California’s voter-approved state spending limit – which requires the state to return money to taxpayers and dedicate more money to schools if revenue is above a prescribed limit over two consecutive years – will be a “major issue” in the budget process beginning this year, the Legislative Analyst’s Office (LAO) reported April 21. The report is an indication that any tax increases approved by the Legislature and governor would not go into the general fund, but would have to be partially refunded to taxpayers.

The spending limit – known as the Gann Limit in honor of its author, Paul Gann, who also coauthored the historic property tax reform measure, Proposition 13 – was approved by voters in 1979 and modified in subsequent elections. It establishes an appropriations limit on the state and most types of local governments based on appropriations from tax revenue. The limit, enshrined in Article XIIIB of the state constitution, requires a surplus to be distributed to taxpayers by a reduction of “tax rates or fee schedules.”

The Department of Finance is responsible for annually using a three-step process to determine whether the Gann Limit has been reached: calculate the spending limit (based on prior spending adjusted for population and economic growth); determine the amount of appropriations subject to the limit (appropriations that are not subject to the limit include subventions to local governments, debt service, federal and court mandates, qualified capital outlay projects, and certain emergency spending); and determine the room (if any) left for additional spending.

The Gann Limit has come into play at the state level only once, when it resulted in $1.1 billion in rebates to taxpayers in the 1987-88 fiscal year. But Legislative Analyst Gabe Petek’s report (which refers to the limit as the State Appropriations Limit, or SAL) said a windfall of tax revenue is likely to trigger it again.

“In light of strong revenue collections that have occurred since January, we anticipate responding to the requirements of the SAL will be an important issue for the state budget this year,” the report stated.

The report explained that Governor Gavin Newsom’s January budget proposal estimated the state would have revenue in excess of the limit in some years between 2018-19 and 2021-22. Specifically, according to initial estimates, the state has excess revenue of about $100 million between 2018-19 and 2019-20 and about $500 million between 2019-20 and 2020-21. Newsom’s May revision of the budget will include updated projections.

“Our analysis suggests the SAL will be an even more important factor in the state budget in the coming years …,” the analyst reported. “Projections of the amount of room under the limit are highly uncertain …. That said, under the vast majority of likely outcomes, we anticipate the state will have ‘negative room.’ That is, the state either would need to reduce taxes or issue refunds to taxpayers and make additional payments to schools in these amounts. Further, without significant budget changes, the state likely does not have the capacity for new services or program expansions.”

The analyst said there are two primary reasons that room under the limit has diminished: “First, growth in personal income tax revenue – the state’s largest revenue source – has exceeded the SAL’s growth rate. There are a few reasons for this, but two important factors are: (1) the state’s tax rate structure combined with (2) faster income growth among high‑income earners. As a result, year-to-year growth in appropriations has been higher than increases in the SAL. Second, constitutionally required school spending – driven by faster state revenue growth – has increased faster than school limits. Because the state absorbs appropriations above school limits, this trend has resulted in diminished room for the state.”

The analyst laid out five options for the Legislature to respond to this development: issue tax refunds and allocate excess revenue to schools; increase spending on purposes that are excluded from the limit; reduce proceeds of taxes and spending; make statutory changes to the Gann Limit; and/or place a measure on the ballot asking the voters to change the limit.

“Few of these options, in isolation, are likely to be sufficient to keep the state from exceeding the limit over the next few years,” the analyst stated.