The 2022-23 Budget: Multiyear Budget Outlook

2022-23 BUDGET The 2022-23 Budget: Multiyear Budget Outlook Key Takeaways May Revision Barely Balanced Before Accounting for State Appropriations Limit (SAL) Requirements. Our multiyear assessment, assuming the Governor’s May Revision policies, indicates the state would have narrow operating surpluses and deficits, but a positive ending fund balance through 2025-26. This finding indicates the budget is barely balanced. However, SAL requirements would reach $10 billion to $20 billion per year over the multiyear period. The administration does not include a plan to address these requirements, which would far exceed the state’s operating capacity. Consequently, under May Revision policies, the state would likely have significant budget shortfalls in the out-years. Adopting LAO Revenues Mitigates Budget Impacts of a Recession. Although predicting the next recession is impossible, economic indicators currently suggest a heightened risk of recession within two years. While reserves—which are significant—are one of the most critical tools to prepare for a recession, other steps are warranted given current conditions. Specifically, adopting our revenue estimates, which explicitly incorporate the current heightened risk of a recession, reduces the chances revenues fail to meet expectations. Coupled with multiyear planning, this approach can prevent the state from expanding programs to unsustainable levels. Plan for SAL Requirements Now. We recognize that some policymakers have signaled an interest in pursuing changes to the SAL with voters by 2024. In the meantime, we strongly caution the Legislature against passing a budget with a structural deficit stemming from unaddressed SAL requirements. In contrast to the Governor’s approach, we recommend the Legislature address the state’s constitutional SAL requirements in its budget architecture throughout the multiyear period. Another key way to address future SAL requirements, or a budget problem resulting from a recession, would be to increase reserves this year. The state has a $52 billion surplus—now is the time to prepare for these looming budget problems. GABRIEL PETEK | LEGISLATIVE ANALYST MAY 2022 www.lao.ca.gov 1 2022-23 BUDGET INTRODUCTION This brief presents our office’s independent May Revision policies were adopted. The first section assessment of the condition of the state General of the brief presents our analysis of the budget Fund budget through 2025-26 under our forecast of condition under these assumptions. The second revenues and spending, assuming the Governor’s section provides our comments. ANALYSIS 2022-23 Ending Fund Balance Under LAO operating surplus in 2024-25, and a larger operating Estimates Nearly Identical to Administration’s. deficit in 2025-26. An operating deficit means Figure 1 summarizes the budget’s condition expenditures would be greater than revenues in assuming the Governor’s May Revision policies that year. However, under our estimates, the SFEU were enacted, but using LAO estimates of multiyear would remain positive throughout the period, which revenue and spending. As the lefthand side of the signals the budget is barely balanced under these figure shows, under these assumptions, the state assumptions. These findings are quite similar to would end the budget year with $3.3 billion in the the Department of Finance’s (DOF’s) estimates. Special Fund for Economic Uncertainties (SFEU)— Under the administration’s assumptions, the state the state’s discretionary reserve akin to an ending would have two years of narrow operating surpluses fund balance. This estimate is only $100 million lower and one year of an operating deficit. However, very than the administration’s estimate. importantly, neither of these estimates account Before Accounting for State Appropriations for SAL requirements. While we show what these Limit (SAL) Requirements, May Revision Is requirements would be on the righthand side Barely Balanced. Under our estimates of revenue of the figure, DOF does not include out-year and spending in the out-years, the state would have SAL requirements anywhere in its estimates. a very narrow operating deficit in 2023-24, a small We discuss these requirements on the next page. Figure 1 Before Accounting for SAL Requirements, ...And SAL Requirements Significant May Revision Is Barely Balanced... (In Billions) (In Billions) $5 $5 $18 Billion SFEU SAL Requirement Operating Surplus/Deficit -5 -5 -10 -10 -15 -15 -20 2022-23 2023-24 2024-25 2025-26 -20 2022-23 2023-24 2024-25 2025-26 SAL = state appropiations limit and SFEU = Special Fund for Economic Uncertainties. 2 LEGISLATIVE ANALYST’S OFFICE 2022-23 BUDGET Similar Topline Estimates Obscure Two is on the horizon. (For more discussion of our Important Differences. Although the topline assumptions and the possibility of a coming estimates of our office and the administration are recession, please see: The 2022-23 Budget: very close, there are two key differences between May Revenue Outlook.) our outlooks which largely offset one another. SAL Requirements Left Unaddressed, They are: Compounding Operating Deficits. The state • DOF Explicitly Assumes Higher Costs incurs a SAL requirement when revenues exceed Across the Budget Due to Inflation. Our a specific threshold. (The state can meet these office’s expenditure estimates account for requirements by lowering tax revenues and/or inflation when cost-of-living adjustments are increasing certain kinds of spending.) We do not required by law and in areas where the state include SAL requirements in our estimates of the typically provides these adjustments, for state’s bottom-line budget condition (shown on the example, in employee compensation. For other lefthand side of the figure) because the Legislature program areas, however, higher inflation leads has choices about how to meet these requirements. to an erosion of benefits or service levels rather Those choices can result in very different impacts than increased state costs. This year, DOF took on the budget’s bottom line. As the figure shows, a different approach and developed a method SAL requirements are calculated over two years, to try to account for the effects of higher and the state would have a roughly $18 billion SAL inflation on programs across the budget. These requirement in 2023-24 under our estimates. (This assumptions result in higher costs by about estimate is somewhat lower than the $25 billion $6 billion in each of the out-years. in SAL requirement that we cited in our Initial • LAO Revenues Lower Than DOF, Reflecting Comments, which used the administration’s Current Economic Indicators. In the estimates. Under our office’s lower revenue out-years, LAO revenue estimates are lower estimates, SAL requirements are lower.) As the figure than DOF’s estimates and that difference also shows, the state’s SAL requirements continue grows to about $13 billion by 2025-26. Our to grow in the out-years. These requirements would lower revenue estimates are consistent with far exceed the state’s narrow operating surpluses— current economic indicators—for example, and would compound operating deficits—shown high inflation coupled with tight labor on the left side of the figure. Consequently, under markets—which typically signal a recession May Revision policies, the state likely would have significant budget shortfalls in the out-years. LAO COMMENTS Adopting LAO Revenues Mitigates Budget the Legislature has several tools to prepare for Impacts of a Recession… Although predicting the and use during a recession, which can help the next recession is impossible, economic indicators state avoid or delay these difficult choices. And currently suggest a heightened risk of recession while reserves—which are significant—are one of within two years. Past recessions—with the the most critical tools, other steps are warranted exception of the one induced by the pandemic—have given current conditions. Specifically, adopting our resulted in cumulative revenue losses of tens of revenue estimates, which explicitly incorporate the billions of dollars. In two recent recessions, in fact, current heightened risk of a recession, reduces total revenue losses were around $100 billion. These the chances revenues fail to meet expectations. recessions necessitated very difficult choices for the Coupled with multiyear planning, this approach Legislature about how to cut spending to balance can prevent the state from expanding programs to the budget. As we have discussed previously, unsustainable levels. www.lao.ca.gov 3 2022-23 BUDGET …But if Revenues Are Higher, SAL Plan for SAL Requirements Now: Some Requirements Increase. While adopting lower Short-Term Remedies, but Only Two Long-Term revenue estimates can help the Legislature avoid Solutions. The administration’s multiyear budget some of the downside risk associated with a estimates do not include an estimate of the state’s recession—and accompanying revenue losses— future SAL requirements nor do they include any plan doing so also could underestimate the SAL to address them. In a past report, we outlined some requirements the state might face in the coming short-term options the state has to forestall budget years. Every dollar in tax revenues that the state problems that are likely to arise in the next few years. collects above the limit must be spent on purposes Although these options would significantly mitigate that meet SAL requirements or returned to these short-term issues, they are not long-term taxpayers. As a result, higher revenues would result solutions. Over the long term, the Legislature has in dollar-for-dollar increases in SAL requirements. two choices: (1) reduce taxes in order to slow The trade-offs between different revenue revenue growth or (2) request the voters change assumptions exemplifies the dual risk the state’s the SAL. We recognize that some policymakers budget now faces: on the downside, the risk of a have signaled an interest in pursuing changes to recession and, on the upside, the risk that the state’s the SAL with voters by 2024. In the meantime, we constitutional requirements—paired with its current strongly caution the Legislature against passing budget commitments—will exceed its available a budget with a structural deficit stemming from resources. Counterintuitively, as we described in a unaddressed SAL requirements. This would ensure past report, in the coming years, the state is very the state budget remains on solid footing regardless likely to face budget problems whether revenues of possible future changes to the SAL. In contrast grow faster, slower, or as expected. to the Governor’s approach, we recommend the Considering Implications of Prolonged Legislature address the state’s constitutional SAL Inflation Warranted. Meanwhile, inflation remains requirements in its budget architecture throughout a key unknown for the budget’s condition. Inflation the multiyear. has accelerated recently, with prices increasing Additional Reserves Would Mitigate SAL 8 percent over the last year. While it has contributed and Recession-Induced Budget Problems. to the rapid growth in revenues in 2021-22, it also The administration has pointed to two key tools in the means each dollar of state spending will not go as May Revision that help prepare the state for future far as it would have in recent years. In some areas of SAL requirements or a recession: (1) a significant the budget, inflation-related spending adjustments amount of temporary spending and (2) reserve are automatic under current law, but in many cases, deposits planned in 2024-25 and 2025-26. While the Legislature needs to take action if it wishes to temporary spending can help forestall budget enact them. If inflation adjustments are not enacted, problems, it cannot entirely address these issues service and benefit levels will decline in real terms. for two reasons. First, more than half of the Cash assistance is a straightforward example of administration’s temporary May Revision proposals this dynamic. Current law does not guarantee are SAL excludable, meaning that this spending automatic adjustments to the state’s cash assistance cannot be reduced to address a budget problem that programs when inflation increases. Instead, inflation results from SAL requirements. Second, reducing means the purchasing power of recipients’ state this spending during a recession would still involve assistance declines unless the Legislature acts to difficult choices for the Legislature. Moreover, the adjust benefit levels. While annual inflation has not administration’s planned reserve deposits likely been a major concern for many years, prolonged would come too late. Economic indicators point to a heightened inflation could have significant impacts recession on the horizon within the next two years, on state service levels. Consequently, we think the not three-to-four years from now. The state has administration’s attention to this issue in its multiyear a $52 billion surplus this year—now is the time to estimates is warranted. prepare for these looming budget problems. 4 LEGISLATIVE ANALYST’S OFFICE 2022-23 BUDGET www.lao.ca.gov 5 2022-23 BUDGET 6 LEGISLATIVE ANALYST’S OFFICE 2022-23 BUDGET www.lao.ca.gov 7 2022-23 BUDGET LAO PUBLICATIONS This report was prepared by Ann Hollingshead with contributions from staff across the office, 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. 8 LEGISLATIVE ANALYST’S OFFICE