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LAO Releases Outlook for California’s State Budget

November 21, 2016

 

(Editor’s Note: On November 16, the Legislative Analyst’s Office released a fiscal outlook for California’s state budget, including funding scenarios for K-12 education. The report’s executive summary, and the section dealing with K-12 education, are reprinted below.)

Executive Summary

In this report, we describe our office’s assessment of the condition of the California economy and budget over the 2016-17 through 2020-21 period.

Outlook Subject to Considerable Uncertainty. The condition of the state’s budget depends on many volatile and unpredictable economic conditions, including fluctuations in the stock market. Even in the short term, these conditions cannot be predicted with precision. They are even more difficult to anticipate years in the future. As such, while we have reasonable confidence in our expectations about the economy’s performance in 2017-18, we are much less able to anticipate the economic future in each year thereafter. To reflect these uncertainties, this report emphasizes one estimate of the near-term budget condition through 2017-18 and displays two different estimates of the budget’s condition in 2018-19 through 2020-21.

Positive 2017-18 Budget Outlook. For the near term, under our current economic projections and assuming the state makes no additional budget commitments, we estimate the state would end the 2017-18 fiscal year with $11.5 billion in total reserves. This total includes $2.8 billion in discretionary reserves, which the Legislature can appropriate for any purpose, and $8.7 billion in required reserves, which will be available for a future budget emergency. These reserve levels reflect the continued progress California has made in improving its budget situation.

State Is Increasingly Prepared to Weather a Mild Recession. For the longer term, we estimate the condition of the state budget under two different economic scenarios. They are: (1) an economic growth scenario, which assumes the economy continues to grow, and (2) a mild recession scenario, which assumes the state experiences a mild economic downturn beginning in the middle of 2018. Under the growth scenario, we estimate the budget remains in surplus over the outlook period. Under the recession scenario, we find that the state would have enough reserves to cover almost all of its operating deficits through 2020-21. This means, under our assumptions, the state could weather a mild recession without cutting spending or raising taxes through 2020-21.

New Commitments or Policy Changes Would Affect Outlook. Importantly, these estimates assume the state does not make any changes in any year during the outlook period to its current policies and programs. In addition, the outlook also assumes no new changes in federal policy, even though the recent election results suggest some such changes are now likely. Any such state or federal policy changes could have a significant impact on the state’s “bottom line.”

Education

Education Spending. In this section, we focus on Proposition 98, the universities, student financial aid programs, and child care programs. The “Proposition 98” section estimates total combined spending for elementary and secondary education (commonly referred to as K-12 education), the California Community Colleges, and a large portion of the state’s subsidized preschool program. The next section estimates spending for the University of California and the California State University. The “Financial Aid” section focuses on spending for Cal Grants and Middle Class Scholarships. The last section estimates non-Proposition 98 General Fund spending for the rest of the state’s preschool program as well as most child care programs.

Proposition 98

Proposition 98 Minimum Guarantee for Schools and Community Colleges. State budgeting for schools and community colleges is governed largely by Proposition 98, passed by voters in 1988. The measure, modified by Proposition 111 in 1990, establishes a minimum funding requirement, commonly referred to as the minimum guarantee. Both state General Fund and local property tax revenue apply toward meeting the minimum guarantee. In addition to Proposition 98 funding, schools and community colleges receive funding from the federal government, other state sources (such as the lottery), and various local sources (such as parcel taxes).

Calculating the Minimum Funding Guarantee. The Proposition 98 minimum guarantee is determined by one of three tests set forth in the State Constitution (see Figure 13). These tests depend upon several inputs, including changes in K-12 average daily attendance, per capita personal income, and per capita General Fund revenue. Though the calculation of the minimum guarantee is formula-driven, a supermajority of the Legislature can vote to suspend the formulas and provide less funding than they require. This happened in 2004-05 and 2010-11. In some cases, including as a result of a suspension, the state creates a higher out-year funding obligation referred to as a “maintenance factor.” The state is required to make progress toward meeting this higher obligation when year-to-year growth in state General Fund revenue is relatively strong. Though in most years the state has provided an amount at or close to the minimum guarantee, the state has discretion to provide any amount above the minimum guarantee.

2015-16 and 2016-17 Updates

2015-16 Minimum Guarantee Down $378 Million From Budget Act Estimate. The decrease in the minimum guarantee (see Figure 14) is due to our estimated $1.4 billion drop in General Fund tax revenue relative to budget act estimates. As a result of this revenue drop, the state is no longer required to make the $379 million maintenance factor payment included the June budget package. This drop in the guarantee is offset by a $1 million increase due to various other adjustments.

2015-16 Local Property Tax Estimate Revised Upward. Though the minimum guarantee has fallen from budget act estimates, Proposition 98 local property tax revenue is up $262 million. The bulk of this increase is attributable to higher-than-expected transfers from Educational Revenue Augmentation Funds to schools and community colleges. The increase in property tax revenue reduces Proposition 98 General Fund costs on a dollar-for-dollar basis. Coupling the increase in property tax revenue with the decline in the guarantee results in Proposition 98 General Fund dropping $640 million.

Further Downward Revisions in General Fund Revenue Unlikely to Affect 2015-16 Minimum Guarantee. Under our latest revenue estimates, the operative test for calculating the guarantee in 2015-16 changes from Test 2 to Test 3. Whenever Test 3 is operative, statute requires the state to make a supplemental appropriation if needed to ensure Proposition 98 funding grows as quickly as the rest of the budget. In 2015-16, shifting to Test 3 results in the state needing to make a $53 million supplemental appropriation. This additional funding raises the guarantee up to the Test 2 level. In 2015-16, were General Fund revenue to be further revised downward by as much as $1.6 billion, the required supplemental appropriation would increase correspondingly, bringing the guarantee back up to the Test 2 level. That is, further revenue declines in 2015-16 likely would have no effect on the minimum guarantee.

2016-17 Minimum Guarantee Down $10 Million From Budget Act Estimate. At the time of budget enactment, Test 3 was the operative test in 2016-17. Even under our latest estimates, Test 3 remains operative. In Test 3 years, the minimum guarantee builds upon the prior-year funding level adjusted for changes in per capita General Fund revenue and K-12 attendance. Compared with June budget act assumptions, we estimate General Fund revenue is $1.4 billion lower in 2015-16 and $350 million lower in 2016-17. Because the drop in the prior year is greater than the drop in the current year, the year-to-year growth rate increases. The higher growth rate offsets the decline in the prior-year funding level. After updating for various other inputs, including slightly lower estimates of K-12 attendance, the minimum guarantee is only $10 million below the level assumed in June. Under the latest inputs, the state creates $321 million in new maintenance factor, for a total outstanding maintenance factor obligation at the end of 2016-17 of $873 million. The new maintenance factor created dropped from the June budget package level of $746 million, due largely to the higher General Fund growth rate.

Forecast Assumes State Funds at the Revised Estimates of the Prior-Year and Current-Year Minimum Guarantees. Although the 2015-16 minimum guarantee has fallen by $378 million, the state allocated funding to schools and community colleges based upon the higher June 2016 estimate of the guarantee. After adjusting for changes in various program costs, we estimate that currently authorized 2015-16 spending exceeds the minimum guarantee by $351 million. Historically, in virtually all cases when the prior-year or current-year guarantee has been revised downward, the state has acted to reduce associated spending. For purposes of our outlook, we assume the state designates the $351 million as payment toward its outstanding settle-up obligation. (The state currently has an outstanding settle-up obligation of about $1 billion, mostly related to the 2009-10 minimum guarantee. The state creates a settle-up obligation when the minimum guarantee rises above the level initially assumed in the budget act.) Under this approach, the $351 million is not built into the 2016-17 Proposition 98 base.

2017-18 Budget Planning

2017-18 Guarantee $2.6 Billion Higher Than Revised 2016-17 Level. As shown in Figure 15, we estimate that the minimum guarantee will grow from $71.9 billion in 2016-17 to $74.5 billion in 2017-18, an increase of $2.6 billion (3.6 percent). Test 2 is operative, with the guarantee adjusted for a 2.7 percent increase in per capita personal income and a 0.2 percent decline in K-12attendance. In addition, because General Fund revenue is growing more quickly than per capita personal income, the state is required to make an $894 million maintenance factor payment. After making this payment, the state would end the year with no outstanding maintenance factor for the first time since 2005-06.

Nearly Half of Increase Covered With Property Tax Revenue. Of the $2.6 billion increase in Proposition 98 funding, state General Fund revenue covers $1.4 billion and local property tax revenue covers $1.2 billion. The main factor explaining the increase in property tax revenue is a 5.3 percent increase in assessed property values. This factor accounts for about $930 million of the increase. The other large contributing factor is a $340 million increase in the ongoing savings associated with the dissolution of redevelopment agencies. This increase is primarily due to the phase out of certain one-time costs related to recent changes in the dissolution process.

$2.8 Billion Available for Proposition 98 Priorities. As shown in Figure 16, the 2016-17 Budget Act provided $71.9 billion in funding for schools and community colleges. Of this amount, $496 million was allocated for one-time activities. Though this funding is freed up for other purposes moving forward, the state already has committed through previous budget agreements to $276 million in higher 2017-18 spending. The net effect of these changes, in combination with the $2.6 billion increase in the minimum guarantee, results in the state having $2.8 billion to spend on its 2017-18 Proposition 98 priorities.

State Could Achieve Almost Full Implementation of the Local Control Funding Formula (LCFF) in 2017-18. In recent years, the state has dedicated most new Proposition 98 funding to implementing the LCFF. If the state continued this practice in 2017-18, we estimate it could fund 99 percent of LCFF’s full implementation cost. Specifically, we estimate the state could spend $2.5 billion to close the remaining LCFF gap, increasing per-student LCFF funding by 4.5 percent over 2016-17 levels. Our estimate assumes community colleges continue to receive 11 percent of Proposition 98 funding, the state funds previously agreed-upon commitments, and other K-12categorical programs are adjusted for changes in attendance and cost of living.

2017-18 Guarantee Moderately Sensitive to Declines in State Revenue. We estimate that General Fund revenue could fall as much as $500 million below our estimates in 2017-18 with no change in the minimum guarantee. Even at this lower level, Test 2 would remain operative and year-to-year revenue growth would be large enough to require the state to pay down all remaining maintenance factor. For each additional dollar of revenue decline beyond this level, the guarantee would drop by about 40 cents. Regarding possible revenue increases, the minimum guarantee is mostly insensitive to any increase above the level assumed in our outlook. We estimate that 2017-18 General Fund revenue could increase about $5.5 billion before having any effect on the minimum guarantee. (An increase of this magnitude would make Test 1 operative and provide schools and community colleges about 40 cents of each dollar above the $5.5 billion threshold.) For the purpose of this sensitivity analysis, we assume prior-year revenue and other inputs remain constant. Changes to these factors could affect the thresholds and make the guarantee more or less sensitive.

Outlook for Later Years

Many Economic Scenarios Could Unfold Over the Period. State General Fund revenue over the next four years is likely to be affected by a variety of short-term developments (such as swings in the stock market) as well as long-term trends (such as growth in housing prices). In this section, we describe how the minimum guarantee would respond to two hypothetical economic scenarios – one assuming continued moderate growth over the period and one assuming a mild recession beginning in the middle of 2018. (These scenarios are discussed in greater detail in Chapter 4.) Both scenarios have built in the additional state General Fund revenue resulting from the recent passage of Proposition 55, which extended the income tax rates paid by high-income earners for an additional 12 years. (Though it does not affect the calculation of the guarantee, the recent passage of Proposition 51 is another significant development for schools and community colleges. The measure provides $9 billion in bonds for building and renovations school facilities.)

Under Growth Scenario, Minimum Guarantee Continues to Rise. As shown in the top part of Figure 17, the minimum guarantee under the growth scenario increases from $71.9 billion in 2016-17 to $83.5 billion in 2020-21. The average annual growth rate under this scenario is 3.8 percent. Under this scenario, the state creates little new maintenance factor, ending the period with about $200 million in outstanding maintenance factor obligation.

Under Recession Scenario, Minimum Guarantee Declines in 2018-19 and Remains Below Growth Scenario. As shown in the middle part of Figure 17, the guarantee under the recession scenario declines by $1.4 billion (1.9 percent) from 2017-18 to 2018-19. In 2018-19, the state creates more than $4 billion in new maintenance factor. Even with the state making maintenance factor payments the subsequent two years, the state ends the period with $3.1 billion in outstanding maintenance factor obligation. Under the recession scenario, the guarantee grows from $71.9 billion in 2016-17 to $78.1 billion in 2020-21, an average annual growth rate of 2.1 percent. As shown in the bottom section of Figure 17, by 2020-21 the minimum guarantee under the recession scenario is more than $5 billion below the level in the growth scenario. (Though this scenario assumes the recession does not begin until 2018-19, the 2017-18 year also is affected due to state accrual policies.)

Recession Scenario Serves as Cautionary Tale. Although the recession scenario illustrates one way an economic downturn could unfold, the timing and magnitude of the next recession is highly uncertain. Rather than being a prediction, the recession scenario serves as a cautionary tale about the volatility of Proposition 98 funding. To provide a measure of protection against such volatility, the state in recent years has allocated some of the available Proposition 98 funding for one-time activities. If the guarantee experiences a year-over-year decline, the expiration of this one-time funding provides a buffer that reduces the likelihood of cuts to ongoing school and community college programs.

Local Property Tax Revenue Projected to Rise Steadily Over the Period. Unlike the state General Fund, which tends to be highly sensitive to short-term economic developments, property tax revenue typically grows at a steadier rate. Under both our scenarios, the outlook assumes that property tax revenue grows from $20.9 billion in 2016-17 to $25.6 billion by 2020-21. Property tax revenue covers about 40 percent of the annual increases in the minimum guarantee under the growth scenario and about 65 percent of the increases under the recession scenario. Property tax revenue projections are driven primarily by assumptions of growth in assessed property values. We assume assessed values grow about 5.5 percent per year over the outlook period.

K-14 Cost-of-Living Adjustments (COLA) Projected to Remain Low. The statutory COLA for most K-14 programs is based upon a national price index for state and local government goods and services. Our outlook assumes the statutory COLA remains low throughout the period – hovering around 1 percent.

K-12 Attendance Projected to Decline. Our outlook assumes that K-12 attendance declines by 0.2 percent per year in 2016-17 and 2017-18 and by 0.3 percent per year later in the period. The largest factor explaining this decline is the outlook for birth rates. Whereas the state had about 550,000 births in 2007-08, births had dropped to about 500,000 in 2010-11. We assume births remain at this lower level throughout the period and that the school-age population declines as these smaller cohorts of students replace their larger cohort predecessors. We also assume relatively stable rates of migration from other states and countries.

LCFF Could Reach Full Implementation Soon, Grow for COLA Thereafter. Under our growth scenario, we estimate the state could fully fund the LCFF as soon as 2018-19. In this and subsequent years, growth in Proposition 98 funding would be more than sufficient to cover the LCFF targets as adjusted for changes in attendance and cost of living. Under the growth scenario, after supporting LCFF, the Legislature would have an additional $1.5 billion to $2.5 billion per year to spend on other Proposition98 priorities. Under the recession scenario, we estimate the state would not fully fund LCFF until 2020-21.

Pension Costs Rising Over the Period. Employer contributions to the California State Teachers’ Retirement System (CalSTRS) and California Public Employees’ Retirement System (CalPERS) are a key factor affecting the budgets of schools and community colleges. (CalSTRS administers the pension system for teachers and other certificated employees, whereas CalPERS administers the pension system for classified employees.) The 2014-15 budget included a plan to fully fund the CalSTRS pension system within about 30 years. Under the plan, district contribution rates increase from 8.25 percent of payroll in 2013-14 to 19.1 percent of payroll by 2020-21. In addition, the governing board of CalPERS has taken action in recent years to increase rates and pay down these liabilities more quickly. The latest actuarial estimates suggest that employer contribution rates for CalPERS will increase from 11.4 percent in 2013-14 to 21.1 percent by 2020-21. Compared with 2013-14 levels, total district contributions to CalSTRS and CalPERS are anticipated to be nearly $6 billion higher annually by 2020-21. (Of this total cost increase, about 70 percent relates to CalSTRS.) Under the growth scenario, these higher costs represents about one-quarter of the $24 billion cumulative increase in Proposition 98 funding districts would receive by 2020-21. Under the recession scenario, these costs represent about one-third of the $19 billion cumulative increase in Proposition 98 funding.

To read the complete LAO report, click on the link below:

http://lao.ca.gov/Publications/Report/3507#Executive_Summary

Source:  Legislative Analyst’s Office



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