January 14, 2003

2003-04:
Overview of the Governor's Budget

On January 10, the Governor released a plan for addressing his projected $34.6 billion General Fund budget shortfall. Although this shortfall estimate and the level of required solutions is somewhat overstated, the problem is still enormous. The Governor has proposed a comprehensive plan for addressing the state's fiscal problems. The Legislature faces a formidable task in carefully evaluating the plan's individual elements and the many important policy issues it raises. It is also important that the Legislature take early and decisive action to get the state's fiscal house in order.

Our "Bottom Line"

The Governor's 2003-04 budget proposal lays out a comprehensive strategy for dealing with both California's near-term massive General Fund budget shortfall and the state's longer term structural budgetary imbalance. It does so through major tax increases—which are used to finance the realignment of various health and social services program responsibilities to local governments—as well as deep spending cuts in most program areas; major reductions in local government subventions; and a variety of other loans, funding shifts, and borrowing.

Although the administration has somewhat overstated both the size of the problem and the level of required solutions, its budget sets forth an ambitious plan for dealing with the enormous fiscal problem facing the state. In evaluating and acting on the budget proposals, the Legislature will be confronted with making fundamental decisions about the scope of government services; how these services are distributed among the citizenry; and what the nature, amount, and mix of taxes in California should be. And, it will need to act quickly in order to avoid a further deterioration in the state's fiscal situation.

Total State Spending

The budget proposes total state spending in 2003-04 of $89.2 billion (excluding expenditures of federal funds and bond funds). This represents a decrease of 5.7 percent. General Fund spending is projected to fall from $75.5 billion in the current year to $62.8 billion in the budget year, while special funds spending will rise from $19.2 billion in 2002-03 to $26.5 billion in
2003-04. These totals reflect the proposed $8.2 billion realignment program and elimination of the current vehicle license fee (VLF) backfill to localities, as discussed below.

General Fund Condition

Figure 1 shows the General Fund's condition under the budget's assumptions and proposals. It indicates that:

• Revenues are projected to fall from $73.1 billion in 2002-03 to $69.2 billion in 2003-04, a decline of 5.5 percent. This decline is due to weak underlying growth in revenues from major taxes, and the large amount of one-time receipts in 2002-03 from tobacco securitization and loans from special funds.
• Expenditures are projected to decline from $75.5 billion in 2002-03 to $62.8 billion in 2003-04, a drop of 16.8 percent. The decline reflects both major program reductions and the above-cited program realignment to local governments.
• The large decline in expenditures results in an operating surplus (that is, revenues in excess of expenditures) of $6.5 billion in 2003-04. This causes the cumulative year-end reserve to increase from a minus $5.9 billion in 2002-03 to a positive $531 million in 2003-04.

How the Budget Addresses the Shortfall

The administration has identified a budget problem of $34.6 billion in 2003-04 (see next section for a discussion of the size of the budget shortfall). Using for the moment its definition of the budget problem and the corresponding size of the budget's solutions, Figure 2 allocates the budgetary solutions proposed by the Governor among major categories, and shows the distribution of savings between the current year and the budget year. It indicates that, of the total solutions, roughly 40 percent are related to program reductions; slightly less than one-fourth are related to new taxes that fund realignment; about one-sixth are related to a shift of local government resources to the state; and the remaining one-fifth is split between fund shifts, transfers/other revenues, and loans/borrowing.

Program Savings

Based on our review, we believe that the budget contains approximately $13.7 billion in program savings. This includes the $2.7 billion in current-year reductions (mostly in K-14 Proposition 98 spending) and $11 billion in savings in 2003-04. The budget identifies major proposed reductions in all areas of the budget except criminal justice. It includes major reductions in
K-12 and community college funding; large cuts affecting Medi-Cal services, eligibility, and provider rate reimbursements; and steep declines in California Work Opportunity and Responsibility to Kids (CalWORKs) and Supplemental Security Income/State Supplementary Program (SSI/SSP) grant levels. The budget also proposes to suspend transfers to transportation funds in 2003-04.

Savings Overstated. As we note in the next section, the budget overstates both baseline costs and budget program savings in numerous areas of the budget. Adopting our definition of baseline costs would reduce both the size of the budget problem and the value of program savings shown in Figure 2 by approximately $4 billion. This would reduce the proportion of the total solution due to program savings to roughly one-third, with the other components' shares increasing commensurately.

New Taxes to Fund Realignment

The budget would raise a net of $8.2 billion in new taxes to fund the shift of a like amount of health and social services responsibilities to local governments. The tax increases consist of (1) a 1 percent increase in the sales and use tax (SUT), (2) the imposition of 10 percent and 11 percent personal income tax (PIT) marginal rates on the earnings of high-income taxpayers, and (3) a $1.10 per-pack increase in the state cigarette tax rate. These added taxes would support the shift of approximately $8.2 billion in health and social services related expenditures (an additional $0.1 billion of new revenues would go to compensate state special funds for their associated loss in cigarette tax revenues).

Local Government Reductions

Aside from the realignment proposal (which balances new expenditure responsibilities with new resources), the budget shifts $5.1 billion in resources away from local governments in order to produce General Fund savings. Key components include (1) the elimination of about three-fourths of the subventions to backfill the VLF revenue losses sustained by localities when the VLF rate was reduced, (2) a shift of redevelopment-related funds from local governments to schools, and (3) the elimination of open-space subventions and booking fee reimbursements. These amounts do not include the non-Proposition 98 mandate deferrals, which we are classifying as loans/borrowing.

Fund Shifts

These total $2.2 billion and include (1) student fee increases in all three of the higher education segments, (2) other fee increases for trial courts and various resources programs, (3) use of federal funds to support some child-care costs, and (4) the shift of capital outlay expenditures from direct appropriations to bond funds.

Transfers and Other Revenues

These account for $2.1 billion in revenues. The major component is $1.5 billion in new revenues associated with tribal gaming pacts, which are up for renegotiation in March 2003. This category also includes about $95 million in General Fund revenues from tax proposals involving the eligibility for the investment tax credit and taxation of regulated investment companies.

Loans/Borrowing

This category accounts for $3.3 billion of total solutions. The largest components are the deferral of local government and education mandates, and the deferral of contribution costs to the state's pension funds (either through loans from the funds or the issuance of some sort of pension obligation bonds).

. . . So, How Big Is the Budget Problem?

In November, we projected in our Fiscal Outlook report that the 2003-04 cumulative budget shortfall facing the state would be $21.1 billion, absent corrective actions. In the 2003-04 Governor's Budget, however, the budget problem is estimated to be a much larger $34.6 billion—a difference of $13.5 billion. This has resulted in many questions about why the estimates are so different, and which one most accurately depicts the volume of spending cuts, revenue enhancements, and other actions that will be needed to address the problem.

Basic Reasons for the Difference

The significant gap between these two estimates reflects two principal factors:

• Forecasting Differences. About $8 billion (60 percent) of the discrepancy reflects differences in the two agencies' respective forecasts of revenues and, to a lesser degree, the program caseloads that drive expenditures.
• Definitional Differences. The remaining $5.5 billion (40 percent) of the discrepancy is primarily "definitional" in nature, in that it largely reflects differing assumptions about what the "baseline" level of spending is from which budget adjustments will need to be made. Our standard for this baseline is spending that would occur under current law (or, if more applicable, current legislative practice). In contrast, the administration's baseline in some cases reflects additional spending that would be required to achieve the administration's policy goals as well as proposals that have not yet been adopted.

Forecasting Differences Primarily Involve Revenues

Regarding the first factor above—of the $8 billion of forecasting differences between the proposed budget and our November estimate—about $6.5 billion relates to the administration's lower revenue forecast for the period 2001-02 through 2003-04. Most of this is due to differing assumptions about the economic outlook, projections of capital gains and stock-option income, and cash collections data available at the time each forecast was made. The other $1.5 billion appears, based on our initial review, related to the administration's higher estimate of current-year and budget-year caseload-related costs in such areas as education, Medi-Cal, CalWORKs, criminal justice, and fire suppression.

What Will Our Revised Forecast Show? When the administration developed its budget forecast, it had more up-to-date information about such things as revenue and caseload trends. Unfortunately, these trends have adversely affected the budget outlook. Thus, when we update our own gap estimate next month, we anticipate that it will show the budget problem to have worsened relative to our November estimate of $21.1 billion—probably by over $5 billion. This reflects a potential $4 billion deterioration in revenues from our previous estimate, leaving us roughly $2.5 billion above the budget's estimate for the current and budget years combined. In addition, based on our preliminary assessment of workload and other factors affecting spending, we believe it may be appropriate to add as much as $1 billion to our spending estimate. Thus, taken together, these two factors would increase our estimate of the budget shortfall to the $26-plus billion range.

Explanation of Definitional Differences

As noted above, the remainder of the difference between our November shortfall estimate and the January budget's—about $5.5 billion—is largely definitional. In many cases, this involves things that the administration would like to fund but reflect neither current law nor current practice. These include:

• Reserve. The administration has included $1 billion in its estimate to fund a reserve, whereas our November estimate was simply of the budget deficit that would face California, absent corrective action. This adds $1 billion to the administration's forecast of the problem relative to our estimate. Also, the 2003-04 budget proposes a reserve of about $500 million, and the administration is scoring the difference between this and the $1 billion as a budget solution.
• Mandates. About $1.2 billion is due to different assumptions about how quickly prior-year mandate claims would be paid to school districts and other local governments. The administration's definition of the problem assumes that all of the past claims would be paid in 2003-04. In contrast, our estimate assumes that past claims will be paid over a multi-year period (as has been done in the past).
• Control Section 3.90. About $750 million relates to our differing treatment of the 5 percent reduction in state operations that was required by Control Section 3.90 of the 2002-03 Budget Act. We score $250 million savings in 2002-03 and $500 million savings in 2003-04 related to this provision in our baseline, on the grounds that the 5 percent reduction is part of current law. In contrast, the administration assumes no savings from this provision in its baseline, but scores all savings from its state operations reductions toward its solution to the 2003-04 problem.
• Policy Priorities and Other Factors. The remaining $2.5 billion relates mainly to the administration's inclusion of various funding priorities and other factors in its spending baseline that exceed current-law requirements. One example is Proposition 98, where the administration assumes baseline spending which is significantly more than current-law requirements. Another example is in higher education, where the administration's spending baseline assumes the Governor's desired "partnership" funding level, which would be roughly $350 million higher than our baseline estimate. Fully funding the partnership at the administration's proposed level would result in increases for California State University (CSU) and University of California (UC) of over 10 percent—or twice the increases needed to cover enrollment and price increases during 2003-04. Finally, there are instances where the administration added costs for factors—regarding, for example, wage costs, caseloads, and interest expenses—which were above the baseline, then showed savings by not funding them.

Practical Implications

In summary, the real differences between the two agencies' estimates consist of about $2.5 billion in revenues and roughly $500 million in expenditures. If our projections are realized, this would imply that the scope of budget solutions needed to address the 2003-04 shortfall would be $3 billion less than proposed by the administration.

The remaining $5.5 billion difference between our respective estimates, however, do not have any implications for the amount of real solutions that must be achieved. Instead, they result in differences in the scoring of the size of the problem and the corresponding size of the budget solutions that are embedded in the budget's proposed expenditure levels.

In Any Event, Timely Action Still Critical. Despite the differences as to the true magnitude of the problem at hand, its precise magnitude does not change one very important factor—namely, regardless of which baseline is used, it is extremely important that the Legislature take timely and meaningful action to address the budget shortfall, which by any standard, is extremely daunting, and will only get worse if left unaddressed.

Total Budget Spending by Program

As shown in Figure 3, most program areas would experience major General Fund reductions in 2003-04 under the Governor's proposals. It should be noted that the major declines in state spending shown for health and social services reflect both the realignment proposal and deep program-specific cuts. The Governor's specific proposals in individual program areas are discussed in detail later in this brief.

The Budget's Economic and Revenue Projections

The budget's projections reflect the ongoing weakness in both U.S. business investment and foreign demand, and their impacts on California's high-tech industries. It assumes that economic growth in the state will remain sluggish through much of 2003, before accelerating to a more moderate pace in 2004. Specifically, it projects California personal income—a key determinant of the state's revenue performance—will grow by only 3.3 percent in 2003, before accelerating to a more moderate pace of 5.3 percent in 2004. As indicated in Figure 4, these projected income increases are well below those anticipated when the 2002-03 budget was enacted last September. This is a key factor behind the downward adjustment to the administration's revenue forecast.

Forecast Is on Conservative Side. The administration's economic forecast for California is significantly below our November projections, as well as those of most other economic forecasts made in late 2002. The one exception is University of California, Los Angeles, which has an outlook similar to the administration's. The budget's conservative forecast is primarily related to its assumption that the rebound in business capital spending on high-tech goods and services will begin in early 2004, or about one-half year later than assumed by most other forecasts.

Revenue Outlook. The administration projects that General Fund revenues will grow from $72.2 billion in 2001-02 to $73.1 billion in 2002-03, before falling to $69.2 billion in
2003-04. Numerous policy-related factors are embedded in these figures, including the one-time law changes accompanying the 2002-03 budget involving tobacco securitization, suspension of the teachers' tax credit, withholding on stock options and certain real estate transactions, and one-time loans and transfers. The 2003-04 revenue estimates include $1.5 billion in new revenues related to tribal gaming receipts, and $326 million in one-time transfers and loans. After adjusting for these factors, underlying revenues are projected to increase by just 1.4 percent in 2002-03 and 2 percent in 2003-04.

Comparison to the November LAO Forecast. After adjusting for the newly proposed tax law changes, the administration's revenue forecast is below our November projections by $883 million in the prior year, about $2.1 billion in the current year, and roughly $3.5 billion in 2003-04—for a three-year total of about $6.5 billion. This reduced estimate reflects (1) more current data on prior-year actuals, (2) differing assumptions about stock options, and (3) the administration's more conservative estimates regarding future economic growth in California.

LAO's Current Assessment. Based on updated information on soft prior-year actual revenues, weak year-end 2002 tax collections, and continued economic softness, it is likely that we will revise our own revenue outlook downward next month—by roughly $4 billion. This downward revision, however, would still leave us about $2.5 billion above the administration's revenue forecast, reflecting our continued belief that California's economic recovery will accelerate in the second half of 2003, or about six months earlier than assumed by the administration.

Tax Proposals

Realignment-Related Tax Increases

As indicated previously, as part of the administration's plan to restructure certain state and local programs, additional PIT, SUT, and cigarette taxes have been proposed. The revenue generated from the additional taxes—estimated to be an aggregate of $8.3 billion on an annual basis—will be used to fund program responsibilities to be transferred from the state to localities.

New High-Income PIT Marginal Brackets. The administration is proposing new PIT marginal tax brackets of 10 percent and 11 percent for high-income taxpayers. For joint filers, the 10 percent rate would affect taxpayers with taxable incomes of over $272,000, and the 11 percent bracket would affect those with taxable incomes of greater than $544,000. (The income thresholds would be one-half of these amounts for single filers.) The administration estimates that these new brackets will generate additional revenues of $2.6 billion in 2003-04.

SUT Rate Increase. The budget proposes that the current SUT rate be increased by one cent for realignment purposes. The administration estimates that the revenues deriving from such an increase would be approximately $4.6 billion in 2003-04.

Cigarette Tax Rate Increase. The budget proposes that the tax rate on cigarettes be increased by $1.10 per pack. Currently, cigarettes are taxed at the rate of $0.87 per pack. Thus, the proposal would more than double the existing tax rate. The revenue raised would be an estimated $1.2 billion annually. Of this amount, roughly $100 million would be used to backfill the revenue decreases in Proposition 10 and Proposition 99 funds that would occur due to decreased cigarette consumption stemming from the price increases the higher tax rate would induce.

General Fund Tax Increases

In addition to the realignment-related tax proposals, the budget includes several changes that would increase General Fund revenues by $95 million in 2003-04, and by increasing amounts thereafter. These include provisions that would (1) prohibit banks from utilizing Regulated Investment Companies to avoid California income taxes, (2) clarify income reporting requirements for certain multi-national businesses, (3) clarify the industries that are eligible for the manufacturers' investment tax credit (MIC), and (4) extend the MIC past 2003. Under existing law, the MIC would likely expire in 2004, since manufacturing job growth between January 1994 and January 2003 will likely be less than the 100,000 required in statute to keep the program in effect.

The Budget's Realignment Proposal

The budget proposes a major realignment of state, county, and court program funding responsibilities. Under this plan, the state shifts responsibility to counties for roughly $8 billion of health, child care, and social services programs—and reduces by $300 million state General Fund support for trial courts.

To offset these fiscal changes, the budget raises a net $8.2 billion from increased PIT, SUT, and cigarette taxes and provides this funding to counties and the courts. Similar to the state-county realignment enacted in 1991, the administration does not include these new revenues in its calculation of Proposition 98's minimum funding guarantee.

Figure 5 summarizes the realignment proposal and the increased county program costs associated with it.

Comments

The 1991 realignment plan enacted by the Legislature was largely a successful experiment in the state-county relationship. Most notably, the increased program flexibility and reliable funding stream provided under the 1991 plan allowed counties to develop innovative and less costly approaches to providing mental health services.

Our review of the administration's current proposal indicates that it could serve as a reasonable starting point for the Legislature to discuss the desirability of expanding realignment. We note, however, that the budget proposal is primarily a conceptual sketch. Significant work will be needed to "fill in the details." This work will need to occur on an expedited basis if the state is to realize a full year of program cost savings, as anticipated in the budget plan.

The realignment plan would benefit from a program-by-program review by the Legislature and the active participation by counties in this discussion. Issues meriting review include:

• Will counties have sufficient program authority to manage the proposed increases in funding responsibilities?
• Would other programs benefit from state-county realignment?
• Will the realignment revenue stream "match" the projected growth in program costs?
• How should realignment funds be distributed to counties and shared between programs?
• Could the provisions of the 1991 and 2003 realignment plans be integrated?

Expenditures by Major Program Area

Proposition 98

Figure 6 summarizes the budget's proposed Proposition 98 allocations for K-12 schools and community colleges. It shows a total of $44.1 billion in 2003-04, an increase of $182 million, or 0.4 percent, over the Governor's current-year estimate. This low growth rate is due to the Governor's realignment proposal, which would move $879 million in child care funding out of Proposition 98 and to counties. Adjusting for this factor, there is over $1 billion in additional Proposition 98 resources in 2003-04. The budget allocates almost $1.5 billion in new resources to K-12 schools, and reduces community colleges by $442 million.