Chapter 1

The 2004-05 Budget—The Problem and The Solution

Background

The basic challenge confronting lawmakers in crafting a 2004-05 budget was finding a way to once again close a large budget shortfall, which had plagued the state since 2001-02 when expenditures exceeded revenues due to a revenue plunge. At the beginning of the 2004-05 budget cycle—and subsequent to the new Governor's decision to roll back the statutorily triggered vehicle license fee (VLF) increase—we estimated the budget gap to be roughly $15 billion in 2004-05 and beyond, absent corrective actions (see Figure 1 next page). While in subsequent months there were numerous changes to the underlying revenue and expenditure estimates on which this gap estimate was based, the final budget dealt with a 2004-05 shortfall of approximately that same magnitude.

In this chapter, we (1) discuss the factors behind the 2004-05 shortfall, (2) highlight the major budget solutions included in the 2004-05 budget package, and (3) provide initial comments on how the actions taken in the 2004-05 budget will affect the outlook for 2005-06 and beyond.

Factors Behind 2004-05 Shortfall

2003-04 Budget. One year earlier in the 2003-04 budget, the Governor and Legislature had temporarily closed a major cumulative budget shortfall—estimated to be over $30 billion—primarily through substantial borrowing, an assumed triggered increase in the VLF, and program savings. While the plan had a projected reserve of over $2 billion for 2003-04, its heavy reliance on borrowing and other one-time solutions meant that the structural operating shortfall (revenues minus expenditures) was destined to return in 2004-05. At the time of the budget's passage, our office estimated the operating shortfall would be over $10 billion per year even if all of the 2003-04 budget's assumptions held and revenues grew at a moderate pace.

A key element of the 2003-04 budget was the authorization of a deficit financing bond. The proceeds of this bond were to be used to eliminate the 2002-03 year-end deficit, which at the time was estimated to be $10.7 billion. (In subsequent months, the estimate of the 2002-03 deficit declined, and the maximum amount of bonds authorized to be sold correspondingly fell to $8.6 billion.) Repayment of the bond was tied to one-half cent of the sales tax, and would have cost the General Fund about $2.4 billion annually for about five years beginning in 2004-05.

Post 2003-04 Budget Developments. Following the adoption of the 2003-04 budget, the projected 2004-05 budget shortfall expanded, mainly as the result of two factors:

• First, following the recall election in October 2003, the new administration took office in November and immediately rolled back the statutorily triggered VLF increase which had been assumed as part of the 2003-04 budget. This action resulted in added General Fund costs to replace local revenue losses totaling $2.6 billion in 2003-04 and $4 billion in 2004-05.
• Second, some of the solutions in the 2003-04 budget were adversely affected by court decisions relating to pension obligation bonds and Medi-Cal provider rates.

Although these factors were partly offset by an improving revenue picture, the cumulative shortfall facing policymakers in 2004-05 had climbed to about $17 billion by the time the new budget was introduced in January 2004. This gap consisted of a roughly $2 billion year-end shortfall in the 2003-04 budget and a $15 billion ongoing operating shortfall in 2004-05. Further improvements in the revenue picture between late 2003 and mid-2004 narrowed the gap some. However, the final 2004-05 budget still had to deal with a projected shortfall of roughly $15 billion.

Budget Solution—Key Components

The budget signed by the Governor on July 31, 2004 contained about $16.1 billion in combined two-year solutions. These solutions enabled the state to eliminate the budget shortfall projected for 2004-05 and build up a modest year-end reserve of $768 million. As shown in Figure 2, these solutions can be divided into six categories—namely, (1) program savings, (2) the use of Proposition 57 bonds, (3) other loans and borrowing, (4) fund shifts, (5) increased revenues and transfers, and (6) diversions of local property taxes.

Program Savings. The budget includes about $3.8 billion in program savings. Over half the total is related to a reduction in K-14 education spending related to the suspension of Proposition 98. Other savings include three-month delays in cost-of-living adjustments for California Work Opportunity and Responsibility to Kids and Supplemental Security Income/ State Supplementary Payment grants, reductions in institutional support for the University of California (UC) and California State University (CSU), and unallocated reductions in state operations spending.

Proposition 57 Bond. In December 2003, the Governor and Legislature placed on the March 2004 ballot two measures—namely, Proposition 57, which authorized up to $15 billion in deficit financing bonds, and Proposition 58, which put in the State Constitution an annual budget reserve requirement, an expanded balanced budget requirement, and a prohibition against deficit borrowing in the future. The Proposition 57 bond proceeds were proposed to be used in place of the deficit bond that had been authorized in the 2003-04 budget, and which was being challenged in court. Following voter approval of Propositions 57 and 58, the state sold $11.3 billion in deficit bonds to help with the budget, leaving approximately $3.5 billion in additional bonds available for 2005-06 and subsequent years. Relative to the previously authorized bonds, the Proposition 57 bonds benefited the General Fund in the following two ways:

• Higher Borrowing Amounts. The $11.3 billion in bonds sold this year was $2.7 billion more than the $8.6 billion that would have been allowed by the previously authorized statutory bond.
• Lower Initial Debt-Service Payments. As noted above, the repayment of the previously authorized statutory bonds would have been based on the diversion of one-half cent of the sales tax, costing the General Fund about $2.4 billion annually for roughly five years. In contrast, repayment of the Proposition 57 bonds is based on the diversion of one-quarter cent of the sales tax for up to 14 years, for a savings of $1.2 billion in 2004-05.

Other Loans and Borrowing. This category accounts for $3.5 billion in solutions. It includes $929 million related to the use of proceeds from the sale of a pension obligation bond to offset payments to the Public Employees' Retirement System. It also includes a "settle-up loan" of over $1.2 billion related to 2003-04 and prior-year obligations to Proposition 98 education, and a Proposition 42 loan of $1.2 billion from transportation funds.

Fund Shifts. This category totals $1.8 billion, and includes numerous funding redirections and fee increases. It includes $366 million related to increased higher education fees, which are used to offset General Fund support for UC, CSU, and California Community Colleges. It also in
cludes $450 million related to a new law change requiring that 75 percent of court-related punitive damage awards be allocated the state. The budget assumes that these funds will be used to offset General Fund costs for state programs. Finally, this category includes $216 million related to a federal waiver allowing federal financial participation of the state's current state-only In-Home Supportive Services cases.

Increased Revenues and Transfers. This category includes $1.8 billion in total solutions. It includes targeted tax increases related to a two-year suspension of the teachers' tax credit ($210 million) and a two-year rule change related to the use tax on out-of-state purchases of certain large items such as yachts and airplanes ($26 million). It also includes $333 million from a two-month tax amnesty program beginning in the spring of 2005. The budget also includes various transfers from state transportation funds to the General Fund.

Diversion of Local Property Taxes. The budget includes a $1.3 billion annual diversion of local property tax revenues for the benefit of the General Fund in 2004-05 and 2005-06. This diversion is part of a broader agreement that places limits on future state diversions of certain local taxes and "swaps" VLF backfill payments and property taxes.

Budget Agreements

The final budget includes agreements with K-12 education and local governments. We discuss the detail of these agreements in Chapter 4. However, one element these agreements have in common is a fiscal trade-off. Each entity concedes something in 2004-05—a smaller funding increase in the case of education and a diversion of property taxes in the case of local governments—in return for funding restorations and other commitments in future years.

Budget Gap to Re-Emerge in 2005-06

The 2004-05 budget includes significant ongoing savings and it makes some progress toward resolving the state's ongoing structural budget shortfall. Nevertheless, like the two prior budgets, the current spending plan (1) contains a significant number of one-time or limited-term solutions and (2) obligates additional spending in future years. As shown in Figure 3 (see next page), major one-time savings include: the use of $2 billion in Proposition 57 bonds to support 2004-05 General Fund program spending, $929 million due to the sale of a pension obligation bond, the deferral of $1.2 billion in Proposition 42 transportation spending, and the postponement of local government mandate payments ($200 million) bringing the total of deferred reimbursements to $1.5 billion. In addition, the savings related to the $1.3 billion diversion of local property taxes and the suspension of the teachers' tax credit will expire after two years. Figure 3 also shows that deferred out-year costs associated with actions taken in 2004-05 and prior-year budgets include: Proposition 98 settle-up payments, Proposition 42 loan repayments, and repayment of the VLF "gap" loan from local governments. (The 2004-05 budget does include early repayment of a $1.4 billion loan from the Traffic Congestion Relief Fund, mostly financed by a tribal gaming bond.)

The combination of these factors suggests that state will continue to face out-year budget shortfalls, absent corrective action. Based on the May Revision budget plan, we had previously estimated these out-year shortfalls to be in the range of $6 billion in 2005-06 and $8 billion in 2006-07. The final actions on the budget—which raised ongoing spending commitments relative to the May Revision in several areas—will likely add to these out-year projected shortfalls. While the remaining Proposition 57 bond authority (about $3.5 billion) is available to offset some of these shortfalls, it appears that substantial additional actions will be needed to bring future budgets into balance. We will be updating our projections of out-year budget shortfalls to reflect both the final budget actions and current economic and revenue developments in our annual publication entitled California's Fiscal Outlook, scheduled to be released in November 2004.

Chapter 2

Key Features of the Budget Act and Related Legislation

The Budget Totals

Total State Spending

The state spending plan for 2004-05 includes total expenditures from all funds of $105.4 billion. As indicated in Figure 1, this total includes budgetary spending of $102.4 billion, reflecting $78.7 billion from the General Fund and $23.7 billion from special funds. In addition, spending from selected bond funds totals $3 billion. These bond-fund expenditures reflect the use of bond proceeds on capital outlay projects in 2004-05. 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.

As Figure 1 shows, total state spending falls by a net of $1.9 billion (1.8 percent) between 2003-04 and 2004-05. This consists of a $1 billion (1.3 percent) increase for the General Fund, a $4.3 billion (22 percent) increase in special funds, but a $7.3 billion decline in spending from bond funds.

All three components of spending are affected by special factors. As discussed below, the General Fund spending totals are affected by borrowing, accounting changes, and other deferrals taken to balance the budgets in 2003-04 and 2004-05. The major special funds increase includes new spending associated with the repayment of deficit bonds approved by the voters in March 2004. Finally, over half of the decline in bond fund spending in 2004-05 is related to how education bond expenditures are recorded for budgetary purposes. Specifically, K-12 education bonds are shown as expenditures from bond funds when they are allocated to projects by the State Allocation Board. The 2002-03 and 2003-04 spending totals include allocation of most of the bonds approved by voters in the November 2002 election. However, the 2004-05 expenditure totals do not yet include the allocation of bonds approved in the 2004 election.

The General Fund Condition

Figure 2 summarizes the estimated General Fund condition for 2003-04 and 2004-05 that results from the adopted spending plan.

2003-04. The budget assumes a prior-year balance of $4.2 billion, revenues and deficit bond proceeds totaling $76.5 billion, expenditures of $77.6 billion, and a year-end balance of $3.1 billion. After setting aside $929 million for encumbrances, 2003-04 ends with a positive reserve of $2.2 billion. The 2003-04 General Fund condition reflects the sale of $11.3 billion in Proposition 57 deficit bonds. About $9.3 billion of the proceeds were used to eliminate the 2002-03 deficit and to build up a reserve. The remaining $2 billion is reflected for accounting purposes as both revenues and expenditures in 2003-04—as the bond proceeds are first placed into the General Fund but then are subsequently transferred back out of the General Fund to a special fund.

2004-05. The budget assumes 2004-05 revenues of $77.3 billion, expenditures of $78.7 billion, and an ending balance of $1.7 billion. After setting aside $929 million for encumbrances, the budget reflects a reserve of $768 million. Of the reserve total, $302 million is designated for Proposition 98 purposes, and the remaining $466 million is available for any General Fund purpose.

Programmatic Spending in 2004-05

As indicated in Figure 3, the 1.3 percent increase in 2004-05 General Fund spending is the net result of sharp increases in some programs and sharp decreases in others. In many areas of the budget, spending totals have been affected by special factors in either or both 2003-04 and 2004-05. For example:

• The local government agreement results in increased General Fund spending for K-12 education and community colleges, and a decrease in vehicle license fee (VLF) subvention payments. A key element of the agreement—a shift of property taxes from schools to other local governments in return for the elimination of General Fund VLF backfill payments—boosts K-12 and community college payments by $2.8 billion (as the redirected property taxes are replaced with General Fund proceeds). This is more-than-offset by a drop in VLF backfill payments in 2004-05, which decline from $4.1 billion to zero.
• The repayment of Proposition 57 bonds also involves a shift of property taxes from schools to local agencies (to replace the quarter-cent sales tax that is diverted from local governments to a special fund created for the bond's repayment). This results in a corresponding increase in state funding for Proposition 98.
• Medi-Cal spending in 2003-04 was reduced on a one-time basis by two key factors: (1) a one-time increase in federal funds for the program, and (2) an accounting change shifting Medi-Cal payments from an accrual to cash basis. These one-time solutions are not available in 2004-05 and therefore General Fund expenditures increase substantially in that year.
• The major increase in criminal justice spending reflects the use of one-time federal flexible assistance grants in 2003-04 to offset $852 million in state spending for the program.
• The transfer of Proposition 57 bond proceeds to a special fund raised General Fund expenditures by $2 billion in 2003-04. Subsequent expenditures from these funds to support General Fund programs resulted in $2 billion in General Fund savings during 2004-05.
• Finally, the "all other" category is affected by (1) a refinancing of certain debt-service payments in 2002-03 and 2003-04, (2) retirement payment savings in 2004-05 associated with the sale of a pension bond, and (3) the use of punitive damage awards to offset General Fund expenses in 2004-05.

After adjusting for these and related special factors, underlying spending on state programs is estimated to grow at about 3 percent between 2003-04 and 2004-05.

Evolution of the Budget

In this section, we highlight the major developments in the evolution of the 2004-05 budget, beginning with the Governor's November 2003 proposals and ending in late July 2004, when the budget was signed into law.

November Proposals

After taking office in November 2003, the new Governor called a special session to place a deficit bond issue and a revised spending limit before the voters in March 2004. After several weeks of negotiations, the administration's initial cap proposal was replaced with a measure that (1) restricted future deficit borrowing, (2) required that budgets passed by the Legislature and signed by the Governor be balanced, and (3) required that, beginning in 2006-07, a portion of annual revenues be set aside into a budget stabilization account. In mid-December, the Legislature passed the deficit-bond proposal and the revised companion measure, which were subsequently placed before the voters as Proposition 57 and Proposition 58, respectively. (These measures were subsequently passed by the voters at the March 2004 election.)

The administration also proposed a variety of mid-year budget reductions in health, social services, and other state programs in late November. No action was taken on these measures, however, and many of the mid-year reductions were subsequently incorporated into the Governor's January budget proposal.

Governor's January Proposal for 2004-05

In January 2004, the Governor proposed a 2004-05 General Fund budget that addressed a shortfall estimated to be about $17 billion. As indicated in Figure 4 and discussed below, it proposed widespread spending reductions, borrowing, a diversion of local property taxes for the benefit of the state, and various funding shifts and transfers from transportation funds.

Program Savings. The plan contained about $7 billion in program savings from most areas of the budget. These included:

• A $2 billion reduction in K-12 Proposition 98 spending (accomplished through a suspension of the minimum funding guarantee). The suspension was part of an agreement between the Governor and the education community.
• About $700 million in General Fund reductions for the public universities (partly offset by student fee increases).
• A $2.5 billion reduction in health and social services programs. Key proposals included (1) eliminating social services cost-of-living adjustments, (2) imposing a 5 percent reduction in California Work Opportunity and Responsibility to Kids (CalWORKs) grants, (3) imposing a 10 percent reduction in Medi-Cal rates for certain providers, (4) eliminating the in-home supportive services (IHSS) state-only "residual" program, (5) reducing IHSS provider wages, (6) establishing co-payments and standardizing services in developmental services programs, and (7) creating enrollment caps and block grants for certain health and social services programs.
• A $1.2 billion reduction in transportation funding related to the suspension of the Proposition 42 transfer.
• A $400 million unallocated reduction to corrections.

Proposition 57 Bonds. The budget also assumed $12.3 billion in proceeds from Proposition 57 bonds, which were proposed to be used in place of the $10.7 billion of statutory bonds that had been authorized in the 2003-04 budget. These previously authorized bonds were facing legal challenges at the time.

Other Proposals. The budget's other proposals included: (1) an ongoing $1.3 billion shift of local property taxes from local governments to the benefit of the state; (2) a shift of about $685 million in transportation funds to the General Fund; and (3) a deferral of $1 billion in "settle-up" obligations to Proposition 98 attributable to 2003-04 and prior years. It also proposed significant CalWORKs reforms involving stricter work requirements and greater sanctions, and significant K-12 spending reforms relating to categorical funding.

May Revision

The May Revision reflected an over-$3 billion increase in available total resources, which it proposed to use to (1) scale back many of the budget reductions proposed in health and transportation, and (2) lower the amount of Proposition 57 bonds used in the 2004-05 budget.

Improved Revenue Picture. The revenue picture improved by about $3.3 billion between January and mid-May, when the Governor released his revised spending plan for 2004-05. The improvement was related to (1) approximately $1.3 billion from stronger-than-expected revenues from an abusive tax shelter amnesty program (2) another $1 billion from an accounting change resulting in accruals of additional revenues, and (3) a $1.3 billion increase in the revenue outlook for the 2003-04 and 2004-05 fiscal years combined.

Spending Restorations. As indicated in Figure 5, the Governor used the additional projected revenue proceeds to partially restore reductions that had been proposed in the areas of health, social services, transportation, and education spending and reduced reliance on deficit bonds. Specifically, the administration:

• Dropped the January proposals to eliminate the IHSS state-only residual program, and instead pursued a federal waiver that would result in federal participation in the program.
• Rescinded the proposals to (1) reduce Medi-Cal provider rates by 10 percent, and (2) establish enrollment caps and block grants for various health and social services programs.
• Reduced planned sales of Proposition 57 bonds by $1 billion (from $12.3 billion to $11.3 billion). This preserves a like amount of bonding authority to cover spending in 2005-06 and beyond.

In other areas, the administration eliminated proposals to transfer transportation funds to the General Fund and modified the proposal to suspend Proposition 42 payments. Under the revised plan, the Proposition 42 suspension was replaced by a "loan" from transportation funds. In effect, the amount owed to transportation, along with interest, was proposed to be deferred until 2007-08.

The budget also replaced the $400 million unallocated reduction in corrections primarily with a proposed reduction in employment compensation through renegotiation of existing collective bargaining agreements with correctional officers and other state employees. The administration proposed a law change requiring that 75 percent of court-ordered punitive damage awards be directed to the state's General Fund. Finally, the administration stated its intent that proceeds from bonds related to prospective tribal gaming agreements would be used to repay the loans from the Traffic Congestion Relief Fund (TCRF).

New Agreements. The May Revision embodied the Governor's agreement reached in the spring with local governments, and a compact with University of California (UC) and California State University (CSU). Under the local government agreement, the ongoing $1.3 billion annual property tax shift proposed in January was limited to two years. The agreement also included a complex swap of VLF "backfill" revenues for school district property taxes. In addition, the Legislature was asked to place before the statewide voters in November a constitutional amendment. This amendment would restrict the state's authority to: (1) reduce noneducation local government taxes, except for the $1.3 billion shift of property taxes from these agencies for the benefit of the state budget in 2004-05 and 2005-06 and (2) impose mandates without providing annual reimbursements.

Under the compact with higher education, UC and CSU would receive future funding increases for base support and enrollment increases. The compact also calls for annual increases in student fees, which would be retained by the segments. Finally, it commits the segments to provide annual reports on a variety of activities and outcomes.

Final Budget

Following the May Revision, the Conference Committee met to reconcile the budget differences of the two houses. Following conference actions and approximately six weeks of negotiations between the Governor and legislative leadership, an agreement was reached in late July. The budget was passed by the Assembly on July 28 and the Senate on July 29. After using his line-item veto authority to delete about $116 million ($80 million General Fund) in spending, the budget was signed by the Governor on July 31, 2004.

Comparison to the May Revision. As indicated in Figure 6, the final budget package includes several key provisions from the Governor's May