The 2020-21 Budget: Structuring the Budget

The 2020-21 Budget: Structuring the Budget GABRIEL PETEK LEGISLATIVE ANALYST FEBRUARY 10, 2020 analysis full gutter 2020-21 BUDGET LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2020-21 BUDGET Executive Summary Assessing Fiscal Resilience Is an Annual Activity. California has made significant progress in recent years to make its budget more resilient. Yet the process of achieving resilience can never be considered finished. Rather, the state must revisit its budget condition each year, update its goals, and respond to its current and unique challenges and conditions. This Report Responds to Unique Challenges Posed in This Year’s Budget. This report lays out a framework for evaluating the budget’s structure in the context of the conditions facing the state today. In particular, this year, after enjoying a long period of economic growth, some data suggest that economic growth could slow. Moreover, the state faces a new and plausible risk to the state’s budget’s bottom line from federal draft regulations regarding the types of fees and taxes the state can levy on healthcare providers and payers. These regulations, if enacted, could result in billions of dollars in higher state costs. Two Key Tools in Budget Structure This Year. This report considers two key tools of the budget’s structure important in this context: reserves and operating surpluses. Reserves are monies set aside—like a household’s savings account—that can be used to address future budget problems. Operating surpluses are the annual difference between revenues and spending. Creating a gap between anticipated revenues and planned spending creates a cushion that allows the state to absorb unexpected shortfalls in revenues or increases in costs. As the budget’s multiyear condition faces risks from both economic and noneconomic sources this year, we emphasize the importance of both of these tools in this report. Evaluating the Governor’s Proposed 2020-21 Budget Structure. Using this framework, we evaluate the Governor’s proposed 2020-21 budget structure. The Governor proposes a multiyear budget structure with small operating surpluses, which eliminates a key tool of fiscal resilience despite heightened risk. The Governor proposes the state end 2020-21 with $20.5 billion in reserves. Deviating from the practice of recent budgets, however, the Governor does not devote any significant share of the state’s estimated $6 billion surplus to building additional reserves. This reserve level is sufficient to cover revenue losses of $47 billion, but more reserves would be needed to prepare for a larger scenario (for example, the one that we estimated in our November Fiscal Outlook) or to protect school districts from constitutional declines in funding in a recession. We think that building more reserves or preserving a larger operating surplus would be prudent. Multiyear Planning Supports the State’s Ability to Uphold Its Commitments. At times, concepts like multiyear budgeting and the state’s operating surplus are complex and seem abstract. Yet we do not emphasize the importance of them for their own sake. Rather, the goal of this report is to help decision makers evaluate whether or not the state can afford to keep its current obligations and to determine the extent to which the state can commit to new services. The Legislature has indicated that maintaining service levels in a recession is a key priority. Multiyear budget planning is integral to the state’s ability to achieve this goal. www.lao.ca.gov 1 analysis full gutter 2020-21 BUDGET 2 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2020-21 BUDGET INTRODUCTION Our office long has emphasized the importance surplus in this year’s multiyear budget plan. We of multiyear budget planning. Multiyear budget made this recommendation for three reasons. planning tells the Legislature whether the state First, multiyear budget planning has become a can afford its current and proposed commitments more important part of negotiations between based on what is known today about the economy the Legislature and Governor. Second, certain and state costs. In a variety of contexts, we economic data indicate the prolonged economic also have stressed the importance of reserves. expansion could be weakening and we anticipate Building reserves allows the state to maintain its revenue growth will be slower in the coming years. spending commitments during recessions and Third, other noneconomic sources of risk—outside other temporary budget problems. While reserves the Legislature’s control—are increasingly plausible. are the main tool to foster fiscal strength, they are Consequently, we urge the Legislature to be not the only tool. Operating surpluses—the amount mindful of the budget’s capacity to take on new by which revenues are expected to exceed costs commitments. in the multiyear budget plan—also help insulate the This report has two purposes. First, we lay out state from revenue declines or unexpected cost the basic concepts and analytical framework that increases. we use to evaluate the budget’s structure over a In two of this year’s budget reports—The multiyear period. Second, we apply this framework 2020-21 Budget: California’s Fiscal Outlook and to the Governor’s proposed 2020-21 budget The 2020-21 Budget: Overview of the Governor’s structure to determine whether the state is likely to Budget—we made explicit recommendations to be able to maintain its commitments into the future. the Legislature about maintaining an operating KEY CONCEPTS IN MULTIYEAR BUDGETING The California Constitution requires the The Budget Year Legislature to pass a balanced budget. This Budget Process First Aligns Anticipated means the state cannot appropriate more in Revenues With Estimated Baseline General Fund expenditures than are anticipated Expenditures. The first step in the budget process in resources. While this requirement is relatively is to anticipate how much revenue will be available simple in concept, it can pose a significant for the upcoming year. This process is complex, challenge when resources are insufficient to cover but generally means using assumptions about how existing commitments. The remainder of this the economy is likely to perform over the coming section explains the basic concepts needed to 12 to 18 months and then using those estimates understand how the state balances the budget to project revenue collections. The second step for the upcoming year (the budget year) and over compares those anticipated revenues to the level a multiyear period (for the subsequent few years). of spending required under current law. Spending We then explain sources of legislative flexibility over under current law, which we term “baseline the short and long term and explain why sources spending,” has several components. These include of inflexibility are important to long-term planning. fulfilling constitutional obligations, like minimum Figure 1 (see next page) summarizes the key terms required spending on schools and community introduced in this section. colleges; paying debt service to bond holders; and supporting the programs authorized under current law. The last component includes, for example, www.lao.ca.gov 3 2020-21 BUDGET Reserves Are the Main Tool Figure 1 to Address a Budget Problem. Key Terms in This Report Because the Legislature must ultimately pass a balanced budget, Surplus When projected resources available exceed estimated baseline spending in the budget window.a when the state faces a budget Budget Problem When estimated baseline spending exceeds projected problem, the Legislature must solve resources available in the budget window.a the problem using a combination Revenue Loss A decline in revenues compared to expectations. of tools. The main tool for solving Operating Surplus When projected revenues exceed estimated baseline spending a budget problem is building a over a multiyear period. savings account—called a reserve. Operating Deficit When estimated baseline spending exceeds projected revenues over a multiyear period. If reserves are insufficient to cover the budget problem, however, the Baseline Spending Spending required under current law. For example: Legislature must reduce spending, • Constitutional requirements. increase revenues, and/or take • Debt service on bonds. other actions to bring the budgeted • Authorized caseload and price changes. expenditure level equal to or below • Existing memoranda of understanding. anticipated revenues. • Costs to implement recently enacted legislation. A Deficit (or Surplus) Also Discretionary Spending Spending not required under current law. Can Emerge After the Budget For example: Is Passed. While the state must • New policies or programs. pass a balanced budget for the • Expansions to existing programs, such as increasing eligibility or benefit levels. upcoming fiscal year, nothing • Discretionary price increases or enrollment changes. precludes a deficit (or surplus) from • New memoranda of understanding. emerging after the budget has a In this case, “resources available” includes revenues and discretionary reserves held in the Special Fund for Economic been passed. Specifically, after the Uncertainties. budget is passed in June, actual revenue performance could be updating estimates of caseload, providing statutory weaker than anticipated. We refer price increases, and funding the costs of recently to a decline in revenue—relative to expectations— enacted legislation. as a “revenue loss.” This can cause a budget State Will Either Face a Surplus or Deficit problem in which case the Legislature must realign for Upcoming Fiscal Year. Figure 2 shows a simplified example of the comparison between Figure 2 anticipated revenues and baseline spending. As the Budget Can Face figure shows, for the upcoming year, the state will Surplus or Budget Problem either have: • A surplus if anticipated revenues would exceed baseline spending. This means the Legislature will have additional discretionary resources available to allocate to any public purpose (for example, reducing revenues or increasing spending). • A budget problem if anticipated revenues would be insufficient to cover baseline spending. 4 LEGISLATIVE ANALYST’S OFFICE seuneveR detapicitnA gnidnepS enilesaB seuneveR detapicitnA gnidnepS enilesaB analysis full gutter “A Surplus” Budget problem (a “deficit”) analysis full gutter 2020-21 BUDGET revenues and spending. Similarly, the state could Legislative Flexibility pass a budget that anticipates a lower level of The state constitution entrusts the Legislature revenues than actually occur. In this case, a surplus with the power of appropriation. This means the arises and is available for the Legislature to expend Legislature has a great deal of constitutional in the following budget. authority and control over many aspects of the The Multiyear budget. Nonetheless, some external forces— including the voters, the federal government, State Considers Multiyear Fiscal Condition and the courts—have placed limits on legislative in Planning Documents. When the state is control to reduce baseline spending. We discuss deliberating over the structure of the budget for the the sources of constraints on the Legislature’s upcoming year, statutes require the Department budgetary authority in this section. of Finance (DOF) to submit to the Legislature an Legislature’s Short-Term Flexibility to Reduce estimate of the budget’s multiyear condition for the Spending Is Relatively Constrained. In many three fiscal years following the budget year. (DOF programmatic areas, in the short term (meaning must produce these estimates with the January over a year or two), the Legislature has relatively Governor’s budget, May Revision, and the June little flexibility to make substantial reductions to budget act. By convention, our office also produces state spending. For example, there are various similar estimates—using our own projections—in voter-approved constitutional requirements—like November and May.) Proposition 98 (1988) and Proposition 2 (2014)— Over a Multiyear Period, the State Can that dictate minimum amounts the state must Face a Surplus or Deficit. Even though the spend on different purposes. (Although in both Legislature must enact a balanced budget for the cases the Legislature can suspend certain rules upcoming fiscal year, the budget does not have to with a two-thirds or majority vote and with action be balanced over a multiyear period. As a result, by the Governor.) The Legislature’s authority to over a multiyear period, the state can face a significantly change jointly administered programs deficit or surplus. Again, this calculation compares with the federal government—like Medi-Cal or anticipated revenues to baseline expenditures. Over In-Home Supportive Services—also is constrained a multiyear period, the state could experience an: due to federal law. Finally, in some areas—most notably corrections—various lawsuits have required • Operating surplus when anticipated revenue the state to spend money to comply with court growth would exceed baseline spending orders. In all of these cases, the Legislature has growth on an ongoing basis. nearly unlimited authority to spend more than • Operating deficit when anticipated revenue current law requires, but instead is constrained growth would be less than baseline spending by the balanced budget requirement. Moreover, growth on an ongoing basis. in some cases, once the Legislature takes Uncertainty Grows With Each Year of the action to spend more on a certain program—for Forecast Period. Estimates of the budget’s example, by appropriating bond funds—it can condition—particularly revenues—are always create a long-term and relatively inflexible budget subject to uncertainty. This uncertainty grows with commitment. each fiscal year of the outlook because past data Over the Long Term, Legislature Has Much become increasingly less reliable for predicting More Flexibility. Over the longer term, the future trends. For example, our revenue estimates Legislature has more control to reduce spending. this year are more reliable for 2020-21 than For example, the Legislature could choose not to 2023-24. As a result, the calculation of a surplus appropriate bond funds, resulting in lower debt or deficit for the upcoming budget year is more service costs. The state also can make different reliable than the estimates for the out-years. choices about benefits for future employees, affecting pension costs for decades into the future. Finally, the state can make changes to sentencing www.lao.ca.gov 5 2020-21 BUDGET laws, eventually resulting in changes to spending budget problems gives the Legislature more time on corrections. These are just three examples to address them, in ways consistent with legislative among many. priorities. To the extent that decisions today create More Long-Term Flexibility Makes Multiyear long-term and relatively inflexible obligations Budgeting More Important. The Legislature’s also heightens the importance of examining the ability to constrain cost growth over the long term, multiyear effects of budget year choices. For but not the short term, heightens the importance example, past decisions to provide retroactive of multiyear budget planning. Anticipating future pension benefits created a very inflexible long-term spending requirement for the state. KEY ELEMENTS OF BUDGET STRUCTURE This section of the report focuses on two key the operating surplus is increasing. (If, by contrast, elements of the budget’s structure: (1) operating anticipated revenues were lower than expenditures, surpluses and (2) reserves. This section describes the state would face an operating deficit.) how each of these are measured, discusses how How Do We Measure the Operating Surplus they help the budget withstand—or reduce—a or Deficit? Both our office and DOF produce budget problem, and gives guidance on setting a multiyear estimates of the budget’s condition on target level for each. a semiannual basis. These estimates use similar conventions. For example, both of our offices begin OPERATING SURPLUSES with a forecast of how we expect the economy could perform over the next few years. Using these The first key element in the budget’s structure is economic assumptions, we construct estimates of the budget’s operating surplus. Figure 3 illustrates anticipated revenues. (For instance, after making how operating surpluses accrue. As the figure an assumption about wage and employment shows, over this hypothetical four-year period, growth by industry in California, we estimate how anticipated revenues are higher than baseline much the state would collect in personal income expenditures. In fact, because this hypothetical tax [PIT] revenue from wages and salaries.) Then, shows revenues growing faster than expenditures, we construct forecasts of baseline spending growth using constitutional formulas, models of caseload Figure 3 and prices, and assumptions Illustration of an Operating Surplus about the effects of current law. Comparing forecasted revenue growth to expenditure growth, by Operating Surplus year, yields the estimate of the operating surplus or deficit. SFEU Maintaining an Operating Balance Surplus Reduces Potential Budget Problems. Planning for an operating surplus creates a “cushion” to absorb potential revenue losses. In particular, over Budget Year Budget Year +1 Budget Year +2 Budget Year +3 the course of the multiyear period, revenues will be higher or lower SFEU = Special Fund for Economic Uncertainties. than anticipated. If revenues are lower than expected and the state 6 LEGISLATIVE ANALYST’S OFFICE seuneveR detapicitnA gnidnepS detcanE seuneveR detapicitnA gnidnepS enilesaB seuneveR detapicitnA gnidnepS enilesaB seuneveR detapicitnA gnidnepS enilesaB analysis full gutter 2020-21 BUDGET has an operating surplus, the reduction to revenue to grow. The PIT is the largest revenue source might not result in a budget problem. Conversely, in the state General Fund and grows relatively if the state has no operating surplus, any decline quickly when the economy is expanding. During in revenues results in a corresponding budget a recession, however, PIT collections can decline problem. Figure 4 illustrates how this works. precipitously. In recent years, with growth in While revenues most often are revised wages and financial assets outpacing growth in downward when the state is experiencing a other sectors and increases in marginal PIT rates, recession, downward revisions can occur during California’s revenue system has benefited from economic expansions as well. For example, the relatively fast revenue growth. 2016-17 budget anticipated General Fund revenues Underlying Growth of Baseline Spending. (excluding transfers) would total $124.2 billion The second determinant of the operating surplus for that year. That estimate was ultimately too is the growth rate of baseline spending. (As noted high by about $1 billion, with actual revenues in in Figure 1 on page 4, baseline spending is the 2016-17 now estimated to be $123.4 billion. (For cost to maintain state services authorized under simplicity, this example uses budget year estimates, current law.) Some programs within the budget but the same logic also applies to out-year can grow relatively quickly (for example, some revenue estimates, which are subject to even more health programs), but others grow more slowly uncertainty.) (for example, corrections as inmate population growth has slowed or declined). Programmatic Determinants of Operating Surplus growth also can depend on a variety of factors, like Underlying Growth of Current Revenue demographic trends and economic conditions. Structure. The first determinant of the operating Budget Choices. Each legislative decision about surplus is the rate at which revenues are expected the budget has an effect on the budget’s multiyear Figure 4 How an Operating Surplus Cushions a Revenue Reduction Budget Budget Budget Budget Budget Budget Year Year +1 Year +2 Year Year +1 Year +2 www.lao.ca.gov 7 seuneveR detapicitnA gnidnepS detcanE If the state has planned for an operating If the state does not plan for an operating surplus and revenues decline, the budget surplus and revenues decline, a budget does not necessarily have a problem. problem is immediately created. Anticipated Operating Surplus seuneveR detapicitnA gnidnepS enilesaB seuneveR detapicitnA gnidnepS enilesaB seuneveR detapicitnA gnidnepS detcanE seuneveR detapicitnA gnidnepS enilesaB seuneveR detapicitnA gnidnepS enilesaB analysis full gutter Revenues Revenues Decline Decline Revenues Revenues Decline SFEU Decline Budget Balance Problem State Plans for an Operating Surplus State Does Not Plan for an Operating Surplus analysis full gutter 2020-21 BUDGET condition and—as a result—on the operating Setting an Operating Surplus Target surplus. Generally, these fall into two categories: We suggest the Legislature consider an • One-Time Spending and Revenue operating surplus target at the beginning of each Decisions. Spending and revenue decisions legislative budget process. This target helps set that are one time (that is, only authorized for the structure for the state’s budget and can form one year) or temporary (authorized for a set an overarching guide for decision-making as the period of years) expire. To continue, they must Legislature evaluates individual budget proposals. be reauthorized by the Legislature. A choice This target must be revisited each year because its to allocate resources on a one-time basis level should depend on a variety of moving factors. spends down the surplus for the budget year, These factors are: but leaves the operating surplus intact. • Expected Revenue Growth and Level of • Ongoing Spending and Revenue Decisions. Uncertainty. While our revenue estimates Commitments that are made on an ongoing are always subject to uncertainty, uncertainty basis are indefinite. Once made, ongoing is greater in some circumstances. For expenditures will continue unless the example, when economic signals suggest Legislature takes action to end them. As revenue growth could be weaker than the such, an ongoing choice in one budget year current consensus view—as was the case becomes part of “baseline” spending and in November—we advise targeting a larger revenue in future budgets. In general, a choice operating surplus. to allocate resources on an ongoing basis will • Expected Baseline Spending Growth reduce the operating surplus by a like amount. and Level of Uncertainty. In general, Similarly, a choice to increase revenues on uncertainty about baseline spending is an ongoing basis would increase the state’s caused by factors outside of the Legislature’s operating surplus. control. For example, if the Legislature has Perhaps counterintuitively, there are one-time reason to believe choices by the federal and ongoing spending decisions that can result government or courts are likely to result in in higher operating surpluses. Examples of these higher expenditures than currently assumed, choices are included in the nearby box. Examples of How Budgetary Choices Can Result in Higher Operating Surpluses Paying Down Debt Can Increase the Operating Surplus. The 2019-20 budget focused on paying down state debts—in particular, making supplemental pension payments—as a key tool to improving the budget’s multiyear balance. These supplemental payments reduce the state’s unfunded liabilities, thereby reducing future annual payments to the pension system and reducing costs over a few decades. Taken alone, this action increases the state’s operating surpluses because it reduces costs over the long term. Other Actions Also Can Increase Operating Surpluses. There are other ways the state can achieve long-term savings and thereby increase the operating surpluses. For example, in the past the state has achieved state savings by shifting costs to other entities, including other governments and individuals. Other policy changes aim to lower state costs by reducing the average cost per unit of services—that is, by improving efficiency. Finally, the state can try to reduce costs over the long term by providing services that aim to reduce poverty, improve health outcomes, or avoid natural disasters, among others. 8 LEGISLATIVE ANALYST’S OFFICE 2020-21 BUDGET we advise setting the operating surplus at a decision-making, the related budget problems will higher level. eventually dissipate. • Balancing Current Needs Against Future Budget Problems Also Can Arise as a Result Needs of the State. Maintaining an operating of Ongoing Imbalance. Budget problems, surplus poses a trade-off. Forgoing spending however, are not always the result of temporary today to maintain an operating surplus limits circumstances. Budget problems also can emerge the Legislature’s ability to address current when the underlying structure of the budget is priorities. In some cases the Legislature will misaligned. For example, if the state consistently prefer to address some programmatic needs commits more to spending than it is expected to today. As such, choosing a target operating receive in revenues, a budget problem will occur. surplus often means balancing the state’s Reserves Are the Main Tool for Addressing current needs with its expected future needs. Temporary Budget Problems. By functioning like a savings account, reserves help the Legislature Limitations of Multiyear Planning. Multiyear address a budget problem. Figure 6 (see next budget estimates in general—and operating surplus page) shows this point. When revenues are growing targets in particular—are only a reliable tool to and are anticipated to exceed baseline spending, the degree they are executed with fidelity. Making the state can set monies aside in a reserve. unrealistic or unsupported assumptions about When revenues fall below baseline expenditures, revenues or spending growth—either too high or reserves can be withdrawn to reduce the need for too low—renders both exercises less meaningful budget cuts. Because reserves are limited, they or even counterproductive. This is one of the should only be used for budget problems that are key reasons our office scrutinizes the estimates expected to end—for instance, when the economy and assumptions implicit in the administration’s recovers. Using reserves to cover a budget problem multiyear estimates. It is also the reason we that resulted from an ongoing structural issue produce our own semiannual, independent would deplete the state’s savings account without multiyear estimates. addressing the underlying problem. Reserves Work in Tandem With Operating RESERVES Surpluses to Protect the Budget’s Condition. The second key element of the budget’s Reserves and operating surpluses work in structure is the state’s savings account—reserves. tandem to improve the budget’s condition. First, Reserves are key to the state’s ability to address an operating surplus cushions the revenue loss, a budget problem. As discussed earlier, budget Figure 5 problems arise when revenues are expected to be insufficient to cover baseline spending in a How a Budget Problem Arises as a particular fiscal year. Result of Revenue Loss Budget Problem Likely Will Emerge as a Result of a Revenue Loss. Recessions are the most common reason that large budget problems occur. In a recession, revenues decline due to reduced economic activity. Despite this economic slowdown, absent policy changes, much of the state’s spending base continues to grow. This revenue loss often creates a budget problem in the tens of billions of dollars over multiple years. Figure 5 illustrates this concept. However, recessions are temporary. When they end, Enacted Budget revenues begin to grow again. With good fiscal www.lao.ca.gov 9 seuneveR detapicitnA gnidnepS detcanE seuneveR detapicitnA gnidnepS detcanE analysis full gutter Revenues Decline Budget problem must be addressed by: • Using reserves • Lowering expenditures • Raising revenues Revised Budget 2020-21 BUDGET Figure 6 How Reserves Help Avoid Future Budget Cuts State sets aside some of its revenue when it has a surplus . . . resulting in a smaller budget problem. Then, (1) the Budget Stabilization Account (BSA), (2) the reserves can be used to address a budget problem Special Fund for Economic Uncertainties (SFEU), that remains. Figure 7 has an illustration of how and (3) the Safety Net Reserve. The BSA is the this works. While these tools are both important, state’s general purpose constitutional reserve and they are not equivalent. Unlike an operating surplus, it is governed by the rules of Proposition 2. The reserves are not subject to measurement error. In Legislature is limited in when it can access these fact, once reserves are deposited into an account constitutional BSA deposits. The state’s other they are certain. This is one of the reasons that we primary general purpose reserve account is the say reserves are the main tool for creating a more SFEU. Unlike the BSA, the Legislature has wide resilient budget. discretion to use the funds in the SFEU for any California’s General Fund Reserves. The public purpose. The nearby box describes how the state has three major General Fund reserves: SFEU works in more detail. Finally, the Safety Net 10 LEGISLATIVE ANALYST’S OFFICE seuneveR detapicitnA gnidnepS enilesaB . . . and can use these reserves to reduce the need for budget cuts in the future. detapicitnA seuneveR gnidnepS enilesaB detapicitnA seuneveR gnidnepS enilesaB detapicitnA seuneveR enilesaB gnidnepS Without reserves, the state would need to cut spending to align with revenues. Figure 7 How Reserves and Operating Surpluses Work Together to Protect the Budget Revenues Decline State expects an State sets operating surplus aside reserves A part of this decline is “absorbed” by the operating surplus. The budget problem that occurs is covered by reserves. Reserves Operating Surplus seuneveR detapicitnA gnidnepS enilesaB seuneveR detapicitnA gnidnepS enilesaB detapicitnA seuneveR gnidnepS enilesaB analysis full gutter analysis full gutter 2020-21 BUDGET Reserve was created in 2018-19 to fund the future • Size of Underlying Operating Surplus. The costs for two means-tested programs in the event next criterion for determining a target level of of a recession. reserves is the size of the underlying operating surplus. If the state has planned for a larger Setting a Reserve Target operating surplus, all else equal, the budget Considerations for Setting a Reserve Target. problem associated with a given revenue loss We always recommend the Legislature begin its will be smaller than it could be otherwise and budget deliberations by setting a target level for less reserves will be required. In fact, every reserves. There is no one single, ideal target. dollar of operating surplus offsets revenue Rather, the target should change from year to year losses dollar-for-dollar over multiple years. depending on certain factors. Those are: This means a dollar of operating surplus yields more than a dollar of benefit. In contrast, a • Size of the Revenue Loss. We suggest lower operating surplus means more reserves the Legislature first consider the size of the are required to cover a budget problem. revenue loss for which it wants to prepare. • Willingness to Take Actions During a Revenue losses can be larger or smaller Recession. We noted earlier that the depending on a few different factors. For Legislature has three possible responses to example, for a revenue loss resulting from address a budget problem if reserves are a recession, the key factors are the timing, insufficient to cover the shortfall. Namely, the severity, and length of that recession. To be Legislature can increase revenues, reduce prepared for a larger, more severe recession, spending, or shift costs. If the Legislature the state needs more reserves. is more willing to take these actions, less Understanding the Special Fund for Economic Uncertainties (SFEU) What Is the SFEU? The SFEU is the state’s general purpose reserve. More technically, however, the SFEU is the ending balance of the General Fund. That is, the SFEU is equal to the carry-in balance from the prior year, plus revenues and transfers, and minus expenditures and encumbrances. As a result, the SFEU automatically adjusts to changes in each of these inputs— for example, the SFEU balance increases when anticipated revenues rise or when estimated expenditures fall. In What Cases Can the SFEU Balance Be Negative? The constitutional balanced budget requirement means that the Legislature cannot enact an SFEU balance that is lower than zero. However, once enacted, the SFEU will adjust upward or downward as actual revenues or expenditures differ from expectations. For example, if revenues in the current year fall below expectations, the SFEU balance will automatically decline—sometimes falling below zero. The most recent example of this is the 2011-12 budget package, which anticipated an SFEU balance of $543 million. However, when revenues fell short of expectations, the revised balance was later scored at -$2.2 billion. How Does the SFEU Differ From a Surplus? In a proposed or enacted budget, the SFEU is part of the surplus, but not the entire surplus. When the state has a surplus expected for the upcoming fiscal year, both our office and the Department of Finance include the balance of the SFEU in that estimate. That is because the entire SFEU balance is discretionary and the Legislature could choose to set the fund balance at any other level greater than zero. However, our calculations of the surplus also include any other discretionary spending proposals—that is, spending not required under current law. www.lao.ca.gov 11 analysis full gutter 2020-21 BUDGET reserves are needed. On the other hand, if the Past Publications Noted Budget Problems Legislature would prefer to cover most or all Likely to Range From $20 Billion to $40 Billion. of a future budget problem with reserves, then Our past budget publications have estimated more reserves would be needed. ranges of reserves that would be needed for the • Ability to Take Actions During a Recession. state to weather various types of recessions with While the Legislature has a great deal of minimal reductions to ongoing programs. Based on control over the state budget, there are the experience of recent recessions, we estimate some areas of the budget in which the the state would need about $20 billion in reserves Legislature has less flexibility to reduce to cover a budget problem associated with a mild costs. The areas where the Legislature has recession (a revenue loss of about $40 billion) more flexibility might not align with those or $40 billion to cover a moderate recession (a where the Legislature would prefer to make revenue loss of about $80 billion). (The nearby box budgetary reductions. For example, while the describes how the concepts of “budget problem” Legislature has significant discretion to lower and “revenue loss” differ.) General Fund spending on the universities, Reserve Target Will Change Depending on many policymakers might prefer not to do so. Operating Surplus. Those estimates of budget Conversely, it might be appealing to reduce problems assume the state has no operating debt payments or pension contributions surplus. Yet, if the state does have an operating during a recession, but the Legislature has surplus, it directly would offset reserves needed. very little flexibility to do so. For example, if a recession is expected to last three years, a $1 billion operating surplus would offset revenue losses by $3 billion, lowering reserves needed by a like amount. How a Budget Problem Differs From a Revenue Loss 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. There a two key reasons for this: • Operating Surplus Lowers Potential Budget Problem. First, as this report has discussed extensively, if the state has an operating surplus, that will “cushion” an initial revenue loss to some extent. This means that revenues can decline relative to expectations by some amount before they actually fall below baseline spending. • Constitutional Spending Requirements Fall When Revenues Fall. Second, some state expenditures adjust automatically to changing revenue conditions, also offsetting revenue losses. For example, the state’s required debt payments under Proposition 2 (2014) likely will fall by at least $1 billion or $2 billion over a multiyear period, leading to a smaller budget problem. (The state’s other annual debt payments—for example, for bond debt service— would not be affected.) In addition, required General Fund spending on schools and community colleges—under the provisions of Proposition 98 (1988)—also usually declines when revenues do. If the Legislature does not wish to reduce school and community college spending in a recession, the budget problem would be larger than what we have described here, and more reserves would be required. 12 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2020-21 BUDGET 2020-21 BUDGET STRUCTURE This section applies the analytical framework to a large degree—the multiyear condition of the from this report to the budget structure for budget. They are: 2020-21. In particular, we evaluate the proposed • Economy Continues to Grow, Albeit at structure of the Governor’s budget and offer a Slower Pace. The Governor’s budget alternatives and recommendations to improve its assumes the economy will continue to grow resilience. but at a more modest pace than recent Prior Budgets Affect Starting Place for years. Job growth is expected to continue 2020-21. The starting place for each annual but will slow as the pool of workers looking budget is the result of the cumulative effects of for jobs continues to shrink. Wage growth is decisions made in the past. The 2020-21 budget is expected to increase as employers compete influenced, in particular, by a number of significant for workers. Housing construction is expected choices from 2019-20. First, last year’s spending to pick up after plateauing during the last few plan allocated a large dollar amount of discretionary years. spending toward new ongoing purposes. • Modest Revenue Growth. The Governor’s Specifically, the budget included $4 billion in new budget assumes General Fund revenues discretionary spending, which is expected to grow about 2 percent per year, increasing grow to $6 billion over time. On the other hand, from $150 billion in 2019-20 to $164 billion in the budget dedicated a large amount of funding 2023-24. In contrast, revenues grew 6 percent to accelerating payments toward state debts. in 2018-19 and are expected to grow While those payments are likely to eventually save 5 percent in 2019-20. the state billions of dollars over the long term, in • Managed Care Organization (MCO) Tax 2020-21 those payments are saving the General Approved. After enacting the 2019-20 budget Fund less than $100 million. in June, the Legislature reauthorized the MCO tax in September. The MCO tax generates THE GOVERNOR’S PROPOSED General Fund benefit by taxing enrollment BUDGET STRUCTURE in MCOs and using that revenue to offset General Fund costs in Medi-Cal. The MCO tax This section describes and evaluates the requires federal authorization. The Governor’s Governor’s proposed budget structure for 2020-21. budget assumed the federal government First, we outline the assumptions that underline the would eventually approve it in 2021-22. Governor’s multiyear budget estimates and evaluate After the release of the Governor’s budget, their reasonableness. Second, we describe the however, the federal government indicated key choices the Governor makes that affect the it will not approve the tax. (A spokesperson budget’s multiyear condition. Those assumptions for the administration has indicated they and choices result in the key elements of the continue to expect to come to an agreement budget’s structure: the operating surplus and with the federal government on this issue.) reserves. Third, we describe those key elements The Governor’s budget assumed no benefit and provide our assessment of them. from the MCO tax in 2020-21, but an annual Key Assumptions benefit of $1 billion to $2 billion over the multiyear period. While the Governor’s budget includes hundreds of assumptions, we describe three key ones Assumptions Are Reasonable, but Uncertain. here. Each of these assumptions are vital to the We find the administration’s assumptions to be underlying condition of the budget and dictate— generally reasonable on net. On one hand, our own office’s most recent estimates of multiyear www.lao.ca.gov 13 analysis full gutter 2020-21 BUDGET revenue growth are somewhat higher than the • $2.7 Billion to One-Time or Temporary administration’s estimates—averaging 3.4 percent Spending. The Governor dedicates $2.7 billion over the period. This represents a net difference of of this surplus to one-time or temporary $5.6 billion across 2021-22 to 2023-24. (While our spending—which we define to mean spending revenue estimates were put together a couple of that will occur under law for fewer than four months before the administration’s were, there have years. Unless reauthorized, this spending will not been any major reversals in economic trends not continue in future years thereafter. that would likely cause us to substantially change • $1.6 Billion of Surplus to Ongoing Spending these estimates.) On the other hand, given that (Growing to $1.9 Billion Over Time). The MCO tax approval is uncertain, the administration Governor’s spending proposals also include takes an optimistic approach in assuming it $1.6 billion in ongoing spending, representing ultimately is approved. roughly one-quarter of resources available. Because some of these ongoing proposals Key Choices are phased in over a multiyear period, we The primary choices the Governor makes estimate the cost at full implementation of in the budget that affect its multiyear structure these proposals is $1.9 billion annually. are in allocating the surplus. We estimate the • $235 Million to Accelerate Planned Governor had a $6 billion surplus to allocate in CalPERS Payment. The 2019-20 budget the 2020-21 budget process. (The box below authorized three future supplemental discusses our calculation of the surplus and how payments to state employee pensions: it relates to the state’s net position in financial $265 million in 2020-21, $200 million in statements.) The Governor chooses to allocate that 2021-22, and $35 million in 2022-23. surplus to a variety of purposes, including: The Governor’s budget accelerates the planned out-year payments to the current How Our Calculation of the Surplus Interacts With State Financial Statements State Produces Annual Financial Statements. Each year, the State Controller’s Office works with departments to produce the Comprehensive Annual Financial Report (CAFR). The CAFR displays the state’s finances in compliance with generally accepted accounting principles (GAAP) for state and local governments in the United States. The Governmental Accounting Standards Board—a nonprofit entity—has a key role in establishing GAAP for state and local governments. The State Auditor’s Office audits the CAFR, and the report is released each spring. How the Budget Can Have a “Surplus” and Hundreds of Billions of Dollars of Liabilities. The CAFR includes a statement of the state’s assets and liabilities, which are not reflected in the state budget. For example, the CAFR reflects the state’s hundreds of billions of dollars in liabilities, but those do not appear in the budget. That is because financial statements like the CAFR serve a different purpose than the state budget. Debts like unfunded liabilities have budgetary implications to the extent that addressing them requires more (or less) expenditures in a given year. Financial statements are important for budgetary conversations because they signal the extent to which these future payments will grow. However, the calculation of the state’s budgetary position—for example, the surplus or deficit—in any given year is not otherwise affected by changes in unfunded liabilities and other debts. 14 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2020-21 BUDGET year, resulting in $235 million in additional under Proposition 2. (The box below describes payments this year. Proposition 2 in more detail, including the various ways it improves budget resilience.) The Governor Governor’s Budget Chooses to Suspend allocates these payments to a few different Program Expenditures in 2023-24. The purposes, placing an emphasis on the state’s 2019-20 budget package made a number of unfunded liabilities for teachers’ pensions. While ongoing program augmentations subject to this payment would help to pay down debt, it is suspension on December 31, 2021 if the budget is unlikely to result in state savings over the next few not projected to collect sufficient revenues to fund years. As a result, it has little effect on the multiyear them. The augmentations subject to suspensions budget condition. were in a variety of state programs, including In-Home Supportive Services, developmental Key Elements services, and Medi-Cal. The Governor proposes In this section we describe—and then provide delaying the planned suspensions by 18 months— our evaluation of—the two key elements of the to July 1, 2023. However, because the Governor Governor’s multiyear budget structure: the planned also proposes new spending of roughly the same operating surplus and reserve level. In particular the cost of these suspended programs, he is effectively Governor proposes: choosing to suspend the program expenditures in order to fund its new priorities. Absent the new • Multiyear Budget Structure With Small proposed spending that totals roughly $2 billion in Operating Surpluses. Figure 8 (see next 2023-24, the suspensions would not need to be page) shows the operating surpluses operative. under the administration’s estimates in the Constitutionally Required Debt Payments Governor’s proposed budget. (Importantly, Focus on Teachers’ Pensions. The Governor this figure shows the administration’s also makes choices in allocating constitutional own assessment of its proposals, not our requirements that affect the budget’s structure. independent estimates.) As the figure shows, (These requirements are considered part of baseline the administration’s estimates suggest the spending and so are not included in the allocation proposed budget is in structural balance with of the $6 billion surplus.) In particular, under the operating surpluses near zero in most years of Governor’s revenue estimates, the state is required the period. to make $2 billion in additional debt payments How Proposition 2 Improves Budget Resilience Reserve Deposits Mitigate Revenue Losses. Proposition 2 (2014) aims to insulate the budget from revenue declines in several ways. In particular, it sets aside monies—including from capital gains, one of the most volatile components of state revenues—and dedicates them to budget reserves and debt payments. It therefore first mitigates revenue losses first by taking revenues “off the table” in good economic times, which can lead to lower ongoing spending— increasing the state’s operating surplus. Second, it requires the state to build budget reserves. Some Debt Payments Further Increase Operating Surplus. To the extent that Proposition 2 debt payments are used to pay down debts that result in state savings, the measure also further increases the state’s operating surplus. For example, in the 2019-20 budget, $1.1 billion in Proposition 2 debt payment requirements were used to make a supplemental payment to the California State Teachers’ Retirement System (CalSTRS). This payment is likely to reduce state contributions to CalSTRS over the next few decades, saving the state money. However savings are unlikely to begin accruing for at least a few years. www.lao.ca.gov 15 analysis full gutter 2020-21 BUDGET • Total Reserve Balance of $20.5 Billion. Governor and avoid suspending existing program Under the Governor’s proposed budget, the expenditures in 2023-24. While we acknowledge state would end 2020-21 with $20.5 billion there is a great deal of uncertainty in these in total reserves. This represents an increase estimates, the Governor’s budget effectively of $1.7 billion from the 2019-20 enacted chooses to make new program augmentations reserve level of $18.8 billion. This increase at the expense of existing expenditures subject is nearly entirely attributable to the state’s to suspension. If the Legislature agrees with the constitutional reserve requirement. (Reserve assumptions underlining the Governor’s budget, we deposits would also continue throughout recommend it consider whether the new spending the period, as required under the state proposed by the Governor is a higher priority than constitution and also shown in Figure 8.) the augmentations subject to suspension. Forgoing some of these augmentations also would increase Recommend Legislature Consider Priority the state’s operating surplus over the multiyear of Governor’s Proposals Relative to Proposed period. Suspensions. The administration’s own multiyear Operating Surplus More Important This Year estimates suggest the state cannot afford both Than Prior Years. Reserves are the best tool the to make the new augmentations proposed by the state has to address budget problems that emerge during Figure 8 temporary shocks to the state Operating Surpluses Are Small Under budget—such as a recession. Governor's Budget Proposals and Estimates However, they are a poorly (In Billions) suited and inappropriate tool for addressing ongoing structural budget problems. For example, if $2.5 the state in unable to gain federal approval for the MCO tax, using Required Reserve Deposits 2.0 reserves to cover the budget Planned Operating Surplus problem that likely would emerge would be inadvisable. Similarly, if 1.5 the economy cools and revenue growth weakens—as some 1.0 economic signals suggest—we likely would advise the Legislature against using reserves to cover 0.5 any ensuing budget problems. As such, maintaining an operating surplus is the key tool to prevent 2020-21a 2021-22 2022-23 2023-24 risks like these from developing into deficits—making it more important to the budget condition Key Assumptions Economy continues to grow. than it has been in previous years. MCO tax is approved by federal government starting in 2021-22. By proposing a budget that does Automatic suspensions take effect in 2023-24. not include much of an operating surplus, the Governor eliminates this cushion at the very moment a Budget has an operating deficit in this year as the Governor proposes spending unanticipated prior-year revenues. the risk of doing so is heightened. MCO = Managed Care Organization. Correspondingly, we have recently sharpened our focus on this issue. 16 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2020-21 BUDGET Proposed Reserves Are Sufficient to $2 billion of new ongoing spending. (Our Cover Revenue Loss of $47 Billion. After outlook does not assume any new spending accounting for the proposed operating surplus above what is required to fund existing and constitutional funding requirements, the services.) Governor’s level of reserves could address a • Governor Builds Less in Reserves. revenue loss of $47 billion. (This assumes schools The second reason for the difference in and community colleges are funded at their preparedness is the planned reserve level. In constitutional minimum level.) This is less than our Fiscal Outlook scenario, we assumed the the revenue loss we estimated the budget could state entered the recession with $23 billion in withstand—$57 billion—in our most recent Fiscal reserves. The Governor proposes a reserve Outlook. There are two reasons the Governor’s level of $20.5 billion. budget is less prepared for a recession than our To Prepare for a Larger Revenue Loss, Either Fiscal Outlook anticipated: More Reserves or Higher Operating Surpluses • Lower Operating Surpluses. First, the Are Needed. By proposing a budget with very Governor proposes lower operating surpluses small operating surpluses, the Governor eliminates than our Fiscal Outlook anticipated. In a key tool of recession preparedness. In a particular, our Fiscal Outlook estimated the still-growing but now mature economic expansion, budget would have operating surpluses of supplementing the state’s fiscal resilience by roughly $3 billion each year. The Governor’s preserving a larger operating surplus would be estimated operating surpluses, however, are prudent. Alternatively, if the Legislature chooses to near zero in two years of the period. There follow the Governor’s approach on the operating are two reasons for this difference: (1) the surplus, we advise building more reserves, for Governor assumes lower revenue growth than example, by repurposing some of the Governor’s we do and (2) the Governor proposes nearly one-time spending proposals. CONCLUSION California has made significant progress in recent At times, concepts like multiyear budgeting and years to improve its budget structure, making the state’s operating surplus are complex and seem the state more fiscally resilient. Yet the process abstract. Yet we do not emphasize the importance of achieving resilience can never be considered of them for their own sake. Rather, the goal of this finished. In fact, the goals for state reserves and exercise is to evaluate whether or not the state operating surpluses will constantly shift, updating can afford to keep its current commitments and each year depending on new information about to help decision makers determine the extent to the challenges and conditions facing the state. As which the state can support new services. While a result, the state’s fiscal condition and budget we conduct this exercise based on what we know structure must be revisited each year. today—and our knowledge of the world and the future is limited—it is nonetheless integral to these decisions. www.lao.ca.gov 17 analysis full gutter 2020-21 BUDGET LAO PUBLICATIONS This report was prepared by Ann Hollingshead and reviewed by Carolyn Chu. 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