california legislative analyst's office report: fiscal outlook 2011

8/3/2019 California Legislative Analyst's Office Report: Fiscal Outlook 2011

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Noveber 2011

mac TaylorLegislative Analyst

The 2012-13 Budget:

California’sFiscal Outlook



Legislative Analyst’s Ofce www.lao.ca.gov

Table of Contents

Executive Summary ...................................................1Capter 1

Te Budget Outlook ...................................................3

Capter 2

Economy, Revenues, and Demographics ............... 11

Capter 3

Expenditure Projections ..........................................25



California’s Fiscal Outlook

www.lao.ca.gov Legislative Analyst’s Ofce




Executive Summary

Tis report provides our projections o current-law state General Fund revenues and expendituresor 2011-12 through 2016-17.

Ecooic Recoery Ee Slower Ta ExpectedOne year ago, we wrote that the U.S. economic recovery was progressing more slowly than

previously expected. Once again, we have to make the same observation. While the economy hassome bright spots, including export growth and strength in technology-related service sectors(which are important to Caliornia), weakness in the housing market continues to aect boththe construction industry and the nancial services sector. Te end o the ederal scal stimulusprogram and declining governmental employment also are limiting economic growth. In thisorecast, we project continuation o this slow, arduous recovery, with Caliornia’s unemploymentrate remaining above 10 percent through mid-2014 and above 8 percent through the end o 2017.

LAO Reee Forecast Wold Traslate Ito $2 Billio o “Trigger Cts”Our updated assessment o Caliornia’s economy and revenues indicate that General Fundrevenues and transers in 2011-12 will be $3.7 billion below the level assumed in the 2011-12 budgetpackage passed in June. Under provisions o the 2011-12 budget package, this revenue shortallwould translate into $2 billion o trigger cuts to various state programs. (Tis includes all o the“ier 1” trigger cuts and about three-ourths o the “ier 2” trigger cuts.) Te Director o Financewill determine the actual amount o trigger cuts to K-14 education and several other programs nextmonth based on the higher o this 2011-12 revenue orecast and the orecast o the administration.Our expenditure orecast assumes that this amount o trigger cuts is implemented in 2011-12 andmaintained throughout the orecast period.

Estiated 2012-13 Bdget Proble o $13 Billio$3 Billion Decit at End o 2011-12. Te net eect o (1) the lower projected revenues or

2011-12, (2) the trigger cuts, and (3) the expected inability o the state to achieve about $1.2 billiono other budget actions—as well as a ew other minor changes—would leave the General Fund witha $3 billion decit at the end o 2011-12.




www.lao.ca.gov Legislative Analyst’s Ofce2

$10 Billion Operating Shortall or 2012-13. In 2012-13, the state will ace increased costs due,in part, to the expiration o a number o temporary budget measures adopted in recent years. Mostnotably, under our orecast methodology (which does not incorporate any eects rom a possible

November 2012 ballot measure concerning taxes), General Fund Proposition 98 costs—as well as“settle-up” payments to schools—are projected to rise by $6 billion in 2012-13. Moreover, in 2012-13,the state must repay the $2 billion Proposition 1A property tax loan that was used to help balancethe budget in 2009. We orecast that the General Fund’s 2012-13 operating shortall (the dierencebetween annual General Fund revenues and expenditures) will be $9.8 billion.

$13 Billion Budget Problem to Solve in 2012. Accordingly, we project that the Legislature andthe Governor will need to address a $12.8 billion budget problem between now and the time thatthe state adopts a 2012-13 budget plan.

Projected Ot-Year Ibalaces Gradally Declie

One year ago, the state aced ongoing budget imbalances o around $20 billion per year. Now, weorecast that the General Fund’s operating shortalls will be between $8 billion and $9 billion peryear in 2013-14 and 2014-15 and then decline gradually to about $5 billion in 2016-17. By making very dicult budgetary decisions—including the trigger cuts—the Legislature and the Governorhave strengthened the state’s scal condition considerably.

Big Calleges to Face…Ee Wit a Lower Defcit ForecastOur orecast assumes no ination increases or many state programs and assumes that the

trigger cuts and most other recent program reductions remain in place in uture years. Even underthis modest budget scenario, the state aces an ongoing, multibillion dollar annual decit, even asstate revenues expand. Our orecast assumes that many billions o dollars o state budgetary andretirement obligations remain unpaid through at last 2017.

CoclsioTe Legislature now aces a much smaller budget problem than projected one year ago and the

smallest projected out-year decits since beore the 2007-2009 recession. Unortunately, there areew easy options lef or balancing Caliornia’s budget. Dicult program reductions already havebeen passed, and signicant one-time budget actions may be more elusive than in prior years.Accordingly, the remaining work o eliminating the state’s persistent, annual decit will requiremore dicult cuts in expenditures and/or increases in revenues.

I, however, the Legislature and the Governor were to eliminate the state’s ongoing annual budgetdecit this year or over the course o the next ew years, the ocus o their eorts could nally shif

away rom short-term budget problems and turn to the serious long-term scal issues o the state’saccumulated budgetary obligations and ununded retirement liabilities.




The Budget Outlook

Chapter 1

Tis report provides our projections o thestate’s General Fund revenues and expenditures

or 2011-12 through 2016-17. Our projectionsprimarily reect current-law spending require-ments and state tax provisions, while relying onour independent assessment o the outlook orCaliornia’s economy, demographics, revenues,and expenditures. Tis report aims to assist theLegislature with its scal planning as it beginsto consider the 2012-13 budget. Te basis o ourestimates is described in the nearby box (see nextpage).

Chapter 41, Statutes o 2011 (AB 121, Committeeon Budget), speciies that the Departmento Finance (DOF) willcompare the LegislativeAnalyst’s Oce’s (LAO’s)November 2011 revenueorecast with its December2011 revenue orecast todetermine the extent towhich midyear expen-diture reductions (reerredto as the “trigger cuts”) willbe put in place. Figure 1shows our estimate o thecondition o the GeneralFund through the endo 2012-13 assuming noadditional correctivebudgetary actions. As we

discuss in more detail below, our orecast assumesthat most o the trigger cuts are implemented in

2011-12 and remain in eect through the rest o our orecast period.

he 2011-12 budget package assumed ayear-end reserve o about $500 million. We nowestimate that the General Fund will close the scalyear with a $3 billion decit. (Contributing to thisdecit is an estimated $500 million drop in 2010-11revenues compared with the level assumed in thebudget package.) In 2012-13, expenditures areprojected to exceed revenues by $10 billion. Tis

would leave the state with a year-end decit o about $13 billion, absent any additional budgetary

Figure 1

LAO Projections of General Fund ConditionIf No Corrective Actions Are Taken

(In Millions)

2010-11 2011-12 2012-13

Prior-year und balances -$4,507 -$1,695 -$2,239

Revenues and transers 94,292 84,764 86,038

Expendituresa 91,480 85,308 95,787Ending und balance -$1,695 -$2,239 -$11,988

Encumbrances 770 770 770

Reserveb -$2,465 -$3,009 -$12,758

a Under the LAO November 2011 revenue orecast, a total o $2.04 billion o expenditure trigger reductionswould be implemented, as revenues are $3.7 billion below the amount assumed in the 2011-12 Budget Act .This represents all o the rst tier o trigger cuts and around three-quarters o the second-tier trigger cuts.

b Special Fund or Economic Uncertainties. Assumes no transer to the state’s Budget StabilizationAccount.





Basis or Or EstiatesOur revenue and expenditure orecasts are based primarily on the requirements o current law,

including constitutional provisions (such as the Proposition 98 minimum guarantee or school

unding), statutory requirements, and current state tax policies. Te estimates incorporate eectso projected changes in caseloads, ederal requirements, and other actors aecting program costs.Te estimates are not predictions o what the Legislature and the Governor will adopt as policiesand unding levels in uture budgets. Instead, our estimates are intended to be a reasonable baselineo what would happen i current-law policies continue to operate in the uture.

Impact o Future Ballot Measures Not Considered. Because our orecast is based primarily on current law, our projections do not consider the uture eects o ballot measures scheduled orproposed or uture statewide elections. For example, we have not assumed passage o a November2012 measure increasing General Fund revenues, as reerenced in the budget package. As describedin the “Proposition 98” section o Chapter 3, this results in the creation o additional Proposition 98

payment obligations during the orecast period.

No COLAs or Ination Adjustments Assumed. Consistent with the state’s policies in recentyears, we generally have not assumed annual cost-o-living adjustments (COLAs) or price increasesover the orecast period. Tere are, however some exceptions. For example, the state is requiredto maintain specic benets in its health programs, which include inationary increases. I, by contrast, our orecast included COLAs and price increases or all programs, General Fund costswould be higher by around $3 billion by 2016-17.

Assumption Tat State Prevails in Court Cases. Any multiyear state budget orecast involves various legal uncertainties. Our orecast generally assumes that the state prevails in active, budget-

related court cases. Te state aces an array o active cases, including ones related to redevelopmentagencies, health and social services reductions, and the exclusion o sales tax revenues romProposition 98 calculations. Our projections, however, do not reect a transer o $1 billion romProposition 10 early childhood education programs to reduce General Fund spending, to beconsistent with the treatment o these unds in the 2011-12 budget package.

rigger Cuts Ongoing. Our projections include the impact o the trigger cuts beginning in2011-12 and continuing through the orecast period.

Federal ax and Spending Policies Uncertain. Te activities o the congressional “supercommittee” charged with developing a decit reduction plan—as well as various soon-to-expiretemporary ederal tax policies—mean that there is an unusually large element o uncertainty

about uture ederal policies. As described in “Chapter 2,” we thereore must make a number o assumptions about these matters. In general, our expenditure orecasts assume continuation o current ederal policies. Future ederal actions that are contrary to these assumptions could aect various elements o our orecast positively or negatively.




Legislative Analyst’s Ofce www.lao.ca.gov 5

corrections. Accordingly, the Legislature and theGovernor will have to address this magnitude o problem between now and the time a 2012-13 statebudget plan is approved.

ThE BuDGET FORECAST

Projected 2011-12 Year-Ed Defcit o $3 Billio

Provision or Midyear Expenditure Reductionsin the Enacted Budget. Te 2011-12 budget packageassumed a total o $88.5 billion o General Fundrevenues and transers. Te budget also containedtrigger cuts that would take eect i revenues or

2011-12 were orecast to be less than the amountassumed in the budget package by $1 billion ormore. Tere are two tiers o potential trigger cuts:rst, i revenues are orecast to be $1 billion or morebelow the budget level, and second, i revenues are

orecast to be $2 billion or more below. Te secondtier o cuts—all o which aect K-14 education—isprorated depending upon how much revenues arebelow the budget level. All the trigger cuts may be

put in place i revenues are $4 billion or more belowthe level assumed in the budget.

Under Our Forecast, Most rigger Cuts Assumed to Be Put in Place. We orecast thatrevenues will be $3.7 billion below the budget actamount in 2011-12. As such, under our orecast,a total o $2 billion o midyear expenditurereductions is assumed to be implemented by theGovernor on January 1, 2012 (see Figure 2). Tisrepresents all o the “ier 1” trigger cuts and three-

ourths o the “ier 2” trigger cuts. Te assumeduture eects o the trigger cuts are also shown inFigure 2. Te ultimate magnitude o the triggercuts will be determined by the administrationafer it compares our revenue orecast with itsDecember orecast. Te higher o the two orecasts

Figure 2

Trigger Reductions to General Fund Expenditures by Program Area

(In Millions)

2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 Tier 1 Trigger Cuts

Reduce University o Caliornia budget $100 $100 $100 $100 $100 $100

Reduce Caliornia State University budget 100 100 100 100 100 100

Reduce unding developmental services 100 100 100 100 100 100

Reduce service hours in IHSS by 20 percent and anti- raud eorts

110 210 210 210 210 210

Increase charges to counties or youthul oenders sent to CDCR acilities and reduce CDCR budget

99 166 159 154 152 151

Reduce community college apportionments a 30 — — — — —

Reduce child care unding 17 17 17 17 18 19

Eliminate state grants or local libraries 16 16 16 16 16 16

Eliminate vertical prosecution grants 15 15 15 15 15 15

Extend Medi-Cal provider cuts and copayments to allmanaged care plans

15 15 15 15 15 15

Reduce preschool unding a 6 — — — — —

Total Tier 1 Trigger Cuts ($608) ($739) ($732) ($727) ($726) ($726)

Tier 2 Trigger Cuts

Proposition 98 reductions a $1,436 — — — — —

Total Trigger Reductions $2,044 $739 $732 $727 $726 $726 a Ongoing cuts to Proposition 98 unding are refected in the lower base used to calculate the 2012-13 minimum guarantee.





will be used to determine the level o reductions.(Te administration may implement less than themaximum amount o trigger cuts. Our orecast,however, assumes the maximum amount o trigger

cuts based on our orecasted revenue levels.)

As a result o our lower 2011-12 revenue orecast($3.7 billon lower than the budget package) andthe osetting level o trigger cuts we assume($2 billion), the net deterioration in the GeneralFund condition in the current year due to our lowerrevenue estimate is $1.7 billion.

Other Budget Actions at Risk. In our orecast,we assume that the state will be unable to achieve$1.2 billion in planned 2011-12 budget solutions.Some o the major issues are:

• Medi-Cal . Higher Medi-Cal costs o around $400 million seem likely due, inlarge part, to delayed ederal approval orcost-cutting measures.

• Redevelopment.Our orecast assumes thatthe state will not be able to realize the ullamount o the budgeted savings rom thisyear’s redevelopment agency legislation. We

estimate that the state will only be able toachieve $1.4 billion in savings—$300 millionless than was budgeted.

• Sav ings F ro m S ta te O pe ra ti onal

Efciencies. Te budget package assumedthat the administration would reduceGeneral Fund departmental costs by $250 million through eciencies in depart-mental operations and other cost-reductionmeasures. Our orecast assumes that much

o this savings is unachievable.

$3 Billion General Fund Decit Forecast or 2011-12. As shown in Figure 1, given these variousissues, we orecast that 2011-12 will end with aGeneral Fund decit o $3 billion.

Cotiig Bdget Proble i 2012-13Proposition 98 and Other Costs Contribute to

Estimated $13 Billion Budget Problem. In 2012-13,the state will ace increased costs due, in part, to

the expiration o a number o temporary budgetmeasures enacted in recent years. Most notably,under our orecast methodology (which does notincorporate any eects rom a possible November2012 ballot measure concerning taxes), GeneralFund Proposition 98 costs are projected to riseby $5.6 billion due to growth in the minimumguarantee, very weak property tax growth, and theloss o one-time unding or schools rom the 2011redevelopment legislation. In addition, the statewill owe an additional $400 million in “settle-up”

payments to schools. At the same time, in 2012-13the state must repay the $2 billion Proposition 1Aloan (which was used to help balance the budgetin 2009). We also assume that the state repays$1 billion o loans to special unds. With theGeneral Fund pressured by all o these actors,the state will be let with a 2012-13 operatingshortall (the dierence between annual GeneralFund revenues and expenditures) o $9.8 billion.Accordingly—when combined with the projected“carry-in” decit o $3 billion—the total budget

problem that the state will need to address betweennow and the passage o the 2012-13 budget isestimated to be $12.8 billion, as shown Figure 1.

Projected Ot-Year IbalacesGradally Declie

Structural Decit Signicantly Reduced. Inour report last November, we were projectinga structural decit o $20 billion that persistedover the orecast period. As a result o ongoingspending reductions adopted in the 2011-12 budget

package and improvement in the state’s revenuesituation since last November, we are orecastingsignicantly lower operating shortalls. As shownin Figure 3, our orecast shows an annual budgetproblem o over $8 billion in 2013-14 and 2014-15,declining gradually to about $5 billion in 2016-17.While these numbers are markedly improved rom





-14

-12

-10

-8

-6

-4

-2

$0

2012-13 2013-14 2014-15 2015-16 2016-17

Carry-In Deficit From 2011-12

Annual Operating Shortfall

Operating Shortfalls Decline Gradually

Over the Forecast Period

General Fund (In Billions)

Figure 3

recent years, the state still aces daunting scalchallenges.

LAO COmmEnTSTog Decisios hae RedcedCalioria’s Croic Defcits

Te reduction in the ongoing decit requireddiicult decisions by the Legislature and theGovernor in developing the 2011-12 budget. Toseincluded ongoing provider rate and service reduc-tions in Medi-Cal, substantial grant reductions inincome maintenance programs, a variety o cost-containment measures or community services

or the developmentally disabled, and cuts to thebudgets o the University o Caliornia (UC) andCaliornia State University (CSU), in addition tothe trigger cuts.

In addition, the Legislature enacted two majorpieces o legislation that changed the structureo Caliornia government: ameasure related to redevel-opment agencies (describedin “Chapter 3”) and measures

that shifed various programresponsibilities rom the stateto local agencies (described inthe nearby box, see next page).Both o these measures hada signicant positive impacton the state’s General Fundbudget in 2011-12, but—ascurrently structured—oerlittle direct state scal relie in uture years. In addition,

both o these measures are thesubject o court challenges.

more Tog DecisiosAead

Funding the Proposition 98 Minimum Guarantee Will BeDicult. Under our orecast,

the 2012-13 Proposition 98 minimum guarantee is$4 billion higher than the revised 2011-12 spendinglevel. With the loss o one-time unds relatedto the 2011 redevelopment legislation, General

Fund Proposition 98 costs are projected to rise by $5.6 billion in 2012-13 under our orecast. Giventhe size o this projected increase, together withthe other budget pressures acing the state, theLegislature will need to consider whether it canund the minimum guarantee in 2012-13. I theLegislature determines it needs to suspend theguarantee, then it will need to decide how to reduceProposition 98 spending. Over the last several years,the state has relied heavily on deerring schoolpayments as a means o lowering Proposition 98

spending. Additional deerrals in 2012-13, however,could be unworkable or many districts given themagnitude o the existing deerrals (with 20 percento Proposition 98 payments already made late).

State May Have to Reconsider Restoration o Prior-Year Cuts. In recent years, the state put intoplace a number o temporary reductions to health





and social services spending that expire in the2012-13 scal year. For example, in Caliornia Work Opportunity and Responsibility to Kids, there isover a $400 million restoration o prior-year cuts.

Given the state’s ongoing scal situation, the statemay have to revisit these restorations in 2012-13.

Revenue Increases Also an Option. Given thepotential consequences rom the types o expen-diture reductions discussed above, the Legislaturewill also want to consider revenue increases. Forinstance, the Governor has stated his desire to havecertain increases in as yet unspecied taxes on theNovember 2012 ballot. We would recommend thatthe Legislature continue to review tax expenditure

programs and reconsider various proposals romlast year, such as modications to enterprise zoneprograms and passage o a mandatory (rather thanthe current optional) single sales actor o corporate

prot apportionment.

Big Calleges to Face…Ee Wit Tis Lower Defcit Forecast

As noted above, our budget assumes no cost-o-living adjustments or price increases or many stateprograms. Te impact o not adjusting or inationmeans that the purchasing power o current stateexpenditures will be eroded by ination over theorecast period, and the state will not be able tomaintain the current level o services or many

RealigetBackground. As part o the 201112 budget plan, the Legislature enacted a major shif—or

“realignment”—o state program responsibilities and revenues to local governments. In total, therealignment plan was intended to provide $6.3 billion to local governments (primarily counties) tound various criminal justice, mental health, and social services programs in 2011-12, and increasingunding or these programs thereafer. Te budget provides ongoing unding rom three sources:(1) an ongoing shif o 1.0625 cents o the state sales tax rate, (2) an ongoing shif o vehicle licenseee revenues that previously were allocated to the Department o Motor Vehicles and to cities andOrange County, and (3) a one-time shif o unds rom the Mental Health Services Fund (established

by Proposition 63 in November 2004).

Most o the state scal benet rom realignment in 2011-12 comes rom Proposition 98 savings.Specically, the budget assumes that, by depositing the sales tax revenue into a special und or useby local governments or realignment, these unds are not available or the Legislature to spendor education purposes and thus are not counted as state revenue or purposes o calculating theProposition 98 minimum unding guarantee. Tis action is estimated to reduce the Proposition 98minimum unding guarantee by about $2 billion in 2011-12.

Realignment Revenues Could Outpace Program Costs. We project that the revenues dedicatedto realignment in 2011-12 will total $6.3 billion, roughly equal to the administration’s estimate

o program costs or the realigned programs. Over the longer term, the relationship betweenrealignment revenues and realigned program costs is not certain and will depend on many actors,including actual local costs to supervise the oenders transerred to their responsibility. Based on(1) the administration’s estimates o costs to implement the realigned programs and (2) our estimateso growth in program caseload and program costs, we project that the growth in revenues dedicatedto realignment could exceed local costs—potentially by hundreds o millions o dollars annually.





programs. Under this scenario, by 2016-17 many state employees will have received no net generalsalary increase (considering the net eect o bothscheduled pay increases and recent pension contri-

bution increases) or about a decade. Our orecastalso assumes no restoration o recent budget reduc-tions and trigger reductions. In other words, evenwith these modest unding assumptions, the stateaces ongoing, multibillion dollar annual decits,even as state revenues expand.

Forecast Does Not Account or Repayment o Most Budgetary Obligation. In recent years, theLegislature and Governor have used a number o dierent methods as part o balancing the budget.

Te extent to which realignment revenue growth outpaces program costs, however, is subjectto signicant uncertainty. Actual program caseloads and other costs could be higher than weestimate, depending in part on how local governments implement realigned programs and theirsuccess in containing costs. Also, the realignment legislation established allocation ormulas todistribute the revenues among the aected programs and across counties. Tese ormulas, however,were established only or 2011-12. Tereore, there is uncertainty as to whether the allocationsprovided to specic programs or individual counties will be sucient to keep up with programcosts in the uture.

Risks to Achieving State Savings Estimate. Budget trailer bill language adopted by the Legislaturespecies that the exclusion o the sales tax revenues rom the calculation o the Proposition 98minimum guarantee is contingent upon voter approval o a ballot measure in November 2012providing additional unding or school districts and community colleges. I no ballot measure isadopted satisying these requirements, (1) the state must repay K-14 education or the loss o about$2 billion or the 2011-12 year over a ve-year period, and (2) the sales tax revenues dedicated to2011 realignment would be included in the Proposition 98 calculation in uture years. In addition,the assumption that the realignment revenues are excluded rom the minimum unding guaranteeis subject to some dispute. We note, or example, that a lawsuit has been led by some schooldistricts and education associations challenging the legality o the exclusion.

Legislative Implications. As we describe in our publication, 2011 Realignment: Addressing Issues

to Promote Its Long-erm Success, there are several issues the Legislature should address beore theend o the current scal year to increase the likelihood that realignment is implemented eectively and achieves the Legislature’s objectives over the longer term. Tese include: establishing ongoingunding allocation ormulas that are responsive to changes in program caseloads and costs over time,providing local governments with appropriate programmatic and nancial exibility to managethese new resources, and creating the right scal incentives to promote good program outcomes.

We estimate that the state will have accrued majorbudgetary obligations at the end o the orecastperiod, including: (1) $10 billion in interyeardeerrals o payments to schools, (2) $10 billion o

maintenance actor in Proposition 98, and (3) over$800 million in loans rom special unds to theGeneral Fund.

Solving the Ongoing Budget Decit Would Not Address Massive Liabilities. Our orecast only includes current-law pension and retiree healthpayments by the state. It does not include addedstate payments to curb the massive (and growing)liabilities or retiree health benets or state and CSUemployees, teachers’ pensions, and UC retirement





benets. Addressing the ununded liabilities o justthe teacher’s retirement und probably will requirebillions o dollars o additional payments annually over the coming decades.

CoclsioTe Legislature now aces a much smaller budget

problem than projected one year ago, as well as thesmallest projected out-year decits since beorethe 2007-2009 recession. Unortunately, there areew easy options lef or balancing Caliornia’sbudget. Dicult program reductions already havebeen passed, and signiicant one-time budgetactions may be more elusive than in prior years.Accordingly, the remaining work o eliminating the

state’s persistent, annual decit will require moredicult cuts in expenditures and/or increases inrevenues.

It is important to note that our orecast does notinclude unding to address some o the state’s key long-term scal and policy problems. I, however,the Legislature and the Governor were to eliminatethe structural decit this year or over the course o the next ew years, the ocus o their eorts couldnally shif away rom short-term budget problemsand turn to the serious long-term scal issues o the state’s accumulated budgetary obligations andununded retirement liabilities.




Economy, Revenues,And Demographics

Chapter 2

ThE ECOnOmIC OuTLOOk

Caliornia and the nation are recovering romthe longest and most severe economic downturnsince the Great Depression. he 2007-2009recession was precipitated by the implosion o overheated housing and inancial markets inCaliornia and throughout the United States, theresulting balance sheet deterioration o nancialrms and households, and the near collapse o world credit markets.

Unemployment in Caliornia—under 5 percent

as recently as 2006—has remained above 11 percent

or over two years now. Over one million jobs havedisappeared rom the state’s economy since early

2008.

Te latest evidence suggests that the state andnational economies continue a slow, arduousrecovery rom this staggering economic drop-o.Our economic orecast is summarized in Figure 1and described in more detail below. Our orecastis that Caliornia’s unemployment rate will remainabove 10 percent through mid-2014 and remainabove 8 percent through at least the end o 2017.

Figure 1

The LAO’s Economic Forecast

(November 2011)

2010 2011 2012 2013 2014 2015 2016 2017

United States

Percent change in:

Real Gross Domestic Product 3.0% 1.8% 2.1% 2.8% 3.6% 3.4% 2.9% 2.6%

Personal Income 3.7 5.2 4.0 3.9 5.4 5.3 5.0 4.4

Wage and Salary Employment -0.7 0.9 1.0 1.7 2.1 2.0 1.7 1.1

Consumer Price Index 1.6 3.1 1.5 1.9 2.1 1.9 1.7 1.6Unemployment Rate (percent) 9.6 9.1 9.0 8.5 7.8 7.0 6.5 6.3

Housing Permits (thousands) 585 596 758 1,085 1,417 1,687 1,811 1,841

California

Percent change in:

Personal Income 4.0% 6.0% 4.1% 4.5% 5.6% 5.5% 5.0% 4.7%

Wage and Salary Employment -1.4 1.2 1.3 2.1 2.2 1.9 1.6 1.4

Unemployment Rate (percent) 12.4 12.0 11.8 11.2 10.3 9.6 9.0 8.5

Housing Permits (thousands) 45 46 61 77 91 104 114 124





Te uited States EcooyRecovery Even Slower han Previously

Expected. In November 2010, we wrote that theU.S. recovery was progressing more slowly than

previously expected. Once again, we have to makethe same observation. Figure 2 compares severalkey variables o the May 2011 economic orecasts o the administration and o our oce to our updatedNovember 2011 economic orecast. In 2011 and2012, we orecast that the U.S. economy will growmore slowly than previously expected. In 2011, thelower-than-expected real gross domestic product(GDP) growth results largely rom major downwardrevisions in July in estimates o GDP growth orthe rst quarter o the year. At the time o our

May orecast, ederal data estimated that real GDPin that quarter had grown at a 1.8 percent annualrate. In July, this estimate was revised downward to0.4 percent. Subsequent quarters have seen higherreported GDP growth, but the eects o this rstquarter weakness drag down our annual estimate.Similarly, consensus estimates or real GDP growthin 2012 are lower than they were earlier in the year.

Te employment outlook is somewhat weakerthan we expected in May, and U.S. employment

growth estimates included in our orecast are lower.Tere were some dismal job reports during thesummer. Te initial ederal report o employmentor August, or instance, said that there had been

no net job growth or the nation during that month.Subsequently, however, this gure has been revisedupward to 104,000.

What Parts o the Economy Are Doing Well? Over the last year, U.S. employment has grown mostnotably in the health services, leisure and hospi-tality, mining, trade, transportation/warehousing,and proessional and technical services sectors.Te latter sector (including technology and otherservices important to Caliornia’s economy) has

been among the strongest job producers—up264,000 nationally over the past year. Te manuac-turing sector has gained 220,000 jobs over the last12 months, buoyed, it appears, by healthy exportgrowth, strong levels o equipment investment,and a revived domestic automobile market.emporary help jobs are up 169,000 over the pastyear, including the past three months o 15,000 orgreater growth—potentially a very good sign or theeconomy, as employers requently convert many o these to permanent jobs.

Figure 2

Comparison of May and November Economic Forecasts

(Percent Change From Previous Year Unless Otherwise Indicated)

2011 2012

Administration Forecast

(May 2011)

LAO Forecast

(May 2011)

LAO Forecast

(November 2011)

Administration Forecast

(May 2011)

LAO Forecast

(May 2011) LAO Forecast

(November 2011)

United States

Real gross domestic product

2.8% 2.8% 1.8% 2.9% 3.1% 2.1%

Employment 1.2 1.2 0.9 1.8 1.9 1.0 California

Personal income a 4.4 5.4 6.0 4.5 3.8 4.1

Employment 1.3 1.6 1.2 1.9 2.0 1.3

Housing permits (thousands)

55 54 46 87 81 61

a The LAO and administration orecasts o Caliornia personal income diered at May Revision based on our respective treatments o the 2011ederal payroll tax holiday, as described in our report The 2011-12 Budget: Overview of the May Revision . Unlike the May 2011 LAO orecast, theNovember 2011 LAO orecast assumes the ederal payroll tax holiday is extended into 2012. This results in personal income in 2012 being higherthan it would be without such an assumption.





What Parts o the Economy Are Not Doing Well? Te U.S. and Caliornia economies continueto be dragged down by the construction sector. Teweakness in the housing market continues to aect

other sectors too, including the nancial activitiessector, which has seen weak job growth over thepast year. Consumers are still showing signs o signicant stress, with consumption pulled downsharply by their need to reduce debt and theirdiculty in obtaining credit. Moreover, while theFederal Reserve continues to rely on aggressivemonetary policy—with a multiyear commitmentto near-zero interest rates—the eects o the 2009ederal scal stimulus now are wearing o, withreal ederal government purchases o goods and

services declining rom 2010 levels. Te end o theederal scal stimulus and budgetary woes also areaecting the nation’s local and state governments,among which employment has declined recently.Federal government employment also has beendeclining over the past year.

Slow Recovery Expected hroughout Our Forecast Period. Following the deep 1981-82recession, the U.S. economy bounced back quickly—with real GDP growth o 4.5 percentin 1983 and 7.2 percent in 1984. As shown inFigure 1, however, no such bounce back appearsto be in store or the U.S. economy. We orecast aslow, steady recovery through 2017 with annualreal GDP growth ranging between 2.1 percent and3.6 percent. Unemployment is expected to gradually decline or the U.S., reaching about 6 percent by theend o 2017. Housing permit activity is expectedto grow—welcome news or the construction andother related sectors—even though the 1.8 millionhousing permits we orecast or the nation in 2017remains 15 percent below the peak levels o 2005.

Te Calioria EcooyWeaker Job Growth Tan Previously Expected.

As shown in Figure 2, we have downgraded ourorecast or Caliornia employment growth sinceMay. We now orecast 1.2 percent employmentgrowth in the state in 2011 and 1.3 percent in

2012—both down rom prior orecasts. Housingpermits—a key indicator or the state’s very weak construction sector—are now orecast to be evenlower than in our May orecast. State and local

employment contraction also is expected tocontribute to the weak labor market in the state.

Personal Income Surprisingly Strong DespiteWeak Job Growth. Despite the state’s weak jobgrowth, personal income growth in Caliornia in2010 and 2011 has proven to be airly strong. Tisorecast incorporates somewhat stronger personalincome estimates or the state in 2010 and a higherorecast or 2011, as shown in Figure 2. For 2012,this orecast or personal income growth in the

state is higher than it otherwise would be due toour assumption that the ederal employee payrolltax cut is extended to 2012. We made no suchassumption in May. (Assumptions about ederalpolicy are discussed urther below.)

Forecast Riss ad ucertaitiesFederal Policy Is a Key Uncertainty in the

Economic Forecast. Like other state revenueorecasters, we rely on national economic dataprovided to us by a major economic orecastingcompany. Te data incorporate numerous assump-tions about ederal scal, monetary, regulatory,tax, and other policies. We use this inormation toinorm many parts o our economic and revenueorecasts—utilizing our own judgment whenappropriate.

For this orecast, however, there is considerableuncertainty about short-term and medium-termederal iscal and tax policies. his uncertainty arises due to the activities o the congressional“supercommittee” charged with recommending

substantial decit-reduction measures in the comingweeks, the scheduled expiration o the 2011 employeepayroll tax reduction and emergency unemploymentinsurance benets, and the scheduled expirationo various tax cuts enacted under the prior ederaladministration (and extended under the currentadministration) at the end o 2012. Accordingly,





current national economic orecasts must makemany assumptions about what ederal policy willbe a ew months and a ew years rom now. Oureconomic and revenue orecasts generally incor-

porate the ollowing assumptions:

• Te employee payroll tax cut and emergency unemployment insurance benets will beextended or 2012 and then phased out overseveral years.

• Tere will be no sequestration (automaticederal spending cuts beginning in 2013)resulting rom the ailure o Congress toenact decit-reduction measures now beingconsidered by the supercommittee. Instead,Congress and the President will enact apackage o decit-reduction measures toreplace sequestration that will begin to takeeect in 2014. Tese measures are assumedto stabilize, but not reduce, the ederal debt-to-GDP ratio.

• he various ederal tax cuts originally enacted during the prior ederal adminis-tration will be extended an additional yearto 2013. (his produces changes in state

revenue estimates since, in prior orecasts, weassumed these tax cuts’ expiration at the endo 2012 caused some taxpayers to acceleraterecognition o capital gains rom 2013 to2012. Instead, in this orecast, we assumethat acceleration occurs rom 2014 to 2013.)

Clearly, many o these assumptions may not come to pass, but they do seem to relecta consensus o economists about a reasonableapproach or orecasting the U.S. economy in the

coming years. Compared to these assumptions,actual ederal actions in the coming months couldeither produce additional short-term benet orthe economy (or example, by extending payrolltax reductions or the next ew years to employers,as well as employees) or result in an additionalshort-term drag (or example, i the payroll taxreduction is not extended or sharp decreases in

ederal domestic and deense spending take eectthrough the sequestration process).

No Estate ax Receipts Assumed or the State.

In 2001, as a part o the tax reductions enactedduring the prior ederal administration, the ederalgovernment adopted reductions over several yearsto its estate tax and eliminated a tax code provisionknown as the “credit or state death taxes.” Testate credit was eliminated entirely or estates o those dying ater December 31, 2004. In 2010,Congress and the President agreed to extend thetemporary 2001 estate tax legislation—includingelimination o the state death tax credit—until theend o 2012. Under current ederal law, thereore,

the pre-2001 estate tax regime will resume at thebeginning o 2013, including the state death taxcredit. Nevertheless, most observers believe that, nomatter what Congress does to the estate tax in 2012,there will no longer be a credit or state-level estatetaxes. Our orecast assumes that this consensusis correct. Pursuant to Proposition 6 (1982), thestate may only collect estate taxes equal to the statedeath tax credit in ederal law. Accordingly, ourorecast assumes that the state receives no estatetaxes during this orecast period. We advise theLegislature to assume no such revenues duringits 2012-13 budget process unless there is a clearindication rom Congress that a state death taxcredit will be adopted.

I our assumption proves to be incorrect andCongress allows the state death tax credit toresume, the amount o revenues the state wouldreceive beginning in 2012-13 is highly uncertain.Te level o revenues in this scenario would depend,or example, on how many and how large theestates are that are subject to taxation. Tis could

total several hundred million additional dollarsor the General Fund in 2012-13 and perhaps over$1 billion per year thereafer. (Tese additionalrevenues, i they were to be received, also wouldincrease the state’s Proposition 98 minimumguarantee by an amount equal to around one-hal o the revenue increase.)





Europe and the Financial Markets. Europe’swoes—principally the eared deault o Greece,Italy, Spain, and other nations on their nationaldebt—have rattled investors in recent months.

Recently, European leaders have taken actionsintended to help stabilize the debt problems o heavily leveraged national governments there.Should the eorts o European leaders ail, some earthat the negative eects o national bond deaultscould imperil European banks, thereby threateningcredit markets and nancial rms tied to thosebanks around the world. At the present time, wedoubt that these issues will have a substantial eecton the U.S. economy. In Caliornia, or instance,European trade is a relatively small part o the

state’s imports and exports. Moreover, banks andother rms around the world now have had monthsto prepare themselves or European debt deaults.

A “Double-Dip” Recession? Probably Not.A double-dip recession in the U.S. now appearsunlikely. Our orecast assumes that the economy grows slowly, but steadily, in the coming years. Itis possible, however, that certain negative events inthe coming months could precipitate one or morequarters o economic contraction not assumed inthis orecast. For example, additional turmoil in thenancial markets could cause such contraction. Inaddition, the eects o ederal sequestration cutsor any major decline o consumer and businessconidence due to ailure o Congress and thePresident to agree on decit reduction goals couldaect the economy negatively.

Data Limitations. It takes time or the state’stax agencies to compile data rom tax returns thatis used by revenue orecasters. For our personaland corporate income tax orecasts, or example,

we rely signiicantly on data compiled by theFranchise ax Board (FB) and presented on aroutine biannual schedule to both our oce and theadministration—with the rst set o data generally submitted each year in late April or May and thesecond set in late November or December. (Te FBalso posts these “exhibit packages” on its website.)

Te next FB exhibit package likely will includesome o the rst solid data on 2010 Caliorniawages and salaries, capital gains, and other incometax inormation. By the time the administration

completes its December revenue orecast, it may have the benet o reviewing this or other FBdata that were not available or use in this orecast.Such FB data could result in the administration’srevenue orecasts being somewhat higher or lowerthan ours.

In addition, we note that since we prepared thiseconomic orecast, ederal job growth data has beenrevised upward or both August and September—by a total o 102,000 jobs over the two months.

Tese upward adjustments (not reected in oureconomic orecast) would have improved the 2011employment levels assumed in our orecast—as wellas state revenues—slightly.

ThE REvEnuE OuTLOOk

Caliornia’s General Fund is supported by revenues rom a variety o taxes, ees, licenses,interest earnings, loans, and transers rom other

state unds. Over 90 percent o the total, however,currently is derived rom the state’s “big three”taxes—the personal income tax (PI), the salesand use tax (SU), and the corporate income andranchise tax (C). A summary o our revenueprojections is shown in Figure 3 (see next page).(Note that, beginning in 2011-12, this iguredoes not include SU unds—estimated to total$5.1 billion in 2011-12—redirected rom theGeneral Fund to the Local Revenue Fund 2011 topay or specied local programs.)

Figure 4 (see page 17) shows the dierencesbetween our orecasts o 2010-11 and 2011-12revenues, as compared with those assumed inthe 2011-12 budget package. For 2010-11, aterincluding the most recent inormation availableto us on accruals and other adjustments, GeneralFund revenues were approximately $500 million





PI Holding Up Well Despite Weak Economic,Financial Market News. Our PI orecast or2011-12 is higher than assumed in the budgetact (excluding the $4 billion unallocated revenue

assumption) despite the weaker outlook or theeconomy and inancial markets. Income taxwithholding and estimated payments have heldup well since May, and overall revenue attributableto tax year 2010 appears to have been surprisingly high given the slow reported growth in personalincome. We attribute this mainly to strongergrowth in capital gains and some other categorieso taxable income than we would typically expectbased on the perormance o asset markets andreported personal income growth. Specically,

some recent initial public oering (IPO) activity in the technology sector and extraordinary bonusincome or some high-income earners may accountor this unexpected strength.

Capital Gains Bounced Back From 2009 Low,but Slower Growth Forecast Ahead. Capital gainsincome consists o gains rom sales o assets, such asstocks, bonds, and real estate. axable capital gains

below budget act expectations, spread across allo the Big Tree revenue sources. For 2011-12, ourorecasted revenues are $3.7 billion less than thoseassumed in the budget package.

Under current law, our estimate o 2011-12revenues will be compared with the comingDecember estimate o the Department o Finance(DOF). Te higher o the two estimates will be usedto determine the amount o any “trigger” reduc-tions (as discussed in “Chapter 1”).

Persoal Icoe TaxAt the end o 2010, temporary PI rate increases

and reductions in the dependent exemption creditexpired. Tis is a major reason why PI revenue isorecast to grow between 2010-11 and 2011-12 by only about 2 percent. (I, by contrast, there had beenno such temporary PI increases in 2010, the growtho the PI would be about 7 percent between 2010-11and 2011-12.) Our orecast assumes that PI revenuesgrow by 5.2 percent per year between 2011-12 and2016-17.

Figure 3

LAO General Fund Revenue Forecast

(Dollars in Millions)

Revenue Source 2010-11 2011-12 a 2012-13 2013-14 2014-15 2015-16 2016-17

Personal income tax $49,779 $50,812 $53,134 $55,692 $57,682 $61,811 $65,625

Sales and use tax 26,983 18,531 19,980 21,573 23,220 24,483 25,856

Corporation tax 9,838 9,483 9,432 9,958 10,806 11,316 11,492

Subtotals, “Big Three” ($86,600) ($78,826) ($82,546) ($87,223) ($91,708) ($97,610) ($102,973)

Percent change 7.3% -9.0% 4.7% 5.7% 5.1% 6.4% 5.5%

Insurance tax $2,070 $1,895 $1,989 $2,210 $2,326 $2,434 $2,536

Vehicle license ee 1,330 80 5 — — — —

Other revenues b 2,395 2,511 2,546 2,148 2,314 2,530 2,479

Net transers and loans 1,897 1,451 -1,048 -1,126 -966 -235 -162

Total Revenues and Transfers

$94,292 $84,764 $86,038 $90,455 $95,382 $102,339 $107,826

Percent change 8.3% -10.1% 1.5% 5.1% 5.4% 7.3% 5.4% a Beginning in 2011-12, does not include unds redirected rom the General Fund to the Local Revenue Fund (LRF) 2011. Sales and use tax unds

deposited into the LRF in 2011-12 are estimated to total $5.1 billion. Also, 2011-12 revenues are lower due to the expiration o temporary taxincreases passed in 2009.

b Does not include the resumption o estate tax revenues in 2012-13 and beyond.





income is a very volatile part o PI revenues—onethat is virtually impossible to predict well, but caninuence PI receipts upward or downward by billions o dollars per scal year. Overall, as shown

in Figure 5 (see next page), we are assuming thattaxable capital income (as a percent o personalincome) has bounced back rom its 2009 low—buoyed by strong investment markets in 2010—butwill grow at a slower rate going orward.

Since May, two actors have placed downwardpressure on our capital gains orecast or 2011.First, our outlook or Caliornia real estate pricesis even weaker now than it was in May. Second,this past summer’s stock market slump caused

stock prices—as measured by the Standard andPoor’s 500 stock index—to be roughly 9 percentlower or the third quarter o 2011 than assumed inour May orecast. While we generally assume thatstock prices will rise in the uture, the eects o thissummer slump result in our current assumptionso stock prices being lower throughout the orecastperiod than assumed in our May orecast.

Despite these dual downward pressures, ourorecast assumes that capital gains income or

Caliornia taxpayers will total $69 billion in2011—down just 6 percent rom our May orecast.Tis reduction is relatively small since we haveincorporated in this orecast a positive adjustment

to account or the healthy estimated PI paymentsthe state has received recently and current IPOactivity in the technology sector.

While the actors described above have helpedthe recent rebound o capital gains, we do notorecast that Caliornia capital gains will rise toprerecession levels during the orecast period. Asnoted above and illustrated in Figure 5, capitalgains generally are slightly lower over the orecastperiod than our May projections.

Capital gains orecasts—dicult as they are toorecast—can shif materially during the course o any scal year. Accordingly, it is possible that highercapital gains than we orecast could lead to PIrevenues being billions o dollars higher or lower thanour orecast in 2011-12 or any uture year.

Wages and Salaries—More Growth or High-Income Earners. In our report Te 2011-12Budget: Overview of the May Revision, we noted

Figure 4

November 2011 LAO Revenue EstimatesCompared With 2011-12 Budget Package

General Fund (In Millions)

2010-11 2011-12

Revenue Source

LAO November 2011

Forecast Budget

Package Difference

LAO November 2011

Forecast Budget

Package Difference

Personal income tax $49,779 $50,027 -$248 $50,812 $50,408 $404

Sales and use tax 26,983 27,140 -157 18,531 19,009 -478

Corporation tax 9,838 9,963 -125 9,483 9,012 471Subtotals, “Big Three” ($86,600) ($87,130) (-$530) ($78,826) ($78,429) ($397)

Other revenues a $5,795 $5,754 $41 $4,486 $8,561 -$4,075

Net transers and loans 1,897 1,897 — 1,451 1,465 -14

Total Revenues and Transfers

$94,292 $94,781 -$489 $84,764 $88,456 -$3,692

a The 2011-12 budget package assumed a $4 billion “unallocated revenue assumption” as miscellaneous revenue in 2011-12. The $4 billion isincluded as “other revenues” or the budget package columns in this gure.





a signicant PI orecasting dierence betweenour oce and the administration related to high-income tax lers. Forecast dierences or this groupare important because o the higher marginal tax

rates on their income. Specically, prior to passageo the 2011-12 budget package, both our oce andDOF had diculty reconciling the very strong PIresults rom last spring with the ocial economicdata. Revenues were coming in much higher thanthe ocial labor and other economic data seemedto support. In the Governor’s May Revisionorecast, the administration assumed that higherPI totals resulted in large part rom huge growthin 2010 o salaries and wages or high-incomewage and salary earners—those tax lers with

over $200,000 o adjusted gross income (AGI). Atthe same time, the administration assumed thattax lers with less than $200,000 o AGI saw theirwages and salaries all by several percentage points.In our May orecast, we also assumed some highergrowth or high-income wage earners—though notas much as the administration assumed—and smallgrowth in wages or lower-income groups.

Since we lack hard data rom PI returns or2010, we still must make a rough estimate o wageand salary growth or that income year. In thisorecast, we assume higher 2010 wage and salary

growth than we did in May or both higher-incomeand lower-income groups. Specically, we assumethat those with over $200,000 o AGI saw theirwages and salaries grow by 7.5 percent in 2010,while those with under $200,000 o AGI saw theirwages and salaries grow by 2.5 percent. In ourorecast, higher-income earners’ wage and salary growth outpaces that o lower-income earnersthroughout the orecast period.

Sales ad use Taxes

We estimate that General Fund SU revenueswill total $18.5 billion in 2011-12, which is2.5 percent, or $478 million, lower than the levelassumed in the 2011-12 Budget Act. A large parto the decline is due to the so-called “Amazoncompromise” that delays taxation o certain onlinepurchases to 2012-13.

In 2012-13, we estimate that SU will growstrongly to $20 billion, a7.8 percent increase rom2011-12. Over the rst threeyears o the orecast period,SU revenues are expectedto grow at an average rate o 7.8 percent—somewhat asterthan personal income—beoredropping to more modestgrowth during the remaindero the orecast period.

Recent Policy ChangesR e d u c e G e n e r a l F u n d

SU Revenues. In 2011-12,General Fund SU revenuesare projected to all signii-cantly rom 2010-11 levels,relecting the net eect o:(1) the “uel tax swap” passedby the Legislature in 2010,

2

4

6

8

10

12%

1985 1990 1995 2000 2005 2010 2015

Capital Gains Forecast Slightly Lower Than in MayFigure 5

May 2011

November 2011

Capital Gains as a Percent of Personal Income

Forecast

LAO Forecast





under which the state no longer collects salestax on gasoline, (2) the realignment o somestate responsibilities to local government (whichredirects $5.1 billion in state SU receipts to cities

and counties), (3) the expiration o the temporary 1 percent SU rate increase adopted in 2009, and(4) projected growth in the SU base o nearly 7 percent. Policy changes and underlying growth,taken together, reduce state General Fund SUrevenue rom $27 billion in 2010-11 to an estimated$18.5 billion in 2011-12. Our orecast assumes thatthe 2011-12 SU policies outlined above continuethrough the remainder o the orecast period.

Factors Aecting Forecast. Te main deter-

minant o SU receipts is taxable sales. Abouttwo-thirds o taxable sales result rom retailspending by consumers, including a signicantportion on personal vehicles and large householdpurchases, both o which declined sharply duringthe recession. Other important categories o taxablesales are the purchase o building materials involvedin new constructionas well as business-t o- b u s i n e s s t ax ab letransactions, where thepurchasing business isthe nal consumer o thesold item.

axable Sales Fell D i s p r o p o r t i o n a t e l y During the Recession.From 2007 to 2009, taxablesales ell approximately 19 percent while personalincome declined by just2 percent. Te reduction

in taxable sales relativeto income—illustrated inFigure 6—was the resulto: (1) consumers andbusinesses curtailingcostly purchases such ashousehold appliances,

new vehicles, and business machinery; (2) increasedhousehold savings rates; and (3) the long-termtrend toward greater consumption o nontaxablegoods (services and other products, such as those

purchased online, or which the collection o SUhas been limited).

axable Sales Now Making Up Lost Ground. Since the start o the modest recovery, taxable saleshave increased somewhat aster than personalincome, signaling a correction to the decline intaxable sales discussed above. We expect this trendto continue through the rst three years o ourorecast, as illustrated in Figure 6 in the upward-sloping line beginning in 2011. We expect that

consumers and businesses will gradually returnto more normal levels o taxable spending relativeto income during this period. axable sales in thenal two years o the orecast grow approximately 5.5 percent annually as growth levels o over theremainder o the orecast period.

Taxable Sales Forecast to Rebound

Figure 6

26

28

30

32

34

36

38%

Taxable Sales as a Percent of Personal Income

1992 1995 1998 2001 2004 2007 2010 2013 2016

Forecast





Uncertainties in the SU Forecast Could Impact Actual Revenues. axable sales typically are inluenced by (1) employment and incomegrowth, (2) household savings rates, (3) the

availability o consumer and business credit, and(4) overall condence in the economy. Tese actorscould dier substantially rom our underlyingassumptions in the ollowing ways:

• HouseholdSavingsRates,Incomes,and

EmploymentAffectSpendingPatterns.Inrecent months, national household savingsrates have allen to prerecession levels(savings tend to increase during recessionsas consumers curb spending and pay down

debt), likely indicating that savings builtup over the past ew years have supportedrecent growth in taxable sales. Shouldemployment, income, or savings rates vary signicantly relative to our expectations,actual taxable sales could dier substan-tially rom our orecast.

• ConsumerCreditAvailabilityInuences

SpendingDecisions. Te availability o consumer credit in the next ew years(presently at historically low levels)is also signiicant, as credit generally allows consumers to nance large taxablepurchases—such as vehicles, appli-ances, personal electronics, and homeimprovements.

• ConsumerandBusiness Confidence

MayAffectFutureSpending. Nationalconsumer conidence indicators are attheir lowest levels since the end o therecession. Weak conidence about the

economy, however, does not seem to haveaected consumer spending—as evidencedby steady vehicle and retail sales in recentmonths. I current low consumer condenceabout the economy drives Caliornians tospend less on taxable goods over the nextseveral months, SU receipts would growmore slowly than our orecast projects. In

particular, we are concerned that possiblecongressional deadlock over the supercom-mittee’s decit reduction package couldaect consumer behavior during the holiday

spending season. Congressional deadlock could impair business condence as well,which could lead businesses to postponetaxable investments—on machinery andother equipment, or instance.

Corporatio Tax Likely to Bottom Out in 2011-12 or 2012-13

Beore Rebounding. Corporation tax revenues or2010-11 are estimated to have totaled $9.8 billion,slightly higher than the previous scal year. We

project C receipts will be slightly lower in 2011-12and 2012-13, but then grow steadily to $11.5 billionby the end o the orecast period.

Prots Forecast Stronger…Corporate prots—the main driver o our C revenue orecast—noware projected to be higher than indicated in our lastorecast in May 2011. Specically, we now assumethat beore-tax national corporate proits willbe $2 trillion in 2011, which is 15 percent higherthan the value used in our previous orecast. Teweak labor market, productivity growth, exportexpansion or certain U.S. products, and growingconsumer demand all appear to be contributing tothe strength in corporate prots.

…But ax Credits Dampen Benets o Prot Growth on C Revenues. As proits increase,however, businesses will be more able to use new orpreviously earned state tax credits (such as researchand development or enterprise zone credits) toreduce taxes owed.

Net Impact o Recent Policy Changes NowReducing Revenues. In addition to tax credits, various major C policy changes o recentyears aect the revenue outlook. In 2009-10 and2010-11, these policy changes had the net impacto increasing C revenues. he expected neteect o these recent changes to C policies willbe to lower revenues by around $700 million in





2011-12, compared to estimates o what revenueswould have been had these policies not changed.Tis net negative eect is expected to grow, likely to over $1 billion annually or the remainder o

our orecast period. Tis is shown in Figure 7.Te recent major policy changes aecting the Corecast are:

• ChangesinMultistateBusinessTaxation.

Te elective single sales actor—the newoption or businesses to annually choosewhich method is used to determine theirCaliornia taxable income—and associatedtax law changes are estimated to reduce Crevenues by around $1 billion per year.

• Major Revenue Accelera t ions . heLegislature has enacted several measuresover the last ew years that have acceleratedrevenue collections and delayed the useo tax deductions or credits. Te actionsinclude the suspension, or 2008 through2011, o largerbusinesses’ useo net operatingloss deductions.Tis increased Crevenues. Since2008, however ,business losses haveaccumulated andwill be deductibleagainst incomea g a i n s t a r t i n gin tax year 2012.Recently enacted—and modiied—p e n a l t i e s o n

c o r p o r a t et ax p ay e r s w hoare ound to haves i g n i i c a n t l y underpaid theirtaxes also serveto accelerate C

collections. Tis occurs as businesses try to avoid the penalties by paying uprontsome o the tax they might have paid laterollowing an audit.

• Expanded Credi t Use. Recent legis-lation also aected the use o tax credits.Te single largest change is that creditsare now easier to use due to a law thatallows transers o certain credits betweencompanies that are treated as parts o asingle business group or tax purposes.

Uncertainties in the C Forecast. ForecastingC revenues is very dicult. Several actors couldresult in our orecast being too high or too lowby large margins in any given scal year. Besidesthe usual uncertainties in orecasting corporateprots, there are some particularly dicult issuesnow or C orecasting.

• Lags inGettingCertainData. As thereare long lags in getting certain data,

-2

-1

0

1

$2

08-09 09-10 10-11 11-12 12-13 13-14 14-15 15-16 16-17

Net Losses

Estimated Effects of

Recent Policy Changes on CT RevenuesChanges From Revenues Otherwise Expected (General Fund, In Billions)

Figure 7

Net Gains





developing our orecast requires us toestimate data associated with prior years.For example, the latest year or which wehave irm data rom FB on Caliornia

taxable prots is 2009. For C revenues,this signiicantly impairs our ability toknow how recent policy changes already have aected revenues. As described earlier,the administration may receive additionalinormation on 2010 C returns rom FBprior to releasing its December orecast.

• Recent Pol icy Changes Reduce the

ReliabilityofForecastsintheNearTerm.

Our orecast involves identiying patterns

among economic variables and assumingthese patterns will persist. In the past,or example, the ratio between Caliorniataxable proits and national proits hastended to return to a stable level ateroccasional increases or decreases. Due torecent C policy changes in Caliornia,however, this ratio may be a much less useulguide or orecasting Caliornia proits.Accordingly, these policy changes—aswell as the recent volatility o the economy during the recession and the current slowrecovery—make it less likely that historicalpatterns will reemerge in the near term.his results in a need to incorporate asigniicant degree o judgment into ourorecasts.

DeograpicsOur orecasting process also involves exami-

nation o population and other demographic trendsin the Caliornia economy. Tis is our rst orecastto incorporate 2010 Census results. Future orecastswill incorporate them more, as we have time toexamine additional Census data. Our demographic

orecast or 2010 through 2017 is summarized inFigure 8.

Population Growth Slowed Considerably in

the Late 2000s. Population estimates or yearsbetween Censuses typically are subject to someuncertainty, but it now appears that Caliornia’spopulation growth slowed considerably in thesecond hal o the 2000s. Growth seems to havebeen especially low in 2005 and 2006 at the heighto the housing bubble, as high housing prices may have discouraged new people rom moving to thestate and encouraged some outmigration. It alsoappears that large numbers o undocumentedimmigrants may have lef the state at the end o the

decade in response to the lack o job opportunities.

Population Growth Forecast to Pick Up Slightly in Future Years. We expect population growthto return to around 1 percent a year by 2013.Combined domestic and oreign net migrationappears to have been negative rom 2005 to 2010,but we expect it to turn positive beginning in 2012due to lower housing prices and slowly expanding job growth in the state. We project Caliornia’spopulation will reach 40 million in 2017.

Most o the state’s population growth willcome rom natural increase. Te state still has arelatively young population, and births consis-tently outnumber deaths by about 300,000 peryear. Birth rates have been alling and shouldremain airly low even as the job market improves.Death rates, meanwhile, are alling sharply,and we expect this to continue. Tis means thatCaliornia’s population—like the nation’s—willbecome proportionately older in the coming years,presenting ederal, state, and local governments

with new challenges in service delivery and theunding o health, social services, social insurance,and pension programs.





Figure 8

The LAO’s Demographic Forecast

(In Thousands)

Estimated Forecast

2010 2011 2012 2013 2014 2015 2016 2017

Totals (July 1st ) 37,345 37,619 37,964 38,373 38,793 39,217 39,626 40,051

Change 268 274 345 408 421 424 409 425

Percent change 0.72% 0.73% 0.92% 1.08% 1.10% 1.09% 1.04% 1.07%

Births 512 511 513 528 544 561 576 579

Deaths 242 242 244 246 247 250 253 255

Net domestic migration -88 -169 -93 -49 -51 -57 -79 -69

Net oreign migration 86 174 169 180 182 176 170 170




Chapter 3

In this chapter, we discuss our General Fundexpenditure estimates or 2010-11 and 2011-12, as

well as our projections or 2012-13 through 2016-17.Figure 1 (see next page) shows our orecast or majorGeneral Fund spending categories or all o theseyears. Below, we rst discuss general budgetary trends and then discuss in more detail our expen-diture projections or major program areas.

2011-12 Otloo General Fund expenditures in 2011-12 are

6.7 percent below their 2010-11 levels, due orthe most part to the shif o some $5.5 billion o

expenditures rom the General Fund to the LocalRevenue Fund 2011 (as part o the realignment o state programs to local responsibility). In total,General Fund expenditures are orecast to beslightly (1 percent) lower than the budgeted amountdue to the net eect o the trigger cuts and increasedcosts in some program areas.

Expeditre Growt Drig teForecast Period

Sharp Growth in 2012-13. In 2012-13, ourorecast shows General Fund spending climbingby 12 percent. A large component o this is theadditional $5.6 billion in Proposition 98 expen-diture combined with the $2 billion Proposition 1Aproperty tax loan that the state must repay.

Lower Growth Projected Afer 2012-13. Ourorecast shows overall General Fund spendinggrowing by 3.6 percent in 2013-14, 4.7 percent

in 2014-15 and in 2015-16, and 4.1 percent in2016-17. As shown in Figure 1, this equates to an

average annual growth rate o 5.8 percent between2011-12 and 2016-17. Te period is characterizedby consistently high growth rates in two areas thatrepresent over hal o the General Fund budgetin 2016-17: (1) Proposition 98 spending or K-14education and (2) Medi-Cal. Te remainder o thebudget is projected to grow at a modest 3.5 percentannually over the orecast period. Tis modestgrowth is due in part to the stated legislative policy o having no automatic ination adjustments ormany programs (as discussed in “Chapter 1”). For

instance, our orecast assumes no growth in theGeneral Fund appropriations to the universitiesor the courts afer 2012-13.

PROPOSITIOn 98

State budgeting or public education belowthe university level is governed largely by Proposition 98, passed by voters in 1988. hemeasure, modied by Proposition 111 in 1990,

establishes a minimum unding requirement,commonly reerred to as the “minimum guarantee.”Both state General Fund and local property taxrevenues apply toward meeting the minimumguarantee. Proposition 98 monies support K-12education and the Caliornia Community Colleges(CCC), constituting about 70 percent o undingor these programs. Tese programs also receive

Expenditure Projections





support rom the ederal government, other statesources, and various local sources. Proposition 98monies also subsidize preschool or low-incomeamilies.

Calculating the Minimum Guarantee. heProposition 98 minimum guarantee is deter-mined by one o three tests set orth in the StateConstitution. hese tests are based on severalinputs, including changes in K-12 average daily attendance (ADA), per capita personal income,

and per capita General Fund revenue. houghthe calculation o the minimum guarantee isormula-driven, a supermajority o the Legislaturecan vote to suspend the ormulas and provide less

unding than the ormulas require. Tis happenedin 2004-05 and 2010-11. As a result o a suspensionor a “est 3” year (when the Proposition 98guarantee grows more slowly than per capitapersonal income), the state creates an out-yearobligation reerred to as a “maintenance actor.”When growth in state General Fund revenues is

Figure 1

Projected General Fund Spending for Major Programsa


Estimates Forecast

Average AnnualGrowth From

2011-12 to 2016-17 2010-11 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17

Education

K-14—Proposition 98 $35,691 $31,664 $37,240 $39,649 $41,810 $44,556 $46,451 8.0%

Other Proposition 98 obligations b — — 841 841 573 391 391 —

Child care — 1,064 1,008 1,019 1,114 1,209 1,361 5.2

CSU 2,542 1,976 1,976 1,976 1,976 1,976 1,976 —

UC 2,711 2,072 2,071 2,070 2,069 2,068 2,067 —

Student Aid Commission 1,257 1,403 1,570 1,720 1,954 2,128 2,308 10.5

Health and Social Services

Medi-Cal 12,437 15,140 15,611 16,734 18,245 19,567 21,036 6.8

CalWORKs 2,079 1,065 1,448 1,468 1,360 1,250 1,234 3.0

SSI/SSP 2,861 2,752 2,815 2,888 2,968 3,055 3,151 2.7

IHSS 1,436 1,530 1,281 1,328 1,377 1,438 1,504 -0.3

Developmental Services 2,437 2,526 2,733 2,843 2,966 3,095 3,231 5.0

Mental Health 1,794 1,252 1,273 1,319 1,345 1,351 1,357 1.6

Other major programs 3,136 1,890 2,088 1,985 1,990 1,886 1,874 -0.2

Corrections and Rehabilitation 9,217 7,749 8,311 8,139 8,222 8,344 8,569 2.0

Judiciary 1,657 1,214 1,213 1,228 1,227 1,227 1,227 0.2

Proposition 1A Loan Costs 91 91 1,986 — — — —

Infrastructure Debt Service c

5,344 5,345 5,216 6,317 6,809 7,114 7,295 6.4 Other Programs/Costs 6,790 6,576 7,107 7,683 7,906 8,106 8,220 4.6

Totals $91,480 $85,308 $95,787 $99,205 $103,909 $108,761 $113,253 5.8%

Percent Change -6.7% 12.3% 3.6% 4.7% 4.7% 4.1% a Under the LAO November 2011 revenue orecast, a total o $2.04 billion o expenditure trigger reductions would be implemented, as revenues are

$3.7 billion below the amount assumed in the 2011-12 Budget Act . This represents all o the rst tier o trigger cuts and around three-quarters o thesecond-tier trigger cuts.

b Includes Quality Education Investment Act payments as well as 2011-12 settle-up payments.c Does not include General Fund debt-service costs o lease-revenue bonds unded through the Caliornia Community College portion o

Proposition 98 unding.





healthier (as determined by a specic ormula alsoset orth in the Constitution), the state is requiredto make a maintenance actor payment, thereby accelerating growth in K-14 unding. Another

type o Proposition 98 obligation is created whenthe nalized estimate o the minimum guaranteeor a particular year ends up being higher than theProposition 98 appropriation or that year. Whenthis happens, the state needs to make a “settle-uppayment” (or series o payments) to ensure theguarantee is met.

Crret-Year Propositio 98 AdjstetsFigure 2 shows the major current-year

Proposition 98 adjustments resulting rom our

orecast. Based upon updated 2011-12 inormation,the Proposition 98 calculations have changed inthree ways, each o which is described below.

Unmet 2011-12 Revenue Projections Result in Proposition 98 rigger Cuts o $1.5 Billion.Te 2011-12 Budget Act appropriated $48.7 billionin Proposition 98 unding. Under our revisedcurrent-year GeneralFund orecast, revenuesare $3.7 billion below2011-12 budget assump-t i on s , w hi c h w ou ldt r i g g e r $ 1 .5 b i l l i oni n c o r r e s p o n d i n gProposition 98 cuts. Asa result, revised 2011-12Proposition 98 spendingwould be reduced to$47.2 bil lion. Specically,all the Proposition 98ier I reductions wouldbe enacted—resultingin a $30 million cut toCCC apportionments(accompanied by a eeincrease beginning insummer 2012) as well asa $6 million cut to theState Preschool program

(with an additional $17 million non-Proposition 98General Fund being cut rom other child careprograms). Additionally, almost all o the ier IIreductions would be enacted—resulting in the

elimination o the Home-to-School ransportationprogram (or hal-year savings o $248 million),an additional $72 million cut to CCC apportion-ments, and a $1.1 billion reduction to K-12 revenuelimits. Whereas budget legislation authorizes arevenue limit reduction o $1.5 billion, we estimatea somewhat smaller reduction given our estimateso General Fund revenues and the Proposition 98minimum guarantee. Te reductions would beeective beginning January 1, 2012, except or therevenue limit reduction, which would take eect

February 1, 2012.

Assume Higher Base and Large Settle-UpObligation Moving Forward. Te 2011-12 budgetpackage proposed that a ballot measure beapproved to raise additional revenue or schoolsand community colleges. he budget package,

2011-12 Proposition 98 Estimates

Figure 2

a Assumes no ballot measure. All sales tax revenues are included in Proposition 98 calculations.Difference between spending level and guarantee would become new settle-up obligation.

46.0

46.5

47.0

47.5

48.0

48.5

49.0

$49.5

Budget ActSpending Level

Spending LevelAfter MakingTrigger Cuts

Estimate ofMinimum Guaranteea

(In Billions)

$48.7

$47.2

$49.1





however, also contained a provision speciying thati no such ballot measure passed, the state wouldbe required to provide an additional $2 billion insettle-up payments or K-14 education, reecting

the increase in the 2011-12 minimum guarantee i certain sales tax revenues had been included in theProposition 98 calculations. o date, no such ballotmeasure has been adopted. Tereore, in calculatingthe minimum guarantee or 2012-13, our orecastassumes that all sales tax revenues are includedin the Proposition 98 calculation, increasing the2011-12 spending base by $2 billion. Tat is, eventhough the spending level with the trigger cutswould be $47.2 billion, we calculate the 2012-13guarantee assuming a 2011-12 base o $49.1 billion.

Te budget package species that this settle-upobligation is to be paid in equal installments over ave-year period, beginning in 2012-13. We estimateannual payments o almost $400 million to satisy this obligation.

Revisions in Redevelopment Savings Result inHigher General Fund Costs. Te 2011-12 budgetpackage also assumed the state would receive$1.7 billion in General Fund savings as a result

o redevelopment agencies making “remittancepayments” to school districts. As discussed in moredetail later in this chapter, our orecast assumesthe state will receive $300 million less than theinitial estimate. As a result, the General Fundshare o Proposition 98 costs or 2011-12 is up by about $300 million. (As specied in current law,we assume any increase in local redevelopment-related revenue or school districts would provideno General Fund benet afer 2011-12.)

Propositio 98 ForecastSteady Increases in Proposition 98 MinimumGuarantee Troughout Period. Te top part o Figure 3 shows our projections o the Proposition 98minimum guarantee throughout the orecast

Figure 3

Proposition 98 Forecast


2012-13 2013-14 2014-15 2015-16 2016-17

Minimum Guarantee General Fund $37,240 $39,649 $41,810 $44,556 $46,451

Local property tax 14,023 14,159 14,295 14,459 15,067 a

Totals $51,263 $53,808 $56,105 $59,015 $61,518

Percent change 4.3% 5.0% 4.3% 5.2% 4.2%

Proposition 98 “Test” 2 1 1 2 2

Key Factors

K-12 average daily attendance 0.08% -0.07% -0.24% -0.13% 0.01%

Per capita personal income (Test 2) 4.04 3.41 3.61 4.74 4.10

Per capita General Fund (Test 3) 4.28 5.29 4.81 5.85 4.74

Preschool through community colleges (P-14)cost-o-living adjustment

3.09 1.75 2.16 2.41 2.51

Year-to-Year Change in Guarantee $2,127 $2,545 $2,297 $2,910 $2,503 Baseline Costs

P-14 attendance $82 $18 -$54 $1 $71

P-14 COLA 873 669 888 1,146 1,249

Backll o one-time actions 2,283 — — — —

Totals $3,238 $687 $834 $1,147 $1,320

Funds Available/Shortall (+/-) -$1,111 $1,858 $1,463 $1,763 $1,183 a Our orecast assumes the state will have ully repaid the Economic Recovery Bonds by the end o all 2016, with the “triple fip” ending in spring 2017 and related local property

tax revenues thereater fowing back to schools and community colleges.





period. For 2012-13, we project the minimumguarantee will be $51.3 billion, or 4.3 percent, higherthan the revised prior-year level (o $49.1 billion).Tereafer, we project year-to-year increases in the

minimum guarantee ranging rom $2.3 billionto $2.9 billion, reecting 4 percent to 5 percentannual increases. Although not reected in thegure, the state’s outstanding maintenance actorobligation would remain more than $10 billionthroughout the orecast period. Also not shown inthe gure, we assume the state continues to carry a $1.5 billion settle-up obligation rom 2009-10but makes no associated payments throughout theperiod. We also assume the state continues to make$450 million payments associated with the Quality

Education Investment Act in 2012-13 and 2013-14and then makes a smaller nal payment to retirethe obligation the ollowing year.

Except or 2012-13, Year-to-Year Growthin Guarantee to Exceed Growth in BaselineCosts. Te middle part o Figure 3 shows someo the key actors that underlie the orecast and/or drive education costs. As shown, K-12 ADAis projected to be virtually at throughout theperiod. Projected growth in per capita GeneralFund ranges rom 4 percent to 6 percent whereasgrowth in per capita personal income is slightly less,ranging rom 3 percent to 5 percent. Te cost-o-living adjustment (COLA) or preschool throughcommunity colleges (P-14) hovers around 2 percentthroughout the period. Te bottom part o Figure 3compares our projection o the year-to-year changein the Proposition 98 minimum guarantee withthe amount needed to und annual increases inbaseline costs. As shown in the gure, except or2012-13, the minimum guarantee would grow by more than is needed or the state to und changesin enrollment and ination. Over the last our yearso the period, the guarantee would grow by a totalo $6.2 billion more than needed to cover baselinecosts. Nonetheless, as discussed in more detailbelow, the state still would ace notable budgetchallenges.

major Propositio 98 IssesWe believe the Legislature should be mindul

o several major issues as it begins to crat aProposition 98 budget or the coming scal year.

Eect o Current-Year rigger Cuts on School Districts Will Vary. Unsurprisingly, given thediversity among Caliornia’s school and community college districts, the Proposition 98 triggerreductions will aect dierent types o districtsdierently. Understanding these impacts can helpinorm the Legislature’s 2012-13 budget decisions.

• Some Districts AlreadyHavePlanned

forReductions. Te districts that wouldbe aected the least adversely by triggercuts are those that built their 2011-12budgets assuming some reduction inProposition 98 per-pupil spending. Tesedistricts likely budgeted cautiously giventhe continued uncertainty regarding atax package, concerns with the reliability o the $4 billion in additional revenueassumed late in budget negotiations, andthe borrowing constraints they aced dueto the new 2011-12 deerral o $2.1 billion.As a result o already making program-matic reductions, many o these districtsare carrying relatively solid reserves. Tus,these districts likely will respond to triggercuts by drawing down their reserves butmake ew, i any, midyear reductions.

• OtherDistrictsSignicantlyAffected. Incontrast, the districts likely to be the mostaected by the trigger reductions are thosethat made ew initial reductions in their2011-12 programs. Instead, these districts

were more optimistic in their budgetassumptions—both assuming additionalstate revenue would materialize in 2011-12and increasing their borrowing to sustainprior-year program levels. Tese districtswill tend to be carrying less robust reserves.As a result o all these local decisions, these





districts will ace much more diicultoptions in response to the trigger cuts.hey, like the districts described above,likely will rst draw down their reserves. I

their reserve levels, however, reect only theminimum levels required by state law, they would not be adequate to absorb the entirecut. School districts also will ace challengesgiven that collective bargaining and impasseprocesses likely will make negotiatingadditional urlough days dicult, despitebeing authorized in state law. Given schooldistricts also cannot impose teacher layosmidyear, these districts could need to makesignicant reductions in classied sta and/

or service programs that rely on temporary teachers. Under a worst-case scenario,these districts could run out o cash the lastew months o the year, be unable to makepayroll, and require an emergency state loan(or which the district pays all associatedcosts and loses local control or a period o up to 20 years).

Given Size o Budget Problem, Legislature Needsto Consider Whether It Can Fund the MinimumGuarantee in 2012-13. Based upon our orecast, the2012-13 minimum guarantee would be more than$4 billion higher than the revised 2011-12 spendinglevel (afer making the trigger cuts). With a projected2012-13 overall state budget shortall o $13 billion,the state will need to consider whether it can providethat large o an augmentation to school districts andcommunity colleges. I the Legislature determinedthat such a sizeable Proposition 98 augmentationwould make balancing the overall state budgettoo diicult, it could consider suspending theProposition 98 minimum guarantee and providingeither no or less growth in Proposition 98 unding.Retaining the revised 2011-12 spending level orproviding a smaller-than-$4 billion augmentationwould aect districts dierently. As discussed above,some districts would be either keeping program-matic support at or making slight programmaticincreases. In contrast, other districts would have to

make programmatic reductions in 2012-13 undereither o these scenarios.

Remainder o Forecast More Robust but Not

Enough to Retire Existing Obligations. As showntoward the bottom o Figure 3, we project theminimum guarantee will increase by an averageo $2.5 billion a year—or $10 billion cumula-tively—rom 2013-14 through 2016-17. Even thisnotable growth, however, does not appear su-cient to allow the state to retire all o its existingProposition 98-related obligations. For example,even i the state dedicated this entire amounttoward unding revenue limit COLAs and payingdown the existing revenue limit decit actor, it

still would end the period with almost $1 billionin outstanding revenue limit obligations. Over thecourse o this period, the state would have oregoneCOLAs or all other Proposition 98 programs,and it would have continued to make more than$10 billion in late Proposition 98 payments eachyear. Moreover, by the end o the period, thestate still is projected to be carrying a more than$10 billion maintenance actor obligation and a$1.5 billion settle-up obligation.

Maintenance Factor Issues Remain. In recentyears, disagreements have emerged regarding howto run the Proposition 98 calculations in certainsituations, with dierences in interpretationleading to results that can dier by billions o dollars. Te main disagreements relate to whenmaintenance actor is created and paid. Forexample, in 2011-12, depending upon one’s inter-pretation o the State Constitution and associatedstatutory provisions, either no maintenanceactor was created or $2.5 billion in maintenanceactor was created. Moreover, the issue o how to

pay maintenance actor can aect the long-termProposition 98 unding level. Depending on one’sinterpretation o how to pay maintenance actor,dierences o hundreds o millions to billions o dollars are at stake. o make matters even morecomplicated, dierent combinations o perspectiveson maintenance actor creation and payment canlead to even greater dierences in results. Unless





the Legislature (or voters) resolve these disagree-ments, calculating the Proposition 98 minimumguarantee will become increasingly problematicmoving orward.

Cild Care ad Deelopet (CCD)raditionally, CCD programs have been unded

through a combination o state Proposition 98General Fund and ederal unds. he 2011-12Budget Act departed rom this practice and insteadused non-Proposition 98 General Fund or thestate’s share o all CCD programs except or StatePreschool. Tus, we include State Preschool withinour Proposition 98 orecast but run a separateorecast or the remaining CCD programs.

Current-Year Adjustments or CCD Programs.Te 2011-12 Budget Act provided $374 million inProposition 98 General Fund monies or StatePreschool and $1.1 billion in non-Proposition 98General Fund or all other CCD programs. Tetrigger cuts would result in a $23 million reductionto these programs ($6 million in State Preschooland $17 million in reductions to all other CCDprograms). We expect most programs will realizethese savings by disenrolling some children whoare currently being served. (Current law generally requires programs to disenroll children romamilies earning the highest incomes rst.) Morethan osetting the drop in non-Proposition 98spending, we estimate 2011-12 General Fund childcare costs have increased by $26 million due tohigher-than-expected Stage 2 caseload.

Future CCD Costs Reect Ripple Eects o emporary CalWORKs Policy Changes. Movingorward, we project overall CCD costs (excludingState Preschool) will decline slightly in 2012-13,

then grow to almost $1.4 billion by 2016-17. ForCaliornia Work Opportunity and Responsibility toKids (CalWORKs) child care, we project a declineand then slow growth in costs over the early yearso the period, largely resulting rom temporary CalWORKs policies that were in eect or 2009-10through 2011-12. Speciically, participation in

CalWORKs Stage 1 child care (unded through theDepartment o Social Services) has decreased by nearly 30 percent since 2008-09 due to temporary exemptions that allowed certain amilies to receive

cash grants without meeting work participationrequirements. We assume that this reduction inStage 1 caseload will subsequently lead to reducedStage 2 and Stage 3 caseload over the next severalyears, thereby curbing the state’s child care costs.We project costs will increase more rapidly (average o 10 percent) in the latter three yearso our orecast, when we expect normal childcare usage patterns will resume and increases inoverall CalWORKs caseload will have resulted inmore child care enrollments. For non-CalWORKs

CCD programs (General Child Care, AlternativePayment, and migrant programs), we assume costsincrease gradually over the orecast period, withyear-to-year changes growing rom 1 percent in2012-13 to 5 percent by 2016-17. Tis trend reectsdeclines and then slow growth in the populationo children under age our, together with annualCOLA rates o roughly 2 percent.

hIGhER EDuCATIOn

In addition to the community colleges (whichare discussed above as part o the Proposition 98orecast), the state’s public higher educationentities include the University o Caliornia (UC),the Caliornia State University (CSU), and theCaliornia Student Aid Commission (CSAC).

uC ad CSuCurrent-Year rigger Cuts or Universities.

Based on our revenue orecast, we have assumed

$100 million in trigger cuts each or UC and CSU.Cuts o this magnitude amount to about 4.5 percento the universities’ General Fund support. However,given that the universities’ core unding alsoincludes a signicant amount o tuition revenue,the programmatic reduction experienced by theuniversities would be about 2 percent at UC and3 percent at CSU. Te universities have limited





cost obligations. Tis is no longer the case, withUC recently reinstituting employee payrollcontributions and UC employer contributionstoward UCRP. Tese contributions, however, are

insucient to cover all o UC’s projected retirementcosts. Tough UC recently has begun requestingincreased state General Fund support to help closethis gap, the state has yet to appropriate unds orthis purpose.

Calioria Stdet Aid CoissioCal Grant Programs. Most o the state’s direct

General Fund support or student nancial aid isprovided through the CSAC’s Cal Grant programs,which oer tuition coverage and subsistence grants

to eligible students. Tese costs are aected bothby the number o students participating in theprograms and the universities’ tuition charges. Asdiscussed above, we do not anticipate signicantchanges in enrollment levels. However, recenttrends in tuition increases, coupled with statementsby the universities, suggest that UC and CSU tuitionwill continue to increase. As a result, we project thatCal Grant costs will increase rom $1.4 billion in2011-12 to $2.3 billion at the end o the orecastperiod. Our orecast also takes into account costs

associated with passage o the Caliornia DreamAct o 2010. Among other provisions in the act,Chapter 604, Statutes o 2010 (AB 131, Cedillo),makes some nonresident students eligible to receivestate nancial aid beginning in 2013.

key IssesGiven that state General Fund resources are

likely to continue to be severely constrained or thenext several years, the Legislature aces several key questions with regard to the higher education budget.

• HowMuch Should Students Pay? Asnoted above, the universities have signaledthat they could continue to increase tuitionsignicantly or at least the next severalyears. Te Legislature may wish to providedirection to the universities with regard tothe share o education cost that non-needy students should be expected to pay.

options or accommodating midyear reduc-tions, as most decisions aecting workload orthe remainder o the academic year (admissionsand course scheduling or example) were made

months earlier. Unless the universities indsources o replacement revenue (such as through amidyear tuition increase), they will have to accom-modate the reductions with some combination o drawing down reserves, borrowing, and reducingper-student costs.

Overall University Costs Projected to Be Flat Troughout Forecast. Our orecast assumes theuniversities’ annual General Fund operating costswill be roughly $4 billion over the course o the

orecast period. Tis reects our overall orecastapproach o not providing automatic COLAs,as well as an absence o college-age populationgrowth.

Enrollment Projected to Be Flat. Enrollment atthe universities is aected by demographic changesin the student population as well as demand amongeligible individuals. we project that demographicgrowth in the student population will slow and thenbecome negative by the end o the orecast period.Tough enrollment demand at the universities isdicult to project, as it depends on many dierenteconomic and social orces, we assume a modestincrease in demand would generally be canceledout by the projected demographic declines.We thereore assume no increase in university enrollment during the orecast period.

UC Retirement Program Costs Not Included inForecast. Because no statutory ormula or plan hasbeen adopted governing state support or the UCRetirement Program (UCRP), we did not include

General Fund costs or UCRP in our orecast. Basedon discussions with UC, however, we estimate thatUC could request state General Fund contribu-tions exceeding $400 million annually by theend o the orecast period. Beginning in the early 1990s, neither the state nor UC employees madecontributions to UCRP. Tis was because UCRPinvestments were sucient to cover retirement





• HowCanCalGrantCostsBeManaged?

Because state law currently provides ora corresponding increase in Cal Grantpayments when UC and CSU raise their

tuition, state General Fund costs are drivenin part by independent actions by the univer-sities’ governing boards. In some cases, theuniversities’ decisions to increase tuitionare made afer passage o the state budget.Te Legislature may wish to explore ways tobetter manage its own expectations or CalGrant costs at the time o budget passage.

• HowShould theUniversitiesReduce

OperatingCosts? Since the onset o the

current recession, General Fund supportor UC and CSU has declined by about aquarter. Much o this reduction has beenbackilled with revenue rom studenttuition increases. Given the likelihood o continuing state budget constraints orthe next several years, it may be necessary or the universities to urther reduce theiroverall costs. he Legislature may wishto express expectations with regard tocost-saving opportunities related to actorssuch as aculty teaching and researchexpectations, student remediation rates,articulation o course sequences, studentassessment and placement, and expansiono distance education and other alternativemodes o instruction.

• HowShould theState AddressUCRP

Costs? As noted above, UC’s current eortsto restart UCRP contributions envision acorresponding increase in General Fundsupport, reaching several hundred million

dollars per year by the end o the orecastperiod. Besides the magnitude o any augmentation, the Legislature also willhave to consider how state support would beadjusted in uture years, including potentialincreases or decreases in UCRP normalcosts and ununded liabilities.

hEALTh AnD

humAn SERvICES

Overview o Services Provided. Caliornia’smajor health programs provide health coverageand additional services or various groups o eligible persons—primarily poor amilies andchildren as well as seniors and persons withdisabilities. Te ederal Medicaid program, knownas Medi–Cal in Caliornia, is the largest state healthprogram both in terms o the amount o undingand number o persons served. In addition, thestate supports various public health programs,community services, state-operated acilities orthe mentally ill and developmentally disabled,

and health care insurance or children throughthe Healthy Families Program. Beyond thesehealth programs, the state provides a variety o human services and benets to its citizens. Teseinclude income maintenance or the aged, blind,or disabled; cash assistance and welare-to-work services or low-income amilies with children;protection o children rom abuse and neglect; andthe provision o home-care workers who assist theaged and disabled in remaining in their own homes.Although various state departments oversee the

management o these programs, the actual delivery o many services is carried out by county welareand child support oces, and other local entities.Health programs are largely ederally and stateunded, while most human services programs havea mixture o ederal, state, and county unding.

Overall Spending rends. Te 2011-12 budgetprovided $25.2 billion in General Fund spendingor health and human services (HHS) programs.Tese costs would have been signicantly higher,

but the realignment package discussed earliershifed $3.5 billion o state costs to counties. Wenow estimate that these General Fund costs willbe about $25.9 billion in 2011-12, primarily dueto higher-than-anticipated costs in Medi-Cal andIn-Home Supportive Services (IHSS). Based oncurrent law requirements, we project that GeneralFund spending or HHS programs will increase





to about $27.2 billion in 2012-13 and $28.6 billionin 2013-14. Over the inal three years o theorecast, we project that spending will increase by about $1.6 billion each year, eventually reaching

$33.4 billion. All o our estimates include annualsavings o about $325 million pursuant to thetrigger reductions or Medi-Cal programs operatedby the Department o Developmental Services andIHSS.

Although the average annual increase in HHSspending is 5 percent during the orecast period,there is substantial variation in spending growthrates by program. General Fund spending or thestate’s largest HHS program, Medi-Cal, averages

6.8 percent per year during the orecast period.Conversely, the Supplemental Security Income/State Supplementary Program (SSI/SSP) andCalWORKs programs are both projected to haveaverage annual growth o around 3 percent.

Anticipated Lower Caseload Growth ReducesCost Pressures. he recent recession raisedunemployment and reduced income, resultingin historically high numbers o Caliorniansenrolling in state HHS programs. As a result,caseload growth or many HHS programs rom2008-09 through 2011-12 was well above historicaltrends. Our economic orecast assumes modestbut sustained employment growth over the nextve years. Accordingly, our caseload projectionsor many HHS programs relect substantially lower growth rates compared to the experience o recent years. Tis in turn reduces cost pressures.Below, we discuss spending trends in the majorHHS programs.

Impact o Federal Aordable Care Act (ACA).

Te ACA, also reerred to as ederal health carereorm, is ar-reaching legislation that will changehow millions o Caliornians access health carecoverage. Among many other provisions, the newederal law expands ederal unding and eligibility or the Medi-Cal Program and mandates thatindividuals obtain private or public health coverage.

Some key provisions will not take eect until 2014.Te scope o ACA is so broad that it will be yearsbeore all o its provisions will be ully implementedand its overall ramications ully understood. Our

scal orecast includes some signicant budgetary adjustments to account or the implementationo ACA. Some o these adjustments result in costincreases or the state while others result in savings.

medi-CalOverall Spending rends. We estimate that

in the current year General Fund spending orMedi–Cal local assistance administered by theDepartment o Health Care Services will amountto $15.1 billion. Tis is about $450 million, or

3.1 percent, more than appropriated in the 2011-12Budget Act . We project that General Fund supportwill grow to $15.6 billion in 2012-13, a 3.2 percentincrease rom current-year expenditures. helargest actors contributing to this year-over-yearspending growth are: (1) increases in caseload,utilization o services, and rising costs or thoseservices; (2) costs or replacing one-time savingsrom a budget maneuver that accelerated providerpayments and reduced expenditures in the 2011-12budget; and (3) ull-year savings in 2012-13 rom

various cost-containment measures implementedin part o 2011-12. Afer 2012-13, we project thatGeneral Fund spending will increase by about8 percent each year, reaching a total o $21 billionby 2016-17.

Key Program Cost-Drivers. We assume that thecost per person or Medi-Cal health services willgrow at an average annual rate o 5.4 percent overthe entire orecast period. We also project that thenumber o individuals enrolled in Medi-Cal undercurrent eligibility rules will grow at an average rateo only 0.8 percent per year. However, the overallMedi-Cal caseload will grow more than 6 percentannually due to actors related to the ACA, mostnotably expanded eligibility beginning in January 2014. Te impact o the ACA on our Medi-Calspending orecast is discussed below.





Key Assumptions Related to Cost-Containment Measures. Te 2011-12 budget assumed savingsrom a variety o cost-containment measures, suchas copayments and utilization limits, or which the

state is still awaiting ederal approval. Our orecastassumes the implementation o these measures willbe delayed several months, resulting in an erosiono 2011-12 budget savings. We assume, however,a ull year o savings rom the cost-containmentmeasures in 2012-13. We also assume the statewill implement provider rate reductions recently approved by the ederal government, despiteongoing legal challenges.

ACA Impacts. Implementation o ACA will

have a series o impacts on the Medi-Cal Programover the orecast period. For example, the ederalgovernment will initially cover the health servicecosts or individuals who become eligible orMedi-Cal in 2014 under the expanded eligibility categories required in the ACA. Our spendingorecast captures a partial-year eect in 2017,when the state will pay or a small proportiono costs associated with the expanded eligibility categories. Te state will also share costs or any increase in caseload in existing eligibility categoriesthat results rom persons enrolling in Medi-Calin response to the individual coverage mandatecreated under ACA. We note that, due to ACA,our estimates related to caseload growth and otheractors impacting program expenditures contain asignicantly greater degree o uncertainty.

metal healtWe estimate that General Fund spending or the

Department o Mental Health (DMH) in 2011-12will be about $1.3 billion and will grow very slowly,approaching $1.4 billion by 2016-17. GeneralFund spending would have remained virtually unchanged during the orecast but or an almost$80 million increase in DMH sta costs to providetreatment services or mentally ill inmates at a newprison acility in Stockton.

Current-Year Impacts. As shown earlierin Figure 1, General Fund spending or DMHprograms decreased rom almost $1.8 billionin 2010-11 to $1.3 billion in 2011-12. his net

decrease o $540 million can be attributed to twomain actors: (1) realignment-related state savingso $762 million rom replacing General Fundexpenditures or the Early and Periodic Screening,Diagnosis, and reatment Program and MentalHealth Managed Care with Proposition 63 unds;and (2) partially osetting cost increases (includingadditional General Fund expenditures to replaceexpiring enhanced ederal matching unds thatwere available in the prior year).

Deelopetal SericesWe estimate that the General Fund spendingor developmental services in 2011-12 will total$2.5 billion, assuming that the “revenue” triggerdiscussed earlier is pulled to achieve $100 millionin ongoing savings. We project that General Fundsupport will grow to more than $2.7 billion in2012-13, an increase o more than 8 percent romcurrent-year expenditures. his year-over-yearprojected growth is largely due to increasedcaseload, utilization o services, and rising costs or

community services provided by regional centers. Itis also due to the expiration o temporary providerpayment reductions that were implemented as acost-cutting measure.

We project that General Fund support will growto $3.2 billion by the end o the orecast periodin 2016-17. Tis projected growth is largely dueto increased caseload, utilization o services, andrising costs or community services. Our orecastassumes that regional center caseloads will growat an annual average rate o 3 percent, and thatcosts overall will grow at an average annual rateo about 5 percent.

CalWORksOverall Spending rends. For 2011-12, the

state budget provided $1 billion rom the GeneralFund or CalWORKs. Tis amount reects the





impact o the 2011 realignment legislation, whichshifed about $1.1 billion in CalWORKs grant coststo the counties. We project that General Fundspending or CalWORKs will be about $1.1 billion

in 2011-12 or approximately $75 million above the2011-12 Budget Act appropriation, due to higher-than-projected caseload. From this current-yearbase, we project spending will increase by about$400 million in 2012-13, stay airly at in 2013-14,and then decline in each o the next three yearsto around $1.2 billion in 2016-17. Te increasein CalWORKs costs over the next two years isprimarily the result o (1) the restoration o short-term reductions, (2) caseload growth, and (3) thestate’s ixed ederal emporary Assistance or

Needy Families (ANF) block grant, which doesnot adjust or caseload changes. Long-term costdeclines are primarily driven by projected declinesin caseload levels.

Cost o Restoring Short-erm Policy Changes.For 2011-12, the Legislature achieved majorongoing CalWORKs savings through grant andeligibility reductions and additional short-termsavings o over $400 million. he short-termsavings included (1) extending certain exemptionsrom work participation requirements with a corre-sponding $375 million reduction in county block grants or employment services and child care and(2) suspending the case management portion o theCal-Learn program or teen parents who remain inschool, or a General Fund savings o $44 million.Our orecast reects the complete restoration o these reductions beginning in 2012-13. (We notethat the state General Fund bears 100 percent o these costs because the ederal ANF block grantand county realignment unds do not adjust orcaseload or policy changes.)

Caseload Levels Driven Mainly by Economic Conditions. Historically, changes in employmentlevels have signiicantly aected CalWORKscaseload growth. During the recent economicdownturn, the growth rate o the CalWORKscaseload increased signiicantly. Conversely,

during previous periods o employment growth,the CalWORKs caseload grew at a slower rate ordeclined. Our orecast o CalWORKs caseloadrelects this empirical relationship between

caseload and employment. Te budget orecastscaseload growth o 1.2 percent in 2011-12. Basedon recent caseload data, we estimate slightly higher caseload growth o 2.5 percent, resulting inadditional costs o about $75 million. In 2012-13, asemployment growth begins to increase, we projectcaseload will grow by only 0.6 percent. Beginningin 2013-14, we expect the caseload to gradually decline over the remainder o the orecast period.

SSI/SSP

State expenditures or SSI/SSP are estimated tobe $2.8 billion in 2011-12 and 2012-13. Beginning in2013-14, we project that General Fund support orSSI/SSP will increase by an average o $80 millionper year, reaching $3.2 billion by 2016-17. heprojected spending increases are primarily due toaverage annual caseload growth o about 2 percentwith somewhat higher growth rates in the lateryears to reect the aging o the population.

IhSSFor 2011-12, we estimate that General Fund

spending or IHSS will exceed the budget actappropriation by roughly $300 million, resultingin total costs o about $1.5 billion. We then projectthat costs will decrease to around $1.3 billion in2012-13. Tese amounts reect implementation o revenue triggers mentioned earlier and a specicIHSS trigger discussed below which will resultin combined savings o $110 million in 2011-12and $350 million annually thereafer. Finally, weproject only modest growth in program cost inthe out-years.

Budget Solutions and Unrealized Savings.Te 2011-12 budget reects a package o solutionsincluding (1) receipt o additional ederal undsdue to a provider tax and implementation o theCommunity First Choice option under the ederalACA, (2) elimination o services or recipients





whose need or services has not been certied by a medical proessional, (3) a medication dispenserinitiative, and (4) program integrity activities.Altogether, the budget assumed these initiatives

would result in about $600 million in programsavings in 2011-12. However, we estimate that thispackage will only save about $200 million in thatyear. Most o the unrealized savings in 2011-12are related to delays in the implementation o themedication dispenser initiative and the Community First Choice option, along with overestimation o savings rom other solutions.

Medication Dispenser Initiative and Budget rigger.As part o the 2011-12 budget, the Legislature

established a medication dispensing pilot programintended to improve medication compliance amongMedicaid recipients, estimated to result in annualnet cost avoidance o $140 million rom reducednursing home placement and hospital admissions.Budget legislation requires the Department o Finance (DOF) to report to the Legislature by April10, 2012 on how much savings the pilot is likely to achieve. At that time, the Legislature will haveuntil July 1, 2012 to enact alternative legislation toachieve a total o $140 million in ongoing savingsrom the medication pilot and/or new initiatives.I the DOF determines that these legislativeactions are insucient to achieve $140 million insavings, an across-the-board reduction in IHSShours sucient to meet this savings target willbe implemented in 2012-13. Our orecast assumesthat no savings rom the medication dispensingpilot will be achieved in 2011-12, but that the ull$140 million target will be achieved beginning in2012-13.

Caseload Growth. Our orecast assumes

that IHSS caseload will grow 3 percent per yearthroughout the orecast period. Our orecast ishigher than the trend observed in 2009 and 2010,but below the rapid caseload growth that occurredprior to those years.

JuDICIARY AnD

CRImInAL JuSTICE

Te major state judiciary and criminal justiceprograms include support or two departments inthe executive branch—the Caliornia Departmento Corrections and Rehabilitation (CDCR) and theDepartment o Justice—as well as expenditures orthe state court system.

CDCRWe estimate that General Fund spending or the

support o CDCR operations in the current yearwill be about $7.7 billion, which is $1.5 billion, or16 percent, less than the 2010-11 level o spending.

Tis primarily reects the estimated savings rom(1) the realignment o certain lower-level oenders,parole violators, and parolees to counties beginningOctober 1, 2011 and (2) use o realignment revenuesin the current year to reimburse CDCR or lower-level oenders in state prison who were sentencedprior to October 1. Our estimate o current-yearspending is also lower because o assumed triggerreductions. Counties would be required to pay $125,000 per year to the state or each juvenileoender committed to the Division o Juvenile

Facilities, resulting in an estimated savings o $79 million in the General Fund cost o operatingstate youth correctional acilities in 2011-12. Inaddition, there would be a $20 million unallocatedreduction to CDCR’s budget.

Our orecast projects that General Fundspending on corrections will increase to about$8.6 billion in 2016-17. As indicated above, the2011-12 realignment package assumed that theLocal Revenue Fund 2011 (realignment revenues)

would reimburse CDCR about $1.2 billion or costsincurred in 2011-12 or lower-level oenders in stateprison who were sentenced prior to October 1, 2011.Our orecast assumes that the General Fund willreplace the $1.2 billion in 2012-13 and uture years.In addition, as discussed in more detail below, ourprojections also reect actions to reduce the state’sinmate population as well as additional costs that





construction o tens o thousands o additionalprison beds. Our projections assume that about15,300 additional beds will be constructed pursuantto AB 900 during the orecast period, resulting in

an estimated $800 million in additional GeneralFund expenditures annually to sta and operatethe new acilities. As the new acilities are built, theLegislature will need to make policy and budgetary decisions regarding the level o programming andstang to be provided at these acilities, whichwill determine the actual increase in operationalcosts. Given the likely magnitude o these eventualcosts, as well as the signicant reduction in thestate’s inmate population resulting rom the ederalcourt ruling to reduce prison overcrowding, the

Legislature may want to hold o rom movingorward with some o the projects authorized underAB 900.

Jdicial BracWe estimate that General Fund spending or

the support o the judicial branch in the currentyear will be about $1.2 billion, which is roughly $500 million lower than the amount appropriatedin the 2011-12 Budget Act . Tis estimate primarily reects the estimated General Fund savings rom

the realignment o court security to county sheris.Our orecast assumes that state spending on the judicial branch will remain roughly lat rom2011-12 through 2016-17.

CDCR will incur to sta and operate new prisonacilities expected to be constructed during theorecast period.

Projected Savings From Reduced InmatePopulation... Our orecast assumes that therealignment o certain criminal oenders romthe state to the counties will reduce CDCR expen-ditures by $1.5 billion annually upon ull imple-mentation in 2014-15. Although this realignmento services would signicantly reduce the state’sinmate population, and go a long way towardscomplying with a ederal court order to reduceprison overcrowding, it may all short in meetingthe requirements within the deadlines established

by the court. (Please see nearby box or moredetailed inormation about the ederal court order.)Tus, our orecast assumes annual savings o over$100 million beginning in 2012-13 rom additionalinmate population reduction measures that wouldlikely need to be adopted to comply with the courtorder. However, the actual savings achieved wouldlargely depend on the specic actions taken tourther reduce prison overcrowding.

…But Increased Costs to Operate Planned AB900 Facilities. In 2007, the Legislature enactedChapter 7, Statutes o 2007 (AB 900, Solorio),in order to relieve the signicant overcrowdingproblems acing state prisons and improverehabilitation. Specically, AB 900 authorizes the

Federal Cort Order to Redce Priso OercrowdigOn May 23, 2011, the U.S. Supreme Court issued a ruling in a lawsuit against the state

involving prison overcrowding. Specically, the court upheld the ruling o a ederal three-judgepanel requiring the state to reduce overcrowding in its prisons to 137.5 percent o the system’soverall “design capacity” within two years. Currently, the state prison system is operating at

roughly 180 percent o design capacity—or about 32,000 inmates more than the limit establishedby the three-judge panel. Te ruling, however, did not speciy the particular measures that thestate must implement to comply. On June 7, 2011 and July 21, 2011 the administration submittedreports to the three-judge panel describing specic measures that were recently taken, as wellas those in the process o being implemented, to reduce overcrowding in Caliornia prisons.For more detailed inormation, see our recent publication, A Status Report: Reducing PrisonOvercrowding in California (August 2011).





OThER PROGRAmS

Redeelopethe 2011-12 budget package included two

measures designed to generate (1) $1.7 billion instate education savings in the current year and(2) about $400 million in increased resourcesor school districts annually thereater. Underthese measures, each city or county with aredevelopment agency must choose whether toretain its redevelopment agency and make annualremittance payments to local school districts orallow its agency to be eliminated. Under eitherscenario, school districts receive additional localunding, either rom remittance payments or

property tax revenues redirected rom the expiredredevelopment agencies. In 2011-12, the remittancepayments are intended to offset state undingobligations or schools. In 2012-13 and utureyears, the ongoing remittance payments (about$400 million annually) are intended to supplement the resources the state provides to schools.

Our orecast estimates that state educationsavings in the current year will be about $1.4 billion,about $300 million less than the amount assumed

in the budget because:

• As permitted by law, DOF reduced the remit-tance payment obligations or certain localgovernments that experienced increases intheir redevelopment debt obligations.

• Some cities and counties are expectedto allow their redevelopment agencies toexpire and that the amount o property taxes redirected rom the expired agencieswill be less than the local governments’

remittance payments.

• Some o the remittance payments andproperty tax revenues will be allocated toschool districts that do not receive stateunding or apportionments (so-called

“basic aid districts”). Tese unds, thereore,will not oset state school costs.

On November 10, 2011, the Caliornia Supreme

Court heard a case challenging the constitutionality o the redevelopment bills. A decision is expectedby January 15, 2012.

Eployee CopesatioDuring 2010-11, the Legislature ratied new

memoranda o understanding (MOUs) with eacho the state’s 21 collective bargaining units. TeseMOUs reduced state employee compensation coststhrough (1) the Personal Leave Program (PLP),which decreased most employees’ pay by about5 percent or the rst 12 months o the new MOU’s,and (2) increased employee pension contributions.Te 2011-12 Budget Act also directed the CaliorniaPublic Employees’ Retirement System (CalPERS) toreduce employee health benet costs by $80 million(General Fund).

Net Costs Beginning in 2012-13. Our orecastassumes that the state will achieve all o theMOU-related employee compensation savingsanticipated in the 2011-12 Budget Act ($135 millionGeneral Fund) , but only $47 million o the antici-

pated savings in health benets costs. Beginning2012-13, our orecast assumes that employeecompensation costs grow because:

• Te temporary salary reductions associatedwith the PLP end in 2011-12.

• Employees at the top step o the salary rangewill receive pay increases as provided by the MOUs.

• Employee health care costs increase at anaverage annual rate o 7.6 percent.

By 2016-17, we orecast employee compen-sation costs (nonretirement) will be more than$550 million higher than in 2011-12, principally due to higher health care costs.





Pblic Eployee Retireet CostsOur orecast reects current-law increases in the

state’s annual payments to (1) pension programs orstate and CSU employees, (2) teachers’ pensions,

(3) state and CSU retiree health benet programs,and (4) pension programs or judges. (Te teachers’pension program is administered by the CaliorniaState eachers’ Retirement System [CalSRS], andthe other three programs are administered by CalPERS.) Figure 4 shows the recent history andorecasted trend or General Fund budgetary costsrelated to these retirement programs.

CalPERS Contributions Driven by Pay Raises,Investments, and Actuarial Methods. Our orecast

assumes that the state’s required contribution toCalPERS or state and CSU pensions rises rom$3.6 billion (all unds) in 2011-12 to $3.8 billionin 2016-17. (O the $3.6 billion to be contributedin 2011-12, about $2.1 billion is expected to bepaid rom the General Fund. Tis General Fundcontribution grows to $2.2 billion in our orecast

in 2016-17.) Tis assumes that CalPERS does notchange its current actuarial rate-setting practices(including rate “smoothing”) and that in 2012-13and beyond, CalPERS investment returns hit the

system’s assumed investment target o 7.75 percentper year. Moreover, it assumes only the pay increases or state workers that are included incurrent MOUs—or most, a single 3 percent or4 percent pay increase during the entire ve-yearorecast period. Te orecast assumes that stateworkers continue to pay more in contributions toCalPERS throughout the orecast period, as agreedin collective bargaining agreements that wereapproved during the past year.

Tese various orecast assumptions limit thegrowth o the state’s CalPERS contribution ratesin our model. I, by contrast, pay raises were torise aster than we assume, investment returnswere to be signiicantly less, and/or actuarialmethods o CalPERS were to change, the state’srequired payments to CalPERS could be hundreds

o millions o dollars morethan we orecast in 2016-17.

CalSRS ContributionDriven by Rates Set inStatute and eacher Salary Growth. he orecastassumes that the state’scontributions to CalSRSgrow rom $1.3 billion in2011-12 to $1.5 billion in2016-17. State contribu-tions in 2011-12 are basedon a 2009-10 payroll levelor K-12 and community col lege teaching and

administrative personnelo $27.1 billion. Te prelim-inary estimate or 2010-11upon which the state’s2012-13 contributions willbe based is $26.2 billion(down 3.2 percent rom

Current-Law State Retirement Costs to Keep GrowingGeneral Fund (In Billions)

Figure 4

1

2

3

4

5

6

$7

1990-91 1993-94 1996-97 1999-00 2002-03 2005-06 2008-09 2011-12 2014-15

CalSTRSCalPERS Retirement Programsa

CalPERS Retiree Health Programb

Other

Amount for 1997-98 includes an over $1 billion state payment related to a major court case involving CalPERS.

Includes the budget item for these costs and LAO estimate of the General Fund share of the implicit subsidy for annuitantbenefits that is paid along with employees' health premiums.

a

b





2009-10). We assume that statewide payroll remainsairly at through the orecast period.

ypically, the state pays about 4.5 percent o

prior-year teacher payroll to CalSRS, as requiredin contractual commitments that are outlinedin the Education Code. Te system also receivespayments rom school districts and teachers tocover pension program costs, which also are xedin the Education Code. Pursuant to its contractualobligations, the state must contribute additionalunds each year when certain ununded liabilitiesemerge, as they did ater the decline o worldnancial markets in 2008. In our orecast, theseadded contributions total $106 million in 2011-12

and grow to $394 million by 2016-17. (Tese addedcontributions are very small compared to thebillions o dollars o additional unding per yearthat CalSRS will require to remain solvent andeliminate its ununded liabilities over the next ewdecades.)

Retiree Health Costs to Continue Increasing.he orecast assumes continued pay-as-you-gopayments or the vast majority o state and CSUretiree health costs. Tese are orecast to grow rom$1.5 billion in 2011-12 to $2.3 billion in 2016-17.his represents an average 9.4 percent annualgrowth rate during the orecast period. Tis growthis driven by two elements: (1) projected annualgrowth in state employee and retiree health planpremiums and (2) a rising population o state andCSU retirees.

Ununded Liabilities Persist. he state’sretirement programs are projected to havesignicant—and growing—ununded liabilitiesthrough the orecast period. Because our orecast

includes only current-law pension contributionrequirements, it does not include unding sucientto begin to reduce CalSRS’ ununded liabilities(currently estimated to be around $4 billion peryear beginning immediately to eliminate theliabilities over the next 30 years, assuming thatCalSRS achieves its investment targets over thelong term). Moreover, because the state is not

required under current law to contribute additionalunds to UC to address its ununded pension andretiree health liabilities, the orecast includes noGeneral Fund resources to assist UC or these

purposes. It also includes virtually no GeneralFund support to begin paying down large unundedretiree health liabilities or current and past stateand CSU employees. I the state does not take actionconcerning these liabilities soon, the extra costsneeded to retire these ununded liabilities over thenext ew decades will increase dramatically.

Debt Serice o Irastrctre Bodshe state uses General Fund revenues to

pay debt-service costs or principal and interest

payments on two types o bonds used primarily to und inrastructure—voter-approved generalobligation bonds and lease-revenue bonds approvedby the Legislature. We estimate that GeneralFund costs or debt service on these bonds will be$5.2 billion in 2012-13, which is roughly equal tothe state’s General Fund debt-service costs every year since 2009-10. General Fund debt-service costshave not increased signicantly over this period ora ew reasons. Most notably, the Legislature andGovernor enacted legislation to oset some General

Fund debt-service costs with transportation unds.Additionally, the administration slowed the paceo bond sales over the last 18 months, includingthe cancellation o state bond sales during the rsthal o 2011.

Over the orecast period, however, debtservice is projected to grow 6.4 percent annually over the period, reaching $7.3 billion by 2016-17.Projections o debt-service costs depend primarily on the volume o past and uture bond sales, theirinterest rates, and their maturity structures. Teexact timing o bond sales depends upon when various bond-related programs will be in need o unds and the accessibility o nancial and creditmarkets. In general, our orecast assumes thatthe slower pace o bond sales continues or many programs because they currently have sucientbond proceeds to cover their spending needs or





the initial portion o the orecast. Nonetheless, overthe entire orecast period, we assume that a totalo about $36 billion o already authorized generalobligation and lease-revenue bonds will be sold as

currently approved projects move orward. A largeshare o this—about $24 billion—is rom the nearly $54 billion in inrastructure bonds authorized by voters in 2006 and 2008. It also reects the growingissuance o lease-revenue bonds or the prisonsystem authorized by the Legislature in 2007. Wealso expect that transportation debt-service costswill exceed available transportation unds duringthe orecast period and the General Fund willresume paying a portion o these costs. Our orecastis based on the expected sale o bonds that have

already been authorized, but does not include any proposed bonds (such as the water bond scheduledor the 2012 ballot).

Debt-Service Ratio (DSR) Expected to Rise.Te DSR or general obligation and lease-revenuebonds—that is, the ratio o annual General Funddebt-service costs to annual General Fund revenuesand transers—is oten used as one indicatoro the state’s debt burden.Tere is no one “right” levelor the DSR. he higher itis and more rapidly it rises,however, the more closely bondraters, nancial analysts, andinvestors tend to look at thestate’s debt practices and themore debt-service expenseslimit the use o revenues orother programs. Figure 5shows what Caliornia’s DSRhas been in the recent past andour DSR projections or theorecast period.

h e D S R w e a r eprojecting—over 7 percent atits peak—is higher than it hasbeen in the past. In part, thisrelects declines in General

Fund revenues, as well as the continued sale o thelarge bonds approved since 2006. o the extentadditional bonds are authorized and sold in utureyears beyond those already approved, the state’s

debt-service costs and DSR would be higher thanprojected in Figure 5.

State-madated Local Progras(no-Edcatio)

Over the last several years, the Legislaturehas taken various actions to reduce or deercosts or state mandates on local governments(cities, counties, and special districts). heseactions include permanently repealing mandates,suspending statutory requirements to implement

mandates, and deerring payments towardsretiring the state’s backlog o mandate claims (over$1 billion). Te 2011-12 budget shifed the respon-sibility and unding or providing certain mentalhealth services to K-12 students rom countiesto schools (commonly reerred to as “AB 3632”program). his action eliminates the need orongoing mandate payments to counties or thisprogram. Our orecast assumes that the Legislature

Projected Debt-Service Ratioa

Figure 5

a Ratio of annual General Fund debt-service payments to General Fund revenues and transfers.

1

2

3

4

5

6

7

8%

1986-87 1991-92 1996-97 2001-02 2006-07 2011-12 2016-17

Previously Sold

Authorized, but Unsold

Forecast





continues to suspend all mandates it suspended in2011-12. Our orecast also assumes that the statemakes annual payments to retire the backlog o mandate claims, as specied in current law. Under

these assumptions, state costs or mandates wouldincrease rom $48 million in 2011-12 to roughly $200 million annually throughout the orecastperiod.





Legislative Analyst’s Ofce

Legislative AnalystMac aylor ....................................................................................................................... 445-4656

Deputy Legislative AnalystDaniel C. Carson .............................................................................................................319-8303

Corrections, Transportation, and EnvironmentDeputy: Anthony Simbol ...............................................................................................319-8350Managing Principal Analysts:

Farra Bracht, ransportation ...................................................................................319-8355

Mark C. Newton, Environment ...............................................................................319-8323

Education

Deputy: Jennier Kuhn ...................................................................................................319-8332Managing Principal Analyst:Steve Boilard, Higher Education.............................................................................. 319-8331

Health and Human ServicesDeputy: odd Bland ........................................................................................................319-8353Managing Principal Analyst:

Shawn Martin, Health ...............................................................................................319-8362

State and Local FinanceDeputy: Jason Sisney.......................................................................................................319-8361Managing Principal Analyst:

Marianne O’Malley, General Government ............................................................ 319-8315

california legislative analyst's office report: fiscal outlook 2011

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