Legislative Analyst's Office Analysis of the 2003-04 Budget Bill

Proposition 98 Budget-Year Priorities

The Governor's budget offers a reasonable set of solutions for addressing the 2003-04 budget situation. We highlight a number of areas, however, that are worthy of careful consideration and deliberation. Below, we identify these areas and discuss opportunities the Legislature has for responding strategically in K-14 education to the most pressing problems it is likely to face in the budget year.

Building the 2003-04 Education Budget With Due Caution

Overall, the Governor's budget proposal for K-12 education is balanced and reasonable. The proposal contains three primary components. It: (1) reduces the level of funding deferrals, (2) relies on ongoing rather than one-time spending reductions, and (3) provides school districts with greater fiscal and programmatic flexibility to respond to these reductions. We recommend the Legislature adopt this general approach and include the same basic components in the budget.

Below, we discuss the importance of including each of these three components in the budget. We then propose LAO alternatives for specific K-12 education programs. Next, we discuss two other high-priority issues: (1) the child care realignment and (2) the funding reduction proposed for the California Community Colleges (CCC). We end this section by discussing two Proposition 98 issues—our revised estimate of the minimum guarantee in 2003-04 and the implications of suspending the guarantee. 

Reduce the Level of Deferrals—Education Credit Card Maxed Out

As part of its budget solution in 2001-02 and 2002-03, the Legislature opted to defer significant education program costs to the subsequent fiscal year rather than make additional spending cuts. The result has been a steadily growing balance on the state's education "credit card." Figure 1 shows the obligations that the state has made from prior- and current-year funding deferrals.

In the 2001-02 budget, the Legislature deferred $931 million in categorical program costs to 2002-03. This lowered the 2001-02 Proposition 98 appropriation level—thereby lowering the minimum guarantee for future years. It also helped the state meet the 2002-03 minimum guarantee without additional General Fund cost. In the 2002-03 budget, the state relied even more heavily on deferrals as a way to avoid further spending reductions. As part of the 2002-03 Budget Act, the Legislature deferred $681 million in categorical program costs to 2003-04. In AB 8x (2003-04 First Extraordinary Session), the Legislature approved two other deferrals from 2002-03 to 2003-04—$1.1 billion of school districts' June apportionments and $122 million of state-reimbursable mandate costs.

Given the large and growing backlog of mandate claims, the mandate deferral presents special problems for the state. By the end of 2002-03, the state is likely to have a total of almost $900 million in outstanding Proposition 98 mandate liabilities.

Budget-Year Mandate Costs. Although district costs for ongoing mandates total about $210 million annually, the Governor's budget provides only $110 million for 2003-04 mandate costs. Thus, his proposal generates an increase in mandate deferrals of around $100 million, assuming no new mandate claims are approved.

The cumulative impact of all these deferrals has maxed out the education credit card. Each year the state relies on deferrals and other one-time solutions rather than ongoing solutions, the problem intensifies the following year. For example, if the state wants to capture budget-year savings by deferring additional apportionments, it would need to defer not only June apportionments but also May apportionments. Deferring such apportionments could cause many districts to experience serious cash flow problems. In come cases, these deferrals might even result in school districts only being able to cover payroll costs by incurring additional debt.

Establish Deferral Repayment Plan. We recommend the Legislature begin gradually paying off deferrals and develop a repayment plan to eventually restore all deferred funds. For 2003-04, the Governor's budget (1) repays $681 million in funds deferred from 2002-03 to 2003-04 and (2) restores the $681 million in base funding. While we believe the Governor's proposal heads in the right direction, we suggest an alternative repayment plan that prioritizes paying off specific deferrals faster than others. (Please see Figure 2 in the next section of this write-up, entitled "LAO Spending Alternatives.") In future years, we recommend the Legislature make it a priority to repay deferrals before making expenditure increases or funding new programs.

Make Ongoing Spending Reductions

Of the $2 billion in K-12 education solutions adopted by the Legislature in AB 8x, we estimate that around $1.8 billion was one-time in nature. Because few solutions made in 2002-03 were ongoing, the Legislature will essentially need to identify a new set of solutions in 2003-04. The Governor's budget proposes a total of $1.6 billion in ongoing spending reductions. The $1.6 billion is primarily due to a $1.5 billion across-the-board reduction to the proposed categorical block grant. In addition, the Governor proposes several minor targeted reductions. Faced with the need to identify $1.6 billion in new K-12 solutions, we believe the Legislature should make the same level of ongoing spending reductions as proposed in the Governor's budget. As discussed above, we would not advise the Legislature to use additional deferrals as a budget-balancing tool, as this generates increasingly difficult management problems at the local level and erodes future budgetary choices at the state level.

Provide Schools Greater Fiscal and Programmatic Flexibility

The Governor proposes continuing the $1.5 billion in across-the-board cuts to both revenue limits and categorical programs as well as making targeted cuts to various programs. To provide more flexibility in light of these cuts, the Governor's budget proposes to merge 58 K-12 categorical programs into a K-12 Categorical Block Grant. We believe this proposal takes a significant step in the right direction and, in conjunction with categorical reform, the $1.5 billion in proposed across-the-board reductions are reasonable. The Governor's proposal, however, does not adequately address the negative local incentives that led to the initial creation of the categorical programs. In addition, it misses several opportunities to extend the reforms. Please see our alternative categorical reform proposal later in this chapter.

An LAO Spending Alternative

We have identified approximately $427 million of additional Proposition 98 funding needs for 2003-04 because either (1) the Governor's budget under-funded specific programs or (2) the Legislature increased 2003-04 obligations because of actions taken to date in the First Extraordinary Session. We recommend that the Legislature fund these priority needs, and make other funding reductions to stay within the proposed Proposition 98 funding level. These alternatives are described in Figure 2. Specifically, we recommend:

• Set-Aside Funding for Special Education Deferral ($214 Million). As discussed in the 2002-03 Mid-Year Revisions: Proposition 98 piece in the "Crosscutting Issues" section of this chapter, we believe that the Legislature's deferral of special education funding in AB 8x may result in a federal maintenance of effort (MOE) problem. Because an MOE violation could risk federal funds, we recommend the Legislature take two actions immediately: (1) direct the State Department of Education (SDE) to work with the federal Department of Education (DOE) to seek a possible waiver and (2) set aside $214 million for special education pending the outcome of SDE's discussion with DOE. This $214 million, if needed, would also reduce the state's level of outstanding deferrals. There is a similar MOE issue in the Governor's 2003-04 proposal that could cost the state an additional $28.5 million in General Fund (for which we also suggest setting aside funding).
• Paying Ongoing Mandate Costs ($100 Million). We recommend the Legislature increase funding for reimbursable state mandates by $100 million to better represent the ongoing costs of existing mandates. This approach reduces the growth of the state's education deferrals. To eliminate some of the negative incentives the current funding mechanism creates, we recommend folding the mandate funding into the Core Service Block Grant recommended in the "Governor's Categorical Program Reform Proposal" section of this chapter.
• Fully Funding State Intervention and Sanction Programs ($50 Million). The cost of fully funding the state's intervention and sanction programs is higher than proposed in the Governor's budget in part because the Legislature rejected the proposed elimination of funding for a second cohort in the High Priority Schools Grant Program.

To partially offset these additional costs, we have identified $274 million of recommended savings. The Governor's budget proposes using $250 million for equalization and $24 million to fund various other programs. Although equalizing revenue limit funding is an important goal, we think providing a $250 million augmentation for equalization, while at the same time making a $612 million reduction to revenue limits as part of an across-the-board cut, seems contradictory. We suggest the Legislature amend current law to delay equalization funding until the state can first pay for the base program.

Because the additional savings we have identified do not fully offset the additional costs, we suggest continuing a small portion of the categorical program deferrals ($153 million of the $681 million) into 2004-05. We believe that this alternative minimizes the total amount of deferrals. (As discussed later, we recommend the Legislature use any additional 2003-04 Proposition 98 funding to further reduce the level of education deferrals.)

Highlighting Other High-Priority Issues

In this section, we discuss two other high-priority issues: (1) the Governor's child care realignment proposal and (2) the proposed reductions to CCC.

Child Care Realignment Merits Consideration

The Governor's budget proposes a major "realignment" of state and county program funding responsibilities. Under this proposal, the state would shift responsibility for most child care programs administered by SDE to the counties. As we discuss in detaillater in this chapter, the state's existing child care system creates significant problems for families and local providers. For example, the system: (1) requires local providers to comply with cumbersome rules regarding allowable expenditures, attendance accounting, eligibility, and reimbursement rates; and (2) treats families with similar incomes differently, depending on whether they have received assistance through the CalWORKs program.

In view of these problems, we believe the Governor's child care realignment proposal merits legislative consideration. Realignment would give counties the flexibility to use child care funds as part of an integrated county strategy to serve low-income families and to tailor their child care programs to meet the needs of their communities' working poor. It would also reduce administrative complexity in the system by allowing counties to provide child care under their own set of program rules.

California Community Colleges Face Sizeable Reduction

The Governor's budget proposes $4.1 billion in Proposition 98 funding for CCC, which is $442 million, or 9.8 percent, less than the revised current-year amount. Of this amount, $215 million is associated with targeted reductions to various categorical programs. The remaining savings are associated with two interrelated factors—changes in enrollment and student fees. The Governor's budget assumes savings due to an anticipated 5.7 percent decline in enrollment. This decline is expected to occur as a result of the proposed increase in student fees. The higher fee rate, however, will also generate additional revenue, which acts as a direct offset, thereby creating additional General Fund savings. 

Most Spending Reductions Are Reasonable. Given the state's fiscal situation, we believe that most of the CCC reductions proposed by the Governor are reasonable. Total funding for categorical programs would be reduced about 25 percent from the revised current-year level, with changes to individual programs ranging from a 56 percent reduction (for the Fund for Student Success) to an 11.7 percent increase (for the administration of financial aid programs).

Fee Increase Reasonable. The proposed budget would increase community college fees from $11 to $24 per unit. The increase would amount to $338 dollars per year for the average full-time student. This would be the first fee increase in over a decade; in fact, fees were reduced twice in the 1990s. While the proposed increase is large in percentage terms, CCC fees would still be the lowest in the nation. We also note that all financially needy students are eligible to have their fees waived, and thus will not be affected by the increase. Finally, many middle-income students are eligible for a federal tax credit, which means they too will not be affected by the proposed increase.

Legislature May Wish to Restore Some Enrollment Funding. We believe that the proposed fee increase will affect enrollment and this impact should be accounted for in enrollment budgeting. We believe that the magnitude of the decline projected by the Governor, however, may be too large. This is because the Governor's proposal does not take into account the likely shift of some enrollment demand from the public universities to CCC in response to planned fee increases at the universities. Moreover, to the extent that the Legislature wishes to expand enrollment growth in higher education, it makes sense to focus that growth at the lower-cost community colleges.

Funding an Additional 25,000 Students. If the Proposition 98 minimum guarantee is higher than assumed in the Governor's budget and the Legislature does not suspend the guarantee (please see the next section for more detail on these Proposition 98 issues), then we recommend designating additional funding for CCC enrollment. Specifically, we recommend the Legislature fund an additional 25,000 full-time equivalent students, which is 2.6 percent of the current-year level. We believe this would more accurately reflect the level of enrollment CCC is likely to experience in the budget year. This would impose a Proposition 98 General Fund cost of $100 million, which could be funded by a higher guarantee.

Addressing Two Overarching Proposition 98 Minimum Guarantee Issues

Finally, in this section, we address two overarching Proposition 98 issues. We first provide our estimate of the Proposition 98 minimum guarantee in 2003-04. We then discuss the implications of suspending the Proposition 98 minimum guarantee.

Estimated Higher Proposition 98 Minimum Guarantee in 2003-04

We estimate that the 2003-04 Proposition 98 minimum guarantee for K-14 education is $373 million higher than assumed in the Governor's budget. This increase is due primarily to our higher estimate of budget-year General Fund revenues. If the estimate of the minimum guarantee remains above the level assumed in the Governor's budget, then we recommend the Legislature meet the higher guarantee by (1) expiring more of its debt (that is, paying off additional deferrals) and (2) funding additional enrollment at the community colleges.

Figure 3 shows the Proposition 98 amounts available for 2002-03 and 2003-04 under the Governor's budget forecast and under our forecast. For 2002-03, we forecast that the minimum guarantee will be $93 million lower than the Governor's mid-year revisions due to lower projections of General Fund revenues.

For the budget year, Figure 3 shows that our estimate of the Proposition 98 minimum guarantee is $373 million higher than assumed in the Governor's budget. This increase is primarily due to our estimate of General Fund revenues being $1.5 billion above the Governor's budget. In addition, our estimates of per capita personal income are higher than the Governor's and our estimates of state population are slightly lower. All of these factors lead to a higher minimum guarantee. We recommend the Legislature use any additional Proposition 98 funding to (1) further reduce the outstanding deferral costs and (2) provide up to $100 million for additional community college enrollment growth as discussed above. 

Our Forecast Has Downside Risks. In the 2003-04 Budget: Perspectives and Issues, we indicate that the main risks to our fiscal forecast are on the downside. To the extent that the economic recovery is delayed, the state could have significantly less Proposition 98 funding available. Because of the potential downside risks, we suggest that the Legislature make real cuts in 2003-04, reducing the base program and beginning to address the backlog of deferrals.

How Does Proposition 98 Suspension Work?

Up to this point, our analysis assumes that the Legislature would appropriate at the Proposition 98 minimum guarantee for 2003-04. However, the Legislature has the option to suspend the minimum guarantee, which we discuss below.

Changes in General Fund Revenues Have Major Proposition 98 Implications. The minimum funding requirement for Proposition 98 programs in 2003-04 is sensitive to changes in General Fund revenues. Assuming the Governor's proposal, the state would enter 2003-04 with a $3.5 billion "maintenance factor" that would have to be restored to the Proposition 98 base in future years. (A maintenance factor was created in 2001-02 when General Fund revenues fell significantly.) Starting from the General Fund revenues assumed in the Governor's budget, roughly half of any increase in General Fund revenues (either because of improved economic conditions or tax increases), would have to be spent on Proposition 98 programs. This relationship would continue until General Fund revenues increased by slightly over $7 billion, at which point the maintenance factor would be fully restored, and all additional revenues could be used for any purpose.

Impact of Realignment Proposal on Proposition 98. For 2003-04, the Governor proposes to increase taxes by $8.3 billion related to his realignment proposal. (Of this amount, $8.2 billion would provide funding for the realigned programs.) Because the new realignment revenues would be placed in a special fund, the administration indicates that it did not include the realignment revenues in its calculation of the Proposition 98 minimum-funding guarantee. Including these revenues in the calculation would raise the state's minimum funding level for schools by about $3.5 billion because of the requirement to restore the maintenance factor.

What About Suspending Proposition 98? Current law allows the state to suspend Proposition 98 in an urgency bill other than the budget bill. If suspended, the entire amount of any new General Fund tax revenues could be used for budget-balancing purposes.

Suspension would allow the Legislature to appropriate funds at any level determined appropriate for K-14 education. Under suspension, the state would achieve real savings but would continue to have a maintenance factor (the difference between the actual appropriation level and the long-term Test 2 Proposition 98 funding level) that would have to be paid over time.

Figure 4 illustrates the impact that suspending Proposition 98 to accommodate a General Fund revenue increase in 2003-04 would have on K-14 spending in 2003-04 and future years. Alternative 1 assumes the Governor's proposed 2003-04 Proposition 98 funding level of $44.1 billion and assumes the Governor's $8.3 billion of new tax revenues associated with realignment do not count toward Proposition 98. Alternative 2 illustrates the impact if instead the Legislature (1) increased state taxes to generate $8.3 billion in General Fund revenues, (2) suspended the Proposition 98 guarantee, and (3) provided the Governor's proposed Proposition 98 funding level.

In the example, Proposition 98 suspension would allow the state to (1) increase General Fund revenues, (2) provide school districts and community colleges the same amount they would have received absent an increase in General Fund revenues, and (3) not affect future-year Proposition 98 funding requirements. The maintenance factor is the same because we have assumed that Proposition 98 spending is equal under both scenarios. Therefore, the same "gap" between 2003-04 spending and the long-run requirements of Proposition 98 would remain.

In summary, realignment is not the only way available to the Legislature to raise new revenues without simultaneously increasing Proposition 98 spending. The Legislature can raise additional General Fund revenues from new taxes that count toward the Proposition 98 funding calculation, and yet through a one-time suspension of the minimum guarantee, it can (1) provide the same level of Proposition 98 funding for 2003-04 as proposed by the Governor and (2) not affect the long-term funding requirements of Proposition 98.