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2013

Other Budget Issues

Last Updated: 2/26/2013
Budget Issue: Accrual method raises forecasting accuracy, Proposition 98, historical budget data concerns
Program: Revenues
Finding or Recommendation: Recommend that Legislature reject administration's proposed revenue accrual trailer bill, adopt temporary budget bill language concerning accruals, and direct administration to develop a simpler, logical revenue accrual method for future fiscal years.
Further Detail

Background

“Net Final Payment” Revenue Accrual Method. Pursuant to Control Section 35.50(e) of the 2012-13 Budget Act (page 725), a significant portion of the additional 2012 income tax revenues from Proposition 30 will be “accrued,” or attributed, to the 2011-12 fiscal year (which ended on June 30, 2012—about four months before Proposition 30 was approved by voters on November 6, 2012). The control section describes this accrual method using a term coined by the Department of Finance (DOF)—the “net final payment accrual methodology.” The control section applies the new accrual method only to revenue generated from new tax laws enacted during 2012, which include both Proposition 30 and Proposition 39. Accrual method changes, such as this one, do not change the amount of revenue collected or assumed to be collected by the state, but instead change the fiscal years to which revenue is attributed in the state’s budgetary-legal basis accounting system.

Rationale for Net Final Payment Accrual Method. A rationale advanced by the administration in proposing this accrual method was its partial resemblance to revenue accruals under generally accepted accounting principles (GAAP). (We discussed accruals in general and the compliance of a similar, earlier accrual proposal with GAAP in a 2011 report.) Because Proposition 30 was approved in November 2012 and applies its higher income tax rates for upper-income taxpayers retroactively to the beginning of 2012, the resulting “doubling up” of revenue collections in early 2013 was another rationale for accruing part of the measure’s additional tax proceeds to the 2011-12 fiscal year. Under this rationale, one could say that it makes sense to accrue a part of the Proposition 30 revenues related to tax year 2012 to 2011-12, since some of the taxable income involved was generated during the 2011-12 fiscal year.

Accrual Method Reduces Proposition 98 Minimum Guarantee in 2012-13. Because this accrual method reduces the year-over-year General Fund revenue growth from 2011-12 to 2012-13, it results in a lower Proposition 98 minimum funding guarantee for schools in 2012-13, compared to the guarantee that would be calculated without this new accrual method.

Proposal

Trailer Bill Proposal to Permanently Codify New Accrual Method. The administration proposes that the Legislature enact a budget trailer bill to codify permanently the use of this new accrual method. Specifically, “notwithstanding any other law,” the proposed trailer bill would prohibit DOF from using the “estimated net final payment accrual methodology,” except for tax revenues accrued under “any initiative measure enacted on or after January 1, 2012.” In effect, the measure would require use of the “estimated net final payment accrual methodology” for initiative measures passed in 2012 or thereafter, including Propositions 30 and 39. This is consistent with how DOF treated revenue accruals in the 2013-14 Governor’s Budget proposal.

How the Accrual Method Works. Permanently codifying the new accrual method for Propositions 30 and 39 and subsequent initiative tax changes means, for example, that each calendar year’s Proposition 30 collections will be attributed in part to the fiscal year that ends on June 30 of that calendar year (“the first fiscal year”), with the rest attributed to the fiscal year beginning on July 1 of that calendar year (“the second fiscal year”). For instance, a portion of tax year 2013 Proposition 30 revenues would be accrued to the 2012-13 fiscal year as the first fiscal year for 2013 tax collections, with the rest accrued to 2013-14 as the second fiscal year for 2013 tax collections. Currently, with regard to Proposition 30 revenues, the administration indicates that about 60 percent would be accrued to the first fiscal year, with the remaining 40 percent accrued to the second fiscal year. The DOF has chosen to accrue more of the revenues to the first fiscal year in light of the state’s recent tax law amendments to require estimated tax filers —those making payments on income not subject to withholding, such as capital gains—to pay 70 percent of estimated tax liabilities in the first half of each calendar year. (Actual estimated tax payment percentages during this period generally are below 50 percent.) Like other revenue accruals, the net final payment accruals would be calculated each year by the Franchise Tax Board and DOF.

LAO Comments

Recent Accrual Changes Are Complicating Revenue Forecasting. In our 2011 report, we discussed the state’s initial adoption of accrual revenue accounting in 1966 and the subsequent history of accruals in the California budget. In 2008, the Legislature amended revenue accrual laws to increase one-time revenues available to help balance the 2008-09 budget by about $1.8 billion—primarily, by shifting tax revenues that otherwise would have been attributed to 2009-10 to 2008-09 instead. (See page 18 of our 2008-09 California Spending Plan publication for more information.) These 2008 amendments—not consistent with GAAP—remain in place today and have been complicated by statutory accelerations of various income tax payments that were adopted to help the state deal with recent budget and cash flow problems.

On top of all of these recent policy changes is the new net final payment accrual method. As we discussed in our November 2012 Fiscal Outlook (see page 3), these various changes result in significant uncertainty concerning a fiscal year’s budgetary revenues until many months after the fiscal year’s conclusion. By our reckoning, under the new accrual method, the state will not know how many revenues are booked to a fiscal year until at least 660 days after the end of the fiscal year. As a result, the chances of large forecast errors by us and the administration—potentially affecting prior, current, and subsequent fiscal years at the time of each annual budget’s passage—are increasing. Put another way, these changes and the new accrual method mean that our state’s elected leaders have even less certainty concerning budgeted revenues at the time they adopt the state’s annual spending plan each June.

Accrual Approach Makes Proposition 98 Calculations Even More Complicated. Considerable accrual estimating errors could result in significant changes to the state’s Proposition 98 school funding requirements. If updated revenues—identified many months after the end of a fiscal year—are lower than budgeted, the state likely would have appropriated more than necessary to meet that fiscal year’s minimum guarantee under Proposition 98. Because these updated estimates would not be available until long after the close of the fiscal year, the state might not be able to bring spending down to the minimum guarantee. This higher spending level could, in turn, increase the minimum guarantee in future years. Conversely, if updated revenues are higher than budgeted, the state likely would have provided less than the minimum guarantee, creating a “settle-up obligation.”

LAO Recommendations

Recommend Rejection of Trailer Bill Proposal. We recommend that the Legislature reject the proposed accrual trailer bill. The proposed accrual approach would permanently add to the complexity of the state’s budgeting system, including Proposition 98 calculations in each annual budget. It increases the chances of large forecast errors at the time of each annual budget’s passage. Nevertheless, given the significant budgetary changes that would be required to undo the net final payment accrual method immediately, we suggest that the Legislature authorize this accrual method via control section language in each annual budget act until a replacement accrual method is adopted, as discussed below.

Recommend Simpler, More Transparent Accrual System In Future Years. As we discussed in the November Fiscal Outlook, we are now convinced that the problems introduced to the budgetary process by the new accrual method outweigh the new method’s benefits. Accordingly, we recommend that the Legislature direct the administration to develop a simpler, logical budgetary revenue accrual system in the 2014-15 Governor’s Budget (to be presented on January 10, 2014), preferably one that returns—either immediately or over a multiyear period—revenue accrual policies to something like they were before the 2008 amendments. Such a policy would allow the books to be closed on a fiscal year much sooner, with some degree of certainty. Alternatively, to help ensure the accuracy of state revenue forecasts and improve transparency, we recommend that the Legislature require the administration to document accruals regularly in simple, lay-person terms in an online “accrual guide,” beginning in January 2014.

Defining the Accrual Method Is Crucial. We note that the administration’s proposed trailer bill does not define the “estimated net final payment accrual methodology” proposed for permanent codification. Given the need for the Legislature to understand the revenue estimates that it must place in the annual budget, we suggest it is crucial that this important term be clearly and simply defined. Such a definition is important regardless of whether the accrual method is to be placed in the budget bill temporarily (as we suggest) or the method is to be required under state law permanently (as the administration proposes). Such a definition would limit the ability of future administrations to manipulate a highly technical element of budgeting in a manner that has the effect of skewing calculation of the Proposition 98 minimum guarantee.

If Trailer Bill Is Passed, Some Budget Reporting Deadlines Need Reconsideration. In the event that the Legislature adopts the administration’s trailer bill proposal, reconsideration of several budget reporting deadlines now in state law should be reconsidered. For example, the nine-month Proposition 98 recalculation and certification timeline in Education Code Section 41206 would need to be reconsidered if the trailer bill is approved. In addition, longstanding budget practice (codified in Section 13337[a] of the Government Code)  requires the administration to make the final full report on each fiscal year’s “actual revenues and expenditures” in the Governor’s Budget Summary on January 10, just over six months following the end of each fiscal year. As a consequence, official state records of budget revenues and expenditures—such as those displayed in DOF’s Chart A-1—are not updated for subsequent changes after publication of the Governor’s Budget just over six months after fiscal-year end. Under the new accrual method, this final report on “actual” revenues—if still delivered six months after the end of the fiscal year—will be quite incomplete, thereby rendering inaccurate the historical records of each fiscal year’s revenues and expenditures. Accordingly, if the Legislature adopts the trailer bill proposal, we suggest that the Legislature amend statutes to require DOF to report anew on each fiscal year’s General Fund and Education Protection Account revenues and expenditures each January and May until the results are finally known some time later.

Code Placement of Accrual Statutory Provisions. The administration’s proposed trailer bill would place provisions concerning the new accrual methodology in the Revenue and Taxation Code. Other key budgetary accrual requirements, however, are currently in Section 13302 and nearby sections of the Government Code. Should the Legislature adopt the administration’s trailer bill or an amended version, we suggest that any code provisions instead be placed near the accrual provisions that are already in the Government Code.