September 2006

California Spending Plan 2006-07

Contents

Chapter 1 Overview of the 2006-07 Budget

Programmatic Features of the 2006-07 Budget

Budgetary Debt and the 2006-07 Budget

Out-Year Impacts of the 2006-07 Budget

Chapter 2 Key Features of the Budget Act and Related Legislation

The Budget Totals

Evolution of the Budget

State Appropriations Limit

Budget-Related Legislation

Chapter 3 Expenditure Highlights

Proposition 98

Higher Education

Health

Social Services

Judiciary & Criminal Justice

Transportation

Resources and Environmental Protection

Capital Outlay

Other Major Provisions

Chapter 1

Overview of the 2006-07 Budget

The 2006-07 budget sharply increases funding for education, provides targeted increases in several other program areas, and prepays nearly $3 billion in budgetary debt incurred during the 2002-03 through 2004-05 fiscal years. The expanded commitments included in this spending plan are in striking contrast to the four previous years, when policymakers were faced with closing major budget shortfalls. This turnaround has been made possible by much stronger-than-expected revenues. As one indication of this strength, between mid-2005 and mid-2006, the revenue estimates for the 2004-05 through 2006-07 fiscal years rose a combined total of $17 billion (see Figure 1), reflecting much better-than-expected performances from the personal income tax and corporation tax.

The revenue improvement that occurred in 2003-04 through 2005-06-when combined with past budget-related borrowing and various one-time and ongoing savings enacted in the 2003-04 through 2005-06 budgets-resulted in the accumulation of over $9 billion in carry-over balances that were available to support spending in 2006-07. The 2006-07 budget uses over $7 billion of these carryover balances, along with $94 billion in revenues projected in 2006-07, to finance over $101 billion in spending during the year, 9.5 percent more than in 2005-06.

Programmatic Features of the 2006-07 Budget

Key programmatic features of this budget are as follows:

• Allocates $7 billion in new funds for K-12 Proposition 98 education, resulting in an over 11 percent increase in per pupil funding relative to the level provided in the 2005-06 Budget Act.

• Provides an over 10 percent General Fund increase for California Community Colleges, including funds for district equalization, block grants to districts, and for the backfill of foregone revenues resulting from a reduction in community college fees from $26 to $20 per unit beginning in spring 2007. With the 2006-07 increases, the state has met its goal of fully achieving equalization among the community college districts.

• Provides General Fund increases of 8.5 percent for the University of California and 7.4 percent for California State University, including additional General Fund support in lieu of planned fee increases for 2006-07.

• Provides the full $1.4 billion annual Proposition 42 transfer of sales taxes on gasoline to fund transportation programs, and it repays $1.4 billion of past Proposition 42 loans (that is, transfers which were deferred in 2003-04 and 2004-05).

• Includes largely one-time funding for hospitals to increase patient capacity to meet public health emergencies, such as an avian flu pandemic.

• Increases funding for county block grants for California Work Opportunity and Responsibility to Kids, child welfare services, and foster care.

• Includes funding for the pass-through of the federal January 2007 Supplemental Security Income cost-of-living adjustment, which-under the terms of the previous 2005-06 budget package-had been delayed until April 2007.

• Includes large increases to the Department of Corrections and Rehabilitation to cover inmate population increases and health-related costs.

• Includes added funding for local law enforcement and local flood control.

The budget does not include any major tax changes. However, it does include the administration’s proposals to extend two previously enacted measures for one year. These are (1) the suspension of the teachers’ tax credit and (2) an increase-from 90 days to one year-in the time period that vessels, vehicles, and aircraft purchased outside of California must be kept out of state to avoid the use tax.

Budgetary Debt and the 2006-07 Budget

The 2006-07 spending plan includes $2.8 billion in prepayments of budgetary debt that had been incurred in prior years. About one-half of the total is related to repayment of transportation loans (cited above and discussed in more detail in the transportation section). The remainder is accelerated repayments of other special fund loans that had planned repayment dates in the future. These include payments toward deficit-financing bonds (Proposition 57), local government mandate claims, and settle up of prior-year Proposition 98 obligations. Taking into account these prepayments, along with the new debt created by the Proposition 98 settlement (discussed below), the General Fund will have roughly $22 billion in budgetary debt outstanding at the close of 2006-07.

Other Actions Associated With the 2006-07 Budget

While not part of the budget package for 2006-07, agreements reached between the Governor and Legislature in three areas will have implications for General Fund spending, particularly in future years.

Proposition 98 Settlement. Following enactment of the budget, the Legislature approved a $2.9 billion settlement proposed by the administration relating to funds that some education groups claimed were owed to K-14 education for 2004-05 and 2005-06. Under this settlement, K-14 Proposition 98 will receive annual payments of $300 million in 2007-08 and $450 million per year beginning in 2008-09 until the obligation has been met.

Infrastructure Package. The Governor and Legislature reached agreement in late April on a bond package totaling $37 billion, to be submitted to voters for authorization in November 2006. These include $19.9 billion for state and local transportation projects, $10.4 billion for K-12 and higher education projects, $4.1 billion for various flood management programs, and $2.9 billion for housing and development programs. If approved, debt service on these four bonds would be roughly $100 million in 2007-08, rising to over $2.7 billion in future years when all the bonds were sold.

Collective Bargaining Agreements. The Legislature approved new agreements with 19 of 21 employee bargaining units. (All but one agreement were approved in August 2006.) These agreements result in $632 million ($270 million General Fund) in additional compensation costs during 2006-07. Most employees receive a 3.5 percent general salary increase in 2006-07, and some receive a one-time $1,000 bonus.

Out-Year Impacts of the 2006-07 Budget

The 2006-07 budget is balanced with a significant reserve. As noted above, however, revenues are over $7 billion less than expenditures in 2006-07, with the difference being covered by the drawdown of carryover reserves available from 2005-06. While nearly $3 billion of the difference is due to prepayments of budgetary debt, the remaining $4 billion-plus shortfall reflects ongoing difference between revenues and expenditures for General Fund programs. Based on our out-year estimates of revenues and expenditures, we estimate that this imbalance will continue in 2007-08 and 2008-09 absent corrective action, with annual operating shortfalls in the range of $4.5 billion and $5 billion projected for this period. We will be updating our projections for 2006-07 and future years to reflect economic, revenue, and expenditure developments in our annual publication entitled California’s Fiscal Outlook, scheduled to be released in November 2006.

Chapter 2

Key Features of the Budget Act and Related Legislation

The Budget Totals

Total State Spending

The state spending plan for 2006-07 includes total budget expenditures of $128.4 billion. This includes $101.6 billion from the General Fund and $26.9 billion from special funds. As Figure 1 shows, the combined spending total from these funds is up $11 billion (9.5 percent) from 2005-06. 

The figure also shows that spending of bond proceeds for capital outlay jumped from $5.6 billion in 2004-05 to $11 billion in 2005-06, before falling back to $3.6 billion in 2006-07. 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 2005-06 is primarily related to 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 2005-06 and 2006-07 that results from the adopted spending plan. 

2005-06. The figure shows that 2005-06 began with a prior-year carryover balance of $9.5 billion. This large balance is related to the sale of over $11 billion in deficit-financing bonds and other forms of budgetary borrowing in previous years, as well as the carryover of unanticipated revenues (associated with both higher tax liabilities and amnesty payments) received in 2003-04 and 2004-05. The figure also shows that revenues and expenditures were an identical $92.7 billion during 2005-06, leaving the fund balance at the end of the year at $9.5 billion, unchanged from the prior year. After accounting for $521 million in year-end funds encumbered by state agencies, the unencumbered year-end reserve was $9 billion.

2006-07. Figure 2 shows that revenues are projected to increase to $94.4 billion (1.7 percent), and that expenditures are projected to increase to $101.6 billion (9.5 percent). The $7.2 billion difference between expenditures and revenues is covered through the drawdown of the 2005-06 year-end reserve, leaving a remaining reserve of about $1.8 billion at the close of 2006-07. This total includes $472 million in the newly created Budget Stabilization Account (as required by Proposition 58, which was approved by the voters in 2004) and $1.3 billion in the Reserve for Economic Uncertainties.

Programmatic Spending in 2006-07

Figure 3 shows General Fund spending by major program area for 2004-05 through 2006-07. 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 total spending.

In terms of overall budget growth, the figure shows that General Fund expenditures are projected to rise by 9.5 percent between 2005-06 and 2006-07. Three sets of factors contribute to this increase: (1) one-time and ongoing program increases in education and selected other areas of the budget; (2) rising costs related to program utilization, health care costs, and caseloads; and (3) repayment of past budgetary debt. In terms of specific program areas:

• General Fund spending on transportation jumped by 76 percent between 2005-06 and 2006-07. The 2005-06 total includes the annual transfer of sales taxes on gasoline from the General Fund to transportation special funds. The 2006-07 total includes both the annual transfer and an additional $1.4 billion loan repayment associated with Proposition 42 transfers that had been deferred from earlier years.

• The second largest percentage increase is in criminal justice, where spending is being boosted by prison inmate population growth, rising health care costs, and targeted increases in spending for courts and local law enforcement.

• The third most rapid increase is in the area of health, reflecting rising costs and utilization of services, as well as largely one-time spending increases to deal with public health emergencies, in particular the threat of an avian flu pandemic.

• Higher education is projected to increase 9.4 percent. The 2006-07 totals include funds to cover both base increases (that is, growth to cover salaries and other cost increases) of over 5 percent plus enrollment growth for all three segments. The base increases for California State University (CSU) and University of California (UC) include General Fund monies to replace student fee increases previously planned for 2006-07. The budget also includes General Fund spending to offset a reduction in community college fees from $26 to $20 per unit beginning in spring 2007.

• K-12 education increases by 7.8 percent. While this is slightly less than the overall average, it is important to note that the gain follows a rapid 11.5 percent increase in 2005-06.

• All other spending increases by only 2.3 percent. The spending totals for both 2005-06 and 2006-07 include one-time expenditures for repayment of budgetary debt-that is, loans from schools, local governments, and the private sector in recent years.

General Fund Spending Over Time

Figure 4 shows General Fund expenditures from 1990-91 through 2006-07 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, real per capita spending fell significantly during the 2001-02 through 2004-05 period, before rebounding in 2005-06 and 2006-07. General Fund spending is now 30 percent higher than the peak reached in 2000-01. Adjusted for inflation and population, however, real per capita spending is still slightly below the 2000-01 peak.

Evolution of the Budget

In this section, we highlight the major developments in the evolution of the 2006-07 budget, beginning with the original Governor’s January budget proposal and ending in June 2006, when the budget was signed into law.

Governor’s January Proposal for 2006-07

Although the January budget was based on revenue projections that were less optimistic than the budget that was ultimately enacted in June, the budget proposal still was able to more or less fully fund a “current services” budget in most areas in 2006-07 and still have resources left over for other priorities. This improved outlook relative to previous years reflected both much stronger-than-expected revenues projected for 2005-06 and 2006-07 and the availability of large reserves carried over from 2004-05 (itself due to better-than-expected revenue performance, as well as budgetary borrowing and program savings in previous budgets).

Reflecting this improvement, the Governor’s budget proposed significant funding increases for K-12 and higher education and funding to cover caseload and cost increases in most other state programs. As shown in Figure 5, the budget for K-12 education fully funded enrollment and cost-of-living adjustments (COLAs) and provided an additional $1.2 billion in program spending. The increases were allocated to the equalization of school district funding, restoration of COLAs foregone in prior years, mandate payments, new teacher retention initiatives, and several other new categorical programs. The budget also included first-year funding of after school programs as required by Proposition 49.

In higher education, the budget included funds for the Governor’s compact with the UC and CSU systems, and included General Fund monies in lieu of 8 percent student fee increases that had been planned for 2006-07.

In the area of transportation, the budget made the full transfer of Proposition 42 revenues (that is, sales taxes on gasoline) to transportation funds, and included an additional $920 million of repayments for loans made from transportation funds in previous years.

Finally, the budget included funds for the phase-in of 150 new judgeships over three years and targeted increases in the correction’s budget for inmate and parolee programs.

The budget included targeted savings in social services and state operations. For example, it delayed the pass-through of the federal COLA to Supplemental Security Income/State Supplementary Program (SSI/SSP) grants from April 2007 to July 2008 (the pass-through had been previously delayed from January 2007 to April 2007 by legislation enacted with the 2005-06 budget). It also included reductions in funding for county administration of social services programs, child care, and welfare-to-work services. In state operations, the budget assumed unspecified savings of $158 million.

Governor’s Infrastructure Plan

In conjunction with the January budget, the Governor proposed a ten-year infrastructure plan. Areas of capital improvement included transportation, education, flood control and water supply, public safety and courts, and other public service infrastructure. The plan included $68 billion in new general obligation bonds, of which $25 billion would be submitted to the voters for authorization in 2006, and the balance to be authorized over the subsequent four election cycles.

Legislative Package Submitted to Voters. After several months of negotiations, the Governor and Legislature reached agreement in late April on a bond package totaling $37 billion, to be submitted to voters for authorization in November 2006. These include $19.9 billion for state and local transportation projects (Proposition 1B), $10.4 billion for K-12 and higher education programs (Proposition 1D), $4.1 billion for various flood management programs (Proposition 1E), and $2.9 billion for housing and development programs (Proposition 1C). In addition, the Legislature passed Chapter 34, Statutes of 2006 (AB 142, Nuńez), which appropriates $500 million for flood control.

May Revision

Major Revenue Improvement. In the months following the release of the January budget, the state revenue picture improved dramatically. Total receipts during the January-through-April period exceeded the budget forecast by well over $4 billion, with more than $3 billion of that gain occurring in April alone. While some of the increase appeared to be related to one-time transactions, the May Revision projected that some of the increase was ongoing as well. Its revised forecast of General Fund revenues was up from the January estimate by $4.8 billion in 2005-06 and $2.7 billion in 2006-07, for a two-year increase of $7.5 billion.

How New Revenues Were Allocated. As shown in Figure 6, the May Revision proposed that the additional $7.5 billion in revenues be used in three major ways.

• First, the administration proposed that about $4.3 billion of the total be used for spending on state programs. This included: additional Proposition 98 spending of $2.9 billion; largely one-time spending for hospitals of $400 million for public health emergencies such as an avian flu pandemic; and additional spending in the Department of Corrections and Rehabilitation of $500 million to cover inmate population increases and rising expenditures for health care.

• Second, the May Revision included an additional $1.6 billion in prepayments toward outstanding budgetary debt that had been accumulated in previous years. This included $1 billion toward outstanding deficit-financing bonds, as well as $600 million related to Proposition 98 settle-up payments and loans from special funds and local governments. Combined with the $1.6 billion already proposed in January, the additional proposed payments brought the total amount of loan repayments in the May Revision to $3.2 billion.

• Third, the May Revision included a 2006-07 year-end reserve of $2.2 billion, or $1.6 billion more than the $613 million reserve proposed in January.

Other Provisions. In addition to the 2005-06 and 2006-07 increases for Proposition 98, the May Revision proposed to settle a lawsuit related to $2.9 billion in Proposition 98 funding. Under the proposal, annual payments averaging roughly $400 million would be made over seven years, beginning in 2007-08.

Final Budget

Following the May Revision, the Senate and Assembly took actions on the revised proposal, and the budget was sent to Conference Committee to reconcile the differences between the houses. Following conference actions and subsequent negotiations between the Governor and legislative leadership, an agreement regarding the budget was reached in late June. The resulting budget was passed by both houses of the Legislature on June 27, 2006. After using his line-item veto authority to delete about $320 million ($114 million General Fund) in spending, the Governor signed the budget on June 30, 2006.

Comparison to the May Revision. The final budget package (see Figure 7) reflects a number of elements of the Governor’s May Revision plan. It funds Proposition 98 at a level that is roughly consistent with the May Revision, although it allocates funding within the overall Proposition 98 budget somewhat differently. For example, it provides additional funds for school district equalization and economic impact aid than proposed in the May Revision. It also combines a portion of the funding proposed in the May Revision for various categorical programs into block grants. In higher education, it adopts the Governor’s proposal to provide additional General Fund monies in lieu of planned student fee increases in 2006-07. In addition, it reduces community college fees from $26 to $20 per unit in spring 2007. As proposed in the May Revision, the final budget includes significant funding increases in corrections for inmate population growth and health care.

In other areas, it includes $190 million in largely one-time funding for hospitals to increase patient capacity to meet public health emergencies, or about one-half the $400 million proposed in the May Revision. It passes through the federal COLA for SSI/SSP grants in January 2007. These grants had been delayed until April 2007 under the 2005-06 budget package, and this delay was assumed in the May Revision. Finally, the final budget contains additional public safety funding for local governments.

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 $16 billion below the limit in 2005-06 and, based on the revenue and expenditure estimates incorporated in the 2006-07 budget, are expected to remain $16 billion below the limit in 2006-07. There are two main reasons that the state remains well below the limit in 2006-07 despite the large expenditure increase:

• First, about $7 billion of the 2006-07 expenditure increase is financed by a draw-down of reserves carried over from prior years. The limit is applied to the appropriations of tax proceeds (including appropriations into reserves but excluding appropriations out of reserves), thus, spending supported from previously accumulated reserves are not subject to the limit.

• Second, much of the increased funding that was supported by taxes is in areas, such as K-12 education and transportation, which are exempt from the state’s limit.

Budget-Related Legislation

In addition to the 2006-07 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 the budget enactment. Our current estimate of the General Fund’s condition also include the impacts of collective bargaining agreements and certain other legislation approved by the Legislature subsequent to the budget’s enactment.

Chapter 3

Expenditure Highlights

Proposition 98

The 2006-07 budget package includes $55.1 billion in ongoing Proposition 98 funding for K-14 education. This represents an increase of $5.2 billion, or 10.3 percent, from the funding level proposed in the 2005-06 Budget Act. Figure 1 shows Proposition 98 funding, by source, for K-12 schools, community colleges, and other affected agencies.

Budget Package Also Includes $2.8 Billion in One-Time Funds. As discussed in more detail later in this section, the budget package also includes an additional $2.8 billion in one-time funds for K-14 education ($2.5 billion for K-12 and $305 million for community colleges). Of these one-time monies, $2.3 billion is for meeting the higher 2005-06 Proposition 98 minimum guarantee (which increased after the 2005-06 budget was enacted due to higher-than-expected state tax revenues), $283 million is for settling up prior-year Proposition 98 obligations, and almost $250 million is from unspent prior-year Proposition 98 funds.

General Fund Share of Proposition 98 Driven by Property Tax Shifts. As shown in Figure 1, the budget assumes that $13.8 billion, or 25 percent of overall 2006-07 Proposition 98 spending, will be funded by local property taxes. The remaining 75 percent is supported by the General Fund. This is about the same proportional split as in the prior year. It is a significant increase, however, from 2003-04-when the General Fund share of Proposition 98 was roughly 65 percent. The increase in the General Fund share is due to various state-level decisions regarding the allocation of local property tax revenues between school districts and other local governments.

K-14 Education Credit Card Update

During the state’s recent difficult budget times, a number of actions were taken to defer spending or borrow funds. Specifically, as one of its midyear 2001-02 budget solutions, the Legislature decided to defer significant education program costs to the subsequent fiscal year. (Rather than a budget reduction, these deferrals resulted in districts receiving some program funds a few weeks later than normal.) In addition, the state delayed reimbursement of outstanding mandate cost claims dating back to 1995-96. Similarly, as of 2005-06, the state also had not fully restored ongoing revenue limit reductions made in 2003-04. We have referred to these outstanding debts as the education “credit card.”

Figure 2 shows that the budget makes significant progress in paying down the education credit card, reducing it by about 40 percent. Specifically, the 2006-07 Budget Act includes slightly more than $300 million to fully restore the revenue limit “deficit factor” and provides almost $1 billion to school districts and community colleges for the costs of prior-year mandates. Despite this progress, however, the budget includes only $34 million for 2006-07 K-14 mandate costs, which is approximately $120 million less than needed to cover all anticipated costs. In addition, the budget continues to defer to the subsequent fiscal year approximately $1.3 billion in K-14 costs.