Major Expenditure Proposals In the 2006-07 Budget

Proposition 98 is a set of formulas for determining a minimum annual funding level for K-12 schools and community colleges (K-14 education). While the formulas get rather complicated at times, the goal of Proposition 98 is a relatively straightforward one. Generally, Proposition 98 provides K-14 schools with a guaranteed funding source that grows each year with the economy and the number of students. The guaranteed funding is provided through a combination of state General Fund and local property tax revenues. The actual amount the state is required to spend on Proposition 98 depends on specific calculations or “tests” (see Figure 11).

Figure 11

Proposition 98 Basics

ü Over Time, K-14 Funding Increases to Account for Growth in K-12 Attendance and Growth in the Economy.

ü There Are Three Formulas (“Tests”) That Determine K-14 Funding. The test used to determine overall funding in a given budget year depends on how the economy and General Fund revenues grow from year to year.

· Test 1—Share of General Fund. Provides around 41 percent of General Fund revenues. While not applicable since 1988-89, this test may begin to determine the minimum guarantee near the end of the decade.

· Test 2—Growth in Per Capita Personal Income. Increases prior-year funding by growth in attendance and per capita personal income. Generally, this test is operative in years with normal to strong General Fund revenue growth.

· Test 3—Growth in General Fund Revenues. Increases prior-year funding by growth in attendance and per capita General Fund revenues. Generally, this test is operative when General Fund revenues fall or grow slowly.

ü Legislature Can Suspend Proposition 98. With a two-thirds vote, the Legislature can suspend the guarantee for one year and provide any level of K-14 funding.

ü Mechanism Exists to Ensure Growth With Economy and Attendance. When Test 3 or suspension occurs, the state creates a funding gap called maintenance factor. Proposition 98 contains a mechanism to accelerate spending to restore maintenance factor and close the gap in future years.

The minimum funding guarantee is based on the previous year’s appropriation level plus an amount required under one of the three tests. If the state approves more K-14 funding than is required under Proposition 98, the additional spending becomes part of the long-term funding base. Thus, actions to “overappropriate” Proposition 98 have consequences for future budgets and the state’s long-term financial condition.

The Governor’s budget proposes to increase Proposition 98 expenditures by $4.3 billion in 2006-07 compared to the revised 2005-06 spending level. This increase is composed of three components. First, the Proposition 98 minimum guarantee increases by $2.2 billion. Second, Proposition 49 requires the state to spend $426 million above the minimum guarantee to expand the state’s after school program. Third, the Governor’s budget would provide $1.7 billion to restore K-14 funding roughly to the funding target in Chapter 213, Statutes of 2004 (SB 1101, Committee on Budget and Fiscal Review). This act suspended the Proposition 98 minimum funding guarantee for 2004-05 by about $2 billion and established a target funding level for K-14 education if revenues increased. Although General Fund revenues in 2004-05 were significantly higher than originally estimated, Proposition 98 expenditures in both 2004-05 and 2005-06 fell short of this target.

Figure 12 shows how the new 2006-07 funding is spent. The budget provides $2.9 billion for baseline cost increases, including $2.6 billion for cost-of-living adjustments (COLAs) for K-12 and community colleges. Since the minimum guarantee only increases by $2.2 billion, funding the base program would cost almost $700 million more than required by the minimum guarantee.


Figure 12 Proposition 98 Expenditure Plan 2006-07 Governor’s Budget
(In Millions)

Baseline Adjustments
Cost-of-living adjustment	$2,566.8
Attendance	304.9
Mandates	133.6
Other	-96.9
Subtotal	($2,910.7)
New or Expanded Programs
Proposition 49 after school	$426.2
K-12 revenue limit increases	406.2
CCCa equalization	130.0
Recruitment and retention	100.0
Arts and music	100.0
Other CCC proposals	60.1
Other K-12 proposals	198.2
Subtotal	($1,420.3)
Total	$4,311.0

Details may not add due to rounding.
a California Community Colleges.

The budget proposes to spend an additional $1.4 billion to create new programs and expand existing ones. Major expansions include $426 million for after school programs, and $406 million in K-12 revenue limit increases for equalization ($200 million) and restoration of a prior-year COLA ($206 million). For community colleges, the budget provides $130 million for equalization and $60 million for other increases.

Why Is the COLA So High?

The annual budget typically provides most Proposition 98 programs with a COLA to reflect the higher costs schools experience due to inflation. The K-12 COLA (also used for community college programs) is based on the gross domestic product deflator for purchases of good and services by state and local governments (GDPSL). Based on GDPSL data available at the time the budget was developed, the administration estimated a 5.2 percent COLA rate for K-14 programs, resulting in a cost of $2.6 billion in Proposition 98 funds in 2006-07.

Based on more recent data on actual inflation in the state and local government sector, we estimate a K-14 COLA of 5.8 percent. Fully funding our higher estimate would cost just over $300 million more than the level currently funded in the Governor’s budget, or a total of $2.9 billion. Final data needed to calculate the K-14 COLA factor will be available at the end of April.

Costs Affected by Energy and Construction Costs. As shown in Figure 13, the projected budget-year COLA of 5.8 percent is considerably higher than K-12 COLAs have been in recent years, and substantially


Figure 13 Rates for K-12 Cost-of-Living Adjustment (COLA) and COLA Factors
2002-03 Through 2006-07
	2002‑03	2003‑04	2004‑05	2005‑06	2006‑07 Estimatea
K-12 COLA	2.0%	1.9%	2.4%	4.2%	5.8%
K-12 COLA Factors
Nondurable goods—including oil and gas	-3.5%	3.6%	4.5%	12.1%	14.0%
Gross investment—including construction	1.9	1.9	1.3	3.7	5.8
General government employee compensation	4.1	4.6	4.4	3.6	3.8

a Projected based on three quarters of 2005 data and estimates for first quarter of 2006.

higher than other COLAs provided in the state budget. (For a detailed discussion of COLAs, see “An Overview of State Expenditures” earlier in this document). The figure also displays the historical and projected growth rates for the primary inputs to the overall GDPSL-general government employee compensation, gross investments (which include construction and building costs), and nondurable goods (which include costs for oil and gas). As shown in the figure, however, 2006-07 estimates for these latter two factors appear significantly higher than they have been in prior years. This is primarily due to substantial increases in the costs of energy and construction, in part resulting from the hurricanes in the fall of 2005.

High General Fund Revenues, But Little Additional Proposition 98 Costs

Our forecast projects General Fund tax revenues will be $1.2 billion higher than the administration’s estimate in 2005-06 and $1 billion more in 2006-07. We estimate that the additional revenues in 2005-06 will increase the minimum guarantee by $465 million. Since the Governor’s 2005-06 spending level is $265 million above the minimum guarantee, the extra revenues would only require an additional $200 million in Proposition 98 spending in 2005-06. For the budget year, the additional revenues would increase the minimum guarantee by only $115 million. (This small increase-relative to the additional $1 billion in 2006-07 revenues-is because our year-to-year growth in estimated General Fund revenues is actually somewhat less than the administration’s.) Because the Governor’s budget provides $2.1 billion above the minimum guarantee, the state would have no additional obligation for 2006-07. However, the cost of meeting the Chapter 213 target funding level would increase by roughly $115 million.

K-14 Funding Is Linked to State’s Fortunes

It is important for the Legislature to consider the significant increase in Proposition 98 spending proposed by the Governor in the context of the administration’s overall General Fund spending plan. As discussed in “Part I” of this document, the Governor’s budget raises the issue of whether the proposed level of expenditures-including funding for education-can be sustained in future years. We estimate that if his budget were adopted, the state would face operating deficits of almost $4 billion in 2007-08 and $5 billion in 2008-09. In addition, these are several factors that could add significantly to these shortfalls. These include: (1) the loss of various court decisions, (2) unfunded costs related to retirement-related obligations, and (3) major reductions in revenue in the event of an economic slowdown.

The fiscal health of the state is important to K-14 education. When times are good, state spending on schools and community colleges results in new and expanded programs and extra base increases. When the economy-and state revenue-slows, the state typically cuts categorical programs and inflation adjustments.

The Governor’s budget proposes to spend $1.4 billion for new and expanded Proposition 98 programs in 2006-07. Thus, the issue facing the Legislature is whether the state can afford this higher level of spending in 2007-08 and beyond. Given the state’s continuing fiscal pressures, we suggest the Legislature balance the need to get the state’s “fiscal house” in order with its desire to approve new discretionary funding for K-14 education.

Proposition 98 Issues Affect Long-Term Cost of K-14 Education

As discussed above, Proposition 98 determines the minimum amount the state must spend on K-14 education each year based on several factors. While the constitutional provisions of Proposition 98 have not changed in recent years, state actions and initiatives have affected the calculation of the minimum guarantee for 2006-07 and beyond. The Legislature faces several issues relating to Proposition 98 that could affect the General Fund cost of meeting the minimum guarantee in future budgets. We discuss two of the most significant issues below.

Rebenching the Test 1 Factor. The Test 1 factor requires that Proposition 98 receive a minimum fixed percentage of General Fund revenues. When Proposition 98 was passed by voters in 1988, the Test 1 factor was set at 40.7 percent-that is, spending on K-14 education had to make up at least 40.7 percent of overall General Fund spending. To date, Test 1 has been operative only in 1988-89, the first year after Proposition 98 was passed by voters.

In 2004-05, the state transferred property tax revenues to local governments as part of a (1) vehicle license fee revenue “swap,” and (2) a financing mechanism to pay off the deficit-financing bonds passed by the voters in March 2004. By shifting property taxes to local government, the state met the Proposition 98 minimum guarantee by increasing General Fund spending to backfill the reallocated property tax revenues. These transfers total $6.8 billion in 2006-07.

To hold schools harmless from the shift of property taxes, the Test 1 percentage must be adjusted. This adjustment represents an important issue for the Legislature because we project that Test 1 may become operative again as early as 2008-09. While there is general agreement for the need to adjust Test 1, there are several ways to calculate this adjustment. The difference in the Test 1 percentage generated by different methodologies can be large-as much as 0.5 percent of General Fund revenues, or $500 million.

Since 2006-07 is the final year of significant adjustments resulting from the recent local government agreements, we believe it makes sense to adjust the Test 1 factor now. In addition, because Test 1 is a major factor influencing long-term General Fund spending projections, making this adjustment during the coming year will give the Legislature a clearer picture of the impact of its budget-year decisions on the state’s fiscal situation over the next few years.

Budgeting for Proposition 49. The budget provides $426 million in Proposition 98 spending above the minimum guarantee to expand the state’s after school program as required by Proposition 49. We continue to recommend the repeal of Proposition 49 because (1) it triggers an autopilot augmentation even though the state is facing a structural budget gap of billions of dollars, (2) the additional spending on after school programs is a lower budget priority than protecting districts’ base education program, and (3) existing state and federal after school funds are going unused. If the Legislature chooses to implement Proposition 49, the Legislature will need to clarify how Proposition 49 interacts with the Proposition 98 guarantee.

K-12 Proposition 98

The Proposition 98 allocation to K-12 schools (including property tax revenues) is proposed at $48.4 billion, or $8,030 per pupil for 2006-07. This represents an increase of $604 per pupil, or 8.1 percent, from the current-year estimate. Figure 14 displays the Governor’s proposed use of $1.2 billion in discretionary funds in the budget year. Implementing the requirements of Proposition 49 accounts for $426 million. The initiative requires the state to expand existing after school programs for K-8 students by a specific amount starting in 2006-07. An additional $406 million is proposed to equalize K-12 district revenue limits ($200 million) and restore past-year reductions in revenue limits ($206 million). Finally, the budget proposes to spend almost $400 million for a number of new K-12 categorical programs, including programs to help attract and retain teachers in low-performing schools ($100 million) and an arts and music block grant ($100 million).


Figure 14 Governor’s K-12 Discretionary Spending Proposals
2006-07 (In Millions)
	Amount
Governor's Proposals
Proposition 49 after school	$426.2
K-12 revenue limit increases	406.2
Teacher recruitment and retention	100.0
Arts and music	100.0
Physical education	85.0
Beginning teacher support	65.0
Digital classroom grants	25.0
Fresh Start	18.2
Total	$1,225.6

In addition to its decision on the overall Proposition 98 level of spending the Legislature will face other key issues:

School Districts Face Difficult Fiscal Condition. Various financial pressures have created a difficult fiscal environment for school districts. Weak district financial conditions left over from the recent economic slowdown, loss of funding due to declining enrollment, and the need to begin budgeting for retiree health care costs present a fiscal challenge that many districts will be unable to meet satisfactorily. While retiree health costs represent a long-term financial threat to districts, the rapid escalation in these costs projected over the next decade could seriously degrade the quality of education provided in some districts. We suggest several steps the Legislature could take to encourage districts to address these issues.

Mandate Finance in Need of Reform. The budget includes $134 million to pay for the ongoing costs of state-mandated education programs in 2006-07. This is the first time in four years the Governor’s budget has included funding for these costs. Our review of the current K-12 mandates process, however, indicates that the process could be streamlined, reducing state and local administrative costs and making mandate funding more predictable for both districts and the state.

Is It the Right Time for New Categorical Programs? The budget provides almost $400 million for several new categorical programs. For many of these new programs, the administration has not been able to articulate the problems that it is trying to solve or how the new programs would address the identified problem. These programs focus on narrow issues while leaving broader issues like state and district fiscal solvency unaddressed. Given that both the state and school districts face difficult budget pressures, we believe it is unwise to direct funding to these lower priority issues.

Higher Education

The state’s higher education system includes the University of California (UC), the California State University (CSU), and the California Community Colleges (CCC), as well as agencies charged with coordinating higher education policy and administering state financial aid programs. Annual adjustments in the state’s cost of providing higher education funding largely arise from three major factors: (1) enrollment, (2) inflation, and (3) student fee levels.

Enrollment Growth. The state uses a “marginal cost” formula that estimates the added cost imposed by enrolling each additional full-time equivalent (FTE) student at the public universities. An increase in the state’s college-age population is a key determinant of increases in those who are eligible to attend each segment. Therefore, most enrollment growth projections begin with estimates of the growth of this population group. As shown in Figure 15, the rate of growth in the college-age population will peak in a couple of years, after which population growth for this age group will slow.

Inflation. Higher education costs rise with general price increases. For example, inflation increases the costs of supplies, utilities, and services that are purchased by campuses. In addition, price inflation creates pressure to provide COLAs to maintain the buying power of faculty and staff salaries.

Student Fees. Student fees constitute an important source of general revenue for all three segments. Through these fees, nonneedy students pay a portion of their own education costs. (In general, financially needy students receive financial aid to cover their fees.) The state currently has no formal policy for setting fees. Thus, fees can be adjusted annually to increase, decrease, or maintain the share of cost borne by students. Cost increases not covered by a student fee increase are generally covered by increased General Fund spending.

Overall Funding Trends. Despite the state’s difficult budget situation in recent years, general-purpose funding (including student fee revenue) received by the higher education segments has generally kept pace with cost increases due to inflation and enrollment growth. This funding increased by about $1.9 billion between 2002-03 and 2005-06, which reflects a 15.5 percent increase over the period.

UC and CSU. The Governor’s budget proposes General Fund support of $5.8 billion in 2006-07 for the state’s public universities. This represents an increase of $385 million (7.1 percent) over the current year. This amount would fund enrollment growth of 2.5 percent, which would serve 5,149 additional FTE students at UC and 8,490 additional FTE students at CSU. The Governor’s budget also reflects a proposed new formula for calculating the marginal cost of serving additional students. Under this formula, the state cost of serving an additional UC student would increase by 34 percent from the current-year amount, while the state cost for an additional CSU student would increase by about 8 percent.

The budget also includes two General Fund base increases for the segments: a 3 percent increase to cover cost increases, and an additional increase provided in lieu of planned fee increases at the universities. When the two base increases are combined for each segment, UC and CSU would receive base increases of 5.8 percent and 5.2 percent, respectively.

CCC. The budget proposes about $4 billion in General Fund support for CCC, almost all of which is Proposition 98 funding. Under the Governor’s proposal, General Fund spending would increase by $501 million, or 14.5 percent, from the current year. When student fee revenues and property taxes are also considered, the budget proposal would increase funding for CCC by $581 million, or 10.3 percent.

The Governor’s budget proposal includes augmentations of $149 million for enrollment growth of 3 percent, $265 million for a 5.18 percent COLA, $130 million to advance the state’s efforts to equalize apportionment funding among community college districts, and $50 million to expand the Governor’s career technical education initiative. The budget proposes no fee increases.

The Governor’s budget proposal for UC and CSU follows predetermined funding targets he negotiated with the segments in 2004. We believe the Legislature should instead set its own priorities. Specifically, for all three higher education segments (including CCC) we advise the Legislature to (1) determine higher education funding needs based on the anticipated costs of enrollment growth and other factors, and (2) determine how these additional costs should be shared between the state and students. In our Analysis of the 2006-07 Budget Bill, we discuss how such an approach would work and make a number of specific recommendations about programmatic funding, student fees, and related policy impacts. We highlight the major issues raised in that analysis below.

New Enrollment Costs Are Driven by Population Growth. One of the fundamental budgeting decisions for higher education is how many additional students to fund. In our Analysis, we recommend increasing enrollment funding to accommodate growth in the college-eligible population, as well as modest increases in participation rates. This approach would result in savings relative to the Governor’s budget.

Fee Decisions Should Be Driven by Share-of-Cost Considerations. The Governor’s budget in effect treats student fee increases as a “cost” that can be “bought out” by state General Fund resources. In contrast to that approach, we think fees should reflect a policy choice about what share of their educational costs students should pay. In our Analysis, we recommend that students maintain their current share-of-cost in the budget year.

Marginal Cost Formula Should Be Revised. As part of the 2005-06 budget package, the Legislature directed our office and the Department of Finance to convene a working group to develop a new formula for determining the marginal cost of serving each additional FTE student at UC and CSU. The working group was unable to reach a consensus on a new marginal cost formula. The Governor’s budget reflects the administration’s own marginal cost formula. In our Analysis, we recommend the Legislature adopt an alternative marginal cost formula that would better reflect actual costs. Our recommendation would achieve savings relative to the Governor’s budget, but would fund enrollment growth at a higher rate than would be provided under the existing marginal cost methodology.

Funding Allocation Mechanism Could Undermine CCC Equalization Efforts. The Governor’s budget provides $130 million to advance the state’s current effort to equalize apportionment funding among community college districts. However, these equalization efforts will be gradually eroded if the existing method for allocating general apportionment revenue is not changed. In our Analysis we discuss how the Legislature can achieve and sustain its equalization objectives.

Administration of Financial Aid Programs Could Be Improved. The state has struggled with how to structure the administration of its financial aid programs. As directed by the Legislature, we recently released a report evaluating structural options available to the state for administering state financial aid grant programs and federal student loan programs. In our Analysis, we recommend the Legislature authorize a single agency, with one board and executive director, to administer these programs.

Health Services

Governor’s Proposal Increases General Fund Commitments

California’s major health programs provide health coverage and additional support services for various groups of eligible persons, but primarily poor families and children as well as seniors and persons with disabilities. Medi-Cal is by far the largest state health program with an average monthly caseload estimated to reach about 6.7 million persons in the budget year. The Healthy Families Program (HFP), which provides coverage only to children, is assumed in the Governors budget plan to reach an enrollment of 933,000 by June 2007. In addition, the state supports various public health programs, community services and state facilities for the mentally ill and persons with developmental disabilities, and community substance abuse treatment programs.

Overall Growth Trend. If the spending levels proposed in the 2006-07 budget are adopted, General Fund spending on health services programs will have grown by $10.9 billion, or almost 63 percent, from 1999-00 through 2006-07. That represents an average annual growth rate of about 7.1 percent.

Main “Cost-Drivers.” Much of the increase in General Fund expenditures has been driven by increases in caseload, cost, and utilization of services in Medi-Cal. Increased expenditures for prescription drugs, hospitalization, and long-term care for the aged and disabled have been a significant component of this increase in program costs. Growth in caseloads and costs for community services for persons with developmental disabilities and the mentally ill have also contributed significantly to the increase in General Fund spending for health services.

The Governor’s budget plan includes a number of major budget proposals that would result in significant and ongoing commitments of General Fund resources for the support of health programs. We discuss several examples below.

Enrollment in Children’s Health Coverage. The administration is proposing various changes in the Medi-Cal and HFP to enroll more eligible children in health coverage and to increase the number of children in such programs whose families renew enrollment each year. The successful implementation of these proposals would result in additional General Fund costs in future years for the additional caseload of children who were added to the rolls of Medi-Cal and HFP.

Staffing Expansions. The administration proposes to add 534 positions for the support of health programs and administration of Medi-Cal and public health programs. The budget would also add 453 positions to the state hospital system to respond to deficiencies found in federal civil-rights investigations. If approved by the Legislature, many of these positions would require General Fund support on an ongoing basis.

Provider Rate Increases. The Governor’s budget proposal would allow a temporary 5 percent rate reduction for certain Medi-Cal providers to expire in January 2007, in effect providing a rate increase for part of 2006-07 and beyond. The proposed budget would also increase rates in the Medi-Cal Program for long-term care facilities, federally qualified health clinics, and some managed care plans. A 3 percent rate increase would be provided to regional center system vendors. These rate increases would all require ongoing state General Fund support in the future.

Disaster Preparedness Efforts. The proposed budget would increase General Fund support for various activities intended to prevent a flu pandemic or other public health outbreaks in the state and to respond more effectively in the event such a disaster occurs. A number of these activities are proposed to continue into 2007-08 and beyond.

We indicate in “Part I” of this volume, the state is still facing significant fiscal challenges despite projected hefty revenue increases during our forecast period. Federal policies affecting California’s health programs are likely to aggravate the state’s future General Fund gap. We project that the state is likely to exhaust its carryover of surplus federal funds for the support of HFP as soon as 2007-08, making it likely that General Fund support for HFP would have to increase markedly if the present eligibility and benefit levels were to be maintained. Also, in about three years, the recently enacted Federal Deficit Reduction Act will result in the loss of about $250 million annually in General Fund revenues from so-called quality improvement fees now collected from Medicaid managed care plans.

Under these circumstances, the Legislature should carefully consider its opportunities for achieving savings in the near term. For example, our analysis indicates that recent changes in the way the federal government is implementing the new Medicare Part D prescription drug benefit will allow the state to make corresponding reductions in the Medi-Cal Program. We also recommend that some of the proposed new disaster preparedness activities be supported with newly available federal funds and other funding sources instead of the General Fund, and that the Legislature reject some of the Department of Health Services (DHS) staffing requests that we found lacked sufficient workload justification.

Invest in Reforms Offering Future General Fund Savings. We believe that the Legislature could initiate cost-cutting reforms in health programs that, perhaps with some initial state investment, are likely to pay off over time in significant reductions in state health program costs. These reform options include the following:

The above proposals are outlined in more detail in “Part V” of this volume “Major Issues Facing the Legislature,” and in the “Health and Social Services” chapter of the Analysis of the 2006-07 Budget Bill.

Social Services

California’s major social services programs provide a variety of benefits to its citizens. These include income maintenance for the aged, blind, and disabled; cash assistance and welfare-to-work services to low-income families with children; protecting children from abuse and neglect; providing home-care workers who assist the aged and disabled in remaining in their own homes; and subsidized child care for families with incomes under 75 percent of the state median. Under the Governor’s budget proposal, General Fund expenditures for the state’s social services programs would be $9.4 billion in 2006-07, about 9.6 percent of proposed General Fund expenditures for all purposes.

Overall Growth Trend. Since 2002-03, total General Fund spending for social services programs has been relatively flat, rising from $8.8 billion to just over $9.4 billion proposed for 2006-07. The $600 million increase over these four years represents an annual growth rate of 1.7 percent, less than the typical caseload growth in a number of social services programs. In contrast, General Fund spending on all other programs has increased at an average annual rate of 6.4 percent during this time period. As a result social services share of the total General Fund budget has declined from 11.4 percent to 9.6 percent.

This relatively flat growth in social services is attributable to many factors including additional federal funds (and corresponding General Fund savings) for In-Home Supportive Services, state COLA suspensions, delays in passing through federal Supplemental Security Income COLAs, shifting habilitation services (previously provided in the Department of Rehabilitation) to the Department of Developmental Services, and not funding inflationary cost increases for county administration.

The Governor’s budget continues the recent pattern of minimal increases in General Fund support for social services programs, in amounts that are generally less than would be required to maintain current service levels based on inflation. With respect to grant payments, the budget follows current law, which suspends both the July 2006 California Work Opportunity and Responsibility to Kids (CalWORKs) COLA and the January 2007 Supplemental Security Income/State Supplementary Program (SSI/SSP) COLA. The budget further delays the “pass-through” of the federal SSI COLA from April 2007 to July 2008. Compared to current law, this results in General Fund savings of $48 million in 2006-07, rising to $185 million in 2007-08.

Freezing State Participation in County Administration. The Governor proposes trailer bill legislation which limits state participation in county administration costs for salaries, benefits, and overhead to the amount appropriated in the 2005-06 Budget Act, adjusted for caseload. The proposal applies to all county administered health and human services programs. It results in General Fund savings of $21.2 million in Medi-Cal administration. No savings are achieved in social services programs because county allocations have been frozen with respect to price increases since 2001-02.

New Initiatives. The Governor proposes $5.6 million from the General Fund for 81 new positions for the Community Care Licensing Division within the Department of Social Services. The additional inspectors will increase the rate of random visits from the current 10 percent of facilities to about 20 percent. The Governor also proposes $19.1 million from the General Fund to support a child welfare services initiative. This proposal would increase adoptions, expand funding for kinship support services, provide additional funding for transitional housing for foster youth, and fund recently enacted legislation.

Judicial and Criminal Justice

Community Care Licensing Proposal Ignores Enforcement Gaps. The Governor’s proposal to increase the number of routine inspections of care facilities and foster homes should be sufficient to meet an existing statutory requirement that all facilities be visited at least once every five years. However, increased inspection alone, as the Governor proposes, will not guarantee safer facilities. The Legislature could consider enacting legislation (1) requiring that family child care homes be subject to civil penalties when unsafe conditions are not remedied on a timely basis and (2) replacing the current “permanent” license with a license that must be renewed.

Increasing County Flexibility. The Governor’s proposal to increase adoptions and kinship support represents a one size fits all approach to improving child welfare because it assumes that these approaches are the key to improving performance in each county. Pursuant to current law, counties have developed individualized self-improvement plans to meet federal performance outcome measures in child welfare services. The Legislature could consider redirecting the proposed increase for adoptions and kinship support into flexible grants for use by the counties in their self-improvement plans which are specifically designed to meet local improvement goals.

Proposal for Freezing County Administration Raises Many Issues. The Governor proposes trailer bill legislation to limit increases in state support for county administration (salaries, benefits, and overhead) to changes in caseload, with no adjustment for inflation. Most budgets for county administration (with the exception of Medi-Cal) have been frozen since 2001-02. Depending on their priorities, counties may elect to backfill with their own funds to cover the cost of inflation. The Governor’s proposal would restrict future legislative flexibility to adjust funding and service levels.

Budget Presents Substantial Risks. The Governor’s budget assumes that the state will successfully appeal a lower court ruling in the Guillen lawsuit. If the state’s appeal is denied, there would be one-time costs for retroactive grant payments of $336 million in 2006-07 in the CalWORKs program. In addition, the state would face ongoing grant costs of $122 million each year, unless it enacted legislation to reduce grants prospectively. Furthermore, the state faces a potential disallowance of $100 million in federal funds for foster care because the state was out of compliance with federal rules concerning identical treatment of relative and nonrelative foster parents back in 2001.

Budget Does Not Address Impacts of Deficit Reduction Act. The President signed the Deficit Reduction Act of 2005 on February 8, 2006. With respect to social services programs, we estimate potential net costs of $1.1 billion for federal fiscal years (FFYs) 2006 through 2010, with the majority of the costs occurring after FFY 2008. Most of these costs are for potential federal penalties and required General Fund backfills if the state cannot meet increased federal work participation rates in the CalWORKs program. The Governor’s budget, prepared before this legislation was enacted, does not reflect any of these costs. There are a variety of strategies which the Legislature could consider in order to increase work participation thereby potentially avoiding or reducing these penalties.

The judicial and criminal justice portion of the budget consists primarily of funding for the California Department of Corrections and Rehabilitation (CDCR), the Judicial Branch, and the Department of Justice (DOJ). The CDCR is responsible for the incarceration and supervision of nearly 300,000 felons, including about 168,000 adult inmates, and over 115,000 parolees. The Judicial Branch includes the Supreme Court, Courts of Appeal, 58 trial court systems, the Judicial Council, and the Habeas Corpus Resource Center. The DOJ enforces state laws, provides legal services to state and local agencies, and provides support services to local law enforcement primarily through the operation of the state’s 11 crime laboratories.

Spending for judicial and criminal justice programs represents about 11 percent of total General Fund spending. In the past ten years, the budget for these programs has grown at an average annual rate of about 8 percent. Below we discuss some of the factors that have led to increased spending, as well as briefly summarize recent budget initiatives.

Corrections. In recent years, corrections spending has primarily been driven by (1) growth in the number of inmates, (2) correctional officer salary increases, and (3) court mandates related to inmate health care. Recent budget initiatives to reduce spending have sought to reduce the number of parolees returned to prison for nonviolent offenses, as well as spending on staff overtime.

Judicial Branch. Growth in state spending for court operations has resulted primarily from increases in court employee salaries, and county charges for services provided to the courts (for example, court security). Budget strategies to reduce General Fund spending included one-time and ongoing unallocated reductions, as well as the establishment of new and increased court fees.

Corrections. The Governor’s budget proposes to increase spending from all sources for corrections by $364 million, or 4.7 percent. This includes funding for all correctional departments that reported to the Youth and Adult Correctional Agency prior to the enactment of Chapter 10, Statutes of 2005 (SB 737, Romero), which consolidated all of the correctional departments into a single entity-the CDCR. The overall increase is largely driven by costs associated with a growing inmate population, salary increases, and the implementation of court settlement agreements. Other augmentations are included for inmate health care services, and inflation on operating expenses and equipment.

Judicial Branch. Overall, the budget proposes to increase spending for the judicial branch by $140 million, or 4.3 percent. This includes funding for the Trial Court Funding program (primarily superior courts), as well as the judiciary (Supreme Court, Courts of Appeal, Judicial Council and the Habeas Corpus Resource Center). The increase is the result of salary and benefit increases, as well as an augmentation for trial courts and the judiciary for inflation and growth based on the year-to-year change in the state appropriations limit. The budget also restores funding for one-time reductions and loans made in prior years. No reductions are proposed for the judicial branch.

Reorganization of Correctional Departments. The reorganization of the state correctional agencies into one department was intended to improve the efficiency and effectiveness of the state criminal justice system, as well as to improve accountability. During last year’s legislative budget and policy discussions on the reorganization, the administration committed to providing the Legislature updates on its progress in accomplishing the numerous and varied goals and objectives of the reorganization.

To date, the department has provided no information demonstrating whether, or to what extent, the reorganization has improved departmental operations and resulted in efficiencies and a higher degree of effectiveness. As we discuss in the “Judicial and Criminal Justice” chapter of our Analysis of the 2006-07 Budget Bill, the department has failed to provide numerous reports intended to facilitate legislative oversight. It will be important for the Legislature to follow-up with CDCR on the implementation of policy reforms, with a focus on the department’s progress to date and its timeline for reaching full implementation.

Proposed Expansion of Inmate and Parolee Programs. Consistent with the goals of the newly created CDCR, the administration proposes funding for new and expanded programs for inmates and parolees designed to reduce recidivism. While many aspects of the Governor’s proposal are consistent with recent legislative efforts to reduce the number of inmates who return to prison, we believe the administration’s proposal attempts to address too much too fast. For example, the “recidivism reduction” initiative requests more than $50 million in 2006-07 to implement over 20 program enhancements to address a variety of programmatic concerns. We think it will be important for the Legislature as part of budget discussions to consider whether the department can realistically accomplish all that CDCR has proposed to reduce recidivism in the budget year in light of the numerous other demands currently being placed on CDCR by court settlement agreements and prison overcrowding. For a detailed description and assessment of the administration’s recidivism reduction proposal, please see our Analysis of the 2006-07 Budget Bill.

More Autopilot Spending and Less Legislative Control of the Court Budget. The Governor’s budget proposes to expand use of formula-based budgeting for the courts by annually adjusting the entire court budget based on the year-to-year change in the state appropriations limit (SAL). In 2005-06, pursuant to Chapter 227, Statutes of 2004 (SB 1102, Committee on Budget and Fiscal Review), the budget for the Trial Court Funding program was adjusted based on the projected change in SAL to reflect inflation and growth in that program. The Governor’s budget would expand this formula-based budgeting methodology to all of the programs in the state judiciary, including the Supreme Court, Courts of Appeal, and the Judicial Council as well as to judicial salaries. The administration also proposes to make most of the $3 billion in spending for the courts available without regard to the fiscal year. We could identify no policy rationale for the proposed expansion of autopilot budgeting. Based on our review, we think the Governor’s proposal would result in overbudgeting of the courts, as well as reduced legislative oversight of a significant amount of state spending.

Transportation

California’s state transportation programs are funded by a variety of sources. The State Highway Account has traditionally provided the primary source of state funding for transportation, with revenues generated mainly by an excise tax on gasoline and diesel fuel (referred to as the gas tax) and truck weight fees.

In 2000, the Legislature enacted the Traffic Congestion Relief Program (TCRP) to supplement state transportation funding between 2000-01 and 2005-06, primarily by redirecting the sales tax on gasoline from the General Fund to transportation purposes. The original TCRP was to provide funding for several transportation programs, including $4.9 billion for 141 specified projects and about $2.7 billion for new projects in the State Transportation Improvement Program (STIP), local streets and roads, and mass transportation programs.

The TCRP was later extended by statute through 2007-08. In addition, in March 2002, the voters passed Proposition 42, which committed the sales tax on gasoline to transportation on an ongoing basis. However, Proposition 42 also contained a provision that allows this funding to remain in the General Fund under certain circumstances.

Overall Growth Trend. Figure 16 shows expenditures on state transportation programs from state and federal fund sources between 2003-04 and 2006-07. The figure shows that total expenditures on state transportation programs are estimated to be significantly higher in 2005-06 and 2006-07 than they have been in past years. This increase in expenditures is attributable to fully funding Proposition 42 in the current and budget years, as well as reauthorization of the federal transportation program in August 2005. While gas tax and weight fee revenues remain the primary source of funding for transportation in California, these revenues have not contributed to the increase.


Figure 16 Expenditures on State Transportation Programs
(In Billions)
			Estimated	Projected
	2003-04	2004-05	2005-06	2006-07
State funds	$3.8	$5.2	$6.2	$6.2
Federal funds	2.3	2.5	3.4	3.5
Totals	$6.1	$7.7	$9.6	$9.7

Governor’s Proposals

The Governor’s Budget. The 2006-07 budget includes a number of proposals related to transportation funding. In the aggregate, these proposals would result in significantly higher levels of transportation funding in 2006-07 than in recent years. Specifically, the budget proposals include:

Strategic Growth Plan. In addition to the transportation funding proposals specific to the 2006-07 budget, the Governor is proposing a Strategic Growth Plan (SGP). The SGP lays out a ten-year funding plan to improve state infrastructure and includes $107 billion for transportation in particular. The key features for the transportation component of the plan include:

2006-07 Budget Proposal Boosts Funding, but No Money for New Projects. The budget proposes to fully fund Proposition 42 and provide $920 million in early repayment of a previous suspension. In addition, the budget assumes that $1 billion in tribal gaming bond revenues will be received in 2005-06. However, even if fully realized, the funding increase would not provide for additional projects beyond what has already been scheduled for delivery. This is because many projects have to “catch up” on prior-year delays that resulted from the redirection of transportation funds to nontransportation uses due to the state’s overall fiscal condition.

Bonds Would Provide One-Time Funding Increase. The GO bonds proposed in the SGP would provide a one-time infusion of funding to transportation. How effectively this additional funding would address the state’s transportation priorities, however, would depend on the types of projects funded. For instance, the state has already committed to many projects in STIP and TCRP, which do not yet have full funding. Thus, additional resources will be needed to complete these projects. Furthermore, the new federal act earmarked $3.7 billion in federal dollars to provide partial funding to many projects statewide. To the extent that the Governor’s bond provides full funding for projects that are high in state priority, the impact on mobility and congestion could be significant. Otherwise, the effect on congestion and mobility would be less noticeable.

Similarly, the timing of when projects funded by the bond proposals could be delivered affects their ability to address statewide congestion and mobility issues. To the extent the proposed projects have been defined and scoped, project delivery could be sooner than if these projects are still in the early stages of the planning process.

Administration Has Failed to Demonstrate Projects’ Congestion Benefits. Instead of adhering to the existing STIP fund allocation process, the Governor’s plan would inject most of the $12 billion in GO bond funds into a list of projects selected exclusively by the administration. The existing state process requires projects to be defined, scoped, and fully funded by Caltrans or a regional transportation agency before receiving STIP funds. Although requested, the administration has not provided the Legislature with the proposed projects’ costs, congestion benefits, or estimated completion date. In the absence of this information, the Legislature is unable to assess the merits of the Governor’s proposed projects.

Revenue Bond Would Crowd Out Highway Maintenance and Rehabilitation. Beginning in 2015 and continuing for 30 years, the Governor’s proposal would take “off the top” up to $1.025 billion annually from state gas tax and weight fee revenues for debt service on a $14 billion revenue bond. This would reduce the amount of funding available for highway maintenance and rehabilitation, which are funded almost exclusively by gas tax and weight fee revenues. Providing adequate funding for these activities while paying debt service on the bond would necessitate either an increase in the gas tax or weight fees, or a redirection of Proposition 42 funds.

Long-Range State Funding Requirement Should Be Assessed. The state does not currently have an up-to-date assessment of its transportation needs. Such an assessment is necessary for the Legislature and the administration in order to determine how much funding the state should provide for transportation.

How Should State Funding Be Provided? Transportation spending has traditionally been funded from user fees such as the state’s 18 cent per gallon excise tax on gasoline and diesel fuel. The tax approximates a fee charged for the provision of roads used by the driver. Thus, it provides a clear signal to road users of the cost of the service they receive. Accordingly, we think that the state should continue to rely on user fees to provide ongoing funding for transportation.

The Governor’s proposal to firewall Proposition 42 would eliminate the state’s authority to suspend the transfer of gasoline sales tax revenue to transportation when the state faces tight fiscal conditions. While this proposal would enhance long-term funding stability for transportation, it would also remove a budget balancing tool that has been used when the state faced tight fiscal conditions.

Resources

Resources and Environmental Protection Programs. The state’s resources and environmental protection programs are administered under the Resources and California Environmental Protection (Cal-EPA) Agencies, respectively. The Resources Agency, through its 26 departments, boards, commissions, and conservancies, is responsible for the conservation, restoration, and management of California’s natural and cultural resources, including state parks and wildlife habitat. The Cal-EPA, through its six departments, boards, and offices, is responsible for the protection and improvement of the state’s environmental quality and public health, mainly through regulatory programs that control, mitigate, and clean up the impacts of pollution on the environment.

Overall Growth Trend. State expenditures for resources and environmental protection programs have increased from about $2.9 billion in 1999-00 to $4.6 billion in 2006-07. This reflects a 69 percent increase, or an average annual increase of about 7 percent. The increase mostly reflects growth in expenditures from fee-based special funds and bond funds, while General Fund expenditures proposed for 2006-07 ($1.6 billion) are roughly the same as 1999-00 spending-an increase of $250 million.

Given the weakened condition of the General Fund, a number of program activities that have traditionally been funded from the General Fund-such as resources land management, wildlife resource assessments, and state park maintenance-have experienced expenditure reductions over this period. In fact, when adjusted for inflation, General Fund expenditures proposed for resources and environmental protection programs in 2006-07 are actually lower than the 1999-00 level.

Bond fund expenditures increased during this period, reflecting the availability of these funds from five resources bond measures (totaling $11.1 billion) approved by the voters between 1996 and 2002. These bond measures provide funding for a mix of water, park, and land acquisition and restoration purposes. In general, funds from these five bonds have not been used to replace General Fund expenditures. Rather, these funds have largely supported new or expanded local assistance loan and grant programs (such as for local parks, water conservation projects, and wastewater treatment plant upgrades) or been used to increase capital outlay expenditures, such as for land acquisitions for state parks or conservation purposes. These bond funds are running out, however. At the end of 2006-07, only about $950 million of the $11.1 billion allocated in the five bonds will remain available for new projects.

The bulk of the increase in special fund spending during this period is due to new or increased fee revenues. A significant proportion of the increases in special fund expenditures since 1999-00 reflect expenditures that fully or partially offset General Fund reductions. This has occurred mainly in regulatory programs where fees are levied on the regulated parties that benefit directly from the state program. In this regard, fees have replaced General Fund revenues to a significant degree in the Air Resources Board, Department of Pesticide Regulation, and the State Water Resources Control Board.

Cost Drivers. Some resources departments own and operate public facilities, such as state parks and boating facilities, which drive their costs. In addition, the state’s resources and environmental protection programs include a number of regulatory programs whose costs are driven by their regulatory activities. Finally, some resources activities have a public safety purpose, and the cost drivers include emergency response costs that can vary substantially from year to year.

Flood Protection and Water Management. The budget proposes significant expenditures for various flood protection and water management activities.

For flood protection, the budget proposes increases of $38.2 million for state operations and local assistance and $41.3 million for capital outlay in the Department of Water Resources’ (DWR) flood management program in 2006-07. With these increases, DWR’s total flood management budget for 2006-07 will be about $109 million. The requested increases for state support are for maintenance work on levees and flood channels, evaluation of levees and channels to identify deficiencies, floodplain management (including floodplain mapping), and emergency response. The requested increases for local assistance are for maintenance of and improvements to local levees in the Delta region. The requested increases reflect the second year of a three-year budget plan to begin addressing what the department has characterized as a “crisis” in flood management.

For water management, the budget includes $249.9 million of state funds-spread throughout eight state departments-for the CALFED Bay-Delta Program (CALFED) in 2006-07. Of this amount, $26.4 million is proposed from the General Fund, with the balance mainly from various bond funds ($181.2 million) and State Water Project funds ($39 million). This level of expenditure is a 23 percent reduction from the current year, mainly reflecting a decline in available bond funds. The Governor is currently evaluating proposals to reform CALFED’s organizational structure as well as a draft long-term finance plan for the program. Given the status of the Governor’s review, the budget proposed in January does not reflect any significant changes to how CALFED is financed or governed.

Finally, although not reflected in his budget proposal, the Governor, as part of his SGP, proposes new bonds to be placed before the voters in 2006 and 2010 that would provide a total of $9 billion for flood protection ($2.5 billion) and water management ($6.5 billion). The Governor’s SGP also proposes a new assessment on retail water suppliers that would raise around $5 billion in revenues over ten years. These revenues would be used to support a variety of water management projects, with two-thirds of the funds collected being returned to local public agencies, private entities, and nonprofit organizations for regional water management projects.

Reorganizing the State’s Energy-Related Activities. The budget proposes expenditures in six energy-related state entities. Although the budget does not contain a proposal to reorganize California’s energy-related activities, the Governor’s budget document acknowledges that the administration is sponsoring legislation (AB 1165, Bogh), to do this. The Governor’s proposal contained in this legislation would create a single Department of Energy that would be charged with making the state’s energy policy. The current California Energy Commission, Electricity Oversight Board, California Power Authority, and California Energy Resources Scheduling Division in DWR would all be abolished, and their functions transferred to the new department. Under the Governor’s proposal, a modified Energy Commission would be created in the new department, with responsibilities limited to permitting new power plants, approving energy efficiency standards, and permitting electricity transmission infrastructure. The latter responsibility would be transferred from the California Public Utilities Commission where it currently resides.

Addressing Fiscal Issues in the Department of Fish and Game. The budget proposes $311 million from various sources for the Department of Fish and Game in 2006-07. The fee-supported Fish and Game Preservation Fund (FGPF) is the department’s largest single source of funding, providing $94 million and supporting about one-third of the department’s expenditures. The budget proposes a number of actions to bring FGPF into balance in the budget year due to revenue shortfalls. These include reducing FGPF expenditures by over $7 million, shifting funds among various accounts within the fund, and increasing the General Fund support of the department by $10 million.

Flood Protection and Water Management. In general, the budget’s requested increases for flood management are justified in light of the flood management challenges facing the state that were identified in a recent DWR White Paper-Flood Warnings: Responding to California’s Flood Crisis. However, the increases reflect a small fraction of the funding requirements identified in the White Paper. To some extent, the larger funding requirements are addressed in the bond proposals that are part of the Governor’s SGP. The Legislature should consider how the budget and bond proposals fit with one another and the appropriate mix of General Fund and bond funds in addressing the state’s flood management funding requirements.

Flood Protection. There are other issues that the Legislature should consider when evaluating solutions to the state’s flood management problems that are not addressed in the budget. First, the Legislature should consider the role for beneficiaries of the Central Valley flood control system-such as property owners living behind the levees-to help pay a portion of the infrastructure-related costs of the system. While the Governor’s SGP references support for a funding contribution from the beneficiaries, the Governor does not propose a specific mechanism to accomplish this.

Second, the Legislature should consider strategies to reduce the likelihood of ill-advised development approvals in flood-prone areas. One such strategy would be to require local agencies to make a determination that a new development has an adequate level of flood control, as they must currently do for water supply. This strategy has been included in AB 1899 (Wolk), introduced this session.

Finally, while the budget proposes increased funding to local agencies for the maintenance of Delta levees that are outside the state’s Central Valley flood system, it does not address the issue of the lack of state oversight over the operations and maintenance of these levees. The Legislature should consider increasing the state’s oversight of these levees as a cost-effective measure to reduce the state’s risk of incurring significant emergency response and repair costs when these levees fail.

Water Management and CALFED. Regarding CALFED, there are a number of actions that the Legislature can take to improve the program. First, the Legislature should revise the program’s organizational structure to better focus authority and responsibility for CALFED policy making and program management within the administration. Second, the Legislature should set expenditure priorities for CALFED and establish much needed performance measures for the program. Third, the Legislature should provide guidance statutorily on how to implement the “beneficiary pays” funding principle in financing CALFED. While the Legislature has on a number of occasions stated its intent that the program be funded according to this funding principle, there remains much disagreement as to how to implement it, as demonstrated by the administration’s failure to deliver a CALFED water user fee proposal pursuant to legislative direction.

Resource Bonds. There are a number of issues for the Legislature to consider when evaluating the Governor’s, as well as other, proposals for new resources bonds. First, the Legislature should retain an appropriate level of oversight of bond expenditures. The Legislature’s oversight is substantially weakened if bond funds are “continuously appropriated” and thus outside of the budget process as they are in the Governor’s proposal.

Second, in evaluating bond proposals, the Legislature will need to consider the funding eligibility of private entities, which in our view is mainly a policy choice. (Under the Governor’s bond proposals, private entities are eligible for grant funds.) We believe that the Legislature should explicitly declare its policy position on this matter in the bond measure.

Third, the Legislature should take action to ensure that bond-funded administrative costs are reasonable. In order to do this, the Legislature should provide a reasonable limit on, and definition of, administrative costs funded from bond proceeds.

Finally, in cases where a bond measure allocates funds for a programmatic purpose that is already being carried out by another existing program, the bond measure should explicitly address how the programs will be consolidated or at least coordinated. In analyzing the Governor’s bond proposals, we found a number of cases where it was unclear how programs funded by the bonds fit within existing programs with similar purposes.

Reorganizing the State’s Energy-Related Activities. While the long-term market structure for electricity in the state has been settled, we think that the timing is right for the Legislature to create a more efficient and accountable structure for the state’s energy-related activities. We recommend a revised organizational structure that should improve the state’s ability to address the energy challenges that remain whether or not a reorganization is adopted. (See “Part V” of this volume for a more detailed discussion of our recommendation.)

Employee Compensation

Pay for State Employees. The state’s costs for paying state employees are determined through collective bargaining with employee unions. The pay, benefits, and working conditions for these employees are typically spelled out in memoranda of understanding (MOUs) negotiated between unions and the state. Costs for state employees (including higher education) are projected to total more than $25 billion in 2006-07, about one-half of which is supported from the General Fund. As shown in Figure 17, 18 of the state’s 21 units will have expired MOUs by July 2, 2006. (One of the remaining three units-the state’s attorneys-currently has its MOU pending before the Legislature.) When a union has an expired MOU, the terms of that agreement generally remain in effect until a new MOU is signed and approved by the Legislature.


Figure 17 Status of Memoranda of Understanding (MOUs)
Unit Number	Bargaining Unit
MOUs Continuing Through 2006-07
7	Protective Services and Public Safety
9	Professional Engineers
MOUs Awaiting Legislative Action
2	Attorneys, Administrative Law Judges, and Hearing Officers
MOUs Expiring on or Before July 2, 2006
5	Highway Patrol
6	Corrections
8	Firefighters
10	Professional Scientific
16	Physicians, Dentists, and Podiatrists
18	Psychiatric Technicians
19	Health and Social Services/Professional
MOUs Currently Expired
1	Administrative, Financial, and Staff Services
3	Educators and Librarians (Institutional Settings)
4	Office and Allied
11	Engineering and Scientific Technicians
12	Craft and Maintenance
13	Stationary Engineer
14	Printing Trades
15	Allied Services (Custodial, Food, Laundry)
17	Registered Nurses
20	Medical and Social Services
21	Education, Consultants, and Librarians (Noninstitutional Settings)

Retirement Costs. As part of the employee compensation package, the state makes annual contributions to various retirement programs to fund benefits for state employees and teachers that will be paid out in the future. In recent years, the state’s retirement costs have increased significantly. For instance, state General Fund retirement costs have increased from $2.8 billion in 2002-03 to a projected $4.2 billion in 2006-07. The largest factors in this increase are the poor investment performance of retirement funds in the early part of the decade and rising health care costs. The state’s General Fund retirement costs for 2005-06 and 2006-07 are summarized in Figure 18.


Figure 18 General Fund Costs for Retirement Programs
(In Millions)
	Estimated 2005-06	Proposed 2006-07
State Retirement Plans
Public Employees’ Retirement Fund	$1,336	$1,366
Teachers’ Retirement Fund	1,081	1,080
Judges’ Retirement Funds	144	155
Defined Contribution Plansa	—	48
Subtotals	($2,561)	($2,649)
Other Retirement Benefits
Health and Dental Benefits for Annuitants	$895	$1,019
Social Security and Medicareb	401	420
Subtotals	($1,296)	($1,439)
University of California (UC) Retirement Programs
UC Retirement Plan	—	—
Health and Dental Benefits for UC Annuitantsb	$71	$71
Subtotals	($71)	($71)
Totals	$3,928	$4,159

a State's contribution to supplemental retirement plan for correctional officers and their supervisors and managers.
b Legislative Analyst's Office estimates.

Increased Pay for Some Employees. The Governor’s budget includes funds ($303 million, of which $135 million is from the General Fund) to pay for the costs of previously negotiated MOUs with 5 of 21 employee bargaining units (and associated managers). Among the largest components of these costs are the final raises under the state’s 2001 MOUs with highway patrol and correctional officers. In addition, the Governor’s budget includes $68 million (of which $57 million is from the General Fund) for compensation increases connected to the Plata v. Schwarzenegger court order concerning prison medical staff.

Retirement Costs. The Governor’s budget includes no significant proposals to change the way the state funds retirement benefits. As shown in Figure 18, the state’s 2006-07 General Fund retirement costs are projected to rise by over $200 million. Required contributions to the state’s two largest pension systems have leveled off due to modest growth in employee payrolls and the California Public Employees’ Retirement System’s new policies to stabilize employer contribution rates. The costs of health and dental benefits for retired state employees, however, continue to rise rapidly. About two-thirds of the total increase in General Fund costs for retirement benefits results from projected higher costs to provide health and dental benefits to 200,000 retired state employees and their dependents.

Local Government Mandates

Costs Will Probably Be Higher Than Budgeted. The budget-typical of recent practice-includes no funding for possible new MOUs. As shown in Figure 17, only three bargaining units have current MOUs extending past July 2, 2006 (including the proposed contract for the state’s attorneys). Combined, these three bargaining units represent about 12 percent of the state’s civil service employees. New MOUs for the other 88 percent of employees, if any, probably will increase costs above those included in the budget proposal. It would cost about $120 million ($65 million of which would come from the General Fund) for each 1 percent salary increase for state personnel in the other 18 state employee unions. In addition, most expiring MOUs require the state to pay a specific percentage of average health plan premium costs for employees. Even without new MOU agreements, rising state health plan premiums in 2007 would increase the amount the state must pay for health premiums. If no new MOUs are negotiated, costs for health, dental, and vision benefits could increase annually by up to $120 million (about one-third from the General Fund) for rank-and-file employees, assuming a 10 percent increase in 2007 state health plan premiums. The Governor’s budget includes no funding for these potential costs.

Unfunded Liability for Retiree Health. Under state law, the state pays for most of the costs of health plan premiums for retired state employees and their dependents. Annual payments are rising significantly to pay for existing retirees’ benefits. Like most governments across the United States, the state has set aside no assets that could be used to fund part of the future costs of benefits for the state’s current and past employees. Under a new governmental accounting rule to take effect soon, the state and other governmental entities will be required to calculate the unfunded liability for retiree health benefits (similar to the one already calculated for pension benefits). As we discuss in “Part V” of this publication, this liability will be very large-for the state, some school districts, many local governments, and UC. The Governor’s budget proposes a $252,000 appropriation for the state’s first actuarial valuation of retiree health liabilities, which is required under the new accounting rule. The Legislature should consider steps to encourage disclosure of liabilities and to plan for future costs. Finally, in anticipation of the results of the state’s proposed actuarial valuation, the Legislature could begin taking actions to address the future costs of retiree health benefits. Specifically, we recommend that the Legislature consider setting aside funds to moderate long-term budgetary pressures in this area.

The California Constitution generally requires the state to reimburse local governments, including schools and community colleges, when it mandates a new program or higher level of service. During times of fiscal difficulty, however, the state frequently has delayed making these mandate payments, resulting in the accrual of a large backlog of unpaid mandate claims.

Partly to address these matters, the state’s voters approved Proposition 1A in 2004. This measure requires the Legislature annually to take one of the following actions regarding each state-mandated local program: appropriate funds in the budget to pay its outstanding bills, “suspend” the mandate (render it inoperative for one year), or repeal it (permanently eliminate it or make it optional). Two categories of mandates-those relating to K-14 education and employee rights-however, are exempt from the payment requirement. Proposition 1A also authorizes the state to pay over a term of years unpaid non-education mandate claims incurred prior to 2004-05.

The Governor’s budget includes $240 million (General Fund) and $1.7 million (special funds) under the Commission on State Mandates’ budget item to pay noneducation, nonemployee rights mandate claims in 2006-07. (Funding for K-14 mandates is included under the K-12 and community colleges budget items. The $240 million for noneducation mandates includes: