The 2023-24 Budget: Multiyear Assessment

2023-24 BUDGET The 2023-24 Budget: Multiyear Assessment GABRIEL PETEK | LEGISLATIVE ANALYST | FEBRUARY 2023 Summary Budget Problem Likely Larger in May. Due to a deteriorating revenue picture relative to expectations from June 2022, both our office and the administration anticipate the state faces a budget problem in 2023-24. Although the Governor’s budget revenue estimates are reasonable, they are likely a bit too high. In particular, using recent revenue collections and economic data, we estimate there is a two-in-three chance that state revenues will be lower than the Governor’s budget estimates for 2022-23 and 2023-24. Our best estimate is that revenues for these two years will be roughly $10 billion lower—implying a larger budget problem by about $7 billion. (Many other factors also will affect the actual size of the budget problem.) That said, after adjusting for inflation, anticipated revenues for 2023-24 still would remain about 20 percent higher than before the pandemic. Governor’s Budget Likely Unaffordable in Future Years. Under the administration’s projections, the state faces operating deficits of $9 billion in 2024-25, $9 billion in 2025-26, and $4 billion in 2026-27. Because of the state’s constitutional spending requirements, revenues would need to be higher by more than these amounts for the state to be able to afford the spending level currently proposed. For example, to eliminate the operating deficit in 2024-25, revenues would need to be roughly $20 billion higher than the Governor’s budget projection. Our analysis suggests this level of revenue is quite unlikely—there is only a one-in-five chance the state can afford that spending level. Baseline Budget More Likely to Be Affordable in Coming Years. By contrast, the chances the state will collect enough revenue to cover the “baseline budget” are much higher. (We define the baseline budget as the spending level after removing reserves deposits and all one-time and temporary spending currently authorized or planned under Governor’s budget.) Specifically, there are even chances (one in two) that revenues would be sufficient for the state to pay for all of its baseline programs. Why We Advise Holding Off on Using Reserves for Now. The main benefit of reserves is that they help the state to maintain its core spending over the long term, despite the state’s volatile revenue structure. Although state revenues are moderating from a historic peak, they are not yet consistent with recessionary levels. Using reserves now to maintain the recent spending peak would mean the state would have less reserves available to pay for its core services if revenues declined further or in the event of a recession. Consequently, we recommend the Legislature hold off using reserves unless revenues decline by more than the $10 billion identified in this report. Revenue declines beyond $10 billion would reflect levels below historical averages and could impact the state’s core spending level. As a result, if revenue losses go beyond an additional $10 billion through 2023-24, we think using reserves would be warranted. Alternatives for Addressing the Budget Problem. Instead of making withdrawals from reserves, there are a variety of other actions the Legislature can take to address the additional shortfalls we have identified in the report. In particular, the Legislature could consider: (1) suspending deposits into the state’s rainy-day fund (although this would require action by the Governor); (2) reducing more one-time and temporary spending; (3) shifting more costs than currently proposed by the Governor; and/or (4) increasing revenues, for example, on a temporary basis. www.lao.ca.gov 1 2023-24 BUDGET INTRODUCTION The state has faced four recessions in the last is a heightened risk of this cooldown progressing three decades. Three of those—the recession to a recession. As a result, planning for further in the early 1990s, the dot-com bust in the early revenue declines would be prudent. Moreover, 2000s, and the Great Recession—resulted in large the multiyear budget is out of balance under the revenue shortfalls and ensuing multiyear deficits, Governor’s proposals. This means the state is more even for some years after each recession ended. likely to face budget problems over the next few The most recent COVID-19 induced recession years if the Governor’s budget is adopted. was acute, but short-lived. Ultimately, unlike with This situation makes legislative choices about previous downturns, state revenues did not decline budget solutions this year particularly pertinent. in response. In fact, the immediate aftermath of this In particular, solutions used this year will affect recession was marked by robust revenue growth. the availability of options in a future year, should As a result, in the last two years, the state saw a recession occur. In that event, revenues would historic budget surpluses—including $47 billion in decline an additional $30 billion to $50 billion 2021-22 and $55 billion in 2022-23. compared to the estimates presented here. Although the state faces a budget problem This brief provides our current assessment of this year, anticipated revenue shortfalls this year the scale of the coming budget problems under the do not yet reflect a recession. Rather, revenues Governor’s budget proposals. We also provide our have declined relative to their recent peaks due guidance to the Legislature about how to address to Federal Reserve actions taken to cool an these shortfalls given current economic conditions. overheated economy. We do, however, think there FUTURE SHORTFALLS VERY LIKELY Budget Problem Likely Larger in May are likely still a bit too high. In particular, using recent revenue collections and economic data, Budget Problem Emerged Due to we estimate there is a two-in-three chance that Lower-Than-Expected Revenues. Due to state revenues will be lower than the Governor’s a deteriorating revenue picture relative to budget estimates for 2022-23 and 2023-24. expectations from June 2022, both our office and Based on current information, our best estimate is the administration anticipate the state faces a that revenues for these two years will be roughly budget problem in 2023-24. In particular, under $10 billion lower. our estimates, the Governor’s budget faced an $18 billion budget problem. This deficit is occurring Budget Problem Likely About $7 Billion primarily because the state’s June 2022 revenue Higher—Requiring Additional Solutions. If the projections—although reasonable at the time— Governor’s May Revision revenues are lower by were too high. The main reason for these lower $10 billion, the budget problem would be about projections is action by Federal Reserve, which $7 billion larger, necessitating an equal amount of repeatedly increased interest rates with the aim of additional budget solutions. (This estimate of the cooling the economy and, in turn, slowing inflation. budget problem accounts only for formula-driven changes in constitutional spending on schools Governor’s Budget Revenue Estimates Likely and community colleges, but not other spending Too High for 2022-23 and 2023-24. Although estimates, such as differences in caseload, the Governor’s budget revenue estimates are federal funding, or other constitutional formulas, reasonable—particularly when the administration whose effects can be very unpredictable. put together its estimates in late December—they 2 LEGISLATIVE ANALYST’S OFFICE 2023-24 BUDGET The actual estimate of the budget problem One-in-Five Chance the State Will Be Able in May will be higher or lower depending on to Afford Multiyear Spending Levels. While both administration revenue projections and these other our and the administration’s forecasts suggest estimates.) Although our estimate of the budget the state faces operating deficits, revenues could problem is larger than the one addressed by the differ substantially from these estimates. Figure 1 Governor’s budget, we would still characterize it as displays the distribution of most likely revenue manageable, as discussed in further detail below. outcomes over the multiyear (in grey). As seen in Governor’s Proposed Trigger Restorations the figure, the revenues required to balance the Unlikely to Materialize. To address the estimated budget (in red) are considerably above the most $18 billion budget problem at Governor’s budget, likely scenario in all but 2026-27. For example, to the administration proposed nearly $14 billion in eliminate the operating deficit in 2024-25, revenues spending-related solutions. Of these spending would need to be roughly $20 billion higher than reductions, the Governor proposes making the Governor’s budget projection. Our analysis nearly one-third—or nearly $4 billion—subject to suggests this level of revenue is quite unlikely— trigger restoration language. Under this proposed there is only a one-in-five chance the state can language, program spending that otherwise would afford that spending level. (The box on the next have occurred in 2023-24 would not be allocated page explains how we conduct this analysis.) as part of the June budget act. However, if in For reference, the Governor’s budget assumes a January 2024 the administration estimates there revenue level that is somewhat higher than our main are sufficient resources available to fund these forecast through 2023-24 and somewhat lower in expenditures, those programs the out-years. would be restored halfway through the fiscal year. Given we anticipate Figure 1 an even larger budget problem than estimated by the Governor, Governor’s Budget Likely Unaffordable in we find it unlikely—specifically, Coming Years a one-in-five chance—that these (In Billions) trigger restorations can be afforded in 2023-24. The Main Forecast shows revenue estimates we think have even odds of being too high or too low. The Revenues to Support Governor's Budget shows the amount of revenue needed to afford the Governor’s Budget Likely Governor’s Budget. The grey shaded area shows the range of most likely revenue outcomes. Unaffordable in Coming Years $280 The administration projects the 260 multiyear condition of the budget Revenues to Support under the Governor’s revenues 240 Governor's Budget and spending levels. Under those projections, the state faces 220 operating deficits of $9 billion in 2024-25, $9 billion in 2025-26, and 200 Main Forecast $4 billion in 2026-27. Because of 180 the state’s constitutional spending requirements, revenues would 160 need to be higher by more than 2021-22 2022-23 2023-24 2024-25 2025-26 2026-27 these amounts for the state to be able to afford the spending level currently proposed. www.lao.ca.gov 3 2023-24 BUDGET How Did We Construct This Analysis? Our analysis starts by estimating how much revenues ultimately could differ from our Fiscal Outlook multiyear revenue forecast (with updated current-year estimates) based on the state’s historical experience. (Our Fiscal Outlook revenues are our best estimate of the revenue assumption that has even odds of being too high or too low.) We then look at where in this range of potential revenue outcomes the Governor’s proposed level of spending falls. This allows us to assess how likely it is that revenues could be high enough to support the proposed spending. Specifically, we assess how often in the past revenues experienced a positive deviation large enough to meet or exceed the proposed level of spending (adjusted for constitutional, formula-driven spending). Even Chances Revenues Will Be Figure 2 Sufficient to Maintain “Baseline” Budget. We also assessed the Baseline Budget More Likely to Be likelihood the state will collect enough Affordable in Coming Years revenue to maintain “baseline spending” over the multiyear period. (For the (In Billions) purposes of this analysis, we define the state’s baseline budget as the The Main Forecast shows revenue estimates we think have even odds of being too high or too low. The Baseline Budget shows state spending after removing all one-time and temporary spending in ongoing program spending level after the Governor’s budget. removing all one-time and temporary The grey shaded area shows the range of most likely revenue outcomes. spending the administration estimates $280 is currently authorized or planned under Governor’s budget. For the purposes 260 of this analysis, we also assumed the state would suspend its annual deposits 240 into the state’s constitutional reserve.) As shown in Figure 2, using the likely 220 range of plausible revenue outcomes, Main Forecast 200 we find the chances the state can afford Baseline Budget the baseline budget are roughly even. 180 Specifically, there are even chances (one in two) that revenues would be sufficient 160 for the state to pay for all of its baseline 2021-22 2022-23 2023-24 2024-25 2025-26 2026-27 programs. As we have outlined before, relying on a revenue estimate that presents even chances of a surplus and a deficit helps the state avoid making commitments it cannot sustain while also not foregoing program expansions that likely can be supported. 4 LEGISLATIVE ANALYST’S OFFICE 2023-24 BUDGET ADDRESSING THE SHORTFALLS As we discussed above, the state is likely to …And Maintain Core Spending. While there face a larger budget problem in May and additional is more than one reasonable way to define core shortfalls in the out-years. These shortfalls would spending, we define it as the amount of ongoing represent additional budget problems that the spending that can be supported over the long Legislature would have to address with a combination term in the context of an inherently volatile revenue of actions. While the state’s main tool for addressing structure. (What programs the Legislature prioritizes a budget problem is its reserves, for reasons we as core spending depends on its priorities.) In any describe below, we do not advise the Legislature use given year, the core spending level might be above reserves to address the shortfall at this time. Instead, or below the amount of revenue received, depending we suggest the state use a combination of other on whether the state is experiencing a surge or actions, which include: spending reductions, revenue downturn in revenues. Over the long-term, the state increases, and cost shifts. In this section, we discuss can avoid cuts to core spending by setting aside our guidance for the Legislature as it addresses the money in reserves when revenues are peaking and additional budget problems likely to materialize this spending those amounts during downturns. In other year and, possibly, in future years. We begin with our words, given the volatility in the state’s revenues, guidance regarding reserves specifically and then turn reserves are the state’s key tool for avoiding cuts to the state’s other options. to core spending. Even With Revenue Declines, Spending Why We Advise Holding Off on Using Remains Above Historically Recent Peaks. Reserves for Now Since around 2020, the state has seen historic surges As we discussed in the previous section, we expect in revenues—and ensuing historically large surpluses the revenue shortfall to be larger in May by around and spending levels. However, while revenues are $10 billion. (This would imply a larger budget problem moderating from the recent peak, they are still of around $7 billion.) Nonetheless, we still advise the above average historical levels. For example, even Legislature to hold off on using reserves to cover that after adjusting for inflation, anticipated revenues larger budget problem. If revenue losses go beyond for 2023-24 remain about 20 percent higher than that additional $10 billion, using reserves would be before the pandemic. Moreover, the Governor’s warranted. We explain our reasoning in this section. proposed spending level—as a share of the economy Reserves Are a Key Tool to Address Revenue shown in Figure 3 on the next page—remains above Volatility… As our office has discussed extensively in peaks from the early and mid-2000s. None of these past reports, California’s General Fund tax revenues levels—both on the revenue and spending side—are are relatively volatile. State revenues tend to grow consistent with shortfalls seen during recessions. when the economy is expanding and shrink during Because Recent Budgets Focused on periods of downturns or when financial market One-Time and Temporary Spending, Ongoing conditions are tightening. In the last couple of Spending Level Is Still Sustainable. Recognizing decades, the state has faced a choice about how to that recent rapid revenue growth was unsustainable, prevent that volatility from resulting in large cuts to the Legislature focused recent surpluses on programmatic spending. The state could reform the one-time and temporary spending, allocating tens underlying tax structure to make it less volatile, which of billions of dollars to these purposes. By limiting nearly certainly would involve reducing tax rates for expansions to ongoing programs, the Legislature higher-income earners. Or, the state could address kept ongoing government services roughly in line volatility by building reserves—funds that can be with underlying revenue trends. One way to measure saved during upswings and spent during downturns. this is the probability analysis we presented earlier. Over many years, lawmakers and voters have clearly Under that analysis, the state has roughly even signaled a preference for using reserves to maintain chances of collecting sufficient revenue to maintain program stability. its baseline spending level through the multiyear. www.lao.ca.gov 5 2023-24 BUDGET This signals that lawmakers have committed to an Alternatives for Addressing the ongoing spending level that is sustainable—that is, Additional Budget Problem in line with core spending—but spending above that Instead of making withdrawals from reserves, base is less so. this section outlines alternatives for addressing the Using Reserves Now Would Maintain Spending budget shortfalls that would arise from an additional Peak, but Eliminate a Tool for Future Shortfalls. $10 billion in revenue shortfalls. The main benefit of reserves is that they help the Suspend Budget Stabilization Account state to maintain its core spending over the long (BSA) Deposits. Although we do not think reserve term, despite the state’s volatile revenue structure. withdrawals are merited at this time, we think The state’s revenue and spending are moderating suspending the otherwise constitutionally required from a historic peak, and are not yet consistent with BSA deposits is warranted. As is the case with recessionary levels. There is about a 50-50 chance making BSA withdrawals, suspending BSA deposits the state can afford its ongoing spending level. would require that the Governor to declare a Using reserves now to maintain the recent spending budget emergency. peak would mean the state would have less reserves Reduce Additional One-Time and Temporary available to pay for its core services if revenues Spending. After accounting for proposed budget declined further or in the event of a recession. solutions, the administration estimates the state Consequently, we recommend the Legislature has $15.2 billion in one-time or temporary spending hold off using reserves unless revenues decline by scheduled for 2023-24, $9.3 billion in 2024-25, more than the $10 billion identified in this report. and $6 billion in 2025-26. These are amounts Revenue declines beyond $10 billion would reflect that seemed affordable in June 2022, but that no levels below historical averages and could impact longer appears to be the case. The state can solve the state’s core spending level. If revenue losses essentially all of the currently estimated budget go beyond an additional $10 billion for the budget problems by suspending deposits into the BSA window, however, we think using reserves would and reducing this spending. (This would include be warranted. eliminating the spending currently proposed for delay.) If the Legislature wished, it could make some of these reductions subject to automatic trigger restoration if the state collects more Figure 3 revenue than currently anticipated. Increase Costs Shifts Despite Decline, General Fund Spending and/or Revenues. Rather than Would Still Remain Above Peaks using spending reductions alone, General Fund Spending as a Share of State Personal Income the Legislature could use other solutions to address the budget problem while still avoiding using 8% reserves—at least for a continued manageable budget problem. 7 First, the state could shift more costs than the $4.3 billion currently 6 proposed by Governor. (We expect 5 to release an analysis on these cost shifts, with additional options for the 4 Legislature, in the coming weeks.) Second, the Legislature could 3 consider increasing revenues, for 90-91 94-95 98-99 02-03 06-07 10-11 14-15 18-19 22-23 example, on a temporary basis to cover the interim shortfalls. 6 LEGISLATIVE ANALYST’S OFFICE 2023-24 BUDGET www.lao.ca.gov 7 2023-24 BUDGET 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