Budget Overview 2014

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M A C TAY L O R L E G I S L A T I V E A N A L Y S T J A N U A R Y 1 3 , 2 0 1 4

The 2014-15 Budget:

Overview of theGovernors Budget


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2 Legislative Analysts Of ce www.lao.ca.gov


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www.lao.ca.gov Legislative Analysts Of ce 3

TABLE OF CONTENTSExecutive Summary ............................................................................. .....................5

Overview ...................................................................................................................7

Economy and Revenues ........................................................ .................................14

Governors Major Proposals .......... ........................................................................18Rainy-Day Fund ............................................................................................................................ 18CalSTRS ........................................................................................................................................... 22Proposition 98 .............................................................................................................................23Higher Education ........................................................................................................................ 28Health and Human Services ....................................................................................................32Infrastructure ................................................................................................................................34Resources and Environmental Protection ..........................................................................37Judicial and Criminal Justice ...................................................................................................40


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EXECUTIVE SUMMARYThe Governors Budget Proposal

Proposes $2.3 Billion Reserve. On January 9, 2014, the Governor presented a budget packagethat included $151 billion in spending rom the General Fund and special unds, an $11 billionincrease over the revised 2013-14 level. Te Governor proposes a $2.3 billion reserve at the end o2014-15comprised o $1.6 billion in the rainy-day reserve created by Proposition 58 (2004) and$693 million in the General Funds traditional reserve. Recent, sharp increases in personal incometax (PI ) collectionsdriven largely by soaring stock prices in 2013have improved the statesbudget condition signicantly.

Major Features o the Governors Budget. Te budget package uses much o the large projectedgrowth in the Proposition 98 budget to pay down $6.2 billion in school and community collegesde errals. Outside o Proposition 98, the budget accelerates $1.6 billion in payments or the states

prior decit nancing bonds. In addition, the Governor proposes a rainy-day und measureor the November 2014 ballot that would base deposits on capital gains related revenuesthe

states principal source o revenue volatility. Te Governors budget includes a plan or allocating$850 million in cap-and-trade auction revenues and proposes $618 million to address the stateswater challenges. Further, the budget includes $815 million or de erred maintenance in rastructureprojects.

LAO Comments

Governors Budget Would Continue Cali ornias Fiscal Progress. Cali ornia has madesubstantial progress in recent years in addressing its prior, persistent state budgetary problems.Tis progress has been acilitated by a recovering economy, a stock market that has been soaringrecently, increased revenues rom the temporary taxes o Proposition 30, and the Legislaturesrecent decisions to make ew new ongoing spending commitments outside o Proposition 98. Teproposal continues the Governors ocus on paying down the wall o debt, a selection o budgetaryliabilities the state incurred in addressing its past budget problems. Te Governors emphasis on debtrepayment is a prudent one. Overall, the Governors proposal would place Cali ornia on an evenstronger scal ooting, continuing Cali ornias budgetary progress.

Addressing Some o Cali ornias Biggest Budgetary Issues. Te Governors proposal or a newrainy-day und requirement emphasizes the importance o regular state contributions to a larger

budget reserve. So does ACA 4, the measure currently scheduled or the November 2014 statewideballot. In general, setting aside money or a rainy day is exactly what the state should be doing whenrevenues are soaring, as they are now. In this report, we discuss issues the Legislature will want toconsider or these and other rainy-day und alternatives. With regard to another difficult budgetaryissue or Cali orniaaddressing the large un unded liabilities o the states teachers retirementsystemwe suggest that the state set aside unds beginning this year in anticipation o a uturelong-term unding plan.


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OVERVIEWThe Governors Budget Proposal

On January 9, 2014, the Governor presentedhis 2014-15 budget proposal to the Legislature.As displayed in Figure 1, the Governors spendingplan includes $151 billion in spending rom theGeneral Fund and special unds combined. Tisreects an $11 billionor 8 percentincrease over2013-14 revised levels.Recent, sharp increasesin personal income taxcollectionsdriven largelyby soaring stock prices in

2013have improved thestates budget conditionsignicantly.

AdministrationsBudget Forecast

Improved GeneralFund Condition.Figure 2 displaysthe administrationsprojection o the GeneralFund condition. TeJune 2013 spending planassumed that 2013-14would end with a$1.1 billion reserve. TeGovernors budget nowestimates a $3 billionreserve or the state at

the end o 2013-14. Te$1.9 billion increase in the2013-14 reserve is largelyexplained by:

Figure 1

Governors Budget Expenditures(Dollars in Millions)

Fund Type

2012-13

Revised

2013-14

Revised

2014-15

Proposed

Change From 2013-14

Amount Percent

General Fund a $96,562 $98,463 $106,793 $8,331 8.5%Special funds 37,724 41,153 43,979 2,826 6.9 Budget Totals $134,286 $139,616 $150,772 $11,156 8.0%

Selected bond funds $6,715 $8,181 $4,166 -$4,015 -49.1%Federal funds 70,431 85,803 84,562 -1,241 -1.4a Includes Education Protection Account created by Proposition 30 (2012).

Figure 2

Governors Budget General Fund ConditionIncludes Education Protection Account (In Millions)

2012-13 2013-14 2014-15

Prior-year fund balance a -$1,100 $2,254 $3,938Revenues and transfers 99,915 100,147 106,094 b

Total resources available $98,816 $102,401 $110,032

Expenditures $96,562 $98,463 $106,793 c

Ending fund balance $2,254 $3,938 $3,239 Encumbrances $955 $955 $955

Reserve d $1,299 $2,983 $2,284

Budget Stabilization Account $1,591

Special Fund for Economic Uncertaintiesd

$1,299 $2,983 693a The 2014-15 Governors Budget Summary , as released on January 9, 2014, included an $832 millionnet increase in the 2012-13 entering fund balance, compared to data in the states June 2013 enactedbudget plan. The number listed on this line for 2012-13 reects a $274 million downward adjustmentrelated to personal income tax accruals for 2011-12 and pr ior years, reecting an error identied by theadministration subsequent to the release of the Governors budget.

b Amount differs from that in the 2014-15 Governors Budget Summary . To improve the comparability withprior-year gures, the number listed here includes all revenues, including those transferred to the BudgetStabilization Account, resulting in $1.6 billion higher revenues than shown in administration totals.

c Includes $1.6 billion to accelerate the retirement of economic recovery bonds.d Lower than displayed in the 2014-15 Governors Budget Summary by $274 million due to the downward

adjustment described in footnote a.

Higher 2011-12, 2012-13, and 2013-14Revenues. Over 2012-13 and 2013-14combined, the administration nowestimates General Fund revenues and nettrans ers to be $4.8 billion higher thanbudget act estimates. In addition, thereis a $558 million upward und balance


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adjustment or 2011-12 and prior yearsmainly related to revenue accruals.

Higher General Fund Proposition 98Spending. Te administrations estimated

revenue gains are in large part offset by$3.6 billion in increased General Fundspending on schools and communitycolleges in 2012-13 and 2013-14. Inaddition, the administration has revised itsnon-Proposition 98 spending estimates or2012-13 and 2013-14changes that, on net,improve the budget condition by a smallamount.

Governor Proposes $2.3 Billion Reserve at Endo 2014-15.Te Governors budget plan includesGeneral Fund spending in 2014-15 that exceedsrevenues by about $700 million. Te budget,however, includes several one-time spending items,including a $1.6 billion one-time supplementalpayment to retire the states outstandingeconomic recovery bonds (ERBs). Te Governorcan trigger this supplemental payment underProposition 58 (2004), the states existing rainy-day

und requirement. (Te supplemental paymentwill result in an early retirement o the ERBs,generating General Fund savings rom expirationo the so-called triple ip in 2015-16about oneyear earlier than otherwise would be the case.)Te Governor proposes the state end 2014-15 witha total General Fund reserve o $2.3 billion$700 million below the revised reserve levelat the end o 2013-14. Te 2014-15 reserve is acombination o $1.6 billion in the Proposition 58rainy-day und (known as the Budget StabilizationAccount [BSA]) and $693 million in the GeneralFunds traditional reserve, the Special Fund orEconomic Uncertainties (SFEU).

Major Features of the Governors Budget

Figure 3 displays the major eatures o theGovernors budget proposal. In recent years, theprimary ocus o the budget process has beenon the General Fund. Until the 2013-14 budgetdeliberations, the state had aced a multibilliondollar General Fund short all in nearly every yearover the preceding decade. Recently, however, theneed or these actions has diminished, and this yearthe state is aced with choices on how to allocateseveral billion dollars o surplus General Fundresources. Te Governors budget reects this shifin ocus away rom the General Fund, as many ohis major proposals are or special und programs.

Below, we describe the major proposals in theGovernors budget plan.

Proposes $2.3 Billion Reserve. For the rsttime since 2007-08, the Governors budget reectshis intent to trans er unds to the BSA. (UnderProposition 58, the Governor determines whetherthe scheduled BSA trans er occurs annually.)Specically, the budget plan shifs 3 percent($3.2 billion) o General Fund revenues to thisrainy-day und. Hal o these unds must go toaccelerate repayment o the ERBs, which were usedto nance state budget decits o the early 2000s.

Includes New Rainy-Day Fund ConstitutionalProposal. Te Governors budget package proposesto replace ACA 4the rainy-day und measurecurrently scheduled or the November 2014ballotwith an alternative measure. Specically,the measure would base the required depositsinto the rainy-day und on projections o capital

gains-related PI the states principal source orevenue volatility. In addition, the proposal wouldcreate a Proposition 98 reserve to attempt to reduce volatility within the Proposition 98 budget.

Pays Down State Debts. Te Governorsproposal reects his continued ocus on repayingitems on the wall o debt. As discussed above, hal


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o the trans er to the BSA will be used to acceleratethe pay down o the ERBs. Te Governor plans touse much o the large growth in Proposition 98

unding to pay off the remaining school andcommunity college de errals ($6.2 billion). Te

Proposition 98 package also includes $188 million

or the Emergency Repair Program (ERP).Additionally, the plan provides unds to pay off$1.6 billion in special und loans in 2013-14 and2014-15 combined, including a $328 millionHighway Users ax Account loan and $100 million

o the loan rom the Greenhouse Gas (GHG)

Figure 3

Major Features of the Governors BudgetReserve/Rainy-Day Fund

End 2014-15 with $2.3 billion reserve (including $1.6 billion in Proposition 58 reserve). Create new rainy-day fund mechanism to replace existing Proposition 58 reserve with new Proposition 98 reserve.

Paying Down State Debts (One-Time Costs)

Accelerate pay down of economic recovery bonds by about one year ($1.6 billion General Fund). Pay off remaining school and community college deferrals ($6.2 billion Proposition 98 funds).

Repay $1.6 billion in special fund loans in 2013-14 and 2014-15 combined. Provide $188 million for school repairs.

Education

Provide additional $4.5 billion for K-12 Local Control Funding Formula. Increase funding for community college student support ($200 million). Provide 3 percent increase for community college enrollment growth ($155 million). Provide unallocated base augmentations to UC and CSU ($142 million each). Create $50 million grant program for universities and community colleges to change service delivery. Shift debt-service payments into CSUs budget.

Health and Human Services

Exempt certain Medi-Cal providers from recoupment of prior-year payment reductions previously enjoined.

Restrict overtime for IHSS workers in response to new federal regulations.

Infrastructure

Deliver to Legislature rst ve-year infrastructure plan since January 2008. Provide $815 million in one-time funds (from General Fund and other funds) for deferred maintenance projects. Authorize $500 million in lease-revenue bond authority for jail construction.

Cap-and-Trade

Allocate $850 million in cap-and-trade auction revenues to various programs, including: $250 million forconstruction of the high-speed rail system and $200 million for low-emission vehicle program.

Water

Propose $618 million plan (almost all from special funds) for various water-related programs, including

protecting groundwater basins, augmenting local water supplies, and improving ood protection. Transfer safe drinking water program from Department of Public Health to State Water Resources ControlBoard.

Judiciary and Criminal Justice

Provide $105 million ongoing increase to judicial branch. Assume two-year extension of court-ordered population cap.

Other Programs

Assume that most state employees receive at least 2 percent pay increase in 2014-15 ($173 million all funds).


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Reduction Fund. (As described later, the lattertwo repayments are related to the Governorsin rastructure and cap-and-trade proposals.)

Includes $11.8 Billion or Proposition 98 Above 2013-14 Budget Ac t Levels. Te Governors

budget includes $11.8 billion in Proposition 98spending increases$7.6 billion attributable to2014-15, $3.7 billion attributable to 2012-13 and2013-14, and $503 million or earlier years. O the$11.8 billion, $6.8 billion is designated or one-timepurposes and $5 billion or ongoing purposes. Mosto the one-time unding is allocated or payingoff the school and community college de errals($6.2 billion). O the ongoing unding, $4.5 billionis or the school district Local Control FundingFormula (LCFF).

Proposes Increased General PurposeFunding or Universities. Te Governor proposesunallocated base budget increases o $142 millioneach or University o Cali ornia (UC) andCali ornia State University (CSU) in 2014-15.Tese increases represent the second annualinstallment in a our-year unding plan proposedby the Governor last year. Te Governor conditions

his proposed annual unding increases or theuniversities on their maintaining tuition at currentlevels. Similar to last year, the Governor does notpropose enrollment targets or enrollment growth

unding or the universities.In rastructure Proposals Include $815 Million

or De erred Maintenance. According to theGovernors Budget Summary , the administrationintends to deliver to the Legislature the rstve-year in rastructure plan since 2008. Tebudget plan includes major proposals related toin rastructure, including $815 million (mostly

rom special unds) or de erred maintenanceprojects. In addition, the budget proposes to shif$211 million in remaining bond authority rom various school acility programs, such as seismicmitigation, to new school construction and school

modernization. Similar to last year, the Governorproposes to shif debt-service payments into CSUsmain appropriation. Te Governors budget planalso proposes $500 million in lease-revenue bondauthority to help counties construct and modi y jail

acilities.Proposes $850 Million Cap-and- rade

Spending Plan. In 2006, legislation was enactedto reduce GHG emissions statewide to 1990 levelsby 2020. Among these efforts, the states cap-and-trade program places a cap on aggregate GHGemissions rom entities responsible or roughly85 percent o the states GHG emissions. TeGovernors budget includes a plan or allocating$850 million in cap-and-trade auction revenues,including $250 million or the states high-speedrail project.

Includes $618 Million Plan or Water Projects.In October 2013, the administration releaseda draf plan to address water challenges acingthe state. Tese challenges include limited anduncertain water supplies, poor quality o sur acewater and groundwater, impaired ecosystems, andhigh ood risk. Te Governors budget package

includes $618 million to implement some aspects othe plan.

The Administrations Multiyear Forecast

Forecasts Balanced Budgets Trough2017-18. Te administrations multiyear budgetprojection reects both its updated revenue andexpenditure projections, as well as projectionso various proposals made by the Governor inhis 2014-15 budget plan. It projects that GeneralFund revenues will annually exceed expendituresafer 2014-15, resulting in an operating surplus o$1.7 billion in 2015-16, growing to $2.3 billion in2017-18. Compared to our November orecast, theseoperating surpluses are much lower. Tis disparityresults in large part rom a ew billion dollars ineach year or wall o debt payments that are not


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included in our orecast. Even with these payments,the administration orecasts that 2017-18 wouldend with an $8.3 billion reserve$4.6 billion in theBSA and $3.7 billion in the SFEU. Consistent withstandard orecasting conventionsincluding our

officesthe administrations multiyear orecastimplicitly assumes continuation o the currenteconomic expansion or several years.

LAO Comments

Governors Budget Would ContinueCali ornias Fiscal Progress. Cali ornia hasmade substantial progress in recent years inaddressing its prior, persistent state budgetaryproblems. Tis progress has been acilitated bya recovering economy, a stock market that hasbeen soaring recently, increased revenues romthe temporary taxes o Proposition 30, and thestates recent decisions to make relatively ewnew non-Proposition 98 spending commitments.Overall, the Governors proposal would placeCali ornia on an even stronger scal ooting andcontinue Cali ornias scal progress. By allowingdeposits to the states existing Proposition 58

rainy-day und to resume, the state can begin tobuild a strong precedent or accumulating reservesduring good revenue times. Te Governorsplanned early repayment o the states decit bondswould ree up sales tax resources now dedicatedto bond repayment to support the General Fundbeginning in 2015-16 or so. Te Governor alsoprudently proposes to continue paying downspecial und loans and other wall o debt items,including his plan to pay off all school paymentde errals rom Proposition 98 unds. Finally, theGovernor proposes limited new spending outside oProposition 98, some o which is one-time spendingcommitments such as his de erred maintenanceproposal.

Governor Prudently Prioritizes DebtRepayments. In crafing his 2014-15 budget

proposal, the Governor started with a possiblesurplus comparable in size to the one we estimatedin our November 2013 scal orecast. (While theadministrations revenue estimates are somewhatlower, so are its Proposition 98 and some other

spending estimates.) Te Governor prioritizedmaking wall o debt repayments in his proposal. Inthe budget summary, the administration estimatesthat the Governors plan would reduce the wall odebt by $11.8 billion in 2014-15. Tese reductionscan be broken into three categories: (1) ERB wallo debt costs that are mandatory, which are about$2 billion in 2014-15; (2) Proposition 98 wall odebt reductions o about $6.7 billionprincipallythe Governors choice to propose pay downs oschool payment de errals (to be paid rom theoverall pot o state unds required to be providedto schools); and (3) the remaining $3 billion or soo wall o debt repayments in the Governors plan.Tis $3 billion consists mainly o the Governorsplanned $1.6 billion payment to retire theremaining ERBs one year early and his proposed$1 billion o payments to pay off past loans romthe states special unds. While the Governor has

the authority under Proposition 58 to trigger theaccelerated ERB repayment, this decision andat least some o his proposed special und loanrepayments represent choices that he made indesigning his budget proposal. In general, wethink the Governors ocus on debt repaymentsis a prudent one. Te Legislature, however, hasthe ability to amend the Governors special undloan repayment plan by adding different special

und loan repayments, deleting others, changingproposed repayment amounts, or adopting broaderchanges to ees and expenditures o the special

unds involved.Goals o Governors Rainy-Day Proposal Are

the Right Ones. As described in the Rainy-DayFund section o this report, regularly contributingto a larger rainy-day und is exactly the direction


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the state should be taking at a time when revenuesare soaring. Te Governors proposal would basedeposits into the rainy-day und on capital gainsrelated revenuesthe principal source o staterevenue volatility. Te states experience with

constitutional ormulas, however, suggests that anyormula-based proposal merits care ul legislative

consideration. In the Rainy-Day Fund sectiono this report, we discuss some o the actors theLegislature may wish to consider in weighing aconstitutional rainy-day und requirement.

Governors Overall Proposition 98 PlanReasonable. We believe the GovernorsProposition 98 plan provides a reasonable mixo one-time and ongoing spending. By retiringthe $6.2 billion in outstanding K-14 de errals,the Governors plan would eliminate the largestcomponent o the school and community collegewall o debt by the end o 2014-15. In addition toreducing outstanding one-time Proposition 98obligations signicantly, the Governors plan alsowould increase ongoing programmatic spendingsignicantly by augmenting both the LCFF andcommunity college programs. Te mix o one-time

and ongoing spending is particularly important in2014-15 given the minimum guarantee likely will be very sensitive to volatility in General Fund revenues,with estimates o the guarantee potentially swingingwidely over the coming months.

Governors Higher Education ProposalsSimilar Concerns as Last Year. Te Governorshigher education budget plan is very similar tolast year, with the continuation o most o hisproposals relating to unallocated base budgetincreases; no specied expectations with regardsto operations, acilities, or per ormance; and noenrollment expectations. As with last year, weremain concerned that his plan would lead to lessresponsiveness rom the segments in meeting statepriorities as well as diminished state guidance andoversight.

Focus on De erred Maintenance Positive. Asdescribed earlier, the Governors budget proposes$815 million or de erred maintenance projects.We believe that it is important or the state to beginto address its accumulated de erred maintenance

needs. While de erring annual maintenance lowerscosts in the short run, it ofen results in substantialcosts over the long run. Te Governors plan is apositive rst step towards dealing with an importantand ofen ignored program.

Issues With Other In rastructure Proposals.Te Governors budget contains severalin rastructure ideas and proposals, includingones relating to school acility unding, CSU debtservice, and county jail construction. With regardsto rethinking the nancing o school acilities, theLegislature would have many issues to consider

rom differences in local revenue-raising abilityamong districts to the distribution o any state

unds among districts, the stability o that unding,and the incentives provided or districts to buildand maintain acilities cost-effectively. Regardingthe Governors CSU debt-service proposal, weare concerned that the approach diminishes the

Legislatures oversight over the universitys use ostate unds. And with respect to the Governorsproposal or $500 million in bond authority orcounty jail construction, we suggest that theLegislature seek rom the administration additionalin ormation on county jail needs and other issues inconsidering the proposal.

Cap-and- rade Proposal Unlikely to MaximizeEmission Reductions. Te Governors budgetproposes a plan or using $850 million in auctionrevenues generated rom the cap-and-trade program

or various projects to GHG emissions. Mostnotably, the plan includes $250 million or thestates high-speed rail project. As discussed later inthis report, we are concerned that the Governorsproposal likely would not maximize the reductiono GHG emissions.


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Governors Integrated Approach or WaterHas Merit. he Governors budget proposes$618 mil lion to begin implementing a plan toaddress water challenges acing the state. We

ind that the Governors integrated approach

has merit, though we lay out some policyconsiderations and unding issues that theLegislature may want to consider in weighing theGovernors proposal.

Setting Aside Some Money or CalS RS Now Would Be Smart. he Governors BudgetSummary expressed an interest in workingwith school districts and teachers over thecoming year to reach agreement on a long-termCali ornia State eachers Retirement System(CalS RS) unding plan that would ully undthe system over a 30-year period. We agreewith the Governor regarding the key goal o ashared responsibility to achieve a ully- unded,sustainable teachers pension system withinabout 30 years. In the meantime, however, wesuggest that the state set aside some moneyduring the 2014-15 budget processwhen thestate is experiencing a signi icant in lux o

revenuesin anticipation o the states adoptiono a long-term CalS RS unding plan.

Planning or Possibility o Even HigherRevenue Estimates in May. In May, when theGovernor presents his revised budget plan to theLegislature, both the administration and ouro ice will release new economic and revenueestimates. Given recent economic and taxcollection data, however, there is a signi icantpossibility that 2013-14 and perhaps 2014-15revenue estimates will rise by a ew billiondollars. he states recent revenue gains are goodnews or state inances. hese gains re lect thestates continuing economic recovery, whichseems to be accelerating somewhat. Nevertheless,

a signi icant portion o the recent revenue surgeprobably results rom capital gains-relatedPI caused by large increases in stock pricesthroughout 2013. he Governor is prudent towarn Cali ornians that this revenue surge may

prove short-lived.When a similar revenue surge materialized

in the late 1990s, we now know that state leadersmade spending and revenue commitments thatcontributed to the states inancial problemsthroughout the last decade. We advise theLegislature to avoid making similar mistakesthis year. he Governors plan contains anumber o eatures that would help improve thestates iscal ooting, including an emphasis ondebt repayments and an e ort to improve thestates rainy-day und requirements. By makingrelatively ew ongoing new non-Proposition 98spending commitments, the Governor isattempting to minimize, as much as possible,

uture budget pressures that could result rommaking such new commitments today.

In the event that revenue projectionsincrease between now and May, the Legislature

would ace important decisions regarding howto allocate additional revenues. Much o anysuch revenue increases could be required tobe spent on schools and community collegesunder Proposition 98. A ter addressing theserequirements, we believe the Legislature shouldgive highest priority to increasing the size o theGovernors proposed reserves and sett ing asideadditional unds in anticipation o making biggerpayments on the states key retirement liabilities(including payments to address Ca lS RSun unded obligations). In order to keep thestate on a sound iscal ooting, we advise theLegislature to make only limited and targetedongoing program commitments rom additionalrevenues that may be identi ied this spring.


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Administrations Economic Forecast

Recovery Expected to Accelerate

Somewhat. Te administrations 2014-15 GovernorsBudget economic orecast assumes that the currentmoderate economic recovery will accelerate in2014, leading to broad-based improvements inboth the U.S. and Cali ornia economies over thenext two years. Tis orecast incorporates thenegative impact o the recent ederal governmentshutdownwhich caused most economists tolower expectations or 2013 economic growthbutassumes these effects were short-lived and there ore

will not linger into 2014. Te administrationexpects the U.S. economy (as expressed byreal gross domestic product [GDP]) to expand2.5 percent in 2014, accelerating to 3.1 percentgrowth in 2015. Tese growth rates are on par withrates seen typically during a mature economicexpansion, reecting the consensus outlook thatU.S. economic growth is returning to more normallevels. Figure 4 summarizes the administrations

economic orecast or 2013 and 2014 and comparesit with other recent estimates, including those romour office.

Recent Economic Improvements. In orderto meet the Governors January 10 budgetdeadline, administration officials nalize someo their work on this economic orecast bymid-December. Economic data rom December andJanuary, including a strongly positive revision toGDP during the period coinciding with the ederalgovernment shutdown, suggest the U.S. economymay be per orming somewhat stronger than

previously estimated. Tis strength is reectedin the most recent economic orecast includedin Figure 4 rom IHS Economics (an economicsadvisory rm), which indicates the U.S. economy,as measured by real GDP, per ormed better in2013 than either our office or the administrationestimated when completing our most recent

orecasts.

ECONOMY AND REVENUES

Figure 4

Comparing Administrations Economic Forecast With Recent Forecasts2013 2014

2013-14Budget

Act

LAONovember

2013

DOFJanuary

2014

IHSEconomics

January2014

2013-14Budget

Act

LAONovember

2013

DOFJanuary

2014

IHSEconomics

January2014

United StatesPercent change in: Real gross domestic

product2.0% 1.5% 1.7% 1.9% 2.8% 2.5% 2.5% 2.7%

Personal Income 2.8 2.8 2.8 2.9 5.1 4.7 4.6 4.6 Employment 1.5 1.6 1.6 1.6 1.6 1.7 1.6 1.7CaliforniaPercent change in: Personal income 2.2% 2.1% 2.6% NA 5.7% 5.4% 4.6% NA Employment 2.1 1.7 2.1 NA 2.4 2.2 2.3 NAUnemployment rate 9.4 8.9 8.9 NA 8.6 7.8 7.9 NAHousing permits

(thousands)82 88 87 NA 121 120 114 NA

NA = Not applicable.


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Federal Actions No Longer Seem a SignicantTreat to Growth in 2014. Te partial shutdowno ederal government operations in October 2013and uncertainty about whether Congress wouldincrease the ederal governments so-called debt

ceiling likely slowed economic growth somewhatin the nal quarter o 2013. Tese risksalongwith the automatic spending cuts known assequestration and the Federal Reserves gradualtightening o monetary policyconstituteda threat to consumer, business, and investorcondence that could have slowed the modestrecovery. Fortunately, these risks now appearto be ading or the ollowing reasons: (1) thegovernment shutdown does not seem to haveaffected economic prospects, (2) the debt ceilingwas extended until early 2014, and debate on theissue appears less contentious than it was in 2013,(3) Congress passed a bipartisan budget agreementto sofen the sequestration spending cuts, and(4) nancial markets have reacted calmly to dateupon announcement by the Federal Reserve thatit would begin tapering, the gradual eliminationo its unconventional bond purchase program.

Administrations Revenue Forecast

As shown in Figure 5, the administrationsnew revenue orecast projects the GeneralFund will book $100.1 billion o revenues andtrans ers in 2013-14 and $106.1 billion in 2014-15.(Administration summaries show estimated2014-15 revenues o $104.5 billion. Tis isreduced by the amount o the Governors planned$1.6 billion trans er to the BSA, the states existingProposition 58 rainy-day und. We display allGeneral Fund revenues in our summaries so thatgures are more comparable to those o prioryears.) Both Figure 5 and Figure 6 (see next page)show how several key revenue metrics have been

revised above levels in the states 2013-14 budget act(passed in June 2013) in both our offices November2013 revenue projections and the administrationsrevised January 2014 projections.

Key Points

Revenue Forecast Now Signicantly AboveBudget Act Projections. As shown in Figure 6, theadministration has increased its revenue orecast

Figure 5

Comparing Administrations General Fund Revenue Forecast With Prior Forecastsa

General Fund and Education Protection Account Combined (In Millions)

2013-14 2014-15

2013-14Budget Act

LAONovember

2013

DOFJanuary

20142013-14

Budget Act

LAONovember

2013

DOFJanuary

2014

Personal income tax $60,827 $66,002 $64,287 $67,132 $71,363 $69,764Sales and use tax 22,983 22,809 22,920 24,702 23,561 24,071

Corporation tax 8,508 8,278 7,971 9,095 8,851 8,682 Subtotals, Big Three Taxes ($92,318) ($97,089) ($95,178) ($100,929) ($103,775) ($102,517)

Insurance Tax $2,200 $2,163 $2,143 $2,265 $2,343 $2,297Other revenue 2,249 2,254 2,480 1,858 1,874 2,046Transfers and loansb 331 342 346 -385 -375 -765 Total Revenues and Transfers $97,098 $101,847 $100,147 $104,667 $107,617 $106,094a The Department of Finance (DOF) Governors budget forecast updated revenues for prior years as well, 2011-12 and 2012-13, that are not shown here. These updates increase

available General Fund revenue from those years by a combined $2.3 billion above the2013-14 Budget Act assumptions.b Does not include transfer of revenues from General Fund to Budget Stabilization Account to improve comparability of totals with those of prior years.


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compared to the orecast used in the states 2013-14budget plan. For the our scal years o 2011-12through 2014-15 combined, the administrations

orecast o total General Fund revenues andtrans ers is now $6.7 billion higher than last years

budget act orecast. About one-hal o this increase($3 billion) is the result o the administrationsnew higher revenue and trans er estimates or2013-14. Also included in the $6.7 billion total is$536 million o higher PI and corporation tax(C ) revenue accruals and adjustments or 2011-12and prior years, which the administration reportsas an increase to the beginning 2012-13 GeneralFund balance. Compared to the administrationsbudget act projections, the new revenue estimatesinclude a net amount o $300 million more otrans ers out o the General Fund across the ourscal yearslargely accelerated special und loanrepayments proposed by the Governor in his2014-15 budget plan.

Higher Estimates Due Largely to HigherPI Projections. Across the our scal years, theGovernors budget orecast or PI revenue is$7.6 billion above the 2013-14 Budget Act estimate,as shown in Figure 6. Tis total consists o higher

estimates o $56 million in 2011-12 and prior years,$1.4 billion in 2012-13, $3.5 billion in 2013-14, and$2.6 billion in 2014-15. Te improvement in theadministrations PI revenue estimates is offsetsomewhat by lower estimates o C revenue (acombined $517 million across the our scal years)and sales and use taxes ($452 million over theperiod).

Personal Income Tax

PI Revenue Depends on Volatile CapitalGains. Te PI is the states largest revenuesource, accounting or two-thirds o GeneralFund revenue in 2014-15 in the administrationsprojections. In addition to traditional sources oincome such as hourly wages and salaries, the

Figure 6

Change From 2013-14 Budget Act Revenue Projections toThose in Recent State Revenue ForecastsGeneral Fund and Education Protection Account Combined (In Billions)

2011-12and Prior

Years 2012-13 2013-14 2014-15

Change From2013-14 Budget Act

All Four YearsCombined

Personal Income Tax (PIT)LAO November 2013 forecast -$0.5 $1.1 $5.2 $4.2 $10.1Administration January 2014 forecast 0.1 1.4 3.5 2.6 7.6

Big Three PIT, Sales, andCorporation Taxes Combined

LAO November 2013 forecast $1.5 $4.8 $2.8 $9.2Administration January 2014 forecast $0.5 1.6 2.9 1.6 6.6

Total Revenues and TransfersLAO November 2013 forecast $1.6 $4.7 $3.0 $9.4Administration January 2014 forecast a $0.5 1.7 3.0 1.4 6.7a Unlike the LAO November 2013 forecast, reects Governors proposals for accelerated loan repayments to certain state special funds in 2014-15

and other adjustments, which result in a net amount of $300 million more transfers out of the General Fund for the four scal years combined.Like the LAO November 2013 forecast, the amounts displayed in this line do not reect the Governors planned transfer of 2014-15 revenues tothe Budget Stabilization Account.


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tax is paid on realized capital gains, principallyrom the sale o stocks, bonds, and real estate.

Tese types o assets are concentrated amonghigh-income taxpayers in the states top marginalincome tax brackets. Te 1 percent o taxpayers

with the most income typically have paid around40 percent o PI in recent years (rising to nearly50 percent on occasion), a large portion o whichis in the orm o capital gains taxes. In additionto its concentration, capital gains are determinedlargely by sometimes turbulent and unpredictablestock prices. In the space o ve years, orexample, tax agency data shows that estimatedPI revenues rom realized capital gains peakedat $10.9 billion in 2007, ell to $2.3 billion in 2009,and returned to $4.2 billion in 2011. Actual dataon capital gains realizations and taxes lags byaround a year and a hal , meaning that 2012 datawill become available this year.

Recent Forecasts Account or 2013 StockGains. Figure 7 shows the upward trend oU.S. stock prices during 2013, as measured by theS&P 500 stock index. Both the administrationsrevised PI orecast and our offices November 2013

orecast attempt to account or this developmentin their estimates o capital gains income. Teadministrations upward PI revenue adjustmentsin 2013-14 and 2014-15 result primarily rom highercapital gains estimates.

Recent Data Suggest Potentially Higher PIRevenue. Many high-income taxpayers makeestimated payments throughout the year as theirincome materializes. December and Januaryare important months or these payments,as year-end payments are due January 15th.December estimated paymentsas well as PIwithholdingwere stronger than we expected. Inthe next ew days, we will have more in ormationabout January estimated payments. Based on recent

S&P 500 Index Rose Notably During 2013Figure 7

1,300

1,400

1,500

1,600

1,700

1,800

1,900

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec


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tax collection trends, we would not be surprised atall i actual PI revenues or 2013-14 exceeded theadministrations revised projections by a ew billiondollars. Tis assessment denitely could change inthe coming months i positive trends in stock prices

were to change or i there were negative surprisesin state tax collections between now and April.Nevertheless, we advise state leaders to plan or thesignicant possibility that revenue estimates or2013-14 and perhaps 2014-15 will be higher when

they are revised in mid-May.

GOVERNORS MAJOR PROPOSALS

Rainy-Day FundState Has a Volatile Revenue System.

Principally due to revenues rom capital gainspaid mostly rom the states highest-incometaxpayersthe states revenue structure is volatile.In many years, the normal volatility o capital gainscan result in annual revenues being a ew billionabove or below ours or the administrations revenue

orecasts. While our volatile revenue structurepromotes strong growth in revenues over thelonger term, its inherent uncertainty complicatesbudgetary planning. One o the most importanttools the state can use to reduce budgetary volatilityis its rainy-day reserve. Specically, by setting

aside revenues when times are good, the state can:(1) avoid ongoing spending commitments thatcannot be sustained over time and (2) build up areserve to cushion the impact o the next economicturndown.

State Constitution Contains Rainy-Day FundRequirement. Proposition 58 (2004) created thestates rainy-day und, known as the BSA. Eachyear, Proposition 58 requires that 3 percent oestimated General Fund revenues be deposited intothe BSA. Until the states prior decit nancingbonds are repaid, hal o the annual deposit goesto accelerating the repayment o those bonds. Tedeposits continue until the BSA reaches either$8 billion or 5 percent o General Fund revenues,whichever is greater. Proposition 58 authorizes

the Governor to suspend or reduce the amount othe deposit by executive order. Te Legislature cantrans er up to the entire balance o the BSA back tothe General Fund by majority vote.

States Experience With Proposition 58. Te

state deposited unds into the BSA twicein2006-07 and 2007-08, or a total rainy-day undo $1.5 billionbut the und was emptied whenrevenues plummeted during the nancial crisis.Since 2007-08, governors have suspended the BSAdeposit each year.

ACA 4 Rainy-Day Fund Measure Scheduled or November 2014 Ballot. In 2010, the Legislature voted to place ACA 4 be ore voters. AssemblyConstitutional Amendment 4 aims to increasethe maximum size o the state rainy-day undto10 percent o estimated General Fund revenueswhen state revenues are experiencing strong growthand to limit the amount that can be withdrawn

rom the und in any single year. Tese changeswould tend to urther mitigate budgetary volatilityin the uture. In addition, in certain circumstances,some o the unds trans erred to the rainy-day undcould be used or one-time in rastructure-related

purposes and or paying down other liabilities.Deposits to Rainy-Day Fund Under ACA 4.

Assembly Constitutional Amendment 4 includestwo requirements or making deposits to therainy-day und. First, the measure continues thecurrent practice o requiring a deposit equal to3 percent o estimated General Fund revenues each


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September. Second, ACA 4 requires another depositin May when the state is experiencing particularlystrong revenue growth. Specically, the Maydeposit would equal the amount by which annualestimated General Fund revenues were above

(1) the historical trend o General Fund revenuesor (2) the prior years General Fund expendituresadjusted or change in population and cost oliving, whichever is less. Te historical trend oGeneral Fund revenues would be calculated eachyear by the Director o Finance. Specically, themeasure requires the calculation to be based on alinear regressiona statistical analysis techniquethat involves adjustments to exclude the revenueeffects o changes in tax policy that have been ineffect or less than 20 years.

Governors Proposal

Budget Proposes to Replace ACA 4 With Alternate Measure. Te Governors budgetproposes a rainy-day und that aims to reducebudgetary volatility by basing the size o a requireddeposit on capital gains-related revenuestheprincipal source o state revenue volatility. Our

comments are based on the general descriptionin the Governors Budget Summaryand ourdiscussions with administration staff. Specically,the Governors proposal:

Increases the Size o Rainy-Day Fund.Te Governors proposal increases thesize o the rainy-day und to 10 percento estimated General Fund revenues.Tis larger reserve would provide greater

protection against unexpected revenueshort alls.

Amount o Deposit Based on CapitalGains Revenues. Compared with ACA 4,the Governors proposal uses a differentmethod or determining the size o theannual required deposit. Specically,

we understand the Governors proposalwould require certain projected capitalgains income taxes exceeding 6.5 percento annual General Fund revenues to bedeposited to the rainy-day und. Deposits

would be trued up over the next twoyears as more capital gains and other

ormula data emerges.

Creates a Proposition 98 Reserve. TeGovernor proposes that a portion o arequired rainy-day und deposit go into aProposition 98 reserve (essentially, as wethink o it, a dedicated reserve within therainy-day und). Tis portion would be

determined by calculating the part o theincrease in the Proposition 98 minimumguarantee caused by capital gainsrevenues over the 6.5 percent thresholddescribed above. Te Proposition 98reserve deposit would count towardmeeting the minimum guarantee in thatyear, but as the deposit would be held inreserve, total appropriations to schoolsand community colleges would be lessthan the minimum guarantee in the yearswhen deposits are made. In a subsequentyear, when year-to-year growth in theguarantee is insufficient to und speciedgrowth and cost-o -living adjustments(COLA), unds rom the Proposition 98reserve would be distributed to schoolsand community colleges. In this instance,the Proposition 98 reserve distributions

would provide schools and colleges withunding above the minimum guarantee

in some o the more difficult scal years.Because the minimum guarantee can behighly sensitive to changes in GeneralFund revenues, in some years withsignicant capital gains, most or all o


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the proposed rainy-day und depositsunder the Governors plan would go tothe Proposition 98 reservemeaningthose unds would remain unavailable ornon-Proposition 98 spending in the uture.

Limits Withdrawals. For any portiono the rainy-day und outside o theProposition 98 reserve, the Governorsplan would limit the amount that can bewithdrawn in the rst year o a revenuedownturn. Specically, the state would belimited to withdrawing hal o that parto the rainy-day und in the rst year o adownturn. For the Proposition 98 reserve

itsel , in certain instances, we understandthat the Governors plan would allow the

ull amount to be withdrawn i neededto provide specied growth and COLAadjustments to schools and communitycolleges.

Allows Funds to Be Used to Pay DownVarious Liabilities. As described in theGovernors Budget Summary , the proposalallows the amount otherwise required to betrans erred to the rainy-day und to insteadbe used to pay down various budgetaryliabilities, such as those on the Governorswall o debt.

LAO Comments

Goals o Both ACA 4 and Governors Proposal Are the Right Ones. Assembly Constitutional

Amendment 4 and the Governors proposal bothprovide mechanisms to take money off the tableduring good times in order to build larger rainy-dayreserves. By doing so, either plan could reducebudgetary volatility, resulting in more predictable

unding or state and local programs. Te measuresseek to make contributing to a rainy-day und a

regular eature o the budget process. We believe thisis precisely the direction the state should be takingto improve its budgeting practicesparticularly ata time when state revenues are soaring due in largepart to rising stock prices.

States History With Constitutional BudgetaryFormulas. Cali ornias state budget system is already very complex. Formula-driven ballot measureshave added considerably to this complexity.Proposition 98, as currently administered, isunderstood by a small number o insiders. TeGann limit, as amended by Proposition 111, hasseldom played a signicant role in the state budgetprocess, and its detailed estimateslisted in obscureappendices o annual administration budgetdocumentsare difficult to athom. Given thisexperience, writing additional budgetary ormulasinto the Constitution could diminish the publicsalready limited understanding o the states budgetsystem.

Legislature Should Consider FormulasCare ully. As is likely to be the case with anyrainy-day und ormula to be written into the StateConstitution, both ACA 4 and the Governors

proposal probably would produce un oreseen orunintended consequences or the state in the uture.As described earlier, we understand the Governorsproposal would require certain projected capitalgains taxes exceeding 6.5 percent o annual GeneralFund revenues to be deposited to the rainy-day und.As income distributions change in the uture and asstock prices and capital gains grow or decline overtime, this constitutional threshold could result in astronger or weaker rainy-day und requirementingeneral, meaning less or more exibility or theLegislature and the Governor to address theirbudget priorities during some periods o time. In theaverage and median scal year since the mid-1990s,capital gains taxes have made up around 7 percento General Fund revenues. While 6.5 percent,there ore, currently represents something like a


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normal year or capital gains, that may not bethe case over time. Similarly, ACA 4 contains alinear regression calculation that requires manyadjustments and assumptions to be made to account

or tax policy changes over the prior 20 years. We

have concerns about the workability and reliabilityo this calculation. Given these concerns, we advisethe Legislature to consider these proposed ormulascare ully.

Formula-Based Decisions Ofen Made UsingImper ect In ormation. Various rainy-day undproposals o recent years seem to assume that thedata necessary to compute their ormulas exists,is knowable with some certainty at a given pointin time, and is not subject to interpretation. Tisis ofen not the case. For example, revenues ora given scal year remain uncertain or abouttwo years, complicating calculations required byACA 4. In addition, by May when the Legislatureand Governor would nalize the estimate o capitalgains and the amount o the deposit under theGovernors proposal, the state would have no harddata on capital gains taxes or the scal year justending and imper ect in ormation or the year

be ore that. Moreover, projections o uture capitalgains taxes are well known to be unreliableapoint the Governor has made orce ully during thepast year. As such, locking a reserve ormula intothe Constitution based on capital gains projectionsshould be considered care ully by the Legislature.

Concerns Regarding Possible Shif o Powerto the Executive Branch. Under ACA 4 and theGovernors measure, the amount o the depositswould be dependent on various estimates. AssemblyConstitutional Amendment 4 contains ormulasexplicitly required to be compiled by the executivebranch. While we understand the estimates in theGovernors proposal would be subject to legislativereview, uture governors may well premise theirapproval o state budget bills on legislative agreementto their administrations ormula calculations. In

such a scenario, the Legislature would see more o itspowers shifed to the executive branch.

Both Measures Effectiveness Likely Affectedby Proposition 98 Interactions. Both ACA 4and the Governors measure make choices

regarding how Proposition 98 interacts withthe non-Proposition 98 side o the budget. Forexample, some large inuxes o revenues canresult in little growth in the states rainy-day undunder ACA 4 due to Proposition 98. Under theGovernors measure, in a similar year o revenuegrowth, nearly all o the revenues set aside orrainy-day und purposes may sometimes go to theProposition 98 reserve.

How Should the Legislature Proceed?

Possible Alternative Approaches. Despite ourconcerns, both ACA 4 and the Governors proposal

oster a critical debate. Both aim to address oneo the states most challenging budget problemsrevenue volatility. While we think that both ACA 4and the Governors proposal have meritorious

eatures, other alternatives could be considered bythe Legislature. I the Legislature wishes to place

be ore voters a revised constitutional rainy-dayund requirement, the measure could ocus on

simple, incremental changes to the Proposition 58requirement. Below, we list some options that theLegislature may wish to consider in this regard.

Increase Size o Reserve. Increasing thesize o the Proposition 58 reserve, the BSA,would provide the state greater protectionagainst unexpected revenue short alls.

Limit Amount o Withdrawals. Limitingthe amount that can be withdrawn romthe BSA in any single year could improvethe states ability to mitigate budgetaryshort alls in multiyear recessions, but woulddiminish the ability to cover a signicantbudget short all in any single scal year.


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Limit Frequency o Withdrawals. Limitingthe requency o withdrawals to a speciednumber o years in any decade couldincrease the likelihood that the rainy-day

und would be used only when needed

most.

Limit Frequency o Suspensions. Limitingthe requency o BSA suspensions orreductions to a specied number o yearsin any decade could encourage moreconsistent rainy-day und deposits.

Consider Balance Between Proposition 98and Other Expenditures. In amending

Proposition 58or in considering anyrainy-day und proposalthe Legislaturewill have to consider the extent to whichthe Proposition 98 and non-Proposition 98sides o the budget, respectively, areconstrained in periods when the rainy-day

und is being lled and aided whenbudgetary trends are weak.

Ensure Reserve Deposit Plans Consistent

With Annual Budget Agreements.Proposition 58 currently requires theGovernor to decide whether to suspendor reduce scheduled trans ers to the BSAno later than June 1. Yet, the Legislaturepasses the annual budget on June 15, andthe Governor signs the budget plan onor be ore July 1. Proposition 58 could beamended to allow the Governor to alter hisinitial June 1 determination on or be oreJuly 1 to ensure the states rainy-day unddeposit plan is compatible with the budgetplan adopted by the Legislature.

Cali ornia Can Build radition o SoundFiscal Stewardship. Assembly ConstitutionalAmendment 4 and the Governors proposal shouldlead to an important budgetary discussion by

lawmakers. Regardless o the Legislatures decisionabout a possible constitutional ballot measure,decisions made in this years budget process canbegin a new tradition o setting aside revenueswhen times are good to provide a cushion or

when revenues decline. Te Governors budgetproposal to reinstate the annual deposit to theBSA, or example, could create a strong precedent

or accumulating reserves during good revenuetimes. Further, the proposal is evidence that theProposition 58 mechanism can work. I revenueestimates rise even more between January andMay, the Legislature and the Governor have thechance to build an even larger reserve than theGovernor proposes this year. Trough actions suchas these, the state can establish a tradition o soundscal stewardshipwith or without any proposedconstitutional change.

CalSTRS Longstanding Funding Problems. CalS RS

has not been appropriately unded or much oits 100-year history. Simply put, CalS RS is not

unded enough to ensure its solvency over the long

term. Moreover, state law does not even make clearwho is responsible or providing more undingto the system: teachers, districts, or the state. Tebasic pension math is clearCalS RS must receivemore money. In our view, now is the time or actionto begin addressing this very difficult problem.

30-Year, Full-Funding Plan Should Be Focus Now. We agree with the Governor that the key goalo the state should be developing a plan o sharedresponsibility to achieve a ully- unded, sustainableteachers pension system within about 30 years. TeCalS RS board has stated that this is the denitiveapproach to addressing the systems undingproblem. Tis will be a very expensive proposition,potentially requiring around $5 billion per yearinitially (growing over time) in extra resources

rom some combination o the state, districts, and


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teachers. Tis amount will remain substantial overthe long term regardless o the act that stock priceshave been growing recently.

Setting Aside Some Money Now Would BeSmart. Te Governor suggests that state officials

and the education community attempt to cometo agreement on how the state, districts, andteachers respectively will und CalS RS over thelong term. In the meantime, however, a portiono the states 2014-15 budget reserve could be setaside in anticipation o making the rst depositto CalS RS afer development o a new long-term

unding plan over the next year or two. In anyevent, the responsibility to adopt a solution will inthe end rest squarely with the Legislature and theGovernor.

Over the Long erm, the States Role ShouldChange. Te Governors budget summarycomments that the states long-term role as a directcontributor to CalS RS should be evaluated. Weagree. Employers and employees should be partnersin dened benet pension systems, and the stateis not the employer o Cali ornias public schoolteachers. In our November 2011 publication on the

Governors initial pension proposal, we noted thatthe state canand probably shouldplay a keyrole in addressing the large un unded liability thatexists or past and current teachers benets. Wealso have suggested that the state create a plan or future teachers benets to be paid completely bydistricts and teachers over the long term.

Proposition 98Proposition 98 unds K-12 education, the

Cali ornia Community Colleges (CCC), preschool,and various other state education programs.Te Governors budget includes $11.8 billionin Proposition 98 spending increases. O thatamount, $7.6 billion is designated as 2014-15Proposition 98 spending, $3.7 billion is additional

unding attributable to 2012-13 and 2013-14, and$503 million is attributable to earlier years. O the$11.8 billion, $6.8 billion is designated or one-timepurposes and $5 billion or ongoing purposes.Under the Governors budget, ongoing K-12per-pupil unding would increase rom $7,936 in

2013-14 to $8,724 in 2014-15an increase o $788(10 percent).

Changes to the Minimum Guarantee

2012-13 Minimum Guarantee Up $1.9 Billion.As Figure 8 shows, the administrations revisedestimate o the 2012-13 minimum guaranteeis $58.3 billion, a $1.9 billion increase rom theestimate made at the time the 2013-14 budget planwas enacted. O the increase in the minimumguarantee, roughly $1.8 billion is due to GeneralFund revenues being $1.7 billion higher thanassumed in the 2013-14 budget plan, and theremainder is due to an increase in baseline propertytax revenues. (Te 2012-13 minimum guaranteeis a est 1 year, in which increases in propertytax revenues result in higher unding or schools

Figure 8

Increase in 2012-13 and 2013-14 Proposition 98 Minimum Guarantees(In Millions)

2012-13 2013-14

Budgeted Revised Change Budgeted Revised Change

Minimum GuaranteeGeneral Fund $40,454 $42,207 $1,752 $39,055 $40,948 $1,893Local property tax 16,011 16,135 124 16,226 15,866 -361 Totals $56,465 $58,342 $1,877 $55,281 $56,813 $1,532


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and community colleges.) Tough the Governorsestimate o the minimum guarantee has increased,his estimate o 2012-13 Proposition 98 spending is$130 million lower, primarily due to lower-than-expected student attendance. Te higher minimum

guarantee combined with lower-than-expectedcosts create a total settle-up obligation o$2 billion.

2013-14 Minimum Guarantee Up $1.5 Billion.Te administrations revised estimate o the2013-14 minimum guarantee is $56.8 billion, a$1.5 billion increase rom the amount assumed inthe 2013-14 budget plan. Tis increase is due to thehigher 2012-13 minimum guarantee and higheryear-to-year growth in per capita General Fundrevenues, offset slightly by lower-than-anticipatedgrowth in student attendance. Tough theminimum guarantee is up $1.5 billion, the statesGeneral Fund Proposition 98 requirement is up by$1.9 billion due to estimates o local property taxrevenues decreasing by $361 million. Te Governoralso has a revised estimate o 2013-14 spending,which is down $150 million primarily due to

lower-than-expected student attendance. Tehigher minimum guarantee combined with lower-than-expected costs creates a 2013-14 settle-upobligation o $1.7 billion.

2014-15 Minimum Guarantee $4.7 Billion

Above Revised 2013-14 Level. As Figure 9 shows,the Governors budget proposes $61.6 billion intotal Proposition 98 unding or 2014-15. Tisis $4.7 billion higher than the revised 2013-14spending level. Te increase is driven by stronggrowth in General Fund revenue and increasesin property tax revenues. ( est 1 is operative in2014-15, such that marginal increases in propertytax revenuesexcept or RDA asset revenuesareresulting in a higher Proposition 98 minimumguarantee.)

Wall of Debt Proposal

One o the largest components o theGovernors budget plan is his proposal to retireall wall o debt obligations, including schooland community college obligations, by the endo 2017-18. Te state currently has a total o

Figure 9Proposition 98 Funding(Dollars in Millions)

2012-13Revised

2013-14Revised

2014-15Proposed

Change From 2013-14

Amount Percent

Preschool $481 $507 $509 $2

K-12 EducationGeneral Fund $37,740 $36,361 $40,079 $3,718 10%Local property tax revenue 13,895 13,633 14,171 537 4 Subtotals ($51,634) ($49,995) ($54,250) ($4,255) (9%)

California Community CollegesGeneral Fund $3,908 $4,001 $4,396 $395 10%Local property tax revenue 2,241 2,232 2,326 94 4 Subtotals ($6,149) ($6,233) ($6,723) ($489) (8%)

Other Agencies $78 $78 $77 -$1 -1% Totals $58,342 $56,813 $61,559 $4,746 8%

General Fund $42,207 $40,948 $45,062 $4,115 10%Local property tax revenue 16,135 15,866 16,497 631 4


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$11.5 billion in such outstanding school andcommunity college obligations$6.2 billion inde errals (late payments), $4.5 billion in unpaidmandate claims, $462 million or ERP, and$410 million or the Quality Education Investment

Act (QEIA). (Te state also has a $1.5 billionoutstanding Proposition 98 settle-up obligation,which can be used to pay off the obligationsmentioned above.) We discuss the Governors plan

or retiring these obligations below.Retires All School and Community College

De errals by End o 2014-15.Te Governorproposes to pay down all $6.2 billion inoutstanding school and community collegede errals by the end o 2014-15. As Figure 10shows, the Governor designates Proposition 98

unding rom 2012-13, 2013-14, and 2014-15 to paydown these de errals. Under the Governors plan,all higher Proposition 98 spending proposed in2012-13 and 2013-14 is used or de erral pay downs.About one-third o the new spending proposed or2014-15 is or de erral pay downs.

Makes Final $410 Million QEIA Payment.QEIA provides unding to low-per orming

schools or various improvement activities and tocommunity colleges or career technical education.Trough the QEIA program, the state is providingadditional unds to schools and communitycolleges as part o a Proposition 98 settle-upagreement relating to 2004-05 and 2005-06.Although statute requires a $410 million paymentto ully retire the states 2004-05 and 2005-06settle-up obligations, the estimated costs o theQEIA program in 2014-15 are $316 million. (Fewerschools are now participating in the program.) TeGovernor proposes to redirect the $94 million in

reed-up unds to the ERP (as discussed urtherbelow).

Provides $188 Million or ERP. Te ERP wascreated in 2004 through legislation associatedwith the Williams settlement and is intended to

provide low-per orming schools with a total o$800 million or emergency acility repairs. Othe $188 million proposed or ERP in 2014-15,$94 million is being redirected rom ree-up QEIA

unds (mentioned above) and $94 million is coming

rom unspent prior-year Proposition 98 unds.Under the Governors proposal, the state wouldhave $274 million in outstanding ERP obligationsat the end o 2014-15.

Retires Remaining Wall o Debt Obligationsby End o 2017-18. Te Governor proposes toretire all remaining wall o debt obligations in the

ollowing three years, with all obligations paidoff by 2017-18. In 2015-16, the Governor wouldprovide $1.5 billion to retire the states outstandingProposition 98 settle-up obligation. Becausesettle-up payments can be provided to schools andcommunity colleges or any purpose, the Governorproposes to dedicate these settle-up unds orrepaying the remaining $274 million owed or ERPand paying off $1.2 billion in outstanding mandateclaims. Te remaining $3.2 billion in mandate-claim payments would be spread across 2016-17and 2017-18.

Other Major Proposition 98 Proposals

Figure 11 (see next page) shows all majorchanges to Proposition 98 spending in 2014-15. Asthe gure shows, the budget provides $7.6 billion in

Figure 10

Governor Proposes to Pay DownAll Outstanding K-14 Deferrals

(In Millions) K-12 CCC Totals

Pay down scored to:2012-13 $1,813 $194 $2,0072013-14 1,520 163 1,6832014-15 2,238 236 2,474 Total Proposed

DeferralPay Down

$5,571 $592 $6,164


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policy-related spending increases. O this amount,$5.2 billion reects program augmentationsand $2.5 billion is or paying down the last oschool ($2.2 billion) and community college($236 million) de errals. As shown in the gure,

the largest programmatic augmentation is or theschool district LCFF. We discuss this and othernotable proposals below. For community colleges,we discuss the Governors Student Success andSupport Program (SSSP) proposal later in theHigher Education section o this report andthe Governors $175 million maintenance-relatedproposal later in the In rastructure section.

Provides $4.5 Billion or LCFF Increases. Teproposed $4.5 billion increase in LCFF undingreects an 11 percent year-to-year increase andis estimated to close 28 percent o the remaininggap between school districts 2013-14 undinglevels and the LCFF ull implementation rates.Under the Governors proposal, we estimatethe 2014-15 per pupil LCFF unding level

would be approximately 80 percent o the ullimplementation rates. Te Governor also proposesto add two categorical programs to the LCFFSpecialized Secondary Programs ($4.8 million)and agricultural education grants ($4.1 million).

Under the Governors proposal, school districtsreceiving unding or these two programs in2013-14 would have those unds count towardstheir LCFF targets beginning in 2014-15. (Nochange would be made to the LCFF target rates.)Te currently required categorical activities wouldbe lef to districts discretion. Te Governors planalso provides county offices o education (COEs)with an additional $26 million in LCFF unding.Te administration projects that this increasewill be sufficient to provide COEs their ull LCFFtarget rates in the budget year.

Proposes New Automated Budget Formula or LCFF Funding. Te Governor proposesstatutory language requiring that a speciedpercentage o annual Proposition 98 unding

automatically bededicated to LCFFeach year (the exact

percentage has yet tobe determined). Undercurrent law, prior-yearLCFF appropriationsare continuouslyappropriatedthat is,these appropriations areautomatically made toschool districts, evenwithout an approvedstate budget. Increases inLCFF unding, however,are made at the discretiono the Legislature andmust be approved inthe annual budget.

Figure 11

Increases in 2014-15 Proposition 98 Spending

(In Millions) Accounting Adjustments

Remove prior-year one-time actions -$2,423Fund QEIA program outside of Proposition 98 -361Adjust energy efciency funds -101 Subtotal (-$2,885)

Policy Changes

Fund increase in school district LCFF $4,472Pay down remaining deferrals (one-time) 2,474Augment CCC Student Success and Support Program 200Augment CCC maintenance and instructional equipment (one-time) 175

Fund 3 percent CCC enrollment growth 155Provide 0.86 percent COLA to select K-14 programs 82Increase funding for K-12 pupil testing 46Fund increase in COE LCFF 26Other changes 1 Subtotal ($7,631) Total Changes $4,746 QEIA = Quality Education Investment Act; LCFF = Local Control Funding Formula; CCC = California

Community Colleges; COLA = cost-of-living adjustment; and COE = county ofce of education.


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Under the Governors proposal, the Legislatureeffectively would have no role in making this keydetermination moving orward.

Other Changes to Existing Programs. TeGovernors budget plan includes several other

notable changes. Te budget provides $82 millionto und a 0.86 percent COLA or most K-12categorical programs and community collegeapportionments. Te Governor also provides a$46 million increase or pupil testing to reect thehigher cost o administering new standardizedtests aligned to the Common Core State Standards.Te budget also reects a $101 million reductionin unding or Proposition 39 energy projects. (TeGovernor estimates that the amount o corporatetax revenues deposited into the Clean Energy JobCreation Fund in 2014-15 will be $101 million lowerthan assumed in the 2013-14 budget plan, thusrequiring a corresponding reduction in unding.)

o accommodate the reduction, the Governorprovides no additional unding in 2014-15 or therevolving loan program ($28 million savings) andreduces school and community college grantsby $65 million and $8 million, respectively. Te

Governor also proposes to add three mandatesUni orm Complaint Procedures, Public Contracts,and Charter Schools IVto the Mandate BlockGrant. Given none o the three mandates isrelatively costly, the Governors plan does notprovide an associated increase in block grant

unding.Proposes Simplication o Rules or

Independent Study. o acilitate the use o onlineinstruction, the Governor proposes to create asimplied independent study program or grades9-12. Current independent study programs requirethat each student assignment within a course betranslated into an equivalent number o classroomhours or purposes o generating unding. Underthe Governors proposal, independent studyprograms alternatively could choose to translate

each course into an equivalent number o hours orpurposes o generating unding. Te Governor alsoproposes to allow student-teacher ratios in thesecourses to exceed limits established by current law,provided these changes are collectively bargained

by local education agencies.

Governors Overall Proposition 98Plan Reasonable

Plan Contains Prudent Mix o One- ime andOngoing Spending. We believe the GovernorsProposition 98 plan provides a reasonable mix oprogrammatic unding increases and pay downs ooutstanding obligations. By retiring the $6.2 billionin outstanding K-14 de errals, the plan wouldeliminate the largest component o the schooland community college wall o debt. Dedicatinga substantial amount o new unding to one-timepurposes also helps the state minimize any uturedisruption in school unding as a result o revenue volatility or an economic slowdown. Tough asignicant amount o unding is dedicated toone-time purposes in the Governors plan, hisplan also signicantly increases LCFF unding

and provides a variety o community collegeaugmentations, thereby building up ongoingprogrammatic support.

2014-15 Minimum Guarantee Very Sensitiveto Changes in General Fund Revenues. Because2014-15 is a est 1 year in which a relativelylarge maintenance actor payment is required,marginal increases or decreases in General Fundrevenues can result in dollar- or-dollar changesin the minimum guarantee. (As weve previouslydiscussed, this is driven by the states approachto paying maintenance actor in est 1 years.)As a result, estimates o the 2014-15 minimumguarantee will be highly sensitive to changes inGeneral Fund revenues and could experience largeswings over the coming months. Tis volatility andassociated swings in the guarantee makes a prudent


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mix o one-time and ongoing support particularlyimportant.

Concerns With Proposal to Automate Future LCFF Funding Increases. Tough we believethe Governors overall Proposition 98 plan is

reasonable, we have concerns with his proposal toset in statute the specic share o Proposition 98

unding that would be dedicated to LCFF each yearmoving orward. Tough we believe the bulk o

uture K-12 unding increases should be dedicatedto unding LCFF, we are concerned that such anapproach would remove the Legislatures discretionto appropriate unding and make key budgetdecisions. Given the considerable loss o associatedlegislative authority and discretion, we recommendthe Legislature reject this proposal.

Higher EducationCali ornias publicly unded higher education

system consists o UC, CSU, CCC, Hastings Collegeo the Law (Hastings), the Cali ornia StudentAid Commission (CSAC), and the Cali orniaInstitute or Regenerative Medicine (CIRM).As shown in Figure 12, the Governors budget

provides $13 billion in General Fund support orhigher education in 2014-15. Tis is $1.2 billion(10 percent) more than the revised current-yearlevel.

Major Higher Education ProposalsTe majority o the new unding is or

base increases at the universities, increases inapportionment unding and two categoricalprograms at the community colleges, repayingbonds that support CIRM research, as wellas increased participation in Cal Grants andimplementation o the new Middle ClassScholarship program.

Proposes Increase in General PurposeFunding or Universities. Te Governor proposesunallocated base budget increases o $142 millioneach or UC and CSU in 2014-15. Tese increasesrepresent the second annual installment in a

our-year unding plan proposed by the Governorlast year. Under this plan, the universities, whichreceived 5 percent base unding increases in thecurrent year, would receive the proposed 5 percentincrease in 2014-15, ollowed by 4 percent increases

Figure 12

Higher Education General Fund Support(Dollars in Millions)

2012-13Actual

2013-14Revised

2014-15Proposed

Change From 2013-14

Amount Percent

University of California $2,566 $2,844 $2,987 $142 5%California State University a 2,473 2,789 2,966 177 6California Community Colleges b 4,269 4,390 4,828 438 10California Student Aid Commission c 1,559 1,682 1,904 222 13California Institute for Regenerative Medicine 53 97 284 187 193Hastings College of the Law 9 10 11 1 13Awards for Innovation in Higher Education 50 50 N/ADebt-service obligations d (1,027) (1,027) (1,255) (228) (22) Totals $10,930 $11,812 $13,030 $1,218 10%a Includes health benet costs for CSU retired annuitants.b Includes Quality Education Investment Act funds.c Includes federal Temporary Assistance for Needy Families funds and monies from the Student Loan Operating Fundboth of which directly offset

General Fund expenditures for Cal Grants.d Amounts, which include debt service on general obligation, lease-revenue, and UC general revenue bonds, are shown for reference only, as they

already are reected in the lines above.


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in each o the subsequent two years. (Te increasesor both universities are based on 5 percent o

UCs support budget, resulting in an increase o5.6 percent or CSU.) About $10 million o CSUsincrease is related to a new proposed process or

unding capital projects (discussed later in theIn rastructure section o this report).

No Enrollment argets or Universities. Similar to last year, the Governor does not proposeenrollment targets or enrollment growth unding

or the universities. Te Governors budgetdocuments show resident enrollment at in thebudget year at UC, growing by 2 percent at CSU,and decreasing by 8 percent at Hastings. (Teadministration indicates these enrollment levelsare shown or display purposes only and do notconstitute an enrollment plan.)

Assumes No uition Increases. Although theGovernor acknowledges in his budget summarythat college is relatively affordable or Cali orniaspublic-college students (due to high publicsubsidies, relatively low tuition and ees, and robustnancial aid programs), he conditions his proposedannual unding increases or the universities on

their maintaining tuition at current levels. Underhis plan, tuition levels, which have not increasedsince 2011-12, would remain at through 2016-17.

Requires UC and CSU to Adopt SustainabilityPlans. Te Governor proposes budget languagerequiring the UC and CSU governing boardsto adopt three-year sustainability plans byNovember 30, 2014. Under this proposal, theuniversities would project expenditures or eachyear rom 2015-16 through 2017-18 and describechanges needed to ensure expenditures do notexceed available resources (based on GeneralFund and tuition assumptions provided by theDepartment o Finance [DOF]). Te segments alsowould project resident and nonresident enrollment

or each o the three years and set per ormancetargets or the outcome measures approved in last

years budget. (Under current law, UC and CSUare required to report annually by March 1 on aspecied set o per ormance measures.)

Signicantly Increases CCC Funding. Inaddition to paying off CCC de errals (discussed

earlier in the Proposition 98 section o this report),the Governor provides signicant programmaticincreases to the CCC system. Tese augmentationsinclude $200 million or the Student Success andSupport categorical program (discussed in moredetail below), $175 million (one-time) or de erredmaintenance and instructional support (discussedlater in the In rastructure section o this report),$155 million or 3 percent enrollment growth (anadditional 34,000 ull-time equivalent students),and $48 million to provide a 0.86 percent COLA toapportionments.

Proposes Major Augmentation or CCCCategorical Program. Te Governor providesa $200 million augmentation to CCCs SSSP( ormerly known as matriculation), whichrepresents a tripling o current-year unding or thecategorical program. Te SSSP unds assessmentand orientation services or new students, as well as

academic counseling or both new and continuingstudents. O the $200 million, $100 millionwould be allocated to districts in support o allCCC students (using a ormula based on studentenrollment). Te remaining $100 million wouldbe allocated to districts specically to target highneed CCC students. Te Chancellors Office wouldbe tasked with dening what constitutes highneed as well as with developing a methodology orallocating these monies to districts. Te Governorsintent is or districts to provide additionalservicesbeyond the base services provided underSSSPso as to reduce student achievement gaps(related to students gender, ethnic/racial group, ordisability). Te Governors budget also expressesa desire or districts to improve coordination oSSSP with CCC categorical programs that serve


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similar students and also would permit districtsto reallocate up to 25 percent o unds rom threeCCC categorical programs to other programs thatserve high-need students.

Proposes New Innovation Awards. Also

included in the Governors budget is one-timeunding o $50 million or awards to encourage

innovation at UC, CSU, and CCC campuses.Proposed budget language denes three statepriorities: (1) signicantly increasing bachelorsdegree attainment in the state, (2) shortening timeto degree, and (3) easing trans er across segments.Campuses, both individually and in groups, couldapply or awards to implement innovative highereducation models that achieve these priorities.A committee o ve Governors appointeesrepresenting DOF and the segments governingboards (including the State Board o Education)and two legislative appointees selected by theAssembly Speaker and Senate Rules Committeewould make award decisions. Te committeewould look or proposals that reduce the costs oinstruction; involve collaboration across campuses,segments, and educational levels; are replicable;

and show commitment rom campus officials andstakeholders.

Funds Implementation o Middle ClassScholarship Program. Te budget provides$107 million or the rst year o scholarship awardsunder this new program, as approved in last yearsbudget legislation. Students at UC and CSU with

amily incomes up to $100,000 quali y or awardsthat cover 40 percent o their systemwide tuition(when combined with all other public nancial aid).Awards decrease in size or students with amilyincomes between $100,000 and $150,000, such thata student with a amily income o $150,000 qualies

or an award covering 10 percent o tuition. Telegislation directs CSAC to reduce award amounts

or all students proportionately i the appropriationis insufficient to provide ull awards to all

eligible applicants. Te commission will make apreliminary determination about whether awardswill need to be prorated in April, afer receiving theuniversities estimates o quali ying students.

Funds Cal Grant Participation Growth.

Te budget also provides $103 million orincreased participation in Cal Grants. A portiono this growth is due to a surge in new awardsin the current year, which increases renewals inthe budget year. (Te budget does not assumeadditional growth in the number o new awards or2014-15.) In addition, the second cohort o DreamAct students accounts or about one-quarter o theincrease.

Mixed Review of Governors Proposals

Below, we provide our initial assessment o theGovernors higher education proposals.

Does Not Link University Funding to StatePriorities. Although the Governor enumeratesseveral higher education priorities in his budgetdocuments ( or example, reducing the cost oeducation and improving affordability, timelycompletion rates, and program quality), his

unding plan includes large unallocated increasestied only to maintaining at tuition levels. Tebudget requires the universities to set per ormancegoals, but does not establish state per ormanceexpectations or link the universities undingto meeting these expectations. Tis approachdiminishes the Legislatures role in key policydecisions and allows the universities to pursuetheir own interests rather than the broader publicinterest. Te state could connect university undingwith state priorities in a variety o ways. Forexample, the state could allocate new unding orspecic purposes such as a COLA, maintenanceprojects, or pension obligations. It also coulduse the per ormance results the universities arerequired to report in March to in orm undingdecisionsincluding the allocation o new unding


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among the segmentsrather than committing inadvance to specied annual augmentations.

uition Freeze Likely to Increase FutureVolatility. We remain concerned that lockingin tuition and ee levels or a total o six years,

as proposed by the Governor, could lead tolarger increases and greater tuition volatility or

uture students. A tuition policy that allows ormoderate increases and provides a rational basis orallocating costs between state and students is morelikely to serve the states interests in the long run.

Sustainability Reports Could Help In ormBudget Discussions. By requiring UC and CSUto develop an expenditure plan and per ormancegoals based on the administrations estimateo available resources, the expenditure planscould help clari y the trade-offs involved inthe unding levels included in the Governorsbudget. We would emphasize, however, thatthese reports should be treated as only a startingpoint or discussion because they would reectonly the administrations resource proposalsand the segments own per ormance targets. TeLegislature may have different ideas regarding how

much to invest in higher education (both throughstate appropriations and tuition policies) and whatoutcomes to expect rom the universities.

In ormation to Date Suggests GovernorsCCC Enrollment Growth Proposal May Be ooHigh. We have concerns that the Governor may beproviding too much unding or CCC enrollmentgrowth. Afer several years o strong demand ora CCC education during the recent recession, anumber o

Budget Overview 2014

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