Sitemap

May 15, 2007

Overview of the 2007-08 May Revision

The administration released its May Revision yesterday, identifying over $2 billion in new budget solutions to address a comparable level of increased budgetary problem. In this document, we provide our initial assessment of the problem definition and the viability of the administration’s proposed solutions.

Summary

Major Changes in the May Revision

Changes in Revenues and Expenditures Since January. The administration’s estimates for major tax revenues are down $243 million combined over the current and budget years since January. Stronger-than-expected 2006-07 revenue growth is more than offset by weakness in 2007-08. General Fund costs are higher for Proposition 98 and prisons. The administration has also provided a more realistic estimate of gambling revenues and delayed the sale of pension obligation bonds.

New Budget Solutions. These factors led to the administration putting forward over $2 billion in new budget solutions. The administration proposes to sell EdFund, capture tobacco securitization revenues now rather than over time, expand a redirection of public transit funds for General Fund purposes, and eliminate a scheduled increase for Supplemental Security Income/State Supplementary Program (SSI/SSP) recipients.

Reserve. Under the administration’s estimates, the state would end the budget year with a reserve of $2.2 billion.

LAO Comments

Revenue Estimate Reasonable. The administration’s revenue forecast for the state’s major revenues is reasonable. While our estimates for individual taxes differ from the administration’s, offsetting forecasts result in similar totals.

Reserve Likely Overstated by $1.7 Billion. The May Revision makes a number of optimistic assumptions about its proposals—such as the legality of its public transit proposal, its estimates of gambling and property tax revenues, and assumed savings from midyear reductions. In total, we estimate that the Governor’s reserve is likely overstated by $1.7 billion, and the May Revision would leave only a $529 million reserve. This reduced reserve would be subject to additional risks and cost pressures.

Out-Year Problem Has Worsened. We estimate that, under the Governor’s proposals, state expenditures would exceed revenues by more than $3 billion in 2007-08. This shortfall would grow to more than $5 billion in 2008-09 due to a number of one-time solutions contained within the May Revision.

Focusing on Eliminating Deficit-Financing Bond Debt Should Not Be an Immediate Priority. The administration continues to dedicate $1.6 billion in supplemental appropriations to pay off the state’s deficit-financing bonds early. This would help the state’s budget beginning in 2009-10. Due to the precariously balanced 2007-08 budget, we believe these funds could be better used in addressing near-term budget problems.

LAO Bottom Line

The administration has attempted to address a $2 billion decline in the state’s fiscal outlook. Due to several overly optimistic assumptions, however, the May Revision overstates its reserve by about $1.7 billion—leaving an estimated reserve of $529 million. Even this reserve level would be subject to considerable risks and pressures. As a result, the Legislature will face a significant challenge to develop a 2007-08 budget that realistically reflects revenues and spending while maintaining a prudent reserve. As it sets its own priorities, it should identify solutions that realistically balance the state’s finances on an ongoing basis while also avoiding new ongoing commitments (absent identified funding to pay for them).

Major Features of the May Revision

In order to address a shortfall between the state’s revenues and expenditures, the Governor’s January budget proposed a number of budget-balancing actions, including a major redirection in transportation funds and significant reductions in social services. Since January, the administration’s view of the budget outlook has worsened by more than $2 billion. Consequently, it has proposed new solutions to offset these higher costs and lower revenues. These changes are summarized in Figure 1.

 

 

General Fund Condition

Figure 2 shows the administration’s estimate of the General Fund’s condition taking into consideration its May Revision proposals. It shows that the current fiscal year began with a prior-year balance of $10.5 billion. Consequently, even though current-year spending is expected to exceed revenues by $6.1 billion, the administration projects that the state will start 2007-08 with a balance of $4.4 billion. In the budget year, expenditures would exceed revenues by $1.5 billion. The administration estimates the state would end the budget year with a reserve of $2.2 billion. This is slightly more than the $2.1 billion reserve assumed in the January budget proposal.

 

 

Changes in Revenues

The administration’s new revenue forecast projects stronger current-year tax revenues than in January, but this increase would be more than offset by downward adjustments in the budget year. Specifically, the current-year estimate shows increased revenues from major sources of $563 million—driven by improved personal income tax and corporation tax revenues. The struggling housing market and other economic factors have led the administration to reduce its budget-year estimate by $806 million. Personal income, sales, and insurance tax revenues are all assumed to be lower, partially offset by stronger corporation tax revenues.

Changes in Expenditures

Compared to the Governor’s January budget, proposed expenditures for the budget year are up $624 million. The major increases in budget-year expenditures since January are due to:

• Added General Fund spending to: (1) meet the higher 2007-08 Proposition 98 minimum guarantee ($104 million), and (2) reflect the altered treatment of a proposal to redirect public transit funds to benefit the General Fund ($627 million).

• Recognition that the pension obligation bonds will not be sold in 2007-08. The bonds were proposed to reduce General Fund retirement payments by $273 million (as well as increase revenues by $252 million). The administration now assumes the sale will occur in 2008-09.

These increased costs are partially offset by a proposed suspension of a January 2008 SSI/SSP cost-of-living adjustment (COLA) (reducing spending by $185 million).

Economic and Revenue Forecast of the May Revision

Economic Forecast

The economic forecast underlying the May Revision’s fiscal estimates assumes that both the nation and California will experience continued, though modest, economic growth over the next couple of years. As shown in Figure 3, the state’s economy is expected to experience slower growth than in 2006, with personal income growth averaging in the mid-5-percent range and growth in jobs well under 2 percent. Growth will be slowest in 2007, in part due to the drag on the economy associated with the housing market’s problems, before strengthening in 2008 and beyond. The May Revision’s forecast for continued modest economic growth reflects the consensus views of most economists at this time.

Revenue Forecast

The May Revision projects that General Fund revenues and transfers will total $96.2 billion in 2006-07 and $102.3 billion in 2007-08, for a budget-year growth of $6.1 billion (6.4 percent). This represents a two-year increase of $1.1 billion over the amount of revenues forecast in January 2007 in the 2007-08 Governor’s Budget, reflecting the administration’s EdFund and tobacco securitization proposals—partially offset by the decline in the state’s major tax revenues. Figure 4 summarizes the changes, which are discussed in more detail below.

 

 

• Corporation taxes were revised up by over $640 million for the two years combined. This reflects the recent healthy performance of corporate profits and greater-than-projected revenue receipts from them collected since January. Through April, for example, corporate tax receipts were $564 million above expectations.

• Sales and use taxes have been revised down by almost $500 million, all of which occurs in the budget year. Of this amount, over one-half is due to a weaker economy, while over $200 million reflects a higher spillover into the Public Transportation Account (PTA) primarily caused by increased retail gasoline prices.

• Personal income taxes are down a net of about $160 million. Revenues are up in the current year and down in the budget year.

• Insurance taxes are down by over $225 million, primarily reflecting a recent Board of Equalization ruling regarding how the timing of insurance premium receipts are treated.

• Other revenues and transfers are up by about $1.4 billion, including $0.6 billion in the current year and $0.8 billion in the budget year. This includes gains of $1 billion from the sale of EdFund and nearly $960 million in tobacco securitization revenues, and reductions of about $250 million associated with pension obligation bonds and close to $200 million in tribal gambling receipts. We discuss the tobacco securitization revenues in more detail in the nearby box.

LAO Assessment of May Revision Economic and Revenue Forecasts

We find that the May Revision’s economic and revenue forecasts are generally reasonable in light of the uncertainties that characterize both the economy and revenue picture. Our own revised economic forecast, while a bit stronger than the administration's in some areas, is similar in its general thrust—continued modest economic expansion with weakness in 2007 and strengthening thereafter. Likewise, our revenue forecast, while different for many of the state’s individual revenue sources, has a similar bottom line. Thus, from this perspective, the administration's projections are reasonable.

The economic and revenue outlooks face two main uncertainties. First is the economic uncertainties associated with the outlook for the housing market in light of recent sales declines, foreclosures, and price reductions. Second is the future path of crude oil and retail gasoline prices. Adverse developments in these areas could significantly impact both overall economic performance and state revenues. Likewise, key elements of the revenue base, such as capital gains and stock options, are highly volatile and, therefore, difficult to accurately predict. As shown in Figure 5, the administration is projecting that capital gains and stock options will experience modest growth in the near future. Relatively small differences in actual growth rates, however, could generate revenue swings of hundreds of millions of dollars.

 

Increased Revenues From Tobacco Bonds Tobacco Securitization. Under the terms of a 1998 agreement which California and most other states signed with four leading tobacco companies, the state receives annual tobacco settlement revenue (TSR) payments in perpetuity, including an estimated $10-plus billion over the first 25 years. In 2003, to help balance the state’s budget, the state converted a portion of this future TSR stream into an upfront payment of $4.5 billion. In return, those investors who provided the $4.5 billion will be repaid over time, with interest, from the TSRs when they are actually received. A second round of tobacco securitization was done in 2005. Refinancing Yields More Revenues Than Expected. The Governor’s January budget proposal assumed that the previously issued tobacco bonds would be refinanced to take advantage of lower interest rates and other favorable market conditions. The budget assumed that the refinancing would raise an additional $900 million, which for budgetary purposes would be transferred to the General Fund on the following schedule: $300 million in 2007-08, $450 million in 2008-09, and $150 million in 2009-10 (connected to the timing of increased costs for payments to schools under the Quality Education Investment Act). Ultimately, the refinancing raised an additional $357 million beyond what was assumed in January, for a total of $1.257 billion. May Revision Proposes to Accelerate General Fund Benefit. The May Revision proposes to transfer these bond proceeds to the General Fund entirely in 2006-07 ($600 million) and 2007-08 ($657 million). Thus, the May Revision includes $957 million in current- and budget-year revenues beyond what was assumed in January. By accelerating the transfers to the General Fund, this proposal worsens the state’s operating deficit in 2008-09 and 2009-10 relative to January’s schedule.

Programmatic features of the May Revision

Figure 6 provides information on the major programmatic features of the May Revision affecting the General Fund. Below, we discuss the administration’s proposals related to Proposition 98, EdFund, and transportation.

 

 

Proposition 98—K-14 Education

Figure 7 compares the Governor’s revised budget for 2006-07 with the revised budget for 2007-08. As shown in the figure, Proposition 98 funding increases by $2.2 billion, or 3.9 percent, year over year. Two-thirds of this increase is covered with higher property tax revenues whereas one-third is covered with additional General Fund support. Using revised attendance estimates, the overall Proposition 98 increase translates into a 4.4 percent increase in K-12 per pupil spending and less than a 1 percent increase in community college spending per student.

 

 

Major Proposition 98 Adjustments. The Governor’s May Revision makes Proposition 98 adjustments to 2005-06, 2006-07, and 2007-08. For 2005-06, it increases the General Fund share of Proposition 98 by $316 million, due primarily to a downward adjustment in local property tax revenues. (See box below for information on this issue.) For 2006-07 and 2007-08, the May Revision increases the Proposition 98 minimum guarantee by $372 million and $104 million, respectively, due to healthier-than-expected General Fund revenues. These adjustments to the current year and budget year are shown in Figure 8.

 

 

 

Uncertainty Regarding Historical Property Tax Receipts Approximately one-third of local property taxes are currently allocated to local schools (including community colleges). Virtually all these property tax receipts offset dollar-for-dollar the state’s General Fund financing obligations under Proposition 98. The LAO property tax growth forecast for 2007-08 is lower than that of the Department of Finance (DOF). This is due to different assumptions about the effect of the real estate slowdown and the amount of property tax receipts that will flow to local schools. For this reason, the LAO General Fund forecast for Proposition 98 is $190 million higher than that of the DOF. Beyond this budget-year forecasting difference, there is also a serious risk related to baseline property tax revenues. During the 2005-06 fiscal year, the growth in property tax receipts received by K-12 school districts was significantly lower than the growth in overall property tax receipts around the state. This shortfall led to a gap of approximately $280 million between actual receipts and the budgeted amount. (The May Revision recognizes these higher costs.) There are a number of possible reasons for this difference and the state has experienced some differences between these growth rates in prior years. However, the shortfall in growth rates during 2005-06 was unprecedented by historical standards, and we do not yet understand the reasons it happened. The allocation of property tax revenues has been particularly complicated in recent years (due to such factors as the vehicle license fee swap, two-year property tax shift in 2004-05 and 2005-06, the “triple flip,” and the growth of redevelopment). This potentially explains some of the problem. Year-to-year timing differences between the collection of revenues by counties and the receipt of revenues by schools could also explain the 2005-06 shortfall. It is possible, for instance, that additional receipts may flow to the schools during the 2006-07 fiscal year, which may counterbalance the low growth in 2005-06. In making its Proposition 98 baseline forecasts, DOF has assumed that this rebound will occur, and also that it will be large enough in magnitude to compensate for the effects of the lower receipts in 2005-06. There is, however, a significant chance that the shortfall will not be fully compensated by higher growth in 2006-07. As a result, the state could face up to $310 million in additional 2006-07 Proposition 98 General Fund spending and $350 million in additional 2007-08 spending.

Major Changes in Ongoing Proposition 98 Spending

As shown in Figure 9, the May Revision totals include several changes to the Governor’s budget. Of greatest magnitude, the administration proposes to restore Proposition 98 funding for the Home-to-School Transportation program ($627 million) and fully fund the Proposition 98 minimum guarantee. The Governor’s budget initially had proposed to reduce Proposition 98 funding for the program and lower the guarantee. The May Revision provides $247 million to increase the K-14 COLA from the January estimate of 4.04 percent to the final rate of 4.53 percent. It also reduces support for community college apportionments by $80 million to adjust for unrealized enrollment. It makes no change to the administration’s January proposal to increase Proposition 98 funding for child care by $269 million, and it continues to provide virtually no funding for the ongoing cost of mandates (estimated to be about $185 million in 2007-08).

 

 

Expands Programs and Creates New Programs. Whereas the Governor’s budget funded no ongoing program expansions or new ongoing programs, the May Revision proposes numerous ongoing initiatives. Building off of current-year initiatives, it includes $50 million for expanding preschool, $25 million to fund a higher reimbursement rate for the school meals program, and $25 million for hiring additional counselors focused on career technical education. It also includes slightly more than $100 million for about a dozen other special ongoing initiatives. The May Revision also redirects $100 million from the High Priority School Grant Program (HP Program) to two new initiatives—hiring new career technical education teachers ($50 million) and new teachers of college preparatory classes ($50 million). The administration states that this redirection has been agreed to by the plaintiffs in the Williams settlement.

Technical Error Creates $366 Million Problem. The May Revision also makes attendance-related adjustments to K-12 education and community colleges. For K-12 education, it adjusts average daily attendance (ADA) upward by slightly more than 19,000 in the current year and almost 14,000 in the budget year. Despite these ADA increases, the May Revision scores $293 million in attendance-related savings relative to the Governor’s budget. We determined that this reduction was due to a technical error whereby the $350 million provided in the current year for revenue limit equalization was not carried forward, thereby understating the costs to the base budget for 2007-08. After adjusting for the 2007-08 COLA, this $366 million error can be addressed by: (1) making reductions to Proposition 98 spending of a comparable amount to stay at the minimum guarantee, (2) using special fund or one-time Proposition 98 monies to increase K-14 funding while still staying at the minimum guarantee, or (3) identifying other General Fund monies and appropriating above the guarantee. For community colleges, the May Revision reduces apportionments by $80 million to account for unrealized enrollment.

LAO Approach. In constructing the Proposition 98 ongoing package, we recommend the Legislature cover baseline costs (such as mandates and other already authorized programs) prior to funding new programs. We also recommend covering the $366 million attendance-related cost within the Proposition 98 minimum guarantee. To cover this cost, we recommend rejecting all of the Governor’s new ongoing proposals. Rejecting all of these proposals, however, still leaves more than $200 million in unfunded attendance-related costs. We recommend using one-time Proposition 98 funds to cover this remaining shortfall. In addition, rather than redirecting HP funds to new initiatives, we recommend augmenting Economic Impact Aid. Such an approach would allow districts serving low-income students and English learners to determine what types of additional teachers and services likely would be most effective.

Major Changes in One-Time Proposition 98 Spending

As shown in Figure 10, the May Revision contains $542 million in additional one-time funds. Coupled with the one-time funds provided in the Governor’s budget, over $800 million is available for one-time K-14 expenses. This amount is split about evenly between current-year “settle-up” funds and Proposition 98 Reversion Account funds.

 

 

Proposed Uses of One-Time Funds. Of these funds, almost $200 million is provided for the Emergency Repair Program, $100 million is provided for a special initiative relating to school safety plans, and $100 million is provided for K-12 and community college career technical equipment. Other sizable proposals include $65 million for assisting districts in providing the state with student-level data, $50 million for community college nursing programs, $50 million for teacher recruitment and retention, slightly less than $50 million to cover deficiencies in mandatory supplemental i