The State Appropriations Limit

The State Appropriations Limit GABRIEL PETEK LEGISLATIVE ANALYST APRIL 2021 analysis full gutter AN LAO REPORT Executive Summary The State Appropriations Limit (SAL) Likely to Limit Spending Growth in the Budget Year and Future Years SAL Will Be an Important Issue at May Revision. Proposition 4 (1979) established an appropriations limit on the state and most types of local governments. The appropriations limit is based on appropriations from tax revenue. If the state has revenues above the limit over two consecutive years, the State Constitution requires the state to split the excess between taxpayer rebates and additional spending on schools. In the Governor’s budget, the administration estimated the state would have revenues in excess of the limit in some years between 2018-19 and 2021-22. Specifically, according to initial estimates, the state has excess revenues of about $100 million between 2018-19 and 2019-20 and about $500 million between 2019-20 and 2020-21. These amounts represent less than 1 percent of the limit in these years. The administration will update its estimates at the May Revision. In light of strong revenue collections that have occurred since January, we anticipate responding to the requirements of the SAL will be an important issue for the state budget this year. SAL Likely to Be a Major Issue Over the Next Few Years. Our analysis suggests the SAL will be an even more important factor in the state budget in the coming years. The figure below shows our projections of the likely “room” under the limit over the next few years. Projections of the amount of room under the limit are highly uncertain, as shown by the wide range of possible outcomes in the figure. That said, under the vast majority of likely outcomes, we anticipate the state will have “negative room.” That is, the state either would need to reduce taxes or issue refunds to taxpayers and make additional payments to schools in these amounts. Further, without significant budget changes, the state likely does not have the capacity for new services or program expansions. Why Is the Limit Estimated State Appropriations Limit Room an Issue Now? (In Billions) More Likely Less Likely There are two primary $20 reasons that room under 10 the limit has diminished. First, growth in personal income tax revenue—the -10 state’s largest revenue -20 source—has exceeded -30 the SAL’s growth -40 rate. There are a few -50 reasons for this, but two important factors -60 2020-21 2021-22 2022-23 2023-24 2024-25 are: (1) the state’s tax rate structure combined with (2) faster income www.lao.ca.gov 1 analysis full gutter AN LAO REPORT growth among high-income earners. As a result, year-to-year growth in appropriations has been higher than increases in the SAL. Second, constitutionally required school spending—driven by faster state revenue growth—has increased faster than school limits. Because the state absorbs appropriations above school limits, this trend has resulted in diminished room for the state. How Can the Legislature Respond? Options for Legislative Consideration. In the coming months and years, the Legislature will face decisions about how to respond to state tax revenues nearing the limit. This report describes various options that the Legislature could consider in response. They fall into five categories: (1) issue tax refunds and allocate excess revenues to schools, (2) increase spending on excluded purposes, (3) reduce proceeds of taxes and spending, (4) make statutory changes to the SAL, and (5) go to the voters. Short- and Long-Term Options Needed. Few of these options, in isolation, are likely to be sufficient to keep the state from exceeding the limit over the next few years. For example, this year, the Legislature could decide to issue refunds and provide additional funding to schools. This response might not be sustainable over the long term, however. As existing program costs increase, revenues available for appropriation could be insufficient to meet current service levels. Consequently, changes to the state’s revenues and expenditures would be required. Alternatively, should the Legislature pursue statutory changes to the SAL, those changes would be unlikely to be sufficient to avoid reaching the limit in the next few years. In that case, considering placing a measure before the voters could be needed. Constructing a Plan. We recommend the Legislature construct a short- and long-term plan for how it wishes to respond. To aid the Legislature in constructing this plan, the figure below summarizes the options presented in this report, when each option could take effect, and our estimate of the potential magnitude of each potential change. Consider Timing and Amounts of Various Policy Options Policy Option Timing Amount Issue tax refunds and allocate excess Immediate. Legislature can pursue immediately. However, Tens of billions revenues to schools significant, ongoing refunds and school allocations could require more structural changes to the state budget. Increase spending on excluded purposes Immediate. The Legislature can increase spending on excluded Billions purposes in the 2021-22 budget. Reduce proceeds of taxes and spending Depends. The Legislature can pursue these reductions Tens of billions immediately, but major reductions to state services would take time to implement. Make statutory changes to the SAL • Shift room under school district limits to the Immediate. Legislature could implement in budget trailer bill Five billion state. legislation in 2021-22. • Redefine local government subventions. A Year or So. The Legislature could enact the statute in budget Up to ten billion trailer bill legislation, but the policy change would take the administration time to implement. Go to the voters • Request temporary increase in the state’s limit. A Year or More. The Legislature could place a measure on the Unlimited • Request change to school and community ballot to request a change. Tens of billions college limits. • Request change in when reserves are counted A couple billion toward the limit. • Request more fundamental change. Unlimited 2 LEGISLATIVE ANALYST’S OFFICE analysis full gutter AN LAO REPORT INTRODUCTION In the late 1970s, voters passed Proposition 4 will update this estimate at the May Revision. (1979), which added Article XIIIB to the State As such, the state appropriations limit (SAL) or “the Constitution. Article XIIIB established an limit” will be an important issue in state budgeting appropriations limit on the state and most types this spring. Perhaps more importantly, as discussed of local governments. (These limits also are in this report, our estimates suggest the growth in referred to as “Gann limits” in reference to one state appropriations subject to the limit are likely of the measure’s coauthors, Paul Gann.) The to significantly outpace growth in the limit in the appropriations limits later were amended by coming years. Absent a revenue downturn in the Proposition 111, which was passed by voters in coming years, the Legislature most likely will have 1990. The purpose of the appropriations limits to make major changes to state budgeting. is to keep real (inflation adjusted) per-person This report begins with background information government spending under 1978-79 levels. on how the limit works for the state, school For more information about the history of the districts, and local governments. Next, we explain appropriations limit, see our previous reports, why the limit is a constraint for state government. including The 2017-18 Budget: Governor’s Gann Importantly, our analysis suggests this constraint Limit Proposal, The State Appropriations Limit, and will be a major issue for California in the next An Analysis of Proposition 4 the Gann “Spirit of 13” few years. Then we discuss some administrative Initiative. issues in the appropriations limits for both the state At the time of Governor’s budget this year, the and school districts. We conclude with a variety Department of Finance (DOF) expects the state to of short- and long-term policy options—both of collect revenues in excess of the limit in some years which we think the Legislature will need to take—in between 2018-19 and 2021-22. The administration response to the issue. HOW THE LIMIT WORKS FOR THE STATE The SAL calculation has three steps: (1) calculate total level of state spending, adjusted for a variety the spending limit, (2) determine appropriations of factors, in 1978-79 (known as the base year). subject to the limit, and (3) determine the room (if In determining the base year, the Legislature had any). These steps are described in this section and to make a variety of choices about how to count summarized in Figure 1 on the next page. DOF has various appropriations. For example, the Legislature the responsibility for executing these calculations. had to determine which types of spending would While the Legislature determines annual count at the state level versus the local level. appropriations and defines key parameters of the Increase Limit by Growth Factor. Each year, calculation in statute, it does not have a direct role the state grows the limit by multiplying the previous in administering the limit. year’s limit by a growth factor. The two most important inputs to the growth factor are: Calculate the Spending Limit • Measure of Economic Growth. This growth First, the state calculates the limit. This limit, as factor is calculated by taking: (1) California shown in the top part of Figure 1, is the previous fourth quarter personal income, as measured year’s limit grown for the SAL growth factor. by the U.S. Bureau of Economic Analysis, Build Off of 1978-79 Base Year. The provisions divided by (2) the civilian population of the of Proposition 4 keep real per capita government state, as measured by DOF. (The State spending under the 1978-79 level, adjusted for population. As such, today’s limit is based on the www.lao.ca.gov 3 analysis full gutter AN LAO REPORT Constitution refers to this measure as the • Subventions to Local Governments. “cost-of-living” adjustment.) The Constitution allows subventions to local • Measure of Population Growth. The SAL governments to be counted against that local growth factor’s second major input is change government’s limit (instead of the state’s limit). in population. To measure population, the The term “subvention” was not defined in formula uses a weighted average of the Proposition 4. The implementing legislation change in the school population and the passed in 1980 established the definition of change in the state’s civilian population. subvention as: “only money received by a local agency from the state, the use of which is unrestricted by the statute providing the Determine Appropriations subvention.” Subject to the Limit • Debt Service. The Constitution defines Second, the state determines appropriations this exclusion as: “appropriations required subject to the limit. These are determined by first to pay the cost of interest and redemption estimating proceeds of taxes from all state sources charges ... on indebtedness existing or legally and then subtracting exclusions. authorized as of January 1, 1979, or on Determine Proceeds of Taxes. All state bonded indebtedness thereafter approved proceeds of taxes are included in the limit according to law by a vote of the electors...” regardless of their fund source. This means the In implementing legislation, the Legislature limit applies not only to the General Fund but chose not to include some outstanding debt also all special funds that receive revenues from that existed in 1979—such as unfunded taxes. Revenues from nontax sources—like user fees—are not included in the SAL. Some revenues, such as taxes Figure 1 on cigarettes from Proposition 56 How the State Appropriations Limit (SAL) Works (2016), were excluded from the SAL by the voters. Federal funding Step 1 also is excluded from the SAL. Calculate the Spending Limit So, the first step in calculating appropriations subject to the limit Prior-Year Limit is to estimate the total proceeds of taxes subject to the limit. Adjust for SAL Growth Factor (Major Inputs Are Economic Growth and Population Growth) Assume All Revenues Subject to the Limit Are Appropriated. Under the constitutional provisions This Year’s Limit of the SAL, all tax revenues are considered appropriated Step 2 unless explicitly excluded. For Determine Appropriations Subject to the Limit from Proceeds of Taxes example, reserve deposits are considered appropriations in the Appropriations Subject to the Limit Exclusionsa year the deposit is made. This means there is no such thing as “unappropriated” tax revenues. Step 3 Reduce Appropriations for Determine the Room Exclusions. The Constitution • If proceeds of taxes (after exclusions) are below the limit over a two-year period, do nothing. • If proceeds of taxes (after exclusions) are above the limit over a two-year period, split between allows the state to reduce school and community college spending and taxpayer rebates. proceeds of taxes for certain aExclusions are appropriations that are not counted towards the state appropriations limit. exclusions. These exclusions are: For example, spending on capital outlay is excluded. 4 LEGISLATIVE ANALYST’S OFFICE analysis full gutter AN LAO REPORT pension liabilities—as an exemption • Certain Emergency Spending. under this language. The Constitution also allows expenditures • Federal and Court Mandates. The on emergencies to be excluded from Constitution created an exclusion for appropriations subject to the limit. However, appropriations that are required to comply those expenditures must meet three specific with mandates imposed by the courts or the conditions. The spending must be: (1) related federal government. To qualify as a mandate to an emergency declaration by the Governor, for SAL purposes, the federal or court (2) approved by two-thirds vote, and requirement must result in an expenditure (3) dedicated to an account for expenditures for additional services “without discretion” or relating to that emergency. “unavoidably make the provision of existing services more costly.” In our office’s view, Determine the Room the mandate must have been created after Third, the state compares the limit (calculated 1978-79 to qualify as an exclusion. Otherwise, in step 1) to appropriations subject to the limit the cost of that mandate would have been (calculated in step 2) to determine the difference. included in the base year’s limit. If appropriations subject to the limit are less than • Qualified Capital Outlay Projects. The the limit, the state has room under the SAL. If Constitution allows expenditures on appropriations subject to the limit exceed the limit capital outlay projects to be excluded from (on net) over any two-year period, there are excess appropriations subject to the limit. Statute revenues. The Constitution requires that these defines this as: “an appropriation for a fixed excess revenues either be: asset (including land and construction) with a useful life of 10 or more years and a • Appropriated for purposes exempt from value which equals or exceeds one hundred the SAL. thousand dollars ($100,000).” • Split between additional school and community college district spending and taxpayer rebates. HOW THE LIMITS WORK FOR OTHER ENTITIES Proposition 4 not only created an appropriations • Determine Base-Year Appropriations limit for the state, but also for most types of local Subject to Limit. Like the state, districts government entities, including: counties, cities, calculated their appropriations subject to special districts, and local educational agencies. the limit for the base year of 1978-79. This This section describes how the appropriations limits required districts to determine proceeds work for these other entities. of taxes, including their local property tax collections and subventions they received School and from the state, in that year. Like the state, Community College Districts districts determined their appropriations subject to the limit, less exclusions such District SAL Calculations. State statutes as debt service. As implemented by the detail the process by which districts administer Legislature, districts counted a share of state their limits. (All school districts, county offices of funding at the district level, with remaining education, and community college districts have state funds, including funds for categorical local appropriation limits. Throughout this section programs, counted at the state level. we use the term “district” to refer to these entities.) The key steps are: www.lao.ca.gov 5 analysis full gutter AN LAO REPORT • Grow Appropriations Limit. Like the their limits and reduce the state’s room. Currently, state, districts grow their prior-year limits to there is about $17 billion in district revenues above establish their current-year limits. Specifically, their limits that is counted at the state level. each district adjusts its prior-year limit for Some Districts Have Room Under Their (1) statewide growth in per capita personal Limits. Although most districts have proceeds income, and (2) changes to its student of taxes in excess of their local limits, about population. School districts measure their 10 percent of districts are below their limits. We student population using average daily refer to this difference between the limit and attendance, whereas community colleges use appropriations subject to the limit as “room.” This full-time-equivalent enrollment. situation can occur if a district had a historically • Determine Appropriations Subject to high appropriations limit, or if a district has been Limit. After a district establishes its limit, experiencing relatively slow growth in funding. it follows several steps to determine how Collectively, districts have $5 billion in room. much of its revenue from proceeds of taxes Illustrative Example: How the State and to count toward its limit. For most districts, District Limits Interact. Figure 2 shows the proceeds of taxes is the sum of their share of relationship between the state and district the local property tax, parcel taxes, interest appropriations limits when the state absorbs on investments, and general purpose state districts’ excess appropriations. In most cases, funding (for example, the Local Control when a district exceeds its appropriations limit Funding Formula for school districts or (shown in the graphic as School District 1), the the apportionment formula for community state increases its own appropriations subject colleges). The funding districts receive to the limit, thereby reducing the state’s own through categorical programs counts toward room. Districts that are below their appropriations the state’s limit and is not part of the district limits have room available, but that room calculation. Similar to the state, districts can exclude Figure 2 expenditures related to How the State and District Limits Interact meeting federal mandates or court orders. State’s Limit Funding That Cannot Be Counted Toward District Limits State Appropriations Subject to the Limit “Room” Is Counted at the State Level. In most cases, districts have greater Annual Limit proceeds of taxes than they are School District 1 able to count toward their local Revenues limits. The portion of funding (whether from the state or property District Revenues Above the Limit State absorbs district revenues above taxes) that cannot be counted their limits, resulting in less room for the state. toward district limits is counted using the state’s limit. The state has two ways to allow districts to Annual Limit spend above their limits. Either School District 2 the state transfers some of its Revenues own limit to districts or it absorbs some of the district’s excess This school district has room under its limit. appropriations and counts those at This room is not moved to the state. the state level. Either mechanism allows the districts to spend above 6 LEGISLATIVE ANALYST’S OFFICE analysis full gutter AN LAO REPORT is not transferred to the state (see School reduce their appropriations subject to the limit District 2 in the graphic). by exclusions, such as debt service and costs for complying with mandates. Local Governments Very Small Amount of State Funding to Local Government SAL Calculations. Local Governments Counted as Subventions. The Constitution and state statutes detail the Each year, the state dedicates tens of billions of process by which local governments administer dollars in General Fund and special fund monies their limits. The key steps are: to local governments—particularly counties—for • Determine Base-Year Appropriations a variety of purposes. For example, the state Subject to Limit. Like the state, local dedicates funding to counties for the administration governments calculated their appropriations of several health and human services programs, subject to the limit for the base year of like California Work Opportunity and Responsibility 1978-79. Local governments determined to Kids and Medi-Cal. The state also provides proceeds of taxes, including their local funding for a broad range of programmatic property tax collections, and subventions they activities, for example, in criminal justice, housing received from the state. and homelessness, and transportation. However, very little of this funding is counted toward local • Grow Appropriations Limit. Like the state, governments’ limits because funding must be local governments grow the prior year’s unrestricted to meet the statutory definition of limit to establish the limit for the current a subvention. Consequently, the state counts year. The constitutional growth factors local this funding towards its limit. The administration governments can use are different and much currently counts two major categories of funding more flexible than the state’s and districts’ to local governments as subventions: the vehicle factors. For example, counties can use any license fee (VLF) and property tax backfills that the of the following population adjustments in state has provided to locals. calculating their limits: (1) the change in population within the county, (2) the change Cities and Counties Have Substantial Room in population in the county and all counties Available Under Their Limits. According to data that have contiguous borders with it, or (3) the from 2018-19, only 6 counties (10 percent) and change in population within the incorporated 68 cities (14 percent) have spending that is above portion of the county. 80 percent of their limits. A substantial majority of cities and counties (82 percent of counties and • Determine Appropriations Subject to 70 percent of cities) have spending at or below Limit. In general, for most local governments, 60 percent of their limits. Collectively, counties have proceeds of taxes is the sum of their local nearly $100 billion while cities have $55 billion in taxes, interest on investments, and state collective room under their limits. subventions. Like the state, local governments www.lao.ca.gov 7 analysis full gutter AN LAO REPORT WHY IS THE SAL A CONSTRAINT FOR THE STATE NOW? History of SAL Room Under the Limit Has Diminished Over the Last Decade. The state’s appropriations SAL Constrained State Spending in subject to the limit fell substantially during the Mid-1980s. Figure 3 shows historical calculations dot-com bust in the early 2000s and again during of the state’s limit and appropriations subject the Great Recession due to the significant decline to the limit. Initially, the SAL had little effect on in state revenues during those downturns. Since state budgeting. During the late 1970s and early around 2009, however, room under the limit 1980s, high inflation and slow revenue growth has narrowed. As we discuss below, there are a increased room under the limit. By the mid-1980s, variety of reasons for this, including: underlying however, strong revenue growth quickly brought growth in revenues (as growth in taxpayers’ state appropriations closer to the limit. In 1986-87, incomes has outpaced economic growth) and the state had excess revenues of $1.1 billion. the voters’ decisions to raise additional revenues, Proposition 4 required the excess to be rebated among others. to taxpayers. Significant Upward Revisions to Revenues Proposition 98 (1988) and Result in Diminished Room. When the 2020-21 Proposition 111 Made Changes to the Budget Act was passed, it appeared the state had SAL. In 1988, voters passed Proposition 98. substantial—that is, tens of billions of dollars—in Proposition 98 is the state’s constitutional minimum room under the limit. This room was due to the funding guarantee for schools and community anticipated recession and associated revenue colleges. Proposition 98 also amended the declines as a result of the pandemic. However, Constitution to require a portion of revenues as of the January Governor’s budget, revenues above the limit—up to 4 percent of the minimum have been tens of billions of dollars higher than funding requirement—to be allocated to schools anticipated. As a result of these significant upward and community colleges. Two years later, revisions in revenue and associated appropriations Proposition 111 also made significant changes to subject to the limit, the state’s room has the SAL. First, the measure changed the population diminished considerably. and inflation growth factors in a way that created more room for state and local appropriations. Second, it required Figure 3 excess revenues to be determined History of the State Appropriations Limit over a two-year period rather than (In Billions) in a single year, making it less $140 likely to trigger taxpayer rebates and additional Proposition 98 120 spending. Third, the measure 100 changed how excess revenues 80 were to be distributed. Specifically, State Appropriations Limit “Room” 60 Proposition 111 required that half of the excess be allocated 40 Appropriations Subject to the Limit to additional district spending 20 and half to taxpayer rebates. Lastly, Proposition 111 added 1978-79 83-84 88-89 93-94 98-99 03-04 08-09 13-14 18-19 21-22 additional categories of Note: Figure reflects administration's January 2021 estimates. appropriations exclusions. 8 LEGISLATIVE ANALYST’S OFFICE analysis full gutter AN LAO REPORT Dynamics Resulting in (2016)—which established state excise taxes on Diminished Room cannabis—further diminished room under the state’s limit. Growth in Personal Income Tax Revenue Has School Spending Growing Faster Than School Exceeded Growth in Personal Income Itself. Limits. Over the past several years, Proposition 98 The most important factor in determining SAL has required the state to provide relatively large growth is change in per capita personal income. increases in funding for schools and community In recent years, per capita personal income has colleges. In large part, these large increases were grown more slowly than the state’s largest revenue driven by the growth in tax revenues described source—the personal income tax. The two key earlier. For schools, general purpose funding grew reasons for this are: (1) the state personal income by an average annual rate of 7.1 percent from tax rates are higher for higher-income earners, 2013-14 through 2019-20. School district limits, and (2) high-income earners have experienced by contrast, grew more slowly. Specifically, the faster income growth than the general population. growth in per capita personal income and student This is amplified by the fact that the state treats attendance (the two factors affecting district limits) capital gains on sales of assets as taxable income, averaged 3.1 percent per year over the period. but capital gains are excluded from the measure Because most school districts have no room under of personal income used to calculate the SAL. their local limits, the state counted most of the Moreover, Californians with the highest incomes increase in school funding over this period toward receive a disproportionate share of their income its own limit. Between 2013-14 and 2019-20, from capital gains. Consequently, capital gains the amount of school funding counting toward revenues account for an outsized portion of the state’s limit increased from $4.9 billion to personal income tax revenue growth, yet they $17.3 billion. Community colleges also experienced do not increase the measure of personal income notable increases in their apportionment funding used to calculate SAL. Figure 4 shows how these over this period, although their increases tended to factors result in differential growth rates between be smaller than those for school districts. personal income, total income for those earning more than $200,000 annually, and personal income tax revenue from Figure 4 those high earners. Growth in Revenues on Personal Income Policy Decisions Accelerated Has Exceeded Growth in Personal Income Itself Underlying Trend. Underlying trends in personal income and Cumulative Percent Increase Since 2010 asset prices would have resulted 150% in faster growth in revenues than the SAL regardless of other tax policy decisions. Decisions to increase tax rates, however, have 100 PIT Revenue $200K+ diminished the state’s room under the limit more quickly. In particular, Adjusted Gross Proposition 30 (2012) increased— 50 Income $200K+ and Proposition 55 (2016) extended—the top marginal Personal Income rates for the personal income tax, thereby resulting in more 2010 2011 2012 2013 2014 2015 2016 2017 2018 state collections from capital gains. Other new tax levies, like PIT = personal income tax. the passage of Proposition 64 www.lao.ca.gov 9 analysis full gutter AN LAO REPORT Population and Average Daily Attendance declining. For example, school enrollment growth Have Been Flat or Declining. Trends in the state’s has averaged -0.1 percent over the last decade, population—both for civilians and school-aged compared to 2.26 percent in the 1990s. Overall children—also are determinants of the growth in state population growth has averaged 0.7 percent the limit. Over the last decade, state population over the last decade, compared to 1.3 percent in overall and of school-aged children has been flat or the 1990s. HOW MIGHT THE SAL LIMIT STATE SPENDING GROWTH? In the Budget Year Federal Funding Excluded From the SAL. Federal funding, including the $26 billion in fiscal State Has Diminished Room From 2018-19 to relief monies provided to California in the American 2021-22. Based on the Governor’s January budget, Rescue Plan, does not count toward the SAL. state tax revenues already are close to the limit However, the federal government prohibits the state across the budget window. Specifically, the state from using these funds—directly or indirectly— is within a few billion dollars of the appropriations to lower tax revenues. This could create some limit across 2018-19 to 2021-22. While the limit complications for the Legislature’s response to the will change in May due to updated growth factors, SAL, which we discuss in more detail below. increases in the state’s tax revenues that are not spent on excluded purposes will result in either Over the Longer Term diminished room or excess revenues. SAL Likely to Be a Major Issue Over the Next SAL Will Be an Important Issue at May Few Years. While the SAL might be an important Revision. Since the Governor’s budget was issue for the Legislature to consider as it crafts the released, tax collections for the General Fund 2021-22 budget, our analysis suggests it will be an have continued to exceed expectations. For even more important factor in the state budget in example, as of March, tax collections are ahead the coming years. Figure 5 shows our projections of the Governor’s budget projections by more of the likely room under the limit over the next few than $10 billion for 2020-21. Due to limited room under the state’s limit, Figure 5 these strong collections suggest the Estimated State Appropriations Limit Room SAL will be an important issue in crafting (In Billions) the budget. That said, there also are More Likely Less Likely many other factors that will affect the $20 SAL calculations at the May Revision. 10 For example, the administration will update the calculation of the limit itself, which we expect to increase as a result -10 of recently released data on personal -20 income. In addition, the calculation will -30 reflect updated estimates of excluded -40 spending reflecting decisions made -50 by the Governor in the May Revision -60 budget proposal. 2020-21 2021-22 2022-23 2023-24 2024-25 10 LEGISLATIVE ANALYST’S OFFICE analysis full gutter AN LAO REPORT years. (The nearby box describes our methodology refunds to taxpayers and make additional payments for arriving at these estimates in more detail.) to districts in these amounts. Within a few years, Projections of the amount of room under the limit there is a good chance of a substantial amount of are highly uncertain, as shown by the wide range negative room. Specifically, by 2024-25, the state of possible outcomes in the figure. That said, under is more likely than not to have negative room in the vast majority of likely outcomes, we anticipate excess of $10 billion. As a result, we anticipate the the state will have “negative room;” that is, the Legislature will need to make—potentially major— state would either need to reduce taxes or issue changes to the state budget in the coming years. Methodology for Forecasting State Appropriations Limit (SAL) Room The analysis described in this section uses historical data and forecasting techniques to account for a wide range of possible economic and policy scenarios, which drive different SAL outcomes. These models make a number of important assumptions. For example, we assume: • The long-term trend of higher income growth among high-income Californians continues, resulting in faster growth in state revenues. • The future level of new and expanded special fund taxes and fees will be similar to the past. • The Legislature continues to dedicate spending toward excluded and non-excluded purposes in similar proportions to historical trends. • School district limits grow at roughly the same rate as the statewide limit. ADMINISTRATIVE ISSUES IN THE SAL In this section, we describe a variety a significant share of these costs are assumed to of administrative issues in the SAL that be reimbursed by the federal government—and we recommend the Legislature direct the therefore excluded from proceeds of taxes—the administration address. administration currently is not counting any of the state’s emergency spending as an exemption Emergency Spending under the SAL. Administration Is Not Counting State Significant Share of State Spending on Spending on Emergencies as Exclusions. Recent Disasters Qualifies as Exemption. Over the past two years, the state has spent We think much of the state spending on these billions of dollars on the coronavirus disease emergencies meets the criteria needed for an 2019 (COVID-19) public health emergency. emergency exemption and should be excluded The administration currently estimates direct in the state’s SAL calculations. (Federal funding response costs related to COVID-19 will be is already excluded from the SAL, so federal $15 billion across 2019-20 through 2021-22. In reimbursements to the state for emergency 2018-19 through 2020-21, the state also spent spending would not count as exclusions.) As roughly close to $5 billion for wildfire response and mentioned above, certain conditions must exist for remediation through the Disaster Response and state spending on an emergency to qualify as an Emergency Operations Account (DREOA). While exemption, which exist in these cases: www.lao.ca.gov 11 analysis full gutter AN LAO REPORT • Governor Declared Emergency. change. Under current law, VLF does not meet the First, to qualify as an exemption, spending statutory definition of a subvention and should not on emergencies must be made in response be counted as such. Changing the treatment of VLF to a declared emergency by the Governor. in the SAL calculations would result in diminished The Governor declared a state of emergency room of about $3 billion annually. related to the COVID-19 pandemic on School and Community College March 4, 2020. This emergency is still ongoing. Since 2018, the Governor also Districts Exclusions declared states of emergency related to State Limit Affected by District Estimates various wildfires. For example, the Governor of Excludable Appropriations. One aspect of declared a state of emergency related to districts’ calculation of particular importance to the the Camp wildfire on November 8, 2018, state is the amount of spending districts attribute and related to the LNU Lightning Complex to federal and court mandates enacted after and other wildfires burning statewide on 1978-79. This is important because the amount a August 18, 2020. district spends on these mandates does not count • Appropriations Made From DREOA. toward the limit of either the district or the state (if Second, to qualify as an exemption, the district is over its limit). According to the latest funds must be spent from a fund that is available data, districts identified about $650 million appropriated for the emergency and the in mandated spending. Based on our recent appropriation must have been approved review, we think the actual amount could be at with a two-thirds vote. The administration least several hundred million dollars higher, which has made all of the above expenditures could reduce the amount of spending shifted from using DREOA, a fund that is continuously districts to the state by a similar amount. Below, we appropriated for state emergencies. The most describe the two areas where we think additional recent authorizing legislation for DREOA, expenditures could be excluded. Chapter 2 of 2019 (AB 73, Committee on Medicare Payroll Taxes. Federal law has Budget), received a two-thirds vote in both required all schools and community colleges to houses of the Legislature. participate in the Medicare program since 1986. After accounting for federal reimbursements, Similar to private employers, the law requires exempting these appropriations—as provided for in districts to pay a tax equal to 1.45 percent of the Constitution—could result in around $1 billion of payroll. We found that nearly all of the $650 million additional room in each year in the budget window. in mandated expenditures districts currently report are related to the Medicare payroll tax. Vehicle License Fees About 10 percent of districts, however, currently do not account for this tax in the calculation of VLF Does Not Meet Statutory Definition of their local limits. Requiring all districts to account Subvention. Statute defines state subventions for this expenditure in their calculations would as monies that local governments can use for increase excluded appropriations by approximately any purpose. When Proposition 4 was passed, $150 million. VLF revenues—taxes levied on the registration Services for Students With Disabilities. of vehicles—were a flexible funding source that The federal government provides a significant the state passed along to local governments, amount of funding for schools. As a condition thus meeting this statutory definition. In the of receiving some of these funds, the federal 1991 and 2011 realignments, the state dedicated Individuals With Disabilities Education Act requires these revenues to the new financial obligations schools to identify students with disabilities and of counties for realigned programs and provide services and supports necessary for these responsibilities. However, the state did not stop students to obtain a public education. Federal law counting VLF as a subvention under this policy established most of the core requirements of this 12 LEGISLATIVE ANALYST’S OFFICE analysis full gutter AN LAO REPORT act prior to 1978-79. Since that time, however, Net Effect of Administrative Congress periodically has amended the law to Recommendations require schools to provide additional services. For Diminished Room Under the State’s Limit. example, in 1986, the federal government began Exempting emergency appropriations from the requiring districts to provide certain services to SAL—as provided for in the Constitution—could infants and preschool children with disabilities. provide around $1 billion of room in each year in Other changes enacted after 1978-79 range from the budget window. In addition, scrutinizing school giving parents more control over the services and community college district mandate spending provided for their children to defining certain likely would increase room under the state’s limit categories of disabilities more expansively. by several hundred million dollars per year. In Currently, districts do not exclude these additional contrast, however, counting the VLF against the costs in the calculation of appropriations subject state’s limit would reduce room by a few billion to their limits. The state does not currently require dollars per year. Overall, we anticipate addressing districts to track these incremental costs, but we these administrative issues in the SAL would estimate they would represent at least a couple result in less room by a couple of billions dollars in hundred million dollars statewide. each year in the budget window. As summarized in figure 6, we recommend the Legislature direct the administration to make these changes to their calculation of the limit as part of the final budget this year. Figure 6 Summary of Recommended Administrative Issues Issue Recommendation Emergency Spending • Exclude state spending from DREOA on recent Governor-declared emergencies from appropriations subject to the limit. Vehicle License Fees (VLF) • Stop counting VLF revenues to local governments as a subvention. School and Community College Districts Exclusions Medicare Payroll Taxes • Require all districts to exclude Medicare payroll taxes in their calculations. Services for Students With • Require all districts to exclude federal Disabilities mandates related to services for students with disabilities enacted after 1978-79 from their calculations. DREOA = Disaster Response and Emergency Operations Account www.lao.ca.gov 13 analysis full gutter AN LAO REPORT HOW CAN THE LEGISLATURE RESPOND? In addition to addressing administrative issues, exclusions, subventions to local governments and the Legislature faces decisions about how to spending on capital outlay projects, the Legislature respond to approaching the limit. Options range can exercise some discretion. Under current law, from reducing appropriations subject to the limit— new funding to local governments would have which can be done in a variety of different ways— to be provided on a very flexible basis to count to asking the voters if they wish to make a change as a subvention. (Subventions to school districts to the limit itself. This section describes those would not increase the state’s room because most various options. (Because reserve deposits count districts are already at their limits, meaning the as appropriations subject to the limit, unallocated additional funds would revert back to the state as state revenues automatically count against the described earlier.) The existing statutory definition state’s spending limit. Thus, the Legislature does of capital outlay, by contrast, is fairly broad. This not have the option of saving revenues in reserves means funding for some existing state priorities, as a means of responding. In contrast, however, like more spending on housing, likely would qualify. we note that federal funding does not count toward As with other options, however, pursuing more the state’s appropriations limit. Consequently, spending on excluded purposes over the long the federal fiscal relief provided by the American term might need to be paired with other budgetary Rescue Plan does not affect the SAL.) These changes, such as reductions to existing services options are not mutually exclusive. In fact, we due to cost growth. anticipate the Legislature will need to pursue Reduce Proceeds of Taxes and multiple options over the short and longer term. Spending Issue Tax Refunds and Allocate Third, the Legislature could preemptively reduce Excess Revenue to Schools proceeds of taxes. This would automatically The first option in responding to SAL is for the result in less spending on schools and community Legislature to implement Section 2 of Article XIIIB. colleges and would require the Legislature to make Specifically, the state could have excess revenues corresponding reductions in other spending so in one or more years in the current budget window that the budget remained balanced. The state has or in future years. If the Legislature chooses this more flexibility to do this within the General Fund option, any excess revenues over two years would than it does for some special funds because some be equally divided between taxpayer rebates and of those have voter-directed purposes. However, education spending. Over time, these actions— the Legislature also could reduce special fund rebates and education spending—could require revenues and spending. Our analysis suggests the structural changes to the budget if existing program state likely would need to lower revenues (and, costs grew faster than revenues available for correspondingly, spending) by tens of billions of appropriation. In practice, these changes could dollars over the next few years to avoid collecting require significant reductions to nonschool program excess revenues. However, as described in the spending. nearby box, pursuing an option to preemptively reduce revenues also could mean the state would Increase Spending on Excluded lose fiscal relief funds from the federal government. Purposes Make Statutory Changes to the SAL Second, the Legislature could dedicate excess revenues on excluded purposes. For some The fourth option is to make statutory changes exclusions, like federal and court mandates, to the SAL that give the state more room, but legislative decisions play little role in increasing or are consistent with the constitutional provisions decreasing the excluded spending. But for two and voters’ intent in Proposition 4. The options 14 LEGISLATIVE ANALYST’S OFFICE analysis full gutter AN LAO REPORT described below could collectively result in as much unused room have approximately $5 billion in room as $15 billion in additional room. Over the longer available. If the state were to adopt this approach, term, however, the state could still run out of room. it could continue allowing districts to shift some of As our analysis in Figure 5 indicated, there is about the state’s limit whenever they exceed their local a 60 percent chance the state will have more than limits. Allowing shifts to occur in both directions $15 billion in annual excess revenues by 2024-25. would increase flexibility for the state while still As such, if the Legislature pursued these statutory adhering to the principals of Proposition 4 by changes, other actions—either implementing the maintaining the same aggregate appropriations limit provisions of Article XIIIB or otherwise—still could across districts and the state. Moreover, this would be required. not introduce new constraints on district budgets. Shift Room Under District Limits to State. Redefine Local Government Subventions. Current law provides for the state to shift some of The state could consider amending statute to its limit to any district that would otherwise exceed redefine the term subvention, and count more its local limit. This shift, however, only occurs in appropriations at the local, instead of state, level. one direction—from the state to districts. We think Such a change would better reflect the dramatic the Legislature could amend the law to provide for changes in the state-local relationship that have shifts in the opposite direction. Specifically, the occurred since 1980. As a result of the 1991 state could require districts to reduce their limits and 2011 realignments, for example, the state by the amount of any unused room, and increase now provides local governments with a revenue its own limit by a corresponding amount. The latest source for their share of certain program costs, data suggest that the 10 percent of districts with whereas the state and local governments used to The American Rescue Plan (ARP) and the State Appropriations Limit (SAL) ARP Discourages States From Using Fiscal Relief Funds to Make Revenue Reductions. The state is expected to receive $26 billion in fiscal relief funds from the federal government in the ARP. Federal statute prohibits the state from using the funds to directly or indirectly offset a reduction in the net tax revenue of the state through a change in law, regulation, or administrative interpretation. This prohibition applies from March 3, 2021 to the last date on which the state expends the funds. (The state has until December 31, 2024 to use the funds.) As of this writing, we do not yet know how strictly the U.S. Department of the Treasury will interpret the statutory restrictions on these funds. A strict interpretation of the statute could mean the state would not be able to make revenue reductions using General Fund dollars without forgoing an equal amount of federal recovery funds. How Does the ARP Affect SAL Decisions? We have two questions about how the ARP might affect legislative decision-making around the SAL. If the state collects excess tax revenues and issues tax refunds, would the federal government require the state to return a like amount of fiscal relief funds? Given that the SAL existed in the State Constitution prior to March 3, 2021, we think the state has a strong argument that it should not be required to return federal funds. However, if the state proactively reduces proceeds of taxes, would the federal government require the state to return a like amount of fiscal relief funds? We are not sure how the federal government would interpret the rules, but in this case, it seems more likely the state would have to forgo some federal fiscal relief. If this is the case, taking preemptive action to address the limit—for example by reducing taxes and spending—would double the effect on the state budget. That is, each $1 in reduced revenue would reduce state resources by $2. www.lao.ca.gov 15 analysis full gutter AN LAO REPORT share in these costs. (We describe these changes state made the change using a fiscal definition, it in the nearby box. For more information about could result in the state counting up to $10 billion realignment see: Rethinking the 1991 Realignment in additional spending as subventions, mainly and 2011 Realignment: Addressing Issues to to county governments. Using a policy-driven Promote Its Long-Term Success.) definition, the amount of new subventions Updating the definition of subvention to account would be lower. for these structural changes would be consistent This policy change largely would affect counties, with principles of the state-local relationship in but would be unlikely to result in very many—or realignment. Specifically, counting realignment any—counties exceeding their limits. Collectively, revenues at the local level would count the counties have about $100 billion in unused room appropriations at the level of government making and, as noted earlier, very few counties are close many of the decisions about that spending. Further, to their limits. However, the state also could also counting these revenues at the local level would structure this policy to ensure it does not results in maintain the spirit of Proposition 4. The aim of that a local government exceeding its limit, for example, measure was to keep government appropriations, by counting local government revenues in excess of at all levels of government, below the adjusted their limits at the state level. This would be similar 1978-79 level. This change would still adhere to the procedure the state currently has in place for to that basic principal, but would count some school districts. spending within local government limits, instead of Go to the Voters the state’s limit. The Legislature would face choices in Fifth, the Legislature could choose to request implementing this statutory change. One option changes to the state’s limit from the voters. There would be to redefine subventions as are many different ways by which the Legislature any appropriation to local governments for could request this change. We discuss some of programs over which local governments have fiscal those options here. responsibility. Another option would be to center Request Temporary Increase in the State’s the definition on which entity of government has Limit. The Constitution allows the state’s voters more policy responsibility for the program. If the to change the appropriations limit for any entity of State-Local Relationship Has Changed Since 1978 Counties administer many programs on behalf of the state, including most health and human services programs. Historically, counties were responsible for some of the costs of these programs and used local revenue to pay those costs. After Proposition 13 (1978)—the landmark decision by voters to limit property taxes—local governments’ property tax revenues dropped by roughly 60 percent. In response, the state provided a “bailout” to partially backfill local governments’ revenue losses. For counties, this backfill developed into an ongoing change in the state-county fiscal partnership. Today, the state provides dedicated revenue streams to counties to pay for their share of costs for “realigned” programs. Realigned programs are those programs administered at the local level but whose fiscal responsibility is shared between the state and counties (and in some cases, federal government). The state provides dedicated revenues—about $14 billion—to counties for these programs due to their limited ability to raise revenue and due to other provisions of Proposition 4 (1979), which require the state to reimburse state-imposed local requirements. Within limits, counties have discretion over how to use realignment revenues to meet program needs and requirements. 16 LEGISLATIVE ANALYST’S OFFICE analysis full gutter AN LAO REPORT government for a period of up to four years. Under district limits under Proposition 111—would this rule, the Legislature could request the voters maintain spending limits for schools while providing provide a temporary increase in the appropriations greater flexibility in the calculation of those limits. limit. This would give the state time to pursue Request Change in When Reserves Are longer-term and more structural changes to the Counted Toward the Limit. Another change state’s budget (such as reductions to taxes and the Legislature could request voters make is spending) in the meantime. with respect to when reserve deposits and Request Change to School and Community withdrawals are counted toward the limit. College Districts’ Limits. Under the provisions Proposition 2 (2014) required the state to set of Proposition 98, the state is required to spend aside more funds in reserves. Under Proposition 4, minimum amounts on schools each year. As reserve deposits are counted in the year they are noted earlier, largely due to faster growth in made (instead of the year they are withdrawn). revenues, growth in district spending (under While Proposition 2 requires the state to set Proposition 98) has outpaced the limit on aside minimum amounts in reserve each year, school district spending (under the provisions of Proposition 4 limits reserve deposits like other Proposition 4). This trend has reduced the room state appropriations, creating a tension between available under the state’s limit because any school these two constitutional calculations. Instead, the spending that exceeds district limits counts at the voters could change the limit calculation so that state level. To maintain the goal of Proposition 98 to reserves count toward the limit in the year they are provide a certain amount of funding to schools— withdrawn. without crowding out other state spending—the Request More Fundamental Change. Legislature could consider asking the voters to The voters are permitted to make any changes to modify districts’ limits. There are different ways the SAL that they deem appropriate. Instead of to modify districts’ limits depending on the a four-year increase or other narrower changes, Legislature’s preferences. For instance, asking for the Legislature could request more far-reaching or a change to the calculation of districts’ limits—like permanent changes, increases, or modifications the changes made to city, county, and special to the SAL. www.lao.ca.gov 17 analysis full gutter AN LAO REPORT CONSTRUCTING A PLAN We anticipate the Legislature will need to take would be required. On the other hand, should the action related to the SAL this year and over the Legislature wish to pursue alternative options, next few years. As such, we recommend the statutory changes are unlikely to be sufficient to Legislature construct a short- and long-term plan avoid reaching the limit in the next few years. In for how it wishes to respond. On the one hand, the that case, considering placing a measure before the Legislature may wish to issue refunds and provide voters could be needed. additional funding to schools. This solution might To aid the Legislature in constructing its plan, not be sustainable over the long term, however. Figure 7 summarizes the options presented in this As existing program costs increase, revenues report, when each option could take effect, and available for appropriation could be insufficient our estimate of the potential magnitude of each to meet current service levels. Consequently, potential change. changes to the state’s revenues and expenditures Figure 7 Consider Timing and Amounts of Various Policy Options Policy Option Timing Amount Issue tax refunds and allocate excess Immediate. Legislature can pursue immediately. However, Tens of billions revenues to schools significant, ongoing refunds and school allocations could require more structural changes to the state budget. Increase spending on excluded purposes Immediate. The Legislature can increase spending on excluded Billions purposes in the 2021-22 budget. Reduce proceeds of taxes and spending Depends. The Legislature can pursue these reductions Tens of billions immediately, but major reductions to state services would take time to implement. Make statutory changes to the SAL • Shift room under school district limits to the Immediate. Legislature could implement in budget trailer bill Five billion state. legislation in 2021-22. • Redefine local government subventions. A Year or So. The Legislature could enact the statute in budget Up to ten billion trailer bill legislation, but the policy change would take the administration time to implement. Go to the voters • Request temporary increase in the state’s limit. A Year or More. The Legislature could place a measure on the Unlimited • Request change to school and community ballot to request a change. Tens of billions college district limits. • Request change in when reserves are counted A couple billion toward the limit. • Request more fundamental change. Unlimited LAO PUBLICATIONS This report was prepared by Ann Hollingshead with assistance from Brian Uhler and Kenneth Kapphahn, 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