Legislative Analysts Office, October 2003

California Spending Plan 2003-04

Chapter 1

The 2003-04 Budget—
The Problem and The Solution

Scope of the Problem

The Legislature was faced with addressing an enormous two-year General Fund budget shortfall in developing the state's spending plan for 2003-04. Using the administration's "baseline" revenue and expenditure totals, this two-year cumulative shortfall was estimated at about $38 billion. Although the shortfall was closer to $30 billion by our own accounting (see shaded box, next page), the gap was huge by either standard, accounting for well over one-third of annual General Fund spending. The administration's projected shortfall was the basis for estimating the amount of budgetary actions that would be needed to bring the 2003-04 budget into balance.

How the Problem Developed

During the extremely strong boom period of the late 1990s, when both the economy outperformed expectations and stock market-related activity soared, unexpectedly large gains in state revenues occurred. The Governor and Legislature fully allocated these revenues to numerous purposes, including increases in education funding, expansions in health care coverage, and tax relief. Shortly thereafter, however, the economy significantly slowed and the stock market bubble burst, causing revenues to fall dramatically in 2001-02. Because the state failed to scale back spending or augment revenues commensurately, it proved unable to fully come to grips in either 2001-02 or 2002-03 with the large operating shortfalls that emerged. It is the compounding effect of these annual operating shortfalls that was responsible for the huge cumulative budget shortfall confronting the state in 2003-04.

Annual Operating Shortfalls. As shown in the top of Figure 1, annual General Fund revenues and expenditures were roughly in balance in 2000-01. However, following the economic downturn and stock market decline, revenues plunged by over $12 billion the following year, and remained depressed in 2002-03. Despite the significant budget-balancing actions that were undertaken in both 2001-02 and 2002-03, the General Fund experienced huge operating shortfalls of over $11 billion in both of these years. The persistence of these shortfalls reflected continued weakness in the economy and associated state revenues, as well as smaller-than-anticipated savings from the budget actions that had previously been taken, particularly in 2002-03.

The figure also shows that the operating shortfall would have more than doubled to $23 billion in 2003-04, had no further budget-balancing actions been taken following the adoption of the 2002-03 budget. This projected deterioration was primarily related to the fact that many of the budget solutions adopted in 2001-02 and 2002-03 were one-time or limited-term in nature. Examples include the deferral of debt-service payments, borrowings from special transportation funds, and securitization of tobacco settlement receipts. The expiration of savings from these actions alone would have created a large shortfall in 2003-04 under even favorable economic circumstances. As it turned out, however, persistent weakness in the economy only served to aggravate the budgetary imbalance facing policymakers in 2003-04.

Cumulative Budget Shortfalls Resulted. The successive years of annual operating shortfalls resulted in a major projected cumulative budget gap by the close of 2003-04. Absent any corrective actions after the 2002-03 budget was enacted in September 2002, the cumulative shortfall would have grown from $3.5 billion in 2001-02 to $14 billion in 2002-03, and to $38 billion in 2003-04.

 

How Big Was the Shortfall? As we noted beginning in January 2003, we believe that the administration overstated by about $8 billion both the size of the underlying 2003-04 cumulative budget problem and the corresponding magnitude of real solutions needed to deal with it. This overstatement was due to three main factors: First, the administration's baseline expenditure totals included funding for various priorities of the Governor (such as the partnership for higher education as one example) that exceeded current-law and/or current-service spending requirements which are the basis of LAO estimates. Second, the administration's baseline expenditure and revenue estimates did not include solutions adopted in the 2002-03 budget. The budgetary benefits from these solutions were then "scored" against the 2003-04 problem definition. Examples of this factor include state operations reductions and the second tobacco bond sale. Third, the administration counted improvements in the baseline revenue and expenditure picture (for example, from lower interest costs, caseload savings, and 2002-03 revenue improvements) as "solutions" to the budget problem, instead of as adjustments to the baseline revenue and expenditure levels themselves. Because the administration's "scoring" of the budget was adopted by the Legislature for purposes of its budget deliberations, we have also used the administration's estimates in our presentations in this report so as to avoid the confusion that might arise from using multiple sets of numbers. However, we believe that the use of the administration's methodology and figures overstate the true magnitude of the 2003-04 budget problem that faced the Legislature and, thus, the real solutions needed to address it.

The Budget Solution—Key Components

The adopted 2003-04 budget package addresses the projected cumulative shortfall through a variety of actions, which are summarized in Figure 2. These include:

• Loans/Borrowing. Over $16 billion of the shortfall is dealt with through borrowing, either from the private credit markets or internal sources (largely intergovernmental loans). The main borrowing involves a planned $10.7 billion deficit financing bond, whose proceeds will be used to eliminate the accumulated 2002-03 year-end deficit. Other budgetary borrowing includes the planned issuance of $1.9 billion in pension obligation bonds, the deferral of mandate payments to local governments, and loans from special funds. Finally, we have included $834 million of foregone vehicle license fee (VLF) backfill payments to local governments for the July 1 through October 1, 2003, period in this category. Current law provides for the General Fund to eventually repay localities for their loss of the backfill (see discussion in Chapter 4).
• Program Savings. The budget includes about $9.2 billion in program savings from throughout the budget,
  including K-12 and higher education, criminal justice, Medi-Cal, Supplemental Security Income/State Supplementary Program (SSI/SSP), employee compensation, and resources. This category includes the $930 million in one-time savings in Medi-Cal associated with an accounting shift from an accrual basis to a cash basis. Some of the expenditure reductions, particularly in higher education, are offset with fee increases.
• New/Accelerated Revenues. The main components of this category are the assumed (1) one-time proceeds totaling $2 billion from a second tobacco securitization bond sale originally authorized in 2002-03 and (2) ongoing increase of $680 million from new and renegotiated tribal gaming compacts. This category also includes (1) the use of the LAO's revenue forecast for 2003-04, which was $587 million higher
• than the administration's May Revision estimate; (2) the transfer of unused balances from a variety of special funds; and (3) additional revenue from abandoned property.
• Shifts to Other Funds. The budget relies on $2.2 billion in new one-time, federal funds in 2002-03 and 2003-04 combined. About one-half of this total is used to offset Medi-Cal costs and the remainder covers other state spending in a variety of other program areas. Other components in this category include shifts of capital outlay spending to bond funds and of certain resources-related spending to fees.
• VLF Tax Increase. The budget anticipates $3.4 billion in additional revenues to local government due to the triggered increase in the VLF rate. This assumes that the higher VLF rate will be in effect for automobiles registered on or after October 1, 2003. This increase will result in a commensurate reduction in General Fund spending.
• Deferrals. This category primarily consists of the deferral of (1) Proposition 42 payments to transportation programs and (2) year-end education apportionments to K-12 school districts.

As shown in Figure 2, the sum of these solutions is $39.4 billion, or $1.2 billion more than the administration's $38.2 billion projected budget shortfall. Since the administration's definition of the budget shortfall had already included $1 billion to fund a reserve, the additional $1.2 billion in solutions results in a projected cumulative reserve of $2.2 billion at the close of 2003-04.

Budget Gap to Re-Emerge in 2004-05

Although the 2003-04 budget does include significant amounts of ongoing actions, the majority of savings adopted are one-time or limited-term in nature. Significant one-time or limited-term actions include the $16 billion in borrowing, the $2 billion tobacco securitization bond sale, the $930 million in savings from the Medi-Cal accounting change, and the deferral of $856 million in transportation spending.

Although these actions did help to eliminate the 2003-04 budget shortfall, their one-time or limited-term nature means that they did not address
the ongoing mismatch between revenues and expenditures that has existed since 2001-02. In fact, many of the actions will have the effect of increasing out-year obligations. For example, the annual debt-service payments on the deficit financing bond will be about $2.5 billion beginning in 2004-05, assuming that repayment occurs over a roughly five-year period as proposed.

The expiration of one-time savings and the added out-year costs for debt service will combine to produce a sizable operating shortfall in 2004-05 of slightly more than $10 billion. Taking into account the projected current-year reserve ($2.2 billion), this means that the cumulative deficit at the close of 2004-05 would be roughly $8 billion, absent further corrective actions.

Chapter 2

Key Features of the Budget Act and
Related Legislation

The Budget Totals

Total State Spending

The state spending plan for 2003-04 authorizes total state expenditures from all funds of $100.9 billion. As indicated in Figure 1, this total includes budgetary spending of $93.5 billion, reflecting $71.1 billion from the General Fund and $22.3 billion from special funds. In addition, spending from selected bond funds totals $7.5 billion. These bond-fund expenditures reflect the use of bond proceeds on capital outlay projects in a given year. The General Fund costs of these outlays, however, involve the associated ongoing principal and interest payments that must be made until the bonds are retired; thus, for budgetary scoring purposes, these costs show up as General Fund debt-service expenditures.

The amount of 2003-04 budgetary spending compared to 2002-03 represents a net reduction of $3.9 billion (4 percent)—a $7 billion (9 percent) decline for the General Fund, partly offset by a $3.2 billion (16 percent) increase for special funds.

The General Fund Condition

Figure 2 summarizes the estimated General Fund condition for 2002-03 and 2003-04 that results from the adopted spending plan and related legislation.

2002-03. Figure 2 shows that expenditures ($78.1 billion) exceeded revenues and transfers ($70.9 billion) by slightly over $7.2 billion in 2002-03. When combined with a negative carry-in balance of $2 billion and year-end encumbrances of $1.4 billion, this operating shortfall would have produced a cumulative year-end deficit of $10.7 billion at the close of the fiscal year. This deficit, however, was taken "off book" and thus eliminated for budgetary scoring purposes by the issuance of a $10.7 billion deficit financing bond, leaving the year-end reserve at zero.

2003-04. Figure 2 also shows that revenues in the current year are projected to be $73.4 billion, or $2.2 billion more than the expenditure total of $71.1 billion. This results in a planned reserve of $2.2 billion, which is equivalent to slightly over 3 percent of General Fund spending during the year.

Programmatic Spending in 2003-04

Most areas of General Fund spending are declining markedly in 2003-04. As shown in Figure 3, spending for K-12 education is down 0.5 percent, spending for health is down 1.5 percent, and the higher education segments will experience declines ranging from 8 percent to 17 percent.

Regarding these decreases, however, it is important to note that while General Fund spending is down sharply, total support for most programs is at or above prior-year levels. For example, the decline in health spending is more than accounted for by the Medi-Cal accounting shift from an accrual basis to a cash basis and the increased federal funds for Medi-Cal. Likewise, the drop in General Fund support for higher education and criminal justice spending is largely offset by higher fees, while the major decline in "all other" spending is related to the issuance of pension bonds in lieu of General Fund contributions to the Public Employees' Retirement System. Absent these special factors, overall program spending in the 2003-04 budget is roughly similar to the prior year's level. Nevertheless, after accounting for caseload, inflation, and other factors affecting costs, 2003-04 spending is well below the level that would support baseline spending requirements (that is, spending levels that would have been required based on laws in effect in 2002-03). Thus, in real terms, the budget has somewhat declined.

Evolution of the Budget

In this section, we highlight the major developments in the evolution of the 2003-04 budget, beginning with the Governor's proposed mid-year adjustments in December 2002 and ending in August 2003, when the budget was signed into law.

December Mid-Year Reductions

In our November 2002 report, California's Fiscal Outlook, we estimated that the state faced a cumulative year-end General Fund shortfall of $21 billion in 2003-04. On December 6, the Governor released a list of proposed mid-year adjustments totaling $3.4 billion in 2002-03 and $6.8 billion in 2003-04, and called on the Legislature to enact these savings as an initial step toward addressing the state's enormous budget problem. The majority of these proposed mid-year savings were related to across-the-board cuts to K-14 education programs, the elimination of social services cost-of-living adjustments (COLAs) , and various reductions in Medi-Cal.

Governor's January Proposal for 2003-04

In January, the Governor proposed a 2003-04 General Fund budget which incorporated his proposed 2002-03 mid-year savings discussed above, as well as numerous other actions to cover a shortfall that the administration estimated to be $34.6 billion. This plan attempted, over an 18-month period, to both (1) deal with the full magnitude of the budget shortfall and (2) eliminate the ongoing structural imbalance between annual revenues and expenditures (so that a deficit would not automatically re-emerge in 2004-05). The January plan included $5.5 billion in 2002-03 savings as well as $29 billion in 2003-04 savings.

Some of the plan's major features included the following:

• About $8 billion in new revenues from (1) new 10 percent and 11 percent marginal personal income tax rates on high-income taxpayers, (2) a one-cent sales tax rate increase, and (3) a $1.10 per pack increase in cigarette taxes. The proceeds of these taxes were to be used to fund a realignment of various health and social services program responsibilities from the state to local governments.
• Deep spending cuts in most program areas. These included: (1) a 15 percent cut to provider rates and the elimination of several optional benefits under the Medi-Cal program; (2) cuts in California Work Opportunity and Responsibility to Kids (CalWORKs) and SSI/SSP grants of about 6.2 percent; (3) major reductions in General Fund spending on higher education funding (mostly offset by higher fees); (4) across-the-board reductions to K-12 education spending; and (5) savings in employee compensation, achieved through either reductions in workforce or renegotiation of collective bargaining agreements.
• The elimination of the VLF backfill payments to local governments beginning in April 2003.
• A variety of loans, funding shifts, new revenues from renegotiated tribal gaming compacts, and funding redirections.

Actions Following January Budget

In the months following the release of the January budget, the Legislature enacted various savings provisions totaling about $3.3 billion for 2002-03 and $3 billion for 2003-04. These mid-year savings actions—which were about $2.2 billion less in 2002-03 than the $5.5 billion requested by the administration—included many of the reversions, cuts, and funding redirections proposed by the Governor in December. In K-12 education, however, the Legislature replaced the program reductions proposed by the Governor with a deferral of cash payments to school districts from late 2002-03 into early 2003-04, creating one-time savings. The Legislature also rejected administration proposals involving the elimination of VLF backfill payments to localities and the reduction in health care expenditures.

May Revision

In the May Revision, the administration asserted that the budget problem had increased from $34 billion to $38 billion, or about $4 billion. This reflected a number of relatively modest technical adjustments to projected revenues and expenditures, which together added a net of about $1 billion to the projected shortfall. In addition, the administration withdrew
the plan for a second tobacco bond sale (which had been assumed as part of the 2002-03 budget) in favor of a much larger deficit financing bond, and reflected this policy change as an increase in the size of the budget problem. The remaining $1 billion of the budget's deterioration reflected an increase in Proposition 98 spending.

In the May Revision, the administration's basic approach to solving the budget shortfall shifted dramatically. Instead of attempting to fully solve the budget problem in an 18-month period, the May Revision adopted a multiyear approach that relied much more on borrowing and relatively less on near-term spending reductions than did the January proposal. Specifically, the May Revision made the following major modifications to the January spending plan:

• It proposed to move the 2002-03 year-end deficit off book by issuing a $10.7 billion deficit financing bond, which would be repaid over roughly five years using revenues dedicated from a new half-cent sales tax.
• It eliminated all state VLF backfill payments to local governments effective July 1, 2003, and assumed that a VLF rate increase would be triggered by the "insufficient monies" provision of the VLF law. Thus, local governments took less of a reduction than had originally been proposed.
• It restored many of the reductions proposed in the areas of social services, health, and community colleges. It also retained the January proposals to eliminate COLAs to CalWORKs and SSI/SSP and the 15 percent reduction in Medi-Cal provider rates.
• It reduced the realignment proposal (including the new taxes associated with it) from $8 billion down to $1.7 billion.

Final Budget

Following about two months of negotiations and unsuccessful votes on several alternative budget proposals, the Senate reached an agreement on a budget plan in late July. The budget bill was passed by the Senate on July 28, and by the Assembly on July 31. It was signed by the Governor on August 2, following a modest number of line-item vetoes.

Key Features of the Budget. The budget that was adopted contains many of the features of the May Revision proposal, but differs from the Governor's proposal in several significant ways. For example:

• It includes the May Revision's proposed issuance of a $10.7 billion deficit financing bond. However, the repayment of the bond is to come from existing resources—instead of a new tax—beginning in 2004-05.
• It does not include the May Revision's realignment proposal (including the $1.7 billion in new taxes to fund the transfer of various program responsibilities from the state to localities).
• It includes the second $2 billion tobacco bond sale that had been suspended in the May Revision, and the use of about $2.2 billion in newly available one-time federal funds (that resulted from passage of the federal tax and fiscal relief measure in May).
• It includes an increased amount of assumed employee compensation-related savings, and includes language providing the administration with executive authority to reduce and reallocate expenditures among state operations.

2004-05 Savings. The budget package includes language stating the Legislature's intent that the administration not include certain funding adjustments in developing the 2004-05 budget. These include funding for: (1) University of California (UC) and California State University (CSU) salary increases not already approved and enrollment growth; (2) discretionary price adjustments to state, UC, and CSU operations; (3) local mandate reimbursements; (4) direct appropriations for capital outlay in excess of $50 million; and (5) Proposition 98 spending in excess of the minimum guarantee. In excluding these items, the Legislature has already "built in" savings from a traditional baseline budget in 2004-05. This is significant because the estimated $8 billion shortfall in 2004-05 already assumes the above spending reductions relative to current-service levels.

More detailed descriptions of the budget's key programmatic features are included in "Chapter 4."

State Appropriations Limit

Background. Article XIII B of the State Constitution places limits on the appropriation of taxes for the state and each of its local entities. Certain appropriations, however, such as for capital outlay and subventions to local governments, are specifically exempted from the state's limit. As modified by Proposition 111 in 1990, Article XIII B requires that any revenues in excess of the limit that are received over a two-year period be split evenly between taxpayer rebates and increased school spending.

State's Position Relative to Its Limit. As a result of the sharp decline in revenues over the past two years, the level of state spending is now well below the spending limit. Specifically, based on the revenue and expenditure estimates incorporated in the 2003-04 budget, state appropriations were $16.9 billion below the limit in 2002-03 and are expected to be $13.2 billion below the limit in 2003-04.

Budget-Related Legislation

In addition to the 2003-04 Budget Act, the budget package includes a number of related measures enacted to implement and carry out the budget's provisions. Figure 4 lists these bills.

Chapte