The 2022-23 Budget: State Appropriations Limit Implications

2022-23 BUDGET The 2022-23 Budget: State Appropriations Limit Implications Summary SAL Will Constrain the Legislature’s Choices This Year; State Likely to Face Challenges Balancing the Budget in the Next Couple Years. Based on recent tax revenue collection data, the state will face a significant state appropriations limit (SAL) requirement—possibly in the tens of billions of dollars—at the time of the May Revision. The Legislature and Governor can address that requirement with tax reductions and/or with more spending on specific purposes, such as capital outlay. This year, the surplus likely will be large enough to cover those requirements. In future years, however, it is very unlikely this would be the case, requiring the Legislature to make reductions to existing spending. Under our estimates, this could happen as soon as next year. Under the Governor’s Budget, the State Is Very Likely to Face Future, Serious Budget Challenges. If the Legislature adopts the Governor’s budget proposals and the economy continues to grow, the state would not have surpluses large enough to pay for large and growing SAL requirements in future years. If the economy does not continue to grow, the state would face budget problems due to revenue shortfalls. For this analysis we examined 10,000 possible revenue and economic scenarios. In over 95 percent of scenarios, the state faces a budget problem by 2025-26 either due to constitutional spending requirements or a recession. In these scenarios, the state would need to make cuts to existing services to bring the budget back into balance. Options for Avoiding Budget Problems in Future Years. The Legislature has options to avoid budget problems from arising over the next few years. For example, the Legislature can delay paying SAL requirements (for up to two years), change the definition of subventions, and/or reject nearly $10 billion in Governor’s budget proposals and save those funds to meet future SAL requirements. In fact, we recommend all, or nearly all, of the Governor’s budget proposals that do not help the state meet SAL requirements be rejected. However, all of these options are short-term remedies, not long-term solutions. Over the long term, as long as the economy continues to grow, the Legislature has two choices: (1) reduce taxes in order to slow revenue growth or (2) request the voters change the SAL. GABRIEL PETEK | LEGISLATIVE ANALYST MARCH 2022 www.lao.ca.gov 1 2022-23 BUDGET GOVERNOR’S BUDGET LIKELY UNSUSTAINABLE A budget problem occurs when state spending could differ substantially from this median under current law exceeds state resources (dotted line in Figure 1)—either higher or lower. available. Because the state must pass a balanced Figure 1 shows the range of likely outcomes. budget, when a budget problem occurs, the The most likely outcomes are shown in the darker Legislature must take actions to bring the budget shaded area. Less likely outcomes are shown into balance, like cutting spending or raising in the lighter shaded region. Some scenarios revenues. Budget problems most commonly outside these shaded areas also are possible, occur during recessions. Now, however, we have but would be outcomes associated with major determined that future budget problems are likely unforeseen events that dramatically shift the state’s to occur whether revenues grow slower, faster, or economic situation. as expected. The remainder of this section explains If Revenue Growth Falls Below Median, State these dynamics assuming the Governor’s budget Likely to Have a Budget Problem. Because the proposals are adopted. state usually plans to spend all or nearly all of Revenue Growth Can Vary Widely. The its forecasted revenues, the state typically faces budget is based on a projection of revenues. a budget problem if revenues grow slower than Our projections aim to represent the median expected. Figure 2 shows the size of annual budget revenue outcome—in which there is an equal problems under an average recession (assuming chance that actual revenue collections fall above the Legislature adopted the Governor’s budget). or below our projection. However, revenues Figure 1 SAL Revenue Growth Can Vary Widely (In Billions) $350 300 Revenues Exceed Median 250 Revenues Below Median 200 150 Less Likely Outcomes Most Likely Outcomes 100 Median Scenario 50 2020-21 2021-22 2022-23 2023-24 2024-25 2025-26 SAL = state appropriations limit. 2 LEGISLATIVE ANALYST’S OFFICE 2022-23 BUDGET If Revenue Growth at or Above Figure 2 Median, SAL Requirements If Revenue Growth Is Slower Than Expected, Grow Significantly... In contrast, if revenues grow at or above the The State Faces Significant Operating Deficits median, the state would have Median Operating Deficits (In Billions) growing state appropriations limit (SAL) requirements. As described 2021-22 2022-23 2023-24 2024-25 2025-26 in more detail in other publications (see The State Appropriations -$2 Limit), the SAL restricts the use of -4 revenue above a certain threshold. -6 We refer to the restrictions on the use of those revenues as -8 SAL requirements. (See the -10 nearby box for more information -12 on key terms and concepts used in this report, including -14 how SAL requirements work.) Key Terms and Concepts in This Report State Appropriations Limit (SAL) Requirements. Amounts the state is required to allocate to meet its constitutional requirements under Proposition 4 (1979). In short, a SAL requirement arises when the state’s appropriations subject to the limit are expected to exceed the limit itself. The Legislature can meet SAL requirements in one of three key ways: (1) lowering proceeds of taxes (for example, by providing taxpayer rebates), (2) spending more on excluded purposes (for example capital outlay or money to local governments), or (3) issuing taxpayer rebates and providing more funding to schools and community colleges. How Does the State Pay for SAL Requirements? This brief assumes that the Legislature uses General Fund discretionary funds to meet its SAL requirements. That is, we assume the state: (1) meets all of its commitments under current law and policy, including its constitutional requirements; (2) pays for the Governor’s budget proposals; and (3) uses General Fund monies to pay for any SAL requirements that arise as a result of the calculation described above. If the state’s General Fund resources are insufficient to cover these three categories of costs, the result is a budget deficit. Proposals That Do Not Meet a SAL Requirement. Any budget proposals that do not meet one of the three categories listed in the first paragraph do not help the state meet its SAL requirements. This includes, for example, most spending on program benefits, such as for health and human services programs; required or voluntary contributions to the state’s retirement systems; and deposits into the state’s reserves. The SAL and Budget Surpluses. The state has a surplus when spending under current law is lower than resources available in a single year. SAL requirements can exist in tandem with a surplus, but need not. For example, the state can have a surplus that is larger than its SAL requirements (as it likely will this year) or smaller than its SAL requirements (as is the case for many of the scenarios shown in this brief). In fact, the state can even have a SAL requirement and no surplus at all. That is because these calculations are wholly separate—the availability of a surplus depends on how much the state has committed to spending over time, while SAL requirements exist because revenues exceed a limit established by voters in 1979. www.lao.ca.gov 3 2022-23 BUDGET As Figure 3 shows, if revenues grow faster post The 2022-23 Budget: Initial Comments than the median (as shown in figure 1) the state on the State Appropriations Limit Proposal.) is very likely to face large—and growing—SAL Consequently, if revenues grow at or above the requirements, reaching somewhere between median, constitutional spending requirements $20 billion and $45 billion by 2025-26. (Note that would grow faster than available resources, these scenarios assume the state addresses the causing potentially significant budget problems. 2021-22 SAL requirement. That is, the estimates In this scenario, the state would be required to cut already assume the state takes some action similar non-constitutionally required spending to solve the to the various tax rebate proposals introduced by budget problems. the Legislature and Governor in recent weeks.) Regardless of Revenue Growth, Future …As Do Budget Problems. For each dollar Budget Problems Are Very Likely Under the of General Fund revenue, the state is required Governor’s Budget. As a result of these two to provide a certain amount to schools and dynamics—either slower revenue growth resulting in community colleges and a certain amount to operating deficits or faster revenue growth resulting reserves and debt payments. Once tax revenues in larger constitutional spending requirements— reach the appropriations limit, the state not only the budget is very likely to face budget problems faces a dollar-for-dollar SAL requirement, but also in the coming years. Figure 4 shows the range of continues to be required to spend a portion of each likely budget problems assuming the Legislature General Fund dollar on schools and community approved all of the Governor’s budget proposals. colleges and reserves and debt payments. As a As the figure shows, the state most likely would result, for each dollar collected once the state face budget deficits ranging from $5 billion to reaches the appropriations limit, the state faces $20 billion as soon as next fiscal year regardless of roughly $1.60 in constitutional requirements. revenue growth. By 2025-26, those deficits would (We describe this dynamic in more detail in our most likely grow to $20 billion to $60 billion. Figure 3 If the Economy Continues to Grow, The State Faces (Large and Growing) SAL Requirements (In Billions) $10 -10 -20 Most likely scenarios assuming revenues -30 SAL Requirementsa grow faster than the median -40 -50 2020-21 2021-22 2022-23 2023-24 2024-25 2025-26 a This figure shows the annual difference in appropriations subject to the limit and the limit itself. When this amount is negative, the state has a SAL requirement, which it must meet by: (1) spending more on excluded purposes, (2) lowering taxes, or (3) making taxpayer rebates and additional payments to schools. SAL = state appropriations limit. 4 LEGISLATIVE ANALYST’S OFFICE 2022-23 BUDGET Figure 4 If the Legislature Approves the Governor’s Budget, The State Is Very Likey to Face Future Deficits (In Billions) $40 20 10th Percentile -20 25th Percentile -40 50th Percentile 75th Percentile -60 Budget Deficits -80 90th Percentile -100 2020-21 2021-22 2022-23 2023-24 2024-25 2025-26 The State Cannot “Grow Its Way Out” revenues above a certain threshold for SAL of Budget Problems. Higher revenues requirements, no matter how much revenues do not increase the state’s ability to meet grow—higher revenue growth means each SAL requirements. In fact, the opposite is true. $1 collected results in $1.60 of spending As described above, because of the state’s requirements. This dynamic puts the state in an constitutional spending requirements—including untenable fiscal situation. that the SAL requires the state to dedicate all HOW CAN THE LEGISLATURE RESPOND IN THE SHORT TERM? While the budget could face problems either Reject a Significant Share of the as a result of a recession or continued economic Governor’s Budget Proposals growth—both on the upside and downside—this Reject All of the Governor’s Proposals post focuses on the steps the Legislature can That Do Not Meet a SAL Requirement… take to mitigate the budget’s upside risk. That is, The Legislature can forestall budget deficits for a how the Legislature can promote the chances that few years by rejecting all of the nearly $10 billion budget stays balanced if revenues come in at or in Governor’s budget proposals that do not above expectations. This section outlines three meet a SAL requirement and then saving those steps the Legislature can take to mitigate risks in funds in order to meet future SAL requirements. the short term. www.lao.ca.gov 5 2022-23 BUDGET (The Governor’s proposals that Figure 5 meet SAL requirements could be adopted. However, the Legislature Budget Risks Mitigated if Legislature could adopt alternative proposals Rejects All of the Governor's Proposals as long as they meet the SAL That Do Not Meet SAL Requirements requirements.) Figure 5 shows Median SFEU Balance (In Billions) how this action would change the budget outlook. As the figure $40 shows, under the Governor’s Proposals Are Rejected budget policies (orange bars), the That Do Not Meet SAL Requirements 30 Governor's Budget state is most likely to face large and growing budget deficits as 20 soon as 2023-24. If the Governor’s 10 budget proposals that do not meet a SAL requirement are rejected (and those funds are saved instead [blue bars]), the state can most -10 likely delay those deficits until 2025-26. (We list the Governor’s -20 budget discretionary spending -30 proposals that do not help the state meet its SAL requirements -40 in our post The 2022-23 Budget: 2020-21 2021-22 2022-23 2023-24 2024-25 2025-26 Initial Comments on the State Appropriations Limit Proposal. SAL = state appropriations limit and SFEU = Special Fund for Economic Uncertainties. We also describe this concept— proposals that do not meet a SAL Delay SAL-Required Payments requirement—in the box on page 3.) Consequently, we recommend rejecting these proposals. State Also Can Ease Some Short-Term Pressure by Pushing Out Payments… Another …And Save Funds to Meet Future SAL way the state can manage this risk in the short Requirements. The scenario shown in Figure 5 term is by delaying when SAL requirements are assumes the state saves $10 billion in 2022-23 and paid. Under the Constitution, when state revenues then uses those funds to pay for SAL requirements exceed the limit over two years, the Legislature in 2023-24 and/or 2024-25. As such, the nearly has an additional two years to return the excess $10 billion in funds available as a result of rejecting to taxpayers and make additional payments to these proposals must be saved to help balance schools. Delaying these payments can ease some the budget in the future. That is because, in the of the short-term pressure because the state has coming years, the state is likely to face large an additional year or two of revenue growth—and SAL requirements without a surplus large enough therefore more resources available—to meet to pay for them. (The box on page 3 also described the requirements. the relationship between the surplus and SAL requirements.) The Legislature would not get the …But the State Must Set Aside Funds for same benefit if it rejects these proposals and then Future Requirements or Risk Very Severe spends the funds on excluded purposes because Budget Deficits. However, if the Legislature such an action would not help it meet these chooses to continuously delay making these future requirements. payments, but does not set aside as much as it can to pay for those requirements in the future, it eventually will face the worst-case scenario: 6 LEGISLATIVE ANALYST’S OFFICE 2022-23 BUDGET a future, unfinanced SAL requirement coupled with criteria would apply in the case of this change. a recession. Consequently, delaying action on the Counting more subventions at the local level current-year requirement without setting aside would maintain the spirit of Proposition 4 (1979). funds to meet the requirement in future years would The aim of that measure was to keep government be unwise. appropriations, at all levels of government, below the adjusted 1978-79 level. This change would still Change the Definition of Subvention adhere to that basic principal, but would count The Legislature Also Could Change the some spending within local government limits, Definition of Subvention. Another way to address instead of the state’s limit. this issue in the short term is to change the This Change Would Provide a Short-Term definition of subvention. Under the Constitution Reduction in Appropriations Subject to the and statute, subventions—funding provided to Limit. If the state excluded all funds to local local governments on an unrestricted basis—meet governments, regardless of restriction and/or SAL requirements and are counted, instead, at the method of distribution, we estimate there is around local level. The state could amend the definition $10 billion in existing spending that would no longer of subvention in order to count more funding count toward the state’s limit, but rather count provided at the local level. For example, instead of at the county, city, or special district level. (As of specifying that only unrestricted funds provided to 2018-19, cities and counties had over $150 billion local governments should count as subventions, in collective room under their limits. As a result, statute could state that any funds provided to local changing this definition is unlikely to result in very government count as subventions. We understand many local governments exceeding their limits. that courts generally uphold legislative However, the Legislature could also adopt a interpretations of constitutional amendments so mechanism to ensure the change in policy does not long as they are reasonable and consistent with cause any single entity to exceed their limits.) the purpose of the statute. We think both of those HOW CAN THE LEGISLATURE RESPOND IN THE LONG TERM? Under Current Law, State Government the voters change the limit. (If the economy does Very Likely Cannot Grow More. In the previous not continue to grow, the Legislature will have other, section, we outlined three options to address the even more difficult, budget choices to make.) short-term budgetary risks currently faced by the Reduce Taxes on an Ongoing Basis. The first state. However, none of these, even all together, long-term alternative for the Legislature is to reduce would indefinitely forestall the long-term reality of taxes so that they no longer are growing faster the state’s constitutional constraints. The reality is than the limit. Under this alternative, tax revenues that state tax revenues are growing faster than the and associated spending could still grow, but they limit and the size of state government has reached could not grow faster than the limit itself. As a the limit set by voters in the 1970s. Revenue growth result, the Legislature’s ability to make new program has exceeded growth in the limit for a variety of expansions would be severely constrained. While reasons, including faster income growth among the Legislature could still reallocate funds among higher-income earners, policy decisions by the programs—for example, by spending less in one Legislature, and growth in school spending. As a area, it could make expansions in another—further result of this differential growth, over the long term expansions to programs not coupled with such the Legislature has only two choices: (1) reduce reductions would not be feasible. taxes in order to slow revenue growth or (2) request www.lao.ca.gov 7 2022-23 BUDGET Alternatively, the Legislature Could Request limits under Proposition 111—would maintain the Voters Change the Limit. The Legislature’s spending limits for schools while providing greater second long-term option is to ask the voters flexibility in the calculation of those limits. However, to approve changes to the SAL. As we noted the voters are permitted to make any changes to in a 2021 report on the SAL, there are policy the SAL that they deem appropriate. Instead of a justifications for requesting that the voters change narrower change like this, the Legislature also could school districts’ limits. For instance, asking for a request more far-reaching or permanent changes, change to the calculation of districts’ limits—like the increases, or modifications to the SAL. changes made to city, county, and special district 8 LEGISLATIVE ANALYST’S OFFICE 2022-23 BUDGET TECHNICAL APPENDIX In this section, we describe the basic Kindergarten policy. Under our current assumptions and specifications of our methodology average daily attendance forecasts, this is a for arriving at the estimates in this post. reasonable assumption. Examined Many Possible Combinations • Assumed SAL Requirements Were Paid of Key Variables. Several key variables in our in the Second Year of a Two-Year Net analysis—particularly General Fund revenues, Overage. This analysis assumes SAL special fund revenues, capital gains tax revenues, requirements are paid in the second year of and personal income growth—cannot be a net two-year overage. That is, each time forecasted precisely. Many possible future values the state has negative room in one year, and of these variables are plausible. Variation in these a second year of room or negative room that variables could lead to vastly different budget results in net excess revenues across the situations for the state. To account for this variation, two-year period, we assume the state pays for we examined 10,000 scenarios comprised of those excess revenues in that second year. unique combinations of these key variables. • Assumed Proposition 2 (2014) Our method seeks to mimic how these variables Infrastructure Spending Offsets Baseline have varied from year to year historically, as well Costs. For each scenario, we calculate as how these variables move together over time. a Proposition 2 requirement—including Specifically, we modeled these variables (with Budget Stabilization Account deposit, debt transformations applied in some cases) using a payments, and infrastructure spending, if multivariate normal distribution, with standard applicable—based on General Fund tax deviations and covariances set to match historical revenues, total General Fund revenues, and levels over the last 40 years. Our analysis does capital gains revenues. For years in which not include variation in some parameters, such as infrastructure spending was required, we non-Proposition 98 spending, non-tax revenue, assumed that spending would offset baseline or state appropriations limit (SAL) exclusions. non-Proposition 98 spending (consistent These parameters reflect the policy choices of the with the administration’s treatment in their Governor’s budget and therefore leaving them fixed multiyear forecast). This slightly improves reflects the best estimate of the state’s budget the budget bottom line compared to the position given those policies. Moreover, variation alternative assumption. in any of these parameters would be very narrow Used Governor’s Budget Non-Proposition 98 compared to variation in tax revenue. Spending Estimates. We took the Governor’s For Each Scenario, Calculated SAL budget estimates of other spending as given and Requirements and SFEU Balance. For each did not vary these, up or down, with economic of these 10,000 scenarios, we calculated SAL and revenue conditions. While this could mean requirements based on General Fund and special we understated the severity of budget problems fund tax revenues and holding exclusions fixed. during a recession or slightly overstated the severity Using those calculated SAL requirements, we of budget problems as a result of constitutional estimated Special Fund for Economic Uncertainties spending constraints, these effects generally would (SFEU) balances for each scenario that: be small compared to the figures in this report. • Assumed Proposition 98 Spending For context, in our 2019-20 Fiscal Outlook analysis, Would Remain in Test 1. We assumed we estimated that non-Proposition 98 spending Proposition 98 spending was a fixed share would increase about $1 billion at the height of of General Fund taxes (38.028 percent), a moderate recession. Meanwhile, the median with slight variation by year to account operating deficits shown in Figure 2 averaged for the effects of the state’s Transitional around $10 billion to $12 billion. www.lao.ca.gov 9 2022-23 BUDGET 10 LEGISLATIVE ANALYST’S OFFICE 2022-23 BUDGET www.lao.ca.gov 11 2022-23 BUDGET LAO PUBLICATIONS This report was prepared by Ann Hollingshead, with contributions from Brian Uhler, 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, California 95814. 12 LEGISLATIVE ANALYST’S OFFICE