California Spending Plan 2005-06

The Budget Act and Related Legislation

Chapter 1

The 2005-06 Budget-The Problem and The Solution

Despite improving revenues, California policymakers continued to face significant fiscal challenges in preparing the 2005-06 budget. Although the projected budget shortfall for 2005-06 was considerably smaller than in the three prior years, the state’s ongoing structural budget problem remained a major concern. In this chapter, we (1) briefly review the factors behind the state’s ongoing budget shortfall, (2) highlight the major budget solutions included in the 2005-06 budget package, and (3) provide preliminary estimates of how the actions adopted in the 2005-06 budget will affect the fiscal outlook for 2006-07 and beyond.

Factors Behind Shortfall

California has faced large structural budget shortfalls-that is, persistent operating deficits where annual expenditures have exceeded revenues-since 2001-02, when revenues plunged following the recession and the steep decline in the stock market. Although revenues subsequently improved and some progress was made toward addressing the structural shortfall in the 2002-03 through 2004-05 budgets, policymakers were not able to agree on a sufficient amount of ongoing solutions to eliminate the structural problem. Instead, the 2002-03 through 2004-05 budgets relied heavily on one-time or limited-term solutions-such as borrowing, spending deferrals, and funding shifts-to achieve temporary balance. In addition to providing only temporary savings, many of these solutions resulted in additional future expenditures, as deferred spending and loan repayments come due. At the beginning of the current budget cycle, the state faced repayments on budget-related debt totaling $2 billion in 2005-06 and about $4 billion annually over the period 2006-07 through 2008-09.

Size of Budget Problem. In our November 2004 fiscal forecast, we estimated that the state faced a year-end shortfall in its 2005-06 General Fund budget of nearly $6.7 billion. We also estimated an operating deficit of around $7.3 billion in 2005-06, increasing to $10 billion in 2006-07 as various temporary savings expire and deferred obligations start coming due. In its January 2005 budget proposal, the administration identified an even-larger $8.6 billion projected year-end shortfall in 2005-06. These projected shortfalls declined in the subsequent months due to stronger-than-expected revenues realized in the spring of 2005 (related to both improved economic activity and large amnesty-related tax collections). As a result, by the time the budget was adopted, the projected year-end 2005-06 shortfall had narrowed to around $3.4 billion, and the ongoing structural shortfall in 2006-07 had dropped to slightly under $9 billion.

Budget Solution-Key Components

The 2005-06 budget package contains about $5.9 billion in solutions. These solutions are expected to eliminate the $3.4 billion budget shortfall and establish a $1.3 billion year-end reserve, while at the same time enabling the state to prepay the $1.2 billion vehicle license fee (VLF) “gap loan” from local governments (due in 2006-07). As shown in Figure 1, the solutions fall into four major categories-namely, program savings, fund shifts, loans and borrowing, and revenues from improved tax compliance.

Program Savings. About $4.1 billion of the solutions involve program savings. Nearly three-quarters of this total is from holding Proposition 98 funding for 2004-05 at the level provided in the 2004-05 budget, instead of providing additional funding to reflect revenue improvements since the budget’s enactment. Another $455 million is in social services, mostly related to the suspension of cost-of-living adjustments for California Work Opportunity and Responsibility to Kids and Supplemental Security Income/State Supplementary Program grants. The balance of the savings is from a variety of areas, including state operations, local property tax administration, and employee compensation.

Funding Shifts. About $728 million in General Fund savings are from funding shifts. These include $380 million from retaining certain sales taxes on gasoline (so-called “spillover funds”) in the General Fund instead of using them for public transit purposes. Other funding redirections include a shift of tideland oil revenues from special funds to the General Fund, and the use of federal funds instead of General Fund for certain prenatal care provided under the Medi-Cal Program.

Loans and Borrowing. Although the budget does not use additional deficit-financing bonds beyond those that already have been issued, it does include budget-related borrowing from two sources. First, it relies on a $428 million loan from Merrill Lynch to finance the settlement costs of flood-related litigation (the Paterno case) against the state. The first repayment of this loan occurs in 2005-06, resulting in net General Fund savings of $361 million from the loan. Second, the budget assumes the refinancing of previously issued tobacco settlement-backed bonds, raising $525 million.

Revenues. Although the budget does not include any new General Fund taxes, it does anticipate additional revenues of $94 million related to increased tax compliance efforts.

Out-Year Impacts of the 2005-06 Budget

The 2005-06 budget contains roughly $2 billion in ongoing budgetary savings. We estimate that these savings, coupled with the prepayment of the VLF gap loan, will reduce the projected 2006-07 operating shortfall between annual current law revenues and expenditures by roughly one-third-from around $9 billion to around $6 billion.

We will be updating our projections for 2005-06 and future years to reflect actions taken in the final month of the legislative session, as well as expenditure and revenue-related developments, in our annual publication entitled California’s Fiscal Outlook, scheduled to be released in November 2005.

Chapter 2

Key Features of the Budget Act and Related Legislation

The Budget Totals

Total State Spending

The state spending plan for 2005-06 includes total budget expenditures of $113 billion. This includes $90 billion from the General Fund and $23 billion from special funds. As Figure 1 shows, the combined spending total from these funds is up $9.3 billion (9 percent) from 2004-05.

The figure also shows that spending of bond proceeds jumped from $7 billion in 2003-04 to $14.6 billion in 2004-05, before falling back to $4 billion in 2005-06. Bond-fund expenditures reflect the use of bond proceeds on capital outlay projects in a given year (or, in the case of education bonds, the allocation of the bond authority to specific local projects by the State Allocation Board). The costs associated with debt service on the bonds are included in the General Fund and special funds spending totals. The one-time jump in bond spending in 2004-05 largely reflects the allocation of K-12 education bonds (approved by voters in 2004) to specific projects.

The General Fund Condition

Figure 2 summarizes the estimated General Fund condition for 2004-05 and 2005-06 that results from the adopted spending plan.

2004-05. The figure shows that 2004-05 began with a prior-year balance of $7.3 billion. This large balance was boosted by a net of $3.8 billion in receipts directly and indirectly related to the tax amnesty program adopted in conjunction with the 2004-05 budget (see box below). These payments were received in the spring of 2005, but since they were related to tax liabilities in 2002 and prior years, they were accrued back to the earlier years and reflected as an increase to the 2004-05 carry-in balance. All but $380 million of the $3.8 billion increase is expected to be offset by lower collections related to audits during the 2004-05 through 2006-07 period. A more complete discussion of the fiscal impacts of the amnesty program is included in the box.

The figure also shows that revenues totaled $79.9 billion, or about $1.8 billion less than the $81.7 billion in expenditures, during the year. In addition, the state used $2 billion of deficit-financing bond proceeds. (To date, the state has sold $11.3 billion of the $15 billion in deficit bonds authorized by California voters in March 2004.) After accounting for $641 million in encumbrances (that is, contracts and other spending commitments made in 2004-05 which will be liquidated in 2005-06), the year closed with a reserve of $6.9 billion.

2005-06. Figure 2 shows that revenues are projected to increase by 5.7 percent in 2005-06, to $84.5 billion, while expenditures are projected to increase by 10 percent, to $90 billion during the year. This results in an operating deficit of $5.6 billion. This, in turn, lowers the projected 2005-06 year-end reserve to $1.3 billion.

Programmatic Spending in 2005-06

Figure 3 shows General Fund spending by major program area for the 2003-04 through 2005-06 period. It shows that K-12 spending is the single largest area, accounting for nearly 40 percent of the General Fund total. Higher education, health, social services, and criminal justice spending account for most of the balance of all spending.

The figure shows that, despite the savings actions adopted in the budget (and discussed in “Chapter 1”), expenditures are still projected to increase by over 10 percent in 2005-06-about double the rate of population growth and inflation in the state. As discussed below, this large increase reflects both
(1) ongoing growth in key state programs and (2) a variety of special factors.

Ongoing Program Growth. We estimate that roughly one-half of the total General Fund spending growth is the result of significant spending increases for a variety of state programs. For example, the budget increases per-pupil funding for both K-12 and community college education. It also funds the Governor’s compact for University of California (UC) and California State University (CSU), and provides a 6 percent general cost-of-living adjustment (COLA) for trial courts. The budget also reflects increased costs and utilization in the state’s ongoing Medi-Cal and related health care programs.

Special Factors. The other half of the spending increase is related to such factors as restorations in spending that had been deferred or suspended in 2004-05, and the payment of obligations incurred in prior years. These factors include:

• Proposition 42 Transfer. This transfer of sales taxes on gasoline to transportation special funds was deferred in 2003-04 and 2004-05 but is fully funded in 2005-06. This results in an added cost to the General Fund of $1.3 billion in the current year.

• Prepayment of Vehicle License Fee (VLF) “Gap Loan.” The budget provides $1.2 billion in one-time funds to prepay a loan from local governments that was due in 2006-07. The loan is related to state VLF “backfill” payments to local governments (that is, payments that were made to local governments to compensate them for the reduction in revenues that occurred when the state lowered the rate on vehicle license fees). A portion of these backfill payments had been deferred in late 2002-03 and early 2003-04.

• Mandate Payments. The budget funds about $239 million in mandates, substantially more than provided in 2004-05. About one-half of the total is related to two mandates requiring services for special education pupils, and is included in the Department of Mental Health’s budget.

• “One-Time” Payments Related to Property Tax Shifts. A part of the 2004-05 budget package was a “swap” between the state and local governments, whereby the state stopped funding VLF backfill payments in return for a shift of property taxes from schools to local governments (the school property taxes are replaced with General Fund payments). Payments related to this swap are resulting in a one-time increase in General Fund spending for K-14 education, anticipated in the budget to be over $300 million in 2005-06.

General Fund Spending Over Time

Figure 4 shows General Fund expenditures from 1990-91 through 2005-06 both in current dollars and as adjusted for population and inflation (that is, in real per capita terms). The figure indicates that after growing rapidly in the late 1990s, General Fund spending fell modestly during the 2001-02 through 2003-04 period, before resuming an upward trend in 2004-05. Total spending in 2005-06, is now 15 percent higher than the peak reached in 2000-01. Adjusted for inflation and population, however, real per capita spending is 8 percent below the 2000-01 peak.

Evolution of the Budget

In this section, we highlight the major developments in the evolution of the 2005-06 budget, beginning with the original Governor’s January budget proposal and ending in July 2005, when the budget was signed into law.

Governor’s January Proposal for 2005-06

In January 2005, the Governor proposed a 2005-06 General Fund budget which contained about $9.1 billion in solutions in order to both cover an estimated budget shortfall of $8.6 billion and maintain a $500 million reserve. This budget plan would also have reduced the state’s ongoing structural budget shortfall by roughly one-half-from $10 billion to under $5 billion per year. Figure 5 outlines the key savings contained in the original January budget plan.

Program Savings ($4.7 Billion). Of this total, about $2.3 billion was related to the two-year effect of holding the 2004-05 funding level for K-14 education at the level included in the 2004-05 Budget Act. Roughly $1 billion was related to reductions in social services. This included: (1) a 6.5 percent reduction in California Work Opportunity and Responsibility to Kids (CalWORKs) grants, (2) the elimination of CalWORKs grant COLAs, (3) the suspension of the state COLA for Supplemental Security Income/State Supplementary Program (SSI/SSP) (including no pass-through of the federal COLA), and
(4) the reduction in the state’s contribution to the wages of In-Home Supportive Services (IHSS) workers. Other savings included an increase in state employee pension contributions and other compensation-related savings, the suspension of various local mandates, the elimination of the senior citizens’ property tax assistance program, and a reduction in the senior citizens’ renters assistance program.

Funding Shifts ($0.9 Billion). The budget included three proposals in this area. First, the budget proposed that the state no longer fund annual base program contribution costs for the State Teachers’ Retirement System (STRS). Instead, these costs would be borne by the schools districts or their employees. Second, the budget proposed to retain Public Transportation Account “spillover” funds in the General Fund in 2005-06, instead of using them for public transit purposes. Third, the budget proposed to replace General Fund support for certain prenatal care services with new federal funds.

Loans and Borrowing ($3.4 Billion). The budget proposed to use $1.7 billion in deficit-financing bonds-about one-half of the amount remaining from the $15 billion authorized by voters in March 2004. It proposed to suspend the $1.3 billion Proposition 42 transfer of sales taxes on gasoline from the General Fund to transportation funds. The suspended amount would be paid over a
15-year period. It also assumed that the state would issue a “judgment bond” to finance a $464 million settlement of flood-related litigation (the Paterno case) against the state.

Tax Compliance ($0.1 Billion). The budget assumed a net gain of about $94 million related to tax compliance measures.

Other Features. In other areas, the budget provided increased funding for UC and CSU consistent with the Governor’s compact with higher education. It also included a series of changes to the Medi-Cal Program, including expansion of managed care for families and kids as well as the aged and disabled, new premiums for certain beneficiaries, and an imposition of a cap on adult dental services. It also included significant funding increases for judiciary and criminal justice areas.

May Revision

In the months following the release of the January budget plan, the state revenue picture improved significantly. The May Revision used these revenues to reduce borrowing and increase spending in a limited number of areas. The key changes incorporated in the May Revision plan are highlighted in Figure 6.

Improved Revenues. The May Revision assumed a $4.2 billion improvement in the revenue outlook. Of this total, about $4 billion was related to higher-than-expected tax liabilities, mostly from the personal income tax. The balance-$180 million-was related to an increase in the amount of net proceeds from the tax amnesty programs that had been adopted with the 2004-05 budget.

New Proposals. The May Revision reduced borrowing in two key areas. First, it eliminated the sale of $1.7 billion in deficit-financing bonds proposed in January. Second, it proposed to prepay one-half of the outstanding VLF gap loan from local governments. The key spending proposals were
(1) a restoration of the $1.3 billion Proposition 42 transfer, (2) $250 million in Proposition 98 “settle-up” payments (related to underpayments of the minimum funding guarantee in prior years), and (3) restoration of funds for the senior citizens’ property tax and renters’ assistance programs.

The May Revision retained most of the other January savings proposals, including those related to Proposition 98 education funding, CalWORKs and SSI/SSP grants, IHSS wages, employee compensation, and the STRS contributions. Within Proposition 98, it used the settle-up funds along with savings related to lower enrollment to fund a modest expansion of class-size reduction and a variety of other initiatives. It also retained most of the January proposals related to limited Medi-Cal reform, as well as funding increases for higher education and the judiciary.

Final Budget

Following the May Revision, the Conference Committee met in June to reconcile the budget differences of the two legislative houses. Following conference actions and subsequent negotiations between the Governor and legislative leadership, an agreement regarding the budget was reached in early July. The resulting budget was passed by both houses of the Legislature on July 7. After using his line-item veto authority to delete about $320 million ($114 million General Fund) in spending, the Governor signed the budget on July 11, 2005.

Comparison to the May Revision. The final budget package reflects a number of elements of the Governor’s May Revision plan. It funds Proposition 98 at the May Revision level, contains funding increases for CSU and UC which are consistent with May Revision, and incorporates some of the Medi-Cal changes proposed by the Governor.

However, the final budget also contained some significant changes from the May Revision (see Figure 7). Specifically, it provides for full versus one-half repayment of the VLF gap loan, fully funds the General Fund contribution to STRS, contains only modest reductions related to employee compensation, and includes smaller reductions in social services spending than proposed by the Governor. In the social services area, while the budget suspends state COLAs for both CalWORKs and SSI/SSP grants in 2005-06 and 2006-07, it does not include the Governor’s proposed 6.5 percent reduction in CalWORKs grant levels. Nor does it include the Governor’s proposal to permanently eliminate the statutory CalWORKs COLA or reduce the state’s IHSS wage contribution. The enacted budget also passes-through the federal COLA for SSI/SSP, but with a three-month delay.

In Medi-Cal, the budget expands managed care to additional counties, but generally rejects the administration’s proposal to require the enrollment of aged and disabled beneficiaries in managed care. It also does not include the administration’s proposal to require certain Medi-Cal beneficiaries to pay monthly premiums.

Finally, the final budget does not include $250 million in settle-up payments to schools. These funds were redirected to support the state’s contribution to the STRS program.

How Added Spending Relative to May Revision Was Financed. The additional spending resulting from the changes in the final budget noted above was partly supported by funding redirections. For example, the budget does not include $250 million in settle-up payments to schools that had been proposed in the May Revision. These funds were redirected to support the state’s contribution to the STRS program. Other financing sources included: (1) an increase in the 2004-05 revenue estimate, reflecting stronger-than-expected cash receipts in May; (2) a higher local property tax estimate, which lowers the General Fund spending requirement for Proposition 98; and
(3) a slightly lower 2005-06 year-end reserve.

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 previous sharp decline in revenues, the level of state spending is now well below the spending limit. Specifically, state appropriations were $7.6 billion below the limit in 2004-05 and, based on the revenue and expenditure estimates incorporated in the 2005-06 budget, are expected to be $11.3 billion below the limit in 2005-06.

Budget-Related Legislation

In addition to the 2005-06 Budget Act, the budget package includes a number of related measures enacted to implement and carry out the budget’s provisions. Figure 8 lists these bills at the time of budget enactment. The Legislature also considered various cleanup bills at the end of session, including SB 65 (Committee on Budget and Fiscal Review)-related to education.

Chapter 3

Expenditure Highlights

Proposition 98

The budget package includes $50 billion in Proposition 98 spending in 2005-06 for K-14 education. This represents an increase of $3 billion, or 6.4 percent, from the revised 2004-05 spending level. Figure 1 summarizes the budget package for K-12 schools, community colleges, and other affected agencies. As discussed later, the enacted budget package also includes an additional $407 million in one-time funds for K-14 education ($382 million for K-12 and $25 million for community colleges) needed to meet prior-year Proposition 98 obligations.