Analysis of the 2008-09 Budget Bill: Perspectives and Issues, LAO Alternative Budget Plan

Alternatives to the Governor’s Budgetary Reforms

What Budgetary Reforms Does the Governor Propose? How Would the Proposed Changes Affect the Legislature’s Budgetary Authority? What Alternatives Could the Legislature Consider?

Summary

The Governor proposes that a constitutional amendment be put before the state’s voters related to the state’s budgeting process. The Governor has identified two problems with the state’s current system:

• The state does not save enough during good economic times and is, therefore, ill–prepared for swift deteriorations in revenues.
• Spending formulas make it too difficult to slow spending during bad economic times.

The administration proposes to limit the amount of revenues that the General Fund could receive in any year. In addition, the Governor proposes a system by which the administration could trigger across–the–board reductions if the state’s budget situation declined.

Although the measure would help even out the state’s revenues from year to year, it would also be inflexible to legislative decision making on a year–to–year basis. The proposed across–the–board reductions would fail to prioritize state spending and represent a serious diminution of the Legislature’s authority. Consequently, we recommend that the Legislature reject the proposed changes. We provide, instead, some alternatives it could consider which build upon the positive aspects of the Governor’s proposal.

The Governor proposes that a constitutional amendment be put before the state’s voters related to the state’s budgeting process. In this piece, we describe the budgetary changes that were implemented in 2004 and the Governor’s proposed reforms. Then, we provide an analysis of the proposal and alternatives that the Legislature could consider.

Budgetary Reforms Under Proposition 58

Proposition 58 was approved by the voters in March of 2004. Passed in conjunction with Proposition 57, which authorized the sale of up to $15 billion in deficit–financing bonds, Proposition 58 amended the State Constitution and made a number of changes to the state’s budgeting practices. These reforms were intended to help prevent the state from reaching the same level of budgetary problems that led to the issuance of the bonds. Proposition 58’s key changes are described below.

Balanced Budget. The Constitution has long required the Governor to propose a balanced budget. Proposition 58 also requires the Legislature to pass a balanced budget (expenditures do not exceed estimated available revenues).

Mid–Year Adjustments. The proposition also authorizes the Governor to call a fiscal emergency and special legislative session to address such an emergency. This year, the Governor used this power on January 10 to call the Legislature into special session to address the state’s budget problems. In such a case, if the Legislature fails to pass legislation to address the budget problem within 45 days, it would be prohibited from (1) acting on any other bills or (2) adjourning in joint recess until such legislation is passed.

New Reserve. Proposition 58 creates a second reserve called the Budget Stabilization Account (BSA), in addition to the state’s traditional Special Fund for Economic Uncertainties (SFEU). The Constitution now requires 3 percent of annual General Fund revenues be transferred to the BSA (smaller percentages were required in earlier years). The Governor is authorized to suspend this transfer through an executive order, which the Governor proposes to do for 2008–09. The annual BSA transfer has two components:

• Accelerated Payoff of Deficit–Financing Bonds. One–half of revenues transferred into the BSA are used to provide supplementary debt payments on the state’s deficit–financing bonds. These supplementary payments stop when the bonds are paid off or total BSA supplementary payments total $5 billion. Through the current year, $1.5 billion in supplementary debt payments have been made.
• Budgetary Reserve. Funds not used for supplementary debt payments stay in the BSA as a budgetary reserve. Transfers into the BSA are required until the reserve equals the greater of $8 billion or 5 percent of General Fund revenues (currently about $5 billion).

Transfers Out of the BSA. The Legislature can transfer funds out of the BSA for any purpose through statute. The 2007–08 Budget Act (Control Section 35.60) authorizes the Department of Finance (DOF) to transfer funds out of the BSA if needed to cover state expenses. Earlier this year, DOF transferred the entire balance of the BSA—$1.5 billion—to the SFEU to help close the state’s budget shortfall.

Not Much Time to Work. Under Proposition 58, transfers into the BSA began in 2006–07. With the state’s worsening fiscal situation in the current year, the balance of the BSA has already been depleted. As such, the Proposition 58 changes intended to build up the state’s budgetary reserve have not yet had an opportunity to fully function.

Components of the Governor’s Reforms

At the time this analysis was prepared, the administration had not yet provided the actual text of its proposed measure. Instead, in preparing this analysis, we have relied on the general characterizations of the measure that the administration provided us. Many of the details of how specific provisions would work in practice, therefore, are still unknown. We describe the key components of the Governor’s reforms below. The administration aims to have the measure placed on the November 2008 general election ballot, with an effective date of February 1, 2009.

Problem Definition

The Governor has identified two problems with the state’s current system:

• The state does not save enough during good economic times and is, therefore, ill–prepared for swift deteriorations in revenues.
• Spending formulas make it too difficult to slow spending during bad economic times.

Limit on General Fund Revenues Forces Reserve Build–Up

Ten–Year Revenue Growth Rate. The administration proposes to limit the amount of revenues that the General Fund could receive in any year.

Specifically, the amount would be limited by the average growth rate of General Fund tax revenues over the prior ten years. For instance, the administration estimates that tax revenues have grown by 6 percent between 1998–99 and 2007–08. If the proposal was in effect for 2008–09, therefore, General Fund tax revenues available for expenditure could grow by no more than 6 percent. The limit on revenues would be adjusted to allow for any new revenues from a General Fund tax increase.

Deposits Into New Reserve. In any year in which General Fund revenues were expected to grow by more than the ten–year average (based on a DOF forecast), the “excess” revenues would be deposited into a new reserve called the Revenue Stabilization Fund (RSF). The RSF would be in addition to the state’s two existing reserves, the SFEU and BSA. The administration intends to abolish the BSA once the state’s deficit–financing bonds are paid off (currently expected in 2012–13).

Transfers Out of the RSF. Unlike the state’s current reserves, the Legislature could not generally access the funds in the RSF, including in cases of fiscal emergencies. Instead, funds could only be transferred from the RSF to the General Fund in years in which General Fund revenues were forecasted to grow less than the ten–year average growth rate. In those years, the Legislature could transfer some or all of the RSF balance—up to the ten–year average growth rate—to the General Fund through a two–thirds vote of each house.

Building Up Reserve Balance

The aim of the Governor’s proposal is to build up a substantial amount of funds in the RSF—up to 15 percent of annual General Fund revenues (about $15 billion in today’s dollars). After this amount was met, the measure would require the Legislature to spend any additional funds on a variety of “one–time” purposes:

• K–14 Education. Forty percent could be spent on one–time K–14 education purposes. This spending would be outside of the Proposition 98 minimum guarantee.
• Other Purposes. The remaining 60 percent could be spent on any combination of tax relief, infrastructure, or general obligation bond debt service.

Automatic Mid–Year Budget Reductions

The measure would also establish a system by which the administration could trigger across–the–board reductions if the state’s budget situation declined. The DOF would estimate the state’s revenues and expenditures three times a year—in November, January, and May. If the state’s current–year budget was projected to have a negative reserve, then the administration would trigger reductions. The amount of the reductions would depend upon the severity of the budget shortfall. If the negative reserve was projected to be less than 1 percent of expenditures, then the reductions would be implemented to achieve a 2 percent reduction in spending on an annualized basis. If, however, the negative reserve was more than 1 percent, then the reductions would be implemented to achieve a 5 percent reduction on an annualized basis.

Types of Reductions. If passed, the constitutional measure would give the Governor the authority to achieve the specified percentage reductions in different ways, depending on the type of program.

• Preauthorizations for Entitlement Reductions. The measure would require the Legislature to enact contingency laws for entitlement programs—where spending is driven by requirements in existing law—such as Medi–Cal and the California Work Opportunity and Responsibility to Kids (CalWORKs). These contingency laws would have to specify how reductions would be implemented to achieve 2 percent or 5 percent reductions if triggered. For any programs for which the Legislature failed to enact contingency laws but was required to do so, the Governor would be given the authority to waive any state law in order to achieve the reduction target.
• Other Programs, Including Proposition 98. For other types of programs, the measure would provide the administration the authority to reduce statutory or budget act appropriations. This would include Proposition 98 revenue limit payments to schools, local assistance grants, and prison spending. In the case of Proposition 98, the administration would have the authority to reduce appropriations but not suspend the minimum guarantee. If these reductions resulted in spending below the minimum guarantee, the state would either incur a settle–up obligation or the Legislature would have to suspend the guarantee (with the existing vote requirements).
• Programs Exempt From Reductions. Finally, some areas of the budget would be exempt from reductions—when a certain level of spending is mandated by federal law, or constitutionally or contractually protected (such as debt service). The administration would determine which programs met these criteria.

Turning Off the Reductions. Any reductions would remain in place until turned off by the passage of a new budget or other law.

Implications of the Governor’s Reforms

Changes Would Help Level Out Revenues and Increase Reserves…

The administration shared with us some of its modeling of how the measure would have worked if it had been in effect in earlier years. Under the administration’s projections, the state’s budget problems from the recent past might have been lessened, but not eliminated, if the measure had been in effect. Since we have not reviewed the specific proposed language, we have not attempted to perform our own modeling. It is clear though—by limiting the appropriation of any revenues over the recent average growth rate—annual General Fund revenues would be leveled out under the measure. Budgetary reserves would be built up during good times and available to lessen the effect of revenue downturns.

…But With Potentially Difficult Results

Possible Pitfalls. Formulas, by their nature, cannot predict all future circumstances. As a result, they tend to limit, rather than increase, future policy makers’ options to craft budgets. For instance, as the state comes out of an economic downtown, it may experience above average revenue growth. This growth, however, would be off a lowered base. In such an instance, a portion of revenues would still be transferred to the RSF—despite state spending being at a significantly lower level compared to spending before the downtown. Restoring programs to their pre–downturn service levels could be impossible under the measure (unless taxes were raised).

Measure Could Lock in Structural Imbalance. As we discuss in “Part I” of this publication, the state would continue to face a structural gap between its revenues and spending—even if the Legislature approved all of the Governor’s budget proposals. If the state did not permanently bring its revenue and spending lines into alignment prior to the passage of the administration’s measure, it is possible the measure would permanently lock in this imbalance. That is because the measure would prevent the availability of any funds from higher–than–average revenue growth years from being used to close the gap. Absent the administration’s measure, such a year with healthy revenue growth could allow the state to pay off additional budgetary debt and finally gets its fiscal house in order.

Too Inflexible. For these reasons, we conclude that the proposed ten–year average formula would be too inflexible on a year–to–year basis. Without the ability to adjust to unexpected circumstances, the Legislature would be unnecessarily restricted in the tools available to balance the state budget.

Does the State Need Three Reserves?

Under the administration’s proposal, the state would have three reserves—the SFEU, BSA, and RSF. As part of its proposal, the administration would eliminate the BSA once the state’s deficit–financing bonds are paid off (scheduled for 2012–13). Yet, there is little reason to make the state’s budgeting even more complicated by instituting three reserves—even in the short term. If the Legislature chooses to make changes regarding its budgetary reserves, we recommend modifying, rather than supplementing, the state’s existing two reserves.

Across–the–Board Approach Ill–Advised and Contrary to Balance of Powers

Limited Effort to Set Priorities. Throughout this publication, we critique the administration’s across–the–board reductions approach to the 2008–09 budget. The administration’s budget reductions reflect little effort to prioritize and determine which state programs provide essential services or are most critical to California’s future. Under the administration’s constitutional measure, this across–the–board reduction approach would become the default for any future state budget problems. All state programs (except those determined to be exempt by the administration) would be subject to the 2 percent or 5 percent reductions. The Legislature could determine how those levels of reductions were achieved in a particular program through the passage of a contingency law. The Legislature, however, could not prioritize and determine whether some programs should be protected from any reductions or whether others should experience greater reductions.

Legislature Should Maintain Its Appropriation Authority. The proposed changes also represent a serious diminution of the Legislature’s authority. Under the State Constitution, only the Legislature can appropriate funds and make mid–year reductions to those appropriations. Under the administration’s proposal, however, the Governor would have the authority to determine when across–the–board reductions would occur. Moreover, if the Legislature did not pass the contingency laws envisioned by the measure, the Governor would have the authority to waive state laws affecting the state’s core programs.

Existing Process for Mid–Year Reductions. The administration has not made it clear why the existing process to make mid–year reductions is not sufficient. For past mid–year budget problems, the administration has submitted specific reduction proposals to the Legislature. The Legislature is then given the opportunity to adopt the Governor’s proposals or substitute other alternatives. Proposition 58 formalized this process by authorizing the Governor to declare a fiscal emergency and call the Legislature into special session, as he has done this year. This new process has the added component of the 45–day schedule described earlier to help ensure timely action. While the across–the–board mechanism envisioned by the administration could implement some reductions a few weeks earlier, it does so by denying the Legislature the opportunity to review the impacts of any proposals prior to their adoption.

Building on the Positive Aspects of the Proposal

Based upon the inherent flaws in the Governor’s proposal discussed above, we recommend that the Legislature reject the administration’s approach. The Legislature should not pursue budget changes which take away its appropriation authority or hamstring future budget decisions through a formula. Yet, if the Legislature wishes to pursue alternative budgetary changes, it could build upon the positive aspects of the Governor’s proposal—namely, seeking to build up additional reserves during good times and avoiding formulas driving state budgeting. We discuss some alternatives to the Governor’s approach for both of these areas below.

Strengthening Proposition 58’s Provisions

Determining when and how much money should be transferred to a reserve always involves an inherent tension between the demands for current services and an attempt to prudently save for a rainy day. To encourage additional saving in the future, we believe the Legislature could build upon Proposition 58’s framework. As noted above, due to the state’s financial cycle, the measure has not yet had an opportunity to fully function. Yet, it is apparent that the measure could be strengthened to better meet its original goals.

Increase Total Amount of Reserve. Currently, the BSA has a maximum balance of $8 billion. Building up to this level will take a number of years, particularly until the state pays off its deficit–financing bonds. Even so, with the state’s volatile revenue structure—where multibillion dollar swings in annual revenue forecasts are common—the Legislature should consider increasing the BSA’s maximum balance. Targeting 10 percent of annual General Fund spending as a long–term goal for building up the reserve (currently $10 billion but growing over time) would give the state a greater cushion from economic downturns.

Harder to Access Funds. Currently, the Constitution specifies that BSA funds may be accessed through any statute. The 2007–08 budget provided the authority for DOF to access the BSA balance. In the future, if the BSA funds were more difficult to access, the state might make more conservative budgetary decisions to guard against financially overcommitting the state. For instance, requiring the passage of a separate bill (outside of the budget bill) to access the BSA would make it more difficult to count on using BSA reserve funds in a budget plan.

Mechanism to Increase Transfers in Really Good Years. We appreciate the administration’s effort to transfer excess revenues to a reserve. The problem is determining what revenues are excess in any year and locking that definition into the Constitution. By driving off of the average growth rate, the administration’s proposal would transfer funds to the RSF in roughly half of the years. As an alternative, the Legislature could develop a higher threshold when revenues are considered excess. The Legislature could particularly focus on those years when there is an “April surprise”—personal income tax receipts which surge well beyond the amounts predicted in the budget. When revenues are received in April (which is nearly the end of the fiscal year), we think it would be reasonable to consider them as excess and automatically transfer them to the BSA. (This is in contrast to budget–year revenue forecasts when the Legislature and Governor have the regular budget process to debate how any new funds should be used.) We would suggest limiting such transfers to those years in which the updated revenue total for the year exceeds the budget’s forecast. (This would not require the transfer of revenues that simply catch the state up from earlier soft revenue months.)

Rethinking the State’s Budgetary Formulas

The Governor also identified the large number of formulas driving state budgeting as a key problem. We agree that the state’s budget has become increasingly complicated and confusing—partially as a result of the number of formulas affecting state spending. Yet, even with these formulas, the Governor’s own budget proves that virtually all aspects of the state budget are controllable. Many of the formulas can be, and have been, amended or suspended by the Legislature and/or Governor when necessary.

Difficult Choices. While the Governor proposes formula changes in a couple of instances (regarding reductions to Proposition 49’s afterschool funding and K–12 education cost–of–living adjustments [COLAs]), the administration has not put forward a comprehensive set of proposed changes to budgetary formulas. We believe that engaging in a comprehensive review of state formulas would be a worthwhile effort for the Legislature. The Legislature could systemically review the formulas to determine if they are still needed and continue to reflect today’s priorities. If it chose to “unlock” the state budget by repealing these types of formulas, it would gain a great deal of flexibility in crafting the budget on a year–to–year basis. Such changes, however, would potentially affect the funding of numerous key state program areas, as well as require asking the voters to reverse a number of previously approved propositions. We discuss below the types of propositions and statutory measures which restrict state budgeting. Figure 1 summarizes recent propositions with major General Fund effects in this regard.

Dedicated Tax Revenues. In recent years, there have been a number of approved propositions which raised tax revenues historically used for general purposes but instead dedicated them to specific purposes. As such, these measures restrict the Legislature’s authority to prioritize spending among programs in any particular year.

Locked in General Fund Spending. Other ballot measures have guaranteed that a certain portion of General Fund spending be dedicated to a specific purpose. These measures restrict the Legislature’s ability to alter the relative shares of General Fund spending provided to program areas in any given year.

Statutory Cost Drivers. In addition to the propositions described above, the Legislature has also enacted a variety of statutory formulas and other measures which create cost pressures or increase General Fund spending from year to year.

• The state has a variety of “entitlement” programs laid out in state law—guaranteeing benefits to any individual who is eligible for a program. These include Medi–Cal, a number of social services direct assistance programs, and a portion of the state’s CalGrant financial aid program.
• The state also has a number of statutory COLAs which provide increased funding each year to compensate for the adverse effects of inflation on the purchasing power of the previous year’s funding level. These include most Proposition 98 programs, trial court funding, some portions of Medi–Cal, CalWORKs, and Supplemental Security Income/State Supplementary Program.
• The state offers “defined benefit” retirement programs to its employees, both in the form of pensions and retiree health services. These programs guarantee that employees will receive specific benefits in the future, regardless of the level of state’s costs necessary to provide the services.

Conclusion

The Governor’s proposed budgetary reforms would make future budgeting even more complicated and represent a loss of legislative authority. In putting forward its proposal, however, the administration does raise some legitimate questions about how to better build up the state’s reserves in good times and maximize budgetary flexibility.

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