Building Reserves to Prepare for a Recession

Building Reserves to Prepare for a Recession MAC TAYLOR LEGISLATIVE ANALYST MARCH 7, 2018 analysis full gutter 2018-19 BUDGET Cover Photo: The cover photo image was provided courtesy of Cameron Stone Adams. LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2018-19 BUDGET Executive Summary The Role of Reserves in Preparing for a Recession. Reserves are of critical importance to the health of the state’s budget. In the face of the next recession, these funds will help cushion the impact of the budget problem that emerges. Consequently, setting the level of reserves is one of the Legislature’s most important decisions as it crafts the annual state budget. There is no such thing as an objectively “right” level of budget reserves, so this report provides a framework, with a set of factors, that the Legislature can use to determine its target. Recessions and Budget Problems Revenue Losses. California’s tax structure is quite volatile. Revenues fluctuate in response to underlying changes in the economy and stock market more than most other states. The figure below shows revenue losses over the past three recessions—which have totaled in the tens of billions of dollars over multiyear periods. The Great Recession was the most severe. However, even the dot-com bust in the early 2000s, which in economic terms was more moderate, led to over $80 billion in losses. Budget Problem. A budget problem represents the amount by which expenditures exceed revenues in a given year. A budget problem is not the same as a revenue loss. That is because some state expenditures adjust automatically to changing revenue conditions, in general offsetting losses. We estimate that, on average, automatic adjustments offset roughly half of an initial revenue loss. To put this in more concrete but very rough terms, a moderate recession, like the dot-com bust, could lead to a $40 billion budget problem. A more mild recession might result in a $20 billion budget problem. Planning for a Recession Framework to Plan for a Recession. In this report, we present a framework to help the Legislature plan for the next recession. First, we suggest the Legislature consider the size of the recession for which it would Annual Estimated Tax Revenue Losses by Recession Inflation Adjusted, in 2017-18 Dollars (In Billions) -5 -10 -15 Early 1990s Recession -20 -25 -30 Dot-Com Bust Great Recession -35 -$40 1989-90 1994-95 1999-00 2004-05 2009-10 2014-15 www.lao.ca.gov 1 analysis full gutter 2018-19 BUDGET like to prepare. Second, we suggest the Legislature consider how it would like to respond. As shown in the figure below, there are basically two means: (1) tools that allow the state to prepare in advance of a recession and (2) actions the state must take during a recession. In particular, in preparation for a recession, the state can build budget reserves and spend money on a one-time basis. These actions reduce the size of a potential budget problem later. During a recession, if a budget problem persists, the state must take actions to address it. These actions include spending cuts, revenue increases, and cost shifts. Together, the sum of all these responses equals the size of the budget problem. Reserves This Year Governor Proposes Nearly $16 Billion in Reserves. In his 2018-19 budget plan, the Governor proposes the state enact a reserve level of $15.7 billion, the highest in recent decades. The Governor executes this proposal by making an optional $3.5 billion deposit into the state’s rainy day fund, bringing it to its constitutional maximum. While the Governor’s proposed level would be historic for California, it is not particularly remarkable by national standards. Is the State Adequately Prepared for the Next Recession? For context, this level of reserves would allow the state to weather a mild recession with nearly no additional actions. However, if the state faced a moderate recession with this level of reserves, it would also have to take roughly $25 billion in actions to address a budget problem, including spending cuts, revenue increases, and cost shifts. The Governor’s reserve proposal, therefore, raises fundamental questions about the state’s current—and potential future—level of reserves. In particular: Is the Legislature satisfied with this level of preparation for the next recession? Governor’s Proposal, Counterintuitively, Makes Building More Reserves More Difficult. Given all of the uncertainties that the budget currently faces, we think the Governor’s proposed level of reserves is a reasonable minimum. However, the specifics of the Governor’s reserve proposal—counterintuitively—make building more reserves in the future more difficult. That is because reaching the rainy day fund’s maximum level means that funds which would have been deposited into reserves must instead be spent on infrastructure. This lowers the amount of resources available for building more reserves in the future by roughly $1 billion per year. Alternatives to Build More Reserves. As such, if the Legislature’s target level How the State Addresses a Budget Problem of reserves for this year, or a future year, is greater than $16 billion, it might consider using another more effective way Problem Budget Problem to build reserves. In this report, we offer some alternatives for consideration that would help the Legislature build more reserves equal to than the Governor is currently proposing. These include options Tools to Prepare Actions to Take for a Recession During a Recession outside of the rainy day fund, as well as other budgetary tools that Solutions One-time • Spending reductions Budget reserves • Revenue increases have the same key attributes of spending • Cost shifts reserves. Relative to what the Governor now proposes, using Note: The relative sizes of the boxes above are illustrative. The state can choose one of these alternatives would any allocation of reserves, other tools, and actions to address a budget problem. help make the state even better prepared for a coming recession. 2 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2018-19 BUDGET INTRODUCTION In his 2018-19 budget plan, the Governor proposes This report first describes how a recession leads a total reserve balance of nearly $16 billion, including to a budget problem—the primary reason the state a discretionary deposit of $3.5 billion into the state’s holds budget reserves. Next, it describes California’s rainy day fund. This proposed deposit would fill the policies and practices on reserves. Then, the report reserve to its constitutional maximum level. This action presents the Governor’s reserve proposal for the raises an important question for the Legislature to now 2018-19 budget and considers the proposed level consider: Does the currently proposed level of reserves both historically and among other states nationally. sufficiently prepare the state for the next recession? Next, to aid the Legislature as it evaluates the Setting the budget’s level of reserves is one of the Governor’s proposal, the report presents a framework Legislature’s most important decisions as it crafts that the Legislature can use to plan for a recession the annual state budget. As there is no such thing and determine a target level of reserves. Finally, we as an objectively “right” level of budget reserves, the conclude with our office’s comments on the Governor’s Legislature’s target each year can depend on a variety proposed level of reserves in light of this framework and of factors. In this report, we present a framework for present some alternatives for legislative consideration. the Legislature to use to determine its target level of reserves using a set of specific and measurable factors. HOW A RECESSION LEADS TO A BUDGET PROBLEM Budget reserves help cushion the impact of budget tax on most sources of individual income, including: problems—that is, when revenues are insufficient to salaries and wages, proprietor and partnership income, cover expenditures. The primary reason the state would capital gains, dividends and interest, and retirement face such a shortfall is due to an economic recession. distributions. As Figure 1 (see next page) shows, the (As described in the box on page 6, the state also PIT makes up almost 70 percent of state General can use budget reserves to cover the cost of large Fund revenues. The sales and use tax (SUT)—which unanticipated, one-time expenses.) In this section, we is levied on most tangible personal property sold and describe how a recession leads to a budget problem. used in California—is the second largest General Fund First, we describe how recessions affect state revenues, revenue source. The corporation tax, which is levied quantifying the revenue losses that have occurred in on corporate income, is the third. Although all three of recent downturns. Then, we describe how recessions the largest General Fund revenue sources have grown tend to affect state expenditures. The net of these two over time, the SUT has declined significantly as a share factors is the size of the state’s “budget problem.” of overall General Fund revenues. This decline has occurred in large part because the prices of services Recessions and Revenue Declines (such as health care), which are not subject to the sales Recessions are technically defined as six months of tax, have grown faster than the prices of goods. decline in a country’s gross domestic product (GDP), a PIT Experiences Large Losses During Downturns, broad measure of the size of an economy. Recessions Increases During Expansions. Personal income are often characterized by rising unemployment rates grows each year when the economy is expanding and losses in asset markets (for example, stocks and and either shrinks or grows more slowly when the real estate). Below, we describe how recessions affect economy is not growing. As a result, the growth rate state revenues, with a focus on revenue losses that of PIT revenue fluctuates from year to year. Figure 2 have occurred in recent recessions. (see next page) shows that revenues associated with Personal Income Tax Is Dominant State Revenue the PIT experience more significant year-over-year Source. The personal income tax (PIT) is the state’s changes than personal income itself. There are a variety www.lao.ca.gov 3 analysis full gutter 2018-19 BUDGET Revenue Losses Associated Figure 1 With Past Recessions. Figure 3 Personal Income Tax Is the shows estimates of tax revenue Dominant State Revenue Source losses associated with each of the All General Fund Tax Revenues last three recessions: the recession of the early 1990s, the dot-com bust 70% and ensuing recession in the early Personal Income Tax 2000s, and the financial crisis and 60 Sales and Use Tax Great Recession beginning in 2008. 50 These estimates are calculated by comparing actual revenues (after 40 adjusting for major revenue changes) to a baseline case where revenues 30 continued to grow at their historic 20 rate. (We would note, however, that this exercise is not precise and 10 Corporate Tax different measures of revenue losses could be higher or lower by billions 1950-51 1960-61 1970-71 1980-81 1990-91 2000-01 2010-11 of dollars.) We estimate that revenue losses, in inflation-adjusted terms, totaled roughly $40 billion in the 1990s (averaging $8 billion per year across five years), $80 billion in the of reasons for this. These include: (1) the inclusion of early 2000s ($26 billion per year across three years), capital gains into the PIT base (although they are not and about $115 billion during and after the Great included in the definition of personal income) and (2) the Recession ($30 billion per year across four years). As PIT’s progressive rate structure. the figure suggests, the state does not need to endure severe economic Figure 2 problems to experience significant Income Tax Is More Volatile Than Income revenue losses. Percent Change From Prior Fiscal Year Size of the Recession Does Not Perfectly Predict Revenue 40% Losses. In general, larger recessions result in more revenue losses, but 30 the relationship is not perfect. By most measures, the recession of 20 Personal Income Tax the early 1990s was more severe 10 than the dot-com bust in the early 2000s. For example, unemployment Personal Income in California reached 9.7 percent in mid- to late-1992, but peaked -10 at 6.9 percent after the dot-com bust. However, as noted earlier, -20 revenue losses in the early 1990s -30 were much smaller than those in 1995-96 2000-01 2005-06 2010-11 2015-16 the early 2000s. Two major factors help to explain this. First, between 1990 and 2000, the General Fund 4 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2018-19 BUDGET became increasingly reliant on PIT revenues, relative recessions in the future could lead to larger General to SUT revenues, which are much less responsive to Fund revenue losses. economic conditions. As a result, revenue volatility Recessions and Spending Changes increased between these two events. Second, the dot-com bust involved much more significant losses in While the Legislature makes programmatic the stock market, which affect capital gains revenues. adjustments in response to changing budgetary General Fund Revenue Volatility Has Likely conditions, some spending levels change Increased Since Last Recession. Since the Great “automatically,” either as a result of formulas, caseload, Recession ended, changes in the state’s policies and or price changes. Some programs tend to expand in a economy have likely increased the volatility of General recession, while others tend to decline. Fund revenue. Proposition 30 (2012) enacted, and Proposition 98 Spending Generally Declines Proposition 55 (2016) extended, tax increases on During a Recession. Proposition 98 (1988) governs high-income taxpayers whose income is especially most state funding for schools and community colleges. sensitive to fluctuations in the economy and asset The measure establishes formulas for a minimum markets. In addition, the 2011 realignment of state annual funding requirement, commonly referred to as and local government responsibilities reduced General the minimum guarantee. The minimum guarantee rises Fund revenue from the sales tax, a more stable revenue or falls with a variety of inputs, including: General Fund source. As a result of both of these policy changes, revenue, per capita personal income, and K-12 student the structure of General Fund revenue is likely more attendance, among other factors. The formulas also sensitive to shifts in the economy and asset markets provide for “maintenance factor,” which requires the than it was in the past. In addition, income growth in state to accelerate school funding in strong revenue recent years has been especially fast at the higher end years to compensate for lower funding in weaker of the state’s income spectrum, which creates more years. Given these formulas, General Fund spending volatility in the PIT base. Together, these changes to the on schools and community colleges tends to increase PIT structure and base likely mean that similarly sized when revenues are growing and decline when revenues Figure 3 Annual Estimated Tax Revenue Losses by Recession Inflation Adjusted, in 2017-18 Dollars (In Billions) -5 -10 Early 1990s Recession -15 -20 -25 -30 Dot-Com Bust Great Recession -35 -$40 1989-90 1994-95 1999-00 2004-05 2009-10 2014-15 www.lao.ca.gov 5 analysis full gutter 2018-19 BUDGET decline. The Legislature can provide more than the revenue losses, in some part, during a recession, by minimum funding level for schools and community automatically declining. colleges, but it typically funds at the guarantee. Caseload-Driven Spending Generally Increases Proposition 2 Requirements Also Decline During During a Recession. The funding levels for some a Recession. Proposition 2 (2014) requires the state to programs, particularly in health and human services, make minimum annual reserve deposits and payments depend on a combination of changes in their number toward certain eligible debts. Discussed more later of participants (caseload), the costs per enrollee in this report, under the provisions of Proposition 2, (price), and the intensity at which participants use the state makes these deposits and payments based services (utilization). Examples of these programs in large part on the performance of General Fund include Medi-Cal (the state’s Medicaid program) and revenues, particularly those from capital gains. When CalWORKs, which provides cash assistance and revenues are higher, these requirements are higher services to low-income individuals. During a recession, and vice versa. This means that Proposition 2 offsets these programs’ caseloads (and hence their costs) Reserves Can Be Used for One-Time, Unanticipated Expenses One-Time, Unanticipated Expenses. In addition to recessions, the budget sometimes relies on budget reserves to cover the cost of significant, but one-time, unanticipated expenses. The most sizeable of these are often related to natural disasters and other crises. Compared to budget shortfalls that occur as a result of revenue declines during an economic recession (which result in losses of tens of billions of dollars over multiyear periods), these budgetary costs are relatively small. Examples of Significant Past Costs. The state has incurred notable one-time expenses as a result of several major events. (The state often receives significant reimbursements from the federal government for the cost of natural disasters, but federal aid does not cover the entire cost.) Most recently, state costs of the 2017 California wildfires, while still evolving, are currently projected to be in the high hundreds of millions of dollars. Other examples of significant past events include: • Energy Crisis. When the state’s two largest utilities faced serious financial problems in the early 2000s, the state Department of Water Resources began purchasing electricity on behalf of the utilities’ customers. The state used proceeds from the sale of long-term electricity bonds to finance $11.2 billion in these costs. (Electricity ratepayers, rather than General Fund taxpayers, repaid these bonds financed by a surcharge on electricity bills.) In addition, in response to the crisis, the state spent $1 billion (roughly $1.5 billion in today’s dollars) on various conservation and rebate programs in the 2001-02 budget. • Loma Prieta Earthquake. In 1989, an earthquake in Northern California resulted in severe damage to infrastructure in cities across the region, including the partial collapse of the San Francisco-Oakland Bay Bridge. In response to the earthquake, the state increased the sales tax by a quarter cent to raise $800 million ($1.6 billion in today’s dollars) for disaster relief. • Paterno Lawsuit. In a 2003 decision in Paterno v. California, a state appellate court found the state was responsible for a levee failure along the Yuba River in 1986. The state eventually paid a $464 million settlement to the nearly 3,000 plaintiffs. • January 1997 Floods. Major flooding in Central and Northern California occurred at the very beginning of 1997 after a week of heavy rainfall. The floods resulted in disaster declarations in 48 counties and forced more than 120,000 from their homes. After federal reimbursements, these floods led to nearly $200 million in state costs (over $300 million in today’s dollars). 6 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2018-19 BUDGET tend to rise as more people become eligible for their problem faced by the state is the net effect of changes services. in both revenues and expenditures. Formula-Driven Reductions Can Offset Roughly The Budget Problem Half of Revenue Losses. Over the last few years, A budget problem represents the amount by our annual Fiscal Outlook publications have shown which expenditures exceed revenues in a given year. a hypothetical budget problem that would arise from A budget problem is not the same as the revenue varying levels of revenue losses for the state. Under loss the state experiences during a recession. That is different scenarios ranging from a slowdown in growth because, as described in the previous section, some to a moderate recession, estimated revenue losses state expenditures adjust automatically to changing have ranged from $30 billion to $80 billion over a revenue conditions. In particular, increases in spending multiyear period. In each of these scenarios, automatic contribute to a larger budget problem and declines adjustments to spending have offset roughly half of the reduce the size of the budget problem. The budget revenue loss. STATE BUDGET RESERVES How Reserves Insulate the Budget. Budget Enacted SFEU Balance Cannot Be Less Than reserves are monies set aside for future use, like a Zero. The California Constitution requires the state household’s savings account that is dedicated to to enact a balanced budget each year. Specifically, emergencies. Reserves help insulate the budget from Article IV prohibits the Legislature from enacting a temporary shortfalls, delaying or mitigating the need budget bill that would appropriate more in General Fund for the Legislature to make difficult choices, including expenditures than are available in resources. In effect, spending reductions and tax increases. this means the estimated balance of the SFEU—at the State Has Two Budget Reserves. The state has time of the budget’s passage—cannot be lower than two budget reserves: the Special Fund for Economic zero. However, budget estimates rely on projections of Uncertainties (SFEU) and the Budget Stabilization future revenue that are inevitably uncertain. As such, a Account (BSA). The SFEU is the state’s discretionary deficit can emerge in the SFEU after the passage of the budget reserve—that is, the Legislature at any time can budget, which can be carried into the next fiscal year. appropriate SFEU funds for any purpose by majority Large SFEU Balance Triggers Tax Reductions. vote. Use of funds in the state’s rainy day fund—the California has two statutes that trigger reductions in the BSA—is more restricted. The State Constitution has state’s sales tax rate if balances in the SFEU reach a specific rules regarding how and when the state must certain threshold. Under either statute, the state’s sales make deposits into, or may make withdrawals from, the tax rate would automatically decline by one-quarter BSA. Below, we describe the major policies that guide cent for one calendar year, equal to around $1.7 billion, these two budget reserves. reducing the SFEU by the same amount. Under the first statute, the trigger would occur if the Director of Special Fund for Economic Uncertainties Finance projects the SFEU to exceed about 4 percent SFEU Is the State’s Discretionary Reserve. The of General Fund revenues (currently, about $5.4 billion) 1980-81 Budget Act established within the General in the prior and current year. Under the second statute, Fund the Reserve for Economic Uncertainties. In 1985, the trigger would occur if (1) the “General Fund reserve” the fund was renamed the Special Fund for Economic exceeds about 3 percent of revenues (currently, Uncertainties. Simply put, the SFEU is the difference around $4 billion) and (2) actual General Fund revenues between spending and available resources (most between May 1st and September 30th exceed the administration’s forecasted amounts. notably, revenues) for a given fiscal year. In any year, its balance (the amount by which resources available exceed spending) is the state’s discretionary reserve. www.lao.ca.gov 7 analysis full gutter 2018-19 BUDGET Budget Stabilization Account population (a “fiscal budget emergency”) or (2) in response to a natural or man-made disaster. In the Proposition 58 Governed BSA From case of a fiscal budget emergency, the Legislature may 2004 to 2014. Until 2014, the BSA was governed only withdraw the lesser of: (1) the amount needed to by Proposition 58. Passed by voters in 2004, maintain General Fund spending at the highest level of Proposition 58 required the state to make an annual the past three enacted budget acts, or (2) 50 percent of transfer into the BSA. These required deposits were the BSA balance. to gradually increase from 1 percent of General Fund Constitution Requires “True Up” of BSA revenues in 2006-07 to 3 percent in 2008-09 and Deposits. Under Proposition 2’s true-up provisions, the every year thereafter. Proposition 58 allowed these state reevaluates each year’s BSA deposit twice: once deposits to be suspended by an executive order in each of the two subsequent budgets. The state does issued by the Governor. Between 2004 and 2014 only this because initial estimates of future capital gains two transfers were made to the BSA under the revenues are highly uncertain. This process attempts provisions of Proposition 58. These deposits were to align those original estimates with actual revenues. made in the 2006-07 and 2007-08 enacted budgets Under these reevaluations, the state revises the BSA when the economy was still expanding, but were deposit up or down if excess capital gains taxes are quickly used to address budget deficits that emerged higher or lower than the state’s prior estimates. The later on in the 2007-08 fiscal year. Before 2004, state does not revisit its estimate of the base amount or Proposition 98 required the Legislature to maintain a debt payments in the true-up calculation. “prudent state reserve fund” in the amount deemed Constitutional Deposits Are Lower Once BSA “reasonable and necessary.” Reaches Maximum Size. Under Proposition 2, the Proposition 2 Changed BSA Rules. In 2014, voters state must put money into the BSA until its total passed Proposition 2, amending the rules concerning reaches a maximum amount of 10 percent of General deposits into and withdrawals from the BSA. Under Fund tax revenue. Currently, this is about $13.5 billion. the measure, the amount of each annual deposit is Once the BSA reaches this maximum, funds that would determined as follows: bring the BSA above 10 percent of General Fund taxes • First, the state must set aside 1.5 percent of must be spent on infrastructure. Each year that General General Fund revenues (we refer to this as the Fund tax revenues grow, the maximum level of the BSA “base amount”). also grows. So each year that the state does not face • Second, the state must set aside a portion of a fiscal budget emergency, it would continue to make capital gains revenues that exceed a specified deposits into the BSA to bring the fund to the revised threshold (we refer to this as “excess capital estimate of 10 percent of General Fund taxes. These gains”). deposits would be hundreds of millions of dollars per year, with the remainder going toward infrastructure The state combines these two amounts and then spending. allocates half of the total to pay down eligible debts and the other half to increase the balance of the BSA. Legislature Has Limited Control Over BSA Deposits and Withdrawals. Under the rules of Proposition 2, the Legislature can only reduce the BSA deposit, or make a withdrawal from the BSA reserve, in the case of a budget emergency. This can only occur upon declaration by the Governor and majority votes of both houses of the Legislature. The Governor may call a budget emergency in two cases: (1) if estimated resources in the current or upcoming fiscal year are insufficient to keep spending at the level of the highest of the prior three budgets, adjusted for inflation and 8 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2018-19 BUDGET THE GOVERNOR’S RESERVE PROPOSAL This section summarizes the Governor’s reserve Legislature approves the Governor’s proposal to proposal in the 2018-19 budget and places the reach the BSA maximum, a portion of future years’ proposal in context—both historically and nationally. Proposition 2 requirements must be expended on Governor Proposes $15.7 Billion in Total infrastructure. Under the administration’s current Reserves. In his 2018-19 budget plan, the Governor projections, this would result in a $959 million proposes ending the year with $15.7 billion in total infrastructure spending requirement in 2019-20, reserves (see Figure 4). This would consist of two $947 million in 2020-21, and $987 million in 2021-22. amounts: $13.5 billion in the BSA and $2.3 billion in These are funds that—absent the proposal—would the SFEU. The administration currently estimates a very have been deposited into the BSA under the small “true down” to the BSA in 2017-18, although administration’s own multiyear projections. that may change at the time of the May Revision. (We Proposed Reserves in Context believe there is significant upside to the administration’s 2017-18 revenue estimates, which would result in a This section compares the Governor’s proposed required true up deposit.) level of reserves to California’s historical averages and Governor Proposes Reaching BSA Maximum then to other states. With Optional Deposit. The Governor proposes Governor Proposes Highest Enacted Reserve making an optional deposit into the BSA that would Level in Decades. Figure 5 (see next page) compares bring the account to its constitutional maximum the Governor’s proposed level of reserves to a history (10 percent of General Fund taxes or, currently, of California’s enacted and actual budget reserves. The $13.5 billion). Under the administration’s current blue bars display enacted reserves, or the amount of proposal and revenue estimates, the additional deposit combined SFEU and BSA reserves that was assumed needed to reach the BSA’s constitutional maximum is in the annual state budget for the upcoming fiscal $3.5 billion. In May, if the administration does increase year at the time it was enacted. The dashed line its revenue estimates for 2017-18 and estimates a true shows actual reserves, or the revised level of reserves up deposit is required, it is likely to reduce the optional estimated by the Department of Finance for prior years, deposit by the same amount, keeping the overall after the state has more information about realized proposed BSA balance the same. revenues and expenditures. As the blue bars in the Governor Proposes Making Optional Deposit Statutorily Subject to BSA Rules. The Governor Figure 4 proposes statutory language that would aim to limit Total Reserves Proposed in the the Legislature’s access to the optional BSA deposit Governor’s 2018‑19 Budget under the traditional rules governing constitutional deposits. (This statutory language could be amended (In Billions) in the future.) Under the Governor’s proposal, the Special Fund for Economic Uncertainties (SFEU) Legislature could only access those funds if specific Enacted SFEU in 2017‑18 budget $1.4 budget emergency conditions exist and the Governor Additional SFEU balance proposed in 2018‑19 0.9 calls a budget emergency. Moreover, even in the case Subtotal ($2.3) of a budget emergency, the amount of a withdrawal Budget Stabilization Account (BSA) Balance enacted in 2017‑18 budget $8.5 could not exceed 50 percent of the BSA balance in the True up deposit for 2017‑18a ‑0.1 first year. (The Governor proposed, and the Legislature Required 2018‑19 deposit 1.5 approved, an optional BSA deposit of $2 billion in the Optional 2018‑19 deposit (proposed) 3.5 2016-17 budget, which was executed using similar Subtotal ($13.5) statutory language.) Total $15.7 Governor’s Proposal Creates Infrastructure a The administration currently estimates a small “true down” deposit for 2017‑18, Spending Obligation in 2019-20 and After. If the which would reduce the BSA’s balance by $75 million. www.lao.ca.gov 9 analysis full gutter 2018-19 BUDGET Figure 5 Governor Proposes Highest Enacted Reserve Level in Decades Percent of Revenues and Transfers 15% Enacted Budget Reservesa Proposed Actual Budget Reservesb 10 5 -5 -10 1981-82 1984-85 1987-88 1990-91 1993-94 1996-97 1999-00 2002-03 2005-06 2008-09 2011-12 2014-15 2017-18 a Estimates of budget-year Special Fund for Economic Uncertainties (SFEU) and Budget Stabilization Account (BSA) balances at budget act. b Revised estimates of SFEU and BSA balances after budget enactment. In some years, reflects proceeds of certain bond funds. figure show, over the last few years, California has been is somewhat above that level. (We would note that enacting reserve levels above 5 percent—well above reserve levels across states are not always directly averages in the last few decades. If the Governor’s comparable.) proposed level of reserves is enacted, it would Revenue Volatility Varies by State. Different represent the highest level of enacted reserves held by states rely on different mixes of taxes and fees for the state in decades. As discussed earlier, the balanced their General Fund revenues. For example, some budget provisions of the State Constitution require states rely on general or selective sales taxes as their the state to enact a positive SFEU balance, but actual primary revenue sources, which tend to be more stable reserves fluctuate around zero. revenue sources. Even among states with significant Other States Are Maintaining Similar Reserve PIT revenues, the structure and composition of those Balances. While unusual for California, the state’s taxes can vary. For example, California has a graduated recent reserve balances are only slightly higher rate structure and taxes capital gains as regular than the median reserve level across all 50 states. income. Other states with broad-based PITs have Figure 6 compares median reserve balances across different features. Some levy these taxes at a flat rate, all states to California over 20 years. The chart shows tax different forms of income, and/or include different enacted reserves for 2017-18, updated reserve credits and deductions. All of these features can play estimates for 2016-17, and actual reserve estimates for significant roles in revenue volatility. all previous years. Historically, California’s reserve levels Comparing Volatility and Reserves. Figure 7 (see have been much lower than median reserves across page 12) compares a measure of a state’s revenue all states, particularly during recessions. In 2017-18, volatility score, estimated by the Pew Charitable Trusts, median enacted reserve levels stood just over 8 percent to its enacted reserve level in 2017-18. Pew measured of expenditures, near California’s enacted level. The each state’s volatility score by calculating the average Governor’s proposed reserve balance of 12 percent 10 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2018-19 BUDGET variation in the percent change in a state’s revenue Fund revenues in recent years, driven primarily by (after adjusting for policy changes). As the figure shows, slower growth in individual income taxes and losses California’s revenue volatility score of 8.5 is well above in corporate income taxes. Connecticut, similarly, has average and ranks fifth overall. However, California’s been experiencing slower growth in PIT revenues. enacted level of reserves was near the median level in Officials in that state say these appear to be related to 2017-18. Although we might expect states with higher slower growth overall in the state’s economy. Coupled volatility scores to have accumulated higher levels of with cost pressures in major state programs, both of reserves at this point in the economic cycle, that does these states have had stagnant growth in reserves. not generally appear to be the case. States Reliant on Severance Tax Revenues. Unlike States Reliant on PIT. There are a few other states California, some states levy taxes on the extraction of that, similar to California, rely on the PIT as a major nonrenewable resources, like oil and natural gas. These General Fund revenue source and have relatively “severance taxes” are usually levied on producers as sizable populations of wealthier people (which tends a fixed percent of the commodity’s market value, so to make PIT revenues more volatile). These states the revenue per barrel or other unit of measure varies include Connecticut, Colorado, New York, and New when the price of the commodity rises and falls. As a Jersey. As a percent of total expenditures, California’s result, these revenue sources tend to be very volatile, reserve losses in the Great Recession were greater usually much more so than PIT revenues. Three states than all of these states. In recent years, however, in particular—Alaska, North Dakota, and Wyoming— reserves in California have caught up to, and then all have a high reliance on severance tax revenue, surpassed, balances in these other states. Anecdotally, with 30 percent or more of their overall General Fund California appears to be experiencing more growth in revenue coming from this source. These states tend to its PIT base than these others. For example, Colorado maintain much higher reserve balances than California. has experienced slower overall growth in General North Dakota’s reserve balance stood at 84 percent Figure 6 Comparing California's Reserve Balances to 50-State Median Reserves as a Percent of Expenditures Proposed 15% 10 50-State Median 5 California -5 -10 1999-00 2001-02 2003-04 2005-06 2007-08 2009-10 2011-12 2013-14 2015-16 2017-18 Data from Pew Charitable Trusts and the National Association of State Budget Officers. Data reflect actual reserve levels before 2016-17 and enacted reserve levels in 2016-17 and 2017-18. Reserve balances for California include encumbrances, which our office would typically exclude from total reserves, but remain here for comparability across states. www.lao.ca.gov 11 analysis full gutter 2018-19 BUDGET Figure 7 Revenue Volatility Scores and Reserves by State Volatility Score 18 16 North Dakota 14 12 10 Vermont Colorado California (2017-18) 8 Connecticut California (Proposed) 6 Hawaii Texas New Jersey New York West Virginia 4 South Dakota 2 5 10 15 20 25% Total Reserves Enacted in 2017-18 as a Percent of Expenditures Note: For the purposes of scale, the figure excludes Alaska and Wyoming, which each had reserves balances over 100 percent and volatility scores of 37.6 and 12.9, respectively. of General Fund expenditures in 2010-11, but has than the level held by some states with similarly volatile diminished in recent years. Over the past 20 years, revenue structures, including other PIT reliant states. Wyoming’s balance has averaged about 44 percent of However, there is little evidence of a strong relationship General Fund expenditures and currently stands over between states’ revenue volatility and their current level 100 percent. of reserves. Moreover, other PIT reliant states have Proposed Level of Reserves Is Not Remarkable experienced challenges in revenue collections that by National Standards. In short, while a historical California has not seen. So, while it might seem positive level for California, total reserves currently proposed that California has built higher reserve levels than these by the Governor are only somewhat above average states, given their recent challenges, it could be the by national standards. The proposed level is higher case that their reserve levels should be higher—not the other way around. PLANNING FOR A RECESSION In this section, we describe a framework that problem—for which it intends to prepare. Then, we the Legislature can use to plan for the state’s next would suggest the Legislature decide what combination recession. of responses it would like to use to address the budget Overview of the Framework. To plan for a problem. Figure 8 shows the two available methods. recession, we suggest the Legislature first consider They are: the size of a recession—and its associated budget 12 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2018-19 BUDGET • Tools to Prepare for a Recession. The revenue losses of $80 billion, with a $40 billion budget Legislature has two main tools to prepare for problem. The Legislature could also choose to prepare for a recession. They are: (1) budget reserves and an even larger downturn—for example, one comparable (2) one-time spending. to the Great Recession, although such an event is less • Actions to Take During a Recession. If these likely to be part of the state’s future experience. tools are insufficient to cover the entire shortfall, the Legislature must take actions during a ADDRESSING THE recession to bring the budget into balance. BUDGET PROBLEM These actions include: (1) spending reductions, (2) revenue increases, and (3) cost shifts. After the Legislature has decided the size of the recession and associated budget problem for which Together, the dollar amount of these two responses it would like to prepare, planning for that recession must add to the total size of the budget problem. The rest involves considering two available methods for of this section describes each of these factors in turn. addressing the budget problem. These are described below. ANTICIPATING THE RECESSION Tools to Prepare for a Recession AND BUDGET PROBLEM Budget Reserves. As discussed throughout this In this planning process, we first suggest the report, budget reserves are the most important tool the Legislature determine the size of a recession—and Legislature has to address a budget problem. Making associated budget problem—for which it would like to deposits into reserves has two key features that help be prepared. the budget’s bottom line during a recession. First, Anticipating the Next Recession. No one can making the deposit rather than increasing ongoing predict the timing, size, or length of the next recession. spending lowers the spending base, shrinking the However, the state still must make budgetary decisions size of any future budget problem. Second, making a in anticipation of such an event. The Legislature’s deposit increases the reserve available later to address assessment of the size and timing of the next recession a future budget problem. therefore follows from both its assessment of the probability of various events occurring and how Figure 8 cautious it would like to be. As How the State Addresses a Budget Problem such, when deciding its target level of reserves, the Legislature should first consider the size of the next recession—and associated budget Problem Budget Problem problem—for which it would like to prepare. In general, being prepared for a large recession involves higher levels of reserves. equal to Rough Illustrations of Possible Budget Problems. From past Tools to Prepare Actions to Take for a Recession During a Recession experience and our understanding of Solutions • Spending reductions current revenue volatility, we would One-time Budget reserves • Revenue increases spending very roughly estimate that the state • Cost shifts would face revenue losses of around $40 billion, with a $20 billion budget Note: The relative sizes of the boxes above are illustrative. The state can choose problem, in a mild recession. A more any allocation of reserves, other tools, and actions to address a budget problem. moderate recession might involve www.lao.ca.gov 13 analysis full gutter 2018-19 BUDGET One-Time Spending. Another important tool the on high-income earners. The state has also increased budget has to prepare for a recession is one-time fees, suspended tax credits and deductions, increased spending. One-time spending has the first benefit penalties, and increased resources to enhance taxpayer of reserves as it does not increase the ongoing compliance. expenditure base, thereby reducing the size of a Reduce Spending. The state has taken a variety subsequent budget problem. It does not, however, of actions to reduce spending in past budgets. Some have the second benefit of reserves (setting aside examples include: funds for future use). There are two important types of • Reducing Services. The state has reduced one-time spending in the budget. They are: spending by making both across-the-board and • One-Time General Fund. Some forms of targeted cuts by service or program. For example, one-time General Fund spending more clearly the state has reduced spending on health and reduce the pressure for ongoing spending than human services programs, corrections, courts, others. For example, appropriating funds for debt and universities. payments or information technology projects • Suspending Mandates. Proposition 4 often does not create an ongoing expectation (1979) requires the state to reimburse local for future funds for these purposes. One-time governments for some programs and services the spending on other items—such as new programs, state requires them to provide. In some cases, to services, or grants—can be more difficult to achieve budgetary savings, the state suspended choose not to repeat. these requirements and the associated • One-Time Proposition 98. The formulas reimbursements. governing Proposition 98 generally provide for a • Stopped Providing Cost-of-Living Adjustments lower minimum guarantee when state revenue (COLAs). The budget has historically provided is sluggish or declining. Funding at this lower COLAs, or adjustments to programmatic and guarantee, however, sometimes requires the departmental spending to account for erosions in state to make difficult choices about reducing spending power that result from inflation. During funding for core educational programs. One-time past recessions, the state has not provided COLAs spending within Proposition 98 (for example, for state employee pay and recipients of health and per-student discretionary grants) creates a buffer human services programs, like CalWORKs. that allows the state to fund at a lower level during tough economic times with fewer reductions to Shift Costs. When facing a budget problem, the these core ongoing programs. state has also taken actions that allowed it to provide services without paying for their full costs at the time. In Actions to Take During a Recession some cases, these actions have resulted in increased costs to other entities (including local governments). If the above tools are insufficient to cover the entire In other cases, these actions shifted costs to future budgetary problem, the Legislature must use a set of taxpayers by creating a liability that must later be actions to address the remaining problem. There are three addressed. Some types of actions have since been broad categories of these actions: spending reductions, prohibited by approved ballot measures or were actions revenue increases, and cost shifts. We describe some that could only be done once. As described in the examples of these actions that the Legislature has taken nearby box, in past recessions the federal government in the past in response to budget problems. has taken actions that shift costs away from the state, Increase Revenues. To increase revenues, past but these are generally outside of the state’s control. In budgets have, most notably, increased taxes. For the past, state cost shifts have included: example, the 2009-10 budget temporarily increased • Deferrals. Over many years, the state deferred the state sales tax by 1 cent and the PIT rates by payments to school districts to achieve budget 0.25 percentage points. Similarly, in 2012, voters savings. Sometimes this meant making payments passed Proposition 30, which temporarily increased a few weeks late—for example, at the beginning the SUT by one-quarter cent and increased PIT rates 14 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2018-19 BUDGET Changes in Federal Policy That Shift Costs Away From State In past recessions, the federal government has taken actions to ease states’ budgetary situations. In some cases, increased federal funds can backfill some General Fund spending declines. For example, the American Recovery and Reinvestment Act (ARRA), passed by Congress in February of 2009, provided temporary and one-time funds to California to backfill some state spending. In particular, the 2009-10 budget package included an estimated $8.5 billion in federal funds from ARRA to offset General Fund spending. In other cases, the federal government has provided the state with more flexibility to reduce state-funded programs that it regulates. These changes, however, are often outside of the state’s control in the budget process and therefore are not considered as part of the framework in this section. of July instead of the end of June. In other its budget shortfall. Proposition 58, passed in cases, however, the state shifted payments by conjunction with Proposition 57, prohibits this several months. These longer shifts placed a practice in the future. cash burden on school districts, which meant • Other Actions. Past budgets have taken a they either had to use their internal reserves or variety of other actions to achieve savings. The face external borrowing costs. In the past, the 2003-04 budget shifted the Medi-Cal program state also deferred mandate reimbursements to from an accrual basis (where expenditures are local governments, which generally shifted state booked to the year the obligation is generated) to costs onto these entities. Today, Proposition 1A a cash basis (where expenditures are booked to (2004) restricts the state’s ability to defer most the year the payments are made). This resulted in mandate reimbursements. one-time savings of $930 million. Such actions can • Internal Loans. To address past budget shortfalls, only be done once unless they are later undone. the state has also made loans to the General During the Great Recession, the state also attained Fund from other state accounts known as special budget savings by furloughing state employees. funds, generating one-time savings equal to the Some Spending Solutions Shift Costs. This loans. The General Fund is required to repay framework discusses spending and revenue changes special funds when needed to ensure the special separately from cost shifts. However, in many cases, fund meets the object for which it was created. spending reductions result in cost shifts. For example, The state has been repaying these outstanding in past recessions, the state has reduced General Fund amounts as part of Proposition 2 debt payment spending on the University of California and Califoria requirements over the last few years. State University. To maintain student services, the two • External Loans. In 2004, voters passed university systems have responded by raising fees and Proposition 57, which authorized the state to tuition, shifting costs to students and their parents. issue a bond of up to $15 billion to address SETTING A RESERVE TARGET This section discusses how the Legislature can target level of reserves is determined in conjunction determine its target level of budget reserves using some with all of the other factors discussed in the previous illustrative reserve targets that provide more specific section. Figure 9 (see next page) shows how this could examples of the framework discussed. work in practice in a variety of hypothetical situations. How to Set a Reserve Target. Setting the state’s These figures are very rough, but we hope will provide reserve target is one of the most important decisions the Legislature with some examples of the trade-offs for the Legislature as it crafts each year’s budget. A involved. www.lao.ca.gov 15 analysis full gutter 2018-19 BUDGET Figure 9 Illustrative Reserve Targets Under Hypothetical Budget Scenarios (In Billions) Mild Recession Moderate Recession Anticipating the Recession and Budget Problem Hypothetical revenue loss $40 $40 $80 $80 Formula-driven adjustments -20 -20 -40 -40 Hypothetical Budget Problem $20 $20 $40 $40 Addressing the Budget Problem Reserves $15 $20 $25 $30 One-time spendinga — — 5 5 Actionsb 5 — 10 5 Totals, Actions and Tools $20 $20 $40 $40 a Includes one-time, non-Proposition 98 General Fund spending. One-time spending within the minimum guarantee would help the state fund schools and community colleges at the lower level of the minimum guarantee without reducing ongoing programs. b Includes spending cuts, revenue increases, and cost shifts Note: Reflects cumulative situation over a multiyear period. Each of the scenarios in Figure 9 makes the broad, General Fund spending the prior year and was simplifying assumption that formula-driven spending willing to take $5 billion in actions. adjustments offset about half of revenue losses (and the None of these reserve levels would be sufficient to state reduces school and community college funding cover the costs of a more severe recession, such as the to the level of the minimum guarantee). Under the one that occurred in 2008. That said, these reserves illustrations in the figure, reserve levels total: would still buy the Legislature considerable time as • $15 Billion. A $15 billion reserve level, shown in it made other choices to confront such a budgetary the first column of Figure 9, would be sufficient challenge. to cover a mild recession with an associated Targets Should Grow Over Time. For simplicity, $40 billion revenue loss if the Legislature were we have expressed these targets in dollars, not willing to take $5 billion in actions to address the percentages. However, as the budget continues to problem. (These actions would be spread out grow, these reserve targets would need to increase, over a multiyear period.) ideally with the rate of growth of General Fund tax • $20 Billion. As the second column of Figure 9 revenues. shows, a $20 billion reserve would cover the Trade-Offs in Preparing for Larger or Smaller entire budget problem associated with a mild Recessions. There are trade-offs associated with recession without any additional tools or actions. different levels of preparation. Preparing for larger • $25 Billion. The third column of Figure 9 shows recessions and associated budget problems has that a $25 billion reserve would be sufficient to the clear advantage of allowing the state to maintain address an $80 billion revenue loss associated its programs later—often during times of hardship. with a moderate recession, provided the However, over-preparing has drawbacks. If the state Legislature had made $5 billion in one-time faced a less severe recession than anticipated, it General Fund spending the prior year and was would have missed the opportunity to spend more willing to take $10 billion in actions, spread over a on programs or reduce taxes before the recession multiyear period. started. On the other hand, under-preparing also has • $30 Billion. A $30 billion reserve, in the fourth negative consequences. A more severe recession than column of Figure 9, would be necessary to anticipated results in the Legislature having to take more address a moderate recession, provided the actions—spending cuts, revenue increases, and cost Legislature had appropriated $5 billion in one-time shifts—and typically within a compressed time frame. 16 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2018-19 BUDGET LAO COMMENTS Reserve Target More Important This Year. The • Amend the Statutory SFEU Rules. The Governor proposes reserves of $15.7 billion this year. Legislature could revisit the statutory rules that While this level is high historically for California, it is automatically reduce the SFEU balance if it meets not particularly remarkable by national standards. certain criteria. For example, the Legislature could The Governor’s reserve proposal this year raises increase the thresholds under which the rules are fundamental questions about the state’s current—and triggered. Then, the Legislature could leave the potential future—level of reserves. In particular: Is the optional deposit funds in the SFEU. Legislature satisfied with this level of preparation for the • Create Third Reserve Fund. Alternatively, the next recession? Legislature could create a third reserve fund and Recommend the Legislature Set This Year’s deposit the optional $3.5 billion there instead of Reserve Target at or Above $16 Billion. Using the the BSA. framework described in this report, we recommend 2019-20 Reserves Would Likely Be Higher Using the Legislature set a target level of reserves for the end One of these Alternatives. Under either of these of 2018-19. At this point in the economic recovery, alternatives, total reserves would reach $15.7 billion and given the likely parameters of a coming recession, in 2018-19 as the Governor currently proposes. As we think the level the Governor now proposes is a long as the economy continues to grow, the entire reasonable minimum. We suggest the Legislature also 2019-20 constitutional reserve requirement would be consider its future ideal level of reserves, depending deposited into the BSA, rather than mostly spent on on when it would like to be “fully prepared” for the next infrastructure. As a result, reserves in 2019-20 would downturn. total over $17 billion (under the administration’s current Governor’s Proposal, Counterintuitively, Makes estimates), rather than remaining near the roughly Building More Reserves More Difficult. If the $16 billion as the Governor currently proposes. Legislature’s target level of reserves is greater than Legislature Has Other Tools Available. The $16 billion, depositing optional funds in the BSA, as Legislature has other alternatives for using the the Governor currently proposes, counterintuitively $3.5 billion optional deposit that have the same benefits makes reaching that higher target more difficult. This is as reserves. That is because these options have the because the BSA has a constitutional maximum level two key attributes of reserves. They: (1) reduce ongoing of 10 percent of General Fund tax revenues. Hitting the spending and the size of a potential budget problem maximum creates an ongoing spending obligation of and (2) set aside funds for future use to address a roughly $1 billion per year on infrastructure (under the future budget problem. They are: administration’s current revenue estimates). As such, funds that would have been set aside in the BSA would • Prepaying Pension Costs. Each year, the state be spent on infrastructure instead, lowering the amount is constitutionally required to pay billions of dollars of resources available for building more reserves. in its actuarially required contribution toward state pension costs. The Legislature could use available Options for Legislative Consideration resources in the budget year to prepay $3.5 billion Alternatives to Build More Reserves. Normally, of future years’ pension costs. Prepaying pension leaving these additional funds in the SFEU would costs today would allow the state to reduce be one logical alternative to this proposal. As we future constitutionally required pension costs have noted, however, a large SFEU balance would by $3.5 billion. This arrangement would free up trigger automatic reductions in that reserve. So, if the $3.5 billion of resources in any future year, when Legislature would like more reserves than what the the funds would be needed to address a budget Governor now proposes, it has two options: problem. • Appropriating Expenditures for Future Use. The state is also required each year to make www.lao.ca.gov 17 analysis full gutter 2018-19 BUDGET billions of dollars in payments toward repaying Both of these options have the dual benefits of bond debt service and other necessary costs. reserves—they reduce ongoing spending now and In the budget year, the state could set aside make resources available to address a future budget $3.5 billion for future use, such as debt service problem. Like a third reserve, using one of these or another specific uses, earmarking the funds options, rather than depositing the optional funds into for when they will be needed in the future. Then, the BSA, could help make the state better prepared for when the state faces a budget problem in the a coming recession. future, it could use the $3.5 billion in set-aside funds to offset future costs, effectively freeing up $3.5 billion for any other purpose. LAO PUBLICATIONS This report was prepared by Ann Hollingshead. 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. 18 LEGISLATIVE ANALYST’S OFFICE