Source:LAO November Budget Outlook

The Budget Outlook

Summary

Major Budget Challenges Loom

In approaching the 2005-06 budget, California's policymakers face a deceptively difficult challenge. On the one hand, the strengthening revenue picture, coupled with the availability of the remaining $3.5 billion in authorized deficit-financing bonds that have not yet been used, would enable the Legislature to balance the 2005-06 budget by making a relatively modest amount of hard choices to reduce spending and/or augment revenues.

This would only be a temporary fix, however, as the 2005-06 outlook masks a much more negative underlying budget picture. This is because the 2005-06 budget will be helped by a carry-over balance and various limited-term solutions enacted in the 2004-05 budget which will not be available in subsequent years. As a result, these solutions cannot be counted on to address the state's large and persistent ongoing structural budget shortfall. We project that this shortfall will reach nearly $10 billion in 2006-07 under current-law spending and revenue policies, absent corrective actions.

The size and persistence of this shortfall, even in the face of an expanding economy and strengthening revenues, underscores a critical point that we have made in the past—namely, it is unlikely that California will be able to simply "grow its way out" of this shortfall.

Ongoing Solutions Need Adoption

Given the above, we believe it is critical that the Legislature act now to address the large underlying structural budget imbalance. Every ongoing budget solution that is adopted this year will reduce the amount of actions that will be needed later. Conversely, postponing action will only make the state's fiscal matters worse in the future. Therefore, we recommend that the state adopt real and ongoing solutions to close the budget gap in 2005-06 and that it not sell the remaining $3.5 billion in deficit-financing bonds at this time. Such an approach will have the dual benefits of both (1) reducing the structural deficit in later years through adopting ongoing solutions, and (2) preserving the bonding authority for possible use in 2006-07 or thereafter, when the current-law structural shortfall gets much larger and harder to deal with.

Update on the 2004-05 Budget

Review of the 2004-05 Budget Plan

Proposition 98 Suspension The budget package included a suspension of Proposition 98 and language in Chapter 213, Statutes of 2004, that 2004-05 education spending be set at $2 billion less than the minimum guarantee. (This language, in effect, signals the Legislature's intent to provide more/less funding if the guarantee increases/decreases during the year—for example, due to changes in revenues or attendance.) The difference between this Chapter 213 "target" level and the actual amount appropriated by the budget—$302 million—is shown as a Proposition 98 reserve in the 2004-05 budget.

General Fund Condition Under the budget plan, the 2004-05 fiscal year was estimated to conclude with a reserve balance of $768 million, of which $302 million was earmarked for Proposition 98 and the remaining $466 million was to be available for non-Proposition 98 purposes. Because of the budget's reliance on one-time or limited-term solutions, it was clear when the budget was adopted that the state would continue to face substantial budget shortfalls in the future, absent further corrective actions.

Recent Budgetary Developments

Since the 2004-05 budget was enacted, there have been various developments affecting the revenue and expenditure sides of the budget.

Revenues Up Sharply We estimate that the major taxes will exceed the budget estimate by $2.4 billion over 2003-04 and 2004-05 combined, due to a sharp increase in the corporation tax and more moderate gains in both the personal income tax and the sales and use tax. Partly offsetting the increase in tax revenues is a $364 million decline in nontax revenues, due to lower-than-expected receipts from tribal gaming revenues and the sale of surplus property. The net increase in General Fund revenues is $2.1 billion.

Costs Are Also Up Offsetting a significant portion of the revenue increase are higher state costs totaling about $860 million. The increases are occurring in a variety of areas, including corrections, Medi-Cal, trial court funding, and spending on state operations. In some instances, the higher costs are occurring because the amount of savings resulting from various budgetary solutions is falling short of earlier estimates.

Revised Reserve Taking into account the higher revenues and higher costs, we estimate that the year-end reserve increases by about $1.2 billion, to just under $2 billion.

Proposition 98 Interaction The increase in projected 2004-05 tax revenues increases the minimum Proposition 98 K-14 funding guarantee by about $1 billion compared to the budget plan. Consequently, if the Legislature funds Proposition 98 at the Chapter 213 target level (that is, $2 billion below the guarantee), it would require a $1 billion increase in school appropriations. We have reflected this higher obligation as an increase in the Proposition 98 reserve from $302 million to $1.357 billion. This leaves $614 million of the total reserve available for non-Proposition 98 purposes, only a marginal increase from the $466 million estimated at the time the budget was enacted. Thus, the large increase we project in tax revenues is almost completely offset by increased spending due to the Proposition 98 interaction and higher costs in other program areas.

2005-06 Outlook

We estimate that revenues will climb to $82.2 billion and expenditures will total $89.5 billion in 2005-06, resulting in a $7.3 billion operating shortfall (that is, the difference between annual revenues and annual expenditures). After taking into account the $614 million non-Proposition 98 reserve available from 2004-05, the 2005-06 year-end deficit would be $6.7 billion.

Year-End Condition if Proposition 98 Not Increased If appropriations for Proposition 98 were not increased in the current year, spending in the current year and budget year each would be reduced by $1.4 billion. This would reduce the 2005-06 year-end shortfall from the $6.7 billion shown down to $3.9 billion.

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Last modified: December 6, 2004

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