The 2023-24 Budget: Considering Inflation's Effects on State Programs

2023-24 BUDGET The 2023-24 Budget: Considering Inflation’s Effects on State Programs GABRIEL PETEK | LEGISLATIVE ANALYST | NOVEMBER 2022 SUMMARY State Budget Automatically Accounts for Inflation in Some Areas. There are three mechanisms by which state spending is adjusted for inflation: (1) formulas, in which program spending is statutorily adjusted for certain factors, like a cost of living adjustment (COLA); (2) administrative decisions, in which the Legislature delegated authority to the administration to adjust costs with varying levels of discretion; and (3) legislative decisions, in which specific spending increases are determined through legislative deliberation and are directly approved by the Legislature. There is significant variation in the use of these mechanisms across the budget, such that some areas of the budget automatically account for inflation, but many others do not. Overall, a large share of state spending is adjusted to some degree formulaically or administratively (notably in K-12 education and many health payments), however, a large number of programs are not. Impacts of Not Accounting for Inflation. When programs require specific legislative action to adjust for inflation, those adjustments are less likely to occur. When program spending does not increase to account for inflation, the size and scope of those programs declines. Specifically, not adjusting for inflation can reduce the quantity or quality of state services, lower benefit levels for program recipients, reduce access to services, delay provision of services, or create challenges for hiring and retention. By not automatically accounting for inflation across all programs, however, the Legislature retains flexibility to ensure resources are provided to areas of highest priority. Consider Whether Existing Automatic Adjustments Align With Legislative Priorities. There are benefits to both automatic and legislatively determined adjustments. We do not think that all—or even more—programs should have automatic COLA-like adjustments or more statutory authority for administrative discretion. Broadly, automatic and administrative adjustments reduce the Legislature’s discretion over state spending. That said, the range of approaches and application of inflation adjustments varies in ways that might not always align with legislative priorities. Given current elevated levels of inflation, we suggest the Legislature consider whether the current automatic program spending adjustments target additional resources to areas of legislative priority. Consider the Disparate Impacts of Inflation When Addressing This Year’s Budget Problem. Elevated inflation already has eroded the quantity and quality of state services to some degree. As we anticipate higher inflation to persist to an extent, further reductions to services are likely. Under our Fiscal Outlook, however, the Legislature will face a $25 billion budget problem in 2023-24 and will not have surplus resources available to address inflation absent other spending or revenue changes. As the Legislature deliberates over how to address the upcoming budget problem, we advise considering how to mitigate the dual impact of inflation and funding reductions on programs. INTRODUCTION This brief takes a case study approach to examine how elevated inflation has already impacted— Over the course of 2022, elevated inflation has and could continue to impact—state spending persisted, defying expectations of many professional programs. Consequently, while this analysis covers forecasters. To the degree this continues— a large share of the budget, it is not comprehensive. which our office thinks is likely to an extent— (We discuss the economic context for higher elevated inflation will have significant, although inflation, as well as the potential implications on disparate, consequences across the state budget. www.lao.ca.gov 1 2023-24 BUDGET revenues, in our report, The 2023-24 Budget: growth—could result in elevated inflation that California’s Fiscal Outlook.) Given these impacts, persists in the coming years. Reflecting these at the end of this brief, we provide some comments heightened pressures, our forecast of inflation in and guidance for the Legislature to consider ahead California, shown in Figure 1, has annual inflation of the 2023-24 Governor’s budget. dropping to about 4 percent and remaining there for the next few years. Other economic forecasters also INFLATION BASICS see a significant risk of future inflation exceeding levels seen in recent years. For example, in a recent How Inflation Has Changed to Date. survey of professional forecasters, respondents After decades of relatively low inflation, prices of put a 62 percent probability on U.S. inflation being many goods and services began increasing more 3 percent or higher in 2023—notably higher than rapidly in 2021. There are different ways to measure the 2019 survey and the recent historical average. inflation, each reflecting different segments of the economy. One of the most common and While our forecast presents inflation estimates broad-based measures is the consumer price index we think are most likely to be least wrong, in all (CPI), which reflects the cost of typical goods and likelihood they will be wrong to some extent. services purchased by households. The California The shaded area in Figure 1 shows how inflation CPI was 7.5 percent as of the third quarter of could differ from our main forecast. For example, by 2022, compared to less than 3 percent over the 2026, annual inflation levels ranging from 2 percent previous five years. Other measures of inflation also to 9 percent are plausible. Key factors contributing are relevant to specific areas of state spending. to the current uncertainty include the degree to For example, annual growth in the California which businesses and workers begin to expect Construction Cost Index (CCCI), published by heightened inflation in future years, the degree to the Department of General Services (DGS)— which actions by the Federal Reserve to reduce relevant to capital outlay and other infrastructure inflation are successful, and changes in geopolitical spending—was 13.4 percent in 2021, compared events affecting food and energy prices. to an average of 3.1 percent over the previous five years. The California Necessities Index—a measure of price inflation for basic goods such as food and Figure 1 clothing that is relevant for some Substantial Uncertainty About Future Inflation, human services programs—grew But Heightened Pressures Remain by 6.6 percent in 2021, compared to an average of 3.6 percent over LAO Forecast of California CPI the previous five years. What Might Happen in the 9% Future? The outlook for inflation 8 in the coming years is highly 7 uncertain. The Federal Reserve— 6 tasked with maintaining stable 5 price growth—has started to take actions to slow inflation by cooling 4 the economy. While these efforts 3 very well could return inflation in 2 California to the pre-pandemic 1 norm of 2.5 percent per year, heightened inflation pressures— 2021 2022 2023 2024 2025 2026 such as relatively high levels of consumer spending and wage CPI = Consumer Price Index for All Urban Consumers. 2 LEGISLATIVE ANALYST’S OFFICE 2023-24 BUDGET HOW AND WHEN DOES THE Categories of Costs STATE BUDGET ACCOUNT FOR Salaries and Benefits. Across the state budget, the largest category of state operations costs INFLATION? is for salaries and benefits for state employees. Ultimately, all changes in state spending are Increases in state employee pay typically are legislative decisions as the Legislature holds the established in labor agreements, which are constitutional power of appropriation. That said, negotiated by the administration and ratified by in some cases, the legislature has delegated its the Legislature. Although salary increases for most authority such that some spending changes can employees covered by agreements ratified in 2022 be made without specific legislative deliberation. were below inflation, over the past several years, As a result, there are three general mechanisms for state employee salary adjustments generally kept these spending adjustments, all of which require pace with inflation. Other benefit costs—such as different levels of legislative input. for pensions, retiree health, and employee health • Formulaic Adjustments. Cases in which benefits—also tend to increase with inflation. program spending is adjusted by certain For example, state costs for retiree health are driven factors, like a cost-of-living adjustment by the number of retirees receiving the benefit (COLA). These factors are set and approved in and the cost of health premiums. To the extent state law. These adjustments require limited that inflation drives increases in health premiums, annual legislative input, particularly when the state’s costs would increase automatically. continuously appropriated. Consequently, salary and benefit costs are • Administrative Decisions. Cases in which adjusted for inflation through a combination of the Legislature has delegated authority to the administrative and legislative decisions, as well as administration to adjust costs with varying formulaic adjustments. levels of discretion. In most cases, however, Lease Costs, Operating Expenses, and administrative decisions still require some Equipment. A second major category of state type of legislative approval through statute, operations costs is facilities and equipment. like the annual budget bill or a midyear budget This includes, for example, the cost to state adjustment bill. departments for leases and other rental costs, • Specific Legislative Decisions. In all as well as operating expenses and equipment other cases, budgeted cost increases are (OE&E)—such as printing, communication, and determined through legislative deliberation travel. In terms of rental payments, when a building and are directly approved by the Legislature. is state-owned, the department generally pays In these cases, the Legislature makes specific rent to DGS, which supports DGS’ operations and choices about whether and how to spend maintenance of the buildings. When a department’s more funds to keep up with rising program underlying costs of rent or OE&E increase as a costs. These changes can be one time, result of inflation or other factors, in general, the temporary, or ongoing. department must manage the increase within its existing budget. When budgeted rental amounts The remainder of this section describes how are systematically below actual costs, departments these mechanisms are used across different occasionally will submit a budget change categories of spending. In some areas, the state proposal to the Legislature requesting additional budget automatically adjusts for inflation using appropriation authority to cover these higher costs. these mechanisms, whereas in other areas it Consequently, adjustments for increases in lease does not. costs and OE&E are driven by legislative decisions. www.lao.ca.gov 3 2023-24 BUDGET Lump Sums to Other Entities. In some other correspondingly adjusted upward. (There are some areas of the budget, the state provides lump narrow exceptions to these rules, depending on sum amounts—sometimes referred to as block the department, type of contract, and the terms of grants—to other entities of government, which the agreement.) New awards, grants, and contracts those entities manage as part of their own budgets. can account for inflation as bidders and applicants This includes, for example, the majority of state develop and negotiate costs in their subsequent funding to school districts, which is provided applications and proposals. Budgeted costs only through the Local Control Funding Formula (LCFF); increase, however, if the Legislature increases base funds provided to the universities; and funds funding for the program, otherwise, fewer awards, to the trial courts. In each case, the Legislature grants, and contracts are awarded. might set expectations for the other entities in Capital Outlay. For budgetary purposes, capital using the funds, but to a large extent, the other outlay includes purchases of land and state-owned entity is responsible for making decisions about projects involving construction of new facilities how to allocate state funds, usually alongside other or renovation of existing facilities. Government funding sources (such as local property tax revenue Code allows the State Public Works Board to or student tuition revenue). In these cases, when augment the costs of major capital outlay projects costs increase as a result of inflation, state funds by up to 20 percent with legislative notification. sometimes adjust automatically and sometimes Larger augmentations require legislative approval. do not. For example, there is a statutory annual The same section of Government Code also gives COLA for LCFF based on a measure of inflation, the Department of Finance the authority to change but the Legislature must decide each year what the scope of major projects with notification to adjustments to make to trial courts and universities the Joint Legislative Budget Committee and, in in response to inflation and other cost increases. cases where a project is authorized with multiple Contracts, Grants, and Awards. Through a fund sources, to determine which of the fund variety of processes, including competitive bids, sources will bear the costs of that augmentation. the state regularly awards contracts, grants, and Consequently, up to a certain point, adjustments awards to third-party entities to provide goods for increases in capital outlay costs are made by and services. These types of arrangements exist administrative decisions. across nearly every area of state government, but Provider Rates. For some service-based some illustrative examples include: the California programs, the state pays specific rates to private Department of Transportation, which contracts and nonprofit entities to deliver services to program with construction companies to build and beneficiaries. Examples of provider rates include maintain roads; the Sierra Nevada Conservancy, child care vouchers, Medi-Cal managed care which provides grants to local governments and payments, and developmental service provider nonprofit organizations for forest resilience; and rates. Across these services, there is variation the Department of Housing and Community in how these rates are adjusted for inflation. For Development, which awards funds to developers example, child care vouchers are based on a for affordable housing projects. Typically, inflation survey of market child care costs, however, the does not result in spending increases for existing Legislature must adopt new rates based on those agreements between the state and private entities surveys in order to adjust the value of the vouchers because the state does not renegotiate awards for inflation. In contrast, inflationary pressures or contracts once they are made (although high are incorporated into the Department of Health inflation can increase costs for contractors and Care Service’s process for setting capitated heighten the risk of project failure). This means that, rates in Medi-Cal managed care. This process once a grant, award, or contract has been made, uses a variety of sources of data and projections the contractor or grantee generally bears the risk of costs and prices. Consequently, this process of the project—for example, due to rising prices of results in changes based on both formulaic and materials or energy—and award amounts are not administrative adjustments. In the Department 4 LEGISLATIVE ANALYST’S OFFICE 2023-24 BUDGET of Developmental Services (DDS), although the grant and CalWORKs grants are increased based Legislature recently enacted a plan to support rate on a complex formula based on growth in some models developed in a 2019 study (and updated to 1991 realignment revenues. Consequently, while 2021-22 levels), under current law, providers would there are some formulaic adjustments to program only receive rate adjustments based on future benefits, increases to state-funded benefits largely legislative decisions. are determined through legislative decisions. Administrative Costs. While many health and human services programs are, in large WHAT ARE THE CONSEQUENCES part, jointly financed by the state and federal WHEN STATE SPENDING DOES NOT governments, the state has delegated various ACCOUNT FOR INFLATION? administrative functions—including intake and This section describes the impacts on programs eligibility determinations of new applicants and and services when budgeted spending does not ongoing eligibility case management activities—to account for inflation. Throughout this section, we counties. This includes, for example, Medi-Cal, sometimes discuss spending in terms of its real California Work Opportunity and Responsibility to value. The nearby box describes this term. Kids (CalWORKs), and the Supplemental Nutrition Assistance Program (SNAP). To support these Lowers Quantity of Services. One of the most functions, the state pays a share of counties’ common impacts of elevated inflation for spending costs based expected workload. In the case of programs is a reduction in the quantity of state Medi-Cal, state payments to counties for program services provided. This is true across many areas, administration are automatically adjusted for but in recent months, consistent with significantly inflation annually. For other programs, including higher growth in the CCCI, impacts have been CalWORKs and SNAP, they are not. Consequently, particularly acute in construction-related areas while some programs’ administrative costs are and others making use of heavy mechanized adjusted by formula, others are determined by equipment. These areas include, for example, legislative decisions. housing construction, fire management, and transportation. In these cases, inflation results in a In-Kind, Cash, and Cash-Like Benefits. reduced service level relative to what was originally The state provides some in-kind, cash, and anticipated by the Legislature. As a result, the state cash-like benefits directly to individuals. These will build fewer housing units, treat fewer acres of benefits include, for example, cash assistance forest for wildfires, and perform less maintenance programs like CalWORKs and Supplemental of state roads and highways. In one particularly Security Income/State Supplementary Payment telling, although narrow, example, the California (SSI/SSP), as well as Cal Grants provided to Department and Fish and Wildlife (CDFW) reported students for non-tuition expenses. In general, that one project appropriated in the 2020-21 these benefits are not automatically adjusted for budget—a pest eradication capital outlay project— changes in beneficiaries’ cost of living. Some of experienced a 25 percent increase in estimated these programs also receive other adjustments, cost. As a result, CDFW had to nearly halve the size for example, SSI/SSP grants receive an annual, of the structure it had planned. federally funded COLA on the federal share of the Real Value The real value of a dollar refers to the amount of goods and services that dollar can buy. Over time, the real value of a dollar decreases due to inflation. For example, suppose the state spends $100,000 to provide services to ten people. In the next year, the cost of providing the service increases 10 percent, so the state can only provide those services to nine people. As a result, we can say that the “real” value of the state’s dollar has declined 10 percent. www.lao.ca.gov 5 2023-24 BUDGET Lowers Quality of Services. In other budget Delays the Provision of Services. In some areas, inflation can result in a reduction of quality, cases, elevated inflation results in service delays. rather than quantity, of services. For example, in These challenges are particularly relevant in several county administration of human services programs, construction-intensive areas, but a key example less state funding in real terms can mean local is in housing—specifically, housing projects that governments have lower staffing levels. Fewer are still being planned. High inflation has resulted staff means higher caseloads, which can result in delays as developers have needed to spend in adverse impacts to program timeliness and more time securing additional capital—above accuracy, particularly for redeterminations and case what was originally anticipated—to finance the management. In another similar example, regional projects before construction can begin. In a higher centers—which provide services to consumers inflationary environment, longer delays also can with developmental disabilities—are funded by the lead to higher housing development costs, further state with a core staffing formula that largely has reducing housing production. In other examples, been frozen since 1991. While the formula funds the state departments have held positions open as a Service Coordination position at $34,032 per year, way of managing higher costs without additional regional centers pay, on average, $67,000 for this spending authority. This can result in delays as staff position. Regional centers report that, as a result, are redirected between workloads. they hire fewer service coordinators and those Lowers Real Incomes for Employees and service coordinators carry average caseload ratios Causes Challenges for Hiring and Retention. of roughly 1:78 consumers—above statutory limits, As we discussed earlier, for many years, general which range from 1:25 to 1:66 based on several salary increases agreed to through collective categories of consumer need. These elevated bargaining generally have kept pace with inflation, caseload ratios likely are having negative impacts although those agreed to in 2022 did not. To on service quality and quantity for consumers. the extent salary increases are below inflation, Continued high inflation would further erode the real incomes of state employees will decline. real value of the formula-driven funding level for If persistent, lower salaries can make hiring these positions. and retaining employees challenging for state Lowers Benefit Levels. Elevated inflation also departments. Moreover, when a state department results in lower benefit levels for recipients, in must compete with the private sector and/or local real terms. As described earlier, most state cash government for employees, these challenges and cash-like benefits, such as for CalWORKs, can be particularly acute. As we put together this SSI/SSP, and the non-tuition portion of state Cal analysis, nearly every state department we spoke Grants, currently are not adjusted for inflation. As a with reported some level of difficulty with hiring and result, we expect the real value of these assistance retention and anticipated that continued inflation programs to decline more rapidly than prior years would result in additional challenges. as higher inflation persists. As a result, program Exacerbates Preexisting Challenges. In many beneficiaries will not be able to afford the same cases, inflation does not necessarily cause severe level of goods and services. problems in isolation, but rather exacerbates Reduces Access to Services. In some limited preexisting challenges. For example, in areas like cases, higher inflation can result in reduced access forest management and housing where the state to or longer wait times for state services. In the government recently significantly expanded state case of both DDS and, potentially, Medi-Cal fee for spending, the state is running into supply issues. service, if elevated inflation persists, rates would These supply challenges range from hiring enough erode in real terms. This could further exacerbate contractors to complete needed work to securing issues of coverage, for example by reducing raw materials to build housing. In addition to the number of providers willing to participate in supply shortages, reaching legislative goals for either system. some programs also becomes more challenging 6 LEGISLATIVE ANALYST’S OFFICE 2023-24 BUDGET when there is elevated inflation. For example, the There are benefits to both automatic and Legislature has stated a goal of setting CalWORKS legislatively determined adjustments. We do not grants at 50 percent of the federal poverty level. think that all—or even more—programs should When inflation is high, not only does the purchasing have automatic adjustments or more statutory power of the grant decline more rapidly, but also the authority for administrative discretion. Doing so resources required to meet the Legislature’s goal would reduce the Legislature’s discretion over state increase faster. spending. That said, the range of approaches and Heightens Risks of Project Failure. As we application of inflation adjustments varies in ways mentioned earlier, in some cases, the state can shift that might not always align with legislative priorities. the risk of inflation to contractors when entering into For example, some types of capital projects are agreements and contracts. Contractors for many subject to administrative augmentation whereas state services often already have subcontracts in others are not. Both types of projects may be place with fixed prices for materials, which mitigates infrastructure in the broad sense, with differences— their risk as well. However, persistently high and like ownership of the asset—making one but not very elevated inflation can nonetheless increase the the other eligible for administrative augmentation. risk of contractors failing to meet the terms of the As the Legislature considers the Governor’s budget, contract. Sometimes this results in delays to project we suggest it also consider which programs have completion, for example, if the state has to rebid the preexisting processes for adjusting for inflation and project. But in extreme cases, it could heighten the which do not and whether automatic adjustments risk of project failure altogether. Another key metric align with its priorities. of risk is not only the level of inflation, but also Accounting for Inflation Would Increase changes in it. In some areas, the unpredictability of Budget Problem. In our recently released report, inflation—swings in the rate of growth of prices— The 2023-24 Budget: California’s Fiscal Outlook, can pose greater issues. If inflation is high, but we estimated that the Legislature will face a budget stable, contractors and developers can plan for problem of $25 billion in the upcoming budget it and account for growth in prices in projections. cycle. A budget problem occurs when the state’s Large swings in inflation are much more difficult anticipated General Fund revenues are expected to integrate into plans and therefore can result in to be lower than expected General Fund costs significantly more risk, either for the contractor or under current law and policy. However, as we the state. have discussed extensively here, in many cases, budgetary spending does not automatically adjust LAO COMMENTS in response to inflation—meaning the actual costs to maintain the state’s service level are higher Elevated inflation already has eroded the than what our outlook reflects. Consequently, quantity and quality of state services to some the traditional definition of a budget problem degree. As we anticipate higher inflation to persist, understates the actual budget problem, assuming further reductions to services are likely. Under the Legislature wanted to maintain its current level our Fiscal Outlook, however, the Legislature likely of services. will face a budget problem in 2023-24 and will not have surplus resources available to address Consider Inflation When Addressing the inflation. As the Legislature deliberates over how Budget Problem. The Legislature is likely to face to address the upcoming budget problem, we a double challenge this year: a budget problem advise considering how to mitigate the dual impact coupled with continued, elevated inflation. As the of inflation and funding reductions on programs. Legislature works to address the budget problem, Below, we describe these dynamics in more detail. we suggest policymakers consider the unique impacts of inflation on each of the state’s major Consider Whether Existing Automatic spending programs in conjunction with possible Adjustments to Programs Align With budget solutions. For those programs whose Legislative Priorities. When programs require costs have not been recently adjusted for inflation, specific legislative action to adjust for inflation, budget reductions could result in greater reductions those adjustments are less likely to occur. www.lao.ca.gov 7 2023-24 BUDGET in service. In other cases, pausing automatic response to higher prices, the size of the budget adjustments could free up resources and mitigate problem will increase, meaning corresponding the need for reductions. If the Legislature wants to reductions to other areas also would be required. provide new inflation adjustments in some areas in LAO PUBLICATIONS This report was prepared by Ann Hollingshead and reviewed by Carolyn Chu. The Legislative Analyst’s Office (LAO) is a nonpartisan office that provides fiscal and policy information and advice to the Legislature. To request publications call (916) 445-4656. This report and others, as well as an e-mail subscription service, are available on the LAO’s website at www.lao.ca.gov. The LAO is located at 925 L Street, Suite 1000, Sacramento, California 95814. 8 LEGISLATIVE ANALYST’S OFFICE