The 2023-24 Budget: California's Fiscal Outlook

2023-24 BUDGET The 2023-24 Budget: California’s Fiscal Outlook GABRIEL PETEK LEGISLATIVE ANALYST NOVEMBER 2022 www.lao.ca.gov i 2023-24 BUDGET ii LEGISLATIVE ANALYST’S OFFICE 2023-24 BUDGET Executive Summary Economic Conditions Weigh on Revenues. Facing rising inflation, the Federal Reserve— tasked with maintaining stable price growth—repeatedly has enacted large interest rate increases throughout 2022 with the aim of cooling the economy and, in turn, slowing inflation. The longer inflation persists and the higher the Federal Reserve increases interest rates in response, the greater the risk to the economy. The chances that the Federal Reserve can tame inflation without inducing a recession are narrow. Reflecting the threat of a recession, our revenue estimates represent the weakest performance the state has experienced since the Great Recession. State Faces $24 Billion Budget Problem and Ongoing Deficits. Under our outlook, the Legislature would face a budget problem of $24 billion in 2023-24. (A budget problem—also called a deficit—occurs when resources for the upcoming fiscal year are insufficient to cover the costs of currently authorized services.) The budget problem is mainly attributable to lower revenue estimates, which are lower than budget act projections from 2021-22 through 2023-24 by $41 billion. Revenue losses are offset by lower spending in certain areas. Over the subsequent years of the forecast, annual deficits would decline from $17 billion to $8 billion. Inflation-Related Adjustments Vary Across Budget. The General Fund budget can be thought of in two parts: (1) the Proposition 98 budget for schools and community colleges, representing about 40 percent of General Fund spending, and (2) everything else. Under our estimates, the state can afford to maintain its existing school and community college programs and provide a cost-of-living adjustment of up to 8.38 percent in 2023-24. The extent to which programs across the rest of the budget are adjusted for inflation varies considerably. Because our outlook reflects the current law and policy of the Legislature, our spending estimates only incorporate the effects of inflation on budgetary spending when there are existing policy mechanisms for doing so. Consequently, our estimate of a $24 billion budget problem understates the actual budget problem in inflation-adjusted terms. Save Reserves for a Recession. The $24 billion budget problem in 2023-24 is roughly equivalent to the amount of general-purpose reserves that the Legislature could have available to allocate to General Fund programs ($23 billion). While our lower revenue estimates incorporate the risk of a recession, they do not reflect a recession scenario. Based on historical experience, should a recession occur soon, revenues could be $30 billion to $50 billion below our revenue outlook in the budget window. As such, we suggest the Legislature begin planning the 2023-24 budget without using general purpose reserves. Recommend Legislature Identify Recent Augmentations to Pause or Delay. Early in 2023, we suggest the Legislature question the administration about the implementation and distribution of recent augmentations. If augmentations have not yet been distributed, the Legislature has an opportunity to reevaluate those expenditures. Moreover, in light of the magnitude of the recent augmentations, programs may not be working as expected, capacity issues may have constrained implementation, or other unforeseen challenges may have emerged. To address the budget problem for the upcoming year, these cases might provide the Legislature with areas for pause, delay, or reassessment. www.lao.ca.gov 1 2023-24 BUDGET 2 LEGISLATIVE ANALYST’S OFFICE 2023-24 BUDGET INTRODUCTION Each year, our office publishes the Fiscal Outlook Specifically, lower revenues are expected to in anticipation of the upcoming state budget lead to a deficit of $24 billion in the budget process. The goal of this report is to help the window. Over the subsequent years of Legislature begin crafting the 2023-24 budget. the forecast, annual deficits decline from Our analysis relies on specific assumptions about $17 billion to $8 billion. the future of the state economy, its revenues, and • The State Budget and Inflation. We also its expenditures. Consequently, our estimates are discuss the implications of persistently high not definitive, but rather reflect our best guidance inflation on the state’s spending programs. to the Legislature based on our professional Given that many program areas do not assessments as of November 2022. This year’s account for inflation without direct legislative report addresses four main topics for lawmakers: action, we advise the Legislature keep in mind the programmatic impacts of inflation • Economic Conditions and the Revenue Picture. We discuss the implications of as it considers budget solutions to address persistently high inflation for the economy the deficit. and, in turn, the effects of the economic • Reserves. We conclude with a discussion of environment on our revenue estimates. the state’s reserves, which are the key tool In short, although our revenue estimates do the state has available to address budget not assume a recession occurs, they are problems. We urge lawmakers to begin lower than budget act estimates due to the planning the 2023-24 budget without using heightened risk of an economic downturn. general purpose reserves and, instead, to • The Budget Problem. We then discuss the save those reserves for when the state faces implications of lower revenue estimates for a recession. the budget condition in 2023-24 and beyond. ECONOMIC CONDITIONS WEIGH ON REVENUES Booming Economy Has Led to High Inflation. cooling the economy and, in turn, slowing inflation. Spurred by pandemic-related federal stimulus, the Higher interest rates dampen economic activity U.S. economy entered a period of rapid expansion by increasing borrowing costs for home buyers, in the summer of 2020 that extended through consumers, and businesses, as well as depressing 2021. Over the last year, however, evidence has the value of riskier assets like stocks. The impacts mounted that this rapid economic expansion was of recent interest rate hikes are apparent in certain unsustainable. Amid record low unemployment areas of the economy: home sales have dropped and continued global supply chain challenges, by one-third, car sales are at the lowest level in over businesses have strained to meet surging consumer a decade, and stock prices are down 20 percent demand. As a result, consumer prices have risen from recent highs. Some impacts also can be seen 8 percent over the last year, more than three times in state tax collections. For example, estimated the norm of the last three decades. income tax payments for 2022 so far have been Efforts to Tame Inflation Are Slowing the notably weaker than 2021, likely due in part to Economy. Facing rising inflation, the Federal falling stock prices. Reserve—tasked with maintaining stable price Inflation Pressures Remain, Raising Risk of growth—repeatedly has enacted large interest a Recession. While these slowdowns in certain rate increases throughout 2022 with the aim of areas of the economy have not yet spread more www.lao.ca.gov 3 2023-24 BUDGET broadly, similar historical episodes have ended in recession are unknowable. Because of this, recessions. The longer inflation persists and the adopting revenues consistent with the abrupt onset higher the Federal Reserve increases interest rates of a recession would run the risk of making cuts to in response, the greater the risk to the economy. public services before they are necessary. The chances that the Federal Reserve can tame Fiscal Outlook Revenues Balance Competing inflation without inducing a recession are narrow. Risks. Our revenue outlook—displayed in Despite recent interest rate increases, inflation Figure 1—weighs equally the risks of excess remains well above the Federal Reserve’s stated optimism and excess pessimism. Reflecting the price stability goal. Further, factors that tend to threat of a recession, our revenue estimates predict future inflation—such as recent changes represent the weakest performance the state has in consumer spending, incomes, and prices experienced since the Great Recession. At the for food and energy—suggest that heightened same time, our revenues stop short of reflecting an inflation pressures could remain for some time. abrupt recession. Were a recession to occur soon, These observations suggest that the Federal revenue declines in the budget window very likely Reserve will take additional steps to curb inflation would be more severe than our outlook. in the coming months, further raising the risk of a recession. Economic Environment Figure 1 Creates Challenges for the LAO Revenue Outlook Legislature. The current economic environment poses a substantial General Fund Revenue, Excluding BSA Transfers (In Billions) risk to state revenues. In the past, when economic conditions have $300 The shaded area shows how far revenues been similar to today, revenues could deviate from our main forecast. subsequently have tended 275 Outcomes beyond the shaded area are possible, but revenues most likely will fall to decline. This presents the in the shaded area. 250 Legislature with the challenge of balancing two key risks when 225 selecting a revenue assumption for the 2023-24 budget. On the one 200 hand, adopting overly optimistic revenues which fail to account 175 for the potential of an economic downturn would create a high risk 150 of shortfalls in future years. On 2021-22 2022-23 2023-24 2024-25 2025-26 2026-27 the other hand, while it appears likely a recession will occur, it is BSA = Budget Stabilization Account. far from certain. Further, the exact timing and severity of a possible THE BUDGET PROBLEM In this section, we describe our estimates (through 2026-27). Over both time horizons, we of California’s budget condition in the near expect the state will face deficits, also known as term (in 2023-24) and over a multiyear period budget problems. 4 LEGISLATIVE ANALYST’S OFFICE 2023-24 BUDGET BUDGET YEAR We Anticipate the Legislature Faces a Budget Problem of $24 Billion in Upcoming Year. Figure 2 shows that, under Figure 2 our revenue estimates, the state would have a budget problem of $24 billion in 2023-24. The General Fund Condition Under Fiscal Outlook nearby box describes what the term “budget (In Millions) problem” means in more detail. As the figure 2021-22 2022-23 2023-24 shows, the state also would end 2023-24 with nearly $22 billion in the Budget Stabilization Prior-year fund balance $38,334 $19,885 -$1,166 Account (BSA)—the state’s general-purpose Revenues and transfers 224,089 208,280 208,252 Expenditures 242,539 229,331 226,486 reserve. These funds are available to address Ending Fund Balance $19,885 -$1,166 -$19,400 a budget emergency. (Under the State Encumbrances $4,276 $4,276 $4,276 Constitution, the Governor can declare SFEU Balance $15,609 -$5,442 -$23,676 a budget emergency when estimated Reserves resources in the current or upcoming fiscal BSA balance $21,925 $21,925 $21,925 year are insufficient to keep spending at the Safety Net Reserve 900 900 900 level of the highest of the prior three budgets, SFEU = Special Fund for Economic Uncertainties. adjusted for inflation and population. The Legislature cannot access the BSA without this declaration.) What Is a Budget Problem? A budget problem—also called a deficit—occurs when resources for the upcoming budget are insufficient to cover the costs of currently authorized services. As such, calculating the budget problem involves two main steps: • Projecting Anticipated Revenues. First, we estimate how much revenue will be available for the remainder of the current and upcoming year. This means using assumptions about how the economy is likely to perform over the coming 20 months and then using those assumptions to project revenue collections. • Estimating Current Service Level. Second, we compare those anticipated revenues to the level of spending to support the current service level under the state’s current law and policy. Projecting current service spending, which we also call “baseline spending,” has several components. For example, it requires us to project how caseload will change for means-tested programs, estimate how much federal funding will come to the state based on current federal policy, and make many other assessments. When current service level spending exceeds anticipated revenues, the state has a budget problem. In this document, the budget problem is reflected in the 2023-24 ending balance in the Special Fund for Economic Uncertainties, shown in Figure 2. Budget Problem Must Be Addressed. The State Constitution requires the Legislature to pass a balanced budget. As a result, if—earlier in the process—the state faces a budget problem, the Legislature must solve the problem using a combination of tools. In a recession, the main tool for solving a budget problem is the state’s reserve. If reserves are insufficient to cover the budget problem, however, the Legislature must take other actions to bring the budget into balance. These actions include reducing spending, increasing revenues, and/or shifting costs, for example, between funds, time periods, or entities of government. www.lao.ca.gov 5 2023-24 BUDGET Budget Problem Driven by Lower Revenue (2) significantly lower revenues in 2022-23 Estimates. The budget problem for 2023-24 mainly cause that year’s $3.4 billion deposit to be is attributable to lower revenue estimates. More reduced to zero; and (3) our assumption that specifically, however, the budget problem arises as the state suspends the otherwise required a result of the offsetting effects of five main factors: BSA deposit in 2023-24, due to the budget problem, originally estimated to be $2.9 billion. • Planned Deficit of Nearly $3 Billion for 2023-24. Under the 2022-23 Budget Act • Other Spending Lower by Nearly $3 Billion. assumptions, the state would have ended Across the rest of the budget, our estimates of 2023-24 with a deficit of nearly $3 billion in spending are lower than the administration’s 2023-24. Revenue losses compound this by $2.6 billion across the three-year period. already negative starting point. This figure reflects the net effect of a number of different factors moving in both directions. • Revenues Losses Add to Deficit by $41 Billion. Across 2021-22, 2022-23, Under Our Revenue Estimates, No SAL and 2023-24, our estimates of revenues Requirement in 2023-24. In recent years, the state and transfers (excluding transfers to the appropriations limit (SAL) has placed considerable BSA) are lower than budget act projections limitations on how the Legislature can use revenues by $41 billion. that exceed a specific threshold. Mainly due • Formula-Driven Spending on Schools and to lower revenues, the SAL is less likely to be a Community Colleges Offsets Revenue significant constraint in this year’s budget process. Losses by $13 Billion. General Fund The box on page 9 describes our SAL estimates for spending on schools and community colleges 2022-23 and over the multiyear period. is determined by a set of constitutional formulas under Proposition 98 (1988). MULTIYEAR Under our outlook, the state allocates State Faces Operating Deficits Over the about 40 percent of General Fund revenue Multiyear Period. Figure 3 displays our estimates to K-14 education each year of the budget of the budget’s condition over the outlook period. window. Relative to budget act estimates and consistent with lower revenue, our estimate of required Figure 3 General Fund spending on schools and community State Faces Budget Deficits Across Multiyear Period colleges for 2021-22 through (In Billions) 2023-24 decreases by $13 billion. • Formula-Driven BSA -$5 Deposits Offset Revenue Losses by an Additional -10 $5 Billion. Relative to the Smaller Ongoing budget act, under our revenue -15 Operating Deficits estimates, the state’s required deposits into the BSA would -20 be lower by $5 billion across the three-year period. This -25 $24 Billion Budget decline is driven by three Problem in 2023-24 factors: (1) higher capital -30 gains revenues in 2021-22 2023-24 2024-25 2025-26 2026-27 result in a $1.6 billion increase in the deposit that year; 6 LEGISLATIVE ANALYST’S OFFICE 2023-24 BUDGET As the figure shows, in addition to the $24 billion portions of recent budget surpluses to temporary budget problem the state faces in 2023-24, the augmentations, which “turn off” over the period, state faces annual operating deficits which decline resulting in declines relative to the 2023-24 level. from $17 billion to $8 billion by 2026-27. The Recent Budgets Committed to Growing remainder of this section describes some of the Ongoing Augmentations. The spending key multiyear trends that result in these bottom growth in Figure 5 reflects a combination of line estimates. underlying program growth and recent legislative Revenues Decline, Stabilize, and Then Grow. augmentations. While recent budgets have The key assumption underlying our multiyear committed a significant share of new spending outlook is our estimate of revenues. As we to one-time or temporary purposes, those discussed earlier, our revenue outlook balances budgets also consistently allocated some funds competing risks. It reflects the threat of a downturn, to ongoing purposes—many of which grow but stops short of reflecting an abrupt recession. significantly. For example, the 2021-22 budget As Figure 4 shows, we anticipate revenues will allocated $3.4 billion to new, ongoing spending, decline between 2021-22 and 2022-23 by more expected to grow to about $12 billion by 2025-26. than the budget act anticipated, but then remain Similarly, the 2022-23 budget allocated $2.3 billion largely flat between 2022-23 and 2024-25, before to new, ongoing spending, expected to grow growing again in the last two years of the outlook. to nearly $5 billion by 2026-27. With mostly flat Significant Underlying Program Growth revenue growth, these recent, sizeable, ongoing Somewhat Offset by Reductions in Temporary augmentations place significant pressure on the Spending. We estimate spending growth assuming out-year condition of the budget. current law and policy remains in place, meaning Major Spending Assumptions we assume the Legislature enacts no new policies Our Fiscal Outlook reflects current over the period. Under our assumptions, General law and policy. This means our spending Fund spending would grow from $227 billion in estimates incorporate the fiscal effects of 2023-24 to $246 billion in 2026-27—an increase all enacted policies. In addition, we include of about $20 billion or an average annual growth the fiscal effects of those policies which the of 2.9 percent. (The next section describes some Legislature has repeatedly enacted (absent of the other major spending assumptions that are embedded in these estimates, including Figure 4 specific differences with the Under Our Outlook, Revenues Decline, administration’s budget act Stabilize, and Then Grow assumptions.) The relatively slow overall growth in expenditures General Fund Revenues and Transfers Excluding BSA Deposits (In Billions) is the result of many offsetting factors, shown in Figure 5 on $250 the next page. Namely, faster 240 growth in ongoing programs, Budget Act such as in education, employee 230 compensation, and health and 220 human services programs, would total nearly $35 billion over the 210 period. But this growth is offset by LAO Multiyear Revenue Outlook 200 about $15 billion in lower spending in other areas—including in 190 2021-22 2022-23 2023-24 2024-25 2025-26 2026-27 natural resources, transportation, and housing. In these areas, BSA = Budget Stabilization Account. the state allocated significant www.lao.ca.gov 7 2023-24 BUDGET Figure 5 Factors Affecting Spending Growth (In Billions) $40 CalWORKs 35 Resources and Environment IHSS ...Offset by Reductions in Other 30 Childcare and Preschool Transportation Areas, Largely Temporary Spending Housing Medi-Cal 25 Emergencies Correctionsª Employee Compensation, 20 Pensions, and Retiree Health Other 15 Underlying Growth Concentrated in 10 Education, Employee Compensation, and Health and Human Services... As a Result, Spending Grows $20 Billion Between 2023-24 and 2026-27 5 Schools and Community Colleges a Excluding employee compensation. IHSS = In-Home Supportive Services. statutory commitments to ongoing spending). expenditure estimates. The largest expenditures The remainder of this section describes some included in the administration’s estimates but of the other key spending assumptions in this excluded from our analysis are: (1) spending Fiscal Outlook. $1.7 billion to accelerate the repayment of bond Assume Spending Enacted With Clear debt service in 2024-25, (2) setting aside additional Legislative Intent Occurs... In the Fiscal Outlook, reserve deposits of $1 billion in 2024-25 and we aim to estimate the costs of the state’s $3 billion in 2025-26, and (3) spending $1.9 billion commitments under current law and policy. For in 2023-24 to shift capital outlay projects currently this analysis, we include the costs associated authorized for lease revenue bonds to General with legislative intent language as current policy Fund cash. In addition, the administration included if it meets certain conditions. Specifically, (1) the an unallocated set aside for inflation-related Legislature voted on and approved the policy, costs in their estimates. We do not make a similar (2) the policy is included in budget-related statutes adjustment because those costs do not reflect (for example, in trailer bill) that have force of law, current law and policy. (If we had included these and (3) the policy as described in statute is specific amounts in baseline spending, the budget problem and implementable. would have been larger.) On the other hand, we do reflect spending on school facilities of $2 billion …Which Results in Some Differences With in 2023-24 and $875 million in 2024-25, and the Administration. The administration’s spending broadband spending of $300 million in 2023-24 and estimates at the time of the budget act included $250 million in 2024-25, in which enacted legislative some expenditures that did not meet these criteria. intent language met our criteria. Consequently, those items are not included in our 8 LEGISLATIVE ANALYST’S OFFICE 2023-24 BUDGET November 2022 State Appropriations Limit (SAL) Estimates How the SAL Works. The SAL calculation involves comparing (1) the limit to (2) appropriations subject to the limit. The limit is calculated by adjusting last year’s limit for a growth factor that includes economic and population growth. Appropriations subject to the limit are determined by taking all proceeds of state taxes and subtracting excluded spending. If appropriations subject to the limit are less than the limit, there is “room.” If the converse is true, the state has a SAL requirement. The Legislature can meet SAL requirements in one of three ways: (1) lowering proceeds of taxes (for example, by providing taxpayer rebates), (2) spending more on excluded purposes (for example, for capital outlay or funding to local governments), or (3) issuing taxpayer rebates and providing more funding to schools and community colleges. For more information about the SAL and its recent implications on the state budget, see our reports The State Appropriations Limit and The 2022-23 Budget: State Appropriations Limit Implications. Under LAO Revenue Estimates, State Has Room Across the Budget Window… Under our estimates of revenues and spending, including special funds, the state would have room of $27 billion in 2021-22 and $23 billion in 2022-23. In 2022-23, this is somewhat more room than was anticipated at budget act, mainly due to lower General Fund revenues. In 2023-24, the state still would have $19 billion in room due to a few factors: (1) relatively flat General Fund tax revenues, (2) continued capital outlay spending from recent budget acts, (3) modest growth in other baseline exclusions, and (4) some growth in the limit itself. …But if Revenues Grow Again, State Most Likely Would Face SAL Requirements Again. Under our multiyear outlook, the state would have much less room in 2024-25, about $4 billion, and then face SAL requirements in 2025-26 and 2026-27 of $4 billion and $18 billion, respectively. These SAL requirements occur largely because our estimates of General Fund tax revenues grow faster than the limit itself in these years. Under our outlook, the state also would face budget deficits in these years, making these SAL requirements considerably more difficult to address. That said, while these estimates are highly uncertain and revenues could be significantly higher or lower than our estimates in any given year, on a long-term basis, we expect the state to continue to reach the limit. This will reoccur because historical revenue growth rates exceed the growth in the limit itself. Assume BSA Deposit and Infrastructure and infrastructure spending would result in an Spending Requirement Are Not Suspended improvement in the budget condition by an average After 2023-24. Under the constitutional rules of of roughly $1 billion each year. Proposition 2 (2014), the state must make annual Make CalPERS Contribution Assumptions payments toward certain state debts, deposits Consistent With Recent Experience and LAO into the BSA, and, in some years, infrastructure Forecasts. Our outlook assumes the state makes payments. While the debt payments are required required pension contributions to the California until 2029-30 regardless of the condition of the Public Employees’ Retirement System (CalPERS) budget, BSA deposits and infrastructure payments based on the most recent actuarial valuation—in can be suspended if the state faces a budget this case, as of June 30, 2021, which establishes emergency. Our outlook assumes these payments the state’s contribution rates for 2022-23. Using are suspended in 2023-24, but not in 2024-25 CalPERS’ online tool, we adjust these contribution or later. That said, in at least one of these years, rates based on recent investment returns, the Legislature might have the option to suspend our assessment of economic conditions, and deposits and infrastructure spending if certain expected Proposition 2 debt repayments under conditions are met. Suspending BSA deposits our forecast. The net effect of these assumptions www.lao.ca.gov 9 2023-24 BUDGET is that the outlook assumes that state pension enhancement lasts until the end of the quarter contribution rates are significantly higher than the in which the national public health emergency projected rates published in CalPERS’ most recent (PHE) declaration ends. For the purposes of this actuarial valuation. Specifically, annual General analysis, we assumed the declaration would expire Fund contributions to CalPERS would be higher in January 2023, resulting in an increase in General by $1.7 billion by the last year of our outlook. Fund costs of Medicaid programs in the fourth (A corresponding upward adjustment to The quarter of 2022-23. However, as we completed this California State Teachers’ Retirement System was analysis, the U.S. Department of Health and Human not necessary due to differing funding mechanisms Services did not notify states the PHE would and investment returns.) end in January. Given the federal administration Assume Enhanced Federal Match for committed to providing states 60 days’ notice Medicaid Ends Midway Through 2022-23. regarding the end of the public health emergency, Medicaid is an entitlement program whose the PHE is likely to remain in place after January costs generally are shared between the federal 2023. We estimate a one-quarter extension results government and states. In 2020, Congress in lower General Fund costs of about $450 million— approved a temporary 6.2 percentage point improving the budget bottom line condition by that increase in the federal government’s share of cost amount (this figure is subject to uncertainty). for most state Medicaid programs. This funding INFLATION-RELATED ADJUSTMENTS VARY ACROSS BUDGET The General Fund budget can be thought of of funding to one-time activities, which expire in in two parts: (1) the Proposition 98 budget for 2023-24; (2) program costs decline from 2022-23 schools and community colleges, representing to 2023-24 due to an adjustment for school about 40 percent of General Fund spending, and attendance; and (3) a constitutionally required (2) everything else. In this section, we discuss withdrawal from the Proposition 98 Reserve the budget conditions of each of these parts of supplements the regular Proposition 98 funding the budget—accounting for inflation—and the level. The nearby box gives more detail about the implications of those differences. out-year condition of the Proposition 98 budget. Under Proposition 98 Estimates, State Can In Contrast, the Remainder of the Budget Maintain Program Spending to Schools Even Has a Budget Problem Without Universal Adjusted for Inflation. Under our outlook, the Adjustments for Inflation. In some areas across Proposition 98 funding requirement for schools and the rest of the budget, programmatic spending is community colleges is $108.2 billion ($78 billion adjusted somewhat automatically for inflation— General Fund) in 2023-24, a decrease of $2.1 billion either through formulas or administrative decisions. (2 percent) compared with the enacted 2022-23 Examples of these adjustments include actuarially level. Despite this decrease, the state could afford determined increases in Medi-Cal managed care to maintain its existing school and community rates and administrative discretion over increases college programs and provide a cost-of-living to capital outlay. In other cases, spending increases adjustment (COLA) of up to 8.38 percent in are determined through legislative deliberation 2023-24. (This COLA represents a slight reduction and are directly approved by the Legislature. in the statutory rate that would apply if the Because our outlook reflects the current law Proposition 98 funding requirement were larger.) and policy of the Legislature, our spending The key reasons this COLA can be afforded are: estimates only incorporate the effects of inflation (1) the June budget allocated a sizeable amount on budgetary spending when there are existing 10 LEGISLATIVE ANALYST’S OFFICE 2023-24 BUDGET Proposition 98 Multiyear Outlook Proposition 98 Establishes “Budget Within a Budget.” By requiring the state to set aside certain amounts of funding, Proposition 98 (1988) creates a budget for schools and community colleges within the state’s larger budget. The minimum size of this budget—the “minimum guarantee”—is determined by a set of constitutional formulas. Individual school and community college programs, in turn, are paid out of this budget. A “shortfall” in the context of the Proposition 98 budget means that funding under the guarantee is insufficient to cover the costs of existing educational programs, as adjusted by changes in student attendance and inflation. A “surplus,” by contrast, means that the guarantee exceeds these program costs. Guarantee Grows Over the Outlook Period. Our estimate of the total Proposition 98 spending on schools and community colleges in 2022-23 is $106.7 billion ($78.6 billion from the General Fund and $28.1 billion from local property taxes). The minimum funding requirement grows by an average of $5.6 billion (4.9 percent) per year over the next four years. Most of this growth comes from the state General Fund, but increases in local property tax revenue also contribute. The increases in the guarantee are relatively slow early in the period and faster near the end. Growth in General Fund Portion of the Guarantee Driven by Three Factors. The General Fund portion of the guarantee grows by $16.7 billion from 2022-23 to 2026-27. Most of this increase reflects our General Fund revenue estimates, with the constitutional formulas generally directing about 40 percent of state revenue growth toward the Proposition 98 guarantee. Our estimates also account for two smaller adjustments: (1) an increase of $2.6 billion for the expansion of transitional kindergarten and (2) an increase of approximately $1 billion beginning 2023-24 to fund arts education (based on preliminary Proposition 28 results). Reserve Withdrawals Compensate for Small Shortfalls. The figure summarizes the overall condition of the Proposition 98 budget under our forecast. The negative blue bars early in the period correspond with small shortfalls. Reserve withdrawals, however, reduce the shortfall in 2023-24 and eliminate it entirely in the following two years. (Proposition 2 [2014] created a reserve for schools and community colleges and established rules requiring deposits into and withdrawals from the fund under certain conditions.) The orange bars show the surplus or shortfall after accounting for these withdrawals. By the end of the period, the Proposition 98 budget is back in balance and the state makes a small reserve deposit. Overall, our outlook suggests that the school and community college budget generally is balanced but does not have capacity for new ongoing commitments. Proposition 98 Reserve Compensates for Small Shortfalls Over the Next Few Years Main Forecast (In Billions) $3 Surplus/Shortfall Before Reserves 2 Reserve Deposit or Withdrawal Surplus/Shortfall After Reserves 1 -1 Surplus: available funding exceeds program costs, adjusted for COLA. -2 Shortfall: available funding is less than program costs, adjusted for COLA. -3 2023-24 2024-25 2025-26 2026-27 COLA = cost-of-living adjustment. www.lao.ca.gov 11 2023-24 BUDGET policy mechanisms for doing so. This means that programs in conjunction with possible budget the actual costs to maintain the state’s service solutions. On the one hand, pausing automatic level are higher than what our outlook reflects. adjustments could free up resources and mitigate Consequently, our estimate of a $24 billion budget the need for other reductions. On the other hand, problem understates the actual budget problem for those programs whose costs have not recently in inflation-adjusted terms. That is, assuming the been adjusted for inflation, budget reductions Legislature wanted to maintain its current level of would result in greater reductions in service. If the services, additional spending would be necessary. Legislature wants to provide inflation adjustments Consider Inflation When Addressing the in some areas in response to higher prices, the size Budget Problem. As the Legislature works of the budget problem would increase, meaning to address the budget problem, we suggest corresponding reductions to other areas also would policymakers consider the unique impacts of be required. inflation on each of the state’s major spending SAVE RESERVES FOR A RECESSION A Recession Would Result in Much More the year to deliberate difficult budgetary choices Significant Revenue Declines. While the about spending reductions or revenue increases heightened risk of a recession weighs down our would give the Legislature more time to weigh these revenue outlook, our estimates do not reflect a decisions. Second, we would urge the Legislature recession. Were a recession to begin within the to consider saving reserves for a recession when next several months, revenue declines would be the budget problem could be twice as large as the greater than shown in our revenue outlook. Based one identified in our outlook. on historical experience, should a recession occur In the Meantime, Recommend Legislature soon, revenues could be $30 billion to $50 billion Identify Recent Augmentations to Pause or below our revenue outlook in the budget window. Delay. Recent budgets allocated significant General Purpose Reserves Are Adequate to funds to one-time and temporary purposes, with Cover Budget Problem, but Not if a Recession many large augmentations planned for 2022-23 Occurs. Consistent with lower revenue estimates, and 2023-24. For example, the 2021-22 budget the Legislature faces a budget problem of committed $39 billion in General Fund resources $24 billion in 2023-24—roughly equivalent to to one-time or temporary purposes and the the amount of general-purpose reserves it 2022-23 budget committed $36 billion to similar could have available to allocate to General Fund types of activities. Early in 2023, we suggest programs ($23 billion). Despite this, we suggest the Legislature question the administration the Legislature begin planning the 2023-24 about the implementation and distribution of budget without using general purpose reserves. these augmentations. If augmentations have We say this for two reasons. First, the state will not yet been distributed, the Legislature has an have more information about the budget condition opportunity to reevaluate those expenditures. in May. At that time, revenues could be higher Moreover, in light of the magnitude of the recent or lower than our current estimates and the augmentations, programs may not be working as Legislature will need to enact the final budget in expected, capacity issues may have constrained a very compressed time frame. If revenues are implementation, or other unforeseen challenges significantly lower, the Legislature will need both may have emerged. To address the budget reserves and other budget solutions to address the problem for the upcoming year, these cases might deficit. If revenues are higher, the Legislature will provide the Legislature with areas for pause, not need to make as many spending reductions or delay, or reassessment. revenue increases. Using the beginning months of 12 LEGISLATIVE ANALYST’S OFFICE 2023-24 BUDGET APPENDIX Appendix Figure 1 General Fund Spending Through 2023-24 (In Billions) Outlook Change From 2022-23 2023-24 2022-23 Legislative and Executive $10.9 $9.2 -15% Courts 3.5 3.7 5 Business, Consumer Services, and Housing 2.3 1.3 -43 Transportation 0.6 0.4 -37 Natural Resources 8.6 7.4 -15 Environmental Protection 1.5 2.0 35 Health and Human Services 66.4 68.2 3 Corrections and Rehabilitation 13.6 13.1 -4 Education 18.7 20.9 12 Labor and Workforce Development 1.5 2.0 35 Government Operations 4.9 3.6 -26 General Government Non-Agency Departments 1.8 3.3 78 Tax Relief/Local Government 0.7 0.6 -7 Statewide Expenditures 7.6 6.7 -20 Capital Outlay 2.8 0.5 -82 Debt Service 5.4 5.6 4 Agency Spending Total $150.7 $148.4 -2% Schools and Community Collegesa $78.6 $78.1 -1% Totals $229.3 $226.5 -2% a Reflects General Fund component of the Proposition 98 minimum guarantee. www.lao.ca.gov 13 2023-24 BUDGET Appendix Figure 2 General Fund Spending by Agency Through 2026-27 (In Billions) Average Annual Agency 2021-22 2022-23 2023-24 2024-25 2025-26 2026-27 Growth Legislative and Executive $15.5 $10.9 $9.2 $5.2 $2.8 $2.4 -35.8% Courts 3.3 3.5 3.7 3.8 3.9 4.1 3.8 Business, Consumer Services, and 2.2 2.3 1.3 0.2 0.2 0.2 -46.9 Housing Transportation 2.4 0.6 0.4 0.2 0.2 0.2 -27.2 Natural Resources 11.4 8.6 7.4 4.4 4.6 2.9 -26.5 Environmental Protection 4.2 1.5 2.0 0.5 0.4 0.2 -56.2 Health and Human Services 52.5 66.4 68.2 73.5 77.5 81.9 6.3 Corrections and Rehabilitation 13.7 13.6 13.1 12.4 11.9 11.8 -3.3 Education 20.8 18.7 20.9 21.0 20.6 21.7 1.3 Labor and Workforce Development 1.6 1.5 2.0 1.8 1.1 1.1 -17.1 Government Operations 20.1 4.9 3.6 3.9 4.0 3.8 1.4 General Government Non-Agency Departments 1.8 1.8 3.3 1.0 1.0 1.0 -33.2 Tax Relief/Local Government 0.6 0.7 0.6 0.7 0.7 0.6 0.1 Statewide Expenditures 1.7 7.6 6.7 8.1 8.5 11.7 20.4 Capital Outlay 1.6 2.8 0.5 0.5 0.5 0.5 — Debt Service 5.2 5.4 5.6 5.8 6.0 5.8 1.2 Agency Spending Total $158.6 $150.7 $148.4 $142.9 $143.8 $149.9 0.3% Schools and Community Collegesa $83.9 $78.6 $78.1 $81.8 $87.3 $95.4 6.9% Proposition 2 Infrastructureb — — — $0.8 $0.5 $1.3 -100.0% Total Forecasted Spending $242.5 $229.3 $226.5 $225.5 $231.6 $246.6 2.9% a Reflects General Fund component of the Proposition 98 minimum guarantee. b In 2022-23, amounts are distributed across agencies. In 2023-24, we assumed required infrastructure payments were suspended under Proposition 2 budget emergency provisions. Appendix Figure 3 LAO Multiyear Revenue Outlook (In Billions) 2021-22 2022-23 2023-24 2024-25 2025-26 2026-27 Personal Income Tax $135.9 $125.2 $122.6 $127.1 $144.1 $171.9 Corporation Tax 45.5 37.0 38.6 40.6 33.8 25.1 Sales Tax 32.9 33.3 33.1 34.1 35.3 36.5 Total “Big Three” Revenue ($214.3) ($195.5) ($194.3) ($201.8) ($213.1) ($233.5) Federal Cost Recovery $1.3 $6.9 $7.0 $0.5 $0.3 $0.1 Other Revenues 6.0 6.2 6.8 7.1 7.1 7.2 Total Revenues ($221.5) ($208.7) ($208.1) ($209.4) ($220.6) ($240.8) Transfers $2.6 -$0.4 $0.2 -$1.2 -$0.8 -$1.7 Total Revenues and Transfers $224.1 $208.3 $208.3 $208.2 $219.7 $239.1 14 LEGISLATIVE ANALYST’S OFFICE 2023-24 BUDGET LEGISLATIVE ANALYST’S OFFICE WWW.LAO.CA.GOV (916) 445-4656 Legislative Analyst Gabriel Petek Chief Deputy Legislative Analyst Chief Deputy Legislative Analyst Carolyn Chu Anthony Simbol State Budget Condition K-12 Education Ann Hollingsheada Edgar Cabral, Deputy Michael Alferes Jackie Barocio Economy, Taxes, and Labor Sara Cortez Brian Uhler, Deputy Chas Alamo Kenneth Kapphahn Ross Brown Seth Kerstein Higher Education Brian Weatherford Jennifer Kuhn Pacella, Deputy Ian Klein Health, Developmental Services, and IT Lisa Qing Mark C. Newton, Deputy Paul Steenhausen Jason Constantouros Luke Koushmaro Environment and Transportation Brian Metzker Rachel Ehlers, Deputy Will Owens Sarah Cornett Frank Jimenez Human Services and Governance Helen Kerstein Ginni Bella Navarre, Deputy Sonja Petek Ryan Anderson Eunice Roh Lourdes Morales Nick Schroeder Public Safety and Business Regulation Angela Short Drew Soderborg, Deputy Anita Lee Caitlin O’Neil Orlando Sanchez Zavala Jared Sippel Administration, Information Services, and Support Michael Greer Mohammed Saeed Sarah Barkman Sarah Scanlon Vu Chu Jim Stahley Rey Gonzalez Linda Le Tamara Lockhart Anthony Lucero a General Fund Condition analyst, Fiscal Outlook coordinator. www.lao.ca.gov 15 2023-24 BUDGET 16 LEGISLATIVE ANALYST’S OFFICE 2023-24 BUDGET www.lao.ca.gov 17 2023-24 BUDGET LAO PUBLICATIONS This report was prepared by Ann Hollingshead, with contributions from others across the office, and reviewed by Carolyn Chu and Anthony Simbol. 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. 18 LEGISLATIVE ANALYST’S OFFICE