The 2016-17 Budget: California's Fiscal Outlook

The 2016-17 Budget: California’s Fiscal Outlook MAC TAYLOR • L E G I S L A T I V E A N A L Y S T • NOVEMBER 2015 2016-17 BUDGET TABLE OF CONTENTS Executive Summary ����������������������������������������������������������������������������� 1 Chapter 1: The General Fund Through 2016-17 ��������������������������������������������������� 3 Outlook for the 2016-17 Budget ������������������������������������������������������������������������������������������������������������3 LAO Comments ����������������������������������������������������������������������������������������������������������������������������������������6 Chapter 2: The Economy and Revenues ��������������������������������������������������������������� 9 The Economy ��������������������������������������������������������������������������������������������������������������������������������������������9 Revenues ������������������������������������������������������������������������������������������������������������������������������������������������15 Chapter 3: Spending Outlook ����������������������������������������������������������������������������� 19 Education �����������������������������������������������������������������������������������������������������������������������������������������������19 Proposition 98 ����������������������������������������������������������������������������������������������������������������������������������������������������������������������19 Universities ����������������������������������������������������������������������������������������������������������������������������������������������������������������������������27 Financial Aid ������������������������������������������������������������������������������������������������������������������������������������������������������������������������29 Child Care ������������������������������������������������������������������������������������������������������������������������������������������������������������������������������30 Health and Human Services ������������������������������������������������������������������������������������������������������������������31 Corrections and Rehabilitation ������������������������������������������������������������������������������������������������������������42 Employee Compensation and Retirement Costs ���������������������������������������������������������������������������������43 State Employee Pay and Benefits ����������������������������������������������������������������������������������������������������������������������������������43 CalSTRS �����������������������������������������������������������������������������������������������������������������������������������������������������������������������������������44 Unemployment Insurance ��������������������������������������������������������������������������������������������������������������������46 Debt Service on Infrastructure Bonds �������������������������������������������������������������������������������������������������46 Chapter 4: The General Fund After 2016-17 �������������������������������������������������������49 Main Scenario ����������������������������������������������������������������������������������������������������������������������������������������49 Alternate Scenarios �������������������������������������������������������������������������������������������������������������������������������49 Risks �������������������������������������������������������������������������������������������������������������������������������������������������������52 Conclusion ����������������������������������������������������������������������������������������������������������������������������������������������53 Appendix ������������������������������������������������������������������������������������������������������������������������������������������������54 www.lao.ca.gov Legislative Analyst’s Office i 2016-17 BUDGET Legislative Analyst’s Office www.lao.ca.gov (916) 445-4656 Legislative Analyst Mac Taylor State and Local Finance Education Jason Sisney Jennifer Kuhn Marianne O’Malley Ryan Anderson Carolyn Chu Edgar Cabral Justin Garosi Natasha Collins Ann Hollingsheada Jason Constantouros Seth Kerstein Virginia Early Ryan Millera Paul Golaszewski Nick Schroeder Judy Heiman Brian Uhler Dan Kaplan Brian Weatherford Kenneth Kapphahn Corrections, Transportation, and Environment Health and Human Services Anthony Simbol Mark C. Newton Brian Brown Ginni Bella Navarre Drew Soderborg Amber Didier Ashley Ames Callie Freitag Ross Brown Ben Johnson Aaron Edwards Lourdes Morales Rachel Ehlers Felix Su Paul Jacobs Ryan Woolsey Helen Kerstein Meredith Wurden Anita Lee Shawn Martin Jessica Peters Jonathan Peterson 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 Sandi Harvey Rima Seiilova-Olson a Fiscal Outlook publication coordinators. ii Legislative Analyst’s Office www.lao.ca.gov 2016-17 BUDGET Executive Summary In this report, we describe our office’s current projections for the state budget through 2016-17 and discuss the budget’s condition through 2019-20 under a few different scenarios. Outlook Assumes Current Policies. To produce this report, we must make numerous assump- tions about the future. One key assumption is that the state’s current revenue and spending policies stay in place. In making this assumption, we are not predicting that current policies will stay in place. The Legislature will—and should—change state policies in the future, consistent with its priorities. The projections in this report are intended to help the Legislature understand its fiscal flexibility in considering such changes. The Budget Situation Through 2016-17: Decidedly Positive. The state budget is better prepared for an economic downturn than it has been at any point in decades. In 2015-16, we project that the state’s “Big Three” General Fund revenues—principally the personal income tax—will exceed June 2015 budget assumptions by $3.6 billion, with most of that gain to be deposited into the Proposition 2 rainy day fund. In 2016-17, we project that revenues will exceed spending under current policies, resulting in even further improvement in the state’s fiscal situation. Assuming no new budget commitments are made, we estimate 2016-17 would end with reserves of $11.5 billion. Of this total, the Legislature would have control over $4.3 billion in the Special Fund for Economic Uncertainties, the state’s traditional budget reserve, with the rest of the reserves held for future budget emergencies by Proposition 2. After 2016-17: Risks to Consider. The above estimates are based on our main economic scenario, which assumes the economy continues to grow through 2019-20. This scenario generates significant annual operating surpluses and budget reserves in future years. As such, the state has the capacity under this scenario to make some new budget commitments—whether spending increases or tax reductions. An economic or stock market downturn, however, is possible during our outlook period. To illustrate this economic uncertainty, we provide projections under alternative economic scenarios. Projected reserves provide a major cushion against such economic risks. The more new budget commitments are made in 2016-17, however, the more likely it is that the state would face difficult choices—such as spending cuts and tax increases—later. As such, the Legislature faces the fundamental trade-off between the benefits of new commitments now versus fewer difficult budget decisions later. A sizable reserve is the key to making it through the next economic downturn with minimal disruption to public programs. www.lao.ca.gov Legislative Analyst’s Office 1 2016-17 BUDGET 2 Legislative Analyst’s Office www.lao.ca.gov 2016-17 BUDGET Chapter 1: The General Fund Through 2016-17 This report summarizes our office’s assessment outlook for state spending over the next few years. of California’s economy and budget condition. Our Finally, we discuss the longer-term outlook for main economic scenario assumes the economy the budget condition in Chapter 4. Because the will continue to grow moderately, although many current economic expansion will not last forever, other scenarios—both stronger and weaker—are in Chapter 4 we compare our main scenario possible. In this chapter, we present our estimates to alternate sets of assumptions—including an of the near-term budget condition. In Chapter 2, we economic slowdown and a recession. The box on discuss key revenue trends and our assessment of page 4 discusses some key information needed to the economy. Chapter 3 presents our main scenario understand this report. OUTLOOK FOR THE 2016-17 BUDGET Figure 1 displays our main scenario estimate of the Budget Stabilization Account (BSA). Below, we the General Fund condition through 2016-17. Based explain the basis for these estimates. primarily on higher revenue estimates than were 2015-16: $3�3 Billion Increase in Reserves assumed in the 2015-16 Budget Act, our projections of reserve levels are much higher. We now estimate The improvement in the 2015-16 year-end that 2015-16 will end with $7.9 billion in reserves, reserves—$3.3 billion—is the result of the factors a $3.3 billion increase over the budget act’s described below. assumptions. Assuming Figure 1 no new commitments LAO General Fund Condition Under Main Scenarioa are made in the 2016-17 (In Millions) budget, we estimate that reserves will increase 2014-15 2015-16 2016-17 to $11.5 billion at the Prior-year fund balance $5,253 $2,157 $3,210 Revenues and transfers 112,244 116,315 123,183 end of 2016-17, up by Expenditures 115,340 115,262 121,119 $3.7 billion over 2015-16 Ending fund balance $2,157 $3,210 $5,274 levels. The $11.5 billion Encumbrances -$971 -$971 -$971 reserve would consist of SFEU balance $1,186 $2,239 $4,304 Reserves $4.3 billion in the Special SFEU balance $1,186 $2,239 $4,304 Fund for Economic BSA balance 1,606 5,641 7,234 Uncertainties (SFEU)—the Total Reserves $2,793 $7,880 $11,537 a state’s traditional budget Includes Education Protection Account created by Proposition 30 (2012). SFEU = Special Fund for Economic Uncertainties (the General Fund’s traditional budget reserve) and reserve—and $7.2 billion in BSA = Budget Stabilization Account. www.lao.ca.gov Legislative Analyst’s Office 3 2016-17 BUDGET 2014-15: $266 Million Net Erosion. Under the combination of (1) $937 million higher revenues the state’s complex accrual policies, revenue and transfers, (2) $889 million higher required estimates for 2013-14 and 2014-15 continue to General Fund spending on the Proposition 98 change. These revisions and others affect the minimum guarantee for schools and community current budget situation. The 2015-16 budget plan colleges, (3) $22 million lower net spending on assumed that 2014-15 would end with an SFEU other programs, and (4) a $337 million downward balance of $1.5 billion. We now estimate the SFEU adjustment to the entering fund balance for balance at the end of 2014-15 was $1.2 billion, 2014-15. representing a $266 million erosion. This erosion is Keys to Understanding This Report This Outlook Relies on Many Assumptions. In producing this report, we make assumptions about the future. Many of our decisions about which assumptions to include or exclude inherently involve judgment. As a result, different assumptions are also reasonable. Understanding our assumptions and their implications is crucial to understanding the limitations of this report. Outlook Based on Current State Policies. Our outlook assumes the state’s current revenue and spending policies will remain in place. For example, we assume the temporary taxes passed by voters in Proposition 30 expire, consistent with current law. We also assume the continuation of recent budget practices, such as funding increases for universities and state employee pay increases. This does not mean we believe these policies will or should stay the same. On the contrary, the essence of budgeting is making year-to-year adjustments to spending to accommodate changing legislative priorities. As a result, our outlook is geared toward helping the Legislature think about its options for crafting a 2016-17 budget. Can it continue to afford its current policies? Can it afford additional commitments—whether they be one-time or ongoing spending increases or tax reductions? Our Main Scenario Is One of Many Possible Scenarios. We develop economic scenarios in order to produce our budget outlook. Consistent with standard conventions in economic projections, our main scenario assumes that the economy continues to grow moderately through 2019-20. This, however, is only one of many possible scenarios. Because the current expansion will not last forever, we discuss alternative scenarios in Chapter 4, including: (1) a slowdown scenario in which the economy grows more slowly, and (2) a recession scenario. Future economic conditions, however, could be stronger than our main scenario or weaker than our recession scenario, resulting in very different budgetary outcomes. Different Economic Outcomes Will Affect Future State Budgets. Spending in two programs, which accounts for over half of the General Fund’s budget, is calculated using formulas that rely on unpredictable economic variables. Specifically, Proposition 98 and Proposition 2 depend on fluctuations in state tax revenues and patterns in the stock market. Both of these variables are inherently volatile and unpredictable. As a result, these constitutional requirements—and therefore nearly half of the General Fund budget—cannot be predicted with any precision in the later years of our outlook. 4 Legislative Analyst’s Office www.lao.ca.gov 2016-17 BUDGET 2015-16: $3.5 Billion Higher Revenues. The Work Opportunity and Responsibility to Kids 2015-16 budget package assumed that receipts (CalWORKs) ($90 million). We discuss these from the state’s “Big Three” revenues—the personal spending estimates in greater detail in Chapter 3. income tax (PIT), sales and use tax (SUT), and Two-Thirds of Higher Revenues Deposited corporation tax (CT)—would total $113.3 billion in in BSA. Proposition 2—approved by the voters 2015-16. We now estimate that these revenues will in 2014—changed state rules for budget reserves total $116.8 billion, an increase of $3.6 billion. The and requires the state to pay a minimum amount difference is due to $4 billion higher PIT revenues, of debt each year through 2029-30. The June 2015 $269 million lower SUT revenues, and $144 million budget plan—which incorporated the Governor’s lower CT revenues. In addition, we estimate that May 2015 revenue estimates—required $3.7 billion other revenues and transfers—excluding the in total Proposition 2 payments (split evenly Proposition 2 BSA deposit—will be $100 million between BSA deposits and debt payments). Under lower than 2015-16 budget assumptions. Proposition 2’s “true up” provisions, the Legislature Proposition 98 Less Sensitive to Changes in will revisit the 2015-16 estimates twice—in the Revenues. The 2015-16 budget package assumed 2016-17 and 2017-18 budgets. We now estimate that the minimum guarantee would be $68.4 billion total Proposition 2 requirements for 2015-16 to be in 2015-16. We now estimate the guarantee to $5.9 billion, requiring a $2.2 billion true up deposit be $69.1 billion, an increase of $739 million. to the BSA. This true up deposit brings the BSA In recent years—most notably 2012-13 and balance to $5.6 billion at the end of 2015-16. (Our 2014-15—incremental increases in state General reading of Proposition 2’s true up provisions is Fund revenues have been almost entirely offset based on our understanding of legislative intent. by higher required General Fund spending on An alternate reading of the measure would result in Proposition 98. This was because maintenance a roughly $900 million smaller true up deposit.) factor was owed in these “Test 1” years, which Main Scenario Outlook: can result in nearly a dollar-for-dollar increase in 2016-17 Ends With $11�5 Billion Reserve Proposition 98 spending relative to revenues. In 2015-16, Proposition 98 offsets comparably little of We estimate that growth in total General our higher revenue estimates because we estimate Fund revenues and transfers (5.9 percent) outpaces that the remaining maintenance factor is repaid growth in General Fund spending (5.1 percent) and Proposition 98 spending is driven by changes in 2016-17. The difference between revenues and in per capita personal income rather than state spending increases the SFEU balance by $2.1 billion tax revenues. In addition, most of this increase is in 2016-17. Accordingly, we estimate that the SFEU covered by our higher estimates of local property would end 2016-17 with $4.3 billion. In addition, taxes. As a result, state General Fund costs increase based on our assumption of a somewhat weaker only $27 million above budget assumptions. stock market, we estimate the Proposition 2 BSA Lower Net Spending Across Rest of the deposit would be $1.6 billion in 2016-17. This Budget ($134 Million). We estimate that spending would grow reserves in that fund to $7.2 billion. on non-Proposition 98 programs would be All told, we estimate that 2016-17 would end with net $134 million lower than June 2015 budget $11.5 billion in total reserves, assuming no new assumptions. Most notably, we estimate lower fiscal commitments are made in or before next spending in Medi-Cal ($47 million) and California year’s budget. www.lao.ca.gov Legislative Analyst’s Office 5 2016-17 BUDGET Revenues and Transfers Grow 6 Percent. General Fund Spending Grows 5 Percent. We estimate that revenues and transfers increase Under our main scenario, General Fund spending $6.9 billion, or 5.9 percent, in 2016-17. Revenues grows by $5.9 billion, or 5.1 percent, in 2016-17. from the state’s three largest taxes collectively grow Nearly half of this is the result of significant growth 3 percent in 2016-17 under our main scenario. in Medi-Cal costs. Specifically, we estimate that This is mainly driven by our assumption of a Medi-Cal expenditures will grow $2.5 billion, somewhat weaker stock market, which results in or 14 percent, in 2016-17. Of this increase, over just 3 percent growth in the PIT. In addition, we $1 billion is explained by our assumption that estimate that CT revenues grow nearly 5 percent, the tax on managed care organizations expires while SUT revenues grow modestly at under after 2015-16. We also estimate that General 2 percent due to the expiration of Proposition 30’s Fund spending on Proposition 98 will increase SUT rate increase. While we estimate that the by $770 million. In addition, legislation in 2014 state’s Big Three revenues grow only moderately, changed state contributions to the California State the year-over-year decrease in the size of the Teachers’ Retirement System (CalSTRS), causing Proposition 2 BSA deposit increases total revenues another $533 million increase in estimated General and transfers, as shown in Chapter 2. Fund spending. LAO COMMENTS Bright 2016-17 Budget Outlook. It will be state has made in improving its budget situation. several months before the Legislature adopts a Proposition 2’s rules require that nearly two-thirds revenue estimate for the 2016-17 state budget. of these reserves be held in the BSA solely for future The interim period includes three key collection budget emergencies. The Legislature, however, has months for PIT revenues—December, January, complete control over the remaining $4.3 billion and April. While the revenue picture will become that we show as the SFEU balance. clearer by June 2016, revenues could be a few Future Risks to Consider. As we describe in billion dollars above or below our main scenario Chapter 4, if the economy continues to grow and estimates. To provide a sense of the range of no additional budget commitments are made, outcomes possible, we estimated total reserves our main scenario suggests that the state budget assuming revenues were over $4 billion higher or would be in surplus through 2019-20. Various lower than our main scenario estimates for 2014-15 factors, however, could reduce or eliminate these through 2016-17 combined. Under these alternative surpluses. If the economy were weak, revenues assumptions, total reserves could lie between could be billions of dollars below our main $8 billion and $15 billion at the end of 2016-17 scenario estimates. If the state’s two key pension assuming no new budget commitments were made. boards lower their assumptions concerning future Our main scenario outlook for the 2016-17 budget investment returns, state contributions to the is, therefore, decidedly positive. California Public Employees’ Retirement System The $11.5 billion in total reserves projected and CalSTRS could be billions of dollars higher under our main scenario for the end of 2016-17 than our main scenario estimates by 2019-20. reflects the steady, significant progress that the Prefunding retiree health care benefits for state 6 Legislative Analyst’s Office www.lao.ca.gov 2016-17 BUDGET employees could increase state General Fund current policies over the outlook period even under costs by hundreds of millions of dollars. (We note, some more pessimistic economic scenarios. On however, that Proposition 2 could help to absorb the other hand, if the Legislature were to make some of these retirement-related costs.) We describe new commitments in the 2016-17 budget, it would these and other risks for the budget in greater detail be more likely to face difficult choices—such as in Chapter 4. spending cuts and tax increases—later. As such, Key Considerations for 2016-17. The state the Legislature is confronted with the fundamental is better prepared for an economic downturn trade-off between the benefits of new commitments than it has been at any point in decades. Given now versus fewer difficult budget decisions later. our estimates of state revenues, expenditures, and reserves, the state can generally maintain its www.lao.ca.gov Legislative Analyst’s Office 7 2016-17 BUDGET 8 Legislative Analyst’s Office www.lao.ca.gov The Economy and Revenues THE ECONOMY A budget outlook for California must make should regard any multiyear economic projection assumptions about the future of the economy. in this publication, including our main scenario, As discussed below, however, there are many uncertainties about the economy now (and, for that economic measures assumed in our main scenario matter, at any given point in time). As such, our ability to make accurate “predictions” about the (see next page) compares the key variables in this 2015 main scenario and the administration’s May 2015 economic projections. Figure 1 LAO Economic Assumptions: November 2015 Main Scenario Percent Change Unless Otherwise Noted United States 2014 2015 2016 2017 2018 2019 2020 Real gross domestic product 2.4% 2.5% 3.2% 3.2% 2.6% 2.0% 1.7% Personal income 4.4 4.3 5.2 6.0 6.0 4.7 3.9 Wage and salary employment 1.9 2.1 1.9 2.2 1.9 1.1 0.5 Unemployment rate (percent) 6.2 5.3 5.0 4.7 4.5 4.6 4.8 Consumer price index 1.6 0.2 2.1 2.8 3.1 2.8 2.4 Core PCE price index 1.5 1.3 1.6 2.5 2.9 2.7 2.2 Federal funds rate 0.1 0.2 0.9 2.3 3.8 3.7 3.7 Housing starts (thousands) 1,052 1,183 1,466 1,697 1,626 1,535 1,602 S&P 500 (annual average) 1,931 2,046 2,031 2,105 2,191 2,280 2,372 California 2014 2015 2016 2017 2018 2019 2020 Personal income 4.9% 5.8% 5.8% 6.2% 6.2% 5.3% 4.8% Wage and salary employment 3.1 3.0 2.5 2.3 2.0 1.7 1.5 Unemployment rate (percent) 7.5 6.3 5.5 5.0 4.6 4.5 4.5 Consumer price index 1.8 1.7 2.1 2.8 3.1 2.8 2.4 Housing permits (thousands) 85.1 98.3 98.3 100.8 103.8 106.9 110.1 Single-unit permits 36.4 46.5 51.1 53.9 56.6 58.8 60.9 Multifamily permits 48.6 51.7 47.2 46.9 47.2 48.2 49.2 Population growth 0.9 0.9 0.8 0.7 0.7 0.7 0.7 Note: Based generally on Moody’s Analytics October 2015 U.S. macroeconomic outlook (“baseline” scenario). This November 2015 main scenario reflects a California state macroeconomic scenario developed by the LAO and lowers Moody’s Analytics’ (a) U.S. personal income growth outlook for 2015 through 2018 and (b) S&P 500 assumptions throughout the period beginning in late 2015. Core PCE = Personal consumption expenditures excluding food and energy. www.lao.ca.gov 9 Figure 2 Comparing Recent Economic Outlooks 2015 2016 2017 DOF LAO LAO DOF LAO LAO DOF LAO LAO May May Nov. May May Nov. May May Nov. 2015 2015 2015 2015 2015 2015 2015 2015 2015 United States Percent change in: Real gross domestic product 2.8% 2.8% 2.5% 2.7% 2.7% 3.2% 2.7% 2.7% 3.2% Personal income 3.9 3.9 4.3 4.5 4.5 5.2 5.3 5.3 6.0 Wage and salary employment 2.1 2.1 2.1 1.5 1.5 1.9 1.2 1.2 2.2 Consumer price index 0.0 -0.4 0.2 2.2 2.1 2.1 2.1 2.4 2.8 Unemployment rate 5.5 5.5 5.3 5.2 5.2 5.0 5.2 5.2 4.7 Federal funds rate 0.3 0.3 0.2 1.2 1.2 0.9 2.9 3.0 2.3 S&P 500 (annual average) 2,106 2,101 2,046 2,196 2,166 2,031 2,264 2,233 2,105 California Percent change in: Personal income 4.8% 4.7% 5.8% 5.2% 5.3% 5.8% 5.1% 6.0% 6.2% Wage and salary employment 2.6 2.9 3.0 2.4 2.2 2.5 2.3 1.8 2.3 Unemployment rate 6.5 6.4 6.3 6.0 5.7 5.5 5.8 5.4 5.0 Housing permits (thousands) 99 92 98 111 86 98 127 87 101 How Long Will Growth Continue? longer than before. Still, history suggests we may now be past (or well past) the midpoint of the All Budget Outlooks Based on Economic Assumptions. All projections of state revenues tool to predict the timing or the severity of a and expenditures rely—implicitly or explicitly— recession far in advance. State leaders are advised on many assumptions about the economy and to consider the possibility of a recession in the near consistent with standard convention—assumes Figure 3 economic growth through our multiyear outlook Current Economic Expansion Already Among Longest in U.S. History however, that growth will stall before 2020. Even Data Since 1854 if growth continued throughout this period, its Number of Economic Expansion Months today’s assumptions. As we discuss elsewhere in April 1991 to March 2001 120 this publication, state budgetary conditions will March 1961 to December 1969 106 December 1982 to July 1990 92 July 1938 to February 1945 80 July 2009 to present 77 (so far) scenario. December 2001 to December 2007 73 How Long Will Expansion Continue? As April 1975 to January 1980 58 April 1933 to May 1937 50 Average Economic Expansion, 1945 to 2009 58 Source: National Bureau of Economic Research. World War II, U.S. expansions have tended to be 10 www.lao.ca.gov 2016-17 BUDGET Other Challenges and Uncertainties consideration at the federal, state, and local levels here in California and elsewhere. At As discussed above, a major uncertainty is how the same time, many are concerned about long the current economic expansion will last. The limited wage growth for middle-income California and U.S. economies also face a variety families. How will public policy changes to of major challenges and uncertainties that raise address these issues affect the economy? questions concerning future economic growth. These issues include: • Monetary Policy and Growth. In 2008, • Aging. The population is aging rapidly. This responding to the collapse of the world has contributed to declining participation economy, the Federal Reserve lowered its levels in the labor force. In future decades federal funds rate—one of its key monetary those declines may become more noticeable policy instruments—to essentially zero. and dampen growth in economic output. It has remained at that level ever since. What unanticipated economic changes will This has been an unprecedented period for these major demographic shifts bring? monetary policy, so it is difficult to know what will happen as the federal funds rate • Energy. With much of the world, California is raised (beginning in December, in our is changing how it consumes energy to assumptions). Our main scenario assumes reduce greenhouse gas emissions, with both inflation levels that are somewhat higher costs and benefits for the state. How will than the Federal Reserve’s targets for a few these changes play out here and elsewhere? years as monetary policy aims to stimulate • China and the Global Economy. The employment and wage growth. Some think economic health of China—a growth that the anticipated tightening of monetary powerhouse in recent years—is in question, policy will dull future growth in what they with possible effects (both positive and view as an already fragile economy. negative) for other parts of the global • The Bay Area and Housing. As discussed economy. What will happen to growth in more detail below, California’s economy in China? As growth there wanes, will it currently is quite reliant on growth in cause limited or more significant economic the San Francisco-Oakland and San Jose effects here in California? metropolitan regions, where home prices • Federal Policies. In 2016, voters will elect a and rents have risen markedly recently. new President and a new Congress. Will the What will happen when recent strong 2016 elections pave the way for major changes growth in the Bay Area subsides? There and in corporate tax, defense, immigration, or elsewhere, what will happen to demand trade policies? Will there be major changes and supply in California’s housing sector? to federal health care policies? Will the All economic projections, including our own, rely campaign introduce other major new on past data and experience to estimate what will proposals that could affect the economy? unfold in the future. Therefore, new trends and unprecedented changes, such as some of those • Wages and Incomes. Significant listed above, may limit the reliability of economic increases in minimum wages are under projections. www.lao.ca.gov Legislative Analyst’s Office 11 2016-17 BUDGET The Bay Area in the state. Currently, on a per capita basis, Bay Area tax filers pay more than double the statewide California’s economy and the state budget now average. Put another way, the Bay Area’s population are quite reliant on the San Francisco Bay Area, as totals 17 percent of the statewide total, but its discussed below. residents paid 36 percent of the state’s PIT in 2013. Now Among Nation’s Leading Regions for Job The key reason for this is that Bay Area residents’ Growth. As summarized in Figure 4, parts of the average incomes and effective tax rates are well Bay Area have led the state in job growth over the above statewide averages. Under California’s past year. Unemployment rates there are below the income tax structure, higher-income people pay rest of the state. As we have discussed recently on higher marginal tax rates on their income. our office’s California Economy and Taxes blog When Will Growth Subside? Given California’s (accessible from the LAO home page), the San Jose economic and fiscal reliance on the Bay Area, metropolitan area’s job growth rate has ranked first a key question now arises: when will the Bay among all large metro areas in the nation over the Area’s current, technology-fueled growth subside? past year. California’s job growth has been fairly Moreover, when growth subsides, will it merely strong recently, and that is largely because of the slow down or will it undergo a more severe robust growth in the Bay Area’s technology sector. downturn akin to what happened after the dot.com Residents Pay Significant Share of State Taxes. bubble burst nearly 15 years ago? Finally, as growth As shown in Figure 5, the per capita (per person) subsides, will other large regions, especially Los personal income taxes (PIT) assessed on Bay Area Angeles, be poised for stronger growth that helps residents far exceed those of any other large region Figure 4 Recent Job Data for Largest Metropolitan Areas Not Seasonally Adjusted Data, as of September 2015 Job Growth Unemployment Region Counties in Region Over Past Year Rate San Jose MSA Santa Clara/San Benito 4.8% 3.7% San Francisco MDa San Francisco/San Mateo 4.7 3.1 San Rafael MDa Marin 4.5 3.1 San Diego MSA San Diego 3.5 4.6 Anaheim MDb Orange 3.0 4.0 California Statewide 2.9 5.5 Inland Empire MSA Riverside/San Bernardino 2.8 6.1 Sacramento MSA Sacramento/El Dorado/Placer/Yolo 2.6 5.2 Fresno MSA Fresno 2.5 8.1 Oakland MDa Alameda/Contra Costa 2.1 4.3 Los Angeles MDb Los Angeles 2.0 6.2 United States Nationwide 1.9 4.9 Oxnard-Thousand Oaks-Ventura MSA Ventura 1.5 5.3 Bakersfield MSA Kern -0.2 8.4 a This metropolitan division (MD) is a part of the San Francisco-Oakland Metropolitan Statistical Area (MSA). b This MD is a part of the Los Angeles-Long Beach-Anaheim MSA. Source: U.S. Bureau of Labor Statistics. 12 Legislative Analyst’s Office www.lao.ca.gov 2016-17 BUDGET pick up the Bay Area’s slack? Our main scenario is year—reaching around $450,000 as of September consistent with a slowdown in Bay Area economic 2015. House price growth, however, appears to growth, but a more severe downturn could put have moderated during the past year. House prices more strains on the economy than we now assume. increased by 5 percent over the past 12 months, compared to 13 percent in 2014 and 17 percent in Housing 2013. Despite this slowdown, California’s house Trends in housing costs affect every Californian prices are still growing slightly faster than the rest and many aspects of state and local budgets. Trends of the country. in home buying and rents, therefore, may affect the Rents also have been on the rise in California, pace and length of California’s current economic albeit at a somewhat slower pace than house prices. expansion. As we discuss below, there are some California’s median rent rose from around $1,200 key uncertainties about the future of California’s in 2011 to around $1,350 in 2014, an increase of housing market. 13 percent. Rents have risen somewhat slower than Continued Growth in House Prices and prices in recent years in part because rents did not Rents. California’s house prices have risen decline as much as prices did during the Great rapidly in recent years, as demand for housing Recession. Rents, therefore, have experienced less of has far outpaced its supply. Since bottoming out a rebound than house prices. in late 2011, California’s median house price has Bay Area Has Experienced Exceptional increased by 45 percent—or about 10 percent per Growth in Prices and Rents. House prices and Figure 5 California Personal Income Tax (PIT) Base Varies Regionally 2013 Data, Residents’ Tax Returns Per Capita Total Tax Total Adjusted Average PIT Assessed Gross Income Effective Population Region Assessed (Billions) (Billions) Tax Rate (Millions) San Francisco/Oakland/San Jose MSAs $3,119 $19.9 $314.3 6.3% 6.38 Orange County 1,724 5.3 102.0 5.2 3.10 Statewide 1,460 55.7 1,109.5 5.0 38.16 Ventura County 1,360 1.1 25.2 4.5 0.84 San Diego County 1,355 4.3 91.0 4.7 3.18 Los Angeles County 1,345 13.5 267.3 5.0 10.01 Central Coasta 1,208 1.7 36.6 4.6 1.40 Napa, Solano, and Sonoma Counties 1,187 1.3 29.4 4.3 1.05 Sacramento MSA 964 2.1 54.9 3.9 2.20 North Stateb 542 0.7 20.9 3.2 1.22 San Joaquin Valleyc 541 2.2 67.0 3.3 4.07 Riverside and San Bernardino Counties 530 2.3 77.5 3.0 4.34 Other residentsd — 1.3 23.6 5.6 — a Includes Monterey, San Luis Obispo, Santa Barbara, and Santa Cruz Counties. b Includes all counties north of San Francisco, Napa, Sonoma, Vallejo-Fairfield, and Sacramento MSAs. c Includes Fresno, Kern, Kings, Madera, Merced, San Joaquin, Stanislaus, and Tulare Counties. d Includes California resident tax returns with (1) an address in another California county or (2) an out-of-state address. Returns with out-of-state addresses collectively had $1.1 billion of tax assessed, with an average effective tax rate of 6.5 percent. Excludes nonresident tax returns, which collectively had $2.3 billion of tax assessed. MSA = metropolitan statistical area. www.lao.ca.gov Legislative Analyst’s Office 13 2016-17 BUDGET rents have increased significantly faster in the averaged 146,000 units per year. Our main scenario Bay Area than in the rest of the state. Figure 6 assumes permits will continue to climb over shows the 15-year trend of median home prices in the next few years, but remain below historical San Francisco and in Santa Clara County, which levels. It is not entirely clear why building has includes San Jose. Median house prices in San not returned to historical levels. Several factors, Francisco ($1.1 million) and Santa Clara County however, likely play some role. Data suggests that ($926,000) grew by 15 percent and 13 percent, household formations—for example, when younger respectively, over the past year. Since 2011, house people move out of parents’ homes—have fallen prices in these counties have grown by over in recent years. As discussed in our March 2015 60 percent. Rents in San Francisco and Santa Clara report, California’s High Housing Costs: Causes similarly rose by over 30 percent between 2011 and and Consequences, it is also possible that local 2014. government resistance to building is preventing Building Remains Below Historical Levels developers from incGreraasipngh picro Sduicgtino nO off fnew Despite Price and Rent Growth. Residential housing. Some reports also suggest that builders are Secretary building permits appear to be on pace to total experiencing labor shortages in certain markets. Analyst roughly 98,000 in 2015, a notable increase over Pluses and Minuses for Government Budgets MPA building levels in the prior two years (around and Economy. Recent growth in house prices and Deputy 85,000 per year). Despite this increase, residential rents has contributed to robust growth in state building remains below historical levels, as well and local revenues—particularly property taxes. as below what recent population growth would Statewide assessed property values increased by suggest. During the 2000s, building permits 6 percent in both 2014-15 and 2015-16, compared to an average annual rate of less than 0.5 percent over Figure 6 the preceding five years. Bay Area Home Prices Have Outpaced the Rest of the State We anticipate this robust growth to continue in the Median Home Price near term, with assessed $1,200,000 values projected to grow by just over 6 percent in 1,000,000 2016-17. 800,000 San Francisco Nonetheless, high house prices and rents 600,000 present some risks to the Santa Clara County state’s economy. Rising 400,000 California housing costs force 200,000 Californians to spend more of their income on housing, 2001 2003 2005 2007 2009 2011 2013 2015 leaving less available for other purchases. High ARTWORK #150572 14 Legislative Analyst’s Office www.lao.ca.gov Template_LAOReport_mid.ait 2016-17 BUDGET housing costs also can deter workers from moving term, future growth in the economy and state and to the state’s most productive regions—where local revenues could be dampened if new housing housing costs tend to be the highest—constraining production continues to fall short of demand. business recruitment and expansion. In the long REVENUES Figure 7 summarizes our main scenario Historical Growth Patterns. The PIT generally revenue outlook for California’s General Fund is the key revenue source to consider when thinking through 2019-20. Figure 8 (see next page) shows about the prospects for state revenue growth. We how our key revenue numbers differ from June estimate that the PIT grew by an extraordinary 2015 state budget assumptions (which were based 14 percent in 2014-15, with an additional 7 percent on the Governor’s May 2015 revenue estimates). increase now expected for 2015-16. Since 2000-01, Below, we discuss some key issues concerning the annual growth of PIT has, on average, been (1) the personal income tax (PIT), which generates about 5 percent. (This calculation includes some about two-thirds of General Fund revenues, and tax policy changes that have occurred, as well as (2) the state’s other key taxes. two recessions.) PIT growth has exceeded 5 percent in eight fiscal years since 2000-01 and fallen short Personal Income Tax of that threshold in seven years. Those seven years Our main scenario PIT estimates continue to include ones affected by (1) the bust of the dot. be higher than the administration’s projections com stock bubble in the early 2000s, (2) the bust from earlier this year, as summarized in Figure 8. of the housing bubble in the mid-2000s and the Figure 7 LAO Revenue Summary: November 2015 Main Scenario General Fund and Education Protection Account Combined (Dollars in Millions) 2014-15 2015-16 2016-17 2017-18 2018-19 2019-20 Personal income tax $76,400 $81,676 $84,274 $88,946 $90,057 $91,122 Sales and use tax 23,709 24,971 25,351 25,980 26,808 28,091 Corporation tax 9,714 10,198 10,685 10,842 11,089 11,557 Subtotal, “Big Three” Revenues ($109,823) ($116,844) ($120,311) ($125,768) ($127,953) ($130,770) Percent growth from prior year 11.8% 6.4% 3.0% 4.5% 1.7% 2.2% Insurance tax $2,444 $2,493 $2,582 $2,682 $2,796 $2,903 Other revenues 1,993 2,094 1,727 1,889 1,990 2,090 Transfers to Budget Stabilization -1,606 -4,035 -1,593 -1,550 -1,368 -1,016 Account Other net transfers in (out)a -409 -1,082 156 0 -34 -257 Total Revenues and Transfers $112,244 $116,315 $123,183 $128,789 $131,337 $134,490 Proposition 2 Inputs Taxes on capital gains N/A $13,940 $12,488 $12,604 $11,990 $10,557 As percent of General Fund taxes N/A 11.6% 10.1% 9.7% 9.1% 7.8% a For 2016-17 through 2019-20 (unlike prior fiscal years), no special fund loan repayments are included in this line as transfers out. To the extent those repayments are to be made in future years, they are assumed to occur as Proposition 2 debt payment expenditures. www.lao.ca.gov Legislative Analyst’s Office 15 2016-17 BUDGET Figure 8 Comparing Key LAO and Administration Revenue Numbers General Fund and Education Protection Account Combined (In Millions) 2014-15 2015-16 2016-17 LAO Admin. LAO Admin. LAO Admin. Nov. June Nov. June Nov. June 2015 2015 Change 2015 2015 Change 2015 2015 Change Personal income tax $76,400 $75,384 $1,016 $81,676 $77,700 $3,976 $84,274 $81,652 $2,623 Sales and use tax 23,709 23,684 25 24,971 25,240 -269 25,351 25,761 -410 Corporation tax 9,714 9,809 -94 10,198 10,342 -144 10,685 11,073 -388 “Big Three” $109,823 $108,877 $946 $116,844 $113,281 $3,564 $120,311 $118,485 $1,825 Revenues subsequent recession, and (3) the decline in taxable resident tax returns to fall from around $150 billion income in 2013 (associated with the federal “fiscal in 2015 to around $130 billion in each of the next cliff”) when high-income taxpayers accelerated three years. That drop in capital gains—resulting financial transactions to 2012 in order to avoid from our S&P 500 stock price assumption—causes later federal tax increases. Accordingly, in a year our slow estimated PIT growth rate for 2016-17. unaffected by an income tax cut, an economic The assumed trend for wage income offsets slowdown, or a stock market drop, the state’s somewhat the impact of our capital gains elected leaders reasonably can expect something assumptions. Wages make up the large majority of like 5 percent (or more) PIT growth. taxable income, and our main scenario assumes Slow Growth Assumed for 2016-17. Our main robust growth in wages and salaries reported on scenario anticipates slower PIT growth in 2016-17— California PIT returns of about 7 percent per year only 3.2 percent. The key underlying reason for in 2016 and 2017. the slow growth rate in our 2016-17 PIT estimate It is impossible to predict future stock and is our assumption about stock prices. Specifically, capital gains growth and difficult to precisely we assume that the average closing price of the project wage growth. Therefore, actual PIT results S&P 500 stock index during the current quarter in 2016-17 (and even 2015-16) could result in will be 1,993—below the 2,100 level posted for revenues being billions of dollars above or below much of early 2015. This level was consistent with our main scenario estimates. Yet, in fulfilling its the S&P 500 index as of October 14, when we were constitutional responsibility to determine a state finalizing our main scenario assumptions. With revenue estimate annually for the budget, the the price-to-earnings ratio of the S&P 500 now Legislature must make assumptions about wages above 20—somewhat high historically, but below and uncertain stock prices and capital gains taxes. some prior “bubble” periods—we assume very slow Scheduled Expiration of Proposition 30. future growth of stock prices, consistent with our Proposition 30’s temporary PIT rate increases practices in recent years. Under our main scenario, on the highest-income Californians expire at therefore, the S&P 500 does not return to the 2,100 the end of 2018. As a result, 2018-19 essentially level until the middle of 2017. This causes our reflects a half year of those revenues in our main estimate of net capital gains income on California scenario, and 2019-20 includes no Proposition 30 16 Legislative Analyst’s Office www.lao.ca.gov 2016-17 BUDGET PIT revenues. (The scheduled expiration of Starting in 2014-15, certain sales of Proposition 30’s sales tax rate increase slows manufacturing or research and development anticipated revenue growth in 2016-17 and 2017-18, equipment became exempt from the General Fund as discussed below.) In this main scenario, with portion of the SUT. The administration initially continuing economic growth, there continues projected that the new exemption would reduce to be no “cliff effect” as Proposition 30 revenues General Fund revenue by $486 million in 2014-15 end. The expiration of Proposition 30 slows, but and by more than $500 million in subsequent years. does not stop, PIT growth in our main scenario. The administration’s current estimate for 2014-15 If, however, an economic slowdown were to occur is $128 million—about one-quarter of the amount around 2019, the fall off of Proposition 30 revenues initially projected. Our main scenario assumes that would exacerbate any slowdown or decline in PIT this amount grows to slightly less than $200 million revenues. per year in 2015-16 and 2016-17. As this publication was being drafted, initiative Corporation Taxes. While CT revenues have proposals to extend Proposition 30’s PIT increases steadily grown since the 2011-12 fiscal year, the were being introduced. This publication’s scenarios, 2015-16 budget plan appears to have overestimated however, all assume that Proposition 30 expires CT revenues in 2014-15 and, we expect, in because that is the tax policy in current state law. 2015-16 as well. CT revenues totaled an estimated $9.7 billion in 2014-15, about $100 million less Other Key Taxes than the budget assumption. This was due largely While legislative discussions about revenue to several hundred million dollars in refund estimates recently have focused on the PIT, the two settlements over the past several months. (Under other key state taxes—the sales and use tax (SUT) the state’s complicated process for accruing, or and the corporation tax (CT)—together make up assigning, revenues to specific fiscal years, these around one-third of General Fund revenues. As refunds generally are accrued to prior fiscal years.) such, the SUT and CT also play important roles in While the refunds were not entirely unexpected, determining the state’s annual revenue estimate. it is very difficult to predict their timing. In our Sales and Use Taxes. Estimated General Fund main scenario, CT revenues are projected to total SUT revenue totaled $23.7 billion in 2014-15, $10.2 billion in 2015-16, about $150 million below $25 million higher than the amount assumed the 2015-16 budget assumption. That discrepancy, in the state’s 2015-16 budget plan. In our main however, is relatively small, and estimated scenario, SUT revenues grow to $25.0 billion year-to-year growth in CT revenues currently in 2015-16, about $270 million lower than the reflects a fairly healthy and growing economy. assumption in the 2015-16 budget. Under this Corporate profits and CT revenue have both scenario, SUT revenues then grow more slowly as grown rapidly since the last recession. Our main the one-quarter cent Proposition 30 SUT increase scenario assumes that the rate of growth in ends in December 2016. This results in slower corporate profits will slow considerably for several General Fund SUT growth—around 2 percent years beginning in 2017. This causes estimated CT per year—over the next two fiscal years, with this revenue to grow relatively slowly after 2016-17, but revenue source totaling an estimated $25.4 billion these growth trends may differ substantially from in 2016-17 and $26.0 billion in 2017-18. actual results for a variety of reasons. In particular, www.lao.ca.gov Legislative Analyst’s Office 17 2016-17 BUDGET there are many factors that determine the total apportionment of income between states by multi- amount of CT revenue in any year, including the state corporations. If the state loses that lawsuit, its use of tax deductions and tax credits. Two tax potential liability could be hundreds of millions of provisions in particular can have an enormous dollars or more. (A recent state disclosure to bond effect on final tax collections: net operating loss investors said the potential exposure to refund deductions and research tax credits. Each of these claims in this case could exceed $750 million.) reduces aggregate tax liabilities by more than On the other hand, a recent appellate opinion $1 billion per year. Corporations’ use of these could require health plans (such as Blue Shield provisions in any given year is highly uncertain and and Anthem Blue Cross) to start paying the state’s highly variable, and each can increase or reduce CT insurance tax, with some net revenue gain possible revenue from one year to another by hundreds of for the General Fund. In cases like these, it is millions of dollars. difficult to know how soon revenue gains or losses Litigation. There are always major revenue- will materialize for the state. Large tax cases tend related lawsuits and tax agency proceedings that to result in long appeals and multiple proceedings affect state revenues. At the time this report was spread out over many years. Our main scenario prepared, the state was awaiting an upcoming assumes no changes to state revenue due to these or state Supreme Court decision concerning the other ongoing lawsuits and tax agency proceedings. 18 Legislative Analyst’s Office www.lao.ca.gov 2016-17 BUDGET Chapter 3: Spending Outlook Main Scenario Estimates Reflect Economic spending increases over the period at an average Assumptions. Figure 1 (see next page) displays our annual rate of 3.2 percent. Two key programs— main scenario spending estimates through 2019-20. Proposition 98 and Medi-Cal—experience very Our main scenario assumes that current spending different growth patterns. General Fund spending laws and policies are not changed and that the on Proposition 98 programs grows slowly over the economy grows steadily throughout the period. period at an average annual rate of 1.7 percent, Should the economy fall into recession in the next largely due to two factors. First, the gradual few years, or if the economic growth pattern differs expiration of Proposition 30’s temporary taxes from our assumptions, spending in many programs slows General Fund revenue growth over four fiscal could be very different. For example, state spending years. Second, healthy growth in local property on Proposition 98 education programs depends taxes offset state spending on Proposition 98. on changes in personal income (a broad measure On the other hand, our main scenario reflects of the economy), local property taxes, and state 7.6 percent average annual growth on Medi-Cal, General Fund revenues. Because we cannot the second largest General Fund program. The precisely “predict” how these factors will change, growth patterns in these two key programs explain Proposition 98 spending in the future could be the moderate General Fund spending growth quite different from that shown in the figure. reflected in our main scenario. Moderate Spending Growth Under This Scenario. Under our main scenario, General Fund EDUCATION Education Spending. In this section, we Scholarships, and a few small specialized programs. focus on Proposition 98, the universities, student The last section estimates spending for the rest of financial aid programs, and child care programs. the state’s preschool program as well as child care The Proposition 98 section estimates combined programs. spending for a large portion of the state’s Proposition 98 subsidized preschool program, elementary and secondary education (commonly referred to as Proposition 98 Minimum Guarantee for K-12 education), and the California Community Schools and Community Colleges. State budgeting Colleges. The next section estimates spending for for schools and community colleges is governed the University of California and the California largely by Proposition 98, passed by voters in 1988. State University. The financial aid section estimates The measure, modified by Proposition 111 in 1990, spending for the Cal Grant program, Middle Class establishes a minimum funding requirement, www.lao.ca.gov Legislative Analyst’s Office 19 2016-17 BUDGET commonly referred to as the minimum guarantee. Calculating the Minimum Funding Guarantee. Both state General Fund and local property tax The Proposition 98 minimum guarantee is revenue apply toward meeting the minimum determined by one of three tests set forth in the guarantee. In addition to Proposition 98 funding, State Constitution (see Figure 2). These tests schools and community colleges receive funding depend upon several inputs, including changes in from the federal government, other state sources K-12 average daily attendance (ADA), per capita (such as the lottery), and various local sources (such personal income, and per capita General Fund as parcel taxes). revenue. Though the calculation of the minimum Figure 1 General Fund Spending Under LAO Main Scenario Includes Education Protection Account (Dollars in Millions) Estimates Outlook Average Annual 2014-15 2015-16 2016-17 2017-18 2018-19 2019-20 Growtha Education Programs Proposition 98b $50,497 $49,444 $50,213 $52,110 $52,376 $52,992 1.7% UC 2,991 3,136 3,261 3,391 3,527 3,668 4.0 CSU 2,763 2,988 3,121 3,257 3,393 3,534 4.3 Student Aid Commission 1,527 1,614 1,786 1,935 2,045 2,160 7.6 Child carec 822 942 950 965 984 1,005 1.7 Health and Human Services Medi-Cal 17,521 17,993 20,504 20,915 22,567 24,133 7.6 CalWORKs 619 588 266 178 135 127 -31.9 SSI/SSP 2,790 2,811 2,846 2,883 2,920 2,958 1.3 IHSS 2,193 2,802 2,788 2,883 3,008 3,140 2.9 DDS 3,130 3,496 3,550 3,651 3,760 3,920 2.9 DSH 1,498 1,537 1,542 1,546 1,551 1,551 0.2 Other major programsd 1,997 2,173 2,159 2,168 2,184 2,199 0.3 CDCR 9,499 9,530 9,500 9,523 9,549 9,568 0.1 Judiciary 1,409 1,511 1,515 1,548 1,580 1,613 1.7 CalSTRS 1,486 1,935 2,468 1,728 1,674 1,679 -3.5 Infrastructure Debt Servicee 5,250 5,353 5,602 5,524 6,083 6,041 3.1 Proposition 2 Debt Paymentsf — 227 1,593 1,550 1,368 1,016 — Other Programs 9,347 7,183 7,454 8,048 8,642 9,272 6.6 Totals $115,340 $115,262 $121,119 $123,804 $127,345 $130,575 3.2% Percent change — -0.1% 5.1% 2.2% 2.9% 2.5% — a From 2015-16 to 2019-20. b Reflects the General Fund component of the Proposition 98 minimum guarantee. Average annual growth in the minimum guarantee—the General Fund and local property tax revenue combined—is 2.9 percent over the period. c Stage 1 child care costs included in CalWORKs. A portion of State Preschool costs is reflected in Proposition 98. d Includes DHCS family health and state operations, DPH, DCSS, and DSS programs not itemized above. Smaller health and human services programs are included in “other programs.” e Debt service on general obligation and lease-revenue bonds generally used for infrastructure. Does not include: (1) lease-revenue debt service for community colleges, which is included under Proposition 98, or (2) UC’s and CSU’s debt service, which is included in their respective line items. f For 2015-16, includes $96 million UC pension payment, $84 million loan repayment to the Transportation Investment Fund, and $47 million in interest on special fund loans. Other Proposition 2 debt payments in 2015-16 are reflected in revenues and transfers. Beginning in 2016-17, reflects our estimate of debt payments required under Proposition 2. The Legislature could choose to spend these amounts on additional special fund loan repayments, Proposition 98 “settle-up,” or paying down unfunded liabilities for pension and retiree health benefits. IHSS = In-Home Supportive Services; DDS = Department of Developmental Services; DSH = Department of State Hospitals; DHCS = Department of Health Care Services; DPH = Department of Public Health; DCSS = Department of Child Support Services; and DSS = Department of Social Services. 20 Legislative Analyst’s Office www.lao.ca.gov 2016-17 BUDGET guarantee is formula- Figure 2 driven, a supermajority of Constitution Sets Forth Three Tests for the Legislature can vote Calculating Proposition 98 Minimum Guarantee to suspend the formulas Test 1—Share of General Fund. Ensures Proposition 98 programs receive at and provide less funding least 40 percent of state General Fund revenue. This test applies only when it than they require. This results in a higher funding level than Test 2 or Test 3. Test 1 has been operative 4 of the last 27 years. happened in 2004-05 Test 2—Growth in Personal Income. Adjusts prior-year Proposition 98 and 2010-11. In some funding for changes in K-12 attendance and per capita personal income. This cases, including as a test applies when higher than Test 1 but lower than Test 3. Test 2 has been operative 14 of the last 27 years. result of a suspension, the Test 3—Growth in General Fund Revenue. Adjusts prior-year Proposition 98 state creates an out-year funding for changes in K-12 attendance and per capita General Fund revenue. obligation referred to as This test applies when higher than Test 1 but lower than Test 2. Test 3 has been operative 7 of the last 27 years. a “maintenance factor.” Note: In 2 of the last 27 years, the state suspended Proposition 98. The state is required to make maintenance factor Test 1 remains the operative test in 2014-15. payments when year-to-year growth in state General Test 1, when coupled with maintenance factor Fund revenue is relatively strong. Though in most application, results in the minimum guarantee years the state has provided an amount at or close to going up virtually dollar for dollar with increases the minimum guarantee, the state has discretion to in General Fund revenue. As shown in Figure 3, the provide any amount above the minimum guarantee. $904 million increase in applicable state General Fund revenue increases the minimum guarantee 2014-15 and 2015-16 Updates by $889 million. Part of this increase results from 2014-15 Minimum Guarantee Up $1.3 Billion a higher required maintenance factor payment From Budget Act Estimate. Of this amount, ($541 million). The remainder of the increase in $889 million is covered by state General Fund and the guarantee is due to an upward revision in local $409 million by higher local property tax revenue. Figure 3 Updating Estimates of 2014-15 and 2015-16 Minimum Guarantees (Dollars in Millions) 2014-15 2015-16 2015-16 November 2015-16 November Budget Plan LAO Estimate Change Budget Plan LAO Forecast Change Minimum Guarantee General Fund $49,608 $50,497 $889 $49,416 $49,444 $27 Local property tax 16,695 17,104 409 18,993 19,704 711 Totals $66,303 $67,601 $1,298 $68,409 $69,148 $739 Key Information General Fund tax revenuea $112,068 $112,972 $904 $116,619 $120,119 $3,500 K-12 average daily attendance 5,994,522 5,981,073 -13,449 5,995,889 5,974,494 -21,395 Operative test 1 1 — 3 2 — Maintenance factor paid $5,402 $5,942 $541 — $195 $195 a Reflects General Fund revenue that counts toward the Proposition 98 calculation. www.lao.ca.gov Legislative Analyst’s Office 21 2016-17 BUDGET property tax estimates. A portion of the property and is not directly affected by changes in General tax revision ($243 million) is due to an increase in Fund revenue. The additional revenue does, the amount of ongoing revenue shifted to schools however, require the state to make a $195 million and community colleges from the dissolution maintenance factor payment. Upon making this of redevelopment agencies. (The state dissolved payment, the state will have eliminated its entire these agencies in 2011 and provided for a gradual maintenance factor obligation, ending the year with shift of their revenue to schools and other local no maintenance factor outstanding for the first governments as their debts are retired.) Higher- time since 2005-06. than-expected collections from several smaller Further Changes in Revenue Would Have components of property tax revenue account for the Little Effect on 2015-16 Guarantee. In 2015-16, remainder of the increase. Although local property the guarantee is relatively insensitive to changes tax revenue normally offsets the General Fund in revenue. Under our main scenario, with Test 2 share of Proposition 98 funding, Test 1 years are the operative test and no further maintenance exceptions, with Proposition 98 funding increasing factor payments required, the 2015-16 guarantee with increases in local revenue. no longer depends directly on growth in state Spike Protection Results in Smaller Increase revenue. We estimate that General Fund revenue to Ongoing Funding Level. In most years, could increase by as much as $8 billion above our Proposition 98 funding builds upon the level projections with no corresponding increase in provided in the prior year. This dynamic means the guarantee. Conversely, General Fund revenue that increases in the guarantee in one year usually could fall below our projections by as much as carry forward and result in a comparable increase $4 billion with the only Proposition 98 effect the next year. In 2014-15, however, only the increase being that the state no longer would be required associated with the maintenance factor payment to make the remaining $195 million maintenance carries forward into 2015-16. The remaining factor payment in 2015-16. This dynamic contrasts increase is excluded due to a provision in the State notably with the situation in 2014-15, under which Constitution known as spike protection. This is the guarantee changes nearly dollar for dollar with intended to prevent very large one-time spikes any change in state General Fund revenue. in revenue from increasing the guarantee to an Virtually All $739 Million Increase Covered unsustainably high level moving forward. Since its With Higher Property Tax Revenue. Though the adoption in 1990, spike protection has been applied 2015-16 guarantee is up $739 million, the General to the guarantee twice (in 2012-13 and 2014-15). Fund share of the guarantee is up only $27 million. 2015-16 Minimum Guarantee Up $739 Million Increases in local property tax revenue cover the From Budget Act Estimate. Two main factors remaining $711 million increase. About half of account for this increase. First, the $541 million this amount ($334 million) is due to higher-than- maintenance factor payment from 2014-15 carries expected ongoing revenue from the dissolution forward, increasing the 2015-16 guarantee by a of redevelopment agencies. The remainder is due similar amount. Second, we estimate that General primarily to higher assessed property values. Fund revenue is up $3.5 billion compared with Whereas the budget plan assumed assessed values the budget plan estimate. With Test 2 projected would grow statewide by 5.5 percent, the latest to be operative, the guarantee is determined available data from county assessors indicates that largely by growth in per capita personal income the increase will be about 6 percent. 22 Legislative Analyst’s Office www.lao.ca.gov 2016-17 BUDGET Drop in K-12 ADA Frees Up Some Funding minimum guarantee will grow from $69.1 billion Within Guarantee. Compared to budget act in 2015-16 to $71.4 billion in 2016-17, an increase assumptions, we estimate K-12 ADA has fallen by of $2.3 billion (3.3 percent). Test 3 is operative, about 13,000 in 2014-15 and by about 21,000 in with the change in the guarantee driven primarily 2015-16. Due to a two-year hold harmless provision by projected growth in per capita General Fund in the State Constitution, these ADA declines do revenue. Other factors affecting the guarantee not affect the guarantees in 2014-15 and 2015-16. include a slight decline in K-12 attendance The ADA drops, however, reduce the cost of many (0.3 percent) and the requirement for the state educational programs, including the Local Control to make a $618 million supplemental payment. Funding Formula (LCFF), thereby freeing up (A state law requires a supplemental payment roughly $300 million across the two years for other whenever Test 3 is operative and Proposition 98 Proposition 98 priorities. funding would otherwise grow less quickly than About $2.3 Billion Available for One-Time the rest of the state budget.) Given the guarantee Purposes. For 2014-15 and 2015-16 combined, is still growing more slowly than our projected the minimum guarantee has increased a total of 5.3 percent growth in per capita personal income, $2 billion (see Figure 3). Given the 2014-15 fiscal the state creates a $1.1 billion maintenance factor year is already over and districts are well into obligation. their 2015-16 fiscal year, this additional funding Two-Thirds of Increase Covered With Higher in practical terms is available for one-time Local Property Tax Revenue. Of the $2.3 billion purposes. Combined with the $300 million in increase in the 2016-17 guarantee, the General ADA-related savings from 2014-15 and 2015-16, Fund share is $770 million. A $1.5 billion increase the state has about $2.3 billion to allocate for its in local property tax revenue covers the remainder one-time priorities. Over the past few years, the of the increase in the guarantee, with local property state has used one-time funding to support a tax revenue up 7.8 percent over the 2015-16 level. range of activities including (1) implementation Two main factors account for this increase: of the Common Core State Standards, (2) career • Assessed Property Values Projected to technical education, (3) teacher training and Grow at Relatively Strong Rate. We support, and (4) paying down several outstanding project assessed values will increase by K-14 obligations. As of the 2015-16 budget plan, the 6.3 percent in 2016-17, largely reflecting the state had retired some of these latter outstanding strong recovery in the housing market that obligations but had not entirely paid down the K-14 has occurred over the past several years. mandates backlog. In recent years, the state has This growth rate equates to a $1.1 billion reduced the K-14 mandates backlog considerably increase in local property tax revenue for (by more than $4 billion), but we estimate the state schools and community colleges. still has an unaudited backlog of about $2 billion ($1.7 billion for schools and $300 million for • Final Shift of Revenue From End of “Triple community colleges). Flip.” The triple flip is phasing out during the 2015-16 fiscal year, with the associated 2016-17 Budget Planning local property tax revenue beginning 2016-17 Guarantee $2.3 Billion Higher Than to flow back to schools and community Revised 2015-16 Guarantee. We project the colleges. The total revenue involved is about www.lao.ca.gov Legislative Analyst’s Office 23 2016-17 BUDGET $1.6 billion on an ongoing basis. Schools the 2014-15 guarantee was highly sensitive to and community colleges will receive changes in state General Fund revenue and the $1.2 billion of this amount in 2015-16 2015-16 guarantee is highly insensitive to changes, and the remainder (about $400 million) the 2016-17 guarantee is moderately sensitive. in 2016-17. (The triple flip was a complex Relative to our main scenario, a $1 increase or financing mechanism under which the decrease in General Fund revenue in 2016-17 state diverted local sales tax revenue to pay would cause a corresponding increase or decrease off certain state bonds, backfilled cities and in the guarantee of about 50 cents. If General counties with property tax revenue, and Fund revenue were to increase by $2 billion above backfilled schools and community colleges our main scenario, the guarantee would increase with state General Fund.) by about $1 billion. (If revenue were to increase beyond this level, however, the guarantee would be $3.6 Billion Available for Proposition 98 unlikely to increase further. This is because Test 2 Priorities in 2016-17 Under Main Scenario. would become operative, with the guarantee then As shown in Figure 4, the 2015-16 Budget Act linked to per capita personal income rather than included $68.4 billion in spending to meet the state revenue.) If General Fund revenue were to minimum guarantee (as estimated at that time). Of decline by $5 billion from our main scenario, the this amount, $67.9 billion was ongoing spending guarantee would decline by about $2.5 billion, and $551 million was one-time spending. Given dropping below the prior-year funding level. projected growth in the 2016-17 guarantee to In Past Several Years, State Has Minimized $71.4 billion, the state has $3.6 billion available for Risk by Designating Some Funding for One-Time its 2016-17 Proposition 98 priorities. Activities. Given the difficulty of predicting 2016-17 Guarantee Is Somewhat Sensitive to recessions, stock market slowdowns, and other Changes in State General Fund Revenue. Whereas events that can reduce Figure 4 General Fund revenue, $3.6 Billion Increase in Proposition 98 Funding Projected for 2016-17 the state over the past few years has dedicated some LAO Main Scenario (In Millions) available Proposition 98 2015-16 Budget Act Spending Level $68,409 Back out one-time actions: funding to one-time Secondary school career technical education grantsa -$250 activities. If the guarantee CCC mandate backlog -117 falls below projections, the CCC maintenance and instructional equipment -100 K-12 Internet infrastructure grants -50 expiration of prior-year, K-12 mandate backlog -31 one-time funding provides CCC Cal Grant B administration -3 a buffer, reducing the Total One-Time Actions -$551 likelihood of potential 2015-16 Ongoing Spending $67,858 Annualize preschool slotsb $31 cuts to ongoing K-14 New Funds Available in 2016-17c $3,558 programs. Allocating 2016-17 Minimum Guarantee $71,447 a portion of available a In 2015-16, this program received an additional $150 million from one-time funds. b Funded beginning January 1, 2016. funding for one-time c The state has committed to spend $300 million in 2016-17 for the second year of the secondary school career technical education grants. The state could cover this cost using any available Proposition 98 priorities would mitigate funding from any fiscal year. the effect of a decline 24 Legislative Analyst’s Office www.lao.ca.gov 2016-17 BUDGET in the guarantee from 2016-17 to 2017-18. For growth in the General Fund share of Proposition 98 example, under the recession scenario we discuss in results from the relatively fast growth in local Chapter 4, General Fund revenue declines by nearly property tax revenue, which increases from $8.5 billion (7 percent) from 2016-17 to 2017-18. $19.7 billion in 2015-16 to $24.5 billion in 2019-20. (By comparison, during the last two recessions, The average annual growth over the period is the state experienced much larger year-over-year 1.7 percent for the General Fund and 5.6 percent for declines.) Under the recession scenario, the 2017-18 local property tax revenue. guarantee would experience a year-over-year Growth in Local Property Tax Revenue Covers decline of $4.6 billion. If the state were to designate Majority of Proposition 98 Increase. As shown in some available 2016-17 funding for one-time Figure 5, property tax revenue grows throughout activities, it would reduce the magnitude of the period. As described earlier, the large increases potential reductions to ongoing programs in unfolding in 2015-16 and 2016-17 are due primarily 2017-18. to the end of the triple flip. From 2017-18 through 2019-20, increases are due primarily to our Outlook for Later Years projection that assessed property values—the main Although both the Legislature and schools driver of growth in local property tax revenue— likely view near-term Proposition 98 issues as will grow by about 5 percent per year. Though this the most pressing, a number of significant issues rate is somewhat below our projections for 2015-16 unfold over the forecast period. Most notably, these and 2016-17, it is comparable to historical averages. issues include the phase out of the Proposition 30 This growth equates to additional revenue of about taxes, the phase in of LCFF funding increases, $900 million per year. In addition, we project that and the cost pressures associated with increased revenue shifted from the former redevelopment contributions to the California State Teachers’ agencies will increase by about $340 million in Retirement System (CalSTRS). Members of the 2017-18 and by about $170 million per year in Legislature also have asked whether a deposit in 2018-19 and 2019-20. (A portion of these increases, the state school reserve might occur in the coming however, are offset by increases in excess taxes, the years, thereby triggering the associated caps on share of local revenue that does not count toward school district reserve levels. Below, we describe the minimum guarantee.) the Proposition 98 outlook through 2019-20 under Slower Growth in Guarantee as Proposition 30 our main scenario and examine the above issues in Revenue Phases Out. As shown in Figure 5, the more detail. growth in the guarantee is relatively strong in the Under Main Scenario, Guarantee in 2019-20 near term, with the guarantee projected to grow More Than $8 Billion Higher Than 2015-16. by 3.3 percent in 2016-17 and by 4.4 percent in Figure 5 (see next page) shows our Proposition 98 2017-18. These increases outpace the projected projections under our main scenario from K-14 cost-of-living adjustment (COLA) in both of 2015-16 through 2019-20. As shown in the figure, these years (projected at 2 percent and 2.4 percent, Proposition 98 funding grows from $69.1 billion respectively). Growth in the guarantee slows toward in 2015-16 to $77.5 billion in 2019-20, an annual the end of the period, with the guarantee projected average growth rate of 2.9 percent. General Fund to grow by 1.6 percent in 2018-19 and 2.2 percent in costs grow more slowly, from $49.4 billion in 2019-20. These increases are less than the projected 2015-16 to $53 billion in 2019-20. This slower K-14 COLA in both years (projected at 2.5 percent www.lao.ca.gov Legislative Analyst’s Office 25 2016-17 BUDGET and 2.4 percent, respectively), meaning the state our main scenario, strong growth in per capita would have difficulty funding program expansions. personal income occurs over the period, with The relatively low rate of growth in the guarantee in the annual increase exceeding 5 percent in three these years is due to the phase out of the income tax out of the four final years. When growth in per revenues associated with Proposition 30. Assuming capita personal income exceeds growth in per the economy continues to expand, General Fund capita General Fund revenue, Test 3 becomes revenue and the minimum guarantee will continue the operative test for determining the minimum to increase in those years, albeit at a relatively slow guarantee. Under our main scenario, Test 3 is rate. (The sales tax portion of Proposition 30 phases operative from 2016-17 through 2019-20 and out over the 2016-17 and 2017-18 fiscal years. The the state creates new maintenance factor each amount of revenue generated by the sales tax is of these years. By 2019-20, the total amount of relatively small compared with the income tax and projected maintenance factor outstanding reaches has a smaller effect on the minimum guarantee.) $6.3 billion. State Accumulates Increasingly Large State Projected to Move Closer to Full LCFF Maintenance Factor Obligation Over Period. In Implementation by End of Period. In 2013-14, the Figure 5 Proposition 98 Outlook LAO Main Scenario (Dollars in Billions) 2015-16 2016-17 2017-18 2018-19 2019-20 Minimum Guarantee General Fund $49.4 $50.2 $52.1 $52.4 $53.0 Local property tax 19.7 21.2 22.5 23.4 24.5 Totals $69.1 $71.4 $74.6 $75.8 $77.5 Change From Prior Year Total guarantee $1.5 $2.3 $3.2 $1.2 $1.6 Percent change 2.3% 3.3% 4.4% 1.6% 2.2% General Fund -$1.1 $0.8 $1.9 $0.3 $0.6 Percent change -2.1% 1.6% 3.8% 0.5% 1.2% Local property tax $2.6 $1.5 $1.3 $1.0 $1.0 Percent change 15.2% 7.8% 5.9% 4.3% 4.4% Maintenance Factor Amount created (+)/paid (-) -$0.2 $1.1 $0.1 $2.6 $2.1 Total outstandinga — $1.1 $1.3 $4.0 $6.3 Operative Test 2 3 3 3 3 Growth Rates K-12 average daily attendance -0.1% -0.3% -0.3% -0.5% -0.3% Per capita personal income (Test 2) 3.8 5.3 4.9 5.6 5.3 Per capita General Fund (Test 3)b 5.9 2.7 4.4 1.6 2.1 K-14 cost-of-living adjustment 1.0 2.0 2.4 2.5 2.4 Assessed property values 6.0 6.3 5.1 4.9 4.8 Public School System Stabilization No No No No No Account Deposit? a Outstanding maintenance factor grows each year with changes in K-12 attendance and per capita personal income. b As set forth in the State Constitution, reflects change in per capita General Fund plus 0.5 percent. 26 Legislative Analyst’s Office www.lao.ca.gov 2016-17 BUDGET state replaced most of its former school funding No Deposit Into Public School System formulas with LCFF. In creating this new formula, Stabilization Account (PSSSA) Projected. the state set funding targets considerably higher Proposition 2, approved by voters in November than the 2012-13 funding levels and specified 2014, created a new state reserve known as PSSSA. that the targets were to grow annually with the A related state law imposes a cap on school district K-12 statutory COLA. Given the higher funding reserves in the year after the state makes a deposit targets, the state phased in LCFF implementation, into the state reserve. Deposits are predicated on with full implementation expected in 2020-21. In several conditions, including a requirement for 2013-14, LCFF was 72 percent funded. For 2015-16, the state to have paid off all maintenance factor we estimate LCFF is 90 percent funded. Under created before 2014-15. Though we project this our main scenario, we estimate LCFF would be condition will be satisfied in 2015-16, we do not 96 percent funded by 2019-20 if the state dedicated anticipate the state will meet the other conditions increases in the minimum guarantee largely to during the period. For example, a deposit requires LCFF. (Our estimate assumes the state creates no the minimum guarantee to be growing more new categorical programs throughout the period quickly than per capita personal income, but under but provides growth and COLA to most existing our main scenario the guarantee would grow at a K-12 programs. We also assume community slower rate throughout the period. To meet all of colleges receive 10.8 percent of the available the conditions in any year of the forecast period, Proposition 98 funding, consistent with their share the state very likely would need to experience a of the guarantee under the 2015-16 budget plan.) year-over-year revenue surge of at least several Given the relatively high growth in the guarantee billion dollars relative to our projections. Absent through 2017-18 and the relatively slow growth such a surge, a deposit into the PSSSA would not thereafter, virtually all of the progress toward LCFF occur and the local reserve cap would not take implementation would occur by 2017-18. effect. CalSTRS Rate Increases Phasing In Over Universities Period. State law ramps up school and community college districts’ CalSTRS contributions over State Has Two Public University Systems. the period. As scheduled in state law, district The University of California (UC) educates about contribution rates increase from 10.7 percent of 248,000 full-time equivalent undergraduate and payroll in 2015-16 to 18.1 percent by 2019-20. Based graduate students at ten campuses. The California on CalSTRS’ estimates, district costs will be nearly State University (CSU) educates about 378,000 $3 billion higher in 2019-20 than 2015-16. Under full-time equivalent undergraduate and graduate our main scenario, the minimum guarantee grows students at 23 campuses. (These counts include more than $8 billion over the same period. Under resident and nonresident students.) Both university the recession scenario we develop in Chapter 4 systems receive support for their core programs of this report, however, growth in the minimum from a combination of state General Fund and guarantee would be less than the estimated increase student tuition revenue. In 2014-15, UC received in CalSTRS costs. (The final year of the CalSTRS $3 billion in state General Fund and $2.8 billion increase is 2020-21—one year beyond the end of in student tuition revenue. That same year CSU our forecast period—when district contributions received $2.8 billion in state General Fund and will reach 19.1 percent of payroll.) $2.1 billion in student tuition revenue. www.lao.ca.gov Legislative Analyst’s Office 27 2016-17 BUDGET Certain Components Excluded From Our past practice appears to be a reasonable indicator University Forecast. We use UC’s and CSU’s main of future action. Though most of our assumptions General Fund appropriation as a starting point for are based on recent past practice, in a few areas— our forecast but back out the one-time $96 million notably enrollment growth—we have had to use payment provided in 2015-16 for UC’s outstanding our judgment because the state’s recent actions pension liabilities. Our university forecast also have been somewhat inconsistent. For example, does not include cost increases for CSU retiree over the last ten years, the state has sometimes set health and pension contributions, as we forecast enrollment expectations and funded associated these as part of overall state employee costs. (The growth, sometimes set enrollment expectations state only provides specific augmentations to cover but required UC and CSU to fund the associated pension rate adjustments relative to CSU’s 2013-14 growth from base increases, and sometimes not payroll level, with CSU expected to cover any set enrollment expectations but UC and CSU other pension cost increases from its base budget.) nonetheless increased enrollment. Below, we lay out We also exclude one-time deferred maintenance our key forecast assumptions, and, when applicable, funding for UC and CSU. (We display that funding note any heightened degree of uncertainty in 2015-16 under “other programs” in Figure 1.) surrounding an assumption. Lastly, we exclude Hastings College of the Law Assume Base Increases for UC and CSU from our university forecast, as the state provides Through 2019-20. The state has provided general less than $15 million General Fund annually for the purpose base increases to UC and CSU in each of college. We combine Hastings College of the Law the last three years. In 2013-14 and 2014-15, UC and with other relatively small state programs and run CSU received about the same size general purpose one consolidated forecast for these programs. increases, whereas in 2015-16 they received notably Challenges in Running Current Law Forecast different ongoing base increases. Because the for UC and CSU. Whereas the State Constitution, Legislature has provided base increases the past few state law, and federal law notably constrain years, we assume that UC and CSU will continue some areas of the state budget (for example, K-14 to receive base increases from 2016-17 through education and health care), they do not notably 2019-20. Though state action regarding the size of constrain budgeting for UC and CSU. In any these increases has not been entirely consistent the given year, the Legislature and the two university past three years, we assume UC and CSU receive systems have significant discretion in deciding both the same dollar increases. Specifically, we calculate what cost increases to fund and how to fund those base augmentations for both university systems increases (whether through the General Fund or by increasing UC’s General Fund appropriation tuition revenue). by 4 percent annually. We assume UC and CSU Assumptions Underlying UC and CSU would cover increases in operational costs and Forecast Based Largely on Current State Practice. most facility debt-service costs using these Given these challenges, our university forecast augmentations. relies primarily on current practice rather than Assume Future Enrollment Growth Funded current law. In some university budget areas, From Base Increases. As with other operational including general purpose base increases and cost increases, we assume any enrollment growth certain lease-revenue payments, the state has acted beyond 2015-16 Budget Act expectations would somewhat consistently in recent years, such that be funded from base increases. This is consistent 28 Legislative Analyst’s Office www.lao.ca.gov 2016-17 BUDGET with state practice over the past three years. (For state funding. Such future decisions could impact 2015-16, we assume both segments meet their university spending significantly. enrollment growth expectations and UC receives Under LAO Outlook, University Spending the corresponding $25 million set forth in the Grows by $258 Million in 2016-17. Under our budget act.) An upcoming freshman eligibility main forecast, UC General Fund spending grows study, due to the Legislature in December 2016, to almost $3.3 billion from 2015-16 to 2016-17, may influence future budgetary decisions regarding an increase of $124 million (4 percent). Spending enrollment. Until that study is released, estimating for CSU grows to $3.1 billion, an increase of enrollment changes required to meet UC’s and $133 million (4.5 percent). Over the forecast period, CSU’s traditional eligibility pools is guesswork. UC and CSU spending continues to increase Assume Lease-Revenue Debt Payments to steadily, reaching $3.7 billion at UC and $3.5 billion CSU. For 2016-17 and 2017-18, we assume CSU at CSU in 2019-20. Given the various factors receives additional funding to cover projected highlighted above, actual university spending in increases in its lease-revenue debt service. This any given year could differ significantly from the assumption is based on a previously agreed upon amounts shown under our projections. four-year schedule of increases, for which the Financial Aid Legislature has implemented the first two years of increases. For the last two years of the forecast The California Student Aid Commission period, we assume CSU covers all debt-service (CSAC) is responsible for administering most state increases from within its base increases, consistent financial aid programs. The largest aid program with our general debt-service assumption for both CSAC administers is the Cal Grant program, which segments. serves about 360,000 undergraduate students. This Assume No Tuition Increases. Over the program primarily is funded with a combination last three years, the state General Fund has of state General Fund and federal Temporary covered virtually all authorized UC and CSU Assistance for Needy Families (TANF) monies. cost increases. Moving forward, we assume the Other notable CSAC programs supported by the General Fund continues to bear the full cost, with General Fund include Middle Class Scholarships no increase in student tuition levels. Under such and student loan assumption programs. a forecast, student tuition levels, already flat since Key Assumptions for Forecast Period. For 2011-12, would remain so through 2019-20 (nine Cal Grants, we assume (1) annual participation consecutive years). This would be the longest period growth of 5 percent; (2) the continued phase-in of of flat tuition in many decades. Though it would be awards for Dream Act students, with the program a particularly long period, extended tuition freezes reaching full implementation in 2016-17; (3) the are not entirely unprecedented. For example, the renewal of additional competitive awards (the state universities did not raise tuition from 1995-96 issued 3,250 additional new competitive awards in to 2001-02. Though we assume no increase in 2015-16); and (4) reductions in awards for students tuition under our main scenario, future decisions attending nonprofit colleges, with statutorily regarding tuition are uncertain. In some years authorized reductions scheduled to take effect past, the Legislature has raised tuition levels and in 2017-18 and 2018-19. We also assume the state General Fund support simultaneously whereas in continues to use the same amount of federal TANF other years it has raised tuition levels and reduced funds to offset a portion of General Fund Cal www.lao.ca.gov Legislative Analyst’s Office 29 2016-17 BUDGET Grant costs. Additionally, we assume the continued including continued improvements in outreach phase-in of Middle Class Scholarship awards and and administrative procedures at both the state the continued phase-out of all loan assumption and campus levels. If Cal Grant participation were programs. We assume no tuition increases at to grow by 10 percent rather than 5 percent each the universities. If tuition were raised during the year of the forecast period, annual financial aid forecast period, Cal Grants costs would be higher costs in 2019-20 would be $2.7 billion rather than than reflected in Figure 1. For each 1 percent $2.2 billion. increase in tuition at UC and CSU, annual Cal Child Care Grant Costs would be $16 million higher. Under Forecast, General Fund Financial The state provides subsidized child care Aid Costs Increase by $172 Million in 2016-17. for families participating in California Work Under our outlook, financial aid costs grow from Opportunity and Responsibility to Kids $1.6 billion in 2015-16 to $1.8 billion in 2016-17— (CalWORKs) and some other low-income, working growth of $172 million (11 percent). Of this families. Generally, CalWORKs families progress amount, $142 million reflects higher General Fund through three consecutive “stages” over the course Cal Grant costs. Of the Cal Grant cost increases, of several years, with Stage 1 intended for families $102 million reflects participation growth, seeking employment, Stage 2 for families that have $25 million is continued phase-in of Dream Act gained stable employment and are transferring off awards, and $14 million is higher renewal costs of cash assistance, and Stage 3 for families who for competitive awards. In addition, we estimate have been off of cash assistance for at least two cost increases of $34 million for Middle Class years. Our child care forecast includes expenditures Scholarships and savings of $3.8 million for loan for CalWORKs Stage 2 and Stage 3 care as well as assumption programs. non-CalWORKs care. We include Stage 1 costs Costs Over Period Very Sensitive to in our CalWORKs forecast and a large portion of Assumption About Cal Grant Participation. Of the State Preschool program in our Proposition 98 the cost increases estimated for 2016-17, about forecast. 60 percent is attributable to assumed growth in Cal Under Forecast, Child Care Costs Increase by Grant participation. Over the rest of the period, Net of $8 Million in 2016-17. We project child care our financial aid forecast remains very sensitive spending to increase from $942 million in 2015-16 to assumptions about Cal Grant participation. to $950 million in 2016-17, an increase of less than Though we assume 5 percent annual growth 1 percent. The small increase in 2016-17 costs is based on a historical ten-year average, Cal Grant the net result of several factors, including higher participation has risen even more quickly over the costs for annualizing rate and slot increases begun last three years, with an average annual growth during 2015-16 and applying a 2 percent statutory rate of 10 percent. The recent rise in participation COLA to non-CalWORKs programs. These higher is due in part to efforts to increase the number of costs are offset by the removal of prior-year, high schools electronically submitting grade point one-time funding as well as a small reduction averages (GPAs) for all students. (Submitting a reflecting a 0.5 percent decrease in the birth-to-four GPA is a requirement to apply for the Cal Grant population in California. (State law specifies that high school entitlement award.) Additional non-CalWORKs child care programs be adjusted factors likely are contributing to the increase, annually based on the change in this group.) 30 Legislative Analyst’s Office www.lao.ca.gov 2016-17 BUDGET Child Care Costs Grow Steadily Throughout In 2015-16, California received $573 million Remainder of Forecast Period. We project that in CCDBG funding. The federal government annual child care costs will increase to about reauthorized the CCDBG act in 2014—creating a $1 billion by 2019-20. The bulk of this increase new set of requirements for states. Most notably, is due to our assumption that the state provides the act changed how states are to set provider non-CalWORKs child care programs an annual reimbursement rates, how frequently states are statutory COLA. Over the period, the projected to inspect providers, and how much states must COLA rates range from a low of 2 percent in spend on activities designed to improve the quality 2016-17 to a high of 2.5 percent in 2018-19. The of child care. The U.S. Department of Health and average annual cost of the COLA is $17 million. Human Services and states still are working out (The birth-to-four population is projected to how to interpret and implement some of these continue declining over the period, with the group new requirements. Decisions that (1) the federal 1 percent smaller in 2019-20 compared to 2016-17.) government makes in developing associated California in Midst of Responding to New regulations, (2) California makes in developing its Federal Requirements. In addition to state required CCDBG state plan, and (3) the Legislature General Fund, subsidized child care programs makes in implementing the new state plan all could receive funding through the federal Child have significant impact, affecting state costs and/or Care and Development Block Grant (CCDBG). children served. HEALTH AND HUMAN SERVICES Overview of Health Services Provided. Overview of Human Services Provided. California’s major health programs provide health The state provides a variety of human services coverage and additional services for various and benefits to its citizens. These include income groups of eligible persons—primarily poor families maintenance for the aged, blind, and disabled; and children as well as seniors and persons with cash assistance and welfare-to-work services for disabilities. The federal Medicaid program, known low-income families with children; protection of as Medi-Cal in California, is the largest state health children from abuse and neglect; the provision program both in terms of funding and number of home-care workers who assist the aged and of persons served. The Medi-Cal population has disabled in remaining in their own homes; grown substantially since January 2014, reflecting and community services and state-operated an expansion of those eligible for Medi-Cal and facilities for the mentally ill and developmentally a streamlining of eligibility requirements under disabled. Although state departments oversee the the Patient Protection and Affordable Care Act management of these programs, the actual delivery (ACA), also known as federal health care reform. of many services is carried out by county welfare In addition, the state supports various public health and child support offices, and other local entities. programs. Although state departments oversee the Most human services programs have a mixture of management of these programs, the actual delivery federal, state, and county funding. of many services is carried out by counties and Overall Spending Trends. The 2015-16 budget other local entities. Health programs are largely provides $31.7 billion in General Fund spending federally and state funded. for health and human services (HHS) programs. www.lao.ca.gov Legislative Analyst’s Office 31 2016-17 BUDGET We now estimate that these General Fund costs enrolling in certain state HHS programs. As a will be slightly lower—by a net of $150 million—in result, caseload growth for several HHS programs part reflecting lower caseloads than assumed by the from 2007-08 (the beginning of the recession) to budget for the CalWORKs population. Based on 2011-12 (post-recession) was well above historical current law requirements, we project that General trends. Our main economic scenario assumes Fund spending for HHS programs will increase to employment growth over the next four years, $33.8 billion in 2016-17 and $34.4 billion in 2017-18. although at a slowing annual rate. Accordingly, The significant growth in 2016-17 primarily reflects our caseload projections for several HHS programs higher General Fund Medi-Cal spending, due reflect substantially lower growth rates compared mainly to the assumed repeal of the managed care to the experience of the recent recessionary years, organization tax as of 2016-17 and the inception and in some cases—such as CalWORKs—we are of a state share of costs for the optional Medi-Cal anticipating caseload declines under our main expansion population under federal health care economic scenario over some or all of the forecast reform beginning in 2016-17. We assume that period. This in turn reduces costs pressures. spending for HHS programs will eventually reach Below, we discuss spending trends in the major $38.2 billion in 2019-20 in our main economic HHS programs. scenario. Again, the bulk of the spending growth Medi-Cal in the later years of the outlook reflect growth in Medi-Cal spending, due primarily to medical cost Overall Spending Trends. We estimate inflation and the increasing state share of costs for 2015-16 General Fund spending for Medi-Cal local the optional Medi-Cal expansion population. assistance will be about $18 billion—0.3 percent Although the average projected annual increase (or $47 million) lower than what was assumed in in HHS spending from 2015-16 through 2019-20 the 2015-16 Budget Act. This mainly reflects lower is about 5 percent, there is substantial variation in spending on the Applied Behavioral Analysis spending growth rates by program. For example, benefit as a result of updated caseload and rate over these years, General Fund spending growth for information. Our 2015-16 estimate also assumes that Medi-Cal averages 7.6 percent per year, while the the President’s executive actions on immigration Supplemental Security Income/State Supplementary (discussed in more detail later in this report) will not Program (SSI/SSP) is projected to grow modestly, be implemented. General Fund support increases with average annual growth of 1.3 percent. General 14 percent to $20.5 billion in 2016-17, largely as Fund spending for the CalWORKs program is a result of underlying program growth and the projected to substantially decline at an average loss of savings associated with the managed care annual rate of 32 percent, reflecting both projected organization (MCO) tax, which is assumed to caseload declines as well as the infusion of expire without replacement at the end of 2015-16. non-General Fund funding sources to support the Over the period of our outlook, other significant program, as discussed further below. spending drivers include underlying program Relatively Lower Caseload Growth in growth in caseload and per-enrollee costs, higher Some Programs Reduces Cost Pressures. The costs associated with the newly eligible population recession in the latter part of the 2000s raised under the ACA (the so-called “optional expansion” unemployment and reduced income, resulting population), and a decrease in federal funding for in historically high numbers of Californians the Children’s Health Insurance Program (CHIP). 32 Legislative Analyst’s Office www.lao.ca.gov 2016-17 BUDGET Caseload Has Continued to Climb Steeply. redeterminations are required to grant continued In June 2015—the most recent month for eligibility for enrollees during the interim. which enrollment counts may be considered . . . Which Outlook Assumes Will Be Resolved nearly complete—total Medi-Cal caseload was in 2016-17. Our outlook assumes a large portion over 12.6 million. This includes over 3 million of 2015 redeterminations have not yet occurred for individuals who became newly eligible for the optional expansion population, nor for those Medi-Cal under the optional ACA expansion. subgroups of families caseload that continue to Total enrollment in June 2015 represents a net exhibit uncharacteristic rapid growth. We further increase of roughly 1.3 million (or 11 percent) from assume counties, beginning January 2016, will total enrollment in June 2014. This is significant be able to process all pending redeterminations year-over-year growth, and may in part reflect a on their proper monthly schedule, as well as sustained boost in Medi-Cal uptake and retention discontinue coverage for all individuals who under the ACA (such as enrollment simplification have lost eligibility or failed to respond. Because and outreach). we assume redetermination delays have led to a Delayed Redeterminations Likely Explains progressive buildup of ineligible enrollees remaining Some of Growth . . . We believe a major factor on the program, the net effect of our adjustments behind the persistent rise in caseload are ongoing for catching up with redeterminations—combined delays and restrictions in the ability of counties to with the underlying economic and historical trends process and, when appropriate, terminate eligibility modeled in our outlook—is a temporary, accelerated for many Medi-Cal enrollees during their annual decline in families enrollment. Specifically, we redetermination. As an example, from January 2014 project families enrollment will drop by 260,000 through June 2015, certain segments of the families (or 3.5 percent) in 2016-17, and further decline and children population grew between 3 percent by 50,000 (or less than 1 percent) in 2017-18. We and 4 percent monthly. These same segments adopt a similar approach in projecting the optional grew at similar rates annually between 2010-11 expansion caseload. While there is likely to be some and 2012-13 (the period of sluggish economic additional growth among the optional expansion recovery leading up to ACA implementation). during the near term, particularly as counties We suspect the present high growth rates are address their redetermination backlog, we expect partly the result of many enrollees failing to exit this growth to slow somewhat in the out-years. We the program—even as their incomes rise above estimate optional expansion enrollment will be maximum eligibility thresholds—while new roughly 3 million in 2016-17. individuals continue to enter the rolls each month. We caution that there is considerable Our communications with counties suggest their uncertainty in estimating how redetermination caseworkers continue to face significant barriers delays have impacted caseload to date, as well to completing redeterminations on a timely basis. as projecting when the major issues—such as These include technical challenges with the state’s technical challenges and litigation—will be resolved new automation system for Medi-Cal eligibility in the future. If we have overestimated the extent of and current litigation that blocks the state from the redeterminations backlog, and/or if the backlog terminating coverage for many individuals who lasts beyond 2016, then actual enrollment among fail to respond to the annual redetermination. the optional expansion and families population will In most cases, counties experiencing delays in likely exceed our projections. www.lao.ca.gov Legislative Analyst’s Office 33 2016-17 BUDGET Senior and Disabled Caseload Projected (known as “dual eligibles”). The 2015-16 Budget Act to Rise. We assume enrollment among seniors included over $3 billion in General Fund spending and disabled persons will grow at their historical for dual eligibles’ Medicare premiums. The Board annual rates of 3 percent and 2 percent respectively, of Trustees for Medicare has projected relatively translating to about 25,000 enrollees per year in high rates of growth in Medicare premiums each category. over the next several years. In line with these Projected Growth in Managed Care and projections, our outlook assumes the cost of paying Fee-for-Service (FFS) Expenditures. The for Medicare premiums will grow by roughly fundamental sources of growth in Medi-Cal 7 percent to 9 percent annually from 2015-16 spending are changes in caseload and per-enrollee through 2019-20. This results in General Fund costs. The latter is dependent on growth in health spending on dual eligibles’ Medicare premiums of care prices paid by the program. For example, each over $4 billion by 2019-20. year the state’s actuaries certify capitated rates State Share of Cost for Optional Expansion (fixed monthly, per-enrollee payments regardless Begins in 2017. From 2014 through 2016, the of the number of services enrollees actually use) federal government pays 100 percent of the costs paid to Medi-Cal managed care plans. Generally, for the optional expansion. The federal share will the actuaries use plan-specific historical data on decline from 2017 through 2020, with the state utilization and costs to develop capitated rates, and eventually paying 10 percent of costs. Accordingly, incorporate assumptions about medical inflation our outlook assumes General Fund costs associated and other cost trends. This rate-setting process with this population of roughly $500 million in generally results in capitated rates that increase by 2016-17, growing to over $1.5 billion in 2019-20. several percentage points annually. There is a significant uncertainty in these estimates, We estimate overall expenditures in managed which ultimately depend on the number of new care will grow by about 1.5 percent in 2016-17 enrollees and the associated per-enrollee cost. As and nearly 4 percent in 2017-18, then resume their discussed above, the size of this population is partly historical course of roughly 5 percent annual dependent on the resolution of the redetermination growth in the out-years. The estimated initial backlog. Additionally, the majority of newly eligible slowdown in managed care spending for 2016-17 enrollees are enrolled in Medi-Cal managed care mainly reflects the projected drop in families plans that receive capitated rates for covering enrollment discussed above. Our outlook assumes these individuals. The rates paid to managed care per-enrollee costs in managed care will grow plans for the optional expansion have decreased around 4 percent in both 2016-17 and 2017-18. since the start of the expansion, mainly because These projections are subject to considerable actual utilization and costs among this population uncertainty, particularly if future movements in has turned out lower than initially assumed. We capitated rates differ substantially from recent assume further but smaller decreases in rates for historical trends. Our outlook also assumes overall the optional expansion in 2016-17 and 2017-18, and FFS expenditures will grow by about 4 percent in increases in subsequent years in line with general both 2016-17 and 2017-18. growth in capitated rates. Growth in Medicare Premiums. Medi-Cal CHIP Federal Funding. CHIP is a joint pays for Medicare premiums for those Medi-Cal federal-state program that provides health enrollees who are dually eligible for both programs coverage to children in low-income families, but 34 Legislative Analyst’s Office www.lao.ca.gov 2016-17 BUDGET with incomes too high to qualify for Medicaid. In components: (1) optional enrollment of dual California, both CHIP and Medicaid coverage are eligibles into managed care plans that integrate provided through Medi-Cal. The ACA authorizes their Medi-Cal and Medicare benefits (known as an increase in the federal share of cost for CHIP “Cal MediConnect”); (2) mandatory enrollment from 65 percent to 88 percent from October 1, of dual eligibles into managed care for their 2015 through September 30, 2017. On a full-year Medi-Cal benefits; and (3) making Medi-Cal- basis, this results in General Fund savings of over funded long-term services and supports, including $600 million. There is also the potential for the In-Home Supportive Services (IHSS), available enhanced share to continue through September 30, exclusively through managed care. As part of 2019, if Congress appropriates additional funding. CCI, the state made several other major changes However, as funding for the enhanced share has to IHSS, including the creation of a county only been appropriated through September 30, maintenance-of-effort (MOE) requirement. (We 2017, our outlook assumes the higher amount of discuss this further in the write-up for our IHSS federal funding ends on September 30, 2017. outlook.) Enrollment for CCI began in April Outlook—Based on Current Policy—Assumes 2014 and will continue through July 2016. Over Loss of Offset From MCO Tax . . . The MCO 117,000 dual eligibles are currently enrolled in tax leverages federal Medicaid funds that offset Cal MediConnect, and the state continues to General Fund spending for Medi-Cal local implement the demonstration and plans to conduct assistance by over $1.1 billion in 2015-16. Under an evaluation at the end of the pilot. Current existing law, the tax expires on July 1, 2016. The law requires CCI to demonstrate net General federal government recently issued guidance that Fund savings—as estimated by the Department California’s current MCO tax is likely incompatible of Finance (DOF)—to remain operative each with federal Medicaid requirements. Therefore, fiscal year. Based on how DOF has performed the in order to continue having an MCO tax that calculation in prior fiscal years, it appears CCI is at leverages federal funds to offset General Fund costs risk of failing to meet this current-law requirement beyond 2015-16, the state would have to enact a in 2016-17 due to the assumed loss of associated new, restructured tax that complies with federal MCO tax revenue and the remaining upfront requirements. While the Legislature has considered costs of implementation. Notwithstanding these different approaches to structuring a permissible near-term factors that make achieving net savings MCO tax that generates $1.1 billion in General challenging in 2016-17, we estimate that after the Fund offset, to date it has not enacted legislation to upfront costs are fully phased out by 2017-18, CCI authorize such a replacement. Our outlook assumes has the potential to generate ongoing General Fund the current tax expires at the statutory deadline savings in Medi-Cal over the longer term up to without replacement. In 2016-17 and future years, the low hundreds of millions of dollars annually— this assumption leads to a $1.1 billion increase in even without the MCO tax. Given the current Medi-Cal General Fund spending compared to implementation status of CCI and the potential for 2015-16. savings in future years, we assume CCI continues . . . But Continuation of Coordinated Care to be implemented throughout the outlook period. Initiative (CCI). The CCI is a seven-county demonstration project consisting of three main www.lao.ca.gov Legislative Analyst’s Office 35 2016-17 BUDGET In-Home Supportive Services may work per week and grants the Department of Social Services the authority to terminate the General Fund expenditures for IHSS are provider for continued violation of the hour limits. estimated to be $2.8 billion in 2015-16, and remain For the three months following the expected at about the same level in 2016-17. Beginning in February 1, 2016 implementation date, however, 2017-18, we project that IHSS expenditures will state law authorizes a “non-enforcement period,” increase by about $100 million annually—reaching during which these statutory requirements will not over $3.1 billion by 2019-20. The primary drivers of be enforced. That is, during the non-enforcement increasing costs in IHSS over the outlook period are period, providers who work beyond the statutory caseload growth (which we project to be 4 percent limits will be compensated for the overtime per year) and two primary factors exerting upward worked and the department will not consider this pressure on IHSS providers’ compensation. These to be a violation of the hour limits. Although the factors are: (1) compliance with new federal labor funding included in the 2015-16 budget assumed an regulations that require the state to pay overtime October 2015 implementation start date, at the time compensation and for other newly compensable of this publication, it is unclear whether delayed work activities, and (2) anticipated wage and implementation to February 2016 would result in benefit increases for IHSS providers negotiated one-time General Fund savings in 2015-16. This is through the collective bargaining process and because there is uncertainty surrounding whether through a statutory minimum wage increase. the state would ultimately be responsible for The level spending estimated between 2015-16 retroactively compensating providers for overtime and 2016-17 is the result of these increasing costs worked prior to February 2016. Additionally, if being offset by two main factors: (1) the assumed the state is required to retroactively compensate elimination of General Fund spending authorized providers and the non-enforcement period lasts on a one-time basis in the 2015-16 budget to restore longer than anticipated, IHSS program costs the service hours associated with the previously could be higher than we project in 2015-16. Due enacted 7 percent reduction in IHSS hours, and to the uncertainty surrounding implementation, (2) estimated annual increases in the county our projections do not include one-time savings contribution to the IHSS program that reduce the from delayed implementation. We estimate that state share of cost in IHSS. complying with new federal regulations affecting Compliance With New Federal Labor IHSS providers will be about $360 million annually, Regulations Increases Costs. The 2015-16 budget once fully implemented in 2016-17. included partial-year funding to implement new Future Wage and Benefit Increases. The federal labor regulations that require states to state’s minimum wage is set to increase from $9 (1) pay overtime compensation to IHSS providers to $10 beginning January 1, 2016, at an estimated for all hours worked that exceed 40 in a week, annual General Fund cost of about $72 million. and (2) compensate IHSS providers for time In addition, we project that provider wages and spent waiting during medical appointments and benefits will grow through the collective bargaining traveling between the homes of IHSS recipients. process. Currently, most counties negotiate wages These regulations were challenged in federal court, and benefits at the county level. By the end of but were ultimately validated and are expected to 2016-17, however, the seven counties participating begin implementation on February 1, 2016. Current in the CCI will have transitioned to statewide state law limits the number of hours a provider 36 Legislative Analyst’s Office www.lao.ca.gov 2016-17 BUDGET collective bargaining. If statewide collective in place prior to CCI—about 35 percent of the bargaining in CCI counties leads to faster wage nonfederal share of IHSS program costs. This and benefit growth in these counties, then IHSS increase in county contributions to IHSS costs program costs could be higher than our outlook could decrease our projected state share of cost projects. for the IHSS program by hundreds of millions of Ongoing Funding Source to Restore Hours dollars annually in the out-years. From Prior-Year 7 Percent Reduction of Hours Developmental Services Uncertain. Because the General Fund monies included in the 2015-16 budget to restore IHSS We estimate that General Fund spending service hours that had been reduced by 7 percent for the Department of Developmental Services in prior-year budget reductions were one-time in (DDS) will total about $3.5 billion in 2015-16. nature, our projections assume the elimination of We project that expenditures will increase by this one-time General Fund spending in 2016-17— about $50 million in 2016-17 and reach a total resulting in annual General Fund savings of of about $3.7 billion by 2017-18. These projected approximately $230 million. Both the Legislature expenditure increases are mostly due to cost and the Governor have stated their intent to increases for community services resulting from continue this restoration of service hours beyond (1) a growing caseload (we project 3.5 percent 2015-16 with the use of an alternative funding annual growth) and (2) increased costs per source. If an alternative funding source is not found consumer. The increased costs per consumer in in 2016-17, and the Legislature chooses to again the community are higher due in part to changes support the 7 percent restoration with General in service utilization, the full-year impacts of the Fund, the cost would be about $230 million per state’s minimum wage increase (effective January year (growing with caseload increases in the 2016), as well as compliance with new federal labor out-years). regulations regarding overtime pay for home care Current County Costs of IHSS Tied to CCI. As workers. These estimated expenditure increases discussed in the Medi-Cal section of this report, are partially offset by three main factors. First, we assume CCI continues to be implemented we assume reduced costs in DDS for the purchase throughout the outlook period. We noted, however, of Behavioral Health Treatment (BHT) services. that CCI is at risk of failing to meet a current-law Medi-Cal managed care plans began providing requirement to annually demonstrate net General these services to beneficiaries in September 2014. Fund savings in 2016-17. Should CCI be unwound For existing consumers receiving BHT services because of this, there are implications for IHSS. covered by DDS, we assume these benefits will Specifically, the end of CCI would also eliminate instead be provided by Medi-Cal managed care the IHSS county MOE requirement. The county plans and expenditures will transition to the MOE generally sets counties’ contributions to Department of Health Care Services budget IHSS at their 2011-12 levels, and increases the starting in the spring of 2016. Second, we assume contributions annually by 3.5 percent plus a share reductions in spending for developmental centers of any wages and benefits subsequently negotiated (DCs) as a result of individuals transitioning at the county level. If CCI and the county MOE from the DCs to the community, including all become inoperative, counties’ contributions to consumers at Sonoma DC by the end of 2018 due to IHSS would return to the contribution levels the facility’s anticipated closure. The 2015-16 Budget www.lao.ca.gov Legislative Analyst’s Office 37 2016-17 BUDGET Act reflects the state’s intent to develop and initiate potential fiscal pressures that could drive further closure plans for the remaining DCs (with the spending not assumed in our outlook that could exception of the secure treatment area of Porterville be significant. In particular, compliance by DC), with the last closure planned for 2021. Finally, March 2019 with new federal requirements related we assume less spending in 2016-17 and ongoing to Medicaid-funded community-based services due to the one-time impact of about $62 million in could drive additional state spending. We have General Fund costs assumed in the 2015-16 Budget not accounted for these potential costs due to Act associated with prior-year shortfalls. the high level of uncertainty surrounding the Uncertain Federal Medicaid Funding for implementation of these new requirements and the DCs. We assume that DDS will maintain federal related fiscal impacts. Medicaid funding for most (22 of 26) of the SSI/SSP Intermediate Care Facility (ICF) living units at Sonoma, Porterville, and Fairview DCs that have State expenditures for SSI/SSP are estimated been found by the Department of Public Health to be $2.8 billion in 2015-16, increasing by about to be out of compliance with federal certification $40 million annually to reach an estimated total requirements. This assumption, however, is subject of nearly $3 billion by 2019-20. The projected to some uncertainty. The 2015-16 Budget Act spending increases are primarily due to average included General Fund spending to backfill lost annual caseload growth of about 1 percent. In federal funding associated with four decertified prior-year budget development processes, the ICF units at Sonoma DC, and our outlook assumes Legislature expressed interest in reinstating a the continuation of the General Fund backfill in state-funded cost-of-living adjustment (COLA) for subsequent years. However, the state entered into a SSI/SSP grant recipients. While we do not assume settlement agreement with the federal government, the provision of SSI/SSP grant increases over the effective June 30, 2015, to continue federal funding outlook period, we estimate that applying a state for up to two years related to the remaining COLA to the total SSI/SSP grant—as has been seven ICF units at Sonoma DC contingent on done in the past—would cost over $200 million DDS meeting several conditions. The state is in in 2016-17, increasing to the high hundreds of similar discussions with the federal government to millions of dollars by 2019-20 if applied annually. continue federal funding related to 15 decertified Alternately, if the Legislature chose to apply a ICF units at Fairview and Porterville DCs. If DDS state COLA exclusively to the state portion of the is unable to meet the requirements of the settlement grant, we estimate the COLA would cost about agreement or is unable to negotiate continued $60 million in 2016-17, increasing to approximately federal funding at the three DCs, then the state $300 million in 2019-20 if provided annually. The could lose additional federal Medicaid funding actual cost of providing a state SSI/SSP COLA is associated with the decertified ICF units over the uncertain and largely depends on the methodology outlook period. In such circumstances, the General used to provide the adjustment. Fund could be called upon to backfill the additional CalWORKs lost federal funding. Other Looming Fiscal Pressures. In addition General Fund Spending in CalWORKs to the potential loss of federal funds related Depends Both on Total Program Spending to decertified ICFs at the DCs, there are other and Funding Shifts. The CalWORKs program 38 Legislative Analyst’s Office www.lao.ca.gov 2016-17 BUDGET is funded from a combination of federal TANF years. These projected changes in total spending block grant funds, county funds (almost entirely from all funds reflect the combination of several consisting of revenues provided to counties factors that are described in greater detail below. through realignment), and the state General Fund. Net Savings From Generally Declining In general, the amount of General Fund budgeted Caseloads. The 2015-16 budget assumes that, in CalWORKs equals the difference between relative to 2014-15, the total number of families total estimated program spending requirements receiving CalWORKs assistance in 2015-16 will and other available funds. Because of this, decrease, while the number of adults eligible for year-over-year changes in General Fund support for employment services and the number of children the program reflect both changes in total program enrolled in Stage 1 child care will increase. Based costs as well as changes in the availability of other on recent caseload counts, we estimate that the funding sources. Accordingly, in this section, we decline in total families receiving assistance will first focus on the year-over-year changes in total be faster than estimated (we estimate an almost CalWORKs expenditures from all fund sources, 6 percent decline, while the budget act assumed as a focus solely on the General Fund would mask a roughly 2 percent decline) and that the number changes in the availability of other fund sources of adults eligible for employment services will that support program costs and growth. also decline—rather than increase as assumed Trends in Total Spending From All Funds. As in the 2015-16 budget. We also estimate that the shown in Figure 6, we estimate that total spending number of children enrolled in Stage 1 child from all funds in the CalWORKs program will care will increase in 2015-16 relative to the prior be $5.6 billion in 2015-16—roughly $90 million year, but by a lesser amount than assumed in the (1.6 percent) less than assumed in the 2015-16 2015-16 budget. Taken together, we estimate that Budget Act. This lower estimate primarily reflects a these caseload projections result in lower cash faster-than-expected decline in caseload. From this assistance, program administration, and services 2015-16 level, we project that total spending from costs of roughly $240 million (all funds) in 2015-16 all funds will further decrease by $270 million to relative to what was appropriated in the budget act. a total of about $5.3 billion in 2016-17, followed by Rather than reflect the full $240 million in savings gradual increases in total funding in the following in 2015-16, our outlook reflects only savings of Figure 6 Projected Total CalWORKs Program Funding (In Millions) 2015-16 2016-17 2017-18 2018-19 2019-20 TANF $2,779 $2,779 $2,779 $2,779 $2,779 Realignment funds dedicated to grant increases 287 341 450 514 603 Other realignment/county funds 1,937 1,934 1,932 1,931 1,931 General Fund 588 266 178 135 127 Totals $5,591 $5,320 $5,339 $5,359 $5,440 a Excludes Kin-GAP and TANF funds transferred to the California Student Aid Commission. b Dedicated funds provided from the 1991 realignment Child Poverty and Family Supplemental Support subaccount. c Includes funding from the 1991 realignment Family Support subaccount, the 1991 realignment CalWORKs MOE subaccount, and a 2.5 percent county share of cash assistance costs. TANF = Temporary Assistance for Needy Families and MOE = maintenance of effort. www.lao.ca.gov Legislative Analyst’s Office 39 2016-17 BUDGET about $90 million from a reduced cash assistance of available dedicated funds. These unmet costs caseload. This is because we assume, consistent have been paid for from the General Fund. As the with state practice, that the remaining $150 million amount of dedicated funds has grown each year, in savings—part of funds already allocated to the General Fund share of the cost of the prior counties for program administration and services grant increases has diminished. We estimate that in 2015-16—will remain with counties in 2015-16, dedicated realignment funds will fully support but not be spent and ultimately revert to the state in the prior grant increases beginning in 2016-17, the later years of our outlook. On an ongoing basis, fully offsetting the remaining General Fund our outlook incorporates the full $240 million in contribution, with a limited amount of dedicated savings beginning in 2016-17. funds remaining to potentially provide an Under our main scenario of continued additional (likely small) grant increase in October moderate economic growth and declining 2016. As shown in Figure 6, we estimate that unemployment, we estimate that the total number dedicated realignment funds will continue to grow of families receiving CalWORKs assistance and the in the following years, increasing total program number of adults eligible for employment services spending over time and allowing for annual grant will continue to decline—by roughly 3 percent increases in the range of around 2 percent or in 2016-17 and progressively smaller amounts 3 percent annually. in later years. Based on recent data that suggest We note that the amount of dedicated Stage 1 child care utilization may be increasing revenues available in future years for CalWORKs among families with adults eligible for employment grant increases depends on many factors and is services, we estimate that the number of children uncertain. As discussed in the Medi-Cal and IHSS enrolled in Stage 1 child care will continue to write-ups in this report, our projections assume gradually increase through 2019-20, resulting in that the CCI and the related county MOE in IHSS slowly growing child care costs that will slightly will continue throughout the outlook period. We offset cash assistance and employment services noted, however, that CCI is at risk of failing to meet savings. On net, we project additional caseload a current-law requirement to annually demonstrate savings beyond those identified in 2015-16 of net General Fund savings in 2016-17. Should CCI about $120 million (all funds) in 2016-17, with be unwound because of this, the IHSS county progressively smaller amounts of caseload savings MOE would also be eliminated. If the IHSS MOE in following years through the end of 2019-20. were ended, changes in county costs would result New Grant Increases From Dedicated Funds. in complex interactions among 1991 realignment Beginning in 2013-14, a portion of growth revenues funding formulas that could reduce or eliminate provided to counties under 1991 realignment have further growth in funds dedicated to CalWORKs been redirected to provide a dedicated funding grant increases in the later years of our outlook. source for future CalWORKs grant increases. Net Savings From Full-Year Effect of Under current law, grants are increased each Previously Enacted Policy Changes. Total program October by an amount that it is determined can spending from all funds will be affected in the near be supported on an ongoing basis by dedicated term by previously enacted policy changes that funds. Since 2013-14, two grant increases have been have not yet been fully implemented. We describe provided (each in the amount of 5 percent), the some of these major changes below. combined cost of which has exceeded the amount 40 Legislative Analyst’s Office www.lao.ca.gov 2016-17 BUDGET • Savings From 24-Month Time Clock. (1) federal TANF funds dedicated to CalWORKs The 2015-16 budget assumes $1 million will be flat, (2) realignment funds dedicated to in savings (all funds) from individuals grant increases will gradually increase each year as who have their cash assistance reduced described previously, and (3) other realignment and for failing to meet the program’s work county funds will be virtually flat. Although total requirement after exhausting the 24-month funding for the program remains relatively stable time clock. Our outlook assumes that these throughout the period of our outlook, significant savings will grow to an annual amount of savings accrue to the General Fund under these $20 million by the end of 2019-20. assumptions. Funding Constraints May Require Additional • Savings From Increased Minimum Wage. Fund Shifts to Realize General Fund Savings. The state’s minimum wage increased from Our outlook assumes that General Fund spending $8 per hour to $9 per hour in July 2014 and in CalWORKs will be reduced as displayed in is scheduled to further increase to $10 per Figure 6. However, we note that in practice, certain hour in January 2016. The 2015-16 Budget expenditures in CalWORKs (totaling roughly Act assumes savings in CalWORKs of $500 million) have historically been paid for from roughly $30 million (all funds) in 2015-16 the General Fund for various reasons. In light of from these minimum wage increases this historical practice, it may be difficult to reduce (increased wages can either result in lower General Fund support for CalWORKs to less than monthly cash grants or families leaving around $500 million in any given year. Should assistance). We estimate that savings the need to maintain a minimum level of General from the minimum wage will increase by Fund spending in CalWORKs arise, the state could roughly $15 million (all funds) in 2016-17 still achieve the savings assumed in our outlook to reflect a full year of implementation of by adjusting an existing funding arrangement the $10 per hour minimum wage. between CalWORKs and the California Student Aid Commission as follows: (1) General Fund • Costs From Increased Child Care spending would be maintained in CalWORKs Reimbursement Rates. As part of the as needed above the amounts assumed in our 2015-16 budget package, reimbursement outlook; (2) increased General Fund spending in rates for Stage 1 child care providers were CalWORKs would increase total program funding increased, effective October 2015. The levels above projected current law needs, freeing up 2015-16 budget assumes partial-year costs TANF funds for other purposes; and (3) freed-up from the rate increases of $22 million TANF funds would be transferred to offset General (all funds) in 2015-16. We estimate that Fund spending in Cal Grants. This approach is the costs of the higher reimbursement consistent with recent state practice and would have rates will increase by roughly $7 million no net impact on total funding in either program in 2016-17 to reflect a full year of or on total General Fund spending as reflected in implementation. our outlook. Under Outlook Assumptions, Significant Savings Accrue to General Fund. As shown in Figure 6, throughout the outlook, we assume that www.lao.ca.gov Legislative Analyst’s Office 41 2016-17 BUDGET President’s Executive Actions on Immigration blocking the implementation of the executive action. If the U.S. Supreme Court decides to hear Outlook Assumes Executive Actions Not the case, there is the possibility that a decision Implemented. The President’s executive actions could be rendered before the term of the current on immigration allow certain undocumented federal administration ends, although this is immigrants to request deferred action status, uncertain.) Given the legal challenge, it appears which provides temporary relief from deportation unlikely the executive actions will be implemented and employment authorization. The 2015-16 in 2015-16. Therefore, our outlook assumes Budget Act included $26.7 million General Fund $23.2 million in General Fund savings in 2015-16 to account for potential caseload increases in HHS (some of the funding will be spent as a result of the programs, including Medi-Cal, IHSS, the Cash Legislature’s action to expand Medi-Cal coverage to Assistance Program for Immigrants, CalWORKs, undocumented children) and does not assume any and CalFresh. The executive actions have not yet spending associated with the executive actions for been implemented as a result of legal action. (As of the remainder of the outlook period. the publication date of this report, a federal appeals court had upheld the lower court’s injunction CORRECTIONS AND REHABILITATION General Fund spending for support of the penalties for certain offenders convicted of California Department of Corrections and nonserious and nonviolent property and drug Rehabilitation (CDCR) operations in 2015-16 is crimes, and allowed certain offenders who were estimated to be $9.5 billion, which is a net increase in prison for such crimes to apply for reduced of $31 million, or less than 1 percent, above the sentences. These changes have reduced the 2014-15 level of spending. This estimated increase state prison population and associated costs by primarily reflects additional costs related to (1) making fewer offenders eligible for prison (1) employee compensation, (2) increased staffing and (2) releasing certain resentenced offenders for the California Health Care Facility in Stockton, from prison. Our estimates above assume that and (3) the activation of new infill bed facilities Proposition 47 will result in savings to CDCR likely at Mule Creek prison in Ione and R.J. Donovan in the high tens of millions of dollars in 2015-16 prison in San Diego. These increases are largely and potentially exceeding $100 million annually offset by savings primarily related to a projected beginning in 2016-17. Under the measure, the decline in the prison population and the use of state savings resulting from its implementation out-of-state contract beds for inmates. We estimate (primarily related to impacts on the courts and that spending on CDCR will remain relatively flat prisons) will be used to provide additional funding in 2016-17. for various programs including mental health and Impact of Proposition 47. Proposition 47, substance abuse treatment, truancy prevention, and approved by voters in November 2014, reduced victim services beginning in 2016-17. 42 Legislative Analyst’s Office www.lao.ca.gov 2016-17 BUDGET EMPLOYEE COMPENSATION AND RETIREMENT COSTS In recent years, the state’s resumption of 95 percent of the state’s General Fund employee annual negotiated pay increases for many state compensation costs (such that each 1 percent employees, the Public Employees’ Pension Reform increase in their pay increases General Fund costs Act of 2013 (known as PEPRA), and the state’s by more than $100 million per year). Our main 2014 law to improve funding of the California scenario assumes that these employees, consistent State Teachers’ Retirement System (CalSTRS) with recent practice, receive annual pay increases all have affected state finances. As discussed equal to the rate of inflation and increased state below, our main scenario assumes continuation subsidies for health benefits so that the state’s of recent employee compensation practices, current share of employee health premium costs is pension funding policies, and current pension maintained. Taking into account pay and benefit system investment return assumptions through increases that have already been agreed to and the 2020. The state’s pension boards, however, are assumed future pay and benefit payment increases considering significant changes to these investment described above, the added General Fund costs in assumptions, and the Governor has proposed a 2016-17 would be about $320 million. By 2019-20, plan to prefund retiree health liabilities. Together, the cumulative increase in General Fund state these possible changes to the state’s retirement employee costs under this scenario would be funding policies, along with other factors, may about $1.4 billion above 2015-16 spending levels. increase state spending significantly above our The bulk of these increased costs result from the main scenario assumptions, as described below. assumed inflation-based pay increases. To the extent that ratified MOUs provide smaller or larger State Employee Pay compensation increases, these amounts would vary. and Benefits Rising Health Benefit Costs. In 2014-15, New Labor Contracts Expected in 2016. the state paid about $4 billion for employee and Much of the state’s employee compensation retiree health benefits: about $2 billion for active costs are determined by what is included in employees (about half from the General Fund) and labor agreements—referred to as memoranda of about $2 billion for retirees (nearly all paid initially understanding (MOUs)—between the state and its from the General Fund, with roughly half of the rank-and-file state employee bargaining units. The costs recovered from other funds). By 2019-20, we Legislature must ratify MOUs before they go into estimate that these costs will exceed $5 billion. effect, and the administration typically extends These growing costs result from increased similar pay increases to managers and supervisors. payments for health services, a growing retiree The Legislature may be asked to ratify 18 MOUs base, and the state’s past failure to fund retiree in 2016, including with 3 bargaining units with health benefits during employees’ working lives. MOUs that expired in 2015 and MOUs with 15 Proposed Retiree Health Prefunding Plan. In other units scheduled to expire in July 2016. The his 2015-16 budget plan, the Governor proposed rank-and-file and other employees associated with using the collective bargaining process to these 18 bargaining units represent more than implement a plan to prefund liabilities for retiree www.lao.ca.gov Legislative Analyst’s Office 43 2016-17 BUDGET health benefits. The plan would increase costs in the employer contributions. (To do this, the CalPERS near term in order to generate investment earnings staff plan proposes lowering the assumed rate of and reduce state costs in future decades. The return only after years with strong investment Governor proposed that the state and employees returns.) Such a plan would not necessarily increase each contribute about half of the “normal cost” to costs above our assumptions between now and prefund these benefits. This policy, if implemented, 2019-20. An alternative proposal by representatives could directly increase state General Fund costs of the Governor’s administration suggests that by a few hundred million dollars per year above CalPERS lower the assumed investment return the estimates reflected in this fiscal outlook. In assumption to 6.5 percent over about five years. addition to these direct costs, employee groups If CalPERS phased in a reduction in assumed could seek increases in pay or other benefits to investment returns over the next five years, the offset any portion of prefunding costs borne state’s General Fund contributions could increase by employees. (We have recommended that the by more than $1 billion above our main scenario Legislature review the administration’s proposal assumptions by the early 2020s, with additional with actuaries, health experts, employee groups, payments by other state funds. Lowered investment and others in detailed hearings prior to approving return assumptions could increase state costs any future prefunding proposals.) during some time periods, while the lowered risk of CalPERS Pension Costs Rising . . . In recent CalPERS’ investment portfolio could prevent some years, the state’s contribution rates to the California sharp investment declines and contribution spikes Public Employees’ Retirement System (CalPERS) in future decades. pension plans have increased due to investment CalSTRS losses during the recession and CalPERS’ decisions to change certain actuarial assumptions. Our State Contributions Ramp Up Through main scenario assumes the state’s contributions 2016-17. The 2014 CalSTRS funding plan to CalPERS will increase each year, with General increased contributions from the state, school Fund payments climbing above current levels by and community college districts, and teachers more than $200 million in 2016-17 and more than beginning in 2014-15. The funding plan aims to $700 million by 2019-20. That scenario assumes fully fund CalSTRS’ key pension program by the that CalPERS’ investment return and asset mid-2040s. Our main scenario reflects the state’s allocation policies are unchanged from what they contribution to CalSTRS ramping up through are currently. 2016-17 pursuant to its statutory schedule—from . . . But Could Rise Above Our Assumptions. $1.9 billion in 2015-16 to $2.5 billion in 2016-17, an Concerned with the system’s volatility and its increase of $533 million. changing demographics, the CalPERS board is State Contribution Decreases $740 Million in considering a plan to gradually lower its investment 2017-18 Under Main Scenario. The implementation return assumptions and lower the risk of its of the funding plan—while a reasonable investment allocations slowly over the next few interpretation of the law—differs from our earlier decades. The policy proposed by CalPERS staff understanding. Specifically, beginning in 2017-18, seeks to reduce the assumed return on investments CalSTRS will adjust the state contribution rate very gradually over two or more decades while based on the outcome of a complex calculation preventing large year-over-year increases in that estimates what CalSTRS’ unfunded liabilities 44 Legislative Analyst’s Office www.lao.ca.gov 2016-17 BUDGET would have been if the state made no changes to of its portfolio to less risky investments. It is the pension program since 1990. The calculation unclear whether this investment strategy or other makes the state’s share of CalSTRS’ unfunded factors will result in the CalSTRS board lowering liabilities very sensitive to changes in assets and its assumption concerning future investment liabilities. Mostly due to the large investment returns. If, however, the board votes to lower this return in 2013-14, the state’s share of CalSTRS’ assumption when it evaluates its actuarial practices unfunded liability has decreased from $20 billion in February 2016, the estimate of CalSTRS’ to $15 billion since the state embarked on the unfunded liabilities would increase substantially. funding plan. Accordingly, the state’s contribution Because the complex calculation used to determine declines from $2.5 billion in 2016-17 to $1.7 billion the state’s share of CalSTRS’ unfunded liabilities is in 2017-18 under our main scenario, a $740 million very sensitive to changes in assets and liabilities, the year-over-year decrease. Consistent with our past bulk of this increase would fall on the state. Should practice, this estimate assumes annual investment this scenario come to pass, state contributions to returns will equal CalSTRS’ long-term target of CalSTRS could be up to $1 billion higher than 7.5 percent beginning in 2015-16. reflected in our main scenario beginning in State Contribution Declines in 2017-18 Under 2017-18. (District contribution rates would remain Many Other Scenarios. Based on recent stock unchanged in the near term because they are fixed market trends, the 7.5 percent investment return in state statute through 2020-21.) assumed in our main scenario might be difficult State’s Share of Future Costs Seems Highly to achieve in 2015-16. Figure 7 compares our main Uncertain. As described above, state contributions scenario estimate for CalSTRS contributions to to CalSTRS under our main scenario would two alternate investment return scenarios for be $1.7 billion in 2017-18. If CalSTRS records a 2015-16—3.75 percent and 0 percent. (Because significant investment loss in the current fiscal year of the timing of actuarial valuations, the 2016-17 or they lower their investment return assumption, return will not factor into the initial adjustment of state contributions could be up to $1 billion higher the state contribution rate in 2017-18.) As shown in 2017-18. While CalSTRS has a right to change in the figure, the lower investment returns would its investment return assumptions and seems to reduce state savings beginning in 2017-18. be interpreting the 2014 funding law reasonably, it February 2016 Board Decision Might is unclear that the range of possible state funding Eliminate State Savings. On November 4, 2015, the outcomes discussed above reflect the intent of the CalSTRS board voted to gradually move 9 percent Legislature when it passed the law. Figure 7 State Contributions to CalSTRS Under Three Investment Scenarios for 2015-16a (In Billions) 2014-15 2015-16 2016-17 2017-18 2018-19 2019-20 7.5 percent (main scenario) $1.5 $1.9 $2.5 $1.7 $1.7 $1.7 3.75 percent 1.5 1.9 2.5 1.9 1.9 2.0 0 percent 1.5 1.9 2.5 2.0 2.2 2.3 a Scenarios reflect different assumptions for the 2015-16 investment return. All scenarios assume investment returns equal 7.5 percent each year thereafter. www.lao.ca.gov Legislative Analyst’s Office 45 2016-17 BUDGET UNEMPLOYMENT INSURANCE Interest Payments on Federal Loan. taxes or a decrease in benefits, that could be California’s Unemployment Insurance (UI) taken during the outlook period to address the Trust Fund has been insolvent since 2009, underlying structural mismatch between UI Trust requiring the state to borrow from the federal Fund revenues and expenditures and reduce the government to continue payment of UI benefits. state’s interest payment obligation to the federal California’s outstanding loan balance is estimated government. We note that, pursuant to federal to be $6.7 billion at the end of 2015. The state law, beginning in tax year 2011, the federal UI is required to make annual interest payments tax credit for which employers are eligible (up to on this loan. These General Fund interest costs 5.4 percentage points of the total 6 percent tax on total $171 million in 2015-16. Based on our main the first $7,000 in annual wages of each employee) scenario assumptions about the unemployment rate began to be reduced incrementally for each year the and the Employment Development Department’s state continues to have an outstanding federal loan projections of benefit payments and UI Trust to the UI Trust Fund. The increase in federal UI Fund revenues, the annual General Fund interest taxes paid by California employers due to the tax payments would decline in the following two credit reduction—estimated at $1.3 billion in 2015 years—from $122 million in 2016-17 to $65 million and increasing to as much as $2.4 billion in 2018— in 2017-18 (the year in which we estimate the loan is used to make principal payments that reduce the will be completely paid off). federal loan balance. (The state, however, remains Our projections do not incorporate any responsible to pay the interest payments on any potential actions, such as an increase in UI outstanding loan balance.) DEBT SERVICE ON INFRASTRUCTURE BONDS Debt-Service Ratio (DSR) Has Fluctuated state debt costs from the General Fund to special Over Time. The DSR—the ratio of annual General funds—such as in transportation. Fund spending on debt-service costs to annual DSR Expected to Remain About 5 Percent. General Fund revenues and transfers—is often We estimate that the DSR will remain about used as one indicator of the state’s debt burden. As 5 percent over the next several years. This is shown in Figure 8, the DSR has varied considerably because we project that General Fund revenues and in past decades between about 3 percent and debt-service costs will increase at roughly the same 6 percent. In the late 2000s, the DSR grew to about rate over the projection period. We assume that the 6 percent as large bond measures were approved state gradually sells bonds that have been approved and state revenues dropped due to a recession. by voters or the Legislature. These bonds include More recently, however, the DSR has declined some of the remaining unsold infrastructure to about 5 percent. The modest decline in the bonds that voters approved in 2006 and 2008, as DSR occurred for a variety of reasons, including well as a portion of the water bond approved in rebounding General Fund revenues, refinancing November 2014 (Proposition 1). We note that water of existing debt, and state policies shifting some bond sales are expected to occur over a number 46 Legislative Analyst’s Office www.lao.ca.gov Graphic Sign Off Secretary Analyst MPA Deputy 2016-17 BUDGET of years, so the water bond’s Figure 8 full annual debt-service Debt-Service Ratio costs will not occur until Expected to Remain Around 5 Percent after the forecast period. Our Percent of General Fund Revenues and Transfers Spent on Debt Service projections do not include 7% any additional debt-service Authorized, costs for new bonds that may but Unsold 6 be authorized by the voters 5 or the Legislature during the forecast period. 4 3 2 Bonds Already Sold 1 95-96 00-01 05-06 10-11 15-16 19-20 Projection ARTWORK #150572 Template_LAOReport_mid.ait www.lao.ca.gov Legislative Analyst’s Office 47 2016-17 BUDGET 48 Legislative Analyst’s Office www.lao.ca.gov 2016-17 BUDGET Chapter 4: The General Fund After 2016-17 In this chapter, we present the results of our budget outlook, including the alternative scenarios multiyear budget outlook. First, we describe the we discuss below. future condition of the General Fund budget under Key Definition: Operating Surpluses and our main scenario, which assumes the economy Deficits. In this chapter, we define operating grows through 2019-20. Because the economy will surpluses or deficits as increases or decreases in not grow indefinitely, we then present alternative the state’s total reserves each fiscal year in its two scenarios sketching the potential effects of an main reserve funds—the Budget Stabilization economic slowdown and a recession. We stress Account (BSA) and the Special Fund for Economic that these illustrative scenarios are meant to Uncertainties (SFEU). The SFEU is the state’s provide legislators a rough sense of future budget traditional General Fund budget reserve, the conditions under various economic scenarios. funds in which the Legislature may use for any Finally, we describe various non-economic risks purpose. The BSA is the rainy-day fund created that apply to all scenarios. The Appendix at the end by Proposition 58 (2004) and modified by of this chapter lists the key results of our multiyear Proposition 2 (2014). MAIN SCENARIO Operating Surpluses Assuming Continued increases or tax reductions—or building larger Economic Growth. Figure 1 (see next page) displays reserves. The “remaining operating surplus” bars operating surpluses under our main scenario. in Figure 1 suggest the General Fund could afford If current laws and policies remain in place, the more than $2 billion in additional annual budget General Fund would be in surplus through 2019-20. commitments, but only if the economy continues to BSA deposits would be available only for future grow as our main scenario assumes. Figure 2 (see budget emergencies, as defined by Proposition 2. next page) also summarizes the condition of the The remaining SFEU surplus would be available General Fund in our main scenario outlook. for new budget commitments—including spending ALTERNATE SCENARIOS Illustration of Outcomes if Economy Does Not 2019-20. If this occurred, it would represent the Grow Through 2019-20. As we discussed earlier, longest expansion in U.S. history. Given that some our main scenario assumes continued economic type of economic or stock market downturn is growth and modest stock market gains through possible during the outlook period, we assess the www.lao.ca.gov Legislative Analyst’s Office 49 Graphic Sign Off Secretary Analyst MPA Deputy 2016-17 BUDGET Slowdown Scenario Figure 1 State Still Has Operating Main Scenario: Operating Surpluses Surpluses, Though Much (In Billions) Smaller. Figure 3 displays the result of our economic $7 BSA Deposit slowdown scenario. Relative 6 Remaining Operating Surplusa to our main scenario, we 5 assume revenues are almost $30 billion lower over the 4 four fiscal years combined. 3 Specifically, revenues are 2 several billion dollars lower for the first two fiscal years, 1 $10 billion lower than the main scenario in the third 2016-17 2017-18 2018-19 2019-20 fiscal year, and begin to a Amount that can be allocated in budget or used to build addditional reserves. Note: Operating surplus defined as amount by which total reserves increase. recover in the final fiscal year BSA = Budget Stabilization Account. of the scenario. More than half of the revenue loss is budget’s ability to weather economic conditions offset by lower spending and reserve requirements that are worse than portrayedA inR oTuWr mOaRinK s c#e1n5ar0io5.7 2 under Propositions 98 and 2. In this way, these Specifically, we consider a hypothetical scenario in Template_LAOReport_mid.ait budget formulas serve as “automatic stabilizers” which economic growth slows down beginning in that mitigate revenue losses. This would, however, 2017 and another hypothetical scenario in which also mean that school and community college a recession occurs. The nearby box outlines the spending would be notably lower than under assumptions in these alternative scenarios. Figure 2 LAO General Fund Condition Under Main Scenarioa (In Billions) 2014-15 2015-16 2016-17 2017-18 2018-19 2019-20 Prior-year fund balance $5.3 $2.2 $3.2 $5.3 $10.3 $14.3 Revenues and transfers 112.2 116.3 123.2 128.8 131.3 134.5 Expenditures 115.3 115.3 121.1 123.8 127.3 130.6 Ending fund balance $2.2 $3.2 $5.3 $10.3 $14.3 $18.2 Encumbrances -1.0 -1.0 -1.0 -1.0 -1.0 -1.0 SFEU balance $1.2 $2.2 $4.3 $9.3 $13.3 $17.2 Reserves SFEU balance $1.2 $2.2 $4.3 $9.3 $13.3 $17.2 BSA balance 1.6 5.6 7.2 8.8 10.2 11.2 Total Reserves $2.8 $7.9 $11.5 $18.1 $23.4 $28.4 a Includes Education Protection Account created by Proposition 30 (2012). SFEU = Special Fund for Economic Uncertainties (the General Fund’s traditional budget reserve) and BSA = Budget Stabilization Account. 50 Legislative Analyst’s Office www.lao.ca.gov Graphic Sign Off Secretary Analyst MPA Deputy 2016-17 BUDGET our main scenario. While Figure 3 operating surpluses are Slowdown Scenario: Smaller Operating Surpluses much smaller than under our main scenario, total reserves (In Billions) remain above $10 billion in $7 each year over the period. 6 The budget is much better prepared to withstand an 5 economic slowdown than 4 it was even one year ago, 3 when we discussed a similar slowdown scenario in this 2 publication. 1 In the slowdown scenario described above, 2016-17 2017-18 2018-19 2019-20 we assume that no new Note: Operating surplus defined as amount by which total reserves increase. additional commitments are made in the 2016-17 an economic slowdown even if some additional budget. We also considered budget commitments are made next year. what would happen in this slowdown if we ARTWORK #150572 assume an additional $2 billion in ongoing budget Recession Scenario commitments are made beginning in 2016-17. This Template_LAOReport_mid.ait We next explored the potential effects of a would eliminate the small operating surpluses in recession approaching the severity of the dot.com 2018-19 and 2019-20 shown in Figure 3. While the bust of the early 2000s. Under this scenario, a state would have to use its reserves to cover deficits hypothetical recession begins in 2017, and revenues in those years, the total reserve balance would still are nearly $60 billion lower over the four fiscal be over $6 billion at the end of 2019-20. The budget, years combined. Specifically, revenues are a few therefore, appears to be in a position to withstand billion dollars lower than in the main scenario in Key Assumptions in Our Alternative Scenarios There are four inputs to these scenarios: revenues, Proposition 98, Proposition 2, and other spending. Relative to our main scenario, each alternative assumes lower personal income tax revenues, including lower revenues from capital gains. For the purposes of calculating the Proposition 98 minimum guarantee, we assume local property tax revenues are unchanged but assume slower growth in per capita personal income. These assumptions result in lower Proposition 98 spending. Similarly, lower capital gains taxes reduce Proposition 2 requirements. Lastly, because health and human services caseloads generally increase when the economy worsens, we assume higher net spending in these programs. www.lao.ca.gov Legislative Analyst’s Office 51 Graphic Sign Off Secretary Analyst MPA Deputy 2016-17 BUDGET 2016-17, $18 billion lower in Figure 4 2017-18, $20 billion lower Recession Scenario: in 2018-19, and $16 billion Reserves Cover Operating Deficits Until 2019-20 lower in 2019-20. As shown (In Billions) in Figure 4, deficits return $2 in 2017-18, but reserves are 1 sufficient to cover them 0 until 2019-20. In that year, -1 reserves cover roughly half -2 of the 2019-20 shortfall, -3 with actions necessary -4 to address a $2.4 billion -5 remaining budget problem. -6 Operating Deficit Covered by Reserves The budget fares well in this -7 Operating Deficit Not Covered by Reserves scenario because we assume -8 2016-17 2017-18 2018-19 2019-20 no new commitments in Note: Operating surplus (deficit) defined as amount by which total reserves increase (decrease). 2016-17, allowing the state to build over $9 billion in total reserves before the example, we considered what would happen in the major revenue losses occur in 2017-18. In addition, hypothetical recession if $2 billion in new, ongoing lower spending and reserve requirements under budget commitments were made in 2016-17. In Propositions 98 and 2 offset over half of this that case, the state would face operating deficits revenue loss. one fiscal year earlier than shown in Figure 4. By The budget outlook under the recession 2019-20, the state would face a roughly $7 billion scenario would be worse if the state makes new budget problem with no reserves. ARTWORK #150572 ongoing budget commitments in 2016-17. For Template_LAOReport_mid.ait RISKS Economic uncertainty is only one of many adopted a plan to gradually move a small part risks to consider in budgetary planning. We detail of their portfolio to less risky investments. If the some of these other risks below. boards determine that these investment strategies Pension Costs Could Be Billions Higher. or other factors should be accompanied by lower In recent months, the state’s two key pension investment return assumptions, combined state boards—California Public Employees’ Retirement contributions to CalPERS and CalSTRS could System (CalPERS) and California State Teachers’ be billions of dollars higher by 2019-20 than our Retirement System (CalSTRS)—have been estimates. The precise effect would depend on considering proposals to reduce risk in their (1) the magnitude of the change in assumptions, investment portfolios. CalPERS has yet to adopt and (2) how quickly these changes were a proposal. CalSTRS, on the other hand, recently implemented. While these changes could hurt the 52 Legislative Analyst’s Office www.lao.ca.gov 2016-17 BUDGET state budget over the next few years, they could to taxpayers or tax rate reductions in certain lower costs in future decades. circumstances. None of our scenarios assume Employee Compensation and Retiree rebates or tax reductions occur. Yet, there is a Health Costs Could Be Higher. Next year, the chance that either or both could occur before 2020. Legislature may be asked to ratify memoranda The state’s headroom under its complex spending of understanding with up to 18 bargaining units limit has fallen significantly in recent years. representing more than 95 percent of the state’s Further, larger balances in the SFEU could trigger General Fund employee compensation costs. sales tax reductions. The longer the economic Our main scenario assumes that these employees expansion and the larger the reserve balance grows receive pay increases based on increases in the cost in the SFEU, the greater the chance that tax rebates of living. Our estimates do not reflect, however, or reductions will occur before 2020. the Governor’s proposal to prefund retiree health Assumes State Prevails in Lawsuits. The state benefits through the bargaining process. This is involved in various lawsuits that pose risks to policy could increase General Fund costs by a our multiyear outlook. One case concerns the rules few hundred million dollars per year above the governing how corporations apportion income to estimates reflected in this report. (Some or all California for tax purposes. Another case concerns of these retirement costs could be paid using the state’s use of proceeds related to the 2012 Proposition 2 debt payment funds.) To the extent national mortgage settlement. Consistent with our that salary increases offset employees’ costs of past practice, we generally assume that the state prefunding, state costs could be even higher. prevails in these and other lawsuits. If the state is Assumes Revenue Provisions Not Triggered. unsuccessful in these cases, the potential budgetary California has three budgetary rules—a exposure could be in the hundreds of millions of constitutional spending limit passed in 1979 dollars in each case. and two sales tax statutes—that require rebates CONCLUSION Consider Trade-Offs When Weighing New choices about those programs later. While our Budget Commitments. As history cautions, main scenario indicates that the Legislature the current economic expansion will not last would have the capacity for some new one-time forever. If making it through the next economic or ongoing commitments in the 2016-17 budget, downturn with minimal disruption to public we advise the Legislature to weigh the merits of programs is a priority, a sizable reserve is the those new commitments against the potential for key. Less additional ongoing spending on public larger budget shortfalls when the next economic programs now probably would mean fewer difficult downturn occurs. www.lao.ca.gov Legislative Analyst’s Office 53 2016-17 BUDGET APPENDIX Comparing LAO Budget Outlook Scenarios General Fund and Education Protection Account Combined (In Millions) 2015-16 2016-17 2017-18 2018-19 2019-20 Revenues Total Revenues and Transfers (Before BSA Deposit) Main $120,350 $124,776 $130,339 $132,704 $135,506 Slowdown 120,350 122,276 121,339 122,704 128,006 Recession 120,350 120,776 112,339 112,704 119,506 Spending General Fund Spending Main $115,262 $121,119 $123,804 $127,345 $130,575 Slowdown 115,262 119,815 119,045 122,385 126,882 Recession 115,262 119,043 113,981 117,831 124,755 Proposition 98 Minimum Guarantee (General Fund and Local Property Taxes) Main $69,148 $71,447 $74,599 $75,825 $77,468 Slowdown 69,148 70,215 70,180 70,937 73,382 Recession 69,148 69,475 64,884 66,083 70,969 Proposition 98 General Fund Main $49,444 $50,213 $52,110 $52,376 $52,992 Slowdown 49,444 48,981 47,691 47,487 48,905 Recession 49,444 48,242 42,395 42,634 46,492 Total Reserves Main $7,880 $11,537 $18,072 $23,432 $28,363 Slowdowna 7,880 10,341 12,635 12,955 14,078 Recessiona 7,880 9,613 7,971 2,844 -2,405 a These scenarios implicity assume Proposition 2 budget emergency suspensions or withdrawals in some fiscal years. BSA = Budget Stabilization Account. 54 Legislative Analyst’s Office www.lao.ca.gov 2016-17 BUDGET LAO Publications The Legislative Analyst’s Office (LAO) is a nonpartisan office that provides fiscal and policy information and advice to the Legislature. To request publications call (916) 445-4656. This report and others, as well as an e-mail subscription service, are available on the LAO’s website at www.lao.ca.gov. The LAO is located at 925 L Street, Suite 1000, Sacramento, CA 95814. Legislative Analyst’s Office www.lao.ca.gov