The 2024-25 Budget: Initial Comments on the Governor’s May Revision

2024-25 BUDGET The 2024-25 Budget: Initial Comments on the Governor’s May Revision GABRIEL PETEK | LEGISLATIVE ANALYST | MAY 2024 KEY TAKEAWAYS We Estimate Governor Addressed a $55 Billion Budget Problem. The Governor cites a budget problem of $27 billion. Based on the administration’s revenue estimates and proposals, we estimate the Governor addressed a larger deficit than this—$55 billion. The difference is attributable to what our offices consider to be current law, particularly for school and community college spending. While we would maintain that our approach more accurately reflects current law, these scoring differences do not reflect substantive differences in our views of the state’s fiscal position. The Governor Addresses the Deficit by Adjusting Spending. The May Revision primarily solves the budget problem by adjusting spending. Spending-related solutions (including both school and community college spending and other spending) represent nearly 90 percent of the total solutions. Of this total, $22 billion are related to school and community college funding changes and $16 billion are spending reductions, while the remaining solutions comprise other types, like fund shifts. The Governor also reduces the state’s reliance on reserves—using only $4 billion in reserve withdrawals to cover the deficit, significantly less than the $13 billion proposed in January. Proposed Budget Structure Puts the State on Better Fiscal Footing. The overall structure of the Governor’s May Revision improves the fiscal health of the state in a number of ways. First, by proposing the state use less in reserves, the Governor preserves an important tool to address budget problems, which are likely to continue to emerge. Second, by further reducing one-time and temporary spending, the Governor leverages a “use it or lose it” tool that improves budget resilience. Finally, the Governor proposes new statutory language that would temporarily set aside anticipated surplus revenues for at least a year. While executing this proposal would be technically complex, we think the underlying idea is meritorious. Next Steps for the Legislature. As the Legislature enters the final phase of budget deliberations, we suggest four key areas of consideration. First, given the significant decline in prior-year revenues, the Legislature will need to decide how to address prior-year funding for schools and community colleges. Second, the Governor proposes ongoing spending reductions that total $8 billion within a few years, which involve trade-offs and, in some cases, reductions to core service levels. Although the administration’s focus for ongoing reductions tends to be on newer programs and program expansions, there could be longer-standing programs that the Legislature wishes to revisit. Third, we suggest the Legislature consider whether particular proposed solutions raise serious concerns. For example, two major proposals raise concerns for our office: the suspension of net operating loss (NOL) deductions and unallocated state operations reductions. Finally, given that our revenue forecast is somewhat below the administration’s forecast, we would suggest the Legislature consider whether or not it is comfortable with this downside risk to the state’s budget picture. This risk might be acceptable, however, particularly if the Legislature adopts the May Revision budget structure. www.lao.ca.gov 1 2024-25 BUDGET INTRODUCTION On May 14, 2024, Governor Newsom presented Fund—the budget’s main operating account. In a revised state budget proposal to the Legislature. the coming days, we will analyze the plan in more (The Governor also held a press conference and detail, provide additional comments in hearing released a summary of the budget update on testimony, and update our multiyear forecast of May 10, 2024.) This annual proposed revised the budget’s condition. The information presented budget is referred to as the May Revision. In this in this brief is based on our understanding of the brief, we provide a summary of and comments on administration’s proposals as of May 14, 2024. In the Governor’s revised budget, focusing on the many areas, our understanding of the proposals will overall condition and structure of the state General continue to evolve. THE BUDGET PROBLEM In this section, we present our estimates of the HOW BIG IS THE budget problem that the Governor addressed in BUDGET PROBLEM? the May Revision. The estimates in this section We Estimate Governor Addressed a are predicated on the administration’s revenue $55 Billion Budget Problem. The Governor cites a projections and spending proposals. Our analysis budget problem of $27 billion. Under our estimates, also focuses on the three-year budget window the administration addressed a larger deficit than under consideration: 2022-23 through 2024-25. this—$55 billion. This difference is largely due to What Is a Budget Problem? A budget differences in two areas: problem—also called a deficit—arises when resources for the upcoming budget are insufficient • Schools and Community Colleges. Our to cover the costs of currently authorized services. calculation of the budget problem assumes A budget problem is inherently a point-in-time $22 billion in higher baseline spending on estimate that reflects information available at the schools and community colleges. This time of development, forecasts of future revenues difference mainly relates to our treatment and spending, and assumptions about the extent of changes in the minimum spending to which changes in costs are due to current requirement established by Proposition 98 policy (that is, whether or not they are “baseline (1988). Compared with the estimates from changes”). When changes in costs do not occur June 2023, the minimum requirement has automatically under current policy, we count them decreased significantly in 2022-23 and as budget solutions or augmentations. We take 2023-24. The May Revision assumes spending this approach in order to provide the Legislature on schools and community colleges is visibility into the full scope of the administration’s reduced to the lower level each year and choices. The remainder of this section walks treats all of the corresponding spending through the sources of our differences with the adjustments as baseline changes. Our administration and how those differences impact approach, by contrast, calculates baseline the budget problem estimate. school spending under current law. The difference between these approaches is most evident in our treatment of the Governor’s proposal to “accrue” the cost of $8.8 billion in prior-year payments to schools to future years. 2 LEGISLATIVE ANALYST’S OFFICE 2024-25 BUDGET The administration treats this proposal like an This downgrade reflects weakness in recent automatic change and calculates the deficit collections across income, corporation, and sales assuming it has already occurred. By contrast, taxes. Fourth, some baseline costs are higher we treat the proposal like a policy choice—one compared to January. For example, higher estimated that has not yet occurred—because it would caseload in the state’s Medi-Cal program results in modify a law the Legislature adopted several about $2 billion in higher costs across the budget years ago indicating the state would not window. reduce school spending in the prior year. • Other Solutions. Across the rest of the HOW DOES THE GOVERNOR budget, we also count about $6 billion in PROPOSE ADDRESSING THE other budget actions as solutions that the DEFICIT? administration counts as baseline changes. Figure 1 summarizes the budget solutions that This includes, for example, $1.6 billion in this section describes in detail. (These descriptions spending delays for competitive transit grant reflect remaining proposals after the adoption funds, a sweep of nearly $600 million in of the early action package.) The May Revision unawarded General Child Care slots, and primarily solves the budget problem by adjusting a change in the distribution of funds in the spending. Spending-related solutions (including school facilities program that delays nearly both school and community college spending and $700 million in spending until after 2024-25. other spending) total $48 billion and represent nearly Together, these scoring differences account 90 percent of the total solutions. Spending-related for the roughly $27 billion difference in our office’s solutions include reductions, fund shifts, delays, and accounting of the budget problem and the reversions. In addition, the May Revision includes administration’s scoring. While we would maintain $4 billion in reserve withdrawals, $1 billion in cost that our approach more accurately reflects current shifts, and about $2 billion in revenue-related law, these scoring differences do not reflect solutions. Online appendices 1 and 2 (forthcoming) substantive differences in state’s fiscal position. list all of the solutions by area. Budget Problem Has Shrunk Since January Due to Early Figure 1 Action. In January, we estimated that the budget problem under the How the May Revision Addresses the Deficit administration’s assumptions was $58 billion. The budget problem is Reversion Spending- now slightly lower—$55 billion. There Related Fund Shift are four notable factors contributing Solutions to this difference. First, in April, the Delay Legislature passed an early action package that reduced the size of the budget problem by $17.3 billion School and Community (Chapter 9 of 2024 [AB 106, College Spending Gabriel]). Second, the administration reduced the total amount of new discretionary spending proposals by roughly $200 million (from $1.2 billion Reduction in January to about $1 billion). Third, offsetting this, the administration’s revenue forecast eroded by roughly Reserve Withdrawal $12 billion. (As we discuss more Cost Shift later, our office’s revenue estimates Revenue Related are slightly lower than this.) www.lao.ca.gov 3 2024-25 BUDGET School and Community College for example: an unallocated cut to state Spending operations, an indefinite pause to the multiyear child care slot expansion plan, and a reduction The California Constitution sets a minimum to foster care permanent rates (which would annual funding requirement for schools and be subject to a trigger restoration if revenues community colleges—otherwise known as are sufficient to fund them in the future). Proposition 98. The state meets this requirement through a combination of General Fund spending Fund Shifts. Fund shifts are budget solutions and local property tax revenue. When General that use other fund sources—for example, special Fund revenue declines, the minimum requirement funds—to pay for a cost typically incurred by the usually declines in tandem. Most school spending, General Fund. These shifts reduce expenditures however, does not automatically decrease from the General Fund as they simultaneously when the minimum requirement drops in the displace spending that these special funds current or prior year. Due to lower General Fund otherwise would have supported. As a result, we revenues, the amount of authorized school and consider these to be a type of spending-related community college spending exceeds the minimum solution because they typically result in lower requirements for 2022-23 and 2023-24. The May overall state spending, inclusive of all funds. Revision aligns school and community college We estimate the May Revision includes $5 billion spending to the minimum required level in each year in fund shifts. This primarily includes General Fund of the budget window. This reduces total General costs that have been shifted to the Greenhouse Fund spending on schools and community colleges Gas Reduction Fund, federal funds, and other by $22 billion. special funds. Delays. We define a delay as an expenditure Spending-Related Solutions reduction that occurs in the budget window Reductions. Under our definition, a spending (2022-23 through 2024-25), but has an associated reduction occurs when the Governor proposes expenditure increase in a future year of the that the state spend less money than what has multiyear window (2025-26 through 2027-28). That been established under current law or policy. is, the Governor proposes moving the spending to More colloquially, these are spending cuts. The May a year in the near future. (We do not categorize a Revision includes $16 billion in spending-related proposal as a delay if it would shift the cost outside reductions. This includes: of the multiyear window. As such, some proposals • One-Time and Temporary Reductions. that the Governor calls “pauses,” we refer to as Within the budget window, the May Revision reductions.) Nearly $3 billion of the May Revision eliminates or reduces over $11 billion in spending-related solutions are delays. As a result, one-time or temporary spending. For example, proposed spending is higher in the out-years. the May Revision forgoes nearly $1 billion Reversions. Costs for state programs in provider rate increases in the Managed sometimes come in lower than the amount that was Care Organization package (growing to over appropriated. This often occurs, for example, when $2 billion in 2025-26), reduces $325 million in the state overestimates uptake in a new program funding for the multifamily housing program, or as a routine matter in programs where spending and reduces the Regional Early Action is uncertain due to factors like caseload. When Planning program by $300 million. actual state costs are below budgeted amounts, a • Ongoing Spending Reductions. The May reversion occurs after a period of time—typically, Revision also includes about $5 billion in three years. The reversion returns the unspent ongoing spending reductions in 2024-25, funds to the General Fund. In this year’s budget, the which grow to roughly $8 billion over Governor proposes accelerating some reversions time. These ongoing reductions include, that would have otherwise occurred in the future 4 LEGISLATIVE ANALYST’S OFFICE 2024-25 BUDGET and proposes proactively reverting certain funds Safety Net Reserve. Similar to January, the that otherwise are continuously appropriated (which Governor also proposes withdrawing the entire has the effect of realizing savings from the unspent balance of the Safety Net Reserve—$900 million. funds that would not otherwise occur). While not all The Safety Net Reserve was designed to help of these amounts represent lower state spending cover costs of increasing caseload in Medi-Cal over the long term, they do result in savings and the California Work Opportunity and today at a cost of forgone savings in the future. Responsibility to Kids program in the event of an As a result, we count them as spending-related economic downturn. solutions. We estimate the May Revision includes Cost Shifts about $2 billion in reversions. The May Revision includes about $1 billion in Reserve Withdrawals cost shifts. We define cost shifts as budget actions Budget Stabilization Account. Proposition 2 that achieve savings in the present, but result in (2014) governs deposits into and withdrawals from a binding obligation or higher cost for the state the state’s general-purpose constitutional reserve— in a future year. In that way, these actions can be the Budget Stabilization Account (BSA). Under similar to borrowing, but are often not explicitly these rules, the state can make withdrawals from structured as such. For example, major categories the constitutionally required balance of the BSA in of cost shifts include: an additional $607 million a fiscal emergency, which occurs when estimated in special fund loans to the General Fund, and a resources for the upcoming year are insufficient proposal to shift funding for the Capitol Annex to cover the costs of the previous three enacted project from cash to bond debt service that budgets, adjusted for inflation and population. provides $450 million in budget savings within the Although the Governor has not officially declared a budget window. budget emergency for 2024-25 (or any other year in Revenue-Related Solutions the budget window), we agree that the conditions for a declaration exist. After a budget emergency is We estimate the May Revision includes about declared, the state can withdraw up to half of the $2 billion in revenue-related solutions. The constitutional balance of the BSA. (The Legislature largest revenue solution is a proposal to not allow also can withdraw the entire “discretionary” balance businesses with more than $1 million in income to of the BSA at any time, which are amounts that claim NOL deductions on their taxes in 2025, 2026, were deposited into the fund on top of Proposition 2 and 2027. This proposal provides $900 million in requirements.) In the May Revision, the Governor additional revenue in 2024-25 and over $5 billion proposes withdrawing about $3 billion from the in future years. In addition, the May Revision BSA—significantly less than the roughly $12 billion includes a proposal to increase the Managed Care withdrawal proposed in January. Organization tax and use the nearly $700 million in increased revenues to offset General Fund costs. www.lao.ca.gov 5 2024-25 BUDGET BUDGET CONDITION In this section, we describe the overall condition more than the $14.5 billion proposed in January. of the General Fund budget after accounting for (Under the May Revision, the state would withdraw the May Revision proposals and solutions. We also all of the remaining balance of the School Reserve, describe the condition of the school and community which is available only for school and community college budget. college spending.) General Fund Budget School and Community College Budget Figure 2 shows the General Fund condition Funding for Schools and Community Colleges under the May Revision. The state would end Down $3.7 Billion Over Budget Window. 2024-25 with $3.4 billion in the Special Fund Compared with the estimates included in the for Economic Uncertainties (SFEU). The SFEU Governor’s budget, the administration estimates is the state’s operating reserve and essentially the constitutional minimum funding level for schools functions like an end-of-year balance. The State and community colleges is down $3.7 billion over Constitution’s balanced budget provision prohibits the 2022-23 through 2024-25 period. Most of the state from enacting a negative SFEU balance this decline ($3 billion) is attributable to 2023-24. for the upcoming fiscal year, in this case, 2024-25. This downward revision consists of a $4.2 billion While historically the state mostly has enacted reduction in required General Fund spending, SFEU balances between $1 billion and $4 billion, partially offset by a $489 million increase in local the Legislature can choose to set the balance at property tax revenue. The May Revision includes any level above zero. several actions to mitigate the effects of lower Under May Revision, Reserves Would Total Proposition 98 spending on schools. The primary $23 Billion by End of 2024-25. As mentioned actions are: (1) reserve withdrawals, (2) cost shifts, earlier, the Governor proposes using $3 billion and (3) repurposing of unspent/unused funds. from the BSA and $900 million from the Safety These actions also free up funding for a few Net Reserve to help address the budget problem. smaller augmentations. This means the state would end 2024-25 with nearly Withdraws Remaining Balance in $23 billion in General Fund reserves—considerably Proposition 98 Reserve. The Proposition 98 Reserve is a statewide reserve Figure 2 account for school and community college funding. The Governor’s General Fund Condition Summary budget proposed to make a (In Millions) discretionary withdrawal of $5.7 billion from this account 2022-23 2023-24 2024-25 Revised Revised Proposed to help cover costs for existing school and community college Prior-year fund balance $63,631 $46,260 $9,727 Revenues and transfers 178,544 189,354 205,249 programs in 2023-24 and 2024-25. Expenditures 195,915 225,888 200,974 The May Revision proposes to Ending fund balance $46,260 $9,727 $14,001 withdraw an additional $3.9 billion, Encumbrances $10,569 $10,569 $10,569 drawing down the entire balance in SFEU Balance $35,691 -$842 $3,432 the account. Reserves Increases Size of Maneuver BSA $21,708 $22,555 $19,429 That Would Shift Costs into the SFEU 35,691 -842 3,432 Future. Under the Governor’s Safety net 900 900 — budget, the administration Total Reserves $58,299 $22,613 $22,861 projected the 2022-23 spending SFEU = Special Fund for Economic Uncertainties and BSA = Budget Stabilization Account. level for schools and community 6 LEGISLATIVE ANALYST’S OFFICE 2024-25 BUDGET colleges was $8 billion higher than the required Commits to Additional Spending in a Few minimum funding level. The Governor’s budget Areas. Most notably, the May Revision provides proposed “accruing” these $8 billion in prior-year an additional $300 million to cover a higher payments to future years, without changing the 1.07 percent statutory cost-of-living adjustment amount disbursed to schools and community (COLA) for existing school and community colleges. These costs would be recognized college programs. (The statutory COLA is up from gradually over a five-year period, beginning in 0.76 percent in the Governor’s budget.) The May 2025-26. The May Revision retains this funding Revision also includes $395 million in one-time maneuver and accrues an additional $768 million funding for zero-emission school buses, in addition to future years, reflecting a further decline in the to the $500 million in the Governor’s budget. minimum funding level for 2022-23. ASSESSING THE GOVERNOR’S APPROACH Proposed Budget Structure Puts State on spending allows the state to save these Better Fiscal Footing. Although we will have more other tools to deploy in the future, improving comments on the multiyear outlook for the budget budget resilience. in the coming week or so, the overall structure of the • Introduces Proposal to Save Excess May Revision improves the fiscal health of the state Revenues. While we have not yet seen in a number of ways. Specifically, the May Revision: the specific language, we understand the • Reduces Reliance on Reserves. Compared May Revision includes proposed statutory to his January proposal, the Governor reduces changes that would temporarily set aside reliance on reserves to address the deficit. anticipated surplus revenues for at least a The Governor does so despite the fact that year. While executing this proposal would be the state faces a serious budget problem and technically complex and involve trade-offs, that the administration’s revenue forecast we think the underlying idea is meritorious. In deteriorated between January and May. particular, we are in favor of the Legislature Although this means making more difficult exercising caution when it allocates large decisions this year, using less in reserves surpluses—particularly those associated with now also gives the Legislature more tools revenue surges. Saving some of this surging to address more budget problems that are revenue, rather than spending or committing quite likely to continue to emerge in the it right away, can provide an important coming years. cushion for the state budget to weather revenue downturns. While the administration’s • Further Reduces One-Time and Temporary approach is still forthcoming, the Legislature Spending. The Goveror proposes the state has different options for implementing pull back more one-time and temporary this concept. spending. We think this is the right approach for two reasons. First, when this spending Improves Likelihood the State Can Maintain was adopted, it was understood that it might More Core Services. We encourage the Legislature need to be pulled back if future budget to consider the state’s budget structure and overall problems arise. Second, reducing one-time fiscal health when evaluating the May Revision. and temporary spending is a “use or lose” tool While the proposed budget requires difficult for addressing the budget problem—once choices, its overall structure likely increases the the funds are disbursed to recipients, pulling Legislature’s ability to maintain core services in the them back becomes practically impossible. future. (While there is no single definition of “core Other tools, like reserve withdrawals and cost services,” we use this term to refer to the ongoing shifts, also can be used only once, but at any spending level committed to by the Legislature.) time. Reducing this one-time and temporary www.lao.ca.gov 7 2024-25 BUDGET NEXT STEPS FOR THE LEGISLATURE How Does the Legislature Want to Address • Suspension of NOL Deductions. Typically, School and Community College Funding? One when a business experiences a NOL, it is key question for the Legislature is deciding how allowed to carry forward these NOLs and to address prior-year funding for schools and deduct them from their income in future community colleges. The May Revision continues years. This allows businesses to smooth to rely on a funding maneuver that would contribute profits and losses such that businesses with to the structural budget shortfall in future years. similar profits over time pay similar taxes. As we described in our February report, we Without this smoothing, businesses in riskier recommend the Legislature reject this proposal. or more innovative industries—such as the The proposal establishes a new type of internal technology, motion picture, and transportation obligation, creates pressure for similar cost shifts in sectors—could end up paying more taxes the future, and reduces budget transparency. The than businesses with similar but more stable Legislature has other options for reducing prior-year profits. As such, suspending NOL deductions spending that would avoid these significant would lead to a less equitable tax system. downsides. For example, the Legislature could While the suspension of NOL deductions has bring prior-year spending down by using funds been a go-to budget solution for decades, the from the Proposition 98 Reserve, funding fewer frequency at which this approach has been augmentations, rescinding unallocated grants, and/ used is now starting to raise questions. Should or making targeted reductions to existing programs. the Governor’s proposal take effect, the state How to Balance Trade-Offs When Reducing will have disallowed NOL deductions in nearly Ongoing Spending? The May Revision includes half of years between 2008 and 2027. At this ongoing spending reductions that total $8 billion rate, it seems reasonable to ask whether within a few years. (That said, nearly $3 billion suspensions have begun to meaningfully of this total is attributable to reductions to state undermine the purpose of allowing NOL operations, which might not be achievable deductions in the first place. savings.) Some of these reductions reflect • Unallocated State Operation Reduction. paring back planned expansions of programs, In January, the Governor proposed a for example, in the case of child care. In other one-time, vacancy-related $762.5 million cases, the reductions reflect the elimination of unallocated General Fund reduction across programs altogether, as is the case with public state departments. In the May Revision, the health funding. Each of these decisions involve Governor modifies this January proposal by trade-offs, and some represent reductions to making the reduction ongoing. In addition core service levels. Although the administration’s to the January reduction proposal, the May focus for ongoing reductions tends to be on newer Revision includes a new proposed $2.2 billion programs and program expansions, there could unallocated reduction to state operations in be longer-standing programs that the Legislature 2024-25 and $2.8 billion ongoing beginning wishes to revisit. in 2025-26. This effectively reduces General Do Any Proposals Raise Serious Concerns? Fund state operations costs by 7.95 percent. While structurally the Governor has taken a prudent In total, between the two proposals, the May approach, some specific proposals raise concerns Revision assumes a $3.6 billion unallocated for our office. (Rejecting or reducing either of reduction to General Fund state operations. these solutions or any others would require finding This is a very large unallocated reduction— equivalent alternatives in dollar-for-dollar terms.) constituting more than 10 percent of General Specifically, based on our initial review we have Fund state operations. While we think it is concerns with: a meritorious endeavor for the Department 8 LEGISLATIVE ANALYST’S OFFICE 2024-25 BUDGET of Finance to identify efficiencies in state Is the Legislature Comfortable With the government, we think this proposal is flawed Downside Risk to Revenues? Our revenue for a couple reasons. First, the administration forecast is somewhat below the May Revision has not articulated a strategy for achieving across the budget window. As such, we think it efficiencies. Particularly given the is more likely than not that revenues ultimately administration has stated these savings would will come in below the May Revision. That being not impact existing personnel, wages, or said, we think the administration’s estimates are salaries, it is difficult to imagine how this level a reasonable basis for building the state budget. of savings could be achieved. Second, the Doing so, however, would create a somewhat administration would not begin the process of heightened risk that the state will face additional identifying these savings until the fall. Waiting shortfalls next year. On the other hand, using to identify savings until the fiscal year has the May Revision estimates would diminish the already begun is likely to result in a significant risk of overshooting on budget reductions now. erosion to assumed savings. To the extent that This revenue risk might be acceptable from the administration cannot achieve the full level the Legislature’s perspective, particularly if the of assumed savings, a budgetary shortfall will Legislature adopts the May Revision budget carry into future years. structure. Under that structure, if higher revenues fail to materialize, the budget would still have other forms of resilience to mitigate the effects. www.lao.ca.gov 9 2024-25 BUDGET 10 LEGISLATIVE ANALYST’S OFFICE 2024-25 BUDGET www.lao.ca.gov 11 2024-25 BUDGET LAO PUBLICATIONS This report was prepared by Ann Hollingshead with contributions from staff across the office, and reviewed by Carolyn Chu. The Legislative Analyst’s Office (LAO) is a nonpartisan office that provides fiscal and policy information and advice to the Legislature. To request publications call (916) 445-4656. This report and others, as well as an e-mail subscription service, are available on the LAO’s website at www.lao.ca.gov. The LAO is located at 925 L Street, Suite 1000, Sacramento, California 95814. 12 LEGISLATIVE ANALYST’S OFFICE