Fiscal Outlook 2010

8/8/2019 Fiscal Outlook 2010

1/45

Noveber 2010

mac TaylorLegislative Analyst

The 2011-12 Budget:

CaliforniasFiscal Outlook


2/45

Legislative Analysts Ofce www.lao.ca.gov

Table of Contents

Chapter 1

Te Budget Outlook ...................................................3Chapter 2

Economy, Revenues, and Demographics ............... 13

Chapter 3

Expenditure Projections .......................................... 23


3/45

Californias Fiscal Outlook

www.lao.ca.gov Legislative Analysts Ofce


4/45


Executive Summary

$25 Billion Budget Problem Needs to Be Addressed in Coming MonthsOur forecast of Californias General Fund revenues and expenditures shows that the state must

address a budget problem of $25.4 billion between now and the time the Legislature enacts a 201112state budget plan. Te budget problem consists of a $6 billion projected decit for 201011 and a$19 billion gap between projected revenues and spending in 201112.

201011 Decit. We assume that the state will be unable to secure around $3.5 billion of budgetedfederal funding in 201011. Tis assumption is a major contributor to the $6 billion yearend decitwe project for 201011. We also project higherthanbudgeted costs in prisons and several otherprograms. In addition, our forecast assumes that passage of Proposition 22 will prevent the statefrom achieving about $800 million of budgeted solutions in 201011.

201112 Decit. Te temporary nature of most of the Legislatures 2010 budgetbalancing actionsand the painfully slow economic recovery contribute to the $19 billion projected operating decit in

201112. Tis gap is $2 billion less than we projected one year ago. Actions taken during the 201011budget process to reduce Proposition 98 education spending are a major contributor to the decline.

Ongoing Annual Budget Problems of $20 Billion PersistSimilar to our forecast of one year ago, we project annual budget problems of about $20 billion

each year through 201516. In 201213, when the state must repay its 2010 borrowing of localproperty tax revenues and the full eect of Propositions 22 and 26 hit the states bottom line, ourforecast shows the operating decit growing to $22.4 billion. Because our methodology generallyassumes no costofliving adjustments, our projections probably understate the magnitude of thestates scal problems during the forecast period.

Additional Savings From Proposition 98 Will Be Very DicultOur forecast indicates that General Fund revenues and transfers will decline by over $8 billion

in 201112 due to the expiration of the temporary tax increases adopted in 2009. Because theProposition 98 minimum school funding guarantee is aected by this drop, our budget forecastalready reects a $2 billion fall in the minimum guarantee between 201011 and 201112. Tisreduction would come at the same time that school districts exhaust the billions of dollars ofonetime federal money they have received through the stimulus program and other legislation.


5/45


www.lao.ca.gov Legislative Analysts Ofce2

For these reasons, it may be very dicult to achieve substantial additional budget reductions inProposition 98 in 201112, compared to the levels already reected in our forecast. In other words,if the Legislature funds schools at our projected minimum guarantee in 201112, it would mean

billions of dollars in programmatic cuts to education but not contribute a single dollar to closingthe $25 billion budget problem.

Key Choice: Painful Decisions Nowor Pass Problems to Future Californiansoo oen, discussions of Californias budget situation are framed in extreme terms: the

state about to go bankrupt, debtservice payments hypothetically poised to default, the stategovernment on the verge of collapse. None of these scenarios is remotely likely to occur. Historytells us that the state can nd ways to temporarily patch over its annual budget problems inways that prove suciently palatable to policy makers of both major parties. Periodically, largeinuxes of capital gains allow for temporary relief, and this too aids in patching over the statesnowrecurrent budget challenges. Te Legislature and the new Governor will be tempted in thenext few years to continue patching over the budget problems with temporary xes. Unless plansare put in place to begin tackling the ongoing budget problem, it will continue to be dicult forthe state to address fundamental public sector goalssuch as rebuilding aging infrastructure,addressing massive retirement liabilities, maintaining service levels of highpriority governmentprograms, and improving the states tax system. Accordingly, the state faces a basic choice: begin toaddress todays huge, frustrating budget problems nowor defer the states budgetary and policyproblems to future Californians.

Huge Longer-Term Fiscal Challenges Already Can Be ForeseenOne major reason to stop passing the states problems to future Californians is that the states

longterm scal liabilitiesfor infrastructure, retirement, and budgetary borrowingare alreadyhuge. Te costs of paying down these liabilities already are reected, to some extent, in the states

recurring decits, but these costs will only grow in the future. By deferring hard decisions onhow to nance routine annual budgets of state programs to future years, the state risks increasingfurther the already immense scal challenges facing tomorrows Californians.

Time for a Multiyear Approach to Fixing the BudgetWe continue to recommend that the Legislature initiate a multiyear approach to solving

Californias recurring structural budget decit. In 201112, such an approach might involve$10 billion of permanent revenue and expenditure actions and $15 billion of temporary budgetsolutions. In 201213, 201314, and 201415, another few billion of permanent actions each year couldbe initiated, along with other temporary budget solutions, and so on until the structural decitwas eliminated. Barring another sharp economic decline, such an approach could x Californias

nearterm budget problems by the end of our forecast period in 201516 and give the state exibilityto begin (1) building reserves needed to address the next economic downturn and (2) addressinglongterm scal liabilities.

Te solutions needed to balance the budget will mean unavoidably painful sacrice by todaysCalifornians. Te benet of this sacrice would be putting the state on a sound scal footing. Tatsound footing may allow future Californians to live in a place where the annual state budget processis a chance to improve governments ability to serve its residents.


6/45


The Budget Outlook

Chapter 1

his report provides our projections of thestates General Fund revenues and expenditures

for 201011 through 201516 under current law,absent any actions to close the states budget gap.Our projections primarily reflect currentlawspending requirements and tax provisions, whilerelying on our independent assessment of theoutlook for Californias economy, demographics,revenues, and expenditures. Te report aims toassist the Legislature with its scal planning as itbegins to consider revisions to the 201011 budgetand adoption of the 201112 budget. Te basis of ourestimates is described in the nearby box (next page).

Figure 1 shows our estimate of the conditionof the General Fund through the end of 201112assuming no corrective action. he 201011fiscal year would endwith a $6 billion decit.In 201112, expenditureswould exceed revenuesby $19 billion and leavethe state with a yearenddecit of over $25 billion.Accordingly, we estimatethat the Legislature andthe new Governor willhave to address a budgetproblem of $25 billionbetween now and the timethat they agree to a 201112state budget plan.

201011 TO END IN DEFICIT

Projected 2010-11 Year-End Decit of$6 Billion

$3.5 Billion of New Funding or Flexibility NotYet Approved by U.S. Government. At the timethe Governor signed the 201011 budget packagein October 2010, the administration estimatedthat the General Fund would have a $1.3 billionreserve at the end of 201011. A key assumption inthat calculation was that the state would receivearound $4 billion in federal funding (or additionalflexibility in operating statefederal programs

like MediCal) that had not yet been approvedby the federal government. Recently, the federalgovernment approved a waiver aecting MediCaland other health programs that provides annual

Figure 1

LAO Projection of General Fund Condition if NoCorrective Actions Are Taken

(In Millions)

200910 201011 201112

Prior-year fund balance -$5,375 -$5,371 -$4,591

Revenues and transfers 87,041 93,284 83,530

Expenditures 87,037 92,505 102,756

Ending fund balance $5,371 $4,591 $23,817

Encumbrances 1,537 1,537 1,537

Reservea $6,908 $6,128 $25,354

a Special Fund for Economic Uncertainties. Assumes no transfer to the states Budget StabilizationAccount.


7/45



General Fund savings that is initially estimated tototal around $500 million per year. Our forecastassumes that the state fails to secure the remaining$3.5 billion of additional federal funding or

exibility incorporated into the 201011 budgetpackage. Accordingly, based on that assumptionalone, our projections show a General Fund decitat the end of 201011.

Basis for Our EstimatesOur revenue and expenditure forecasts are based primarily on the requirements of current law,

including constitutional provisions (such as the Proposition 98 minimum guarantee for schoolfunding), statutory requirements, and currently authorized federal funding. In other cases, theestimates incorporate eects of projected changes in caseloads, federal requirements, and otherfactors aecting program costs. Te estimates are not predictions of what the Legislature and theGovernor will adopt as policies and funding levels in future budgets. Instead, our estimates areintended to be a reasonable baseline of what would happen if currentlaw policies continue to

operate in the future. We intend the forecast to provide a meaningful starting point for legislativedeliberations involving the states budget so that corrective actions can be taken.

No COLAs or Ination Adjustments Assumed. In line with the Legislatures policy in recentyears, we generally have not made annual costofliving adjustments (COLAs) or price increaseadjustments over our forecast period. (Health programs are an exception since the costs of currentlaw benets are subject to inationary increases.) In particular, in the 200910 budget packagethe Legislature added to state law a provision stating that most programs, including universities,the courts, and various social services programs, would no longer receive automatic COLAsand ination adjustments. Te impact of not adjusting for COLAs and ination means that thepurchasing power of current state expenditures will be eroded by ination over the forecast periodand the state will not be able to maintain a current services budget. Should the Legislature chooseto provide these adjustments in future years, we estimate that the states annual budget problemswould be even greater than those indicated in our forecastby about $400 million in 201112and, if ination adjustments were provided each year during the forecast, by as much as $3 billionin 201516. If the Legislature were to approve additional state employee pay or benet increases(beyond those included in recent labor agreements), that also would increase costs above thoseindicated in our forecast.

Impact of Future Ballot Measures Not Considered. In keeping with our use of current law asthe basis for our forecast, our projections do not consider any future impact of measures scheduledfor future statewide electionsthe $11 billion water bond and the budget reserve and spendingmeasure passed as part of the 201011 budget package. We do, however, incorporate our preliminary

estimates of the scal eects of propositions that were passed on November 2, 2010.

State Victories in Court Cases Assumed. Our forecast generally assumes that the state eventuallyprevails in active, budgetrelated court cases. (By active cases, we mean open cases at the trial orappellate court level.) Te state faces an array of active cases, including ones related to the budgetedshi of redevelopment funds and various health and social services reductions. Te state also isappealing a threejudge panels order to reduce the prison population to the U.S. Supreme Court.


8/45


Legislative Analysts Ofce www.lao.ca.gov 5

A Net $3 Billion of Other Budget SolutionsLikely at Risk. In addition to the inability to securefederal funding, we assume the state will be unable toachieve the following 200910 and/or 201011 budget

solutions counted on in the 201011 budget package:

Prisons and Medical Care Receiver. Weexpect that expenses of the prison medicalcare Receiver will exceed budgeted amountsby about $780 million and that other prisonexpenses will surpass budgeted totals by$185 million.

Employee Compensation. Recent collectivebargaining agreements and other personnelactions are projected to achieve over$400 million less in savings than assumedin the 201011 budget. In addition, in200910, the state enacted a oneday payrolldelay to achieve onetime savings of about$1 billion. Estimates now indicate the delayachieved savings of $800 million.

MediCal. Around $400 million ofbudgeted savings are estimated to beunachievable in MediCal due to (1) the latepassage of the 201011 budget and (2) our

projection that the program wil l be unableto achieve an unallocated budget reductionof $323 million.

InHome Supportive Services (IHSS)Program. As part of the 201011 budgetpackage, a variety of solutions wereestimated to reduce IHSS costs by$300 million. We estimate that only aboutonehalf of this savings will materialize.In addition, $45 million of budgeted

savings from previously enacted antifraudactivities will not be achieved.

Lower Property Tax Estimate AffectsGeneral Fund Education Spending. Ourforecast assumes lower local property taxrevenues than the 201011 budget package.General Fund spending on Proposition 98,

therefore, is over $400 million higher in ourforecast for 200910 and 201011 combined.

Information Technology Savings. he

budget package assumed the administration would reduce departmentalbudgets by $130 million in 200910 and$140 million in 201011 to capture savingsfrom recent eciencies implemented ininformation technology programs. Ourforecast assumes that much of this savingsdoes not ow to the General Funds bottomline.

200910 and 201011 Revenue ProjectionDown $447 Million. Te 201011 budget packageessentially relied on our oces May 2010 revenueforecast for 200910 and 201011, which was$1.4 billion higher than the administrations. Ourcurrent projection has General Fund revenues$447 million below the budget package forecast for200910 and 201011 combined.

Proposition 22 Reduces General Fund Solutionsby Nearly $800 Million. Tere is some uncertaintyabout what Propositions 22 and 26 mean for statefinance in the short term, as discussed in the

nearby box (see page 6). Our forecast, however,assumes that Proposition 22 prevents the state fromachieving nearly $800 million in budgeted 201011solutionsabout $400 million in nowprohibitedborrowing from the Highway Users ax Accountand $400 million in nowprohibited use of transportation funds to pay bond debt service.

$6.1 Billion General Fund Decit Forecast for 201011. As shown in Figure 1, given all ofthese expenditure and revenue issues, we forecast

that 201011 will end with a General Fund decitof $6.1 billion, absent any corrective actionby the Legislature. Various cash managementactionsincluding payment delays approved bythe Legislature and borrowing from both investorsand state special fundswill facilitate continuedGeneral Fund operations despite the forecasteddecit, as described in the nearby box (see page 7).


9/45



MAJOR NEW BUDGET

PROBLEM IN 201112

With the CarryIn Deficit, a $25 BillionProblem to Address. he vast majority of theroughly $20 billion of budget solutions enacted aspart of the 201011 budget process were onetimeor temporary in nature. At the same time, by theend of 201011 about $8 billion of temporary taxincreases expire, and about $4.5 billion of federalstimulus funding used to reduce General Fund

expenses will be exhausted. For these reasons, thestate will be le with a large operating shortfall (thedierence between annual General Fund revenuesand expenditures) problem in 201112 totaling

$19.2 billion. In addition, the Legislature mustaddress the 201011 yearend decit at or beforethe time it enacts the 201112 budget package.Accordingly, the total budget problem that thestate must address between now and passage of the201112 budget totals $25.4 billion in our forecast,as shown in Figure 1.

Eects of November 2010 Ballot Measures on Our ForecastTree major budgetrelated measures were approved by voters at the November 2 general

election. Proposition 25 changes the vote threshold needed to send a budget bill to the Governorfrom twothirds to a simple majority of each house of the Legislature. Tis may help make iteasier for the Legislature to pass an ontime budget each year. At the same time, voters approvedPropositions 22 and 26, which restrict the Legislatures ability to use certain local funds to helpbalance the budget and raise the vote threshold for passing certain fees from a simple majority totwothirds, respectively.

Our Assumptions Concerning Propositions 22 and 26. We assume that Proposition 22 preventsthe state from borrowing certain transportation special funds for the General Fund, as was assumedin the Legislatures 201011 budget plan. We also assume that loans from such special funds priorto November 3 (the eective date of the measure) are notaected by Proposition 22. Accordingly,

in our forecast, about $400 million of notyetexecuted loans from the Highway Users ax Accountare assumed to be prohibited by Proposition 22. Tis worsens the condition of the General Fundin 201011 by a like amount. Te budgeted use of certain transportation funding to oset GeneralFund debtservice costs also is assumed to be impermissible in 201011, thereby hurting the GeneralFunds bottom line by another $400 million.

In 201112, we assume that Proposition 26 fully reverses the fuel tax swap adopted by theLegislature earlier this year, beginning November 2011 (one year aer voter approval). Accordingly,state sales taxes on gasoline resume (thereby increasing General Fund revenues), excise taxes ongasoline decline, and the General Funds payments for transportation programs resume pursuantto Proposition 42 (2002). A timing lag in Proposition 42 payments means that the net eect of

these measures is near zero for 201112. Te ongoing eect of Propositions 22 and 26approaching$1 billion or more annuallydoes not hit the General Fund until 201213 in our forecast.

Some Uncertainty. Propositions 22 and 26 are complex measures. It is possible that some of thescal eects we describe above would not materialize until a stakeholder successfully sues the statein court to force these budgetary changes. Accordingly, our forecast presents a preliminary pointof view about their eects on the budget. Te actual eect may be dierent in any given scal year.


10/45



Key Considerations Regarding the2011-12 Budget

Sharp Reduction in K14 ProgrammaticSpending Already Reflected in Our Forecast.

Because of the expiration of temporary tax increasesand other factors, General Fund tax revenues areforecast to decline signicantly in 201112, which

drives down the Proposition 98 minimum fundingguarantee in our projections. Te Proposition 98minimum guarantee is forecasted to decline from$49.7 billion in 201011 (when the Legislature

suspended Proposition 98) to $47.5 billion in201112. Te General Funds share of Proposition 98funding is forecast to decline as wellfrom$36.2 billion in 201011 to $34.2 billion in 201112.

Cash ManagementBackground. As we described in our January 2009 report, Californias Cash Flow Crisis, the

state suers from a basic cash ow problem, even in good years. Most revenues are received duringthe second half of the scal year (January to June), while most expenses are paid in the rst halfof the scal year (July to December). In order to meet payments in the early part of the year, the

state obtains shortterm borrowing that is paid back within the scal year, referred to as revenueanticipation notes (RANs). Te state also relies on a pool of borrowable resourcesbalances instate special fundsthat can be borrowed for cash ow purposes.

Billions of Dollars of Payments Delayed in 201011. Te Legislature enacted two sets of cashpayment delays for the 201011 scal year in order to assist with cash management. Te rst wasenacted in special session legislation and allowed for delays of up to $5 billion of scheduled paymentsto schools, universities, and local governments at almost any given time within the scal year.Te second set of delays was enacted in the October budget package and allowed for an additional$4.7 billion of payments to be delayed in October and November in order to avoid the issuance ofregistered warrants (IOUs) and facilitate the issuance of a 201011 RAN. Te Controller also usedhis executive authority to delay other payments in October, such as tax refunds. Tese variouspayment delays will be repaid within the 201011 scal year.

Payment Delays Will Be Needed for 201112. With a few exceptions, there are no statutory provisions for intrayear payment delays in the 201112 scal year. Given our forecast for the signicantdecit at the end of 201011 and the accumulated decit in the General Fund, the state will likelyrequire signicant external cash ow borrowing again in 201112. In addition, to avoid the issuanceof IOUs at certain points in the year, payment delays similar to those approved in 201011 likelywill be needed. Local governments, schools, and community colleges previously have indicatedthat early adoption of payment delays helps them execute their own annual cash borrowings.

Curbing the Decit Would Reduce Cash Pressures in Future Years. Many temporary or

onetime budget solutionssuch as borrowing from special fundsincrease cash pressures byreducing overall borrowable resources. If the Legislature acts to eliminate operating shortfallsin the coming years, we would expect cash pressures, and hence the need for payment delays,to decline. While removing the payment delays will not have a signicant impact on the statesbudget situation, it should reduce the external borrowing costs of local entities and provide morecertainty in scal planning eorts of schools and community colleges. Reducing cash pressurescan also reduce the states need for external borrowing, thus reducing the states borrowing costs.


11/45



At the same time, it is expected that schools willhave spent most of the billions of dollars of recent,onetime federal stimulus and jobs funding approvedby Congress. Accordingly, it may be very dicult for

the Legislature to achieve additional Proposition 98savings as part of its 201112 budget package. Inother words, if the Legislature funds schools at theforecasted minimum guarantee in 201112, it wouldmean billions of dollars in programmatic cuts toeducation but not contribute a single dollar to closingthe $25 billion budget problem.

State Faces Ongoing Constraints on ReducingHealth Programs. Our forecast reflects sharpGeneral Fund increases in MediCal, the states

secondlargest General Fund program, that arerequired under current law and as a result of theexpiration of federal economic stimulus funding.Te American Reinvestment and Recovery Act(ARRA) of 2009 provided an enhanced federalmatch in state support for MediCal that will bephased out as of the end of 201011. Te statesreceipt of billions of dollars in federal assistanceunder ARRA, however, was on the condition that itmaintain the eligibility standards, methodologies,and procedures that were previously in place forMediCal. Tese constraints originally were toexpire along with the provision of ARRA funding.However, provisions in the federal health carereform law essentially extended these maintenanceofeffort requirements for MediCal and alsoapplied them to the Healthy Families Program. Tisessentially takes o the table many options to scaleback these programs that could result in severalhundreds of millions of dollars in state GeneralFund savings annually.

In other areas, such as California Work

Opportunity and Responsibility to Kids(CalWORKs), the expiration of federal economicstimulus funding (known as the emporaryAssistance for Needy Families EmergencyContingency Fund, or ANF ECF) does openup additional options for state savings. Te high

80 percent federal matching rate available underANF ECF for increased CalWORKs grant costsabove the states base costs in 2007 had been adeterrent to cutting General Fund support for

CalWORKs cash assistance, but it is no longer ineect.

Revenue Uncertainty. As we discuss inChapter 2, there are a lot of challenges withforecasting economic activity and revenues inCalifornia following the unprecedented recessionthat ended in 2009. One of the key challenges isforecasting capital gains. Tis is always dicult, butis even more so this year given the huge unrealizedstock and housing capital losses of recent years

and uncertainties about federal tax policy with thepending expiration of various tax cuts. Action orinaction by Congress on the expiring tax cuts inthe coming weeks could aect taxpayer behaviorand the resulting timing of hundreds of millionsof dollars in state revenues related to capital gains.

Of perhaps even greater concern is uncertainty about the federal estate tax. Currently,our forecastlike the 201011 budget packageassumes $2.7 billion of estate tax revenues for theGeneral Fund in 201011 and 201112 combinedbased on current law. Tere has, however, beensignicant speculation that Congress will changeestate tax law to eliminate the states ability togenerate any of these revenues. Should Congressdo this, the budget problem for 201112 wouldincrease by $2.7 billion above the level indicatedin our forecast.

LINGERING BUDGET

PROBLEM OF $20 BILLIONFOR YEARS TO COME

Roughly $20 Billion Annual Problem Forecastrough 201516. As shown in Figure 2, our forecastof General Fund revenues and expenditures shows


12/45



an annual budget problem ofaround $20 billion through201516. With the economicrecovery remaining very

weak and the lack of manypermanent budget solutionsin the 201011 budgetpackage, the ongoing structural decit has not changedmuch since our forecastone year ago. he annualoperating shortfall peaksat $22.4 billion in 201213,when the state must repayits $2 billion Proposition 1A

loan related to local propertytax revenues. hereafter,revenues grow a bit fasterthan expenditures as thestates economic recoverybecomes s t ronger . By 201516, the annual budgetproblem is $19.4 billion.

Projections Likely Understate the States FiscalWoes. We believe that our projections probablyunderstate the magnitude of the states fiscalproblems during the forecast period. First, ourforecast generally assumes no costofliving adjustments or inationary increases in departmentalbudgets. Second, by including only currentlawexpenditures, our forecast does not include fundingto address a number of large liabilities that pose arisk to future state nances, as discussed below.

Massive Liabilities Growing. Unfundedactuarial accrued liabilities in pension and retireehealth funds for state employees, teachers, and

university employees now total $136 billion.(Possible upcoming actions by the states two largestpension systems to lower their assumed annual ratesof investment return would expand this number.)Te California State eachers Retirement System

(CalSRS) estimates that it needs billions of dollarsmore per year in contributionsnot included in our

forecastto retire its unfunded liabilities withinabout 30 years and continue operations past the2040s. Similarly, there are no funds assumed in

our forecast to begin retiring the University ofCalifornia Retirement Plans (UCRP) growingunfunded liabilities. State retiree health liabilitiescontinue to grow, driving upward the associatedGeneral Fund expenditures. Te Legislature tookaction earlier this year to modify state pensionprograms, providing some budget relief now andgreater relief in the future. Te unfunded liabilitiesof state retirement systems, however, loom over thestates budget prospects. Le unaddressed in thenear term, costs to service CalSRS, UCRP, and

retiree health liabilities will only grow, burdeningfuture Californians more and more and requiringeven harder decisions about taxes and services. Testate should look for ways to address these problemssoon, to avoid passing these huge obligations tofuture Californians.

Huge Operating Shortfalls ProjectedThroughout Forecast Period

Figure 2

General Fund (In Billions)

-30

-25

-20

-15

-10

-5

$0

2011-12 2012-13 2013-14 2014-15 2015-16

Carry in Deficit From 2010-11

Annual Operating Shortfall


13/45



MULTIYEAR APPROACH TO

BALANCE THE BUDGET

BEGINNING NOW

Current Budget Problems Hinder Ability toPlan for the Long Term. As discussed throughoutthis report, California faces immense shorttermbudget problems and perhaps even more troublinglongerterm scal challenges. Without immediateaction to begin tackling the structural decit forthe long term, the state may not be able in theforeseeable future to move beyond its currentstumble from one terrible budget problem to thenext. As such, it will continue to be dicult for the

state to address fundamental public sector goalssuch as rebuilding aging infrastructure, addressingmassive retirement liabilities, maintaining servicelevels of highpriority government programs, andimproving the states tax system.

Not Possible to Solve the Whole Problem inOne Year. In a state as complex as California, withan economy as weak as the one we have right now,it is not possible to solve this $20 billion ongoingbudget problem all at once. Te solutions necessary

to address the whole problem are probably notobtainable in the current environment. Instead,this problem will take several years to solve. Soundnancial planning requires that the states leadersagree now to a broad framework for a multiyearapproach to tackling the stubborn budget problem.

Multiyear Approach Requires Real BudgetSolutions. he current fiscal year is the thirdconsecutive one that will end with a General Funddecit. Key contributors to yearend decits havebeen enacted budget solutions that have not beenachieved. For example, earlier in this chapter wediscussed a net $3 billion of 200910 and 201011expenditure solutions that are unlikely to beachieved. Yearend decits have to be carried in tothe next scal year and make the task of balancingthe next years budget much more dicult. omake progress over several years in tackling the

ongoing decit, the Legislature should minimizethe use of risky budget solutions that contribute toyearend decits. Instead, budget solutions needto be realby which, we mean those that have a

high probability of achieving budgeted savings.Te Legislature can maximize the probability ofachieving solutions by passing budgets on time(preferably early) and, in the case of spendingreductions, providing specific direction andauthority to the administration in wellcraedlegislation on how reductions are to be realized.

Revenues Need to Be Part of the Mix. Just asthe Legislature will have to prioritize its spendingcommitments in order to address the ongoing

decit, it will need to examine the revenue side ofthe ledger. Tere are several specic revenue policyareas that the Legislature should consider, such as:

Tax Expenditure Programs. Trough taxexpenditure programsspecial credits,deductions, and exemptionsthe stateprovides subsidies to certain groups orindividuals in ways that oen have notbeen shown to be costeffective. heirmodication or elimination raises revenueswithout having to increase marginal taxrates.

Incre asing C harge s for P rogramBeneciaries. Te Legislature should alsolook to increasing charges in those caseswhere the costs of state programs currentlysupported by the General Fund can appropriately be shied to specic beneciaries.

Extending Certain Temporary TaxIncreases. Te Legislature may also have

to revisit some of the temporary taxincreases that are set to expire by the endof 201011. We think the best candidatesfor extension would be the vehicle licensefee, where a good policy case can be madeto tax vehicles at a rate similar to all otherproperty, and the dependent exemptioncredit, where the current level is more


14/45



consistent with the practice of almost allother states.

Reconsider the Optional Single Sales

Factor. he Legislature may wish toreexamine some corporate tax provisions,such as the existing option of multistatecompanies to switch annually betweenthe new single sales factor methodof profit apportionment and the statestraditional method of apportionment forthese companies. Making the single salesfactor apportionment mandatory, insteadof optional, for multistate companies couldincrease General Fund revenues and help

the states competitiveness. (For moreinformation, see our May 2010 report,Reconsidering the Optional Single SalesFactor.)

Both Permanent and Temporary BudgetSolutions Are Needed in 201112. he basicframework we suggest for policy makers to balancethe 201112 budget would involve a mix of:

Permanent, real andongoing expenditure

r e d u c t i o n s a n drevenue increases.

emporary budgetsolutions, such asshortterm revenueo r e x p e n d i t u r ec h a n g e s , a s s e tsales, special fundloans and transfers,e x t e n d e d s t a t e

employee furloughsor personal leaveprograms, and delaysin lowerpriori ty bondnanced infrastructure projects.

Given our forecast of a $25 billion budgetproblem in 201112, we suggest that the Legislatureand the new Governor target $10 billion ofpermanent budget solutions in 201112 and

$15 billion of temporary budget solutions. Tiswould be a down payment on the multiyearapproach to ending Californias structural decit.

In a Multiyear Approach, More PermanentSolutions Each Year. Figure 3 graphically illustratesin very simplied formhow a multiyearbudgetbalancing approach would work, assumingthe accuracy of our budget decit projections, foreach scal year:

201213. By taking $10 billion of permanentbudget actions in 201112, the size of the201213 budget problem we forecast mightbe reduced from $22 billion to $12 billion.In 201213, the Legislature could address thebudget problem with about $3 billion of newadditional permanent actions (or the growthin savings from previously adopted solutions)and $9 billion of temporary actions.

Multiyear Approach Could Involve Mix ofPermanent and Temporary Solutions

General Fund Budget Solutions (In Billions)

Figure 3

5

10

15

20

25

$30

2011-12 2012-13 2013-14 2014-15 2015-16

Addressed by Prior Permanent Actions

Temporary Budget Actions

Permanent Actions

BalancedBudget


15/45



201314. Adding together the eects of thepermanent budgetbalancing actions in201112 and 201213, the budget problemwe forecast for 201314 could be reduced

from $20 billion to around $7 billion. TeLegislature could address this problem with$3 billion of new additional permanentactions and around $4 billion of temporaryactions.

201415. he prior permanent budgetactions would reduce the 201415 budgetproblem from $20 billion to about$4 billion. Roughly another $3 billion ofnew, permanent budget actions could be

adopted, along with $1 billion of temporarysolutions.

201516. In this simplied scenario, therewould no longer be a structural deficitfacing the state in 201516 due to theaccumulated effects of the permanentbudget actions passed in the previous fouryears.

Naturally, the real work of balancing the budgetwould not be this simple. Tis scenario assumesthat our revenue and expenditure forecast assumptions are correct, ignores the interaction between

any increased revenues and Proposition 98 fundingrequirements, and assumes that no temporarybudgetbalancing actionssuch as borrowingincrease costs (and decits) in later years. Te basicconcept we oer, however, is that the Legislaturecan earnestly chip away at the budget problem,but only bybeginningto enact permanent and realsolutions to reduce spending and increase revenues.

Te solutions needed to balance the budgetwill mean unavoidably painful sacrice by todays

Californians. Te benet of this sacrice wouldbe putting the state on a sound scal footing. Tatsound footing may allow future Californians to livein a place where the annual state budget process isa chance to improve governments ability to serveits residents.


16/45


Economy, Revenues, andDemographics

Chapter 2

THE ECONOMIC OUTLOOK

Te National Bureau of Economic Researchhas determined that the national recession thatbegan in December 2007 ended in June 2009. It wasthe longest recession since World War II and themost severe downturn since the Great Depressionhe 20072009 recession was precipitated bythe implosion of overheated housing markets inCalifornia and throughout the United States, theresulting balance sheet deterioration of nancialrms and households, and the near collapse ofworld credit markets.

Californias recession started even earlier thanthe nations and was deeper. Unemployment in thestateunder 5 percent as recently as 2006hastopped 12 percent for over a year now, as 1.4 millionjobs have disappeared. In 2009, personal income inCalifornia dropped 2.4 percentthe rst annualdecline since 1933.

Slow Recovery Expected to Continue. helatest evidence suggests that the state and nationaleconomies continue their very slow recoveryfrom this staggering economic dropoff. Oureconomic forecastsummarized in Figure 1(see next page)generally reects the currentconsensus that the state and national economieswill continue to recover slowly and sluggishly inthe coming years.

The U.S. EconomySlower Recovery an Previously Expected.

Our recent economic forecasts already assumeda slow recovery, compared to past economicrebounds. Following the deep 198182 recession,for example, the U.S. economy bounced rightbackwith real gross domestic product (GDP)growing 4.5 percent in 1983 and 7.2 percent in1984. Our updated forecast, by contrast, assumesthat real GDP growth will be 2.6 percent in 2010,2.2 percent in 2011, and no higher than 3.1 percentin any of the years between now and 2016.(Figure 2 [see page 15] summarizes our forecasts of

quarterly changes in GDP.) Unemploymentnow9.6 percent nationallyis forecast to remain above9 percent through 2012. Our forecasts of U.S.economic growth in 2011 and 2012 are somewhatlower than our forecasts from the past year.

What Is Causing the Slow Recovery?Te slowrecovery results from a combination of (1) excessinventories of residential and commercial realestate, (2) severely depressed economic condenceamong both individuals and rms, and (3) for many

consumers, a considerably weakened financialcapacity to spend and invest. Consumers areattempting to restore their personal nances amidstthe weak labor markets and diminished housingwealth. Credit remains very tight. While businesseshave been spending more in recent quarters toaddress equipment, software, and other needsthey deferred during the recession, they remain


17/45



very reluctant to hire. Te construction industryremains flat on its backwith few immediateprospectsdue to the massive fall in residentialand commercial real estate markets. While massive

scal stimulus from the federal government helpedcushion the fall, the 2009 stimulus programspending will taper o in the coming quarters, andthe likelihood that Congress will enact additionalscal stimulus appears remote. Te Federal Reservecontinues to take actions to stimulate the economy,but, with interest rates already at very low levels,its ability to achieve much in this regard is limited.

DoubleDip Recession Not Likely. Whileour economic and revenue forecasts reect very

modest assumptions about nearterm growth, theyare by no means a worstcase scenario. A minorityof economic commentators have suggested that adoubledip recessionanother period of diminished economic outputis possible due to thecoming declines of federal economic stimulus,continued weakness in consumer spending,turmoil in the worlds sovereign debt and currencymarkets, and other factors. Our forecast reects

the consensus view that a doubledip recession willnot occur. While employment, personal income,output, and housing permit growth, among othermeasures, are very weak by historical standards

during a recovery, they are not shrinking. Similarly,while we expect low ination through 201516, wedo not forecast a period of deation in the U.S.economy. In large part, our economic outlookreects the view that some key economic measures(such as construction activity) have fallen so far thatthere is little room to fall even more.

The California EconomyEmployment Losses Subsiding. While U.S.

employment has dropped about 5 percent since

2007, employment in California has declined9 percent (1.4 million jobs). In 2010, however, thelevel of job losses in the state has been subsidinga trend we expect to continue. We forecast thatCalifornia will begin to experience a net increasein employment again in early 2011, causingunemployment to creep below 12 percent later inthe calendar year. We expect employment in thestate to grow by only about 100,000 jobs during

Figure 1

The LAOs Economic Forecast

(November 2010)

Actual2009

Estimated2010

Forecast

2011 2012 2013 2014 2015 2016

United States

Percent change in:

Real Gross Domestic Product -2.6% 2.6% 2.2% 3.1% 2.9% 2.8% 3.1% 2.8%

Personal Income -1.7 2.8 3.2 3.9 4.3 5.5 5.4 5.7

Wage and Salary Employment -4.3 -0.5 0.9 2.2 2.2 1.5 1.4 1.2

Consumer Price Index -0.3 1.6 1.6 1.9 2.0 2.1 2.1 2.1

Unemployment Rate (percent) 9.3 9.7 9.6 9.1 8.3 7.9 7.3 6.9

Housing Permits (thousands) 554 596 789 1,243 1,465 1,565 1,689 1,686

California

Percent change in:

Personal Income -2.4 2.8 3.5 4.3 4.8 5.7 5.9 5.7

Wage and Salary Employment -6.0 -1.7 0.7 2.2 2.4 1.8 2.0 1.3

Consumer Price Index -0.4 1.6 1.6 1.9 2.0 2.1 2.1 2.1

Unemployment Rate (percent) 11.4 12.5 11.9 10.5 9.1 8.2 7.1 6.6

Housing Permits (thousands) 34 42 67 79 99 113 121 121


18/45



Modest Growth Expected During Recovery

(Percent Change From Prior Quarter [Annual Rate]U.S. Real Gross Domestic Product)

Figure 2

Forecast

2006 2008 2010 2012 20142007 2009 2011 2013 2015

-8

-6

-4

-2

0

2

4

6%

2011a slower level of job growth for the year thanin any of our recent forecasts. In 2012, we projectslow employment growthin the state, a trend that

should keep unemploymentat or above 10 percent formuch of that year. Growthin later years also remainsfairly sluggish, as shown inFigure 3. otal employment inCalifornia does not return toits 2007 prerecession levels inour forecast until 2016.

Housing Weakness Casts

Formidable Shadow OverEconomy. he main causeof the economic implosionof recent years has beenthe housing market. Fornow, at least, the collapseof Californias residentialhousing sector appears tohave ended. As depictedin Figure 4 (see next page),however, our forecast forCalifornia housing pricesshows a very weak recoverywith minimal average gainsin prices through 2016. Whilehouse prices now are moreaffordableparticularly inlight of low mortgage interestratescredit remains verytight. A large (but dicult tomeasure) hidden inventoryof homes in default or facingforeclosure heavily influences our forecast. Whileresidential building permitsare up in 2010, they are stillbelow 2008 levelswhich,at the time, was the worstyear in recent memory. Ourforecast, as shown in Figure 1,

Forecast

Slow Employment Growth Expected

Percent Change in California Average Annual Employment

Figure 3

-8

-6

-4

-2

0

2

4

6%

1991 1996 2001 2006 2011 2016

expects housing permits to continue to growslowly. Commercial building also continues to


19/45



be exceptionally weak. For all of these reasons,Californias construction sectorhaving endureda crushing 40 percent employment decline since2007is not on track to regain its prerecession

strength in the foreseeable future.

Personal Income Poised to Rise With JobGrowth. As job growth resumes, personal incomein the state rebounds in our forecastrst, fairlyslowly in 2011 and 2012, and then with someincreasing strength thereaer. By 2014, we expectannual personal income growth for California in the5.7 percent to 5.9 percent rangea level consistentwith what we would consider a healthy growth ratefor the state in the long run. Gradually climbing

interest rates contribute to much stronger growthin dividends, interest, and rent income in the lateryears of our forecast. Government benets also growin the later years of our forecast, buoyed by growthin the aging baby boom population and, to someextent, the implementation of federal health carereform. All of these factors should help householdsin California continue to repair their nances, boostconsumer condence, and contribute to several yearsof increased consumption.

REVENUE

PROJECTIONS

Californias General Fundis supported by revenues froma variety of taxes, fees, licenses,interest earnings, loans, andtransfers from other statefunds. About 90 percent of thetotal, however, is derived fromthe states big three taxesthe personal income tax (PI),the sales and use tax (SU),and the corporate income andfranchise tax (C). A summaryof our revenue projections isshown in Figure 5.

Forecast

Minimal Growth in California Housing Prices Expected

(Blended Case-Shiller and Federal Housing Finance Agency Indicesa)

Figure 4

50

100

150

200

250

300

1987 1990 1993 1996 1999 2002 2005 2008 2011 2014

aUses Case-Shiller data for the California metropolitan areas it covers and Federal Housing FinanceAgency data for the rest of the state. First quarter of 2000=100.

Figure 6 (see page 18) shows the dierencesbetween our forecasts of 200910 and 201011revenues, as compared with those assumed in the201011 budget package. For 200910 and 201011

combined, we now project that the big three andother revenues will be $447 million below thebudget package assumptions. In addition, due toour assumption that passage of Proposition 22will prevent the borrowing of some transportationfunds, our net transfer and loans forecast is$378 million lower. In total, for 200910 and 201011combined, our revenue and transfer forecast is$826 million below that assumed in the 201011budget package.

Personal Income TaxEnd of Temporary Tax Increases Affects201112 Forecast. We estimate that PI revenuewill increase from its 200910 level of $44.6 billionto $46.7 billion in 201011. It will then drop oto $44.3 billion in 201112 as the temporary0.25 percentage point rate increase and dependentcredit reduction enacted in February 2009 expireat the end of calendar year 2010. Tese temporary


20/45



tax increases contribute over $2 billion to PIrevenues in 201011. We project PI collections toincrease steadily in the out years as the economycontinues to recover, but we do not expect collec

tions to exceed their 200708 level of $54.2 billionuntil 201516.

PIT Forecast Marked by Capital Gains,Federal Tax Uncertainties. Capital gains areimportant for PI projections because these gainsare concentrated among taxpayers who pay thehighest marginal PI tax rates. As Figure 7 (seepage 19) shows, capital gains fluctuate wildlyrelative to personal income depending on thestate of asset markets, and this always makes them

dicult to forecast. Tey peaked at $120 billion intax year 2000 at the height of the dotcom bubblebut fell to $33 billion in 2002. Similarly, capitalgains peaked at $132 billion at the height of thehousing bubble in 2007, only to fall to $56 billionin 2008. We estimate that capital gains fell furtherto $34 billion in 2009. Our forecast reects modestfuture growth in capital gains through 2016 due toimproving stock prices and slowly increasing realestate values. If our forecast is o, this could havea signicant eect on PI collections and General

Figure 5

LAO General Fund Revenue Forecast

(Dollars in Millions)

Revenue Source 200910 201011 201112 201213 201314 201415 201516

Personal income tax $44,575 $46,731 $44,252 $47,909 $50,868 $54,072 $57,507

Sales and use tax 26,741 27,310 25,370 27,725 29,137 30,397 31,622

Corporation tax 9,500 10,418 8,567 8,125 8,531 9,255 9,963

Subtotal, Big Three ($80,816) ($84,460) ($78,189) ($83,760) ($88,536) ($93,724) ($99,092)

Percent change 5.4% 4.5% -7.4% 7.1% 5.7% 5.9% 5.7%

Insurance tax $2,020 $2,033 $2,060 $2,093 $2,129 $2,168 $2,223

Vehicle license fee 1,380 1,428 159 34

Estate tax 850 1,838 1,988 2,150 2,325 2,515

Sales of xed assets 1,286 1 1 1 7 7

Other revenues 2,378 2,205 2,136 1,861 2,072 2,233 2,342

Net transfers and loans 447 1,021 -853 -1,014 -180 21 18

Total Revenues andTransfers

$87,041 $93,283 $83,530 $88,723 $94,708 $100,478 $106,197

Percent change 5.2% 7.2% -10.5% 6.2% 6.7% 6.1% 5.7%

Fund revenues. For example, for each $10 billionincrease in capital gains, General Fund revenuesincrease by approximately $800 million.

Currently, there are two big variables that makesus particularly uncertain about capital gains. First,there is a large stock of unused losses. axpayersracked up far more capital losses than they couldclaim on returns in 2008 and probably again in2009. Accordingly, we expect that these unusedlosses will hinder revenue growth for many yearsas taxpayers use 2008 and 2009 losses to osetfuture gains.

Second, there is signicant tax policy uncertaintyat the federal level regarding congressional action onexpiring tax cuts. In 2001 and 2003, lower tax rates,including capital gains tax rates, were adopted, andthese federal tax rate reductions are to expire thisyear. Our forecast assumes that this higher federaltax rate on capital gains returns to its higher levelin 2011. Tis would cause some taxpayers to takegains in 2010 that otherwise would be taken in 2011.Te actions Congress takes could aect the timingof these capital gain receipts and other economicand revenue variables in dierent ways. It seems as


21/45



Figure 6

November 2010 LAO Revenue EstimatesCompared With 201011 Budget Package

(General Fund, In Millions)

Revenue Source

200910 201011

LAONovemberForecast

BudgetPackage Difference

LAONovemberForecast

BudgetPackage Difference

Personal income tax $44,575 $44,820 -$245 $46,731 $47,127 -$396

Sales and use tax 26,741 26,618 123 27,310 27,044 266

Corporation tax 9,500 9,275 225 10,418 10,897 -479

Subtotal, Big Three ($80,816) ($80,713) ($103) ($84,460) ($85,068) (-$608)

Other revenues $5,778 $5,760 $18 $7,802 $7,762 $40

Net transfers and loans 447 447 1,021 1,399 -378

Total Revenues andTransfers

$87,041 $86,920 $121 $93,283 $94,230 $947

though the federal tax picture will be somewhatclearer by the time the new Governor releases hisbudget proposal in January.

Sales and Use TaxEnd of Temporary Tax Increase andProposition 26 Affect 201112 Forecast. In201011, we expect SU receipts of $27.3 billion,a 2.1 percent increase over the prior year. he1 percent temporary SU rate increase adoptedin 2009which contributes $4.7 billion of SUrevenue in 201011will expire on June 30, 2011.For 201112, SU revenues are projected to fall to$25.7 billion, reecting the net eect of this ratedrop, projected growth in the SU taxable sales

base of nearly 7 percent, and our assumption thatvoter approval of Proposition 26 on November 2,2010 will undo the fuel tax swap adopted earlierthis year. Under the terms of that measure, thegasoline sales tax is reinstated in November 2011,thereby also increasing General Fund spendingon transportation. Aer 201112, taxable sales areexpected to grow by 4 percent to 7 percent annually.

Taxable Sales Bottomed Out Last Year and Now Are Recovering. Te main determinant ofSU receipts is taxable sales. About twothirdsof taxable sales result from retail spending by

consumers, including a signicant portion on lightvehicles and trucks. Other important categories oftaxable sales are the purchase of building materialsinvolved in new construction and businessto

business transactions, where a business is the itemsnal consumer. axable sales in California appearto have hit bottom in the second half of 2009, andare bouncing back.

As shown in Figure 8, overall consumerspending remains low relative to the levels ofrecent decades, when viewed as a percentageof personal income. It appears there has been alongterm trend toward lower taxable sales, relativeto personal income, which has been inuenced

by: (1) the major recessions of the early 1990s and20072009; (2) a trend toward more consumptionof nontaxable services and other products (such asthose purchased online, for which the collectionof sales and use taxes is more difficult); and(3) increased household savings, particularly in thelast few years.

Corporate TaxCorporate Tax Forecast to Bottom Out in

201213 Before Rebounding. Te C receipts for200910 are estimated to have totaled $9.5 billion, virtually unchanged from the previous fiscal


22/45



Forecast

Capital Gains Expected to Grow Slowly

Capital Gains as Percent of Personal Income

Figure 7

2

4

6

8

10

12%

1990 1995 2000 2005 2010 2015

year. Due to the slow recovery and policychangesenacted by the Legislature, we project C receiptswill fall sharply in 201112 and 201213. hetax bottoms out in 201213

at around $8 billion beforerebounding back to around$10 billion by 201516.

Corporate Prot ReboundDoes Not Necessarily TranslateInto Higher Revenues. hemain factor underlying Creceipts is the level of corporateprots that California taxes.Californias corporate prots,

in turn, reect the economicconditions facing Californians,as well as national and international economic conditions.At times, higher prots do notfully translate into higher Creceipts because these higherprots also make it possible forbusinesses to use more deductions and credits. Precise dataon California taxable protsfor 2009 and 2010 are not yetavailable, but our forecastassumes that corporate protshit bottom in 200809 andrebounded rapidly in 200910.Profits in the final years ofour forecast grow at about5 percent each year.

Policy Changes Reduce LongTerm Revenues.Policychanges made over the past

few years have significantimpacts on corporate taxreceipts over the forecastperiod. As shown in Figure 9(see next page), increases of Creceipts due to policy changesnegated what otherwise would

have been a signicant reduction in C receipts in200910. Recent tax policy changes also will boostreceipts in 201011 by increasing collections by a

Taxable Sales Depressed as Consumers Save More,Spend Less

(As Percent of California Personal Income)

Figure 8

Forecast

25

27

29

31

33

35

37

39

41

43

45%

1990 1995 2000 2005 2010 2015


23/45



net amount of around $1 billion. For the remainderof the forecast period, however, these same policychanges diminish C receipts by between $1 billionand $2 billion each year. Te major policy changes

aecting the forecast include:

Changes in Multistate Business Taxation.Te elective single sales factorthe newoption for businesses to annually choosewhich method is used to determineCalifornia taxable incomeand associatedtax law changes are estimated to reduceGeneral Fund C revenues by up to$1 billion per year within a few years.

Revenue Accelerations. Te Legislature

has enacted several measures over the lastcouple of years that will allow the state tocollect revenues earlier and delay the use oftax deductions or credits. Te accelerationsinclude the suspensions, for 2008 through2011, of larger businesses use of netoperating loss deductions. Recently enactedpenalties on corporate taxpayers who arefound to have signicantly underpaid theirtaxes also serve toaccelerate C collec

tions. his occursas businesses try toavoid the penalties bypaying upfront someof the tax they mighthave been forced topay later followingan audit. In addition,legislation limited theamount of tax creditsa corporation could

use in 2008 and 2009to 50 percent of itstax liability for thoseyears. his boostednearterm receiptsbut leads to increaseduse of those creditsin 2010 and beyond.

Tese changes, collectively, are estimated tobring in around $1.2 billion in 201011 buthave the eect of decreasing C revenuesaer 201112.

Expanded Credit Use. Recent legislation also aected the use of tax credits.Changes in this area include the creationof new temporary tax credits for qualiedemployment and lm production. Also,credits are now easier to use under a lawthat allows transfers of certain creditsbetween companies that are treated asparts of a single unit for tax purposes.Tese changes reduce revenues by up to$500 million per year throughout the

forecast period.

Other Revenues and TransfersEstate Tax Highly Uncertain and Could Swell

201112 Problem by $2.7 Billion. Above, wediscussed how congressional action in the comingmonths could aect capital gains and PI receipts. Inaddition, congressional action or inaction on estatetaxes could signicantly aect the states ability to

Forecast

Recent Corporate Tax Changes Help Short-TermRevenues, But Hurt Longer Term Fiscal Outlook

(In Billions)

Figure 9

aBaseline revenues exclude policy changes made by the state since 2008.

2

4

6

8

10

$12

2008-09 2010-11 2012-13 2014-15

Baselinea

Current law LAO forecast


24/45



receive any of the $850 million of currentlaw estatetax receipts we project for 201011 (a halfyear ofreceipts), as well as around $2 billion of annualreceipts in each subsequent year of the forecast. As

we discussed in prior reports, a 2002 federal lawphased out estate taxes so that, by 2010, the estatetax was eliminated entirely. In 2011, this provisionsunsets so that estate tax laws revert back to 2001lawwhich means that tax rates would return to2001 levels and the state pickup tax is restored.Tis pickup tax reduces federal estate taxes by theamount of state taxes levied on each estate, up to acertain level. As a result, many statesincludingCaliforniaset state tax levels at the maximumexemption level under federal law. Tere have been

considerable eorts in recent years to change thiscurrent federal law to permanently limit both thefederal and state estate tax. If Congress were to actto change the federal law, it appears there is a goodchance the pickup tax exemption would not berestored. In this event, the 201112 budget problemwould increase by $2.7 billion (recognizing theeects of both the halfyear projected estate taxreceipts of $850 million in 201011 and the rstfull year of receipts projected to be $1.8 billion in201112). Later budget problems would grow by

up to $2 billion per year above our forecast. (Teseamounts do not account for any Proposition 98interactions.)

Fixed Asset Sales Slightly Above EnactedBudget Forecast in 201011. Assuming thatrecently announced sales of state oce buildings

and the Orange County Fairgrounds proceedas planned, our forecast projects $1.3 billion ofonetime General Fund revenue in 201011. Tistotal is about $100 million higher than assumed

in the 201011 budget package.

End of Temporary Vehicle License Fee (VLF)Increase Aects 201112 Forecast.Te temporaryVLF increase enacted as part of the 200910budget package expires at the end of 201011. Tistemporary increase generates $1.4 billion of revenuefor the General Fund in 201011. Tereaer, theGeneral Fund VLF rate declines again to zeroin our forecast, although small amounts of VLFpayments trickle in during subsequent scal years

due to late payments. Figure 10 summarizes theVLF and other revenues that the state has receivedfrom the temporary tax package.

Special Fund Loans Dominate the GeneralFund Transfers Forecast. In addition to tax, fee,and other revenues, the General Fund receivestransfers from the states special funds and transfersmoney out to those same special funds. Duringthe forecast period, the states transfers are to bedominated by loans received from special funds (themajor component of the $1.4 billion of net transfersassumed in the budget package for 201011) andloan principal repayments back to special funds($853 million of projected net transfers out in201112, $1 billion in 201213, and $180 million in201314). Our forecast assumes that approval ofProposition 22 on November 2, 2010 eliminates

the possibility of the stateborrowing $378 millionof funds from transportation accounts assumedin the 201011 budget

package. Tis reduces nettransfers and loans in201011 to $1 billion in ourprojections.

Figure 10

Estimated Revenues From Temporary Tax IncreasesEnacted as Part of the 200910 Budget Package

(In Billions)

200809 200910 201011

Sales and use tax1 percentage point increase $1.1 $4.4 $4.7

Personal income taxdependent credit decrease 0.1 1.2 1.1

Personal income tax0.25 percentage point increase 0.8 1.8 1.0

Vehicle license fee0.5 percentage point increase 0.2 1.4 1.4

Totals $2.2 $8.7 $8.3


25/45



DEMOGRAPHIC

PROJECTIONS

Department of Finance (DOF) PopulationEstimates Dier From Census Estimates. Te DOFestimates that Californias July 1, 2009 populationwas 38.5 million and that the states populationincreased by 1 percent (or greater) in each yearbetween 2001 and 2008 and by 0.93 percent in2009. By contrast, the Census Bureauin its annualestimates released prior to next years releaseof 2010 Census databelieved that CaliforniasJuly 1, 2009 population was 37.0 million. heCensus estimates dier from DOFs because theyassume that Californias net annual population

growth rate has been somewhat under1 percent inseveral years during the past decade. Data from the2010 Census to be released in March 2011 shouldhelp resolve this demographic dispute.

Economic Downturn Probably Has Resultedin Fewer Newcomers. Relatively poor economicperformance in California can make it lessattractive for residents of other state and countriesto migrate here. Based on historical experience, ourpopulation model suggests that the recent trend

of Californians leaving the state probably is accelerating and will continue to do so through 2011.At the same time, the economic downturn will

depress net international migration into Californiafor the next several years. Births increase slowlyas women continue to delay childbirth until laterages. Accordingly, as shown in Figure 11, our oce

estimates that total annual population growth inCalifornia will be 0.55 percent in 2010 and projectsthat population growth will be under 1 percentannually through 2015.

Baby Boomers Will Swell Over65 Population.Baby boomers born immediately aer the end ofWorld War II began to reach the age of 65 earlierthis year. As this huge population cohort continuesto reach this age, this group will swell in the comingyears. We project the over65 population generally

will grow over 4 percent per year throughout ourforecast period.

Modest Growth for K12 and CollegeAgePopulation Groups. Our forecast assumes the K12population grows by 0.2 percent or less through201314 before increasing slightly more rapidly.Te 1824 college age group is projected to increasevery modestly through 2013 before beginning todecline thereaer. During the forecast period, thiscollegeaged group largely consists of the ospringof the relatively small Generation Xthose bornin the two decades aer the baby boom.

Figure 11

LAOs California Demographic Forecasta

(In Thousands)

2009a 2010 2011 2012 2013 2014 2015 2016

Totals (July 1st) 38,488 38,699 38,863 39,137 39,453 39,803 40,191 40,643

Percent change 0.93% 0.55% 0.43% 0.70% 0.81% 0.89% 0.98% 1.12%Change in population:

Births 553 548 527 526 534 542 549 557

Deaths -237 -236 -241 -245 -249 -253 -257 -261

Net domestic migration -173 -190 -225 -121 -98 -85 -54 -12

Net foreign migration 210 89 104 114 130 145 152 167

Net Change 353 211 165 274 316 349 389 451a Population gures listed for 2009 reect Department of Finance estimates, which are 1.5 million higher than U.S. Census Bureau estimates

released prior to tabulation of the 2010 Census.


26/45


Expenditure Projections

Chapter 3

In this chapter, we discuss our General Fundexpenditure estimates for 200910 and 201011,

as well as our projections for 201112 through201516. Figure 1 (see next page) shows our forecastfor major General Fund spending categories forall of these years. Below, we rst discuss projectedgeneral budgetary trends and then discuss in moredetail our expenditure projections for individualmajor program areas.

GENERAL FUND

BUDGET TRENDS2010-11 Outlook

General Fund expenditures in 201011 arebillions of dollars below their normal levels dueto onetime or temporary actions, including(1) billions of dollars in federal stimulus fundsreceived, (2) suspension of Proposition 98,and (3) funding shifts to nonGeneral Fundsources. However, General Fund expenditures areforecast to increase from $87 billion in 200910

to $92.5 billion in 201011an increase of6.3 percent. Tis is much more than the budgetedincrease of 0.2 percent that was expected when thebudget was passed in Octoberdue principally toour projection that a signicant amount (around$3.5 billion) of assumed federal funds will not besecured. In addition, we project that several majorprogramssuch as the prison system, InHome

Supportive Services (IHSS), and employeecompensationwill be unable to achieve the full

amount of budgeted reductions.

Expenditure Growth During theForecast Period

Sharp Growth in 201112 as OneTime SavingsMeasures Expire. In 201112, our forecast showsGeneral Fund spending climbing by 11 percent.Tis is principally the result of billions of dollars ofonetime saving measures expiring. For example,MediCal expenditures will increase by about$5 billionthe majority of this is due to expiringfederal funds.

Lower Growth Projected Aer 201112. Ourforecast shows General Fund spending growingby 8.2 percent in 201213, 3.6 percent in 201314,4.8 percent in 201415, and 4.1 percent in 201516.As shown in Figure 1, this equates to an averageannual growth rate of 5.2 percent between 201112and 201516slightly higher than the forecastedrate of personal income growth in the stateduring that period. Te period is characterizedby consistently high rates of growth in two areas

that represent over half of the General Fundbudget in 201516: (1) Proposition 98 spendingfor K14 education, and (2) MediCal. AlthoughProposition 98 spending for K14 education isforecasted to drop in 201112, spending over thefollowing years averages 6 percent annual growthas the economy continues its expected recovery.Te largest growth in our forecast (8 percent)


27/45



occurs in MediCal due to growth in caseload andhealth care costs and, in the last two years of theforecast, the impact of federal health care reform.Te remainder of the budget is forecast to grow at

a modest 3.5 percent over the forecast period. Tismodest growth is due in part to the stated legislativepolicy of having no automatic costoflivingadjustments (COLAs) or ination adjustment forprograms (as discussed in Chapter 1). For instance,our forecast shows no growth in General Fundappropriations to the universities or the courtsaer 201112.

PROPOSITION 98

K14 EDUCATION

State budgeting for K14 education isgoverned largely by Proposition 98, passed by the voters in 1988. Te measure, later modied byProposition 111 in 1990, establishes a minimumfunding requirement, commonly referred to asthe minimum guarantee, for K14 education.Both state General Fund and local property taxrevenues apply toward meeting the minimumguarantee. Proposition 98 monies support child

Figure 1

Projected General Fund Spending for Major Programs(Dollars in Millions)

Estimates Forecast

AverageAnnualGrowthFrom

201112 to201516200910 201011 201112 201213 201314 201415 201516

Education

K-14Proposition 98 $35,669 $36,209 $34,184 $36,733 $38,847 $41,058 $43,270 6.1%

Proposition 98 QEIA and Settle-Up 300a a 750 750 750 750 472 -10.9

CSU 2,288 2,433 2,646 2,646 2,646 2,646 2,646

UC 2,449 2,711 2,815 2,815 2,815 2,815 2,815 Student Aid Commission 1,019 1,079 1,258 1,334 1,413 1,499 1,609 6.4

Health and Social Services

Medi-Cal 10,136 12,595 17,642 18,831 20,291 22,101 23,976 8.0

CalWORKs 1,995 2,143 3,041 3,140 3,130 2,960 2,676 -3.1

SSI/SSP 2,951 2,954 3,033 3,116 3,200 3,287 3,379 2.7

IHSS 1,488 1,419 1,732 1,835 1,903 1,973 2,045 4.2

Developmental Services 2,420 2,541 3,124 3,292 3,473 3,671 3,885 5.6

Mental Health 1,666 1,837 2,142 2,193 2,247 2,305 2,367 2.5

Other major programsb 3,185 2,823 3,327 3,460 3,518 3,457 3,751 3.1

Corrections and Rehabilitation 7,718 9,281 9,034 9,124 9,371 9,546 9,792 2.0

Judiciary 419 1,649 2,016 2,013 2,012 2,012 2,012

Proposition 1A Loan Costs 15 91 91 1,986

Infrastructure Debt Servicec

5,383 5,752 6,926 7,239 8,378 8,848 8,705 5.9 Other Programs/Costs 7,934 6,988 8,995 10,658 11,155 11,755 12,230 8.0

Totals $87,037 $92,505 $102,756 $111,167 $115,149 $120,683 $125,631 5.2%

Percent Change 6.3% 11.1% 8.2% 3.6% 4.8% 4.1% a Consistent with the administrations accounting, Quality Education Investment Act (QEIA) payments are reected as a prior-year adjustment for

2009-10 and 2010-11.b Assumes $500 million annually through 2014-15 in General Fund savings from Medi-Cal 1115 Demonstration waiver. However, actual savings to

the state could be less. Allocation of savings between program areas will be determined during the implementation of the waiver.c Includes transportation and transit debt-service offsets in 2009-10 and 2010-11. Excludes debt service funded within Propostion 98 and other

minor payments included in other departmental budgets.


28/45



care, preschool, K12 education, and the CaliforniaCommunity Collegesaccounting for about70 percent of total funding for these programs.(K14 education funding also comes from the

federal government, other state sources, andvarious local sources.)

Calculating the Minimum Guarantee. heProposition 98 minimum guarantee is determinedby one of three tests set forth in the Constitution.Tese tests are based on several inputs, includingchanges in K12 average daily attendance, per capitapersonal income, and per capita General Fundrevenue. Tough the calculation of the minimumguarantee is formula driven, a supermajority

of the Legislature can override the formulasand provide less funding than the formulasrequire. his happened in 201011, with the

Legislature suspending Proposition 98 andproviding less funding than otherwise required.As a result of the suspension, the state createdan outyear Proposition 98 obligation referred to

as a maintenance factor. When growth in stateGeneral Fund revenues is healthier (as determinedby a specic formula set forth in the Constitution),the state is required to provide additional funding(make a maintenance factor payment) to buildup K14 funding to the level it otherwise wouldhave been absent the earlier reduction. In essence,the maintenance factor allows the state to attainnearterm savings without aecting the longrunlevel of K14 support.

Proposition 98 ForecastMinimum Guarantee Drops in 201112 BeforeRebounding. he top part of Figure 2 shows

Figure 2

Proposition 98 Forecast

(Dollars in Millions)

201011 201112 201213 201314 201415 201516

Minimum Guarantee

General Fund $36,465 $34,184 $36,733 $38,847 $41,058 $43,270

Local property tax 13,193 13,272 13,598 14,014 14,559 15,231

Totals $49,658 a $47,456 $50,331 $52,861 $55,617 $58,501

Percent change -4.4% 6.1% 5.0% 5.2% 5.2%

Proposition 98 Test 2 1 2 2 2 1

Proposition 98 Obligations

Maintenance Factor Created/Paid (+/-) $475 $3,929 -$1,229 -$463 -$392 -$611

Outstanding Maintenance Factor 9,489 13,749 12,996 13,067 13,259 13,189

Key Factors

K-12 average daily attendance -0.12% 0.14% 0.20% 0.17% 0.33% 0.50%

CCC full-time equivalent students 1.40 1.00 1.00 1.00 1.00 1.00

Per capita personal income (Test 2) 0.62 3.33 3.26 3.93 4.13 3.57

Per capita General Fund (Test 3) 5.92 -7.31 6.54 5.42 5.42 5.12

K-14 COLA -0.39 1.78 1.34 1.76 2.23 2.37 YeartoYear Change -$1,946 $2,875 $2,530 $2,756 $2,884

Less Baseline Costs

K-14 COLA -$864 -$663 -$883 -$1,144 -$1,252

K-14 attendance -101 -124 -116 -206 -305

Backll of one-time actions -2,272

Funds Available/Shortfall (+/) $5,184 $2,088 $1,531 $1,406 $1,326 aReects Proposition 98 funding level specied in Chapter 715, Statutes of 2010 (SB 851, Committee on Budget and Fiscal Review).


29/45



our projections of the Proposition 98 minimumguarantee throughout the forecast period. For201112, we project the minimum guarantee willbe about $2 billion lower than the 201011 spending

level due to the expiration of tax increases thattemporarily raised tax revenues in 200910 and201011. For the rest of the forecast period, weproject steady increases in the minimum guaranteeof $2 billion to $3 billion each year. Local propertytax revenues modestly grow each year of theforecast period. In the last year of the forecastperiod, we project the Proposition 98 minimumguarantee and local property tax revenues would

nally be higher than their prerecession levels.

Maintenance Factor Obligation Grows in201112, Remains Large Throughout Period.Figure 2 also shows both how much maintenancefactor is created or paid in each year of the forecastperiod and the total amount of outstandingmaintenance factor. As shown in the figure,we estimate the state will have an outstandingmaintenance factor obligation of $9.5 billion atthe end of 201011. Using the same maintenancefactor assumptions as used to build the lastthree Proposition 98 budgets, $4 billion in new

maintenance factor would be created in 201112resulting in a total outstanding obligation ofabout $14 billion. During the remainder of theforecast period, the state would make relativelysmall maintenance factor payments each year.Because maintenance factor obligations grow (akinto an inationary adjustment) and the requiredpayments are small, we project the state wouldend the forecast period still having an outstandingmaintenance factor obligation of more than$13 billion.

Baseline Costs Much Higher an AvailableResources in 201112, Can Be Covered ereaer.Te bottom part of Figure 2 compares our projectionof the yeartoyear change in the Proposition 98minimum guarantee with the amount needed tofund annual increases in baseline costs. As shown

in the gure, the minimum guarantee would fall$5.2 billion short of fully funding baseline K14costs in 201112. (Tis shortfall would be a fewhundred million dollars higher if the Legislature

chooses to restore the California Work Opportunityand Responsibility to Kids [CalWORKs] Stage 3child care program vetoed by the Governor thisyear.) Tat is, if the state funded at the minimumguarantee level in 201112, school districts andcommunity college districts would face signicantprogrammatic reductions. As shown in the gure,this is due to the decline in Proposition 98 fundingin 201112 coupled with the cost of backlling forthe loss of onetime 201011 budget solutions. Tesereductions would occur at the same time as school

districts exhaust onetime revenues from the federalAmerican Recovery and Reinvestment Act (ARRA)of 2009 and the Education Jobs and MedicaidAssistance Act of 2010. In every subsequent yearof the forecast period, the minimum guaranteefunding level would be sucient to cover growthand COLA and still have $1 billion to $2 billion torestore prior budget reductions. By 201516, theminimum guarantee would grow to sucient levelsthat all growth and COLA costs could be paid andany reductions made in 201112 could be restored.

Funding would be insucient, however, to restorereductions made in 200809, 200910, and 201011.

SettleUp Assumed to Be Paid in InstallmentsThroughout Forecast Period. For 200910, thestate provided $1.8 billion less than the minimumguaranteecreating a settleup obligation ofthat amount. Additionally, for 201011, we assumea new $256 million settleup obligation is createdas a result of the Governors veto of Stage 3 childcare funding (consistent with the administrationsintent). Te 201011 budget contained a $300 millionrst payment toward retiring the 200910 settleupobligation. Consistent with this action, we assumethe state continues to make $300 million annualpayments throughout the forecast periodfullyretiring the settleup obligations in the last yearof the forecast.


30/45



Major Proposition 98 IssuesWe believe the Legislature should be mindful

of several major issues as it begins to develop aProposition 98 budget strategy for the coming

scal year.

Unresolved Maintenance Factor Issues QuicklyReemerge. As we discussed in ourAnalysis of the201011 Budget: Proposition 98 and K12 Education,conicting interpretations of the constitutionalprovisions of Proposition 98 led to uncertaintyover the amount of maintenance factor owed atthe close of 200809. Specically, disagreementexisted regarding whether a maintenance factorwas created when est 1 applied and was lower

than est 2. he 200910 Budget Act resolvedthe issue by declaring that a maintenance factorobligation was created in 200809. Current law,however, does not clarify how this situation shouldbe addressed in future years. In our forecast, thisparticular scenario reemerges in 201112, with thestate potentially creating a maintenance factorobligation of $4 billion in 201112. (As indicatedabove, our forecast assumes a maintenance factoris created.) Dierences of opinion also exist withregards to how maintenance factor payments

should be calculated (either on top of the est 2level or the est 1 level, if higher). Tis particularscenario reemerges in 201213, with an impact ofabout $900 million. (Our forecast assumes thelower Proposition 98 estimate, consistent with themanner in which the minimum guarantee wascalculated in the 200910 and 201011 budgets.)

Potential Reductions on Horizon SuggestRethinking Recent Deferrals. Given the potentiallysizeable drop in the minimum guarantee next year(absent legislative action to add new revenues),one action the Legislature could take early inthe upcoming budget cycle is eliminating the$1.8 billion in K14 payments deferred until July2011. (As part of the 201011 budget package, thestate authorized 201011 spending using fundsborrowed from 201112.) With the projected dropin the 201112 minimum guarantee, the recent

payment deferrals would translate into K14 cutsalmost double the level otherwise needed in201112. Given most districts have been cautiousin increasing 201011 program support as a result

of the recent deferrals and some districts havebeen unable to access cash sucient to supportnew spending paid for by the new deferrals, manydistricts would not be significantly impactedin 201011 if the new deferral payments wereeliminated. In essence, rather than encouragingschool districts to hire new sta for half of the201011 school year merely to have the new staand even more existing sta laid o next year,the state would be encouraging school districts toretain their existing sta levels and plan for fewer

layos next year. Such action would help minimizethe funding cli that could result next year.

Relying on More Deferrals IncreasinglyProblematic. Including the recent deferrals,17 percent of K14 program support is paidusing funds borrowed from the next scal year.In monetary terms, the first $8.2 billion inProposition 98 funds the state provides each yearis paying for K14 services that local educationalagencies already have provided. Tough districtsare assumed to front the cash to support programsuntil the state makes payment, some localeducational agencies (particularly small districts,districts with negative budget certications, andcharter schools) have had notable diculty and/or have not been able to front the cash. As aresult, for these agencies deferrals increasingly aretranslating into de facto cuts. For most districts,big and small, cash management has become anincreasingly signicant issue, with Fiscal Crisis andManagement Assistance eams reporting that thebulk of its district support is now devoted to cashow management. Tese issues also are aectingthe number of districts with negative or atriskbudget certications, with 123 school districts in200708 identied as having these certicationscompared with 174 districts in 200910. Negativecertifications in particular can make districtborrowing signicantly, if not prohibitively, more


31/45



expensive. For all these reasons, the Legislature maywant to avoid adopting new interyear deferrals aspart of its 201112 budget strategy as well as monitordistrict health to determine if more districts could

need an emergency state loan in 201112.

Help Districts by Maximizing Flexibility andSending Signals Early. Tough the state might notbe able to provide monetary relief to distresseddistricts, the Legislature can help school districtsand CCC districts in various ways. Among the mostnotable ways are by retaining existing exibilityprovisions, extending some of those provisions,and exploring new types of exibility. Over thelast couple of years, districts have reported relying

heavily on these flexibility provisions to meetcritical local needs and balance their budgets. Ingeneral, these exibility measure expire at the endof 201213; yet, under state law, districts currentlyneed to project costs through 201314 for budgetingpurposes. Tus, another way the Legislature couldhelp districts is by beginning to think about whatexibility rules it wants in place come 201314. TeLegislature might want to consider fundamentalschool nance reform that could take a coupleyears to develop. Starting these conversations nowwill better position both the state and districts forwhatever transition might happen in 201314.

HIGHER EDUCATION

In addition to the community colleges (whichare discussed above as part of the Proposition 98forecast), the states public higher education entitiesinclude the University of California (UC), theCalifornia State University (CSU), the California

Student Aid Commission (CSAC), and theCalifornia Postsecondary Education Commission.

UC and CSU ExpendituresOur forecast assumes the universities annual

operating costs will be roughly even at about$5.5 billion over the course of the forecast period.Tis reects our overall forecast approach of not

providing automatic COLAs. his amount issomewhat higher than state spending in 201011,which takes advantage of onetime federal stimulusfunds that oset state costs. We discuss the stimulus

funds in more detail below.

Tidal Wave II Is Over. Beginning in the 1990s,sustained growth in the traditional collegeagepopulation created ongoing enrollment pressuresin higher education. Tis demographic bulge hasbeen popularly known as idal Wave II (following alarger demographic surge in the 1960s). While therewas some disagreement over the magnitude of idalWave II, by all accounts the demographic growthhas plateaued and the collegeage population will

actually be declining in the latter years of theforecast. Already the annual number of high schoolgraduates has begun to shrink.

Enrollment demand at the universities resultsnot just from the size of

Documents

Fiscal Outlook 2010