Rethinking California's Reserve Policy

2025-26 BUDGET Rethinking California’s Reserve Policy GABRIEL PETEK | LEGISLATIVE ANALYST APRIL 2025 www.lao.ca.gov 1 AN LAO REPORT 2 LEGISLATIVE ANALYST’S OFFICE AN LAO REPORT Executive Summary Rethinking California’s Reserve Policy. Reserves allow the state to ensure stable funding for its services over time, even when revenue fluctuates unpredictably. Over the last few years, the state has indeed experienced those significant fluctuations—large surpluses followed by significant deficits. This volatility has prompted interest in changes to the state’s reserve policy. The Governor has proposed two changes that, if passed by the Legislature, would go before voters. In this report, we assess those proposed changes. We find that while they would improve upon the state’s reserve policy, they would not reliably ensure stable funding for core services over time, and therefore further changes are warranted. As such, we examine how much the state would need to save in reserves to maintain its core services during future downturns. What Is the Purpose of Reserves? The state will collect more in revenues than the cost of its core service level in some years. In other years, it will collect less. Reserves help smooth the difference—funds are saved when revenues are surging (the green regions in the figure below) and then spent when revenues decline below that long-term trajectory (the red regions). If reserves are insufficient to cover How Reserves Work these shortfalls, the state must $ eventually: (1) raise taxes or (2) cut Spending on core services those services. This means that the grows relatively smoothly more reserves the state has, the more it can mitigate the need for But revenues those cuts and tax increases. are volatile The state will collect more How Do We Evaluate the revenues than its spending Saving money in surplus Performance of Reserve Policies? level in some years (it will years in reserves helps the have a surplus) A reserve policy “performs well” if it state pay for spending when revenues fall short meets the central goal of reserves— that is, it allows the state to save In other years, it enough so that the state can pay for will have deficits spending on its core services when revenues drop. When revenues are Time insufficient for the state to pay for its core service level, we describe the difference as a funding shortfall. To evaluate how much funding shortfalls can be covered with reserves we have constructed simulation-based tools—similar those used in insurance markets and the state’s pension system—that use information about the past to forecast many different variations of the future. We report findings across 50 years and thousands of these simulations. Under Current Law, the State Can Cover One-Third of Funding Shortfalls. We find that the state’s current constitutional rules for building reserves would allow the state to cover about one-third of funding shortfalls. Put another way, if current law remained in place for the next 50 years, and without further saving above this level, cuts to core services and/or tax increases would often be necessary. Governor’s Proposal Improves Upon Current Law, but Further Improvements Are Warranted. The Governor proposes two changes to the state’s reserve policy: (1) raise the cap on constitutional www.lao.ca.gov 3 AN LAO REPORT deposits from 10 percent of General Fund taxes to 20 percent, and (2) make reserve deposits excludable from the state appropriations limit. The Governor’s proposal improves upon current law—rather than one-third, these changes would allow the state to cover about half of funding shortfalls over 50 years. However, even with this change, reductions to core services or tax increases would still be common. In our view, this means further improvements are warranted. LAO Recommended Approach. We put forward two recommendations to improve reserve policy: • Raise the Reserve Cap to 50 Percent by 2055. We first recommend the cap on constitutional reserve deposits be raised from 10 percent to 50 percent of General Fund taxes. The increase could be phased in over time: 20 percent to take effect immediately after the next statewide election, 25 percent in 2030, and increasing by 5 percent every five years until the cap reaches a maximum of 50 percent in 2055. • Two Options to Reach This Higher Threshold. If the cap is raised, the state would also need to set aside more in reserve deposits to dependably reach this higher amount. There are many options for doing this, but given the volatility in the state’s revenues, we think it is important to set aside much more funds in years when revenues are surging, rather than setting aside somewhat more in every year. We suggest two alternative mechanisms to accomplish this: (1) create new, more robust and flexible deposit rules, or (2) keep existing rules in place, but change them to set aside more in capital gains revenues in some years. The figure below shows how the state’s reserve policy would perform under our recommended alternatives. As it shows, we estimate our recommendations would allow the state to cover about three-quarters of funding shortfalls over the next 50 years. These Recommendations Are an Honest Reflection of Revenue Volatility. We understand that building a reserve of this size—even if achieved over three decades—is a dramatic increase and well outside the range of savings targets that have been contemplated by policymakers to date. Yet we do not view these recommendations as overly cautious—to arrive at these estimates, we have used standard tools from actuaries in pensions and insurance markets. These problems are also clear when California’s reserves are compared to other states—California ranks near the top in terms of revenue volatility, but below average in terms of reserves. As such, our recommendations are an honest reflection of the volatility in the state’s tax system. That is, these changes would allow the state to enjoy the advantages of its current revenue structure while protecting critical services for Californians for decades to come. Share of Funding Shortfalls Covered by Different Reserve Policy Options 30% 50% 65% 75% 75% Current Law Governor’s Proposal Increase Reserve Increase Reserve Increase Reserve Cap to 50% by 2055 Cap to 50% by 2055 Cap to 50% by 2055 and Use New, More and Deposit All Excess Robust Different Rules Capital Gains 4 LEGISLATIVE ANALYST’S OFFICE AN LAO REPORT INTRODUCTION Reserves allow the state to ensure stable funding changes sufficient? That is, how much does the for its services over time, even when revenue state need to save in reserves to maintain its core fluctuates unpredictably. By setting aside funds services during future downturns and would the when revenues are surging, the state can maintain Governor’s proposal achieve that goal? If not, what core services when those revenues fall short. is a reserve policy that would? This report aims to Reserves have become particularly salient to the answer these questions by taking a long-term view. budget process in recent years. After allocating That is, we aim to construct a reserve policy that surpluses totaling over $100 billion across 2021-22 has the best chance of withstanding the test of time and 2022-23, the Legislature has addressed and minimizes the need for the Legislature to ask cumulative budget problems of $82 billion in the voters to make further changes to the Constitution years since. Budget problems are also likely to in a few years. persist for the foreseeable future. In fact, given The report is organized as follows. Chapter 1 the scale of both actual and projected deficits, the lays out a framework for establishing a goal for Legislature likely faces the difficult choice about the state’s reserve policy, and then tools that can how to reduce core services in the coming years. be used to estimate how much in reserves the In light of these developments, the Legislature state needs to save to achieve that goal over time. has signaled an interest in making changes to the In Chapter 2, using the tools outlined in Chapter 1, state’s reserve policy. In addition, through this we evaluate the state’s current reserve policy. year’s budget process, the Governor has proposed Chapter 3 examines possible changes to the state’s two changes to the state’s rainy day fund that, if policy, including the Governor’s proposals and our passed by the Legislature, would go before voters. recommended alternatives. This raises an important question: Are these CHAPTER 1: HOW MUCH SHOULD THE STATE SAVE IN RESERVES? This section presents our framework for thinking …And Core Spending Is Not. Meanwhile, the about how much in reserves the state should save. ongoing costs of state programs—the state’s core First, we describe the goal of reserves. Then, we service level—is much steadier. Spending on core describe the ways we can quantitatively evaluate services can fluctuate in response to recessions, whether or not a reserve policy is meeting that goal. for example, because of caseload growth in means-tested programs that occurs in response What Is the Purpose of Reserves? to unemployment changes. However, in general, Revenues Are Volatile… From year to year, growth in core services tracks more stable factors, state revenues can grow very quickly or contract like inflation (especially inflation for pharmaceuticals quickly. Revenues drop during economic and health care) and population (especially in some recessions, when business activity slows, key demographic areas). Conversely, growth in total unemployment rises, and consumer spending spending—rather than spending on core services declines, leading to lower tax collections. Asset alone—does fluctuate much more. This is largely market downturns, like stock market drops or real because the Legislature allocates considerable estate slumps, can also reduce capital gains tax shares of revenue surges to one-time and revenue and other investment-related income, temporary spending. lowering state revenue. Conversely, revenues can grow quickly in response to economic expansions or run ups in the stock market. www.lao.ca.gov 5 AN LAO REPORT Reserves Allow the State to Smooth the whereas the latter would fund a deficit after the Difference. The state will collect more in revenues fact.) The more reserves the state has, the more than the cost of its core service level in some it can mitigate the need for spending cuts or years. In other years, it will collect less. Reserves tax increases. help smooth the difference. As shown in Figure 1, Revenue Downturns Will Occur, the Question reserves can be saved when revenues are surging Is When. The state’s revenue fluctuations are (the green regions) and then spent when revenues often described in terms of risk, like a car owner decline below that long-term trajectory (the red protecting against the risk of an accident or a regions). Importantly, this hypothetical—and the corporation hedging against the risk of changes in estimates of core services in this report—only sales. A more risk-averse car owner might purchase speak to reserve policy on one side of the budget, full-coverage insurance while a less risk-averse car that is, excluding the budget devoted to schools owner might purchase only what is legally required. and community colleges. The nearby box describes Yet these analogies do not well describe the state’s why this is our focus. revenue situation—because, unlike with a car Reserves Allow the State to Avoid Tax accident, the question of revenue drops is not if but Increases and Cuts to Core Services. The State when. That is: the state will face revenue downturns Constitution requires the Legislature to pass a in the future, but we can’t predict when those will balanced budget. So, if the state does not have occur or how big they will be. This makes the state’s enough reserves to cover shortfalls between reserve policy more like an individual saving for revenues and spending on core services, the state retirement. A person saving for retirement does not must eventually: (1) raise taxes or (2) cut those know how long they will live or exactly what their services. (The state also has the option borrow or expenses will be in retirement, but they nonetheless shift costs to address deficits, but only on a limited must plan for this eventuality by making the best and temporary basis. Functionally, borrowing has possible choices in the meantime. That person the same impact as reserves—it moves money from might experience annual fluctuations in their a period when state revenues are surging to one financial situation that causes them to save more or when they fall short—but generally involves higher less in any given year. However, their long-term plan interest costs for the state. The main difference, should be constructed irrespective of these annual however, between reserves and borrowing is that fluctuations. This analogy can be easily extended the former involves setting aside funds up-front to the state’s reserve policy, which can fluctuate from year to year but should be constructed by examining a Figure 1 very long-time horizon in order How Reserves Work to facilitate the stable provision of services. $ Spending on core services How Do We Evaluate grows relatively smoothly Reserve Policies? We Use Simulation-Based But revenues are volatile Tools Similar to Those Used The state will collect more to Analyze Pensions and revenues than its spending Saving money in surplus level in some years (it will Insurance. The state’s reserve years in reserves helps the have a surplus) state pay for spending when policy should hold up not just revenues fall short for a few years or even a couple of decades, but over many In other years, it will have deficits economic cycles. In this report, we test reserve policies over Time 50 years. On an analytical basis, 6 LEGISLATIVE ANALYST’S OFFICE AN LAO REPORT Reserve Policy and the Two Sides of the State Budget State Budget Can Be Thought of in Two Distinct Parts. Functionally, California’s General Fund budget is divided into two parts: one dedicated to K-14 education (about 40 percent of the total) and another part that funds everything else (roughly 60 percent of the total). The reason for this bifurcation is Proposition 98 (1988), which requires the state to set aside minimum amounts of funding for schools and community colleges. With rare exceptions, the state must fund this baseline regardless of other budget pressures. As a result, Proposition 98 creates a separate budget for K-14 education that sits within the state’s larger budget. Budget Conditions Can Diverge. The budget situation within Proposition 98 can diverge sharply from the rest of the budget. For example, there can be a “surplus” within the Proposition 98 budget (meaning that funding under the guarantee is more than sufficient to cover the costs of existing educational programs) even as the rest of the General Fund faces a deficit. That said, the conditions of these two parts of the budget tend to move together because, under the constitutional formulas, funding for schools and community colleges will usually decline in response to drops in revenues. Schools and Community Colleges Have Separate System to Mitigate Revenue Volatility. Revenue volatility is an issue for both sides of the budget, but each side also has distinct and dedicated policies to address that volatility. For schools and community colleges, the main tool is the state’s Public School System Stabilization Account (the Proposition 98 Reserve), which requires the state to save more in reserves when revenues—especially those from capital gains taxes—are surging. These funds must be used to supplement, but not supplant, Proposition 98 spending during a downturn. In addition, school and community college districts themselves hold local reserves to manage unexpected cost increases, as well as state funding declines. Finally, the state has used other tools like deferrals, which uses a principle similar to borrowing to help smooth school spending through downturns. This Report Does Not Address Reserve Policy for Schools. Given the division of the budget and the separate reserve policies in place for schools and community colleges, this report focuses only on the reserve policy for the rest of the budget. That is, the recommendations and estimates in this report only address revenue volatility for the side of the budget that does not include schools and community colleges, and this report does not speak to the adequacy of preparedness for the Proposition 98 budget for revenue downturns. there is nothing inherently correct about this time What Are These Scenarios? Each of these frame, except that it is long enough to allow us to scenarios draws on data from the past—like measure the cumulative effect of several economic long-term growth rates and the stability and the cycles. Predicting the exact path revenues will take persistence of past trends—to make predictions over the next 50 years is, of course, impossible. about the future. However, each individual scenario However, we can make informed estimates about is also unique. That is, it will look different than the the future with tools similar those used in insurance past and all the other scenarios. Some scenarios markets and the state’s pension system. Similar are unfavorable ones, while others are more to actuaries in these fields, we have constructed favorable (see Figure 2 on the next page). In an simulation-based tools that use information about unfavorable scenario, for example, the state could the past to forecast many different variations of the face a series of more moderately sized recessions future. With these scenarios in hand, we can then in close proximity to one another. Or, in a very measure how well a reserve policy performs in not unfavorable scenario, the state could encounter just one or two scenarios, but thousands of them. three Great Recessions over the course of five decades. Conversely, in more favorable scenarios, www.lao.ca.gov 7 AN LAO REPORT the state might only face a series of mild to we use the 90th percentile as our benchmark— moderate recessions, spread far apart over the that is, we measure the effectiveness of various 50 years. reserves policies according to how well they do Choosing the Right Benchmark Scenario. in some of the most unfavorable scenarios, but We do not know which of these scenarios will be not the absolute worst. At this level, we can be the state’s actual future (or if the future will hold reasonably confident a particular policy will have its something else, entirely outside of the scope of our intended impact. Using outcomes from unfavorable scenarios). If the Legislature adopts a reserve policy scenarios to make policy recommendations is that performs well in half of scenarios but poorly in a standard practice for actuaries in fields like the other half (that is, we use the median scenario pensions and insurance. as a benchmark), it would mean there is something How Do We Measure the Core Service Level? like a coin-flip chance that the policy would achieve In addition to simulating revenues, this analysis its desired outcomes. It is reasonable therefore requires us to define the state’s core service to choose a policy that performs well across the level. This is an inherently subjective concept, in substantial majority of scenarios. For our analysis, part because “core services” are not immutable. Figure 2 Future Scenarios Can Vary Widely Unfavorable Scenarios $ $ Spending A scenario can be unfavor- ...or because revenue drops able because revenue drops are very large. are more frequent... Revenue Time Time Favorable Scenarios $ $ A scenario can be ...or because revenue favorable because drops are less common. revenue drops are relatively small... Time Time 8 LEGISLATIVE ANALYST’S OFFICE AN LAO REPORT Instead, core services will change over time as perform. Specifically, a reserve policy “performs the state responds to changes in revenues by well” if it meets the central goal of reserves—that is, expanding or contracting the size of government. it allows the state to save enough so that the state While a portion of temporary surges in revenue will can pay for spending on its core services when be allocated to one-time spending, after a period revenues drop. In this report, when revenues are of time, the Legislature will begin to expand service insufficient for the state to pay for its core service levels in response to sustained revenue growth. level, we describe the difference as a funding As such, we approximate “core service level” using shortfall. A funding shortfall is distinct from a the three-year moving average of enacted revenues, budget deficit, which occurs when revenues are frozen in the year before a revenue decline begins. insufficient for the state to pay for all of its currently While this may be somewhat counterintuitive, this authorized services (not just core services). The method captures the fact that core services are nearby box describes this difference in more detail. a dynamic concept. This method also accounts Analyzing the State’s Reserve Policy. for the fact that, due mainly to other constitutional Throughout the remainder of this report we analyze spending requirements, revenue losses do not different policy alternatives based on how well result in deficits on a 1:1 basis. This is in particular they perform on the criteria we have outlined here. due to Proposition 98 (1988), in which required That is: over a fifty-year period, we measure the spending on schools and community colleges tends share of funding shortfalls that the state can cover to fall when revenues decline. with reserves under different policies, considering A Reserve Policy Performs Well if It Allows scenarios that are unfavorable, but not the worst the State to Pay for Core Services During a possible. In other words, this is our assessment Revenue Drop. Using these estimates of core of the reserves that are needed for the state to spending and revenues in the benchmark scenario, maintain its core service level over time without we then evaluate how well various reserve policies cutting core services or raising taxes. Funding Shortfall Versus Budget Deficit A budget deficit occurs when revenues are insufficient to pay for all of the state’s enacted programs—including both core services and newly enacted or temporary programs. Because of the state’s balanced budget requirement, a deficit must be closed before a budget can be enacted. A deficit is related to, but distinct from, the concept of a funding shortfall described in this report. The key conceptual difference is that a budget deficit will include the effects of recently enacted one-time and temporary spending augmentations, whereas our aim in measuring the state’s funding shortfall is to isolate the costs of the state’s core service level. Further, budget deficits are highly influenced by estimation error and our method abstracts away from these year-by-year particularities. Overall, we would describe funding shortfalls, as measured in this report, as considerably smaller than budget deficits. www.lao.ca.gov 9 AN LAO REPORT CHAPTER 2: WHERE ARE WE NOW? In 2014, voters approved significant reforms However, using the tools described in Chapter 1, to the state’s reserve policy with Proposition 2. this policy falls well short of the amount of reserves This measure substantially improved the state’s that are needed. reserve policy, particularly relative to recent history. PROPOSITION 2 HAS SUBSTANTIALLY IMPROVED STATE’S RESERVE POLICY Before 1980, State Reserves and Surpluses state surpluses also varied widely, as shown on Varied Widely. Before the 1980s, the state’s the left side of Figure 3. In the 1950s, the state had budget was enacted with either a year-end surplus significant reserves and surpluses (the amounts in or deficit (at this time, the state had no balanced Figure 3 are additive, so in the 1949-50 budget, budget requirement). These balances would roll reserves and surpluses represented 42 percent of forward into the next year’s budget, and therefore revenues). In the late 1970s, the state had sizeable surpluses would provide a buffer against revenue surpluses, but no reserves on hand. declines, but they were not explicitly earmarked Proposition 4 (1979) Required California for this purpose. To deal with unexpected budget Governments to Establish Reserve Accounts. shortfalls, the state also created a reserve fund— Partially motivated by the budget surpluses of the Revenue Deficiency Fund—in 1947. The the late 1970s (but not reserves, as the state had fund initially received a balance of $75 million, none), voters passed Proposition 4 in November of representing about 14 percent of the budget at the 1979. This measure placed limits on how much tax time. The $75 million balance remained until it was revenues governments in California could spend. withdrawn roughly a decade later. In this period, Figure 3 A History of California's Reserves Balances as a Share of General Fund Revenues State Had Significant Unbudgeted Surpluses in the 1950s and 1970s From 1980 to 2014, State Saved Very Little in Reserves 0.30 0.30 0.25 0.25 0.20 0.20 Enacted Year End Surplus or Deficit Budget Stabilization Account (Actual) 0.15 0.15 0.10 0.10 0.05 0.05 Special Fund for Economic Uncertainties (Enacted) Revenue Deficiency Fund (Actual) -0.05 -0.05 -0.10 -0.10 1949-50 1954-55 1959-60 1964-65 1969-70 1974-75 1979-80 1981-82 1986-87 1991-92 1996-97 2001-02 2006-07 2011-12 2016-17 2021-22 10 LEGISLATIVE ANALYST’S OFFICE AN LAO REPORT (At the state level, this is referred to as the state also created the Proposition 98 Reserve, which was appropriations limit [SAL]. The measure is also discussed in the box on page 7.) After Proposition 2 referred to as the “Gann limit,” named after one was passed, the state saved significantly more of its authors.) In addition to establishing these in reserves, particularly when compared to the spending limits, Proposition 4 suggested each savings levels from the early 1980s through the entity of government establish a contingency or early 2010s. That said, in percentage terms, the reserve fund in the amount “deemed reasonable BSA balance is comparable to—perhaps even a bit and proper” and requires deposits into these funds smaller than—the Revenue Deficiency Fund of the to be treated as spending subject to the limit. In 1950s. (At its largest, the BSA reached 12 percent response, the state created the contingency reserve of General Fund revenues, while the Revenue for economic uncertainties—a precursor to what is Deficiency Fund was initially set at 14 percent of now the Special Fund for Economic Uncertainties General Fund revenues.) (SFEU). The balance of the SFEU is determined by How Does Proposition 2 Help the State Build the annual budget act and essentially functions like Reserves? Figure 4 on the next page shows how the ending fund balance of the General Fund. The Proposition 2 deposit rules work. The measure SFEU is therefore somewhat akin to the year-end has two main parts. First, it requires the state unallocated surpluses of the 1950s through 1970s. to set aside 1.5 percent of total General Fund Before 2014, State Had Very Little in Reserves revenues (we refer to this as the “base amount”). on Hand. After the 1980s, but prior to 2014, the Second, it requires the state to set aside a portion SFEU was nearly exclusively used as the state’s of capital gains revenues that exceed 8 percent of budget reserve. Throughout this period, as shown General Fund taxes (this is: “excess capital gains”). on the right side of Figure 3, the SFEU balance was Importantly, the state does not set aside all capital generally enacted around 1 percent to 3 percent of gains that exceed this threshold, but only a share revenues—very small compared to the reserves and of them. This share is determined by a complex set surpluses of the decades before. There was only of formulas that can lower excess capital gains by one brief departure from this paradigm. In March anywhere from 0 percent to 100 percent, although of 2004, on the heels of the dot-com bust, voters reductions around 30 percent have been the most passed Proposition 58, which created the Budget common to date. The state combines the base and Stabilization Account (BSA). In the 2006-07 budget, excess capital gains amounts and allocates half to the Legislature deposited $472 million into the BSA pay down debts and the other half to build the rainy and in 2007-08 deposited $1.5 billion. However, day reserve. in the early months of the Great Recession, the State Has Neared or Reached the BSA Cap state acted quickly to withdraw all of these funds. Twice. Proposition 2 limits how much can be This meant California weathered most of the Great saved in the constitutional reserve to 10 percent of Recession with essentially no reserves on hand. General Fund taxes. (There is no limit on how much Proposition 2 Substantially Improved State’s can be saved on a discretionary basis.) Currently, Reserve Policy Relative to Recent History. this is about $21 billion. Once the BSA reaches this In response to the state’s significant budget level, any deposits otherwise required must instead problems during the Great Recession, voters be spent on infrastructure. While the state neared passed Proposition 2 in 2014, making significant this cap in the 2019-20 budget, the cap has only changes to the state’s reserve policy. These been operative twice: in 2022-23 and 2023-24. changes included: (1) new rules for deposits into All told, had there not been a cap on constitutional the BSA, (2) limitations on the Legislature’s ability to deposits, the state would have deposited about access the fund, and (3) a new maximum level for $2 billion more in reserves. constitutional deposits into the fund. (Proposition 2 www.lao.ca.gov 11 AN LAO REPORT available in the current Figure 4 or upcoming fiscal year are insufficient to keep How Proposition 2 Works spending at the level of the highest of the Base Amount prior three budgets, adjusted for inflation General Fund Revenues and population (a “fiscal 50% D Pa e y b m t ents emergency”), or (2) in 1.5% response to a natural 50% Reserve Deposits or man-made disaster. (Under the language of Proposition 2, “resources Excess Capital Gains available” includes General Fund Taxes both revenues and the entering fund balance.) 8% Since 2014, the state has suspended and made withdrawals from the BSA in two years: 2020-21 and 2024-25. In addition, Excess there is a withdrawal planned for 2025-26 Capital Gains under legislative action Not included in formulas taken last year. Debt State Has Made 50% Payments Some Discretionary Reserve 50% Deposits Reserve Deposits. Excess In addition to what has Only a portion been required under of excess capital gains Proposition 2, since 2014, are saved. the Legislature has at Note: For simplicity, this figure does not show the mechanics of true ups and downs. times made discretionary reserve deposits. For Suspensions and Withdrawals Have Occurred example, in 2018-19, Infrequently. In addition to creating new rules for the Legislature created the Budget Deficit Savings reserve deposits, Proposition 2 created new rules Excess Capital Gains Account—which was used to temporarily hold a regarding when otherwise-required deposits can be $2.6 billion optional deposit into the BSA—and suspended and when funds can be withdrawn from the Safety Net Reserve—a reserve specifically the BSA. Specifically, suspensions or withdrawals dedicated to CalWORKs and Medi-Cal. The Safety can only occur if the Governor declares a budget Net Reserve initially received a deposit of emergency. The Governor may call a budget $200 million and the balance of the fund eventually emergency in two cases: (1) if estimated resources grew to a $900 million. 12 LEGISLATIVE ANALYST’S OFFICE AN LAO REPORT YET FURTHER IMPROVEMENTS ARE WARRANTED Proposition 2 Only Allows the State to Cover be necessary. This has been relatively apparent About One-Third of Funding Shortfalls. We have from recent history, as well. Although the state evaluated the effectiveness of Proposition 2 using had surpluses that totaled over $100 billion across the simulation-based tools described in Chapter 1. 2021-22 and 2022-23, Proposition 2 required We find that, under current law, the reserves built only a about $10 billion to be saved over a similar under Proposition 2 allow the state to cover about period. Further, since 2023-24, the Legislature has one-third of funding shortfalls (see Figure 5). addressed $82 billion in budget problems (with Put another way, if Proposition 2 remained in more in deficits likely to emerge in the coming place as is for the next 50 years, in the benchmark years), but at its largest, the BSA balance reached scenario, the state would be able to cover about only $23 billion. one-third of funding shortfalls such that cuts to Compared to Other States, Revenue Volatility core services and/or tax increases would often Is High, but Reserve Balances Are Relatively Low. Comparing California’s current reserve policy Figure 5 to other states offers another perspective on the shortcomings of Proposition 2. Figure 6 on the next Under Current Policy, Reserves Can page, shows a measure of state revenue volatility Cover One-Third of Funding Shortfalls put together by researchers at the Pew Charitable Trusts using 15 years of revenue collection data. According to this measure, California has one of the most volatile tax revenue systems in the country, ranking fifth out of 50 states. However, using data from the Fiscal Survey of States put together by the National Association of State Budget Officers, California’s rainy day fund balances are somewhat below average. Figure 7 (on page 15) shows states’ rainy day funds as a share of total spending in 2024. On this measure, California’s reserves rank 29 out of 50. (In fact, Figure 7 likely overstates California’s reserve balances compared to other states because the data appears to include the SFEU in the state’s rainy day fund balances, although it is not a true rainy day fund.) www.lao.ca.gov 13 AN LAO REPORT Figure 6 Using Recent Data, California's Revenues Among Most Volatile Pew Volatility Score, 15 Year Data Alaska North Dakota Wyoming Utah California New Mexico Oregon West Arizona Delaware Oklahoma Colorado Montana Hawaii Illinois Florida Georgia Texas Idaho New York Indiana Connecticut New Jersey Louisiana Massachusetts Michigan Kansas 50 States South Carolina North Carolina Rhode Island Northeast Missouri Pennsylvania South Midwest Tennessee Minnesota Virginia West Virginia New Hampshire Nebraska Nevada Alabama Maine Vermont Mississippi Washington Ohio Wisconsin South Dakota Kentucky Maryland Arkansas Iowa 10 20 30 40 50 60 14 LEGISLATIVE ANALYST’S OFFICE AN LAO REPORT Figure 7 As a Share of State Spending, California's Reserves Are Below Average Rainy Day Funds as a Share of Spending, 2024 Wyoming Alaska Arkansas New Mexico North Dakota Kentucky Idaho Nevada Alabama Oklahoma Maine West Virginia Massachusetts Texas Nebraska Kansas Connecticut North Carolina New Hampshire Georgia Virginia Oregon Montana Pennsylvania Hawaii Michigan Colorado Vermont California Iowa Ohio South Dakota Mississippi Maryland South Carolina Arizona Utah Minnesota Indiana Wisconsin Louisiana Tennessee Florida Rhode Island New York Missouri Washington Delaware Illinois New Jersey 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 www.lao.ca.gov 15 AN LAO REPORT CHAPTER 3: WHERE DO WE GO FROM HERE? In this section, we evaluate the Governor’s are warranted. As such, this section also presents proposed changes to Proposition 2 using the tools our proposed alternative—new rules for reserve described in Chapter 1. We find that while they deposits that would allow the state to save enough would improve upon the state’s reserve policy, they in reserves to maintain its core services during would not reliably ensure stable funding for core future downturns. services over time, and therefore further changes GOVERNOR’S PROPOSAL Governor Proposes Two Changes to Raising the Reserve Cap Improves Upon Proposition 2. The Governor’s budget includes Current Law, but Further Improvements Are proposed trailer bill language that would put a Warranted. Figure 8 uses the tools described in measure before voters to make two changes to Chapter 1 to evaluate the Governor’s proposal. The Proposition 2. Those are: Governor’s proposal clearly improves upon current law. In particular, in the benchmark scenario, • Raise BSA Cap to 20 Percent of General the Governor’s proposal would allow the state Fund Taxes. The Governor proposes raising to cover about half of funding shortfalls over 50 the reserve cap from 10 percent of General years. (This analysis assumes that, after 2029-30 Fund taxes to 20 percent of General Fund when debt payments become optional, the state taxes. This would not have any impact on the dedicates all of the Proposition 2 requirements to rules that set aside funds each year, but would reserves, rather than splitting those requirements mean the state would save more cumulatively between reserves and debt.) Although this is a over time. • Exclude BSA Deposits Figure 8 From the SAL. The Governor also proposes excluding Under the Governor's Proposal, BSA deposits from the Reserves Can Cover Half of Funding Shortfalls SAL. (Reserve withdraws are already excluded and the Governor does not 30% 50% propose changing that.) This proposal does not impact the constitutional deposit rules, but it could make it easier for the state to save more on a discretionary basis in certain years. (It would also somewhat reduce the budgetary constraints created by the SAL in certain years.) Current Law Governor’s Proposal 16 LEGISLATIVE ANALYST’S OFFICE AN LAO REPORT clear improvement over current law, it also implies set aside minimum amounts in reserve each year, that, even under the Governor’s proposal, either Proposition 4 treats reserve deposits like state reductions to core services or tax increases would appropriations. As we have noted in the past, this still be common. In our view, this means more creates an implicit tension between these two improvements are warranted. constitutional calculations. We think it is reasonable Excluding Reserve Deposits From SAL Has to ask the voters for a change to Proposition 4 to Merit. While Proposition 2 requires the state to bring these measures into congruence. LAO RECOMMENDATIONS In this section, we present our recommendations requirements to reserves, rather than splitting those for changes to reserve policy that would allow the requirements between reserves and debt.) state to cover a more substantial share of funding Importantly, we have found that raising the cap shortfalls in the benchmark scenario. To this end, further than the level proposed by the Governor we have two main recommendations: (1) raise the is the only way to substantively improve upon reserve cap to 50 percent by 2055 and (2) change the proposal. That is, if the state were to raise the rules to set aside more revenues so that the the reserve cap to 20 percent and also increase state can dependably reach this higher threshold. annual deposits—for example, by increasing the base amount—it would not result in a substantial RAISE THE CAP TO improvement in the benchmark scenario. Put 50 PERCENT BY 2055 another way: until it is raised substantially, the cap is the most important binding constraint on the We first recommend that the Legislature raise state’s ability to build reserves. the BSA cap to 50 percent of General Fund taxes. This change need not occur immediately as it will take time for the state to build up reserves through future economic Figure 9 cycles. As such, we suggest the Legislature ask the voters to Raising Reserve Cap to 50 Percent by 2055 Would authorize a scheduled, phased-in Allow the State to Cover Two-Thirds of Funding Shortfalls increase: 20 percent to take effect immediately after the next 30% 50% 65% statewide election, 25 percent in 2030, and increasing by 5 percent every five years until the cap reaches a maximum of 50 percent in 2055. This change alone would improve upon the Governor’s proposal considerably—under our benchmark scenario, the state would be able to cover two-thirds of funding shortfalls across 50 years, rather than only half (see Figure 9). (Similar to the above, this analysis assumes that, after Current Law Governor’s Proposal Increase Reserve 2029-30 when debt payments Cap to 50% by 2055 become optional, the state dedicates all of the Proposition 2 www.lao.ca.gov 17 AN LAO REPORT OPTIONS TO REACH Figure 10 THIS HIGHER Capital Gains Revenues Have Grown Considerably THRESHOLD Since Proposition 2 Was Passed If the cap is raised (In Billions) substantially—ideally to 50 percent by 2055—the state would also $45 need to set aside more in reserve 40 deposits to dependably reach this 35 higher amount. There are many 30 options for doing this, but given the 25 volatility in the state’s revenues, Proposition 2 Passed 20 we think it is important to set aside 15 much more funds in years when 10 revenues are surging, rather than 5 setting aside somewhat more in every year. This strategy avoids 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 forcing the state to save more in years when the budget position is positive, but more marginal. In these years, saving more help insulate the reserve policy against the risk money might come at the expense of high-priority of a paradigm shift where growth in capital gains legislative goals. Saving aggressively in strong revenues is not as robust in the future. revenue years, by contrast, helps avoid those Recommended Alternative System Would more difficult choices. In this section, we present Set Aside Windfalls Relative to Expectations. two alternative mechanisms for reaching a higher We suggest an alternative set of rules for deposits savings goal using this strategy. that uses three steps to identify and set aside windfall revenues. First, the state would calculate Create New, More the average growth rate in revenues over 20 years. Robust and Flexible Deposit Rules Second, using this growth rate, the state would The Legislature could first consider asking voters estimate where revenues would be in the current to replace Proposition 2’s existing framework for year if they had grown at that rate over the past deposit rules with something entirely different. three years. Finally, the state would then deposit the There are several reasons this is appealing. First, difference between actual current-year revenues the existing system is complicated and difficult and this projected amount into reserves. Figure 11 for even for well-informed budget observers to shows how these steps are calculated. The intuition understand. Second, the existing formulas focus of this approach is that we establish a baseline for on capital gains as the key source of revenue “expected” revenue growth based on long-term volatility for the state, but increasingly, the state’s trends. Any revenues above this baseline would revenues have other sources of volatility, like be considered potential windfall funds—one-time corporation tax and even withholding in the resources that are better suited for reserves than personal income tax. Diversifying the way volatility for budget commitments. is measured would ensure the state is capturing This More Robust and Flexible System Would surges in these other revenues. Finally, capital Allow the State to Cover Significantly More in gains revenues have grown substantially since the Funding Shortfalls. As Figure 12 shows, using passage of Proposition 2 (see Figure 10) and while these new, more robust and flexible rules—coupled it is possible that this growth will persist, it is not with an increase in the reserve cap to 50 percent by a guarantee. Changing the structure of the rules 2055—the state could cover about three-quarters to diversify the types of volatility considered could of funding shortfalls over the next 50 years. 18 LEGISLATIVE ANALYST’S OFFICE AN LAO REPORT An even higher share of funding shortfalls could be covered in the Figure 11 unfavorable benchmark scenario with even more expansive rules. How Our New Robust and Flexible However, in the course of our Reserve Deposit Rules Would Work analysis, we found that doing so would require the state to save impractically high levels of reserves $ in more favorable scenarios. As Step 2 Estimate where revenues such, we think a reserve policy Step 1 would be if this growth that covers three-quarters of had continued. Calculate the average growth in funding shortfalls is adequate while revenues over the last 20 years. balancing these trade-offs. Step 3 Deposit the difference into reserves. Keep Existing Formulas, but Set Aside All Excess Capital Gains Although there would be many advantages to replacing the Time existing Proposition 2 formulas with something simpler and more robust, we understand that it might be easier to reach agreement on Figure 12 reserve changes that build off existing policies rather than replace More Robust System Would Allow the them. To this end, below we put State to Cover Significantly More in Funding Shortfalls forward an alternative to building Share of Funding Shortfalls Covered more reserves that keeps the existing Proposition 2 deposit rule 30% 50% 65% 75% structure largely intact, but also focuses on saving more during surges in state revenues. Proposition 2 Does Not Currently Save All Excess Capital Gains. Under current law, the state does not set aside all capital gains but rather a share of them based on a complicated set of formulas. Due to complex interactions, those formulas inconsistently reduce the excess capital gains directed Current Law Governor’s Proposal Increase Reserve Increase Reserve Cap to 50% by 2055 Cap to 50% by 2055 to Proposition 2. As shown in and Use New, More Figure 13 on the next page since Robust Different Rules Proposition 2 was passed, excess capital gains to Proposition 2 have been reduced between 0 percent to 30 percent each year www.lao.ca.gov 19 AN LAO REPORT simpler and more robust. That Figure 13 said, these estimates could be wrong if the future differs State Does Not Currently Save All Excess Capital Gains significantly from that past. This (In Billions) risk is larger for the capital gains approach—which relies on specific $20 18 All Excess Capital Gains assumptions about inherently Share of Excess Capital Gains to Proposition 2 16 unpredictable capital gains—than 14 our simpler alternative—which 12 relies only on more general 10 assumptions about revenue 8 volatility broadly. As such, we view 6 our alternative as a safer and more 4 robust option. 2 2015-16 2016-17 2017-18 2018-19 2019-20 2020-21 2021-22 2022-23a2023-24a OTHER COMPLEMENTARY a Data from 2024-25 budget enactment. All other values are actuals. CHANGES (larger increments are also possible, if not likely, Below, we offer some additional in the future). For example, between 2020-21 and changes to reserve policy that would complement 2021-22, the formulas reduced the share of excess the recommendations above. capital gains that benefit Proposition 2 by $8 billion. Count Reserve Withdrawals Toward SAL. The Saving All Excess Capital Gains Would Allow Governor’s proposal to exclude reserve deposits the State to Save More Revenue Peaks. If the from the SAL is reasonable, but we think this state instead saved all excess capital gains, it would change should be coupled with a corresponding mean setting aside more “peaks” in capital gains change to count reserve withdrawals toward the revenues. This is more appealing than making other limit. Proposition 4 sets up a system in which all changes to Proposition 2 rules—such as raising tax revenues—with only limited exceptions—are the base amount above 1.5 percent or lowering counted at some level of government (for example, the threshold for excess capital gains below the state, or a city, county, or school district). Funds 8 percent. These types of other changes would transferred between these entities of government not set aside more windfall revenues, but rather are counted at some part of the structure. A similar increase the amount that is saved every year (or principle could be extended over time: that is, all tax most years). Setting aside all capital gains revenues revenues should be counted toward the limit, but would increase the state’s spending on both debt the question is when. If the state excluded deposits, payments and reserve deposits before 2029-30. but included withdrawals, from the state’s limit, After 2029-30, the Legislature could choose to it would change the timing of when revenues are dedicate all of these requirements to reserves. counted, but would preserve the overall amount of Along With Changes to Reserve Cap, State tax revenue counted. Could Cover About Three-Quarters of Funding Eliminate Complex Fiscal Emergency Shortfalls. As Figure 14 shows, by setting aside Rules. Under current law, the Legislature may all excess capital gains—coupled with an increase only withdraw reserves if the Governor declares in the reserve cap to 50 percent by 2055—the a budget emergency, which can be triggered state could cover about three-quarters of funding by either a disaster or a fiscal emergency. The shortfalls over the next 50 years. This is essentially calculation for a fiscal emergency is complex the same as the estimated outcome under the and, due to timing issues, can produce alternative to replace the rules with something inconsistent and counterintuitive results. 20 LEGISLATIVE ANALYST’S OFFICE AN LAO REPORT continue to be required Figure 14 to issue a declaration of a budget emergency. Share of Funding Shortfalls Covered by Different Reserve Policy Options Use Cash for Low-Risk Loans That Advance 30% 50% 65% 75% 75% the Legislature’s Policy Goals. If the state were to make the changes outlined in this report—and to have enough savings to cover three-quarters of funding shortfalls—it will mean saving dramatically more in the BSA. It’s entirely plausible that, in 30 years from now, the state would have a reserve of 50 percent of General Current Law Governor’s Proposal Increase Reserve Increase Reserve Increase Reserve Cap to 50% by 2055 Cap to 50% by 2055 Cap to 50% by 2055 Fund revenues. In current and Use New, More and Deposit All Excess Robust Different Rules Capital Gains terms, this is more than $100 billion. The strongest argument against holding reserves of this size is one For example, this calculation can allow a fiscal of opportunity costs— emergency declaration during a sizeable budget that is, a share of those funds would be sitting idle surplus—or could prevent one during a deficit. for years, and in some cases decades, missing an If the state has a more robust reserve policy, as opportunity for the Legislature to address critical recommended here, the Legislature would not want needs of the state. To mitigate this problem, the state these rules—which do not always work as intended— could use the funds on a cash basis to advance some to limit the use of reserves. Additionally, because the of the Legislature’s policy goals. For example, the Governor can declare a budget emergency at any cash in this account could be used to make loans time in response to a disaster, authority to withdraw to support infrastructure and housing. Loans from funds is already available near constantly. For these the fund could be actively managed to keep liquidity reasons, we recommend eliminating the fiscal relatively high while managing downside risk. emergency calculation. That said, to sign a budget bill that uses the BSA, we would recommend Governor www.lao.ca.gov 21 AN LAO REPORT CONCLUSION There are advantages and disadvantages of if reserves are going to be adequate to protect California’s existing revenue structure. On one the state’s core service level, the current policy hand, its progressivity means that the highest falls short. Rather than a reserve of 10 percent of tax rates apply to the parts of the state’s income General Fund taxes, as a long-term target, the state distribution that grow the fastest. But, on the other needs a reserve approaching 50 percent of General hand, that progressive rate structure results in Fund taxes. more revenue volatility, which has clear drawbacks. We understand that building a reserve of this Namely, volatility can jeopardize the state’s ability size—even if achieved over three decades—is to maintain a consistent level of programmatic a dramatic increase and well outside the range services over time. That said, both the Legislature of savings targets that have been contemplated and voters have indicated, through various policies by policymakers to date. Yet we do not view enacted over the last decade, that their preference these recommendations as overly cautious—to is to address these risks not by reforming the arrive at these estimates, we have used standard revenue structure, but by building reserves. tools from actuaries in pensions and insurance The state has indeed made progress on this markets. Rather, we view these figures as an front. With the passage of Proposition 2, the state honest reflection of the volatility in the state’s tax built a rainy day fund from a historical balance of system. That is, these changes would allow the essentially zero to $23 billion. While this represents state to enjoy the advantages of its current revenue an important step forward, it is not enough. structure while protecting critical services for Given the tremendous volatility in state revenues, Californians for decades to come. 22 LEGISLATIVE ANALYST’S OFFICE AN LAO REPORT www.lao.ca.gov 23 AN LAO REPORT LAO PUBLICATIONS This report was prepared by Ann Hollingshead with assistance from Brian Uhler 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. 24 LEGISLATIVE ANALYST’S OFFICE