Budget ‘a dark day’ for state, schools and students

Analysis from CSBA’s Governmental Relations Department

September 16, 2008

Late this afternoon, in a historic but not surprising move, Gov. Arnold Schwarzenegger said he will veto the spending plan passed hours earlier by the state Legislature. Schwarzenegger said the Legislature was “living in debt and denial” and that its budget will only push the state’s fiscal problems into the future. The governor also acknowledged that the Legislature would probably override his veto—a move that would require the same two-thirds vote of the state Senate and Assembly that sent the spending plan to his desk. 

While the budget had been negotiated with legislative leaders over the weekend, the actual language was hastily cobbled together last night; that resulted in chaos in the Capitol, with only a few individuals having advance copies of the details.

There was further confusion brought about by additional demands from Schwarzenegger regarding the increased Budget Stabilization Fund, or “rainy day reserve.” Last night, the governor first threatened to veto the long-overdue budget unless it contained a reserve with three conditions: dedicated transfers into the fund, restrictions on its use and a ceiling equal to 12.5 percent of the general fund.

A budget chock full of gimmicks and quick fixes

Overall, the budget closes a $15.2 billion gap with nearly $6.5 billion in revenues and $8.7 billion in spending cuts. Only $20 million is a permanent revenue increase. The rest is a one-time “shot in the arm” that simply speeds up the receipt of revenue that is already owed under current law.

The revenues come from the following sources:

• $2.3 billion from an acceleration of income taxes through increased withholding at the beginning of the year, instead of spreading out withholding evenly throughout the year, beginning in January 2009
• $1.3 billion from accruing personal income tax revenues received in September 2009 as 2008-09 revenue
• $2 billion from suspending the net operating loss for businesses, prohibiting them from writing off losses for two years. However, a new loss “carry back” provision will allow them to write off these losses (plus more) in future years
• $475 million from back taxes through tax amnesty
• $360 million from the prepayment of limited liability company taxes
• $20 million ongoing from closure of the “yacht tax” loophole

The most significant permanent change relates to corporation taxes. After the net operating loss deduction is restored in two years, corporations will also be able to write off prior-year losses. Analyses by the California Tax Reform Association and California Budget Project, based on prior analyses of similar proposals performed by the California Franchise Tax Board, show that this will cost the state’s general fund more than $500 million per year in lost revenue.

In addition, the agreement will allow corporations to transfer unused tax credits to affiliated corporations or subsidiaries, who can then write them off against their own taxes. The California Tax Reform Association estimates that this could reduce general fund revenue by “billions per year.”

Proposition 98 flat

For education, this budget means essentially flat funding this school year. The budget will provide $58.1 billion for Proposition 98; this represents $800 million less than was provided by the Conference Committee report that CSBA supported and $3 billion below the governor’s projected workload budget, which represents the cost of 2007-08 programs and operations adjusted for inflation and enrollment. The plan does include a 0.68 percent cost-of-living adjustment—but for revenue limits only, which is well below the 5.66 percent COLA required by law, creating a revenue limit deficit of over 4 percent. While it appears that the $58.1 billion are ongoing revenues, it is important to note that this level of funding is based on nearly $6.5 billion in one-time funds and accounting gimmicks. Therefore, funding for Proposition 98 will once again be in jeopardy in next year’s budget.

Lottery securitization

Another element of the budget agreement is the proposal to securitize the state lottery. Under this plan, shares in the lottery would be sold to private investors. Lottery revenue would be used to pay the private shareholders. The share of lottery revenue that currently goes to education would be replaced by general fund revenue. For schools and community colleges, this means that the Proposition 98 guarantee would be increased to compensate for the loss of lottery revenue.

This proposal would require voter approval, presumably in a special election that would be called sometime next spring. It would have no effect on the 2008-09 budget, since revenue from the sale of lottery shares would not be realized until 2009-10. Revenue from securitization would be used to pay off one-time expenses that are currently paid with regular general fund revenue. This has implications for the 2009-10 budget because, if this plan is rejected by the voters, then the projected budget “hole” for that year would grow from $1.5 billion to $7.5 billion—a big difference.

Rainy day fund and authority for midyear cuts

The package passed by lawmakers failed to meet one of the governor’s three demands—but in the confusion in the Legislature, it was unclear until very late in the session which demands the legislative leaders had agreed to.

The plan calls for a ballot measure to beef up the provision for the rainy day fund established by Proposition 58. The new ballot measure would require the fund to grow to 12.5 percent of revenues, rather than the 5 percent required when Proposition 58 passed in 2004—and up from the 10 percent the Legislature originally proposed. This increase in the cap met one of the governor’s demands.

Additionally, 3 percent of general fund revenues must be transferred to the account until the cap is reached or there is a transfer from the fund. This provision met the second of the three gubernatorial demands.

The third demand, to restrict when transfers out of the fund could take place, was ultimately rejected by the Legislature. Compared to prior proposals approved by the Legislature, this provision would have made it easier to dip into the fund in lean years in order to maintain current programs. It also contained a provision related to the “April surprise,” which is the receipt of revenue that comes in above budget projections after the April 15 income tax deadline. Any revenue above 105 percent of the projection could have been spent only for specific, one-time purposes (such as any amount owed for Proposition 98), with the balance shifted to the Budget Stabilization Fund. These provisions would also have required voter approval.

In addition, the package includes legislation to give the governor statutory authority to make certain midyear budget cuts, including the temporary suspension of COLAs (except revenue limit COLAs) and cuts of up to 7 percent for state operations. This statutory authority would only become operative if the voters approve the rainy day fund ballot measure.

From veto to override

Earlier today, the Education Coalition asked the governor to veto the spending plan because it doesn’t address our state’s most pressing needs or create real, long-term solutions. Instead, it temporarily closes some corporate tax loopholes and then creates new and bigger ones that will drain more funds from students and schools.

Now that the threat of the budget veto has turned into a reality, most people around the Capitol agree it is very likely the Legislature will override the governor. Such an action would come with a price. In his opening statement, the governor said he would send the other bills that are now on their way to his desk back to them with a veto. However when pressed further on this, he said he would evaluate the bills based on their fiscal impact. 

Closing the gap in the state budget with one-time revenues, acceleration of payments and gimmicks has been the modus operandi of the Legislature for the last several years, and it has contributed significantly to the fiscal crisis the state is facing. Continuing further down this path is fiscally irresponsible. CSBA Executive Director Scott P. Plotkin said it best—this Legislature’s budget represents “a dark day for California, its schools, and most importantly, its students."

The governor and the Legislature would be wise to heed the old adage about the first rule of holes: When you’re in one, stop digging!