The 2024-25 Budget: California's Fiscal Outlook

2024-25 BUDGET The 2024-25 Budget: California’s Fiscal Outlook GABRIEL PETEK LEGISLATIVE ANALYST DECEMBER 2023 www.lao.ca.gov 1 2024-25 BUDGET 2 LEGISLATIVE ANALYST’S OFFICE 2024-25 BUDGET Executive Summary California Faces a $68 Billion Deficit. Largely as a result of a severe revenue decline in 2022-23, the state faces a serious budget deficit. Specifically, under the state’s current law and policy, we estimate the Legislature will need to solve a budget problem of $68 billion in the upcoming budget process. Unprecedented Prior-Year Revenue Shortfall Creates Unique Challenges. Typically, the budget process does not involve large changes in revenue in the prior year (in this case, 2022-23). This is because prior-year taxes usually have been filed and associated revenues collected. Due to the state conforming to federal tax filing extensions, however, the Legislature is gaining a complete picture of 2022-23 tax collections after the fiscal year has already ended. Specifically, we estimate that 2022-23 revenue will be $26 billion below budget act estimates. This creates unique and difficult challenges—including limiting the Legislature’s options for addressing the budget problem. Legislature Has Multiple Tools Available to Address Budget Problem. While addressing a deficit of this scope will be challenging, the Legislature has a number of options available to do so. In particular, the state has nearly $24 billion in reserves to address the budget problem. In addition, there are options to reduce spending on schools and community colleges that could address nearly $17 billion of the budget problem. Further adjustments to other areas of the budget, such as reductions to one-time spending, could address at least an additional $10 billion or so. These options and some others, like cost shifts, would allow the Legislature to solve most of the deficit largely without impacting the state’s core ongoing service level. Legislature Will Have Fewer Options to Address Multiyear Deficits in the Coming Years. Given the state faces a serious budget problem, using general purpose reserves this year is merited. That said, we suggest the Legislature exercise some caution when deploying tools like reserves and cost shifts. The state’s reserves are unlikely to be sufficient to cover the state’s multiyear deficits—which average $30 billion per year under our estimates. These deficits likely necessitate ongoing spending reductions, revenue increases, or both. As a result, preserving a substantial portion—potentially up to half—of reserves would provide a helpful cushion in light of the anticipated shortfalls that lie ahead. www.lao.ca.gov 3 2024-25 BUDGET 4 LEGISLATIVE ANALYST’S OFFICE 2024-25 BUDGET INTRODUCTION Each year, our office publishes the Fiscal Outlook Due to the state conforming to federal tax in anticipation of the upcoming budget season. filing extensions, however, the Legislature is The goal of this report is to give the Legislature our only gaining a complete picture of 2022-23 independent estimates and analysis of the state’s tax collections after the fiscal year has already budget condition as lawmakers begin planning the ended. Specifically, we estimate that 2022-23 2024-25 budget. This year, this report has three revenue will be $26 billion below budget key takeaways: act estimates. • California Faces a Serious Deficit. • Legislature Has Multiple Tools Available to Largely as a result of a severe revenue decline Address Budget Problem. While addressing in 2022-23, the state faces a serious budget a deficit of this scope will be challenging, the deficit. Specifically, under the state’s current Legislature has a number of options available law and policy, we estimate the Legislature will to do so. In particular, the Legislature has need to solve a budget problem of $68 billion reserves to withdraw, one-time spending to in the coming budget process. pull back, and alternative approaches for school funding to consider. These options, • Unprecedented Prior-Year Revenue along with some others, would allow the Shortfall. Typically, the budget process Legislature to solve most of the deficit largely does not involve large changes in revenue in without impacting the state’s core ongoing the prior year (in this case, 2022-23). This is service level. because prior-year taxes usually have been filed and associated revenues collected. CALIFORNIA ENTERED A DOWNTURN LAST YEAR Higher Borrowing Costs and Reduced As a result, California businesses have had much Investment Have Cooled California’s Economy. less funding available to expand operations or hire In an effort to cool an overheated U.S. economy, new workers. the Federal Reserve has taken actions over the State’s Economy Entered a Downturn in 2022. last two years to make borrowing more expensive These mounting economic headwinds have pushed and reduce the amount of money available for the state’s economy into a downturn. The number investment. This has slowed economic activity in of unemployed workers in California has risen a number of ways. For example, home sales are nearly 200,000 since the summer of 2022. This has down by about half, largely because the monthly resulted in a jump in the state’s unemployment rate mortgage to purchase a typical California home from 3.8 percent to 4.8 percent, as Figure 1 on has gone from $3,500 to $5,400. Some effects of the next page shows. Similarly, inflation-adjusted the Federal Reserve’s actions have hit segments incomes posted five straight quarters of of the economy that have an outsized importance year-over-year declines from the first quarter of to California. In particular, investment in California 2022 to the first quarter 2023. startups and technology companies is especially Recent Revenue Collections Show Impact of sensitive to financial conditions and, as a result, Economic Downturn. With the state’s conformity has dropped significantly. For example, the number to federal actions postponing deadlines for tax of California companies that went public (sold payments on investment and business income stock to public investors for the first time) in 2022 for much of the past year, the state adopted the and 2023 is down over 80 percent from 2021. 2023-24 budget without a clear picture of the impact www.lao.ca.gov 5 2024-25 BUDGET Figure 1 Uptick in Unemployment Rate Triggered a Recession Indicator Federal policymakers use the Sahm Rule to track the start of recessions in real time. The Sahm Rule has accurately indicated—with no false positives—the prior six U.S. recessions as well as California downturns. 16% 14 12 10 8 6 4 Sahm Rule Triggered On 2 1980 1985 1990 1995 2000 2005 2010 2015 2020 Sahm Recession Indicator signals the start of a recession when the three-month moving average of the unemployment rate rises by 0.5 percentage points or more relative to its low during the previous 12 months. of recent economic weakness on state revenues. suggests California’s economy and revenues are Regardless, there have been signs of revenue uniquely sensitive to Federal Reserve actions. weakness over the past year. The portion of Significant Risk That Weakness Could income taxes collected directly from workers’ Persist Into Next Year. Whether the recent paychecks was down 2 percent over the last twelve weakness will continue is difficult to say. However, months compared to the preceding year. Sales the odds do not appear to be in the state’s favor. tax collections have been essentially flat, despite Past downturns similar to this recent episode have above-average growth in consumer prices. The full tended to be followed by additional weakness. extent of revenue weakness, however, came into full For instance, as Figure 1 shows, an increase in the focus recently with the arrival of the postponed tax unemployment rate similar to the recent period has payments. With the deadline passed, collections consistently been followed by an extended period of data now show a severe revenue decline, with elevated unemployment. Similarly, in the past, years total income tax collections down 25 percent in with large revenue declines typically have been 2022-23. This decline is similar to those seen during followed by an additional year of lackluster revenue the Great Recession and dot-com bust. While the performance. History does not always repeat itself slowdown of investment in California companies and might not this time. Nonetheless, there is a and corresponding broader economic weakness significant risk the current weakness could continue likely were primary drivers of this decline, another into next year. important factor was financial market distress in 2022. Overall, the experience of the last few years 6 LEGISLATIVE ANALYST’S OFFICE 2024-25 BUDGET Revenue Outlook Reflects Risk Figure 2 of Continued Weakness. Reflecting the risk of continued weakness, LAO Revenue Outlook our revenue outlook—shown in Total Revenue Excluding Federal Cost Recovery (In Billions) Figure 2—anticipates collections will be nearly flat in 2023-24, after $280 The shaded area shows how far revenues could deviate from our falling 20 percent in 2022-23. main forecast. Outcomes beyond the shaded area are possible, Our outlook then has revenue growth but revenues most likely will fall in the shaded area. 260 returning in 2024-25 and beyond. Based on this trajectory, our revenue 240 outlook expects collections to come in $58 billion below budget act 220 assumptions across 2022-23 through 200 2024-25, with about half of this difference ($26 billion) attributable to 180 2022-23. As always, this forecast is highly uncertain. It is entirely possible 160 that revenues could end up $15 billion 2021-22 2022-23 2023-24 2024-25 2025-26 2026-27 2027-28 higher or lower than our forecast for 2023-24 and $30 billion higher or lower for 2024-25. THE BUDGET PROBLEM Budget Year in 2024-25 that was higher than expected revenue collections. Put another way, last In this section, we describe our estimates of year’s budget planned for a deficit in 2024-25. California’s budget condition for the upcoming That anticipated deficit of $14 billion is the fiscal year: 2024-25. We expect the state will face starting place for the upcoming budget a serious deficit, also known as a budget problem. process and therefore adds to the calculation A budget problem occurs when resources for the of the budget problem. upcoming budget are insufficient to cover the costs of currently authorized services. Figure 3 State Faces a $68 Billion General Fund Condition Under Fiscal Outlook Deficit. Under current law and (In Millions) policy, we estimate the state faces a budget problem of 2022-23 2023-24 2024-25 $68 billion. Figure 3 reflects the Prior-year fund balance $52,561 $167 -$32,792 budget problem in the 2024-25 Revenues and transfers 179,961 189,062 193,255 ending balance in the Special Expenditures 232,355 222,021 222,782 Ending Fund Balance $167 -$32,792 -$62,318 Fund for Economic Uncertainties. Encumbrances $5,272 $5,272 $5,272 The budget problem is the net SFEU balance -$5,105 -$38,064 -$67,590 effect of the following factors: Reserves • State Anticipated a Deficit BSA balance $21,515 $22,074 $22,809 Safety Net Reserve 900 900 900 of Around $14 Billion. SFEU = Special Fund for Economic Uncertainties and BSA = Budget Stabilization Account. The 2023-24 Budget Act planned for a spending level www.lao.ca.gov 7 2024-25 BUDGET • Revenues Are Lower Than Budget Act • Entering Fund Balance Is Lower by Projections by $58 Billion. As described $3 Billion. Budgetary changes to years earlier, collections data to date show a before the budget window are reflected in severe revenue decline, with total income the 2022-23 entering fund balance. (These tax collections down 25 percent in 2022-23. changes occur due to accounting rules, Reflecting the risk of continued economic which sometimes result in the state “accruing” weakness, our forecast anticipates flat or attributing revenues or spending to revenue growth for 2023-24, with positive earlier years, based on when the underlying growth returning in 2024-25 and beyond. economic activity is estimated to have Based on this trajectory, our revenue outlook occurred.) Our estimate of the budget problem expects collections to come in $58 billion reflects a $3 billion downward adjustment in below budget act assumptions across the the entering fund balance as a result of lower budget window. This is the major driver of the revenues. This adds to the budget problem. budget problem. • Reserve Deposits Are Higher by • School and Community College Spending $400 Million. Proposition 2 (2014) requires Is Lower by More Than $4 Billion. the state to set aside minimum amounts to Proposition 98 (1988) establishes a minimum deposit into its reserve, pay down debts, annual funding requirement for schools and and (under certain conditions) spend money community colleges, met with state General on infrastructure. These requirements are Fund and local property tax revenue. When determined by a set of relatively complex General Fund revenue declines, the minimum formulas. Ordinarily, the required set asides requirement usually declines in tandem. increase when revenues increase and drop Most school spending, however, does not when revenues decrease. This year, however, automatically decrease when the minimum due to a variety of idiosyncratic issues, under requirement drops in the current or prior current law and policy, the state’s reserve year. As described in the nearby box, the requirements would increase in response state could decide to reduce Proposition 98 to our revenue forecast. The nearby box General Fund spending by nearly $21 billion describes the reasons why. As we discuss under our outlook, but the automatic reduction later, in response to a budget emergency, is about $4 billion. The budget problem is the Legislature and Governor can decide to therefore lower by about $4 billion in our suspend these deposits and/or withdraw deficit calculation. funds from the reserve. • Other Spending Is Lower by $4 Billion. We estimate spending across the rest of the Multiyear budget will be lower than the administration’s In this section, we describe our estimates of June projections by about $4 billion over California’s budget condition for the multiyear the budget window. The major driver of this period through 2027-28. This projection is based difference is spending on health and human on our main revenue forecast, as shown in Figure 2, services (HHS) programs, where our estimates and spending forecast, as shown in Appendix 2. are lower by about $3 billion. We do not have State Faces Significant Operating Deficits. department- or program-level detail on the Figure 4 on page 10, shows our projections of administration’s HHS spending forecast, so the multiyear condition of the budget under our we cannot give more detail about the nature main revenue forecast. As the figure shows, in of this difference. This lowers the budget addition to the $68 billion budget problem we problem by a like amount. have identified for 2024-25, the state faces annual operating deficits of around $30 billion per year. 8 LEGISLATIVE ANALYST’S OFFICE 2024-25 BUDGET ONLY MODEST AUTOMATIC SPENDING CHANGES IN RESPONSE TO LOWER REVENUES State Has Two Constitutional Reserves with Formula-Driven Requirements. Proposition 2 (2014) governs deposits into (and withdrawals from) the state’s two constitutional reserves: the Budget Stabilization Account (BSA), a general purpose reserve, and the Proposition 98 Reserve, which is dedicated to schools and community colleges. In both cases, reserve requirements tend to go up when revenues increase, particularly when capital gains taxes rise, and vice versa. These requirements are automatically adjusted in response to changes in revenue estimates and both reserves have maximum thresholds. In the case of the BSA, requirements above the maximum threshold must be spent on infrastructure instead. In the case of the Proposition 98 Reserve, reserve withdrawals are sometimes required, especially in tighter fiscal times. Proposition 2 This Year, Most Declines in BSA-Related Requirements Do Not Impact Budget’s Bottom Line. Typically, drops in revenue would result in lower BSA and infrastructure requirements. Under our estimates, the state’s required payments on infrastructure decline by billions of dollars, but because of the way these payments are scored, these changes have no impact on the budget’s bottom line. In addition, BSA deposits increase largely because of the significant downward revenue adjustment to 2022-23. The large downward revenue adjustment means the state must continue to make reserve deposits to reach the 10 percent threshold (under our understanding of the administration’s interpretation of Proposition 2) after 2022-23. Proposition 98 Proposition 98 Sets Minimum Level of School Funding. Proposition 98 (1988) amended the California Constitution to establish a minimum annual funding requirement for schools and community colleges. The state calculates the minimum requirement using formulas that account for various inputs, including General Fund revenue. The state meets the requirement through a combination of General Fund spending and local property tax revenue. The state recalculates the minimum requirement at the end of the year based on revised estimates of these inputs, followed by a second recalculation at the end of the following year. When the minimum requirement decreases, the state can leave school spending at the level it initially approved in the budget or reduce spending to the lower requirement. Estimate of Minimum General Fund Spending Requirement Under Proposition 98 Is Down $21 Billion… Under our outlook, the decline in General Fund revenue reduces the minimum required General Fund spending under Proposition 98 by $21 billion from 2022-23 through 2024-25, which represents a reduction of nearly 38 cents for each dollar of lower revenue. This reduction includes $9.6 billion in 2022-23, $7 billion in 2023-24, and $4.4 billion in 2024-25. The magnitude of the downward revision in 2022-23 is unprecedented for a fiscal year that is already over. Although the state has experienced large swings in the minimum requirement for fiscal years that are currently in progress, revisions to prior fiscal years are typically minor and rarely exceed a few hundreds of millions of dollars. … But Automatic Reduction in School Spending Is Only $4.3 Billion. Although the constitutional minimum funding requirement is down $21 billion, the automatic reduction in school spending over the period is only $4.3 billion. Most of this reduction relates to the automatic elimination of required deposits into the Proposition 98 Reserve in 2022-23 and 2023-24. After accounting for the effects of lower reserve deposits—along with several smaller adjustments—General Fund spending over the three years is down $4.3 billion compared with the June 2023 estimates. This reduction leaves school spending nearly $16.7 billion above the levels that would exist if the state only funded at the constitutional minimum each year of the period. www.lao.ca.gov 9 2024-25 BUDGET These operating deficits represent Figure 4 additional budget problems the Legislature would need to State Faces Serious Budget Problem in 2024-25, address in the coming years, and Significant Operating Deficits in Future Years either by reducing spending, (In Billions) increasing revenues, shifting costs, or using reserves. Although 2024-25 2025-26 2026-27 2027-28 highly uncertain, our projection of the state’s deficits would -$10 accumulate to $155 billion across -20 the forecast window, which is significantly more than the amount -30 of reserves the state has available -40 (about $24 billion). Budget Problem Operating Deficits -50 Extent of Future Deficits -60 Depends on Legislative -70 Decisions This Year. The multiyear deficits shown in Figure 4 are subject to substantial uncertainty. First, revenue estimates can easily The state’s actual costs will be higher or lower differ from our estimates by tens of billions of depending on decisions made by the Legislature, dollars in either direction. Second, these deficits including, for example, about how to fund schools are based on our assessment of the costs of the and community colleges in 2022-23. state’s programs under current law and policy. SOLVING THE BUDGET PROBLEM State Has Various Options to Address the • Reduce Other One-Time Spending. Budget Problem. While addressing a deficit of We estimate the state has at least $8 billion in $68 billion will be challenging, the Legislature has a one-time and temporary spending in 2024-25 number of options available to do so. In this section, that could be pulled back to help address we describe some of the key ones. (Some of the the budget problem. In addition, there are solutions here assume a budget emergency is potentially billions of dollars more in spending declared.) These solutions include: from prior years that has been committed but not yet distributed, and therefore also could be • Withdraw Reserves. Under our estimates, the reduced to help address the budget problem. state would have about $24 billion in reserves to help address the budget problem (assuming • Identify Other Solutions. Even after using a budget emergency is declared). most or all of these solutions, the Legislature still would need to find more solutions • Reduce Proposition 98 Spending. Over to address the remainder of the budget the three-year period, the state could reduce problem. Other options include additional General Fund costs by $16.7 billion if it were cost shifts (such as more loans from special to lower school spending to the constitutional funds), revenue solutions, and ongoing minimum allowed under Proposition 98. spending reductions. One option for implementing some of this reduction would be to use the Proposition 98 Reserve to cover school-related costs that exceed the Proposition 98 minimum requirement in 2022-23. 10 LEGISLATIVE ANALYST’S OFFICE 2024-25 BUDGET Withdraw Reserves 2022-23 are relatively limited because the state has allocated most of the funding attributable to State Could Withdraw Up to $24 Billion the prior year already. Before resorting to cuts or in General Purpose Reserves. As shown in deferrals, however, the state could reduce spending Figure 3, the state has $23 billion in the BSA under in other ways that would be less disruptive our estimates, plus about $1 billion in the Safety for schools. Net Reserve, to address the budget problem. The Safety Net Reserve is available to fund program Proposition 98 Reserve Could Cover costs in HHS programs, like Medi-Cal, while the Spending Above the Minimum Requirement BSA can only be accessed in a budget emergency, in 2022-23. Based on deposits the state made as described below. in 2020-21 and 2021-22, the Proposition 98 Reserve currently holds a balance of $8.1 billion. Budget Emergency Available Under Our (This amount excludes the additional deposits Estimates. The Legislature can only suspend the state had anticipated making in 2022-23 and mandatory deposits or make withdrawals from 2023-24 prior to our lower revenue estimates.) either of its two constitutional reserves—the BSA The state could use up to $7.7 billion of this and the Proposition 98 Reserve—if the Governor balance to cover school spending that exceeds declares a budget emergency. The Governor the Proposition 98 minimum requirement in may declare a budget emergency in two cases: 2022-23. Using the Proposition 98 Reserve in (1) if estimated resources in the current or upcoming this way would allow the state to lower General fiscal year are insufficient to keep spending at Fund spending to the constitutional minimum the level of the highest of the prior three budgets, level in the prior year without reducing the funding adjusted for inflation and population (a “fiscal allocations it previously approved. From an budget emergency”), or (2) in response to a natural accounting perspective, Proposition 98 Reserve or man-made disaster. Under our forecast, a fiscal withdrawals also do not count as spending for emergency would be available both in 2023-24 and the purpose of determining the minimum funding 2024-25. In the case of a fiscal budget emergency, requirement in future years. This means using the the Legislature only can withdraw the lesser Proposition 98 Reserve for 2022-23 also would of: (1) the amount of the budget emergency, or reduce the constitutional minimum requirements (2) 50 percent of the BSA balance (in each year). in 2023-24 and 2024-25. (The formulas governing As of this writing, the Governor has not called a the Proposition 98 Reserve would require the state fiscal budget emergency for 2023-24 or 2024-25. to withdraw the remaining amount in the reserve— Reduce Proposition 98 Spending about $450 million—in 2023-24.) Spending Reductions Would Help Balance State Could Make Reductions to Programs the Budget but Involve Trade-Offs. If the With Unallocated Funds. Although the Legislature reduced school spending to the Proposition 98 Reserve could allow the state constitutional minimum allowed by Proposition 98, to reduce General Fund spending with minimal it would address up to $16.7 billion of the budget disruption to school programs, the reserve balance problem. To obtain these savings, the state would is not large enough to obtain $16.7 billion in have to reduce spending it previously approved in savings by itself. If the state wanted to obtain the 2022-23 and 2023-24. In previous downturns, the maximum possible savings, it would need to make state relied heavily on two main approaches for additional reductions. One option is to reduce implementing such reductions: (1) across-the-board program funding that has not yet been allocated reductions to per-pupil allocations and (2) payment to schools. For example, the state previously deferrals. These options, however, tend to be approved $1.1 billion for grants to community disruptive for school operations, particularly schools that count as spending in 2022-23 but have when the state announces them on short notice. not yet been awarded. (This funding is in addition In addition, the state’s options for reductions in to the roughly $3 billion in funding for community schools that the state approved prior to 2022-23.) www.lao.ca.gov 11 2024-25 BUDGET In addition, several hundreds of millions of dollars Identify Other Solutions in State Preschool funding provided in 2022-23 State Might Have Some Cost Shift Options and 2023-24 is currently not obligated for any Remaining. Cost shifts occur when the state specific purpose. Over the coming months, the moves costs between fund sources or entities— state likely will be able to identify additional grants for example, shifting spending from the General and programs with unspent funds. Reducing grants Fund to special funds or, as has been done in that have not yet been allocated to schools could prior budgets, shifting costs from the state to local allow the state to reduce General Fund spending governments. The state used about $10 billion in while minimizing reductions to funding that schools cost shifts to address last year’s budget problem were already planning to receive. As we explain in and could have some additional capacity to shift the Appendix, if the Legislature took these actions, additional costs again this year. For example, we Proposition 98 funding would be sufficient to think the state would have more capacity to make cover all but $1 billion of ongoing program costs loans from special funds if those loans were made in 2024-25. on a pooled basis, rather than on an individual fund basis. Reduce One-Time Spending State Has Used Revenue Increases to Pulling Back One-Time and Temporary Address Past Budget Problems. For example, Spending Could Provide More Than $10 Billion in 2020-21, the state temporarily suspended in Solutions. We estimate the state has $8.6 billion net operating loss (NOL) deductions, preventing in one-time and temporary spending slated for corporations with net income over $1 million from 2024-25 that can be reduced entirely in order to using NOLs. The state also limited businesses address the serious budget problem. This includes from claiming more than $5 million in tax credits. spending of: $2.2 billion in transportation, The state also has increased broad-based taxes $1.9 billion in natural resources and environment, on a temporary and permanent basis in similar and $1.8 billion in various education programs. revenue downturns. In addition, the Legislature has committed tens of Other Spending Reductions. Given the extent billions of dollars in previous years to one-time and of the deficit, the state might also have to reduce temporary purposes, including billions of dollars other spending—including cuts into its core service in the current year. Some of these funds could be level—in order to balance the budget. In facing withdrawn to address the deficit, but the Legislature budget problems of similar magnitudes, the state would need to request more information from the in the past has made reductions to employee administration to know the precise amounts that compensation and lowered spending on higher could be feasibly reduced. To maximize flexibility education and the judicial branch. The Legislature and mitigate disruption, some of these pullbacks also could explore using more of the state’s recently could merit early action in 2024. reauthorized tax on managed care organization to offset the General Fund costs of Medi-Cal, rather than for other costs, such as increasing provider rates. 12 LEGISLATIVE ANALYST’S OFFICE 2024-25 BUDGET COMMENTS Unprecedented Prior-Year Revenue Revision Legislature Will Have Fewer Options to Creates Unique Challenges. Typically, the budget Address Multiyear Deficits in the Coming Years. process does not involve large changes in revenue Given the state faces a serious budget problem, in the prior year (in this case, 2022-23). This is using general purpose reserves this year is merited. because usually prior-year taxes already have been That said, we suggest the Legislature exercise filed and associated revenues collected. Due to some caution when deploying tools like reserves the federal tax filing extensions, however, the and cost shifts. The state’s reserves—which total Legislature is gaining a complete picture of 2022-23 $24 billion—are unlikely to be sufficient to cover the tax collections after the fiscal year has already state’s multiyear deficits—which average $30 billion ended. This creates unique and difficult challenges. per year under our estimates. These deficits Had the Legislature had complete information likely necessitate ongoing spending reductions, about 2022-23 tax collections in May, as would be revenue increases, or both. As a result, preserving typical, it would have solved much of this deficit in a substantial portion—potentially up to half—of June 2023. At that time, the Legislature would have reserves would provide a helpful cushion in light of had more options available to reduce spending. the anticipated shortfalls that lie ahead. Now that the fiscal year has ended, adjusting spending for 2022-23 across a broad range of programs will be more challenging, including for schools and community colleges and much of the rest of the budget. Early Action Could Increase Flexibility. Given the scale of the budget problem, we suggest the Legislature immediately begin evaluating past spending to find monies that have been committed but not yet distributed. These could be pulled back to help address the budget problem. Taking early action on these reductions could increase the choices available to the Legislature. Once more money has been distributed, fewer options will be available by May. www.lao.ca.gov 13 2024-25 BUDGET APPENDIX 1: OUTLOOK FOR SCHOOL AND COMMUNITY COLLEGE FUNDING Total Proposition 98 Funding Requirement spending in the prior year is $7.7 billion above the Down $18.8 Billion Compared With June minimum requirement. This funding above the Estimates. Under our outlook, the minimum minimum level also becomes part of the base for funding requirement for schools across 2022-23, calculating the minimum requirement in 2023-24. 2023-24, and 2024-25 is $18.8 billion lower than Specifically, it increases the 2023-24 requirement the estimates from June 2023. This reduction by $4.2 billion relative to the amount the state reflects two main adjustments: (1) a $21 billion otherwise would have to provide. Across both years decrease in required General Fund spending and combined, funding under our baseline assumptions (2) a $2.2 billion increase in local property tax is $11.9 billion higher than the amount the state revenue. The reduction in required General Fund would provide if it were to fund at the minimum spending reflects our significantly lower estimates level only. of General Fund revenue, with the minimum Decision About Spending in 2022-23 and funding requirement decreasing nearly 38 cents 2023-24 Affects Calculation of the Funding for each dollar of lower revenue. The increase in Requirement in 2024-25. The Legislature’s local property tax revenue reflects preliminary data decision about whether to reduce funding to the showing growth in 2022-23 and 2023-24. Appendix lower minimum requirement in the current and prior Figure 1 and Figure 2 on the following pages year has significant implications for the calculation provide more detail on these changes by year. of the funding requirement in 2024-25. We estimate As the bottom of Appendix Figure 2 shows, the total that if the state leaves funding $11.9 billion above reduction in the minimum funding requirement is the Proposition 98 minimum requirement across $9 billion in 2022-23, $6.3 billion in 2023-24, and 2022-23 and 2023-24 (consistent with our baseline $3.5 billion in 2024-25. These amounts represent assumptions), the funding requirement in 2024-25 the maximum reductions in school funding—relative would be $113 billion. This level of funding would to June 2023 estimates—the state could make be slightly higher than the estimate the state made while still meeting the Proposition 98 minimum in June 2023. Conversely, if the state were to lower funding requirement. funding in 2022-23 and 2023-24 to the minimum Under Baseline Assumptions, State Would levels allowed under Proposition 98, the funding Provide $11.9 Billion More Than the Revised requirement in 2024-25 would be $108.2 billion. Minimum Requirement in 2022-23 and 2023-24. This level of funding would be about $3.5 billion Although the Proposition 98 funding requirement less than the estimate the state made in June 2023. changes automatically based on updated revenue If the state were to lower spending somewhat but estimates, the law does not automatically adjust not to the minimum levels in 2022-23 and 2023-24, most school spending in the current or prior the funding requirement in 2024-25 would fall year. For 2022-23, we estimate that automatic somewhere between $108.2 billion and $113 billion. adjustments only reduce Proposition 98 spending Total Costs for Existing Programs and by $1.3 billion compared with the level anticipated Statutory Cost-of-Living Adjustment (COLA) in June 2023. This reduction mainly reflects Estimated at $109.3 Billion. Separate from the elimination of the required deposit into the our calculations of the Proposition 98 funding Proposition 98 Reserve (the deposit is no longer requirement, we also estimated the cost of required due to our lower estimates of capital gains maintaining existing school and community college revenue). It also reflects a small increase in costs programs in 2024-25. In making this estimate, for the Local Control Funding Formula and various we accounted for cost increases and decreases smaller adjustments. Accounting for the $9 billion related to (1) changes in student attendance and decrease in the Proposition 98 funding requirement community college enrollment, (2) an estimated and the $1.3 billion decrease in costs, overall statutory COLA of 1.27 percent, and (3) the 14 LEGISLATIVE ANALYST’S OFFICE 2024-25 BUDGET Appendix 1, Figure 1 Comparing Proposition 98 Funding Levels in the Budget Windowª (In Billions) $120 115 $113.0 -$4.8 $8.1 Billion Reserve Withdrawal 110 $111.6 Available During the Budget Window $108.3 $108.2 $10 $107.4 105 $106.0 $106.2 -$4.2 -$7.7 5 $102.0 100 $98.3 95 90 2022-23 2023-24 2024-25 Enacted Budget Level Baseline Funding Assumptionb Minimum Funding Levelc a Reflects total General Fund and local property tax revenue for schools and community colleges. b For 2022-23 and 2023-24, reflects June funding level with automatic adjustments, including elimination of required reserve deposits and baseline adjustments to Local Control Funding Formula. For 2024-25, reflects estimate of the Proposition 98 minimum requirement building upon the baseline spending assumptions in 2022-23 and 2023-24. c Reflects funding level if state funds at the Proposition 98 minimum requirement each year of the period. expiration of various one-time costs and savings balance in the Proposition 98 Reserve. Under our included in the June 2023 budget plan. Under baseline assumption—that is, absent any special our estimates, the total cost for existing programs action by the Legislature—the constitutional in 2024-25 is $109.3 billion. Of this amount, formulas would require withdrawals of nearly $1.3 billion is the cost specifically associated $5.5 billion in 2023-24 and nearly $2.7 billion in with the 1.27 percent statutory COLA. Under our 2024-25. Alternatively, the state could decide baseline assumption (in which the state does to withdraw funds preemptively and use them not reduce funding to the minimum level in the to cover costs that exceed the Proposition 98 current or prior year), the Proposition 98 funding requirement in the prior year. Under this approach, requirement in 2024-25 would be more than enough the state would withdraw $7.7 billion from the to cover the statutory COLA. If the state were to reserve for use in 2022-23 (it would be required to reduce spending to the minimum level, however, withdraw the remaining $450 million in 2023-24). the 2024-25 funding requirement would be about This approach would allow the state to reduce $1 billion less than the cost of existing programs General Fund spending on schools in the prior year adjusted for COLA. without cutting school programs below previously State Estimated to Withdraw Entire approved levels. (This approach also assumes Proposition 98 Reserve Balance. Under our a budget emergency is declared.) Under the outlook, the reductions in Proposition 98 funding Constitution, the Legislature may use withdrawals require the state to withdraw the entire $8.1 billion from the Proposition 98 Reserve for any school or community college purpose. www.lao.ca.gov 15 2024-25 BUDGET Appendix 1, Figure 2 Comparing Proposition 98 Funding Estimates (Dollars in Millions) 2022-23 2023-24 2024-25 Three-Year Totals Proposition 98 Estimates June 2023 Enacted Budget Proposition 98 Funding: General Fund $78,117 $77,457 $79,739 $235,314 Local property tax 29,241 30,854 31,881 $91,977 Totals $107,359 $108,312 $111,621 $327,291 General Fund tax revenueª $204,533 $201,213 $203,116 $608,862 K-12 average daily attendance 0.1% 0.3% -0.2% — Per capita personal income 7.6 4.4 3.1 — Per capital General Fundb -6.2 -0.8 1.4 — Operative test 1 1 1 — LAO December Outlook With Baseline Adjustments Only Proposition 98 Funding: General Fund $76,244 $74,651 $80,111 $231,007 Local property tax 29,778 31,543 32,867 94,189 Totals $106,022 $106,195 $112,979 $325,195 General Fund tax revenueª $179,091 $182,747 $190,099 $551,938 K-12 average daily attendance 0.9% 0.7% 0.7% — Per capita personal income 7.6 4.4 4.3 — Per capital General Fundb -17.8 2.9 5.3 — Operative test 1 3 2 — LAO December Outlook With Funding Reduced to Minimum Level Proposition 98 Funding: General Fund $68,553 $70,491 $75,295 $214,338 Local property tax 29,778 31,543 32,867 94,189 Totals $98,330 $102,035 $108,162 $308,527 General Fund tax revenueª $179,091 $182,747 $190,099 $551,938 K-12 average daily attendance 0.9% 0.7% 0.7% — Per capita personal income (Test 2) 7.6 4.4 4.3 — Per capital General Fund (Test 3)b -17.8 2.9 5.3 — Operative test 1 1 2 — Funding Comparisons Difference From Enacted Budget to LAO Baseline General Fund -$1,873 -$2,806 $372 -$4,307 Local property tax 536 689 986 2,211 Totals -$1,336 -$2,117 $1,358 -$2,096 Difference From LAO Baseline to Proposition 98 Minimum Level General Fund -$7,692 -$4,160 -$4,816 -$16,668 Local property tax — — — — Totals -$7,692 -$4,160 -$4,816 -$16,668 Difference From Enacted Budget to Proposition 98 Minimum Level General Fund -$9,565 -$6,966 -$4,445 -$20,975 Local property tax 536 689 986 2,211 Totals -$9,028 -$6,277 -$3,459 -$18,764 a Excludes non-tax revenues and transfers, which do not affect the Proposition 98 calculations. b As set forth in the State Constitution, reflects change in per capita General Fund plus 0.5 percent. 16 LEGISLATIVE ANALYST’S OFFICE 2024-25 BUDGET www.lao.ca.gov 17 2024-25 BUDGET APPENDIX 2 Appendix 2, Figure 1 General Fund Spending Through 2024-25 (In Billions) Outlook Change From 2023-24 2024-25 2022-23 Legislative, Executive $6.1 $5.2 -15% Courts 3.5 3.7 6 Business, Consumer Services, and Housing 2.6 0.5 -79 Transportation 0.9 0.1 -94 Natural Resources 5.7 4.6 -20 Environmental Protection 0.6 0.4 -33 Health and Human Services 73.4 75.4 3 Corrections and Rehabilitation 14.2 13.5 -4 Education 21.2 21.4 1 Labor and Workforce Development 0.9 1.2 43 Government Operations 4.0 2.3 -42 General Government Non-Agency Departments 1.8 1.7 -3 Tax Relief/Local Government 0.6 0.6 6 Statewide Expenditures 4.8 5.7 18 Capital Outlay 0.5 0.3 -37 Debt Service 5.8 5.9 2 Non-98 Spending Totals $146.4 $142.7 -3% Proposition 98a $75.6 $80.1 6% Totals 222.0 222.8 0% a Reflects General Fund component of the Proposition 98 minimum guarantee. 18 LEGISLATIVE ANALYST’S OFFICE 2024-25 BUDGET Appendix 2, Figure 2 General Fund Spending by Agency Through 2027-28 (In Billions) Average Annual Agency 2022-23 2023-24 2024-25 2025-26 2026-27 2027-28 Growth Legislative, Executive $14.1 $6.1 $5.2 $3.1 $2.5 $2.5 -22.0% Courts 3.5 3.5 3.7 3.8 3.9 4.1 3.5 Business, Consumer Services, and 3.9 2.6 0.5 0.3 0.3 0.2 -28.8 Housing Transportation 1.5 0.9 0.1 0.3 0.0 0.0 -17.7 Natural Resources 13.7 5.7 4.6 4.9 3.5 3.3 -10.9 Environmental Protection 3.9 0.6 0.4 0.1 0.1 0.1 -28.0 Health and Human Services 61.2 73.4 75.4 79.4 84.3 89.9 6.0 Corrections and Rehabilitation 14.8 14.2 13.5 13.1 13.1 13.0 -1.2 Education 20.0 21.2 21.4 20.3 21.3 22.2 1.2 Labor and Workforce Development 1.3 0.9 1.2 1.0 1.0 1.0 -5.5 Government Operations 5.5 4.0 2.3 3.4 7.0 8.1 52.0 General Government Non-Agency Departments 2.3 1.8 1.7 1.8 1.3 1.1 -13.9 Tax Relief/Local Government 0.7 0.6 0.6 0.6 0.6 0.7 3.9 Statewide Expenditures 1.3 4.8 5.7 6.9 8.2 9.1 16.9 Capital Outlay 3.3 0.5 0.3 0.1 0.1 0.0 -48.3 Debt Service 5.2 5.8 5.9 5.9 5.9 6.0 0.6 Non-98 Spending Totals $156.1 $146.4 $142.7 $145.1 $152.9 $161.5 4.2% Proposition 98a $76.2 $75.6 $80.1 $84.5 $87.3 $89.7 3.8% Proposition 2 Infrastructureb $0.0 $0.2 $0.7 $1.7 $4.8 $5.4 95.7% Total Forecasted Spending 232.4 222.0 222.8 229.6 240.3 251.2 4.1% a Reflects General Fund component of the Proposition 98 minimum guarantee. b In 2022-23 and 2023-24, amounts are distributed across agencies. In 2024-25 and after, Proposition 2 infrastructure requirements are assumed to offset existing costs, for example for bond debt service, and so do not result in higher total state costs. www.lao.ca.gov 19 2024-25 BUDGET LAO PUBLICATIONS This report was prepared by Ann Hollingshead, with contributions from Ken Kapphahn and Brian Uhler, as well as others across the office, and reviewed by Edgar Cabral and 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. 20 LEGISLATIVE ANALYST’S OFFICE