FISCAL OUTLOOK As noted above, our November 2014 main perhaps by billions of dollars), particularly in the scenario reflects (1) our best estimate, as of now, later fiscal years displayed. of near-term economic conditions and (2) an Rainy-Day Fund Transfers Reflected assumption that growth generally will continue— in Revenue Tables. Consistent with the and in some respects, accelerate—over the next few administration’s method of displaying the state’s years. Actual results will vary from our current fiscal condition, Figures 4 and 5 and other tables revenue outlook, either positively or negatively (and in this publication deduct transfers from the Figure 4 LAO Revenue Outlook (Main Economic Scenario) General Fund and Education Protection Account Combined (Dollars in Millions) 2013-14 2014-15 2015-16 2016-17 2017-18 2018-19 2019-20 Personal income tax $66,667 $72,201 $74,932 $78,011 $81,521 $83,055 $84,054 Sales and use tax 22,251 23,420 24,653 25,433 26,029 27,238 28,418 Corporation tax 8,519 9,482 10,375 10,287 10,240 10,562 11,163 Subtotals, “Big Three” taxes $97,437 $105,103 $109,960 $113,732 $117,790 $120,855 $123,635 Percent change from prior year — 7.9% 4.6% 3.4% 3.6% 2.6% 2.3% Insurance tax $2,371 $2,435 $2,512 $2,593 $2,687 $2,771 $2,854 Other revenues 2,093 2,050 2,018 1,909 1,940 1,935 1,928 Transfers to Pre-Proposition 2 BSA — -1,606 — — — — — Transfers to Proposition 2 BSA — — -1,974 -1,288 -1,122 -940 -963 Transfers and loans 376 -540 -1,118 -926 -208 -288 -5 Totals, Revenues and Transfersa $102,277 $107,442 $111,397 $116,020 $121,087 $124,335 $127,449 Percent change from prior year — 5.1% 3.7% 4.2% 4.4% 2.7% 2.5% a Totals reflect transfers out of the General Fund to the Budget Stabilization Account (BSA). As such, this is not directly comparable to revenue displays in prior LAO publications. Figure 5 Comparing LAO and Administration Revenue Projections for 2013-14 and 2014-15 General Fund and Education Protection Account Combined (In Millions) 2013-14 2014-15 DOF DOF LAO May 2014 LAO LAO May 2014 LAO May 2014 (Budget Act) Nov. 2014 May 2014 (Budget Act) Nov. 2014 Personal income tax $66,967 $66,522 $66,667 $73,012 $70,238 $72,201 Sales and use tax 22,581 22,759 22,251 23,222 23,823 23,420 Corporation tax 8,398 8,107 8,519 8,980 8,910 9,482 Subtotals, “Big Three” taxes $97,945 $97,388 $97,437 $105,214 $102,971 $105,103 Insurance tax $2,271 $2,287 $2,371 $2,368 $2,382 $2,435 Other revenues 2,164 2,163 2,093 2,414 2,400 2,050 Transfers to Pre-Proposition 2 BSA — — — -1,638 -1,606 -1,606 Transfers and loans 347 347 376 -658 -658 -540 Totals, Revenues and Transfersa $102,727 $102,185 $102,277 $107,700 $105,488 $107,442 a Figures above reflect transfers out of the General Fund to the Budget Stabilization Account (BSA). As such, this is not directly comparable to revenue displays in prior LAO publications. To improve comparability, the LAO and Department of Finance (DOF) May 2014 data for transfers and loans in 2014-15 reflect adjustments to non-BSA transfers adopted in the June 2014 state budget package. 14 Legislative Analyst’s Office www.lao.ca.gov CALIFORNIA’S FISCAL OUTLOOK General Fund to the state’s rainy-day accounts, Personal Income Tax displaying them as transfers out of the General Dominant Revenue Source. In our main Fund. These transfers out are listed as negative scenario, California’s PIT makes up about numbers in Figures 4 and 5, for example. This two-thirds of state General Fund revenues and is a change in practice for our office, such that transfers for the foreseeable future—both before the numbers in these figures are not directly and after the temporary Proposition 30 rate comparable to those in prior LAO publications. increases expire for the state’s highest-income Figure 5 shows the May and November 2014 PIT filers. As we have noted previously, the end revenue estimates on an “apples-to-apples” basis of the Proposition 30 PIT rate increases will not in order to improve comparability. necessarily cause a sudden revenue drop off—a “cliff effect”—for the annual state budget process. General Fund Revenues Above Because these rate increases expire at the end of Budget Act Projections calendar year 2018, it means that state PIT revenues Both 2013-14 and 2014-15 Appear Above essentially will include an entire fiscal year of Budget Projections. State revenue collections Proposition 30 revenues in 2017-18, half a fiscal finished 2013-14 above the projections that were year of those revenues in 2018-19, and none of the included in the June 2014 state budget act. In Proposition 30 revenues in 2019-20. Accordingly, 2014-15, monthly revenue collections have also if the economy is growing at that time, as our been running over $1 billion above the budget main scenario assumes, then the expiration of projections, based on preliminary data through Proposition 30 is likely to result in a slowing of PIT the end of October. revenue growth in 2018-19 and 2019-20, but not an As shown in Figure 5, we currently expect outright decline in PIT revenues. total revenues and transfers for 2013-14 to be Recent Strong Growth of Wage and Salary booked at $92 million above the June 2014 budget Withholding. Wages and salaries are a large and projections. For 2013-14, gains for the personal generally stable part of California’s PIT revenue income tax (PIT) and corporation tax (CT) base. Employers are required to withhold part of were offset by declines, relative to budget act each employee’s paycheck each month and send projections, for the SUT and unclaimed property this money to the state to cover the PIT due on the revenues. employee’s income. Withholding makes up about For 2014-15, we currently project revenues and two-thirds of net PIT collections each year. The transfers to end the fiscal year about $2 billion revenue stream from these withholding payments above the June 2014 budget projections. For provides a real-time indicator of the growth of 2014-15, expected gains for PIT, CT, and the wage and salary income. state’s insurance tax are being offset by weakness, Withholding growth has been strong in relative to budget act projections, for the SUT and 2014. Withholding for each month from April to some minor state revenue sources. We discuss October has been between 7 percent and 11 percent some of the assumptions underlying these figures above the same month in 2013 (after adjusting below. for variation in the number of processing days in a given month from one year to the next). For 2014 as a whole, we assume that wages and salaries for California resident PIT filers will be www.lao.ca.gov Legislative Analyst’s Office 15 CALIFORNIA’S FISCAL OUTLOOK 6.7 percent above 2013 levels—notably higher than estimated payments generally—are cautious. We the 6 percent growth we projected in May, as well think there is a significant possibility that capital as the 5 percent growth assumed in the June 2014 gains reported on 2014 PIT returns will prove state budget package. In 2015, our main scenario to be higher than we now assume. The S&P 500 assumes that wage and salary growth moderates to stock index, for example, has risen substantially 5.1 percent. in recent months—considerably above our prior Estimated Payments Also Showing Strong expectations. The trend in stock and other asset Growth . . . Taxpayers who have significant income prices, as well as recent trends in personal income, from sources other than wages and salaries are suggest that 2014 taxable income from capital gains required to make quarterly estimated payments. and business activity will be above levels indicated Sources of such income include capital gains by estimated payments that have been received from sales of assets such as stocks and real estate, to date. Our near-term fiscal outlook, however, interest and dividend payments, and profits of adopts the cautious assumption that revenue from businesses that are not subject to the state’s CT. As estimated payments through January 2015 and final estimated payments come in each year in April, payments in April 2015 will be fairly consistent June, and September, they provide early indications with the estimated payment trend observed to of the total amount of taxable nonwage income date this year. If capital gains and other estimated that higher-income taxpayers will earn that year. payment sources are stronger than we now assume, In addition to those estimated payments, other this could easily increase 2014-15 state PIT revenues 2014 estimated payments will come into the state by $1 billion or more above our current outlook. treasury in December and January, followed by As discussed elsewhere in the publication, virtually final or extension payments in April. In many all of those increased 2014-15 revenues would go to years, high-income taxpayers make large estimated schools and community colleges under the state’s payments in December and January and large Proposition 98 minimum funding guarantee. payments in April to “settle up” their annual tax Modest Future Stock Price Growth Assumed. liabilities. California’s PIT is heavily reliant on high-income For tax year 2014, the first three estimated taxpayers who pay the highest marginal PIT rates payments are running about 15 percent above the and who receive a large share of capital gains comparable months in 2013. This is a significant and business income. In fact, the top 1 percent of increase, and it contributes to our main scenario California PIT filers paid 50 percent of the state’s assumption that the net amount of capital personal income taxes in 2012. Capital gains— gains income reported on California residents’ generating over $12 billion of PIT revenues in PIT returns in 2014 will be $143 billion—up 2014-15, according to our forecast assumptions— significantly from the $105 billion assumed for are one major source of year-over-year volatility 2014 net capital gains in the June 2014 state budget in PIT collections. As they are closely connected package. with trends of highly variable stock prices, they . . . But Our Outlook Makes Cautious are impossible to predict far in advance with any Assumptions About 2014 Capital Gains. Despite precision. The S&P 500 stock index closed at 2,040 our positive outlook for capital gains, relative to on November 14, 2014—up about 250 points from the most recent budget act assumptions, we believe one year before. In our main scenario, we assume that our assumptions for 2014 capital gains—and that the S&P 500 stock index retreats somewhat 16 Legislative Analyst’s Office www.lao.ca.gov CALIFORNIA’S FISCAL OUTLOOK from these strong recent gains by declining to Corporation Tax just over 1,925 in early 2015 and remaining flat Above 2014 Budget Projections. Refunds to throughout the rest of 2015. We assume modest CT payers have been running below June 2014 growth of about 3 percent per year in the S&P 500 budget assumptions. This is a positive development index in our main scenario beginning in 2016. for net CT collections by the state. As a result, in While every forecast of California’s state budget our main scenario, estimates of net CT revenues must make assumptions about stock prices—either accrued to 2012-13 and of CT revenues in 2013-14 explicitly or implicitly—actual results will vary and 2014-15 are all above budget act projections. from our future assumptions either positively In that scenario, we estimate that CT revenue will or negatively in any given year. As we discuss in grow from $8.5 billion in 2013-14 to $9.5 billion in Chapter 5, a large stock market drop—if one were 2014-15 and $10.4 billion in 2015-16. Our near-term to occur—could cause state revenues to fall by CT outlook reflects strong growth in recent CT billions of dollars in a single year. collections and an assumption that recent trends in CT refunds will continue. Our main scenario Sales and Use Tax assumes that corporate income will continue Below 2014 Budget Projections. Estimated to grow through 2015. In later years, however, General Fund SUT revenue totaled $22.3 billion corporate income is assumed to decline somewhat in 2013-14, $508 million lower than the amount from these high levels. assumed in the 2014-15 budget. In our main Operating Loss Deductions Expected to economic scenario, SUT receipts increase by Remain at Elevated Levels. As we anticipated in 5.3 percent in each of the next two fiscal years, last year’s Fiscal Outlook, corporations significantly totaling $23.4 billion in 2014-15 and $24.7 billion in increased their use of net operating loss (NOL) 2015-16. Our 2014-15 estimate is $403 million lower deductions from $3 billion in 2011 to approximately than the assumption in the June 2014 state budget. $19 billion in 2012. The use of NOL deductions—in Under our main scenario, SUT revenues then grow which corporations deduct a prior loss from more slowly over the following two fiscal years as current tax year profits—was suspended for most the one-quarter cent Proposition 30 SUT increase corporations during tax years 2008 through 2011. ends in December 2016. As with the Proposition 30 We anticipate that NOLs will remain at elevated PIT increases, the timeline of this tax expiration levels throughout the forecast period, but NOL means that the state will see a gradual drop off in use in any given year is highly uncertain. We also Proposition 30 SUT revenues over two fiscal years. expect use of the state’s largest corporate tax credit Prior Years’ Local SUT Adjustment. As program, the research and development tax credit, discussed in Chapter 1, we assume that the to increase somewhat in future years. Beginning in General Fund’s entering fund balance in 2013-14 the 2016 tax year, our forecast takes into account will be lowered by $358 million to reflect a recent legislative actions to increase the amount of prior-year misallocation of SUT revenues to local credits available under the film and television tax governments that recently was identified and credit and California Competes tax program. corrected by the state. We understand that this amount will be booked in the state’s budgetary Other Issues accounting system in this way, thereby not affecting Unclaimed Property Revenues Lower any particular fiscal year’s accrued SUT revenues. Than June 2014 Budget Projections. The State www.lao.ca.gov Legislative Analyst’s Office 17 CALIFORNIA’S FISCAL OUTLOOK Controller’s Office receives various types of $1.3 Billion in Special Fund Loans Assumed property considered to be abandoned by owners. Repaid in 2015-16. Figure 6 displays the loans The state maintains an obligation to reunite these we assume that the General Fund will repay properties with their rightful owners, should they to various state special funds in 2015-16. (If all make a claim. Each month, however, amounts of those payments were made, $1.8 billion in unclaimed in excess of $50,000 become General special fund loans would remain outstanding.) Fund revenues. June and July are the most We assume that any loan with a deadline in law important cash months for unclaimed property. will be repaid by that date. In addition, when it Official reports for July 2014 show cash receipts appears a special fund requires a loan repayment, well below 2014-15 budget assumptions. We assume we assume any loan outstanding to that fund is this reflects an ongoing reduction in the amount of repaid. As discussed in Chapter 1, special fund property received by the state, affecting each year loan repayments count toward the debt payment starting with 2013-14. Over 2013-14 and 2014-15 requirements of Proposition 2. combined, we estimate that revenues related to The three largest loan repayments shown in unclaimed property will be over $100 million Figure 6 have 2015-16 deadlines in law. It appears lower than assumed in the 2014-15 budget package. to us that the Legislature may have considerable Because various parts of the program expire flexibility in determining whether to repay these after 2015-16 under current law, we expect these loans. In addition, while the Greenhouse Gas revenues to decrease around 10 percent in 2016-17 Reduction Fund loan does not have a deadline and remain steady thereafter. in current law, the 2014-15 budget package authorized amounts to be Figure 6 repaid and used for the Special Fund Loans Assumed to Be Repaid in 2015‑16a high-speed rail project (In Millions) beginning in 2015-16. Of Fund Name Amount the $400 million balance Disability Insurance Fund $303.5 currently outstanding Motor Vehicle Account, State Transportation Fund 300.0 from that fund, we State Court Facilities Construction Fund 220.0 assume that half is repaid Greenhouse Gas Reduction Fund 200.0 Occupancy Compliance Monitoring Account 57.0 in 2015-16 and that the Tax Credit Allocation Fee Account 48.0 remainder is repaid in Hospital Building Fund 30.0 2016-17. Electronic Waste Recovery & Recycling Account 27.0 Off-Highway Vehicle Trust Fund 21.0 Major Penalty and Hazardous Waste Control Account 13.0 Fine Revenue Uncertain. False Claims Act Fund 12.7 Each year, the state California Health Data and Planning Fund 12.0 Dealers’ Record of Sale Account 6.5 General Fund receives California Debt and Investment Advisory Commission Fund 2.0 payments from court and California Debt Limit Allocation Committee Fund 2.0 administrative judgments. Drinking Water Operator Certification Special Account 1.6 Illegal Drug Lab Cleanup Account 1.0 In 2012-13, for example, Driving-Under-the-Influence Program Licensing Trust Fund 0.3 $23 million of such Total $1,257.6 payments were received a Reflects principal amounts owed on loans. Interest is reflected on the spending side of the budget in Item 9620—Cash Management and Budgetary Loans. by the General Fund. The 18 Legislative Analyst’s Office www.lao.ca.gov CALIFORNIA’S FISCAL OUTLOOK June 2014-15 budget assumed that the state would including a $950 million payment to the state receive $323 million of such payments in 2014-15, General Fund. On October 2, PG&E filed appeals including a potential $300 million payment from concerning these decisions. Accordingly, there is the Pacific Gas and Electric (PG&E) Company, the now uncertainty about the timing of any General possibility of which had been disclosed publicly to Fund payments by PG&E, as well as the amounts PG&E investors earlier in the spring. The penalties of those payments. Due to this uncertainty, we and fines were related to PG&E operations and assume no General Fund payments by PG&E in practices, including the 2010 rupture of a gas our revenue outlook. It is quite possible that some pipeline in San Bruno. On September 2, the PG&E payments will be received by the General California Public Utilities Commission issued Fund in the future, and if so these payments would decisions by administrative law judges that improve the budget’s bottom line. sought to impose a $1.4 billion penalty on PG&E, www.lao.ca.gov Legislative Analyst’s Office 19 CALIFORNIA’S FISCAL OUTLOOK 20 Legislative Analyst’s Office www.lao.ca.gov Chapter 3 Spending Outlook Figure 1 (see next page) displays our estimates outlook is affected by local revenues because of General Fund spending for 2013-14 and 2014-15, Proposition 98 is funded by a combination of state as well as our outlook for spending through 2019-20. General Fund and local property taxes. While we The estimates in Figure 1 reflect our main economic project growth in overall Proposition 98 funding, scenario. Assuming continued moderate economic our strong outlook for local property tax growth growth, we estimate General Fund spending to offsets what would otherwise be higher General grow at an average annual rate of 2.4 percent. Fund spending necessary to meet Proposition 98 This slow growth rate is primarily explained by requirements. Because Proposition 98 General key assumptions concerning Proposition 98. The Fund spending represents around 40 percent of the assumed expiration of Proposition 30’s taxes and budget, these assumptions are key factors in the slow our assumption that capital gains revenues decline growth rate of spending overall. We discuss this and contribute to slow growth in the Proposition 98 other spending trends throughout this chapter. In minimum guarantee in the later years of the general, this chapter discusses our main scenario outlook. Further, our General Fund spending spending outlook unless noted otherwise. EDUCATION Education Outlook. Below, we discuss our Law (Hastings). Our student financial aid outlook outlook for Proposition 98, the universities, estimates spending for the Cal Grant program, and the state’s financial aid programs. Our Middle Class Scholarships, and a few small Proposition 98 outlook estimates spending for specialized programs. preschool, elementary and secondary education Proposition 98 (commonly referred to as K-12 education), and the California Community Colleges (CCC) combined. Proposition 98 Minimum Guarantee for Our university outlook estimates spending for the Schools and Community Colleges. State budgeting California State University (CSU), the University for schools and community colleges is governed of California (UC), and Hastings College of the largely by Proposition 98, passed by voters in Legislative Analyst’s Office www.lao.ca.gov CALIFORNIA’S FISCAL OUTLOOK 1988. The measure, modified by Proposition 111 in and community colleges receive funding from the 1990, establishes a minimum funding requirement, federal government, other state sources (such as the commonly referred to as the minimum guarantee. lottery), and various local sources (such as parcel Both state General Fund (including Education taxes). Protection Account) and local property tax revenue Calculating the Minimum Funding apply toward meeting the minimum guarantee. Guarantee. The Proposition 98 minimum In addition to Proposition 98 funding, schools guarantee is determined by one of three tests set Figure 1 General Fund Spending Under Main Scenario Includes Education Protection Account (Dollars in Millions) Estimates Outlook Average Annual 2013-14 2014-15 2015-16 2016-17 2017-18 2018-19 2019-20 Growtha Education Programs Proposition 98 $42,794 $46,548 $46,422 $47,555 $48,715 $49,350 $49,909 1.4% Child care 762 822 848 855 865 877 891 1.6 CSUb 2,256 2,696 2,816 2,940 3,069 3,204 3,343 4.4 UC 2,844 2,991 3,106 3,230 3,360 3,494 3,634 4.0 Student Aid Commission 1,056 1,547 1,649 1,783 1,899 1,962 2,029 5.6 Health and Human Services Medi-Cal 16,647 17,239 17,051 17,862 18,678 19,493 20,972 4.0 CalWORKs 1,195 783 766 553 461 447 448 -10.5 SSI/SSP 2,780 2,810 2,847 2,886 2,926 2,967 3,009 1.4 IHSS 2,027 2,248 2,480 2,550 2,625 2,692 2,764 4.2 DDS 2,797 2,956 3,055 3,211 3,315 3,422 3,534 3.6 DSH 1,435 1,463 1,492 1,522 1,560 1,594 1,594 1.7 Other major programsc 1,493 1,663 1,644 1,655 1,655 1,657 1,657 -0.1 CDCR 8,937 9,073 9,066 9,071 9,160 9,263 9,366 0.6 Judiciary 1,215 1,392 1,488 1,515 1,549 1,584 1,621 3.1 CalSTRS 1,360 1,486 1,928 2,413 2,463 2,539 2,617 12.0 Infrastructure Debt 5,132 5,446 5,618 5,543 5,532 6,084 6,390 3.2 Serviced Proposition 58 Early Debt — 1,606 — — — — — — Payments Unallocated Proposition 2 — — 695 292 1,023 827 963 — Debt Paymentse Other Programs 6,054 7,517 7,669 8,394 8,794 9,141 9,634 5.1 Totals $100,783 $110,286 $110,638 $113,829 $117,649 $120,597 $124,376 2.4 Percent change — 9.4% 0.3% 2.9% 3.4% 2.5% 3.1% — a From 2014-15 to 2019-20. b Beginning in 2014-15, includes General Fund debt-service costs for CSU projects. For 2013-14, state spending on debt service for CSU totaled $287 million and is included in “Infrastructure debt service.” c Includes DHCS family health and state operations, DPH, DCSS, DSS state operations, and DSS county administration. Smaller health and human services programs included in “Other Programs.” d Debt service on general obligation and lease-revenue bonds generally used for infrastructure. Does not include General Fund Propostion 98 debt-service costs of lease revenue bonds for the California Community College projects (about $65 million annually) or General Fund debt service costs for UC projects ($201 million in general obligation bond costs in 2013-14). e Amounts required to be spent on debt under Proposition 2 but not assumed elsewhere in our forecast. The Legislature could choose to spend these amounts on certain debt payments described in Proposition 2. Proposition 2 reserve deposits are not displayed in this figure and are instead reflected as transfers in LAO revenue displays. IHSS = In-Home Supportive Services; DDS = Department of Developmental Services; DSH = Department of State Hospitals; CDCR = California Department of Corrections and Rehabilitation; DHCS = Department of Health Care Services; DPH = Department of Public Health; DCSS = Department of Child Support Services; and DSS = Department of Social Services. 22 Legislative Analyst’s Office www.lao.ca.gov CALIFORNIA’S FISCAL OUTLOOK forth in the State Constitution (see Figure 2). These 2013-14 and 2014-15 Updates tests are based on several inputs, including changes 2013-14 Minimum Guarantee Up Slightly in K-12 average daily attendance (ADA), per capita From Budget Act Estimates. Figure 3 compares personal income, and per capita General Fund our updated estimates of the 2013-14 minimum revenue. Though the calculation of the minimum guarantee with what was assumed in the most guarantee is formula-driven, a supermajority of the recently enacted spending plan. Our estimate of the Legislature can vote to suspend the formulas and 2013-14 minimum guarantee is up $177 million. provide less funding than the formulas require. Of this amount, $100 million is associated with This happened in 2004-05 and 2010-11. In some an upward revision in K-12 ADA. Latest ADA cases, including as a result of a suspension, the estimates are up about 10,000 ADA (0.17 percent) state creates an outyear obligation referred to as a “maintenance factor.” Figure 2 The state is required Calculating the Proposition 98 Minimum Guarantee to make maintenance factor payments when year-to-year growth Three Tests Used to Determine Minimum Guarantee: Test 1—Share of General Fund. Provides roughly 40 percent of state General in state General Fund Fund revenues to K-14 education. The guarantee was determined using this test revenue is relatively strong. 4 of the last 26 years. Though in most years Test 2—Growth in Per Capita Personal Income. Adjusts prior-year Proposition 98 funding for changes in K-12 attendance and per capita personal the state has provided an income. The guarantee was determined using this test 13 of the last 26 years. amount at or close to the Test 3—Growth in General Fund Revenues. Adjusts prior-year Proposition 98 funding for changes in K-12 attendance and per capita General Fund revenues. minimum guarantee, the Generally, this test is operative when General Fund revenues grow more slowly state has discretion to than per capita personal income. The guarantee was determined using this test 7 of the last 26 years. provide any amount above Note: In 2 of the last 26 years, the state suspended Proposition 98. the minimum guarantee. Figure 3 Updating Estimates of 2013‑14 and 2014‑15 Minimum Guarantees (Dollars in Millions) 2013‑14 2014‑15 2014‑15 November 2014‑15 November Budget LAO Budget LAO Plan Estimates Change Plan Estimates Change Minimum Guarantee General Fund $42,731 $42,794 $63 $44,462 $46,548 $2,086 Local property tax 15,571 15,686 114 16,397 16,656 259 Totals $58,302 $58,479 $177 $60,859 $63,204 $2,345 Operative Test 3 3 — 1 1 — K‑12 ADA 5,982,431 5,992,567 10,136 5,975,558 5,985,682 10,124 New Maintenance Factor: Created $458 $381 -$77 — — — Paid — — — $2,583 $3,843 $1,260 ADA = average daily attendance. www.lao.ca.gov Legislative Analyst’s Office 23 CALIFORNIA’S FISCAL OUTLOOK from budget act estimates. The remainder of the 2014-15 General Fund Proposition 98 Costs increase is due to 2013-14 General Fund revenue Up Significantly. Of the $2.3 billion increase in being higher than budget act assumptions. General the guarantee, the General Fund share increases Fund revenue that counts toward Proposition 98 $2.1 billion and the local property tax share is up $137 million, with the corresponding increases $259 million. Similar to 2013-14, the increase in the guarantee slightly more than half increase in local property tax revenue is due to this amount. Test 3 remains the operative test various relatively minor adjustments. for calculating the 2013-14 guarantee. Given the Increase Sufficient to Trigger Paydown of increase in the guarantee, the size of the new All Remaining Education Deferrals. Chapter 32, maintenance factor created is smaller compared to Statutes of 2014 (SB 858, Committee on Budget budget act assumptions ($381 million, down from and Fiscal Review), set forth that if the minimum $458 million). guarantees for 2013-14 or 2014-15 came in higher 2013-14 General Fund Proposition 98 Costs Up than budget act assumptions, the first $992 million Slightly. Though the guarantee is up $177 million, in higher-than-assumed growth would be used the General Fund share of the guarantee is up only for paying down remaining education deferrals. $63 million. This is because our estimate of local We estimate the 2013-14 and 2014-15 minimum property tax revenue also is up from budget act guarantees are up a combined $2.5 billion—high estimates. Local property tax estimates are up a net enough to trigger the paydown of all remaining of $114 million due to various adjustments (some deferrals by the end of 2014-15. offsetting), including slight changes in regular $1.5 Billion Available for Other One-Time and supplemental property tax payments as well Purposes. After retiring all education payment as updated estimates of revenue shifted to school deferrals, $1.5 billion would remain available and community college districts from former under our forecast for additional Proposition 98 redevelopment agencies (RDAs). spending in 2014-15. Given the 2014-15 school 2014-15 Minimum Guarantee Up $2.3 Billion year is underway, this funding in practical terms From Budget Act Estimates. Figure 3 also compares is available for one-time purposes. In recent years, our updated estimates of the 2014-15 minimum the state has prioritized various one-time purposes, guarantee with what was assumed in the 2014-15 including paying down the education mandate Budget Act. The increase in the 2014-15 guarantee is backlog, paying down outstanding Emergency due primarily to General Fund revenue being higher Repair Program (ERP) obligations, and supporting than budget assumptions. General Fund revenue new initiatives, such as implementation of the that counts toward Proposition 98 is up $2.2 billion, Common Core State Standards and creation of the yielding a near dollar-for-dollar increase in the California Career Pathways Trust. We estimate the guarantee. Test 1 remains the operative test for state currently has a total of $4.3 billion in unpaid calculating the 2014-15 guarantee. Given the education mandate claims ($3.9 billion for schools significant increase in General Fund revenue, the and $405 million for community colleges). It has size of the required maintenance factor payment is $274 million in outstanding ERP obligations. up notably (now estimated at $3.8 billion, up from Temporary Revenue Surge Would Increase the budget act estimate of $2.6 billion). As of the end 2014-15 Guarantee. The minimum guarantee in of 2014-15, we estimate the state’s total outstanding 2014-15 is highly sensitive to changes in General maintenance factor obligation to be $2.7 billion. Fund revenue. This is because the state has a 24 Legislative Analyst’s Office www.lao.ca.gov CALIFORNIA’S FISCAL OUTLOOK large outstanding maintenance factor obligation, 2014-15 would be excluded from the Proposition 98 Test 1 is operative, and the state has chosen to calculations in 2015-16. This reduces the 2015-16 make maintenance factor payments on top of guarantee from what it would be otherwise, thereby the Test 1 level. In this situation, the guarantee limiting potential fiscal effects on the rest of the increases virtually dollar-for-dollar with growth in state budget. General Fund revenue. Because of this heightened 2015-16 Budget Planning sensitivity to changes in General Fund revenue, together with the possibility that personal in come 2015-16 Guarantee $2.6 Billion Higher tax (PIT) revenue could be higher in 2014-15 than Than Updated 2014-15 Guarantee. Under our assumed in our main forecast scenario, one of main scenario (see Figure 4), the minimum the economic scenarios we considered involved guarantee grows from $63.2 billion in 2014-15 to a hypothetical, temporary surge of capital gains $65.8 billion in 2015-16—an increase of $2.6 billion revenue in 2014-15. Under this surge scenario, (4.1 percent). Test 2 is operative, with the increase we assume General Fund revenue is above our in the guarantee driven by growth in per capita main scenario by $1.5 billion in 2014-15 and personal income. We assume K-12 ADA declines $0.5 billion in 2015-16. The $1.5 billion General by 0.4 percent, but the decline does not affect the Fund increase in 2014-15 results in a $1.5 billion guarantee. This is because the Constitution has a increase in the 2014-15 minimum guarantee. two-year hold harmless provision that insulates Because the guarantee in 2015-16 builds upon the the guarantee from initial drops in K-12 ADA. (As amount provided the prior year, it too increases we assume drops in K-12 ADA every year of the by $1.5 billion. Under this scenario, the “bottom forecast period, the guarantee under our forecast line” of the General Fund benefits virtually none Figure 4 from the revenue growth Comparing Proposition 98 Minimum Guarantee in 2014-15 and is worse Under Three Scenarios off moving forward. (We (In Millions) discuss the temporary 2014‑15 2015‑16 2016‑17 revenue surge scenario’s Main Scenario effects on the state General Fund $46,548 $46,422 $47,555 budget in more detail in Local property tax 16,656 19,389 20,511 Chapter 5.) Minimum Guarantee $63,204 $65,810 $68,066 If General Fund Slowdown Scenarioa General Fund $46,548 $46,155 $44,490 revenue in 2014-15 ends Local property tax 16,656 19,389 20,355 up more than $1.6 billion Minimum Guarantee $63,204 $65,543 $64,846 above our main outlook, Temporary Revenue Surge Scenariob then the spike protection General Fund $48,007 $47,941 $48,870 provisions of the Local property tax 16,656 19,389 20,511 Minimum Guarantee $64,663 $67,330 $69,380 Constitution become a Assumes General Fund revenue is down from the main scenario by $2.6 billion in 2015-16 and operative. As a result, any $8.2 billion in 2016-17. Also assumes home prices and construction activity grow more slowly than under main scenario. growth in the guarantee b Assumes General Fund revenue that counts toward Proposition 98 is above the main scenario by above $1.6 billion in $1.5 billion in 2014-15 and $0.5 billion in 2015-16. www.lao.ca.gov Legislative Analyst’s Office 25 CALIFORNIA’S FISCAL OUTLOOK would be affected beginning in 2016-17.) The state • Revenue Shifts From Former RDAs would not be required to make a maintenance factor Continue to Increase. We project that payment in 2015-16 (as the Test 2 and Test 3 levels ongoing property tax revenue shifted from are very close, with growth in per capita personal RDAs to schools and community colleges income similar to growth in General Fund revenue). increases about $200 million from 2014-15 Entire Increase in Guarantee Covered by to 2015-16—growing to about $1 billion Higher Local Property Tax Revenue. Under our in 2015-16. (We project one-time shifts main scenario, General Fund Proposition 98 costs relating to former RDA assets will remain drop slightly in 2015-16 despite the increase in roughly flat in 2015-16 before decreasing the guarantee. This is because local property tax steadily through the end of the forecast revenue is $2.7 billion (16 percent) higher in 2015-16 period.) compared to 2014-15. The large increase in property $6.4 Billion Available for Proposition 98 tax revenue is mainly a result of the following three Priorities. Figure 5 identifies the amount of factors. (The increases identified below are offset by a funding available for Proposition 98 priorities in small reduction in various other components of our 2015-16 under our main scenario. With a projected property tax estimate.) 2015-16 minimum guarantee of $65.8 billion and • “Triple Flip” Ends. The largest factor is the an ongoing Proposition 98 spending level currently end of the triple flip. Under the triple flip, at $59.4 billion, the state has $6.4 billion for its the state (1) diverted local sales tax revenue 2015-16 Proposition 98 priorities. The Legislature’s to pay off the state’s Economic Recovery key Proposition 98 decisions in the coming budget Bonds (approved by voters in 2004 to help cycle likely will revolve around how best to allocate close the state budget gap), (2) backfilled these funds among preschools, schools, and cities and counties with school and community colleges; how much to designate for community college property tax revenue, and (3) backfilled schools and community Figure 5 colleges with state General Fund. Under our Considerable New Proposition 98 main forecast, the state retires the Economic Funding Projected for 2015‑16 Recovery Bonds by the end of 2014-15. As a LAO Main Scenario (In Millions) consequence, $1.7 billion in local property 2014-15 Budget Act Spending Level $60,859 tax revenue flows back to schools and Back out one-time actions: community colleges in 2015-16. K-14 deferral paydowns -662 K-14 mandate backlog -337 • Underlying Property Tax Revenue Grows Career Pathways Trust -250 CCC maintenance and instructional support -148 at Healthy Rate. Under our main scenario, CCC Economic and Workforce Development -50 we project underlying property tax revenue Preschool quality activities and facility loans -35 to increase 5.5 percent in 2015-16. This is CCC technology infrastructure -1 Total one-time actions -$1,483 slightly lower than the prior-year growth 2014-15 Ongoing Spending $59,377 rate (6.1 percent) but still healthy by historic Annualize approved preschool slots $15 standards. The 5.5 percent increase equates New Funds Available in 2015-16 $6,419 to $950 million in additional local property 2015-16 Minimum Guarantee $65,810 tax revenue. 26 Legislative Analyst’s Office www.lao.ca.gov CALIFORNIA’S FISCAL OUTLOOK ongoing versus one-time purposes; and how much guarantees are higher than under our main to use for starting new initiatives versus sustaining scenario, the state likely could make greater or extending existing efforts. progress in implementing the Local Control In Hypothetical Economic Slowdown, Funding Formula (LCFF). Alternatively, if the Guarantee Could Decline. Because the outlook guarantee over this near-term period is lower for the minimum guarantee in 2016-17 can help than in our main scenario, the state likely would inform the Legislature’s 2015-16 decisions, we also face difficulty sustaining ongoing Proposition 98 examined a hypothetical economic slowdown (and non-Proposition 98) programs. Because scenario that is more pessimistic than our main of the possibility that the guarantee in future scenario (see Figure 4). In this slowdown scenario, years could be lower than the 2015-16 guarantee, we assume General Fund revenue is below our we recommend the Legislature designate some main forecast by $2.6 billion in 2015-16 and Proposition 98 funds in 2015-16 for one-time $8.2 billion in 2016-17. (As discussed in more purposes. Doing so would mitigate downsize detail in Chapter 5, this would reflect a moderate risk while also helping the state pay down its slowdown in overall economic activity and a sharp outstanding one-time obligations (most notably, the stock market decline in 2016.) Despite the drop in multibillion dollar education mandates backlog). General Fund revenue, the minimum guarantee in Outlook for Later Years 2015-16 is largely unaffected. Under this scenario, the operative test shifts from Test 2 to Test 3, but Though both the Legislature and schools a supplemental appropriation is triggered under likely view near-term Proposition 98 issues as Test 3 that results in bringing the guarantee the most pressing, they face several significant almost back up to the Test 2 level. The Test 3 issues throughout the forecast period. Most supplemental appropriation is set forth in statute. notably, the phase out of Proposition 30 taxes, the It is intended to ensure that the Proposition 98 phase in of LCFF funding increases, and the cost and non-Proposition 98 sides of the budget are pressure related to the phase in of the California treated similarly in tight fiscal times. Though the State Teachers’ Retirement System (CalSTRS) 2015-16 guarantee is largely unaffected, the 2016-17 rate increases, all unfold throughout this period. guarantee under the slowdown scenario drops Additionally we examine whether a Proposition 2 $700 million from 2015-16. Under the slowdown deposit, with the accompanying triggered scenario, if the Legislature had committed all reductions in school district reserve levels, might available Proposition 98 funds in 2015-16 for happen sometime during the period. Below, we first ongoing purposes, it would face pressure in describe Proposition 98 under our main scenario 2016-17 either to reduce ongoing programs or through 2019-20 and then discuss each of the above raise additional revenue to sustain the prior-year issues in more detail. ongoing funding level. In Main Scenario, Guarantee in 2019-20 More Designating Funds for One-Time Purposes Than $11 Billion Higher Than in 2014-15. Figure 6 Would Minimize Outyear Risks. Given the (see next page) shows our main Proposition 98 volatility of the state’s General Fund revenues, scenario for 2014-15 through 2019-20. Under our our main scenario realistically could under- or main scenario, the minimum guarantee grows over-estimate the minimum guarantee by from $63.2 billion in 2014-15 to $74.5 billion billions of dollars. If the 2014-15 through 2016-17 in 2019-20—an average annual growth rate of www.lao.ca.gov Legislative Analyst’s Office 27 CALIFORNIA’S FISCAL OUTLOOK 3.3 percent. General Fund Proposition 98 costs historical average. This corresponds to growth of grow more slowly—from $46.5 billion in 2014-15 about $1 billion per year. In addition, under our to $49.9 billion the last year of the period. This main scenario, RDA residual revenue increases by slow growth in General Fund costs results from the slightly more than $200 million per year. When relatively fast growth in local property tax revenue, combined with several other smaller revenue which increases from $16.7 billion in 2014-15 to components, total school and community college $24.6 billion the last year of the period. The average local property tax revenue increases, on average, annual growth over the period is 1.4 percent for the $1.3 billion each year of the period. General Fund and 8.1 percent for local property tax Slower Growth in Guarantee as Proposition 30 revenue. Revenues Phase Out. Under our main scenario, the Local Property Tax Revenue Assumed to growth rates in the guarantee during the first part Grow at About Historical Average. Following the of the period are stronger than during the latter end of the triple flip, we assume local property tax part of the period. For example, the guarantee revenue continues to increase steadily over the grows 4.1 percent in 2015-16 and 2.5 percent in period. Under our main scenario, assessed property 2019-20. The smaller growth rates throughout the values grow at about 6 percent each year over the latter part of the period are due in part to the phase 2016-17 through 2019-20 period—similar to the out of Proposition 30 revenues, with the sales tax Figure 6 Proposition 98 Outlook LAO Main Scenario (Dollars in Billions) 2014-15 2015-16 2016-17 2017-18 2018-19 2019-20 Minimum Guarantee General Fund $46.5 $46.4 $47.6 $48.7 $49.4 $49.9 Local property tax 16.7 19.4 20.5 21.9 23.3 24.6 Totals $63.2 $65.8 $68.1 $70.6 $72.7 $74.5 Change in Guarantee From Prior Year Amount $4.7 $2.6 $2.3 $2.5 $2.1 $1.8 Percent change 8.1% 4.1% 3.4% 3.7% 2.9% 2.5% Change in General Fund From Prior Year Amount $3.8 -$0.1 $1.1 $1.2 $0.6 $0.6 Percent change 8.8% -0.3% 2.4% 2.4% 1.3% 1.1% Change in Local Property Tax From Prior Year Amount $1.0 $2.7 $1.1 $1.4 $1.4 $1.3 Percent change 6.2% 16.4% 5.8% 6.7% 6.5% 5.4% Maintenance Factor Created/Paid (+/-) -3.8 — — 0.8 1.6 1.7 Key Factors Proposition 98 “Test” 1 2 3 3 3 3 K-12 average daily attendance -0.1% -0.4% -0.5% -0.4% -0.4% -0.3% Per capita personal income (Test 2) -0.2 4.1 4.0 5.4 5.6 5.1 Per capita General Fund (Test 3) 7.4 4.4 3.4 3.6 2.6 2.2 K-14 cost-of-living adjustment 0.9 1.6 2.1 2.4 2.7 2.9 Assessed property values 6.1 5.5 5.3 6.2 6.4 5.8 Public School Stabilization Account — No No No No No Deposit? 28 Legislative Analyst’s Office www.lao.ca.gov CALIFORNIA’S FISCAL OUTLOOK rate increases phasing out over 2016-17 and 2017-18 CalSTRS’ liabilities, school and community college and the PIT rate increases phasing out over 2018-19 districts’ contribution rates are set to increase and 2019-20. Because the tax increases phase out beginning in 2014-15 and every year thereafter of gradually over four fiscal years, the effect on the the forecast period. In 2014-15, the rate increase is guarantee is lessened. The slower growth rates, 0.63 percent (for a total district contribution rate however, would make funding ongoing program of 8.88 percent). By the last year of the forecast expansions more difficult. period, the total cumulative rate increase is State Could Make Progress but Likely Not 9.88 percent (for a total district contribution rate Fully Implement LCFF by 2019-20. In 2013-14, the of 18.13 percent). CalSTRS estimates that districts’ state replaced most of its former school funding contribution costs will be $3.1 billion higher in formulas with the LCFF. In creating the LCFF, 2019-20 compared to 2014-15. Under our main the state set funding targets considerably higher scenario, the minimum guarantee in 2019-20 is than the 2012-13 funding levels and specified $11.3 billion higher than 2014-15. that the targets were to be adjusted annually for No Deposit Into Public School System cost-of-living adjustment (COLA). Given the higher Stabilization Account (PSSSA) Projected. funding targets, the state expected the LCFF would Proposition 2, approved by voters in November not be fully funded until 2019-20. For 2014-15, we 2014, created a new reserve—the PSSSA. estimate the LCFF is 80 percent funded. Under Proposition 2 is connected with a recently enacted our main scenario, the LCFF would be 91 percent state law that triggers a reduction in school district funded by 2019-20 if the state dedicated the reserve levels the year after the state makes a increase largely to LCFF. (Our estimate assumes deposit into the PSSSA. Under our main scenario the state creates no new categorical programs (as well as our surge and slowdown scenarios), the throughout the period and all existing categorical state would not make a deposit into the PSSSA. The programs but adult education receive only ADA cap on school district reserve levels therefore would growth and COLA. Consistent with statutory not be triggered at any time during the forecast intent, we assume the adult education program period. receives an additional $500 million in 2015-16. Universities We also assume community colleges continue to receive roughly 11 percent of Proposition 98 The state’s public universities consist of CSU, funds.) Given the higher LCFF targets, growth in UC, and Hastings. The CSU educates about the minimum guarantee would have to outpace 430,000 undergraduate and graduate students COLA rates significantly to fully fund the LCFF at 23 campuses. The UC educates about 240,000 by the end of the forecast period. Whereas annual undergraduate and graduate students at ten COLA rates range from 1.6 percent to 2.9 percent campuses, and Hastings educates about 1,100 over the 2015-16 through 2019-20 period, annual graduate students in law at its one campus. growth in the guarantee ranges from 2.5 percent The universities receive support for their core to 4.1 percent—somewhat but not markedly higher instructional programs from a combination of state than the COLA rates. funds and student tuition revenue. CalSTRS Rate Increases Also Phasing in Considerable Discretion in University Over Period. Based upon legislation adopted Budgeting. In building CSU’s and UC’s budgets, in 2014 that is designed to address outstanding the Legislature is constrained by few constitutional www.lao.ca.gov Legislative Analyst’s Office 29 CALIFORNIA’S FISCAL OUTLOOK requirements and few federal requirements— most graduate students have been flat for notably fewer than for many other areas of the the last four years (since 2011-12). The state budget. Greater discretion also stems from UC has indicated in its proposed budget the ability of CSU and UC to raise revenue through that it plans to raise tuition levels up to student tuition increases. For forecasting purposes, 5 percent annually for the next five years, this high level of discretion translates into beginning in 2015-16. The CSU Trustees university spending being very sensitive to future have not taken similar action for 2015-16. legislative and tuition decisions. Whether CSU plans to hold tuition levels Forecasting Current-Law Provisions Not flat throughout the entire forecast period Necessarily Most Helpful Approach. Additionally, remains uncertain. the state over the last few years has tended not LAO Outlook for Universities Based Primarily to adhere closely to certain statutory and Master on Current Practice. Rather than a current-law Plan provisions affecting CSU’s and UC’s budgets. forecast, we assume university spending over the The state lacks guiding policy altogether for other next few years will grow similarly to how it has university budget areas. Below, we highlight the grown in recent years. Specifically, we assume major areas for which current law provides little CSU and UC will (1) continue to receive base guidance in developing forecasting assumptions. increases; (2) fund any enrollment growth, faculty • COLA. Statute specifies the universities are compensation increases, and most increases in not to receive automatic COLAs. The state, debt-service costs from within those base increases; however, has provided CSU and UC with and (3) hold tuition levels flat. For 2015-16 (and the base increases the last two years. remainder of the forecast period), we assume annual base increases of 4 percent. Consistent with practice • Eligibility Pools and Enrollment Growth. over the last two years, we link these increases to Whereas the Master Plan sets forth that UC’s base budget such that the projected dollar CSU and UC are to draw from specified increase is the same for CSU and UC each year. high school eligibility pools (the top For 2015-16 and 2016-17, we assume CSU receives one-third for CSU and top one-eighth additional funding beyond its base increase to cover for UC), the state has not undertaken an projected increases in its lease-revenue debt service, eligibility study since 2007. As a result, the consistent with legislative action taken in 2014-15. effect of CSU’s and UC’s recent admission Under LAO Outlook, University Spending decisions on eligibility is unknown and Grows by $243 Million in 2015-16. Of this estimating the need for future enrollment amount, $127 million is higher CSU spending and growth has increasingly become $116 million is higher UC spending. The increase guesswork. grows to a total of $256 million in 2016-17, reaching • Tuition Levels. Statute sets forth no policy $280 million by the last year of the forecast period. regarding resident tuition levels. The As noted earlier, the Legislature has considerable Governor has indicated he would like CSU discretion in funding the universities and could and UC to freeze resident tuition levels choose to provide more or less than these amounts. at least through 2016-17. The universities’ Annual funding increases also could be affected tuition levels for undergraduates and by tuition increases. Revenue raised from tuition 30 Legislative Analyst’s Office www.lao.ca.gov CALIFORNIA’S FISCAL OUTLOOK increases could offset part of the General Fund Class Scholarship program, Cal Grant awards for augmentations. Given final tuition levels for Dream Act students, and scheduled Cal Grant 2015-16 and the rest of the period are uncertain, the award reductions for students attending nonprofit universities’ total increases in core funding could colleges. differ significantly from the amounts shown under Other Key Cal Grant Assumptions. We assume our outlook. continued growth in Cal Grant participation Assumed Spending Level Under LAO Outlook based on historical trends and ongoing efforts Roughly Equates to COLA in Core Funding. to increase the number of high school students Roughly half of CSU’s and UC’s core funding comes applying for financial aid. Specifically, we assume from the state General Fund. Thus, a 4 percent 3 percent annual participation growth throughout base General Fund increase roughly equates to a the forecast period. Legislation adopted in 2014 2 percent increase in core funding. This is about requiring high schools to submit student grades to the same as the projected 2015-16 U.S. state and CSAC electronically will contribute to this growth. local price deflator (2.2 percent). Demographically, Consistent with our CSU and UC forecasts, we California’s traditional college-age population assume no tuition increases and no enrollment (18-24 years of age) is projected to decline growth at the universities. We also assume the state 1.2 percent in 2015. High school graduates also are continues to use federal TANF funds to offset a projected to decrease slightly in 2015-16, though portion of General Fund Cal Grant costs. transfers from community colleges could increase Under LAO Outlook, Net General Fund Cal slightly due to increases in community college Grant Costs Increase by $67 Million in 2015-16. enrollment as well as improvements in transfer We estimate General Fund costs for Cal Grants pathways (particularly from CCC to CSU). If the will increase by $89 million, offset by $22 million universities were to hold enrollment levels flat given in General Fund savings resulting from scheduled these demographic trends, their 2015-16 per-student reductions in private college award amounts. Of funding levels would remain about the same in real the cost increases, $53.6 million is participation terms as in 2014-15. growth, $29.6 million is continued phase-in of Dream Act awards, and $6 million backfills Financial Aid one-time funding from loan program balances. The California Student Aid Commission Cal Grant costs are projected to grow by a net of (CSAC) is responsible for administering state $79 million in 2016-17. Annual increases slow financial aid programs. The state’s largest aid following full phase-in of the Dream Act in 2016-17, program is the Cal Grant program, which serves with an increase of $64 million the last year of the about 316,000 undergraduate students. This forecast period. We project total Cal Grant costs to program currently is funded with a combination grow from $1.8 billion in 2014-15 to $2.2 billion the of state General Fund and federal Temporary last year of the period. Assistance for Needy Families (TANF) monies. Too Soon to Forecast Impact of New Tax Outlook for Student Financial Aid Based Credit on Cal Grant Spending. In the 2014 session, Primarily on Current-Law Provisions. Our the state enacted legislation creating the College outlook assumes continued implementation of Access Tax Credit Fund (College Access Fund). existing statutory financial aid policies. Specifically, As set forth in the legislation, individuals may we assume continued phase-in of the Middle make charitable contributions to the College www.lao.ca.gov Legislative Analyst’s Office 31 CALIFORNIA’S FISCAL OUTLOOK Access Fund and, in turn, receive a large tax credit of program implementation because they were (starting at $0.60 per $1 the first year, declining unaware they could qualify for scholarships. to $0.50 per $1 the third year, capped at a total We estimate Middle Class Scholarship Program of $500 million statewide). The tax credit sunsets costs will grow to $111 million, $173 million, and December 1, 2017. Contributions to the fund $237 million in 2015-16, 2016-17, and 2017-18, will support increases in the Cal Grant B access respectively. Following full phase-in of awards in award, which helps low-income students cover 2017-18, we estimate costs will grow more slowly— non-tuition expenses (such as books, supplies, rent, to a total of $244 million at the end of the forecast and transportation). The award amount currently period (compared with the $305 million ongoing is $1,648 per year. After covering associated tax appropriation cap). credit and administrative costs, monies in the Key Policy Decisions Could Increase Financial College Access Fund will increase the Cal Grant B Aid Costs Significantly. The financial aid outlook is access award amount. Given the first contributions sensitive to changes in higher education enrollment to the fund only now are being made, we did not as well as CSU and UC tuition levels. We estimate forecast contributions to the College Access Fund a 2 percent increase in enrollment at CSU and UC and the resulting increase in access award amounts. would add about $30 million to Cal Grant costs The new fund, however, could result in higher Cal and $2 million to Middle Class Scholarship costs Grant B spending, beginning in 2015-16. in 2015-16. We estimate a 5 percent increase in Middle Class Scholarship Spending Increases tuition at CSU and UC would increase Cal Grant Next Few Years but Likely by Less Than Initially costs by about $65 million and Middle Class Planned. The estimated first-year cost of the Scholarship costs by $5 million. Altogether, these Middle Class Scholarship program is lower than changes would add about $100 million to financial budgeted, totaling about $70 million (compared aid costs in the budget year. In addition, increased with the $107 million appropriation). Campuses participation in financial aid programs resulting report discovering that many potential Middle from new outreach efforts within CSU and UC (for Class Scholarship recipients already receive Middle Class Scholarships) and within high schools sufficient aid to cover at least 40 percent of their (for all aid programs) could raise aid costs by tuition and thus are not eligible for awards. In several tens of millions of dollars. Any current-year addition, they believe a number of students might growth in aid spending not yet reported by CSAC not have applied for financial aid in the first year also would have outyear effects. HEALTH AND HUMAN SERVICES Overview of Health Services Provided. program both in terms of funding and number California’s major health programs provide health of persons served. Beginning January 2014, the coverage and additional services for various Medi-Cal population has grown substantially, groups of eligible persons—primarily poor families reflecting an expansion of those eligible for and children as well as seniors and persons with Medi-Cal and a streamlining of eligibility disabilities. The federal Medicaid program, known requirements under the Patient Protection and as Medi-Cal in California, is the largest state health Affordable Care Act (ACA), also known as federal 32 Legislative Analyst’s Office www.lao.ca.gov CALIFORNIA’S FISCAL OUTLOOK health care reform. In addition, the state supports funded. For example, over these years, there is various public health programs. Although state an increase in General Fund savings in Medi-Cal departments oversee the management of these associated with enhanced federal matching funds programs, the actual delivery of many services is for the Children’s Health Insurance Program carried out by counties and other local entities. (CHIP) under ACA. In addition, over these years, Health programs are largely federally and state more General Fund spending in CalWORKs is funded. being offset with county realignment revenues. Overview of Human Services Provided. We assume that spending for HHS programs will The state provides a variety of human services eventually reach $34.3 billion in 2019-20 in our and benefits to its citizens. These include income main scenario. The bulk of the spending growth maintenance for the aged, blind, or disabled; in the later years of the outlook reflect increases in cash assistance and welfare-to-work services for caseload for some categories of enrollees and the low-income families with children; protection of per-person cost of providing health care services in children from abuse and neglect; the provision Medi-Cal. Medi-Cal General Fund spending grows of home-care workers who assist the aged and faster in the latter part of the forecast period as disabled in remaining in their own homes; savings that offset Medi-Cal General Fund costs in and community services and state-operated the earlier years are reduced and as the state’s share facilities for the mentally ill and developmentally of costs for the Medi-Cal expansion under federal disabled. Although state departments oversee the health care reform ramp up. management of these programs, the actual delivery Although the average projected annual increase of many services is carried out by county welfare in HHS spending from 2014-15 through 2019-20 is and child support offices, and other local entities. 3 percent, there is substantial variation in spending Most human services programs have a mixture of growth rates by program. For example, over these federal, state, and county funding. years, General Fund spending growth for Medi-Cal Overall Spending Trends. The 2014-15 budget averages 4 percent per year, while the Supplemental provided $29.5 billion in General Fund spending Security Income/State Supplementary Program for health and human services (HHS) programs. (SSI/SSP) is projected to have average annual We now estimate that these General Fund costs growth of 1.4 percent. General Fund spending for in 2014-15 will be slightly higher—by a net of the CalWORKs program is projected to decline at $47 million—in part reflecting higher caseloads an average annual rate of 10.5 percent, reflecting than assumed by the budget for certain segments both projected caseload declines as well as the of the Medi-Cal population and for the California infusion of non-General Fund funding sources to Work Opportunity and Responsibility to Kids support the program, as discussed further below. (CalWORKs) population. Based on current law Anticipated Lower Caseload Growth in Some requirements, we project that General Fund Programs Relative to Recessionary Years Reduces spending for HHS programs will increase to Cost Pressures. The recession in the latter part $29.7 billion in 2015-16 and $30.6 billion in 2016-17. of the 2000s raised unemployment and reduced This relatively modest growth in General Fund income, resulting in historically high numbers spending over these years is not primarily due to of Californians enrolling in certain state HHS a slowing down in program growth, but rather is programs. As a result, caseload growth for several largely reflective of changes in how programs are HHS programs from 2007-08 (the beginning of www.lao.ca.gov Legislative Analyst’s Office 33 CALIFORNIA’S FISCAL OUTLOOK the recession) to 2011-12 (post-recession) was General Fund spending in 2016-17 compared to well above historical trends. Our main economic 2015-16 is mainly a function of underlying program scenario assumes moderate employment growth growth and decreased savings associated with the over the next five years. Accordingly, our caseload MCO tax (discussed in more detail below). projections for several HHS programs reflect Future Changes in Caseload. Medi-Cal has substantially lower growth rates compared to experienced major caseload growth since the the experience of the recent recessionary years, January 1, 2014 implementation of key provisions and in some cases—such as CalWORKs—we are of the ACA. For September 2014, the preliminary anticipating caseload declines under our main count of enrollees—which will likely be revised scenario over some or all of the forecast period. upward to include individuals later found to be This in turn reduces cost pressures. Below, we retroactively eligible—was over 11 million. This discuss spending trends in the major HHS preliminary count includes 2 million individuals programs. who became newly eligible for Medi-Cal under the optional ACA expansion and 1.1 million previously Medi-Cal eligible individuals who enrolled as part of the Overall Spending Trends. We estimate that mandatory expansion. 2014-15 General Fund spending for Medi-Cal While the main effect of the mandatory local assistance administered by the Department and optional expansions is mostly a one-time of Health Care Services (DHCS) will be caseload increase in the present and short-run, $17.2 billion—approximately 0.2 percent lower than we also expect changes in the state’s economy and what was assumed in the 2014-15 Budget Act. The population to influence the longer-run trend for slightly lower 2014-15 spending estimate mainly enrollment growth (or decline) in the program. reflects increased savings from the managed care This is based on our analysis of historical patterns organization (MCO) tax, due to higher-than- in caseload over the past decade. For example, predicted caseload for newly eligible populations enrollment among the families and children under the ACA. (This is known as optional population grew nearly 11 percent during the expansion.) Our 2014-15 estimate also reflects recession. However, it grew only 1 percent annually higher caseload but lower per-enrollee fee-for- between 2011 and 2013. As discussed below, we service (FFS) costs associated with recent Medi-Cal expect these growth rates to further level off as enrollment among previously eligible populations families’ incomes rise with the improving economy. who, absent the ACA, would not have enrolled Our outlook addresses movements in caseload in Medi-Cal. (This is known as the mandatory due to both (1) the immediate influx from the expansion.) Under our main scenario, General mandatory and optional ACA expansions and Fund support decreases 1.1 percent to $17.1 billion (2) the longer-run historical relationship between in 2015-16 and then grows to $17.9 billion in Medi-Cal enrollment and the state’s economic 2016-17—a year-over-year increase of 4.8 percent. conditions and demographic trends. We project General Fund costs are projected to decrease in that by 2015-16, the average monthly enrollment 2015-16 largely as a result of savings associated with associated with ACA expansions will stabilize at increased federal funding of CHIP under ACA around 2.1 million for the optional expansion and (discussed in more detail below), which offsets 1.1 million for the mandatory expansion. Under other increases in program costs. The growth in our main economic scenario, we project that by 34 Legislative Analyst’s Office www.lao.ca.gov CALIFORNIA’S FISCAL OUTLOOK 2016-17, the underlying trend for enrollment among with disabilities. These projections are subject families and newly eligible adults will switch to a to considerable uncertainty, particularly if the slight decrease of less than 1 percent annually. This relationship between capitated rates in Medi-Cal translates to about 8,000 fewer enrollees per year. and broader health care costs differs substantially Caseloads for seniors and persons with disabilities in the near future. historically track the state’s demographics rather ACA Implementation. Our outlook includes than economic factors. We estimate enrollment adjustments to account for the implementation of among seniors will grow by about 2 percent in several ACA provisions. Many of our ACA-related both 2015-16 and 2016-17, while enrollment among adjustments are based on preliminary data and persons with disabilities will grow by 3 percent in are therefore subject to considerable uncertainty. both years. This adds about 25,000 enrollees per Significant ACA- related provisions include: year to each category. • Mandatory Expansion. The state is Growth in FFS and Managed Care responsible for about 50 percent of the Expenditures. Growth in Medi-Cal expenditures costs of providing health care services for is related to growth in costs across the broader the mandatory expansion. The 2014-15 health care sector. For example, each year the Budget Act assumes General Fund costs state’s actuary certifies the capitated rates paid to of nearly $770 million for this population, Medi-Cal managed care plans. As part of the rate including over $100 million in retroactive development process, the actuary incorporates costs associated with the Medi-Cal information and assumptions about future health application backlog—eligible individuals care cost trends, including medical inflation. whose applications have been delayed for We assume these types of relationships between several months and will receive retroactive Medi-Cal expenditures and broader health care coverage going back to the date of their costs will continue to hold throughout the forecast application. Our outlook projects General period. Based on this assumption, we forecast Fund costs of $880 million (including growth in Medi-Cal expenditures using (1) paid over $100 million for retroactive costs claims data from FFS, (2) summary data on associated with the backlog), which is capitated rate development in managed care, and $110 million more than was assumed in (3) medical inflation forecasts performed by our the 2014-15 Budget Act. The difference is office and other organizations. due to higher caseload estimates based on Under our main scenario, we project that preliminary enrollment data, offset in part overall expenditures in both managed care and by lower assumed per-enrollee FFS costs FFS will grow by about 4 percent in both 2015-16 associated with the mandatory expansion. and 2016-17. These overall growth rates reflect Our outlook assumes all costs associated changes in both caseload and cost per enrollee. with the backlog will be paid in 2014-15. Our forecast of per-member per-month (PMPM) After resolving the backlog, we estimate cost growth for families and children in managed the General Fund cost associated with the care is around 3.5 percent in 2015-16 and 4 percent mandatory expansion in 2015-16 will be 2016-17. In both years, we project PMPM costs in about $770 million. managed care will grow between 2 percent and 2.5 percent for seniors and 3.5 percent for persons www.lao.ca.gov Legislative Analyst’s Office 35 CALIFORNIA’S FISCAL OUTLOOK • Optional Expansion. Effective January through 2015-16. The revenue from these taxes are 1, 2014, California expanded Medi-Cal matched with federal Medicaid funds and are used coverage to include most adults under age to: (1) increase Medi-Cal managed care capitated 65 with incomes at or below 138 percent rates by an amount that offsets the tax paid by the of the federal poverty level who were not MCOs, and (2) offset General Fund costs. In July, previously eligible for Medi-Cal—referred the federal Centers for Medicare and Medicaid to as the optional expansion. The federal Services (CMS) released a letter to states indicating government will pay 100 percent of that health care-related taxes applied specifically the costs for this population from 2014 to a subset of providers (such as Medicaid MCOs) through 2016. The federal share will are not consistent with statutory and regulatory decline between 2017 and 2020, with the requirements. The CMS has advised states to make state eventually paying 10 percent of the changes necessary to bring their tax structures into additional cost of health care services for compliance as soon as possible, but no later than the the optional expansion population. Our end of the next legislative session (that is, in 2016). outlook assumes PMPM costs associated It is likely that California’s MCO tax structure will with this population will be similar to need to be changed because the MCO tax specifically PMPM costs for the current children and targets Medicaid MCOs, which, according to the families population, and projects General CMS letter, are considered to be a subset of providers. Fund costs in the low hundreds of millions Our outlook assumes that the MCO tax will be of dollars beginning in 2016-17. assessed at the current rate of 3.9 percent through the end of 2015-16 and generate General Fund savings • Increased Federal Matching Rate for of roughly $900 million annually in 2014-15 and CHIP. From October 1, 2015 through 2015-16. October 1, 2019, the ACA authorizes a For subsequent years, we assume the state 23 percentage point increase in the federal would have to impose a different tax that does CHIP matching rate (the federal share of not conflict with federal guidelines for health costs)—from 65 percent to 88 percent—in care-related taxes. Prior to authorization of the California. Our outlook assumes the MCO tax in 2013-14, the Legislature authorized enhanced federal matching rate will offset several similar taxes on Medi-Cal MCOs beginning about $500 million in General Fund in 2010. All these prior taxes were at the state’s spending in California’s CHIP—formerly 2.35 percent insurance gross premiums tax, which the Healthy Families Program, now part is charged to all non-health insurance products and of the Medi-Cal Program—in 2015-16. some limited types of health insurance. The state Federal funding for CHIP has been autho- was able to collect these prior taxes from Medi-Cal rized through federal fiscal year 2014-15. MCOs and use them to leverage federal Medicaid Our outlook assumes additional funding funds without objection from CMS. Therefore, for will be authorized for future years. the purposes of our outlook, we assume Medi-Cal Uncertainty in General Fund Savings From MCOs are assessed a tax at the gross premiums MCO Tax. Current state law authorizes a 3.9 percent tax rate after 2015-16, resulting in General Fund tax (equal to the current state sales tax rate) on savings of about $600 million annually. However, premium revenues collected by Medi-Cal MCOs 36 Legislative Analyst’s Office www.lao.ca.gov CALIFORNIA’S FISCAL OUTLOOK there is significant uncertainty around the taxing of regulations that require the state to pay overtime MCOs in light of CMS’s recent letter. compensation to IHSS providers and for other newly Addition of Behavioral Health Treatment compensable work activities, (2) the state’s minimum (BHT) Services Benefit. The 2014-15 Budget Act wage increase scheduled for January 1, 2016, and included trailer bill language requiring DHCS to add (3) anticipated wage and benefit increases negotiated BHT services, such as Applied Behavioral Analysis through the collective bargaining process. (ABA), as a covered Medi-Cal benefit to the extent Compliance With New Federal Labor required by federal law. Subsequent to the passing Regulations and Wage Increases. New federal of the 2014-15 Budget Act, the federal government labor regulations require the state to pay overtime issued guidance that indicated that BHT should be compensation to IHSS providers who work more a covered Medicaid benefit for eligible children and than 40 hours per week and to pay for the newly adolescents with autism spectrum disorder. As of compensable work activities of travel time and September 15, 2014, Medi-Cal managed care plans wait time during medical appointments. These are required to provide medically necessary ABA requirements, which the state will implement services for eligible children. Provision of other BHT beginning on January 1, 2015, represent an services will be implemented at a later date that has estimated annual General Fund cost of about not yet been determined. No funds were included in $360 million. Additionally, the state’s minimum the 2014-15 Budget Act for BHT services in Medi-Cal. wage is set to increase from $9 to $10 beginning Our outlook assumes additional costs associated January 1, 2016, at an estimated annual General with BHT services in the low tens of millions of Fund cost of about $65 million. Finally, future dollars in 2014-15, increasing to about $50 million in wage and benefit increases resulting from 2015-16. These costs are in addition to General Fund collective bargaining between IHSS provider spending of about $70 million annually for children unions and counties will also increase General and adolescents enrolled in Medi-Cal who currently Fund program costs. receive BHT services through the Department of Statewide Collective Bargaining. Because Developmental Services (DDS). We assume that of the implementation of the Coordinated Care these individuals will transition to receiving BHT Initiative (CCI), up to eight counties will be services through Medi-Cal managed care plans in transitioning—over the period from 2014-15 2015-16, and accordingly our outlook shifts General through 2016-17—from negotiating wages and Fund support from the DDS budget to the Medi-Cal benefits at the county level to statewide collective budget in 2015-16. bargaining. If the transition of the CCI counties to statewide collective bargaining leads to faster In-Home Supportive Services (IHSS) wage and benefit growth in these counties, then We project that General Fund spending for IHSS IHSS program costs would be higher than our will increase from about $2.2 billion in 2014-15 to outlook projects. nearly $2.5 billion in 2015-16—and grow by about Developmental Services $70 million in 2016-17. These estimated expenditure increases are primarily driven by caseload growth We estimate that General Fund spending (which we project to be 2 percent annually) and three for DDS will total about $3 billion in 2014-15. factors exerting upward pressure on IHSS providers’ We project that General Fund expenditures will compensation. These factors are: (1) new federal labor increase by about $100 million in 2015-16 and www.lao.ca.gov Legislative Analyst’s Office 37 CALIFORNIA’S FISCAL OUTLOOK reach a total of about $3.2 billion by 2016-17. cost of about $9 million. Other ICF units—at These projected expenditure increases are mostly Sonoma, Fairview, and Porterville—have also due to cost increases for community services faced challenges in meeting federal certification resulting from (1) a growing caseload (we project requirements in surveys conducted by DPH. 3.4 percent annual growth) and (2) increased However, because these units are continuing to costs per consumer. The increased costs per receive federal Medicaid funding as DDS deals consumer in the community are primarily with the identified problems, our outlook assumes due to the state’s scheduled minimum wage that DDS will maintain federal Medicaid funding increase (which increases the cost of services for these ICF units. However, if DDS is unable to provided to consumers), as well as higher costs remedy the problems, then the state could lose for home care because of compliance with new additional federal Medicaid funding associated federal labor regulations (the same regulations with these units over the period—beyond the referenced in the IHSS write-up). These estimated $9 million we have assumed for 2014-15. expenditure increases are partially offset by SSI/SSP two main factors. First, we assume significantly reduced costs in DDS for the purchase of BHT State expenditures for SSI/SSP are estimated services, since Medi-Cal is newly required to to be $2.8 billion in 2014-15, increasing by about provide these services to beneficiaries—shifting $40 million annually to reach a total of about the cost of these services from DDS to DHCS (see $2.9 billion in 2016-17. The projected spending the Medi-Cal write-up for more detail on this increases are primarily due to average annual change). Second, we assume reductions in the caseload growth of about 1 percent. During cost for developmental centers (DCs) as a result the 2013-14 and 2014-15 budget development of individuals transitioning from the DCs to the processes, the Legislature expressed interest in community as well as the expected closure of reinstating a state-funded COLA for SSI/SSP Lanterman DC. grant recipients. While our outlook does not Uncertain Federal Medicaid Funding assume the provision of a COLA over the forecast for DCs. Sonoma DC has been found by the period, we estimate that reinstating a COLA Department of Public Health (DPH) to be out of for the state-funded SSP portion of the grant compliance with federal certification requirements would cost approximately $55 million annually and has therefore lost federal Medicaid funding or $270 million more by 2019-20 if a COLA were for four Intermediate Care Facility (ICF) living provided each year over the period. units. The 2014-15 budget assumed that the four CalWORKs ICF units at Sonoma DC would regain federal certification and that federal Medicaid funding We estimate that General Fund spending would be restored beginning July 1, 2014. in the CalWORKs program in 2014-15 will be However, the four ICF units remain decertified $783 million—roughly, 7 percent higher than at the time of this analysis. Our outlook assumes what was assumed in the 2014-15 Budget Act. that DDS will regain federal certification for these The higher 2014-15 estimate primarily reflects a four units by February 1, 2015, requiring the state slower-than-expected decline in caseload. From to backfill the loss of federal Medicaid funding this 2014-15 funding level, we project that General for seven months of 2014-15 at a General Fund Fund spending will decrease to $766 million in 38 Legislative Analyst’s Office www.lao.ca.gov CALIFORNIA’S FISCAL OUTLOOK 2015-16 and further decrease to $553 million cash assistance (equivalent to the adult’s in 2016-17. These projected decreases reflect portion of the family’s grant). For purposes the combination of several factors including of our projections, we have assumed that (1) savings from an expected ongoing decline General Fund savings from the 24-month in caseload, (2) costs and savings from the time limit will begin in 2015-16 and will implementation of prior policy changes, and eventually reach an ongoing level of up to (3) changes in other CalWORKs funding sources about $20 million annually. that affect General Fund spending in the program. • 5 Percent Grant Increase. The maximum Savings From Declining Caseload. amount of cash assistance that families Historically, changes in economic conditions in the CalWORKs program may receive have significantly affected CalWORKs caseload is scheduled to increase by 5 percent growth. Under our main scenario, we project that in April 2015. (This follows a similar the CalWORKs caseload will continue to decline 5 percent increase that took effect in over the near term as the labor market continues March 2014.) The 2014-15 Budget Act to improve and levels of employment increase. As includes partial-year funding for the April the number of families enrolled in CalWORKs 2015 increase. We estimate that the total declines, costs to provide cash assistance and cost of providing this grant increase will welfare-to-work services as provided for in current rise by roughly $125 million in 2015-16 law will decrease. Specifically, we estimate that to reflect a full year of implementation. declining caseloads will result in year-over-year The General Fund costs of funding this General Fund savings of around $90 million in and the earlier grant increase are offset to 2015-16 and an additional $85 million in 2016-17. some extent with available funds in the Net Costs From Full-Year Implementation Child Poverty and Family Supplemental of Prior Policy Changes. Program spending Support subaccount (hereafter “Child in the near term will be influenced by several Poverty subaccount”)—a part of the 1991 recent policy changes that have not yet been fully realignment funding structure. This implemented. We describe some of the major funding source is dedicated to paying changes below. the costs of these and certain other • 24-Month Time Clock. Beginning future grant increases. In 2014-15, the in January 2013, able-bodied adult General Fund contribution to pay for the CalWORKs recipients are subject to a new two grant increases totals $56 million. 24-month limit on eligibility for assistance We project that this contribution will while participating under state work rules, increase to $126.1 million in 2015-16, in which provide a wider range of options part reflecting full-year implementation for meeting the program’s work partici- of the April 2015 increase and available pation requirement than is available under offsetting funds. alternative federal work rules. After 24 months of participation (not required to be • Drug Felon Eligibility. In April 2015, consecutive) under state rules, able-bodied individuals formerly ineligible for adults are required to comply with less CalWORKs assistance due to drug felony flexible federal rules or face a reduction in convictions will become eligible. This www.lao.ca.gov Legislative Analyst’s Office 39 CALIFORNIA’S FISCAL OUTLOOK change will result in additional General flat going forward. The actual amount Fund costs, primarily for counties to of local indigent health savings that will provide welfare-to-work services to the be available to offset General Fund costs, newly eligible population. The 2014-15 however, is uncertain. Budget Act includes partial-year funding • Special Fund Revenues for Grant Increases for these new costs. We estimate that costs Projected to Rise Over Time. As refer- associated with drug felon eligibility will enced above, the Child Poverty subac- rise by roughly $25 million in 2015-16 to count provides for the growth of certain reflect a full year of implementation. realignment revenues to fund the costs of Changes in Other Funding Sources. The CalWORKs grant increases. We project that CalWORKs program is funded with a combination the amount of Child Poverty subaccount of the federal TANF block grant, the state General funds available to fund the March 2014 and Fund, and county funds (primarily consisting April 2015 grant increases will grow in the of funding provided through realignment). The near term, directly offsetting General Fund state’s annual TANF block grant is fixed, such costs. By 2016-17, we project that all but that year-over-year increases or decreases in total $35.6 million of the costs of the two grant program spending accrue to state and county funds increases will be offset by Child Poverty (including realignment funds). In recent years, subaccount funds. Once Child Poverty General Fund support for CalWORKs has been subaccount funds have fully offset the significantly offset by increases in realignment General Fund costs of providing the two funds. Below, we describe our assumptions prior grant increases—which we project about future changes in realignment funding for will occur beginning in 2017-18—new grant CalWORKs that would affect the level of General increases would be provided under current Fund expenditures in the program in the near term. law commensurate with available funds, • Offsetting Savings From Medi-Cal generally with no further impact on the Expansion Assumed to Remain Flat. The General Fund. We note that our estimate Family Support Subaccount—part of the of Child Poverty subaccount funds that 1991 realignment funding structure— will be available in the future is subject to redirects local indigent health savings significant uncertainty. related to the expansion of Medi-Cal Total Program Spending to Remain Relatively through the ACA to pay for an increased Flat. Under our main scenario, we expect two county share of CalWORKs grant costs. primary trends to affect total spending in the Family Support Subaccount funds directly CalWORKs program. As noted above, continuing offset General Fund grant costs in the declining caseloads will likely result in decreased CalWORKs program. The 2014-15 Budget total spending. At the same time, future grant Act assumes that $725 million in Family increases provided with Child Poverty subaccount Support Subaccount funds will be spent in funds will likely result in increased total spending. CalWORKs. For purposes of our expen- We project that these two trends will largely offset diture projections, we have assumed that each other leading to generally flat total program this amount of offsetting revenues remains spending in coming years. 40 Legislative Analyst’s Office www.lao.ca.gov CALIFORNIA’S FISCAL OUTLOOK CORRECTIONS AND REHABILITATION General Fund spending for support of the Impact of Proposition 47. Proposition 47 California Department of Corrections and reduces penalties for certain offenders convicted Rehabilitation (CDCR) operations in 2014-15 of nonserious and nonviolent property and drug is estimated to be $9.1 billion, which is a net crimes, as well as allows certain offenders currently increase of $136 million, or about 2 percent, above in prison for such crimes to apply for reduced the 2013-14 level of spending. This estimated sentences. These changes will reduce state prison increase primarily reflects (1) increased workers’ population and associated costs by (1) making compensation expenses, (2) additional contract bed fewer offenders eligible for prison and (2) releasing expenses, and (3) the expansion of the correctional certain offenders currently in prison as a result officer training academy. We estimate that of being resentenced. Accordingly, our estimates spending on CDCR will remain flat at $9.1 billion above assume that Proposition 47 will reduce the in 2015-16. While the department is expected to prison population by several thousand inmates— incur increased costs in 2015-16 from the activation resulting in savings of more than a couple hundred of three new infill prison facilities, we estimate that million dollars annually beginning in 2015-16. these costs will be entirely offset by savings from Under the proposition, state savings resulting reductions in the prison and parole population. from its implementation will be used to provide Specifically, we estimate additional reductions additional funding for mental health and substance in the parole population as a result of the 2011 abuse treatment, truancy prevention, and victim realignment of adult offenders to counties and in services beginning in 2016-17. the prison population as a result of voter approval of Proposition 47, discussed below. OTHER PROGRAMS Employee Compensation that state employee compensation costs continue growing after these MOUs expire as follows: Labor Agreements Increase State Costs in 2015-16. The state has active labor agreements • Salary Increases. After the MOUs expire, (memoranda of understanding or “MOUs”) with we assume that all state employees receive each of its 21 collective bargaining units. Under annual pay increases equal to the rate the terms of these MOUs, state General Fund of inflation. In 2016-17, this assumption employee compensation costs will increase by increases our estimate of state salary costs about $300 million in 2015-16 to pay for higher by about $170 million. By 2019-20 under (1) employee salaries and (2) health premium costs our main scenario, this increase rises to for employees and their dependents. $750 million. Assume Costs Grow Beyond Terms of Current • Health Benefit Costs. Under current Labor Agreements. All but two of the state’s labor law, the state pays a fixed percentage of agreements—those with highway patrol officers premium cost for about three-quarters of and fire fighters—expire by July 2015. We assume state employees. The state’s costs for these www.lao.ca.gov Legislative Analyst’s Office 41 CALIFORNIA’S FISCAL OUTLOOK employees’ health benefits increase when CalSTRS health premiums increase even if the MOU Outlook Reflects Cost Increases Under Full is expired. For other employees, the MOU Funding Plan. Along with school and community specifies a flat dollar amount that the state college districts and teachers, the state makes contributes towards premium costs. This contributions to CalSTRS to fund pension benefits flat dollar amount does not increase after for teachers. The CalSTRS defined benefit pension the MOU expires. Our outlook assumes program had a $74 billion unfunded liability as that the state will negotiate new MOUs of the end of 2012-13. To address this shortfall with state employees that maintain the over the next 32 years, Chapter 47, Statutes of 2014 state’s current share of premium costs. In (AB 1469, Bonta), increases contribution rates 2016-17, this assumption increases state from the state, districts, and teachers. Between General Fund health benefit costs by about 2014-15 and 2016-17, the state’s contribution rate $140 million, rising to $370 million by will increase from 3.5 percent to 6.3 percent of 2019-20. statewide teacher payroll. (The state also makes a contribution of almost 2.5 percent to fund a State Employee Retirement Costs program that protects the purchasing power of Contributions to CalPERS to Increase. retirees’ benefits from the effects of inflation.) The Earlier this year, the California Public Employees’ state contribution to CalSTRS was $1.5 billion in Retirement System (CalPERS) board adopted 2014-15. Under the plan, we estimate that state new actuarial assumptions incorporating their contributions will increase to almost $2.5 billion by findings that some state retirees were living longer 2016-17, when the rates are fully phased in, and will and receiving higher salaries than CalPERS continue to grow with statewide teacher payroll previously assumed. Under CalPERS’ new actuarial thereafter. assumptions, the state must contribute more Non-Education State Mandates money towards the pension fund. The pension rate increases are phased in between 2014-15 and 2014-15 Mandate Costs. The 2014-15 Budget 2016-17. Due to these retirement rate increases and Act includes $135.7 million for payments to cities, assumed higher payroll costs, we estimate that the counties, and special districts for state-mandated state’s General Fund contributions to CalPERS local programs, including $100 million for mandate for state and CSU pensions will increase from claims submitted prior to 2004-05. “Trigger $2.7 billion in 2014-15 to $3.1 billion in 2016-17, language” in the 2014-15 Budget Act provides rising thereafter to over $3.3 billion in 2019-20. that if the administration’s 2015 May Revision Retiree Health Costs Continue to Climb. estimates for 2013-14 and 2014-15 General Fund The state pays retiree health benefit costs as they revenues exceed the amounts included in the come due for the vast majority of state and CSU 2014-15 budget, any excess revenues not needed to retirees. We estimate that these costs will grow satisfy the Proposition 98 minimum guarantee—up from $1.8 billion in 2014-15 to more than $2 billion to $800 million—shall be used to pay pre-2004 by 2016-17. In our main scenario, these costs reach mandate claims. As shown in Figure 7, we project $2.8 billion in 2019-20. that an additional $170 million will be allocated for payment of pre-2004 claims in 2014-15 pursuant to this trigger language. 42 Legislative Analyst’s Office www.lao.ca.gov CALIFORNIA’S FISCAL OUTLOOK Future Mandates Costs Around $40 Million Our projections do not incorporate any Annually if Recent Practices Continue. Over the potential actions, such as an increase in UI taxes or last several years, the Legislature has taken various decrease in benefits, that could be taken during the actions to reduce or defer costs for state mandates forecast period to address the underlying UI Trust on local governments. These actions include Fund insolvency and reduce the state’s interest permanently repealing mandates, suspending payment obligation to the federal government. statutory requirements to implement mandates, We note, however, that pursuant to federal law, and deferring payment on the backlog of mandate and beginning in tax year 2011, the federal claims submitted since 2004-05. Assuming that the unemployment tax credit for which employers are Legislature continues this approach, we estimate eligible (up to 5.4 percentage points of the total General Fund costs for state mandates will be 6 percent tax on employee wages up to $7,000) $37 million in 2015-16 and will grow slightly to just began to be reduced incrementally for each year over $40 million by 2019-20. that the state continues to have an outstanding federal loan to the UI Trust Fund. The increase in Unemployment Insurance (UI) federal unemployment taxes paid by California Interest Payments on Federal Loan. employers due to the tax credit reduction— California’s UI Trust Fund has been insolvent approximately $945 million in 2014 and $1.3 billion since 2009, requiring the state to borrow from in 2015—is used to make principal payments that the federal government to continue payment of reduce the federal loan balance. (The state, however, UI benefits. California’s outstanding federal loan remains responsible to pay the interest payments on is estimated to be $8.7 billion at the end of 2014. any outstanding loan balance.) The state is required to make annual interest Department of Forestry and payments on this loan. These General Fund Fire Protection (CalFire) interest costs total $217 million in 2014-15. Based upon our main scenario assumptions concerning We estimate General Fund spending for the unemployment rate and the Employment CalFire to be about $900 million in 2014-15. Development Department’s projections of benefit This amount includes $53 million in one-time payments and UI Trust Fund revenues, General drought-related funding provided in the 2014-15 Fund annual interest payments would gradually budget, as well as an additional $70 million already decline each year—from $217 million in 2014-15 to transferred from the Special Fund for Economic $73 million in 2018-19 (when we estimate the loan Uncertainties to cover higher-than-anticipated will be completely paid off). emergency fire suppression activities during the Figure 7 Calculation for Mandates “Trigger” Under LAO Main Scenarioa (In Millions) 2013‑14 2014‑15 Total Higher General Fund proceeds of taxes $137 $2,182 $2,319 Higher General Fund spending under Proposition 98 -63 -2,086 -2,149 Amounts Provided Under Trigger $74 $96 $170 a Amounts shown are relative to 2014-15 Budget Act estimates. www.lao.ca.gov Legislative Analyst’s Office 43 CALIFORNIA’S FISCAL OUTLOOK first few months of the current fiscal year. Our General Fund spending on debt-service costs to estimate also assumes some additional emergency annual General Fund revenues and transfers—is fire suppression costs due to the continued threat of often used as one indicator of the state’s debt wildfire for the remainder of 2014-15. We assume burden. As shown in Figure 8, the DSR has varied General Fund expenditures for 2015-16 will be considerably in past decades—between about about $850 million. However, this amount could 3 percent and 6 percent. In the late 2000s, the vary significantly depending on the number, DSR grew to 6 percent as large bond measures severity, and location of wildfires. We note that were approved and state revenues dropped due the state is eligible to be reimbursed by the federal to a recession. More recently, however, the DSR government for some state costs incurred fighting has declined somewGhart afopr ha ivca rSietiyg onf rOeafsfons, fires, such as those on federal land. However, our including rebounding General Fund revenues, Secretary estimates do not assume any reimbursements refinancing of existing debt, and state policies Analyst because the amount and timing of future shifting some state debt costs from the General MPA reimbursement is unknown. Fund to special funds—such as in transportation. Deputy DSR Expected to Remain Under 6 Percent. Debt Service on Infrastructure Bonds Under our main scenario, the DSR remains under DSR Has Fluctuated Historically. The 6 percent over the next several years. We assume debt-service ratio (DSR)—the ratio of annual the state gradually sells bonds that previously have been approved by voters or the Legislature. Figure 8 These bonds include some LAO Main Scenario: of the remaining unsold Debt-Service Ratio Remains Under 6 Percent infrastructure bonds that Percent of General Fund Revenues Spent on Debt Service voters approved in 2006 and 2008, as well as a 7% Authorized, but Unsold portion of the water bond 6 approved in November 5 2014 (Proposition 1). We note that water bond sales 4 are expected to occur over 3 a number of years, so the 2 water bond’s full annual Bonds Already Sold debt-service costs will not 1 occur until after the forecast period. 1995-96 1999-00 2003-04 2007-08 2011-12 2015-16 2019-20 Projection ARTWORK #140536 Template_LAOReport_mid.ait 44 Legislative Analyst’s Office www.lao.ca.gov Chapter 4 Implementing Proposition 2 Passed on November 4, 2014, Proposition 2 Review), establishes a maximum level of school changes the way the state pays down debt and district reserves. The Legislature could change this saves money in reserves. The measure also creates statutory provision in the future, unlike the rest of a state reserve for Proposition 98 funding for Proposition 2’s changes to the State Constitution. schools and community colleges. In addition, The effects of Proposition 2 may not be felt by in the year following a deposit to the new schools and community colleges for at least a few Proposition 98 reserve, Chapter 32, Statutes of years. The flowchart in Figure 1 (see next page) 2014 (SB 858, Committee on Budget and Fiscal shows how the new reserve and debt rules will affect state budget calculations. CHOICES ABOUT RULES AND CALCULATIONS Highly Complex Interactions With Other and debt payments—and therefore the amount Budget Formulas. Proposition 2 is highly complex available for other state spending priorities—could and will influence key decisions concerning vary by a billion dollars or more in a given fiscal the state’s reserve and debt policies. Due to year. interactions with the Proposition 98 funding Pre-Proposition 2 BSA Deposits formula for schools and community colleges, Proposition 2 will sometimes produce results Rules Concerning Control Over $1.6 Billion that are difficult to predict and counterintuitive. Deposited to BSA in 2014-15 Budget. Under The state will have various choices to make when Proposition 2, the state can access the Budget implementing Proposition 2. We list some of Stabilization Account (BSA) funds only when those key choices for policymakers in Figure 2 the Governor declares a budget emergency (see page 47) and discuss each below. (Figure 2 (the conditions for which are discussed later in also lists the choices reflected in our fiscal outlook this chapter). Proposition 2, however, does not calculations when applicable.) Depending on the explicitly apply these withdrawal rules to the choices made by policymakers, reserve deposits $1.6 billion that was deposited in the BSA in Legislative Analyst’s Office www.lao.ca.gov CALIFORNIA’S FISCAL OUTLOOK Figure 1 Proposition 2 Summary Debt/Reserve Estimates Proposition 98 Reserve: Conditions for Deposit June Budget Act. Estimate the following: June Budget Act. Are the following conditions met? (cid:127) “Maintenance factor” as of end of 2013-14 paid off. 1.5% of Capital gains revenues over (cid:127) Test 1 in effect. General Fund 8% of General Fund taxes. (cid:127) Proposition 98 not suspended. revenues. (cid:127) Less amounts that must be (cid:127) No maintenance factor created. spent on Proposition 98. YES NO 50%a 50% Proposition 98 Reserve Estimates No deposit Debt Payments required Budget Stabilization Accountb June Budget Act. Estimate effect of (cid:127) Pay down certain capital gains revenues over 8% of “wall of debt” items. Fill rainy-day reserve to 10% of General Fund taxes on Proposition 98 General Fund taxes.c minimum guarantee. (cid:127) Make extra pension/retiree health payments. “True-Up” Process. Capital (cid:127) Reduce resulting amount, if needed, gains portion of reserve deposit to ensure prior-year Proposition 98 adjusted in subsequent two spending grows by changes in fiscal years based on updated enrollment and cost of living. information. (cid:127) Cap amount at the difference between the Test 1 and Test 2 levels. Proposition 98 Reserveb Fill Proposition 98 reserve to no more than 10% of minimum guarantee. True-Up Process. Reserve deposit adjusted in subsequent two fiscal years based on updated information. Withdrawals From Budget Stabilization Account Withdrawals From Proposition 98 Reserve Upon budget emergencyd declaration by Governor and majority of Is Proposition 98 funding sufficient to cover Legislature, transfer to General Fund allowed. changes in enrollment and cost of living? (cid:127) Withdrawal capped at amount needed for budget emergency. YES NO (cid:127) Withdrawal cannot exceed 50% of the fund balance if no withdrawal made in prior fiscal year. Keep funds in Withdraw funds to Proposition 98 reserve.e cover enrollment and cost of living. a Debt payments required for 15 years (through 2029-30). Thereafter, the Legislature may use up to half on debt, with remainder required to be deposited in rainy-day reserve. b Upon budget emergency declaration by Governor and majority votes of both houses of the Legislature, deposits may be suspended or reduced. School district reserve caps are active in fiscal year following deposit in Proposition 98 reserve. c Once the rainy-day reserve reaches 10 percent of General Fund taxes, amounts that would otherwise be deposited in the rainy-day reserve must be spent on infrastructure. d Budget emergency defined as: (1) emergency pursuant to Section 3 of Article XIII B of the Constitution (including natural disasters) or (2) a determination by the Governor that estimated resources in the current or upcoming fiscal year are insufficient to fund General Fund spending in any of the three most recent budget acts, adjusted for inflation and population. e Upon budget emergency declaration by Governor and majority votes of both houses of the Legislature, withdrawals allowed. 46 Legislative Analyst’s Office www.lao.ca.gov ARTWORK #140536 CALIFORNIA’S FISCAL OUTLOOK the 2014-15 budget. There is, therefore, a strong Even if the state’s leaders agreed the $1.6 billion argument that the Legislature has broad authority was not bound by Proposition 2’s rules on reserve to use that $1.6 billion when and how it sees fit, withdrawals, they could leave all or some of this similar to the flexibility provided under the State money untouched and, therefore, available to help Constitution prior to Proposition 2’s passage. In the budget in a future economic downturn. general, the California Legislature has broad power Capital Gains Calculations unless the Constitution specifically constrains the legislative branch. Under this view, the $1.6 billion Proposition 2 requires complex calculations deposited to the BSA in 2014-15 could be be made concerning net capital gains taxes—a appropriated without the Governor first declaring component of the personal income tax that is a Proposition 2 budget emergency. Alternatively, impossible to predict with any great certainty. the Legislature and the Governor could choose Below, we describe decisions the state will face to apply the new Proposition 2 rules to these in administering various capital gains-related funds, meaning the Governor would have to first calculations in Proposition 2 and how these declare a budget emergency before the Legislature decisions could affect state reserve and debt could transfer the $1.6 billion back to the General payment requirements for 2015-16 and beyond. Fund. The decision reached by the Governor and Key Choice About Proposition 2 Calculation Legislature on how to treat this $1.6 billion could Affects Size of Reserve/Debt Payments. The text play a key role in determining the amount available of Proposition 2 references constitutional school for the Legislature in crafting the 2015-16 budget. funding formulas, not statutory funding formulas. Figure 2 Key Choices for the State Related to Proposition 2 Implementation in 2015‑16 Choice for State’s Policymakers Choice Reflected in LAO Budget Estimatesa Pre‑Proposition 2 Budget Stabilization Account (BSA) Deposits Use $1.6 billion previous deposit without a declared Choice for state policymakers only. (A choice was not budget emergency? required in developing our estimates.) Capital Gains Calculations Apply Proposition 98 Test 3 supplement in Yes. Results in $1 billion higher BSA/debt payment Proposition 2 calculations? requirement in 2015-16. Use average or marginal tax rates in capital gains Average. Results in lower BSA/debt payment calculations? requirements. Use administration method for attributing capital gains Yes. taxes to fiscal years? Assume that future capital gains will match long- No. Our method may result in more debt payments term historical averages as a share of the state’s being made in high capital gains years. economy? Budget Emergency Fiscal Calculations Use traditional state accounting methods in making Yes. A variety of alternatives are possible, some calculations? of which would allow a budget emergency to be declared in 2015-16, thereby lowering BSA deposit requirements. a In general, the LAO does not express an opinion on which choices are preferred. Instead, this information is provided to make clear which calculation choices, if applicable, were made in our fiscal outlook budget estimates. Alternative choices would result in different budget estimates. www.lao.ca.gov Legislative Analyst’s Office 47 CALIFORNIA’S FISCAL OUTLOOK One of the statutory school funding formulas, is important to note that the choice the Legislature however, can affect the Proposition 2 calculations— makes in this matter will not affect school funding. potentially having a significant impact on the size It will only affect the amount available for deposits/ of the required BSA deposits and debt payments. debt payments versus the rest of the state budget. Specifically, if the state were to apply the statutory Average vs. Marginal Tax Rates. California formula for the Test 3 supplemental appropriation, has a progressive rate structure with higher levels of the size of the BSA deposit/debt payments would income taxed at higher rates. For example, a single be larger than if the state were not to use that filer making over $500,000 a year pays a marginal formula in making its Proposition 2 calculations. tax rate of 12.3 percent on income above that level, Figure 3 provides an illustration of the effect of this but lesser rates on income below that amount. This choice. Under our main outlook scenario, applying results in an average tax rate on that individual’s the statutory Test 3 formula to the Proposition 2 total income that is less than the marginal rate. calculations in 2015-16 results in a BSA deposit/ Calculating how much capital gains revenue is debt payment requirement that is $1 billion higher captured by Proposition 2 requires an assumption in 2015-16 than the alternative approach, which about whether average or marginal rates are used excludes the formula from the Proposition 2 to estimate the amount of capital gains taxes. calculations. The Legislature will need to decide Although there is no right answer regarding this whether to apply this statutory supplemental decision, estimates using average tax rates will be formula in the state’s Proposition 2 calculations. It somewhat lower than those using marginal tax Figure 3 2015-16 Proposition 2 Requirements Would Be $1 Billion Lower if Alternative Calculation Method Were Used (In Millions) Approach That Considers Approach That Proposition 98 Does Not Consider Test 3 Supplement Test 3 Supplement Calculating Proposition 98 “Increment” General Fund Spending for Proposition 98: Actuala $46,422 $46,422 Less: hypothetical amount without “excess” capital gains taxes -46,276 -45,225 Increment Related to Excess Capital Gains Taxes $145 $1,197 Proposition 2 Requirements for BSA Deposit and Debt Payments 1.5% of General Fund Revenues and Transfers $1,701 $1,701 Excess Capital Gains Revenues Capital gains revenues over 8 percent of General Fund taxes 2,393 2,393 Less: Proposition 98 increment -145 -1,197 Totals $2,248 $1,196 Total Requirement for BSA Deposit and Debt Payments $3,949b $2,897 a This is the amount that we now project would actually be required to be spent for Proposition 98 under current law and practices, using our main scenario assumptions. In other words, school spending would not be affected by the choice made with regard to this Proposition 2 calculation in 2015-16. b This is the amount reflected in this publication’s main scenario fiscal outlook for the state’s General Fund in 2015-16. Specifically, $1.974 billion is deposited to the Proposition 2 BSA, and $1.974 billion is required to be spent on repaying eligible debts under Proposition 2. BSA = Budget Stabilization Account. 48 Legislative Analyst’s Office www.lao.ca.gov CALIFORNIA’S FISCAL OUTLOOK rates. (In this report, we assume an average tax capital gains projections seem to have relied as rate in part because we understand this method much or more on these historical averages as was used by the administration in modeling current or projected stock trends.) With regard Proposition 2 during legislative deliberations last to BSA deposits under Proposition 2, the state spring.) If the state instead were to use marginal tax will subsequently true up capital gains revenues, rates in its Proposition 2 calculations, the estimated providing an opportunity to deposit any capital amount of capital gains captured by Proposition 2 gains taxes above initial projections in the state’s would be larger, meaning higher reserve and debt reserves. Debt payments, however, are not required payment requirements of potentially hundreds of to be adjusted when new capital gains estimates are millions of dollars in years with high capital gains. available in subsequent years. A cautious capital Attributing Capital Gains Taxes to Fiscal gains estimating method therefore could result in Years. Individuals generally pay taxes on a less Proposition 2 debt payments over time because calendar-year basis while the state budgets its they may never be adjusted for subsequent increases revenues and spending on a fiscal-year basis. in capital gains above initial projections. For example, taxes paid in 2015 will generate Budget Emergency Fiscal Calculations revenues in two fiscal years—2014-15 and 2015-16. Accordingly, the state must make assumptions Choices Will Affect Availability of a Budget about how much tax revenue paid during a Emergency. Under Proposition 2, a budget calendar year is applied to each fiscal year. These emergency—when declared by the Governor— issues affect Proposition 2 because, for example, provides the Legislature with the flexibility to use part of the capital gains earned by taxpayers in BSA reserves or reduce BSA deposits. A budget 2015 will go into the 2015-16 reserve and debt emergency is available under Proposition 2’s fiscal calculations. The administration’s current method calculations when estimated resources for the assumes that 30 percent of the 2015 capital gains current or upcoming fiscal year are lower than the will be attributed to 2014-15, with the remaining last three enacted budget spending totals, adjusted 70 percent attributed to 2015-16. There is no single for population growth and inflation. As described correct assumption in this regard, as tax dollars in Chapter 1, under our estimates there would be flowing into state coffers are not clearly “marked” no budget emergency available during the 2015-16 as capital gains or non-capital gains dollars. There budget process based on the fiscal calculation are probably several alternative measures that described in Proposition 2. This, however, is subject would split capital gains taxes between fiscal years to various choices that would affect whether a reasonably for calculating Proposition 2’s reserve budget emergency can be declared by the Governor and debt requirements. under Proposition 2’s fiscal calculations. We made Estimating Methods Could Affect Debt the following choices in our calculations: Payments. We note that some prior administration • Pre-Proposition 2 Deposits. Because there revenue forecasts have assumed that future is a strong argument that the Legislature capital gains will match a long-term historical could appropriate funds from pre-Propo- average of capital gains as a share of the state’s sition 2 BSA deposits by a simple majority economy. This practice may have contributed to the vote, we include as an estimated resource administration’s more cautious revenue estimates in the $1.6 billion that was deposited to the recent years. (That is, at times the administration’s BSA in the 2014-15 budget. www.lao.ca.gov Legislative Analyst’s Office 49 CALIFORNIA’S FISCAL OUTLOOK • Mandates Trigger. Because the cannot predict what type of debt payments $170 million mandates trigger was these will be. Under the state’s traditional not included in official administration estimating practices, this choice means the spending totals when the 2014-15 budget unallocated debt payments do not affect was enacted, we do not adjust the 2014-15 estimated resources. Had we chose instead enacted budget total for that trigger. to book the unallocated debt payments on the revenue side of the budget, estimated • Proposition 2 Debt Payments. The state’s resources would have been $695 million traditional estimate of resources available lower. considers revenues but not expenditures. Near the end of Chapter 1, we displayed Some of the debts eligible for payment our budget emergency fiscal calculation, in under Proposition 2—such as special which 2015-16 estimated resources were $2.1 billion fund loan repayments—are booked on the above the adjusted 2014-15 spending level, revenue side of the budget. Others—such as thereby preventing a budget emergency under contributions to pension systems—appear that calculation. If we had changed all three on the spending side. As shown in Figure 1 choices described above, this budget emergency of Chapter 3, we display “unallocated” calculation would be $2.5 billion “worse,” thereby Proposition 2 debt payments—those that allowing a budget emergency. This would allow are required by Proposition 2 but are not the Governor to declare a budget emergency assumed elsewhere in our outlook—on under Proposition 2’s fiscal calculations, and the the spending side of the budget. Placing Legislature to pass a 2015-16 budget that reduced or these unallocated debt payments on the suspended deposits to the BSA. spending side is a choice we had to make in developing the calculations, since we STRATEGIES FOR PAYING DOWN DEBT Over the next 15 fiscal years, Proposition 2 Addressing Persistent State Debts could result in roughly $15 billion to $20 billion In our May 2014 report, Addressing California’s (in today’s dollars) being used to pay down state Key Liabilities, we discussed a wide variety of debts. These payments are mandatory for the next state debts. Figure 4 lists the specific categories of 15 years—that is, the Governor and the Legislature debts eligible for repayment using Proposition 2’s may not reduce these payments during a budget annual stream of earmarked funding over the next emergency. There are various strategies that the 15 years. (The May 2014 reports provides more Legislature could employ for paying down state information on these debts.) debts with the funds that are earmarked for that Budgetary Liabilities. The state General Fund purpose by Proposition 2. In this section, we owes billions of dollars of budgetary debts to other discuss how the Legislature can approach both state accounts (known as special funds), school its near-term and longer-term choices for using districts, and other local governments. In general, Proposition 2 debt payment funds. these debts are owed because these entities helped 50 Legislative Analyst’s Office www.lao.ca.gov CALIFORNIA’S FISCAL OUTLOOK the state balance its budget in prior years. The state could save taxpayers tens of billions of dollars has an obligation to repay each of the budgetary over the long term. This action would result in a liabilities shown in Figure 4. smaller portion of liabilities being passed to future Retirement Liabilities Already Being taxpayers. Addressed. Many of the state’s retirement-related Suggested Approach debts, including unfunded liabilities for state and the California State University (CSU) employee Plan Needed. We recommend that the pensions, are being addressed with routine annual Legislature develop a plan for use of the Proposition 2 payments over time. We discussed how such debts debt payment funds. The plan could include are already being addressed in our May 2014 report. near-term and longer-term elements, as summarized In June 2014, the Legislature approved a law that in Figure 5 (see next page). As we discuss below, aims to fully fund the California State Teachers’ addressing the state’s retirement-related liabilities Retirement System (CalSTRS) unfunded pension may involve significant logistical issues and liabilities over about 30 years. If Proposition 2 funds trade-offs. Over the next year or two, the Legislature were used to pay down these debts more quickly could work with the administration and state-level than now planned, long-term taxpayer savings retirement systems on a plan to use Proposition 2 would result because a smaller portion of these funds to address selected retirement liabilities in liabilities would be passed to future taxpayers. future years. In the meantime, beginning in 2015-16, Retirement Liabilities Not Being Addressed. the state could tackle a significant portion of the Various other state debts—including tens Figure 4 of billions of dollars of Debts Eligible for Proposition 2 Debt Payment Fundsa unfunded liabilities for (In Billions) health benefits of state Type of Debt Amount government, CSU, and the Budgetary Liabilities University of California Special fund loans to the General Fundb $3.1 (UC) retirees—are not Proposition 98 settle-up 1.5 CalPERS quarterly payment deferral 0.6 being addressed. The Pre-2004 mandate reimbursements owed to cities, counties, 0.6c state, for example, does and special districts not set aside funds for Unfunded Retirement Liabilitiesd the retiree health benefits State and CSU retiree health benefits $64.6 CalPERS pensions for state and CSU employees 49.9 accrued by its employees CalSTRS pensions 20.0 during their working lives. UC retiree health benefits 14.0 Instead, it pays for these UC pensions 12.1 Judges’ Retirement System I pensions 3.3 retiree health benefits on Judges’ Retirement System II pensions Less than 0.1 a pay-as-you-go basis, a Reflects our office’s current understanding of debts eligible under the measure. which is a problematic and b Prior loans of transportation weight fees to the General Fund generally have not been listed as “special fund loans” in official reports and are not included in this category. While there is an argument that these expensive way to address loans are eligible for Proposition 2 debt payment funds, our fiscal outlook does not count payments on the weight fee loans toward Proposition 2 debt payment requirements. the issue. Taking action to c Assumes $170 million in mandate reimbursements are paid under 2014-15 budget act “trigger.” d For CalPERS and CalSTRS, amounts listed include only the portion of unfunded liabilities attributable pay retiree health liabilities to the state government, including CSU. Both of these state-level pension systems also have unfunded with Proposition 2 funds liabilities attributable to other public entities. www.lao.ca.gov Legislative Analyst’s Office 51 CALIFORNIA’S FISCAL OUTLOOK budgetary liabilities listed in Figure 4, as well as a few years. These funds would provide one-time difficult pension problem that has plagued the state resources for state special funds, school districts, for decades: the pension system for judges elected or and local governments. In addition, we think the appointed before November 1994 known as Judges’ Legislature should seriously consider addressing Retirement System I (JRS I). much or all of the JRS I unfunded liability over the Judges’ Retirement System I. JRS I is next few years, which could provide General Fund administered by the California Public Employees’ budgetary savings in the fiscal years thereafter. Retirement System (CalPERS) separate from its Developing a Long-Term Plan. It took the other pension plans and has never been adequately Legislature several years to develop the recent funded. Currently, it is the state’s worst-funded plan to address CalSTRS’ unfunded liabilities. pension system, with an unfunded liability of Evaluating which of the state’s large retirement $3.3 billion and only 2 percent of assets needed to liabilities merit priority in a longer-term cover the system’s liabilities. The state essentially Proposition 2 plan deserves serious consideration. funds JRS I pension benefits on a pay-as-you-go We suggest that the Legislature invite the basis. If the state were instead to fully fund JRS I administration, CalPERS, CalSTRS, UC, and over the next few years using Proposition 2 funds, other stakeholders to respond with proposals the state’s existing pay-as-you-go requirements describing how Proposition 2 funds could help to the system would end. Annual General Fund address one or more of the state’s large retirement- savings of perhaps $200 million, declining slowly related debts over the next 15 years. Proposals over time, would result after the JRS I unfunded should describe in detail the long-term public liability is retired. savings that would result from a commitment Suggested Near-Term Plan. We suggest of Proposition 2 funds to a specific retirement that the Legislature pay down a significant liability. Within the next few years, the Legislature portion of the eligible budgetary liabilities using could take elements from one or more of these Proposition 2 debt payment funds over the next plans—or come up with its own plan—to address a portion of the state’s Figure 5 large, persistent LAO Suggested Approach for Proposition 2 retirement-related debts. Debt Payment Funds Opportunity to Near‑Term Plan Address Retiree Health 9 Liabilities. Not setting Pay down large portion of eligible budgetary liabilities. aside funds for retiree 9 Seriously consider addressing much or all of the Judges’ Retirement health benefits earned System I unfunded liability over the next few years. during employees’ Longer‑Term Plan working lives violates 9 a fundamental tenet of Invite CalPERS, CalSTRS, UC, and others to respond with proposals for using Proposition 2 funds to address one or more of the state’s large public finance—that costs retirement-related debts over the next 15 years. should be paid in the year 9 when they are incurred. Addressing persistent retiree health liabilities merits serious consideration. Setting up retiree health trust fund, however, would involve The state’s current pay-as- significant logistical planning that could take a few years. you-go retiree health 52 Legislative Analyst’s Office www.lao.ca.gov CALIFORNIA’S FISCAL OUTLOOK funding system is much more costly than if the If it chose to use Proposition 2 debt payment state funded those benefits as they were earned. funds to pay down retiree health liabilities, the state Accordingly, reducing and eventually addressing would have a number of significant logistical issues unfunded retiree health liabilities of public entities to consider over the next few years, including: could save taxpayers billions of dollars over the (1) whether to increase fees of special funds that long term. do not currently have the budgetary flexibility to We have long recommended that the state and fund their share of retiree health costs, (2) how other public entities move toward funding retiree to manage federal funding for the share of state health liabilities properly. Proposition 2 provides employee costs funded by the U.S. government, the state with an intriguing opportunity to address (3) whether state employees should pay more to a significant portion of these persistent debts over fund retiree health benefits, and (4) how a state the next 15 years. Other long-term Proposition 2 retiree health trust fund would be administered. plans—such as addressing CalPERS, CalSTRS, or These issues would require detailed review by UC pension liabilities—may have merit, but we attorneys, tax experts, and others. As such, the urge the Legislature to give strong consideration Legislature may wish to act within the next few to using the funds earmarked by Proposition 2 to months to direct state entities to develop a plan for pay state, CSU, and/or UC retiree health liabilities these matters so that Proposition 2 funds could be beginning a few years from now. used for this purpose within the next few years. www.lao.ca.gov Legislative Analyst’s Office 53 CALIFORNIA’S FISCAL OUTLOOK 54 Legislative Analyst’s Office www.lao.ca.gov Chapter 5 The State Budget After 2015-16 Multiyear Budget Outlooks Are Challenging. all of the challenges described above, multiyear Estimating the future condition of California’s budget outlooks like the ones discussed in this General Fund has long been a difficult task. publication depend on their underlying scenarios Revenues—and some spending requirements, and assumptions. There are a variety of economic such as Proposition 98—are driven by volatile and revenue assumptions, for example, that tax revenues and the ebbs and flows of the stock one could adopt in considering the future of market and business income. Moreover, the California’s budget. In this chapter, we describe highly complex interactions of Proposition 2 how three different scenarios could affect the with the stock market, Proposition 98, and state budget outlook after 2015-16: (1) our other elements of the budget are now increasing main scenario (discussed through much of this substantially the difficulty of producing multiyear publication) that assumes continuing, moderate budget outlooks. Finally, it is important for economic growth through 2020, (2) an illustrative readers of this publication to recognize that we and purely hypothetical “slowdown scenario” that are not attempting to predict the actions of state involves a significant stock market drop and much policymakers and voters in the future. As we slower economic growth for a time beginning in described earlier (see “Keys to Understanding This 2016, and (3) another hypothetical scenario that Report” in Chapter 1), we assume in our fiscal considers a “temporary revenue surge” of the type outlook publications that today’s laws and budget California could experience in this fiscal year, if practices remain in place. The state’s leaders can capital gains cause a temporary increase in state use our estimates and other information to make tax collections. decisions about changes in policies that may Main Scenario: increase or decrease state spending or revenues. Surpluses and Budget Reserves Because the state will make such policy changes over time, future estimates of revenue and Economic Assumption: Continuing, spending will not be directly comparable to those Moderate Growth. As discussed in Chapter 2, in this report. our main scenario—like those of many economic Outlook Scenarios Dependent on forecasters—assumes continuing, moderate Assumptions Underlying Them. Considering growth over the next several years. We think our Legislative Analyst’s Office www.lao.ca.gov CALIFORNIA’S FISCAL OUTLOOK main scenario is a reasonable projection, based on Figure 1, we display our assumptions, compared what we observe at the present time, of near-term to those that the administration included in its economic conditions relevant for the 2015-16 May 2014 forecast. (The administration’s May 2014 budget process. After 2015, however, the main assumptions were the basis of the state’s 2014-15 scenario makes assumptions about future economic budget plan.) Figure 1 displays the total amount of growth that may or may not come to pass. Even net capital gains reported by California residents if economic growth continues in future years, on their state tax returns through 2012 and our that growth could be more or less than assumed projections for tax years 2013 and beyond. (Final in our main scenario in any fiscal year. This, in data for 2013 will not be available until sometime turn, has important implications for the state’s next year because some taxpayers just submitted complex budgetary formulas—especially those of their 2013 extension returns a few weeks ago and Proposition 98 and Proposition 2—the outcomes state tax officials require time to compile data from of which can change significantly with different returns.) We assume in our main scenario that economic inputs. 2014 capital gains arGe srpaikpinhgi cdu Se itog nre cOenftf, large LAO Main Scenario Assumes Declining gains in the stock market. It is important to stress, Secretary Capital Gains After 2014. California’s tax revenues however, that even such near-term capital gains Analyst have numerous volatile elements, but among the projections are subject to significant error. Further, MPA more significant sources of revenue volatility are we assume that a slightly declining stock market the state’s tax levies on net capital gains through will cause capital gaDines ptou tdyecline noticeably in 2015 the personal income tax. Every budget outlook and that modest future growth in the stock market must make assumptions about Californians’ capital will cause a gradual decline in net capital gains gains realizations, either explicitly or implicitly. In reported on Californians’ tax forms through 2018, followed by basically no growth thereafter through Figure 1 2020. LAO Main Scenario: Lower Capital Gains After 2014 Under our main Net Capital Gains on Resident Tax Returns (In Billions) scenario’s Proposition 2 $160 calculations, we assume that Actual Projected net capital gains taxes— 140 determined with rough LAO November 2014 120 estimates of the average tax 100 rates paid by taxpayers on the net gains shown in Figure 1— 80 DOF May 2014 (Budget Act) drop from $12.8 billion in 60 2014-15 to $11.4 billion in 40 2015-16, falling to $8.5 billion 20 in 2019-20. By contrast, the administration’s May 2014 2010 2012 2014 2016 2018 2020 revenue forecasts assumed DOF = Department of Finance. growth in capital gains after 2015, albeit from a lower base 56 Legislative Analyst’s Office www.lao.ca.gov ARTWORK #140536 Chapter 5_Figure 1 CALIFORNIA’S FISCAL OUTLOOK than the current high level of stock prices would Surpluses Will Differ If New Budget seem to indicate. (In its June 2014 multiyear forecast Commitments Made. Relative to the budget picture of Proposition 2, for instance, the administration reflected in Figure 2, one-time or ongoing changes assumed that net capital gains taxes would be to tax or spending policies will decrease or increase $9.4 billion in 2015-16 and grow to $10.5 billion in future surpluses and could affect required reserve 2017-18.) deposits as well. Estimates in future editions of this Surpluses and Reserves Accumulate in Main publication will differ from those published here Scenario. Figure 2 shows our current outlook for partly because of such future changes in policy. the state’s General Fund under the main scenario, Changes in economic conditions also will affect which assumes no additional budget policy future estimates. commitments in the future. (Our main scenario, Slowdown Scenario: Surpluses Evaporate for example, reflects the spending listed in Figure 1 of Chapter 3.) For each fiscal year shown, the bar Big Stock Drop and Economic Slowdown: A Graphic Sign Off indicates the combined amount of the required Hypothetical Scenario. The U.S. economy is now Secretary deposit to the Proposition 2 Budget Stabilization into the sixth year of its current expansion—longer Analyst Account (BSA), assuming no suspensions or than the average expansion since World War II. reductions of those deposits, and budget surpluses Currently, we do not anticipate a major decline MPA (which would be available to build additional in the economy in 2014, 2015, or 2016, but it is Deputy reserves or fund new budget commitments). In very difficult to predict when the next economic 2015-16, for example, our main scenario anticipates downturn will occur or how severe it will be. Based a nearly $2 billion BSA deposit and $641 million in on the historical length of economic expansions, it available budget surpluses, which combine to equal Figure 2 the $2.6 billion bar for LAO Main Scenario: Reserve Deposits and Future Surpluses that fiscal year in Figure 2. Over the next three years, (In Billions) Proposition 2 BSA deposits $5.0 Proposition 2 BSA Deposit generally decline due to our 4.5 Remaining Budget Surplusa assumptions of lower capital 4.0 gains after 2014, while the 3.5 remaining surpluses increase. 3.0 By 2019-20, the first year 2.5 with no Proposition 30 2.0 revenues in our outlook, 1.5 there is a $3 billion surplus 1.0 and a $1 billion required 0.5 BSA deposit. In this main 2015-16 2016-17 2017-18 2018-19 2019-20 scenario, the state’s BSA a Amount that can be allocated in budget or used to build additional reserves. For 2015-16, reserves would accumulate to reflects $119 million carry-in deficit from 2014-15. about $8 billion by the end of BSA = Budget Stabilization Account. 2019-20. ARTWORK #140536 www.lao.ca.gov Legislative Analyst’s Office 57 Template_LAOReport_mid.ait CALIFORNIA’S FISCAL OUTLOOK is likely that a significant economic slowdown or shortfalls in both 2015-16 and 2016-17) could be recession will occur prior to 2020. To illustrate the covered by the $4.2 billion in reserves, leaving effect of a hypothetical slowdown on California’s about $400 million still available for 2017-18. budget condition, we developed a rough alternative The remaining reserves likely would be slowdown scenario that assumes some weakness exhausted in 2017-18, requiring state actions to in the U.S. and California economies beginning in address over $1 billion of a remaining budget 2016. Most importantly for California’s tax base, shortfall. Thereafter, budget-balancing actions the slowdown scenario assumes that stock prices would be required to address annual deficits of drop about 20 percent during 2016. (Specifically, $2 billion in 2018-19 and $3.3 billion in 2019-20. In the S&P 500 stock index falls over 350 points in the slowdown scenario, additional BSA deposits are this scenario to levels it last recorded in June 2013.) assumed to be suspended beginning in 2016-17. Graphic Sign Off The slowdown scenario assumes around 1 percent 2015-16 Reserve Decisions Could Prove real gross domestic product (GDP) growth for Crucial. The slowdown scenario is purely Secretary the U.S. in 2016 and 2017 and 3.6 percent annual hypothetical. We are not predicting such a Analyst growth in California personal income during that slowdown will occur within the next few years. MPA period (much slower growth than under our main Yet, economic and budget downturns rarely are Deputy scenario). California unemployment rates begin to predicted far in advance. Under the slowdown rise again by early 2017 as a part of the slowdown. scenario, the budget reserves that we project could Under Hypothetical Slowdown, Surpluses be accumulated by the state in 2015-16 might barely Evaporate. Driven by large stock market-related losses, Figure 3 especially declines in capital $4.2 Billion Reserve Could Cover 2016-17 gains taxes, surpluses in Shortfall in Hypothetical Economic Slowdown California’s General Fund evaporate in 2016-17 in the (In Billions) hypothetical slowdown 2016-17 2017-18 2018-19 2019-20 scenario. The $4.2 billion -$0.5 in reserves that the state accumulates in 2015-16 in -1.0 our main scenario could -1.5 be enough to address a -2.0 multibillion-dollar budget -2.5 shortfall in 2016-17, but -3.0 thereafter additional actions -3.5 would be required to balance Remaining Budget Deficit the General Fund budget. -4.0 Budget Shortfall Addressed by Reserves Figure 3 illustrates the Note: Assumes no additional spending commitments in 2015-16 or thereafter. The 2016-17 shortfalls in this hypothetical budget shortfall displayed consists of a $2.3 billion budget erosion attributable to 2015-16 and a $1.5 billion shortfall in 2016-17. Assumes that Proposition 2 allows sufficient funds from exercise. As the figure Budget Stabilization Accounts to be accessed to cover the 2015-16 and 2016-17 shortfalls. Beginning in 2017-18, amounts shown are annual deficits (differences between annual shows, a $3.8 billion deficit revenues and expenditures) in this hypothetical scenario. in 2016-17 (consisting of 58 Legislative Analyst’s Office www.lao.ca.gov ARTWORK #140536 Chapter 5_Figure 3 CALIFORNIA’S FISCAL OUTLOOK be enough to help the state through one year of a requirements would increase by $1.5 billion in budget downturn. Thereafter, multibillion-dollar 2014-15, taking up virtually all of the increased budget problems could return, requiring new revenues. Perhaps more significantly, this decisions to return the state budget to balance. The $1.5 billion in higher school spending requirements shortfalls in the slowdown scenario are nowhere would persist throughout our forecast period, near the size of those that the state faced during generally reducing future surpluses after the the 2000s, but we stress that future economic temporary revenue gains disappear. For example, slowdowns could be less severe or more severe than the $4.7 billion bar shown for 2018-19 in Figure 2 that in our hypothetical exercise. Our slowdown would be $1.4 billion smaller with this revenue scenario, for instance, does not meet the classic surge due to a smaller budget surplus resulting definition of a recession, in that U.S. GDP does from the higher Proposition 98 spending. Because not fall in any two successive quarters. Rather, of how it would ratchet up Proposition 98 spending, our slowdown scenario involves only one very a temporary revenue surge in 2014-15 would small quarterly decline in GDP, accompanied mean lower surpluses and less money available for by a number of quarters of very slow, but still non-Proposition 98 spending commitments and slightly positive, growth. A harsher economic non-BSA budget reserves throughout the forecast downturn—should it occur—could result in much period. Such a temporary revenue spike would more damage to the budget’s bottom line. The more make the budget’s bottom line more vulnerable reserves the state can accumulate in the near term, to future economic downturns. Under this the better the state budget will be able to weather hypothetical scenario, the amounts required to be the next downturn. deposited to the BSA under Proposition 2 would be slightly smaller in 2015-16 (about $200 million less Temporary Revenue Surge: Smaller Surpluses than in the main scenario). Large One-Time Influx of Revenues: Another Complex Budget … Complex Outlook Hypothetical Scenario. Earlier in this publication, we described the significant possibility that 2014-15 Figure 4 (see next page) lists some of the key personal income tax revenues will be higher than numbers in the scenarios described in this chapter. we indicate in our main scenario. To consider how In conclusion, the state could see the condition such revenue increases could affect the General of its General Fund—and its capacity either to build Fund’s future health, we assumed that everything budget reserves or expand non-Proposition 98 in our main scenario was the same except for a budget commitments—worsen in the future if temporary, capital gains-dominated “revenue (1) revenues decline sharply or (2) revenues increase surge” over the coming several months. Specifically, sharply, but temporarily, in 2014-15. The state’s we assumed $1.5 billion more in revenues in future budget conditions will be marked at times by 2014-15 and $500 million more in revenues in sharp declines in response to economic conditions, 2015-16, compared to our main scenario. We as well as some counterintuitive outcomes like assumed that 75 percent of the additional revenues those in the revenue surge scenario. Furthermore, come from taxes on net capital gains. the state’s budget can be affected by federal policy Ongoing Higher School Costs Would Make It changes and cost trends in health care and other Harder to Balance Budget. Under the hypothetical programs that we do not anticipate today. By revenue surge, the state’s Proposition 98 spending accumulating budget reserves when state revenue www.lao.ca.gov Legislative Analyst’s Office 59 CALIFORNIA’S FISCAL OUTLOOK growth is strong and carefully targeting any new funds to tackle large, persistent debts over the next budget commitments, the state’s policymakers can 15 years, the state’s policymakers can ensure more help keep the recently strengthened budget on a budget flexibility for the General Fund over the healthy track, despite these likely future challenges. long term. Moreover, by using the Proposition 2 debt payment Figure 4 Comparing LAO Budget Outlook Scenarios General Fund and Education Protection Account Combined (In Millions) 2014-15 2015-16 2016-17 2017-18 2018-19 2019-20 Revenues “Big Three” Revenues Main scenario $105,103 $109,960 $113,732 $117,790 $120,855 $123,635 Slowdown scenario 105,103 107,403 105,524 106,968 110,626 112,765 Temporary revenue surge scenario 106,603 110,460 113,732 117,790 120,855 123,635 Total Revenues and Transfers Main scenario $107,442 $111,397 $116,020 $121,087 $124,335 $127,449 Slowdown scenario 107,442 108,840 109,100 111,387 115,045 117,541 Temporary revenue surge scenario 108,942 112,083 116,028 121,091 124,335 127,449 Spending General Fund Proposition 98 Spending Main scenario $46,548 $46,422 $47,555 $48,715 $49,350 $49,909 Slowdown scenario 46,548 46,155 44,490 44,468 45,616 46,094 Temporary revenue surge scenario 48,007 47,941 48,870 50,083 50,762 51,359 General Fund Non-Proposition 98 Spending Main scenario $63,738 $64,216 $66,274 $68,934 $71,247 $74,467 Slowdown scenario 63,738 64,246 66,098 68,867 71,441 74,738 Temporary Revenue surge scenario 63,738 64,032 66,267 68,930 71,246 74,467 General Fund’s “Bottom Line” Annual Proposition 2 Required Debt Payments Main scenario — $1,974 $1,288 $1,122 $940 $963 Slowdown scenario — 1,974 966 835 863 882 Temporary Revenue surge scenario — 1,789 1,280 1,118 940 963 Annual Deposits to Budget Stabilization Accounts Main scenario $1,606 $1,974 $1,288 $1,122 $940 $963 Slowdown scenario 1,606 1,974 — — — — Temporary Revenue surge scenario 1,606 1,789 1,280 1,118 940 963 Annual Budget Surplus/(Deficit): Difference Between Revenues and Expenditures Main scenario -$2,843 $760 $2,191 $3,438 $3,738 $3,073 Slowdown scenario -2,843 -1,560 -1,488 -1,948 -2,011 -3,290 Temporary sevenue surge scenario -2,802 111 892 2,078 2,327 1,622 60 Legislative Analyst’s Office www.lao.ca.gov CALIFORNIA’S FISCAL OUTLOOK www.lao.ca.gov Legislative Analyst’s Office 61 CALIFORNIA’S FISCAL OUTLOOK 62 Legislative Analyst’s Office www.lao.ca.gov LAO Publications The Legislative Analyst’s Office (LAO) is a nonpartisan office which provides fiscal and policy information and advice to the Legislature. 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