Legislative Analyst Reviews “The California Live Within Our Means Act” Initiative

The Legislative Analyst’s Office (LAO) has reviewed the proposed initiatives related to a new state spending limit, Proposition 98 funding, the budget process, Proposition 42 transfers, special fund loans and transfers, and payment of deferred mandate claims. This article will focus on the initiative�s impact on Proposition 98.Current Law

Proposition 98 establishes a minimum funding guarantee for K-14 education in the State Constitution. Under this proposition, K-14 spending is based on the interaction of three different “tests.” Under the test that is normally operative, total spending for K-14 education is based on the actual amount of K-14 spending in the prior year, as adjusted for changes in average daily attendance and per capita personal income. This adjustment is often referred to as the “Test 2″ growth factor.

K-14 funding can be reduced below the level required by Test 2 when either (1) the guarantee is suspended through a two-thirds vote of the Legislature, or (2) an alternative funding formula becomes operative during a low-revenue year (referred to as “Test 3″). When the reduction occurs, a “maintenance factor” is established, which is equal to the difference between actual appropriations and the higher level required by Test 2. In subsequent years, the maintenance factor is restored (thereby causing spending to rise up toward the Test 2 level) through a formula that allocates extra funding to education in above-average revenue growth years. The maintenance factor can also be paid off through over-appropriations by the Legislature. The operation of Test 3 and maintenance factors allows K-14 education funding to automatically slow down during “bad times” and rise again during “good times.”

If the Governor and the Legislature fund Proposition 98 above the minimum guarantee in a given year, the higher spending level becomes the �base� from which future minimum funding guarantee calculations are made. In this regard, an over-appropriation in one year raises the minimum requirements in subsequent years.

How Would the New Proposal Change Proposition 98?

 Eliminates the operation of Test 3 and maintenance factor
 Provides that future over-appropriations must be counted as one-time funding, which would not raise the base upon which future Proposition 98 calculations are made
 Requires the payment of settle-up obligations for years prior to 2004-05 to be paid within 15 years
 Converts the 2005-06 outstanding maintenance factor to a one-time obligation that is required to be paid within 15 years

State Budget Process

The initiative makes changes to the budget process relating to late budgets, midyear adjustments, and reporting requirements. Thus, these changes in the budget process would have an impact on K-14 education.

If a budget is not enacted prior to the beginning of a new fiscal year, this measure requires that the appropriation levels in the prior year�s budget remain in effect until a new budget is enacted.

Following the enactment of a budget, the measure permits the Governor to issue a proclamation declaring a fiscal emergency at the end of any quarter�and call the Legislature into special session to deal with the emergency�when the Administration determines either of the following two conditions:

1. General Fund revenues have fallen by at least 1.5% below the Department of Finance estimate

2. The balance of the Budget Stabilization Account will decline by more than one-half between the beginning and the end of that fiscal year

Once the emergency is declared by the Governor, the Legislature would have 45 days to enact legislation that addresses the shortfall. Absent such legislation, the Governor would be permitted to reduce most items in the budget, either proportionately or disproportionately, to eliminate the shortfall. The reductions could apply to all General Fund spending except for (1) that required by federal laws and regulations, (2) appropriations where the result of a reduction would be in violation of contracts to which the state is a part, and (3) debt service. Any General Fund spending related to contracts, collective bargaining agreements, or laws signed after the affective date of this measure would be subject to these reductions.

Fiscal Impact

According to the LAO, since 2001-02, the state has faced a large �structural� shortfall between revenues and expenditures. Recent budgets have covered this shortfall, partly through spending deferrals, loans, and other one-time or limited-term solutions. As the savings from these limited-term solutions expire, spending under the current law will increase faster than revenues in both 2005-06 and 2006-07, leading to a reemergence of the structural shortfall in those years, absent corrective actions.

The LAO points out�given these circumstances�that the impact of the proposed spending limit on the 2006-07 Budget would depend in large part on how the state addresses the structural shortfall during the 2005-06 and 2006-07 Budgets. If the budget imbalances are eliminated through significant ongoing expenditure reductions, then the proposed limit would not have a major impact on allowable spending levels in 2006-07. However, if the shortfalls are not addressed in this manner, then the proposed limit could constrain spending in 2006-07.

The bottom line for K-14 education, if the spending limit measure is approved, could mean less funding for Proposition 98. In times of budget shortfalls, districts could be faced with midyear cuts. Moreover, the elimination of the maintenance factor provisions would result in less growth in the minimum guarantee for K-14 education than would be the case under current law.

Budget Subcommittees Reject Governor�s Proposal to Shift State�s STRS Obligation to Local K-14 Districts

The budget subcommittees in both houses have rejected the Governor�s proposal to shift teacher retirement costs to school and community college districts. The subcommittees considered two primary issues: (1) whether or not the state should shift its obligation for retirement costs to K-14 districts, and (2) what the potential effects of the Governor�s proposal would be on K-14 districts and the State Budget if the Legislature were to adopt it.

Governor�s Proposal

The Governor proposed to shift responsibility for part of the state�s current contribution to the State Teachers� Retirement System (STRS) to community college and K-12 school districts. It also appears that he proposed to eliminate an existing requirement that the state pay a surcharge to STRS (equal to approximately 0.5% of teacher payroll) when there is an unfunded obligation or a normal cost deficit associated with benefits in effect on July 1, 1990 (this surcharge would be expected to be triggered for the 2004-05 fiscal year). The Governor�s proposal would not have affected an existing state contribution for purchasing power benefits, equal to 2.5% of compensation. According to STRS, this state payment will contribute $581 million in 2004-05.

The Governor�s proposal would have resulted in approximately $469 million in General Fund savings (non-Proposition 98 savings), plus an additional $92 million in savings from the elimination of the surcharge for unfunded obligation. However, these savings assume that the state would not be required to rebench Proposition 98 upwards by the same amount, in which case the proposal would not have resulted in any savings.

The Governor�s proposal would have required a legislative change, so the Administration proposed trailer bill language to effect the change. If the Legislature does not adopt the proposed trailer bill language, the Governor�s proposed shift will not take effect.

According to the Legislative Analyst�s Office (LAO), a recent valuation showed a $23 billion unfunded liability for the entire STRS system. STRS is currently considering options for addressing this shortfall. This unfunded liability would have been exacerbated by the Governor�s proposal to eliminate the 0.5% surcharge.

Local Fiscal Effect of Governor�s Proposal

School and community college districts argued that the Governor�s proposal to shift the $469 million state contribution to them would have resulted in the need for them to make $469 million worth of cuts in their already-tight budgets to pay for this contribution (approximately $429 million for K-12 districts and $40 million for community colleges).

The Administration argued that the proposal allowed local entities to renegotiate their contracts to avoid the $469 million in additional costs�but who really believes this would happen? This would either have reduced employees� take home pay or reduced the level of their retirement benefits. There is some question about whether this forced choice would have been a violation of those employees� contractual rights.

State Fiscal Effect

According to the LAO, the Governor�s proposal would not have resulted in any General Fund savings, because the state would have had to rebench the base Proposition 98 funding level upwards by $469 million. Under current law, the state can only shift a responsibility that was originally designated as not the responsibility of community colleges or school districts (not a Proposition 98 expense) to those entities if it accordingly increases the Proposition 98 minimum guarantee. According to those provisions in law, since the state originally designated the state�s STRS contribution as a non-Proposition 98 expense, it cannot now say that the same contribution is a Proposition 98 expense unless it makes a corresponding $469 million upward adjustment in the total Proposition 98 minimum. This upward shift would have cost $469 million out of the General Fund, thereby erasing any General Fund savings from this proposal.

Conclusion

Since the Legislature has rejected the Governor�s proposal, he is banking on the voters to approve it through the initiative process.

State Revenues Miss the Mark for February

The Department of Finance the week of March 21, 2005, issued a disappointing report on state General Fund revenue for the month of February. The Finance Bulletin showed that revenues were off $389 million for the month, a 9.2% shortfall from the amount projected. The weakness was reported in the personal income tax, which fell short $197 million (or 13.7%), and the sales and use tax, which was off $281 million (or 11.1%). Other General Fund receipts were above forecast by a net $89 million.

The February shortfall combined with the strong collections from December 2004 and January 2005 to place the year-to-date collections just $359 million above estimate, a mere 0.7%, with four months remaining in the fiscal year.

The Finance Bulletin points to several factors that may explain some of the shortfall. First, tax refunds were considerably higher than projected, resulting in the overall weakness in the personal income tax. The February refunds, however, constitute the first month of refunds for 2004 tax liabilities; therefore, a significant portion of the month�s refund could be related to cash flow differences, rather than an inaccurate estimate of the overall level of refunds. Second, Proposition 63, the November 2004 voter-approved initiative that imposed a 1% surcharge on taxable income in excess of $1 million to fund mental health services, created a new forecasting challenge. Month-to-month adjustments to the forecast have been necessary to account for this new revenue source.

In a related report, the Employment Development Department reported on March 18, 2005, that California�s unemployment rate held steady at 5.8% in February, unchanged from the January rate. Compared to a year ago, the state�s unemployment rate has dropped from 6.4%.

Also encouraging was the addition of 27,600 jobs for the month, bringing total employment to 14,681,600. This is significantly better than the January gain of 8,500 jobs. On a year-over-year basis, California�s employment was up 1.6% in February compared to an increase of 1.8% for the nation. Overall, the state�s job market continues to lag the nation�s, with the national unemployment rate at 5.4% for February.

Within California, job market strength as measured by recent upward revision in payroll employment was registered in the San Joaquin Valley, the Sacramento region, and Southern California. The San Francisco Bay Area, on the other hand, had its payroll figures revised downward.

Parcel Tax Legislation Passes First Hurdle

A proposed constitutional amendment that would authorize K-12 school districts, community college districts, or county offices of education to establish a local parcel tax with the approval of 55% of voters, instead of two-thirds of voters as currently required, was approved by the Senate Education Committee on March 30, 2005.

SCA 8 by Senator Simitian (D-Palo Alto) has a long road ahead in the legislative process. It has been referred to the Revenue and Taxation Committee and the Elections, Reapportionment and Constitutional Amendments Committee. The bill must then be approved by a similar number of committees in the Assembly.

As a proposed constitutional amendment, this measure would not go into effect unless approved by a majority of voters at a statewide election, and it requires a two-thirds vote of each house in order to be submitted to the voters.

In addition to reducing the two-thirds requirement to 55% for approval of a parcel tax, the bill defines a parcel tax as �a special tax imposed upon a parcel of real property at a rate that is determined without regard to that property�s value.�

It is the intent of Senator Simitian to conform the vote requirement for imposition of a parcel tax imposed by school agencies to the vote requirement for facility bonds. Proposition 39, approved by the voters at the November 7, 2000, election, reduced the vote required from two-thirds to 55% to increase the property tax rate to pay off bonded indebtedness incurred for the construction, reconstruction, rehabilitation, or replacement of K-14 school facilities.

Senate Rules Committee Rejects Governor�s Nominees for the State Teachers� Retirement Board

The Senate Rules Committee, controlled by Democrats, is refusing to confirm Governor Schwarzenegger�s nominees for the California State Teachers� Retirement Board (CalSTRS), saying he compromised the Board�s independence by declining to go forward in the confirmation process with four of his appointees when they voted against his pension reform proposal.

A fifth nominee, Kathleen Smalley, retained her appointment after declining to join the other Board members in denouncing the Governor�s plan to overhaul the CalSTRS pension system. But Senate President Pro Tem Don Perata (D-Oakland), chair of the Senate Rules Committee, stated that the Rules Committee would reject Ms. Smalley, and would not confirm future nominees until the Governor and lawmakers addressed the degree of independence the Board should have. The five appointees were serving on the Board while awaiting Senate confirmation.

Senator Perata stated that Ms. Smalley was �very qualified,� but that if Schwarzenegger required his appointees to follow Administration policy, senators would use the same criterion in casting their votes. �You can�t have it both ways,� Perata said. �She is a battlefield casualty in a fight over public pensions. We need to have some consistency.�

A spokesperson for the Governor�s Office stated that Senator Perata was caving in to the teachers� unions.

Governor Schwarzenegger also wants schools districts to pay the state�s contribution to CalSTRS, which funds the retirement of about 754,000 educators. The state�s contribution for fiscal year 2005-06 is $469 million. On that subject, Ms. Smalley joined her fellow Board members in criticizing the Governor�s plan. Neither of the Board�s resolutions has legal force, but both were a political embarrassment for the Governor.
The STRS Board�s trustees serve fixed terms and cannot be removed by the Governor or legislators except in exceptional circumstances. But Smalley and the other four nominees had been sitting on the Board since March 2004 (appointees can serve for one year without being confirmed by the Senate) awaiting their confirmation hearings in the Senate, and thus had no protection for their positions.

New Legislation Regarding Selection Process Introduced

You can call it interesting timing, or something else�Senator Bowen (D-Marina del Rey), a member of the Senate Rules Committee, has recently introduced legislation that would establish new procedures by which members of the State Teachers� Retirement Board are selected.

Senate Bill 1055 specifies that the Governor is authorized to appoint five people for a term of four years to the CalSTRS board, subject to Senate confirmation. The bill would also provide that the confirmation by the Senate shall occur within a 90-day period. The bill would additionally prohibit persons appointed by the Governor from sitting on the Board or voting on any proposal before the Board until after being confirmed by the Senate.

It will be interesting to see how far SB 1055 gets in the legislative process; if it makes it to the Governor�s desk it will likely face a veto. If enacted into law, such a policy could have a major impact on all other boards and commissions whose members are appointed by the Governor.