January 2002

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State Budget 

In his proposed $100 billion state budget for the year starting July 1, Governor Gray Davis presented a strategy to deal with a $12.5 billion revenue gap. He said it requires no new taxes. He said he would neither propose nor advocate them.

While it is clear that he does not want new taxes, and he doesn’t expect them, he didn’t slam the door on the Legislature if it put together a package of spending cuts and tax increases.

The Democrat governor’s January 8 State of the State speech and his January 10 budget proposal drew criticism from both Republicans and Democrats, particularly his apparent caveat on higher taxes. The governor’s comments brought follow-up questions from reporters over the next couple of days. Gubernatorial spokesperson Steve Maviglio did not rule out higher taxes if the Legislature sends the governor a package that includes them. The Sacramento Bee reported that the governor’s aides acknowledged that the governor did not rule out signing a compromise plan including tax increases.

At a January 9 news conference, the governor was pressed by reporters to clarify his position. He said, “I don’t expect we’ll raise taxes. I don’t think there will be support for that proposal in the Legislature, and I expect I’ll sign a budget without – without – any tax increase in it. I can’t say it any more clearly.”

In his January 10 budget press release, Governor Davis “made clear his intention to protect funding for education, public safety, and health care without raising taxes.”

However, the governor’s adversaries wouldn’t let it go. Senate Republican Leader Jim Brulte, who noted that the governor did not go as far as President Bush had recently when he said federal taxes would be raised over his dead body. “I think the contrast is striking,” the senator said (Riverside Press Enterprise).

The governor is banking on an economic recovery starting as early as next summer as well as the sale of $12 billion in electricity revenue bonds that would be used to replenish the general fund for $6 billion used to buy electricity last year. The “no-new-taxes” budget also depends on a combination of cutbacks, deferred spending, internal borrowing and accelerated revenue.

In the State of the State address, the governor stressed public safety and security in the wake of the continuing threat of terrorist attack. He vowed to protect education funding “above all else.”

He called the Legislature into special session to deal with the budget crisis, including more than $3 billion in current-year spending cuts and fund transfers announced last November.

Governor Davis also asked the Legislature to urgently approve retroactive eligibility for unemployment insurance for higher benefits that kicked in on January 6 so that they apply to those who lost their jobs as a result of the September 11 terrorist attacks. This will cost employers about $400 million, the governor said, adding that it is a major part of his $1 billion “Economic Stimulus Package.”

The rest of the package is accelerated public works spending that uses $678.3 million from lease revenue bonds for construction, mostly at state colleges and universities. The governor said it will create as many as 13,000 jobs.

The $12.5 billion shortfall – compared to a $6 billion budget surplus a year ago – is a result of an economy hard hit by the energy crisis, the crash of the dot-com industry (an $8 billion decline from 2000-01 in income taxes from capital gains and stock options), and the September 11 “attack on America,” the governor said.

He called his budget proposal “responsible” and “balanced.” He said it will preserve the major gains of the last three years, when the state was flush with tax dollars, and will protect local government (from further state taking of city and county revenues) – and will not increase taxes. Among his basic principles: “I will not advocate raising taxes. That would further burden individuals and businesses struggling to stay afloat in these difficult economic times.”

Closing the budget gap. He proposed a number of specific measures to deal with the $12.5 billion budget problem forecast over 18 months through June 30, 2003, if the state were to spend as usual. About $5.5 billion is gained by borrowing in various ways, while the governor is counting on another $1 billion from the federal government for expenses of incarcerating illegal immigrants, health and human services, child support penalty relief and “homeland security” costs.

Also, some $2 billion in current year spending is to be canceled or deferred if the Legislature passes needed bills in the budget crisis special session convened on January 10.

Additional spending cuts include funding for parks and housing that the governor said would be replaced by anticipated passage of state bonds for those purposes on the March and November ballots.

Kept on the sidelines but to be considered if necessary is a proposal by Treasurer Phil Angelides calling for the state to refinance bond debt and defer payments to future years. This approach could substitute for a proposal to reduce state contributions to the Public Employees Retirement System and State Teachers Retirement System by more than $1 billion. The use of pension money might have to survive a court challenge, even though the Davis administration agreed in return to make it easier for retirees to receive inflation-fighting adjustments in their pension checks.

The governor, refusing to use the words “deficit budget” in response to probing questions at his budget briefing, intends to borrow hundreds of millions of dollars from various special accounts. The largest example is $672 million from the Transportation Congestion Relief Fund, which Finance Director Tim Gage said will “in no way” be jeopardized. There will be no project delays, he said.

Another tactic: “Securitizing” the state’s tobacco settlement money. Mr. Gage noted that seven other states are doing the same thing. California would get $2.4 billion in the current year by selling a bond secured by a portion of the $25 billion in settlement money the state expects to receive over the next 23 years. California would still get about $300 million a year while paying $62 million in bond interest in 2002-03 and $190 million annually for the next 22 years. Mr. Gage said that while the state’s take from the settlement is reduced in the long run, it was a decision weighed against “savaging” state “safety net” programs.

Revenue gains: Squeezing taxpayers. The governor’s budget summary listed about $250 million in additional revenue that the administration does not define as new taxes.  Conforming with federal law requiring Californians to pay at least 90 percent of their tax liability in the form of quarterly estimated payments (the state requirement now is 80 percent) increases revenue to the state by a one-time $210 million in the budget year.

Requiring corporations to use their federal tax-status elections for state purposes would increase state revenue by $30 million.

The budget also saves about $50 million by clarifying a diesel fuel sales tax exemption law for farmers that was passed last year applies only to delivery to the first destination from a farm. The governor noted the defect when he signed the legislation last year and called for the technical corrections.

The state also intends to pick up $25.4 million in interest expense by reducing the rate the state pays in interest on overpayments of corporate and estate taxes, which the governor says is significantly above market rates. The state is not reducing the interest that it charges taxpayers for underpayments.

Tax relief. The governor did not propose suspensions or rollbacks in targeted tax incentives enacted to spur economic recovery in the 1990s, such as the manufacturers investment tax credit and the research and development tax credit. Of course, neither did he suggest enhanced incentives, either. He said the record level of tax relief enacted in the last three years is continued, amounting to $4.5 billion in ongoing relief. Most of that – $3.7 billion – is in vehicle fee (car tax) reductions. There also are long-term care and child care credits for families and relief from taxes on fuel and equipment used by farmers.

The governor also has not endorsed legislative efforts to increase the car tax. Related to that, he pledged to continue state funding to backfill local governments for their loss of vehicle license fee revenue.

“I will not advocate a tax increase to bridge the budget gap. I believe we have enough financial tools to bridge the shortfall without increasing taxes or severely damaging vital programs,” the governor said.

The governor’s budget assumes passage of conformity legislation allowing Californians to take advantage of federal retirement law. The impact on the general fund would be $44 million to $59 million annually in the first three years as additional tax-exempt contributions are allowed for retirement plans.

It also proposes conformity to federal law excluding contributions to charities from the alternative minimum tax ($12 million savings to taxpayers), and to conform to the maximum expenses amount for the dependent care tax credit ($6 million savings to taxpayers).

Counting the aforementioned conformity revenue-raisers (such as higher estimated tax or withholding payments) the budget-year increase from these measures is $240 million, a net revenue gain of $177.5 million. 

Fees and penalties. Millions of dollars in additional fees and fines are proposed, including a 90 percent increase in the penalty for late vehicle registration, which raises $50 million a year. The minimum fee would go from $3 to $10 for the $30 registration fees that are 30 days late.

Drunken drivers would have to pay $120 for the cost of hearing their suspension appeals. Insurance companies and others that want records from the Department of Motor Vehicles would be charged $4 per request, double the current fee, to raise $40 million. Another $4 million would come in from charging $5 for applicants to retake driving tests.

Court fees and fines also would go up. There would be a 20 percent surcharge on all criminal fines, pumping $45.8 million into the state’s general fund. A 10 percent surcharge on civil filing fees would raise $15 million.

The budget proposes to charge Medi-Cal recipients as much as federal law allows in co-payments, which range from $1 to $3, and up to $5 for emergency room visits, deducting these amounts from provider reimbursements.

The budget also proposes to restore the administrative fee of $85 million that existed in 1999-00 for the Disproportionate Share Hospital Program, which serves at least 25 percent Medi-Cal or uncompensated care patients. The fee, established in the early 1990s recession era, had been reduced to $29.8 million over the last several years.

At the Water Resources Control Board, waste discharge permit fees will be increased, shifting support of the program to about 50 percent from fees, compared to the current level of 34 percent. The governor calls this the “polluter pays” principle.

At the Energy Commission, the budget proposes a $25,000 fee for power plant applicants to offset the commission’s estimated $250,000 annual costs associated with proposals to build more electricity generating facilities.

The budget also assumes that Childhood Lead Poisoning Prevention Fees will be increased to the limit currently authorized under program regulations. These are fees paid by gasoline and paint manufacturers.

At the Secretary of State’s office, the budget proposes a $5.7 million Business Fees Fund to continue funding for the second phase of the Business Automation Program.

Economy: Rosy scenario returns to Sacramento. The budget’s income tax revenue forecast for 2001-02 is nearly $2 billion higher, and nearly $1 billion higher for 2002-03, than the Legislative Analyst’s projections last November.

“We expect the recession to be short-lived,” the governor said, stressing that his economists are taking a middle-of-the-road forecasting approach. Recovery from the steepest decline in revenues since the 1930s is expected to begin next summer and growth in the economy should be seen before next December. The state expects employment growth of only 0.3 percent in 2002, compared to 1.8 percent last year and a projected 2.4 percent in 2003.

After nearly 10 percent growth in 2000, personal income in California gained just 1.4 percent last year. A moderate stock market rebound should provide 2.6 percent growth in 2002, according to the Department of Finance.

General fund spending is proposed to total $78.8 billion – nearly 40 percent of it, $31.3 billion, on K-12 education. Health and human services gets the other lion’s share – $22.4 billion. General fund spending grows only $426 million over the current year. The special fund for economic uncertainties: $511 million.

Major general fund revenues from taxes and licenses, including income and sales taxes, amount to an estimated $67.7 billion in the current year ending June 30, well below what the state spent, as it wiped out a multibillion-dollar reserve. Revenues for the budget year ahead are expected to rebound to $74 billion, and the administration expects to sell electricity revenue bonds by summer to repay the general fund for at least $6 billion borrowed to buy power in 2001 and survive the energy crisis (so far).

Budget in perspective: Spending as a percentage of personal income. Total state spending for 2002-03, as a percentage of personal income, is projected to be the third highest in the last 50 years (and probably in history) at 8.78 percent. This is exceeded only by Governor Davis’ prior two budgets, which totaled 9.27 percent (2001-02) and 8.80 percent (2000-01). Expenditures as a percentage of personal income in the governor’s other budget (1999-2000) were seventh highest, at 8.51 percent, only lower than three Jerry Brown budgets (1978-81) and Governor Davis’ other three noted above.

Anti-terrorism. The governor said he is confident that the federal government will reimburse the state for $350 million in “homeland security” expenses, including $129 million for the California Highway Patrol over the next two years, $60 million-plus for CHP overtime, and $24 million for bridge protection.

Public safety. The governor included full funding for a number of public safety programs, such as $232.6 million for COPS and Juvenile Crime Prevention, that have been operating over the past three years, and spending $28 million to maintain the 241 highway patrol officers added over the last two years.

Education.  Proposition 13 is saving the governor’s bacon on education funding. The governor said funding for K-12 education will grow 2.1 percent, or $1.2 billion, from all sources, for a $53.9 billion total. The general fund increase for K-12 is projected to grow by less than 1 percent, while the increase in property taxes, as a result of Proposition 13’s acquisition value assessment system, is projected to grow 7.8 percent. This property tax increase brings the total average up to 2.1 percent. The budget would increase per pupil spending by $136, to $7,058, which the governor said was near the national average.

The governor’s education commitment includes a call for $30 billion in school construction bonds in three $10 billion installments, starting with a measure on the ballot next November.

For the eighth straight year, there would be no involuntary student fee increases at the University of California and California State University systems. Community college fees would remain at $11 per unit, the lowest in the nation.

Health Care. Expansion of the healthy family program to include health insurance coverage for 644,000 children by mid-2003, adding $193 million to the program that is expected to serve 559,000 children by next July.

Child care reform. The budget calls for reforms in the child care system, described as the most generous offered by any large state in the nation. Tightening up the program could save taxpayers $400 million.

Child support. The state will seek federal legislation to exempt California (and other states) from having to pay $157 million in federal penalties for failing to comply with federal timelines for operating an automated child support system at the Franchise Tax Board.

Phantom jobs. The governor said his administration will continue to try to do more with fewer employees, scouring departments and agencies for chronically unfilled positions and eliminating funding for them. This is in addition to the hiring freeze ordered last year to help deal with the budget problem. Over two years, 6,600 vacant positions have been eliminated. The state has 326,000 employees, or 9.2 for every 1,000 people.

Tobacco tax revenue. Estimated tobacco tax revenues will decline $5 million below the 2001 budget level, bringing in $343.2 million in 2002-03, but the administration said there are sufficient fund reserves and increases to other miscellaneous revenues to continue all Proposition 99 (tobacco tax initiative) programs at 2001 levels.

Tax agencies. The budget proposes to require tax preparers who file 100 or more returns to submit them all electronically. It is estimated that $2.2 million can be saved by this action.

The addition of 44.6 personnel years to the FTB budget for “Audit Augmentation” is expected to generate $52 million in revenue in 2002-03. Cal-Tax believes this is an absurd estimate. Cal-Tax has repeatedly questioned how it is possible for new auditors to generate any new money in the near term because, by the time they are hired, trained and sent into the field, they will not have time to finish most audits.

For the State Board of Equalization, its budget is reduced by $7.6 million, reflecting the efficient operations of the board, as contrasted with other government agencies.

Reaction. Senate President Pro Tem John Burton said he will continue to pursue his proposal to raise about $2.5 billion a year by requiring the wealthy to pay more income tax through added 11 and 12 percent brackets. He opposes cutting funding for social welfare programs and is among a number of Democrats who question whether the governor could balance the budget without raising taxes. He called the budget “immoral,” criticizing it for denying cost-of-living increases for welfare recipients and the aged, blind and disabled.

Republican leaders such as Senator Brulte and Assembly GOP Leader Dave Cox vowed to oppose tax increases, and Senate Budget Committee Chair Steve Peace, a Democrat, told the San Diego Union-Tribune: “I believe even having a discussion about a tax increase deflects us from getting the job done of producing a budget.”

Later, Senator Peace noted that former Governor Pete Wilson, facing a $14 billion budget problem in 1991, “begged, borrowed and stole” to keep the state afloat. He said it was wrong to criticize Governor Davis for using a similar budget strategy as far as borrowing funds are concerned. He added that Republican Wilson never got the credit he deserved for rescuing the state from fiscal disaster. Those early 1990s budget strategies saved vital programs from being cut to the core, the Senate Democrat told a joint hearing of legislative budget committees on January 22.

Senator Brulte saw it differently: “What this means is a child born today who enters the work force 20 years from now will pay taxes to fund Governor Davis’ 2002-03 budget, and that’s just … wrong.” (Stockton Record, January 11.)

So did Mr. Cox: The governor’s budget is “defer, delay and deflect.” He said it is like telling a youngster to clean up his room and “five minutes later the room is clean except you discover everything is hidden under the bed.” (San Francisco Chronicle, January 11.)

Assembly Member Carole Migden, a San Francisco Democrat, is pursing legislation to increase the vehicle license fee (car tax). She told the Los Angeles Times that while the governor used “clever phraseology to be sure,” she did not doubt the sincerity of his message to legislators who support tax increases “to tread with caution.”

Assembly Speaker-elect Herb Wesson, a Los Angeles-area Democrat, said tax increases may have to be considered. Meanwhile, he said the Legislature’s challenge is to turn lemons into lemonade.

LAO sees deficit ahead. Relying heavily on one-time solutions and questionable assumptions, Governor Davis’ proposed budget increases the risk of future substantial budget problems, including an operating deficit of $4 billion in 2003-04, the Legislative Analyst’s Office reported on January 15.

Legislative Analyst Elizabeth Hill said the governor’s plan to avoid deeper spending cuts and higher taxes appears to “work on paper” to address the state’s $12-plus billion budgetary shortfall. However, she said “many of its assumptions are overly optimistic.” These, and the largely one-time solutions, result in “substantial long-term out-year costs.”

The LAO said three issues stand out immediately that merit the Legislature’s attention: Revenues, federal funds and Proposition 98 constitutional funding guarantees for public schools.

The administration’s “optimistic assumptions regarding stock options and capital gains” are likely to overstate revenues from personal income taxes (PIT) by about $2 billion in 2001-02 and about $1.3 billion in 2002-03. The report also said that if weak year-end personal income tax collections set a trend for 2001-02, PIT revenues for the current year ending June 30 could fall below the budget forecast by $3 billion or more.

While that state is likely to receive some additional federal support, it is unlikely to meet the governor’s expectations of $1.1 billion. Included are funds to incarcerate undocumented felons, help pay for “homeland” security costs in the wake of the September 11 terrorist attacks, and to waive the substantial penalties for California’s failure to comply with federal child support standards.

The minimum funding requirement for K-12 schools could prove to be up to $900 million above the budget forecast. There is considerable budget risk because minimum funding is dictated by the change in the index for personal income published by the federal government in April or May. The governor’s budget estimates a decline in California per-capita personal income of about 3 percent. The LAO in November forecast a 1 percent decline, placing 3 percent at the low end of a range of probable outcomes. If the federal index is consistent with the LAO’s prediction, the state will have to come up with an additional $935 million in the budget year for K-12 programs funded from the Proposition 98 guarantee.

The analyst also criticized the governor’s budget for failing to address the out-year problem. “This is because it relies heavily on one-time as opposed to multiyear solutions. Indeed, many of the budget’s proposals, such as the securitization of future tobacco settlement revenues, the delay in retirement fund contributions, and the borrowings from special funds, would increase out-year expenditures and thus aggravate the already-projected future imbalances between revenues and expenditures,” the report said.

Analysts also expressed concerns about nearly $143 million in K-12 funding reductions in the current fiscal year, which is more than half over. The $68 million per-pupil block grant program, for example, affects school districts that have already budgeted core functions in the current school year, thus much of the money has already been spent.Gubernatorial spokesperson Hilary McLean responded: “We’re comfortable with our forecasts. We think it’s a very balanced budget” based on “modest estimates.” She noted, however, that the budget is not final. “Any budget, until it is signed, is a work in progress,” she said, adding that revenues will be monitored and if they don’t occur, there will be adjustments.

Meanwhile, in other budget-related developments:

Pension funds. The budget proposal to delay employer contributions to state employees’ and teachers’ pension systems could cost taxpayers more than $10 billion over the next 30 years, the Los Angeles Times (January 16) quoted administration officials. The proposal would provide $1.9 billion to help bridge the state budget revenue gap for 2002-03 without raising taxes or making larger budget cuts. Such a large pricetag on this option has caused the administration to look for less-costly alternatives, The Times reported. Finance Director Gage: “If we can find something that’s cheaper, we’re interested in doing that.”

Agreements between the administration and managers of the pension funds allow the state to back away from the deals if the money isn’t needed or a better option surfaces. One alternative held in reserve is a proposal to refinance state bond issues in a way that allows the state to defer some payments. The sweetener for current and retired state employees in return for use of their pension money is better opportunity to enhance purchasing power of their retirement checks. Better inflation adjustments would be in addition to an interest rate of 8.25 percent, starting in 2004.

Senate Republican Leader Brulte dislikes the strategy: “It’s the political equivalent of a payday loan.” The Assembly Republicans’ lead budget writer, John Campbell: “It is very expensive and it is messing in retirement systems. That has a political stigma.”

Marty Morgenstern, director of the Department of Personnel Management, negotiated the agreements. He said the long-term cost “gives you pause, except that is the cost of money. It is like buying a house. Thirty years from now that amount of money will not be that much.” He said it also is a “nice opportunity … to provide retirees with some retirement protection.”

Both funds have huge reserves and there is no hint that the Davis plan would jeopardize benefits for current or future retirees.

In the early 1990s, then-Governor Wilson reduced the state’s contributions to the state employee system, but public employee unions were able to beat him in court because he had offered nothing in return. Treating the deal as a loan, to be repaid with the rate of interest that would be received on typical investments, and enhancing benefits, would allow the agreements to pass legal muster, according to the Davis administration.  However, public employee unions have already gone to court trying to block the deal, contending it lacked adequate review before approval by the Public Employees’ Retirement System board.

Tobacco settlement money. The Davis administration acknowledged that to get $2.4 billion this year from tobacco settlement money (normally about $500 million a year over the next 24 years), they will pay lenders back $4.2 billion over 22 years. This will use up approximately 40 percent of all tobacco settlement money due California. “Is this the type of trade-off (state legislators) want to do?” asked Ms. Hill.

Paul Knepparath, lobbyist for the American Lung Association of California, was quoted by the San Francisco Chronicle on January 16: “This is a scheme to plug a budget hole that is contrary to the intent of the tobacco lawsuit. It’s a short-sighted ploy that will have long-term negative consequences for health care and tobacco prevention in California.”

Finance Director Gage said the administration decided it would rather get $2.4 billion now and get by with fewer settlement dollars in the future (presumably when the economy will have perked up) than raise taxes or make deeper program cuts.

Pet projects. Legislators have received a 17-page list from the governor’s Department of Finance detailing which of their “pet projects” – also known as budget pork – could not be funded due to the state’s revenue shortage. The Stockton Record reported January 15 that the budget ax fell on $400,000 to upgrade the Stockton Fire Department’s dispatch center. The Pixie Woods children’s park won’t get the $100,000 that it was expecting, and a $50,000 project to help Manteca children have a safe route to school has evaporated.

Assembly Member Barbara Matthews of Tracy said she was particularly disappointed because she had already gone to Pixie Woods and made the presentations. “And they were singing my praises. I was the woman of the hour,” she said. In some cases, the checks have already been received, and these projects will not be canceled.

State may run out of cash. State Controller Kathleen Connell told reporters on January 22 that the state probably will have to borrow $5 billion to pay its bills during the fiscal year starting July 1. She echoed many of the observations made by the Legislative Analyst’s report. Further, she said the state’s cash-flow problem may be even worse at the end of the fiscal year June 30, 2003.