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Education continued to be the top spending priority as Governor Gray Davis unveiled his proposed $88 billion state budget for the first fiscal year of the new century. The budget for 2000-01 focuses on the teaching profession, as the governor urges young people to answer his "call to arms" and become Peace Corps-like volunteer teachers.

"There is no higher calling, no greater public service, no contribution more valued than to join the front line of the future in the classroom," the governor said as he touted innovative plans for cash incentives to motivate teachers and students to improve performance.

It remains to be seen whether he can appeal to "patriotism" and, with financial incentives, gain the thousands of qualified, motivated men and women to enter the teaching profession, if only for four-year hitches. (For the governor's education-related budget initiatives, see Table 1.)

Meanwhile, it doesn't take a rocket scientist to assess California's fiscal condition. Except for post-World War II era and the pre-Proposition 13 "obscene surplus" situation in the mid-1970s, California government hasn't been healthier fiscally. Governments at all levels, with few exceptions, are running budget surpluses. The state, as the governor said, is "flush." And things are looking even rosier down the road.

The governor proposed a 4.5 percent increase in the state's general fund, taking it to $68.8 billion. However, the general fund is yet again overflowing with revenues (see Figure 2) beyond what the governor proposed on January 10, an opening gambit that will be either fine-tuned or overhauled in the legislative process before the fiscal year begins July 1. The overall $88 billion budget includes special funds, gasoline taxes and bond funds.

Another Huge Surplus
In presenting the overall spending plan, the governor noted an additional $6 billion in revenue projected through the end of the next fiscal year, June 30, 2001, that was unanticipated when the current year budget was approved last summer. He acknowledged that December revenues were significantly above budget estimates, so the surplus could be expected to grow. His economists put their budget figures together in November.

Governor Gray Davis

And sure enough, a few days after the budget was formally presented, Legislative Analyst Elizabeth Hill reported that an additional $3 billion in revenues are expected, half in the current year and half in the budget year ahead. The governor's Department of Finance did not quibble with the analyst's figures.

Thus $9 billion in unanticipated revenue has fallen onto the table since the 1999-2000 budget was passed last summer.

California is awash in tax dollars since recovering from the recession in the early 1990s. This is the fourth straight year of massive surpluses, in which the existing tax structure performed beyond belief, particularly the progressive income tax system fueled by stock market capital gains. In three prior years, the budget surpluses were $2.2 billion, $4.2 billion, and, last May, $4.5 billion. Department of Finance crystal ball gazers actually underestimated last year's surplus by $6 billion, as they at one time predicted a deficit of up to $2 billion.

Therefore, unless there is a serious downturn in the stock market causing the economy to go sour, odds are that the $3 billion in the LAO's January 14 report will be modified upward when personal income taxes (PIT) come due in April and the governor issues his annual May revision.

The usually conservative forecasts of the Department of Finance, for example, see a slowdown in capital gains, which account for much of the PIT growth. While capital gains grew an astonishing 22 percent last year, the governor's budget predicts a 5 percent decline this year. It sees capital gains remaining flat in 2001.

Meanwhile, the LAO reported that estimated tax payments in December were up 32 percent over December 1998, indicating a major increase in capital gains, and based on historical patterns, a harbinger for equally strong final personal income tax returns in April.

Spending Pressures
As in past surplus years, lobbyists for education, public employee unions, highway builders, local governments and other special interests are prowling the Capitol, seeking greater shares of the budget pie. The business sector is not without a wish list, too. Already in the governor's initial budget plan is a modest list of targeted tax credits and a long-sought expansion of net operating loss carry-forward provisions. (See Table 2.) The Silicon Valley's high-tech industry seeks tax incentives to bridge the "digital divide" and make the Internet more available to those of modest means.

While the governor has offered targeted tax incentives, only about $167 million is earmarked for these purposes in 2000-01. The major tax cuts in Governor Davis' 13-month-old administration were dictated by the 1998 and 1999 Legislatures and his predecessor, Pete Wilson, in the form of ongoing dependents tax exemptions and an up to 67 percent reduction in the car tax (formally called the vehicle license fee, or VLF). Including a one-year acceleration of the 10 percent second phase of the reduction from next year to this year, the VLF has been reduced 35 percent since January 1, 1999. These cuts are saving motorists more than $1.7 billion a year, and further reductions are programmed to occur by 2002 if revenues remain healthy. The LAO has forecast enough revenue to trigger the remaining VLF reductions.

Governor's 2000-01 Tax Proposals  Revenue Impact (In Millions)   Table 2 2000-01   2001-02 Increase in net operating loss carryover -$1   -$7 Long term-care credit -47   -41 Rural investment exemption -5   -5 Credit for hiring aerospace employees minor   minor Biomass Credit* 0   -10 Graduate student expenses -10   -10 Increase in alternative incremental R&D credit -4   -8 Tax credit for land donation -100   0 Low-income housing credit 0   -1 Total: -$167   -$82 *The first-year (2000-01) is a grant program. Source: Governor's Budget Summary

The VLF cuts are financed by the general fund, which is reimbursing local governments for each dollar they no longer receive from the license tax.

California spending has experienced phenomenal growth. In 1998-99, Pete Wilson's final year as governor, general fund spending totaled $57.8 billion. If the LAO's projection of an additional $3 billion is correct, and the money is spent, the general fund of 2000-01 would total $71.8 billion. That represents a 24 percent increase over three years, which seems even more incredible in times of virtually no inflation and relatively small population growth. (To see where the money goes, see Table 3.)

Holding the Line
Despite pressures from constituent groups, such as public employee unions that achieved major pay and pension increases, the Democrat governor has vowed to hold the line on spending for on-going programs. He wants to set aside half of the surplus for one-time projects. Recognizing the volatility of a revenue stream so dependent on the stock market, the governor's method of operation has been avoiding over-commitment to ongoing programs that would otherwise exacerbate budget problems when the economy slows. This is a good sign for "pay-as-you-go" advocates who support such funding for state public works projects rather than using more expensive general obligation bonds. (See Table 4.)

The governor's penchant for "targeted" tax relief may be music to the ears of those likely to benefit, such as high-tech industries, but the governor has repeatedly vowed to make education the utmost priority for the spending of additional revenues.

Meanwhile, Republican votes are needed to pass the budget bill and they have insisted on use of existing tax dollars to build infrastructure. Pay-as-you-go is likely a major part of the price for GOP budget votes and timely passage of the budget bill. Republicans also want to spend more on education, help out counties, cut college fees by 50 percent, increase the dependent tax credit from $222 million to $314 million, and commit $600 million a year for school construction projects.

Key One-Time Commitments Proposed in Governor's 2000-01 Budget  (In Millions) Table 4 Purpose Amount Smog impact fee rebate $562 Set-aside for legal contingencies 500 Direct appropriations for capital outlay 400 Increase in budgetary reserve 358 Rail projects 121 Tax credit for land donations 100 Set-aside for legislative initiatives 100 Grants for local law enforcement 100 School bus replacement 50 Down-payment assistance for teachers 50 Total: $2.341 billion Source: Legislative Analyst's Office

Why Not Cut More Taxes?
Additional tax-cutting will be debated, particularly in this election year, and the governor's relatively modest proposals of new tax relief likely will be expanded, as they should in instances where they make California's tax structure more competitive.

However, a general tax cut, such as a reduction in the sales or income tax rates, would appear to be politically unfeasible. Leaders of majority Democrats in the Senate and Assembly are four-square against such action. Assembly Speaker Antonio Villaraigosa has even proposed canceling the rest of the car-tax cut and giving the money ($2.5 billion) to education instead of taxpaying motorists.

Taxes and Fees in the Budget
Although the governor has vowed not to raise taxes in his 2000-01 budget proposal, he plans to assess a costly fee on specific businesses. As part of the governor's transportation initiative, he is proposing to increase the state highway account fund revenue by tens of millions of dollars over the next five years by imposing a fee on private companies that install fiber optic cable within state highway rights of way.

Despite this fee, the governor's financial plan has several moderate tax incentives worth $167 million in the next budget year. They are:

• Net Operating Loss (NOL) Carryforward. The governor proposes a 10 percent increase in the NOL that businesses can carry forward to subsequent years. In 2000, the rate would increase from 50 percent to 55 percent, and in 2002, to 60 percent. The NOL would also be extended from five to 10 years. Budget-year impact on revenues is minimal, perhaps $1 million, but, by the 10th year, the change is projected to save businesses $100 million annually. This has been a priority goal of the business community for many years, with a goal of conforming to the 100 percent NOL carry-forward allowed at the federal level.
• Land Preservation Tax Credit. Proposed is the largest tax credit in California history for land preservation. It would be a one-time tax credit capped at $100 million as an incentive for landowners to preserve unique natural habitats and open space.
• Graduate Student Expenses. The governor is proposing an income tax exclusion for graduate school expenses paid by employers, at an estimated annual cost of $10 million. Currently, California law allows a personal income tax exclusion for employer-paid undergraduate employees.
• Central Valley Tax Incentives. On the premise that the state's Central Valley has lagged behind the rest of the state in rebounding from the recession, the governor has proposed two incentives to help business taxpayers improve the Central Valley economy. He wants a $10 million biomass grant program, which would be replaced by a tax credit for 2001-02 and 2002-03. This incentive will result in more clean energy from agricultural waste. He has proposed $5 million for a sales tax exemption on manufacturing equipment when businesses locate in areas with a high unemployment rate of at least 3 percent above the state average. The business must invest at least $150 million and create at least 500 new jobs.
• Aerospace Employment Credit. The governor proposes a tax credit of $1,000 to small, new aerospace companies for each new employee they hire. Since aerospace companies are in high demand in other states and nations, this incentive is needed to attract these companies to California.
• Permanent Extension of Housing Tax Credit. To encourage the development of low-income housing, the governor will propose legislation to permanently extend the $50 million ceiling of state tax credits. The tax credit was expanded from $35 million to $50 million for the 1998 and 1999 tax years.

Other notable tax proposals by the governor include dedicating $562 million of one-time general fund revenues to provide refunds, with interest, to all vehicle owners who paid a $300 smog impact fee on vehicles purchased out of state. These fees, authorized in 1990 legislation, were recently declared unconstitutional by a state appellate court. The total refund cost could reach $665 million if all 1.7 million affected car owners obtain refunds of fees paid since 1991.

Since the early 1990s, an administrative fee was imposed on hospitals that serve at least 25 percent of Medi-Cal patients. In 1995-96, the total administrative fee collected reached $239.8 million. Since this time, the fee has been reduced annually to $84.8 million in 1999-00. For 2000-01, the governor is proposing a further reduction of this fee by an additional $30 million to a total collection rate of $54.8 million.

Transportation: More to Come.
One of the more controversial proposals is the governor's "Transportation 2000" plan. In the State of the State address, the governor pledged to spend $7.5 billion, including $3 billion in new funds on roads, highways, commuter transit and inter-city rail. However, in the proposed budget, the $3 billion would merely come from spending "old transportation funds" sooner.

How does the governor propose to do this? Currently, the state identifies highway projects in a four-year, $4 billion State Transportation Improvement Plan (STIP). The governor is recommending to extend the STIP from four years to seven, which would allow $3 billion of "existing" state and federal funds to be authorized this year. In other words, by accelerating the selection and delivery of transportation projects, the governor will have $3 billion to spend in 2000, including revenue anticipation bonds, rather than in 2002 and 2004 when the funds would otherwise be programmed. 

 Responding to a report by the state controller revealing that more than $1.7 billion of local gas tax revenue is sitting idly in reserves, the governor proposed two "use-it-or-lose-it" measures to expedite the spending of these funds. Specifically, he wants $300 million of transportation funds for street and road improvements spent by June 30. Should the locals choose not to use the money by then, the state will program the funds. The governor also has admonished local entities to "use or lose" $800 million in federal funds for congestion management and air quality programs.

Meanwhile, the governor splashed cold water on a plan pending in the Legislature that would make it easier for counties to enact or renew sales taxes dedicated to local transportation programs. He said he opposes SCA 3 (Burton) as currently written. It allows a one-time statewide majority vote for sales taxes in counties where voters also adopt transportation spending plans. The governor promised to announce in mid-April what he will support for the November ballot. Senate President Pro Tem John Burton said the governor's public announcement, without conferring with him, was a major breach of protocol. Silicon Valley business executives, who are major backers of SCA 3, expressed shock. The governor's words undercut efforts to win at least six Assembly Republican votes needed for the two-thirds to put it on the November ballot.

On the use-it-or-lose-it ultimatum, local government officials responded by saying excessive red tape at the state and federal levels makes it hard to spend all their transportation dollars. The Davis administration questioned the excuse and announced it would consolidate steps to gain approvals. Some 50 project planners, who are responsible for getting projects up and going, have been hired at Caltrans.

E-Government
The governor has proposed several new projects to promote and improve government service over the Internet. He wants to invest $2.1 million in 2000-01 and up to $90 million over five years to create a "One-Stop E-Business Center," which would organize California government on-line services in a single Internet portal. Those with computer access would enjoy a one-stop shop of governmental services and information sources.

The governor did not propose e-Government tax incentives, but Secretary of State Bill Jones and Carl Guardino, leader of the Silicon Valley Manufacturers Group, told reporters in December that closing the "digital divide" would require low-cost computers and access to the Internet. Thus those companies that provide free or cheap Internet service would receive tax credits. Mr. Jones also wants eighth-graders to pass a computer and Internet proficiency exam before advancing to the next grade, plus scholarships for low-income earners for Internet and computer access.

Governor Davis proposed these projects to bring California government into the electronic age of the 21st century:

• A $10 million fund to have revenues readily available to take quick advantage of creative new technology applications in the state government;
• Starting this spring, the Department of Motor Vehicles will allow owners of vehicles to register them over the Internet, using credit cards;
• A $260,000 allotment to the FTB to encourage Californians to file tax returns over the Internet. Due to increased electronic filings in 2000-01, the FTB is expected to reduce processing costs by over $400,000. Over 1.3 million taxpayers used this feature for the 1998 tax season, and over 2 million taxpayers are expected to use e-file this year.
• To improve electronic commerce in the Central Valley, the governor would like to invest $2.1 million in a demonstration grant program to assist rural areas to compete for federal grants for communication infrastructure development.

 The Economy
"Our economy is booming, unemployment is at an historic low, the technological revolution, begun in our Silicon Valley is transforming the globe, our universities are world class, crime rates are heading downward and our budget is balanced," declared the governor in his State of the State address.

Personal income will exceed $1 trillion for the first time in 2000, according to the governor's budget discussion of the economy. Personal income growth is expected to be 6.5 percent, compared to an expected 6.6 percent in 1999. The budget sees it slowing slightly to 5.7 percent in 2001. Non-farm employment is expected to grow 2.9 percent this year, creating more than 400,000 jobs. This compares to 3.3 percent growth last year. In 2001, job growth is expected to slow to 2.5 percent over this year's level.

The three largest revenue sources, personal income ($36.3 billion), sales ($21.3 billion) and bank and corporations ($6.2 billion) taxes, account for 75 percent of total revenues. In 2000-01, the extremely progressive personal income tax is expected to contribute 53.2 percent of all general fund revenues or 43.1 percent of general and special fund revenue. The more you make, the higher rate you pay. The top 7.5 percent of state taxpayers, those with adjusted gross incomes of more than $100,000, make 40.2 percent of the state's total income and paid 65.8 percent of the personal income tax.

Personal income tax revenues were expected to grow 11.6 percent for 1999-00 and 5.4 percent for 2000-01, obviously quite conservative numbers considering the LAO's latest surplus estimate.

Extraordinary gains in the stock market, income from stock options and increased sales continue to be the primary factors of this revenue boost. Capital gains represent 9 percent of total general fund revenues.

The current year's growth in revenue also reflects tobacco company litigation, in which over $500 million is expected in 1999-00 and $400 million in 2000-01.

Overall revenue growth has surprised some and vindicated others, especially those who were vocal in their opposition or support of substantial tax relief approved in the latter half of the 1990s.

Prevailing Wage
Debates have raged at the local level over the issue of prevailing wages, and whether taxpayers are getting the appropriate "bang for their bucks" in construction projects where wages are inflated by use of a formula that favors organized labor. The governor wants to spend $600,000 for the Division of Labor Statistics and Research to assess the impact of prevailing wages. These are typically based on the most frequently used union wage rate of a particular locality. While proponents of prevailing wages contend they offer decent, fair wages, critics retort that these enhanced wages force Californians to spend more tax dollars for fewer public construction projects.

Finally, how does Gray Davis feel about his proposed 2000-01 budget? "This is my best thinking - these are my priorities. Other people see the world differently, I will fight for my budget as written."

- Lisa Martin is policy analyst for Cal-Tax, Ron Roach is communications director and editor of Cal-Tax Digest for Cal-Tax. Cal-Tax vice president Stephen Kroes provided graphs.