The 2016-17 Budget: The Governor’s Reserve Proposal

The 2016-17 Budget: The Governor’s Reserve Proposal MAC TAYLOR • L E G I S L A T I V E A N A L Y S T • FEBRUARY 2016 Summary The Governor’s 2016-17 budget proposal reflects a state fiscal position that continues to improve. However, an economic downturn would result in the deterioration of this favorable situation, perhaps rapidly and in the near future. To help prepare the state for the next downturn, the Governor proposes building more reserves than are constitutionally required. In this publication, we summarize the administration’s estimate for constitutionally required reserve deposits in this year’s budget process. We then analyze the administration’s strategy for building additional reserves. While we concur with the Governor’s overall approach of building a robust level of total reserves, we find that his proposal to deposit optional amounts into the state’s rainy day fund would limit legislative control. At the same time, keeping optional amounts in the reserve over which the Legislature has more control could trigger tax provisions that would reduce reserves. To allow the Legislature to effectively build reserves while preserving legislative control we offer two alternatives: (1) create a new reserve fund, or (2) prepay some 2017-18 bond debt service. BACKGROUND State Has Two Budget Reserves. The state Legislature at any time can appropriate funds in the has two budget reserves: the Special Fund for SFEU for any purpose by majority vote. Unlike the Economic Uncertainties (SFEU) and the Budget SFEU, use of funds in the state’s rainy day fund— Stabilization Account (BSA). Both reserves help the BSA—is more restricted. The State Constitution insulate the budget from situations where revenues has specific rules regarding how and when the state underperform budget assumptions. The SFEU is must make deposits into or may make withdrawals the state’s discretionary budget reserve—that is, the from the BSA. 2016-17 BUDGET Budget Stabilization Account capital gains revenues are highly uncertain. This process attempts to align those original estimates Proposition 2. Proposition 2 (2014) establishes with actual revenues. Under these reevaluations, a minimum amount that the state must use to the state revises the BSA deposit up or down if build reserves and pay down debts each year. That excess capital gains taxes are higher or lower than amount is determined as follows. First, the state the state’s prior estimates. This year, as shown in must set aside 1.5 percent of General Fund revenues Figure 1, the state will make its first true-up deposit (we refer to this as the “base amount”). Second, for 2015-16, in addition to an initial deposit for the state must set aside a portion of capital gains 2016-17. The state does not revisit its estimate of revenues that exceed a specified threshold (we refer the base amount in the true-up calculation; it only to this as “excess capital gains”). The state combines revisits the excess capital gains component of the these two amounts and then allocates half of the estimate. In addition, the state does not adjust debt total to pay down eligible debts and the other half payments when new capital gains estimates are to increase the balance of the BSA. While debt available later, which means that all of the revised payments are mandatory, Proposition 2 allows estimate affects reserves rather than debt payments. the state to reduce reserve deposits in a “budget Constitutional Deposits Continue Until BSA emergency,” as we describe in more detail below. Reaches Maximum Size. Under Proposition 2, Budget Emergency Provisions Limit the state must put money into the BSA until its Legislative Control Over BSA Reserve. Under total reaches a maximum amount of 10 percent Proposition 2, the Legislature can only reduce of General Fund taxes. Currently, this maximum the BSA deposit, or make a withdrawal from the level is about $12 billion. Once the BSA reaches this BSA reserve, in the case of a budget emergency. A maximum, funds that would have been transferred budget emergency can only occur upon declaration into the BSA must be expended on building and by the Governor and majority votes of both maintaining infrastructure. houses of the Legislature. The Governor may call Administration’s Estimates for 2016-17 a budget emergency in two cases: (1) if estimated Required Reserves. The administration estimates resources in the current or upcoming fiscal year are that constitutionally required deposits into insufficient to keep spending at the level of the prior the BSA will total $2.6 billion in 2016-17. This three budgets, adjusted for inflation and population includes a $1 billion true-up deposit for 2015-16 (a “fiscal budget emergency”) or (2) in response and a $1.6 billion initial deposit for 2016-17. to a natural disaster. In the case of a fiscal budget These deposits would build on the BSA’s current emergency, the Legislature may only withdraw balance of $3.5 billion. The administration also the lesser of: (1) the amount needed to maintain estimates Proposition 2 will require $1.6 billion General Fund spending at the highest level of the in debt payments, which we will discuss in more past three enacted budget acts, or (2) 50 percent of detail in an upcoming publication. (We detail the the BSA balance. administration’s Proposition 2 estimates in the Constitution Requires “True Up” of BSA Appendix.) Deposits. Under Proposition 2’s true-up provisions, Estimates for 2016-17 Initial Deposit and the state reevaluates each year’s BSA deposit twice: 2015-16 True-Up Deposit Will Change. The once in each of the two subsequent budgets. The estimates of required BSA reserve deposits will state does this because initial estimates of future 2 Legislative Analyst’s Office www.lao.ca.gov 2016-17 BUDGET change when the administration releases its revised Moreover, the Legislature could use funds from the budget plan in May 2016. Moreover, during next SFEU to cover an unexpected increase in program year’s 2017-18 budget process, the state will revisit costs or to augment programs in a future budget. both of this year’s deposit estimates again in a The 2015-16 budget plan assumed 2015-16 would second true-up deposit for 2015-16 and a first end with a $1.1 billion SFEU reserve. true-up deposit for 2016-17. Large SFEU Balance Triggers Automatic Reserve Reductions. California has two statutes Special Fund for Economic Uncertainties that trigger reductions in the state’s sales tax rate SFEU Is the State’s Discretionary Reserve. if balances in the SFEU reach a certain threshold. Like the BSA, SFEU reserves help minimize actions Under either statute, the state’s sales tax rate would necessary to address a budget shortfall arising from automatically decline by one-quarter cent for revenues underperforming budget assumptions. one calendar year, equal to around $1.5 billion. Unlike the BSA, the Legislature can appropriate Under the first statute, the trigger would occur all funds in the SFEU at any time and for any if the Director of Finance projects the SFEU to purpose. That is, SFEU funds are not subject to the exceed about 4 percent of General Fund revenues restrictions that apply to the BSA. This means, for (currently, about $5 billion) in the prior and example, that the Legislature could use SFEU funds current year. Under the second statute, the trigger to cover a revenue shortfall that may be too small would occur if (1) the “General Fund reserve” to trigger Proposition 2’s fiscal budget emergency. exceeds about 3 percent of revenues (currently, Figure 1 Proposition 2 Provisions Relevant to 2016-17 Budget Process Initial Deposit for Upcoming True-Up Deposit for Current Fiscal Year (2016-17) Fiscal Year (2015-16) “Excess Capital Gains” Portion of capital gains revenues over 8% Excess Capital Gains of General Fund taxes Adjust capital gains estimate based on updated information. “Base Amount” If capital gains are higher, If capital gains are lower, 1.5% of General Fund revenues use new estimate to deposit use new estimate to withdraw additional funds into the BSA. funds from the BSA. 50% 50% 100% 100% Debt Payments Budget Stabilization Account Eligible debts include: Fill rainy-day reserve to 10% of General Fund taxes. (cid:127) Proposition 98 “settle up.” Thereafter, amounts that would otherwise be deposited (cid:127) Special fund loans. in the BSA must be spent on infrastructure. (cid:127) Pensions. (cid:127) Retiree health benefits. BSA = Budget Stabilization Account. www.lao.ca.gov Legislative Analyst’s Office 3 2016-17 BUDGET $4 billion) and (2) actual General Fund revenues to build discretionary reserves because, if the SFEU between May 1st and September 30th exceed the reaches one of these thresholds, its balance will administration’s forecasted amounts. These automatically shrink. provisions make it challenging for the Legislature GOVERNOR’S RESERVE PROPOSAL Governor Proposes Over $10 Billion in budget emergency. Second, the Legislature could Reserves. In addition to $4.6 billion in reserves only access up to half of these funds in the first year assumed in the 2015-16 budget, the administration of a budget emergency. Finally, this deposit would estimates that constitutionally required deposits in be subject to the maximum reserve level for the the 2016-17 budget process will total $2.6 billion. BSA. Under these assumptions, the Legislature enters Governor Proposes Using $2 Billion Optional the 2016-17 budget process with an estimated BSA Deposit in Case of Future True Ups. The $7.1 billion in required reserves. In addition to Governor proposes that the Legislature use the these balances, the Governor proposes increasing $2 billion optional BSA deposit for meeting reserve reserves by an optional $3.1 billion. This includes requirements for 2015-16 and 2016-17 that exceed an increase in the balance of the SFEU by current estimates. That is, these funds would be $1.1 billion and an optional deposit of $2 billion available in the June 2015 budget plan or in future into the BSA. Under the Governor’s proposal, budgets to cover higher BSA deposit requirements. the SFEU balance would grow to $2.2 billion. If future revisions and true ups are less than Meanwhile, the BSA balance would grow to $2 billion, the administration proposes that the $8 billion, $4 billion below the current maximum outstanding funds remain in the BSA. BSA balance. As shown in Figure 2, under the Governor’s plan, by the end of 2016-17 reserves Figure 2 would total $10.2 billion. Governor Proposes Reserves of Over $10 Billion Optional $2 Billion (In Billions) Deposit Subject to Reserves Assumed in 2015-16 Budget $4.6 Proposition 2 Rules. Required Reserves Under the Governor’s BSA true-up deposit for 2015-16 $1.0 BSA initial deposit for 2016-17 1.6 proposal, the $2 billion Subtotal, Required Reserves ($2.6) optional BSA deposit Optional Reserves would be subject to the 2016-17 proposed increase in SFEU $1.1 rules of Proposition 2. 2016-17 additional BSA deposit 2.0 Subtotal, Optional Reserves ($3.1) First, this deposit would Total Reserve Balances $10.2 be accessible only in a BSA = Budget Stabilization Account and SFEU = Special Fund for Economic Uncertainties. 4 Legislative Analyst’s Office www.lao.ca.gov 2016-17 BUDGET LAO COMMENTS Governor’s Proposal However, the Governor’s proposal to deposit an additional $2 billion into the BSA would limit the Placing Additional $2 Billion in BSA Would Legislature’s control over those funds. Normally, Limit Legislative Control. As we noted above, leaving these additional funds in the SFEU would once the Legislature deposits funds into the BSA, be one logical alternative to this proposal. As we it may only access those funds if specific budget have noted, however, a large SFEU balance would emergency conditions exist and the Governor calls trigger automatic reductions in that reserve. Given a budget emergency. Moreover, even in the case of this constraint, and if the Legislature wishes to use a budget emergency, the amount of a withdrawal these funds to build more reserves, we offer two may not exceed 50 percent of the BSA balance alternatives below that would allow the Legislature in the first year. These requirements limit the to build more reserves while preserving legislative Legislature’s ability to access these funds for small control. revenue shortfalls that do not trigger a budget Create New Reserve Fund. Rather than emergency, unanticipated expenditure increases, depositing additional funds into the BSA or or for any other legislative priorities. Moreover, if leaving them in the SFEU, the Legislature could the conditions for a budget emergency exist but the create a new reserve fund. The Legislature could Governor chooses not to call a budget emergency, determine the rules for the use of these funds as it the Legislature would be precluded from accessing considers appropriate, including whether the new any portion of the funds. reserve should be counted in the sales tax trigger Unclear True Ups Can Be Prefunded in the calculations. Like the Governor’s proposal, the BSA. Proposition 2 does not envision prefunding Legislature could apply these funds toward meeting future true ups using existing BSA balances. future true-up requirements, but still maintain Rather, the provisions of Proposition 2 state that flexibility over when and how to use them in the true-up deposits are transferred from the General future. Fund. Given these constitutional rules, it is not at Use Additional Funds to Prepay Some 2017-18 all clear that the Constitution allows for true ups Bond Debt Service. Each year, the state must pay to be prefunded in the BSA as the administration debt service on its outstanding bonds. For example, proposes. If the Legislature accepts the Governor’s the 2015-16 budget provided about $5 billion from proposal but later is unable to use BSA balances for the General Fund for general obligation bond true ups, the Legislature may be forced to use even debt service this fiscal year. Under this option, more discretionary resources for future true-up the Legislature could use $2 billion—or any deposits. other amount that it considers appropriate—to Alternatives prepay a portion of the 2017-18 bond debt service. Prepaying debt service in this way would free up Consider Other Options for Additional a like amount of resources in the 2017-18 budget. Reserves. The Governor’s emphasis on reserves During the 2017-18 budget process, the Legislature in this budget is appropriate. Prioritizing reserves would have the choice to either continue to prepay now will help the state weather the next recession a portion of an additional year of debt service with minimal disruption to public programs. (2018-19)—that is, defer the savings another www.lao.ca.gov Legislative Analyst’s Office 5 2016-17 BUDGET year—or to use the savings in the 2017-18 budget option would preserve legislative control over these for any legislative priority. As with the alternative funds while retaining them for the state’s future above, the funds could also be used to meet future needs, should revenues unexpectedly decline. true-up requirements. Similar to a reserve, this CONCLUSION Establish a Reserve Target. The Governor encourage the Legislature to adopt a robust target has proposed a $10 billion reserve for the end of for budget reserves for the end of 2016-17. 2016-17. We encourage the Legislature to establish Maximize Legislative Control. After the its own target for budget reserves for the end of Legislature determines its target level of budget 2016-17, and the Governor’s reserve level is a good reserves for the end of 2016-17, we advise it to starting point. There is, however, no “right” level prioritize legislative control in deciding where to of reserves. In determining its reserve target, the keep its reserves. There are trade-offs associated Legislature will want to consider its own priorities with reserving additional funds in either the SFEU and its own determination of the future likelihood or the BSA. The Legislature has limited control and magnitude of an economic downturn. over funds in the BSA. Meanwhile, leaving reserves Plan for Unforeseeable Budgetary Risks. in the SFEU may limit the Legislature’s ability to California has enjoyed remarkable economic build discretionary reserve balances. In this report, growth over the past several years and its budget we have outlined two alternatives for building position continues to improve. However, the state additional reserves. These alternatives would allow may be reaching the end of this long economic the Legislature to effectively build reserves in expansion. Given the state’s volatile revenue preparation for the next economic downturn while structure and other unforeseeable risks, we preserving legislative control. 6 Legislative Analyst’s Office www.lao.ca.gov 2016-17 BUDGET APPENDIX Administration Figure A1 Estimates Proposition 2 Summary of Administration’s Requirements for 2016-17 Proposition 2 Requirements 2016-17 Are $3.1 Billion. Figure A1 summarizes (In Millions) the administration’s Base amount $1,863 Proposition 2 estimates. Excess capital gains captured by Proposition 2 1,249 Totals, Proposition 2 Requirement $3,112 There are two components Deposit into Budget Stabilization Account $1,556 that determine the Debt payments 1,556 total Proposition 2 requirements each year. Administration Estimates $1 Billion True-Up First, the base amount is equal to 1.5 percent Requirement for 2015-16. Under Proposition 2’s of General Fund revenues and transfers. The true-up provisions, the state reevaluates each year’s administration estimates this amount to be initial BSA deposit twice: once in each of the two $1.9 billion. Second, excess capital gains equal subsequent budgets. Under these reevaluations, the capital gains taxes exceeding 8 percent of General state revises the BSA deposit up (or down) if excess Fund taxes, minus the amount by which those capital gains taxes are higher (or lower) than the revenues increase the Proposition 98 minimum state’s prior estimates. In other words, if the initial guarantee. The administration estimates that estimate was too low, the Legislature must make $1.2 billion in excess capital gains will be captured an additional BSA deposit, whereas if the estimate by Proposition 2 in 2016-17. As shown in the figure, was too high, the difference is transferred back the administration estimates the total Proposition 2 into the General Fund. As shown in Figure A2, requirement in 2016-17 is $3.1 billion. Of this total, the administration estimates that Proposition 2 half would be deposited into the BSA while the requires the state to make a $995 million true-up other half must be allocated to pay down eligible deposit into the BSA in the 2016-17 budget. debts. Figure A2 Administration’s Estimates of Proposition 2 True Up for 2015-16 (In Millions) Total taxes from capital gains $13,377 Amount equal to 8 percent of all General Fund taxes -9,616 Subtotal, Capital Gains Taxes Over 8 Percent Threshold ($3,761) Less Proposition 98 share -$810 Subtotal, Excess Capital Gains Captured by Proposition 2 ($2,951) Less capital gains portion of debt appropriations made in 2015-16 budget -$978 Less capital gains portion of previous BSA deposit -978 Total, True-Up Deposit Into the BSA $995 BSA = Budget Stabilization Account. www.lao.ca.gov Legislative Analyst’s Office 7 2016-17 BUDGET Administration’s Estimates for 2016-17 In addition, the Governor proposes an optional Required Reserves. Under the administration’s $2 billion BSA deposit. As shown in Figure A3, estimates, the state would deposit $2.6 billion into these deposits would together bring the estimated the BSA reserve in 2016-17. This consists of the BSA balance to about $8 billion by the end of $1.6 billion deposit for 2016-17 and the $995 million 2016-17. true-up deposit for Figure A3 2015-16 described above. Governor Proposes BSA Reserve of $8 Billion Combined with the $1.6 billion BSA deposit (In Billions) made in 2014-15, and Pre-Proposition 2 balance $1.6 2015-16 Budget Act deposit 1.9 the $1.9 billion deposit 2015-16 true-up deposit (estimated) 1.0 made in the June 2015 2016-17 Budget Act deposit (estimated) 1.6 budget package, the BSA Total Required BSA Estimated Balance $6.0 would end 2016-17 with 2016-17 optional deposit (proposed) $2.0 a $6 billion balance. Total Proposed BSA Balance $8.0 BSA = Budget Stabilization Account. LAO Publications This brief was prepared by Ann Hollingshead and reviewed by Ryan Miller. The Legislative Analyst’s Office (LAO) is a nonpartisan office that provides fiscal and policy information and advice to the Legislature. To request publications call (916) 445-4656. This brief and others, as well as an e-mail subscription service, are available on the LAO’s website at www.lao.ca.gov. The LAO is located at 925 L Street, Suite 1000, Sacramento, CA 95814. 8 Legislative Analyst’s Office www.lao.ca.gov