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From the Desk of Mary Ervin, CFRW President
Submitted by Jeanne Solnordal, CFRW Legislative Analyst
December 12, 2023
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CALIFORNIA BUDGET $68 BILLION DEFICIT PREDICTED
CAL MATTERS BY ALEXEI KOSEFF, DECEMBER 7, 2023,
UPDATED DECEMBER 8, 2023
California’s Legislative Analyst’s Office projects a 2024-25 budget deficit twice as large as 2023-24. It says the state could dip into reserves and cut some one-time spending.
With tax revenues in a free fall comparable to the Great Recession and the dot-com bust, California faces a projected $68 billion budget deficit next year that will require spending cuts and reserve funds to close, state finance officials said today.
Per Legislative Analyst’s office of California, a nonpartisan Fiscal and Policy Advisor;
Full report: https://lao.ca.gov/
Executive Summary
California Faces a $68 Billion Deficit. Largely because of a severe revenue decline in 202223, the state faces a serious budget deficit. Specifically, under the state’s current law and policy, we estimate the Legislature will need to solve a budget problem of $68 billion in the upcoming budget process.
Unprecedented Prior Year Revenue Shortfall Creates Unique Challenges. Typically, the budget process does not involve large changes in revenue in the prior year (in this case, 202223). This is because prior year taxes usually have been filed and associated revenues collected. Due to the state conforming to federal tax filing extensions, however, the Legislature is gaining a complete picture of 202223 tax collections after the fiscal year has already ended. Specifically, we estimate that 202223 revenues will be $26 billion below budget act estimates. This creates unique and difficult challenges—including limiting the Legislature’s options for addressing the budget problem.
Legislature Has Multiple Tools Available to Address Budget Problem. While addressing a deficit of this scope will be challenging, the Legislature has several options available to do so. In particular, the state has nearly $24 billion in reserves to address the budget problem. In addition, there are options to reduce spending on schools and community colleges that could address nearly $17 billion of the budget problem. Further adjustments to other areas of the budget, such as reductions in one-time spending, could address at least an additional $10 billion or so. These options and some others, like cost shifts, would allow the Legislature to solve most of the deficit without impacting the state’s core ongoing service level.
Legislature Will Have Fewer Options to Address Multi-Year Deficits in the Coming Years. Given the state faces a serious budget problem, using general purpose reserves this year is merited. That said, we suggest the Legislature exercise some caution when deploying tools like reserves and cost shifts. The state’s reserves are unlikely to be sufficient to cover the state’s multiyear deficits—which average $30 billion per year under our estimates. These deficits necessitate ongoing spending reductions, revenue increases, or both. As a result, preserving a substantial portion— potentially up to half—of reserves would provide a helpful cushion considering the anticipated shortfalls that lie ahead.
California Entered a Downturn Last Year
Higher Borrowing Costs and Reduced Investment Have Cooled California’s Economy. To cool an overheated U.S. economy, the Federal Reserve has taken actions over the last two years to make borrowing more expensive and reduce the amount of money available for investment. This has slowed economic activity in several ways. For example, home sales are down by about half, largely because the monthly mortgage to purchase a typical California home has gone from $3,500 to $5,400. Some effects of the Federal Reserve’s actions have hit segments of the economy that have an outsized importance to California. In particular, investment in California startups and technology companies is especially sensitive to financial conditions and, as a result, has dropped significantly. For example, the number of California companies that went public (sold stock to public investors for the first time) in 2022 and 2023 is down over 80 percent from 2021. As a result, California businesses have had much less funding available to expand operations or hire new workers.
State’s Economy Entered a Downturn in 2022. These mounting economic headwinds have pushed the state’s economy into a downturn. The number of unemployed workers in California has risen nearly 200,000 since the summer of 2022. This has resulted in a jump in the state’s unemployment rate from 3.8 percent to 4.8 percent, as Figure 1 shows. Similarly, inflation adjusted incomes posted five straight quarters of year over year declines from the first quarter of 2022 to the first quarter 2023.
The Budget Problem
Budget Year
In this section, we describe our estimates of California’s budget condition for the upcoming fiscal year: 2024-25. We expect the state will face a serious deficit, also known as a budget problem. A budget problem occurs when resources for the upcoming budget are insufficient to cover the costs of currently authorized services.
State Faces a $68 Billion Deficit. Under current law and policy, we estimate the state faces a budget problem of $68 billion. Figure 3 reflects the budget problem in the 2024 ending balance in the Special Fund for Economic Uncertainties. The budget problem is the net effect of the following factors:
State Faces a $68 Billion Deficit. Under current law and policy, we estimate the state faces a budget problem of $68 billion. Figure 3 reflects the budget problem in the 2024 ending balance in the Special Fund for Economic Uncertainties. The budget problem is the net effect of the following factors:
- State Anticipated a Deficit of Around $14 Billion. The 2023-24 Budget Act planned for a spending level in 2024-25 that was higher than expected revenue collections. Put another way, last year’s budget planned for a deficit in 2024-25. That anticipated deficit of $14 billion is the starting place for the upcoming budget process and therefore adds to the calculation of the budget problem.
- Revenues Are Lower Than Budget Act Projections by $58 Billion. As described earlier, collections data to date show a severe revenue decline, with total income tax collections down 25 percent in 202223. Reflecting the risk of continued economic weakness, our forecast anticipates flat revenue growth for 202324, with growth returning in 202425 and beyond. Based on this trajectory, our revenue outlook expects collections to come in $58 billion below budget act assumptions across the budget window. This is the major driver of the budget problem.
- School and Community College Spending Is Lower by More Than $4 Billion. Proposition 98 (1988) establishes a minimum annual funding requirement for schools and community colleges, met with state General Fund and local property tax revenue. When General Fund revenue declines, the minimum requirement usually declines in tandem. Most school spending, however, does not automatically decrease when the minimum requirement drops in the current or prior year. As described in the text box below, the state could decide to reduce Proposition 98 General Fund spending by nearly $21 billion under our outlook, but the automatic reduction is about $4 billion. The budget problem is therefore lower by about $4 billion in our deficit calculation.
- Other Spending Is Lower by $4 Billion. We estimate spending across the rest of the budget will be lower than the administration’s June projections by about $4 billion over the budget window. The major driver of this difference is spending on health and human services (HHS) programs, where our estimates are lower by about $3 billion. We do not have department or program level detail on the administration’s HHS spending forecast, so we cannot give more detail about the nature of this difference. This lowers the budget problem by a like amount.
- Entering Fund Balance Is Lower by $3 Billion. Budgetary changes to years before the budget window are reflected in the 202223 entering fund balance. (These changes occur due to accounting rules, which sometimes result in the state “accruing” or attributing revenues or spending to earlier years, based on when the underlying economic activity is estimated to have occurred.) Our estimate of the budget problem reflects a $3 billion downward adjustment in the entering fund balance because of lower revenues. This adds to the budget problem.
- Reserve Deposits Are Higher by $400 Million. Proposition 2 (2014) requires the state to set aside minimum amounts to deposit into its reserve, pay down debts, and (under certain conditions) spend money on infrastructure. These requirements are determined by a set of complex formulas. Ordinarily, the required set asides increase when revenues increase and drop when revenues decrease. This year, however, due to a variety of idiosyncratic issues, under current law and policy, the state’s reserve requirements will increase in response to our revenue forecast. The nearby box describes the reasons why. As we discuss later, in response to a budget emergency, the Legislature and Governor can decide to suspend these deposits and/or withdraw funds from the reserve.
Solving the Budget Problem
State Has Various Options to Address the Budget Problem. While addressing a deficit of $68 billion will be challenging, the Legislature has several options available to do so. In this section, we describe some of the key ones. (Some of the solutions here assume a budget emergency is declared.) These solutions include:
- Withdraw Reserves. Under our estimates, the state would have about $24 billion in reserves to help address the budget problem (assuming a budget emergency is declared).
- Reduce Proposition 98 Spending. Over the three-year period, the state could reduce General Fund costs by $16.7 billion if it were to lower school spending to the constitutional minimum allowed under Proposition 98. One option for implementing some of this reduction would be to use the Proposition 98 Reserve to cover school related costs that exceed the Proposition 98 minimum requirement in 2022-23.
- Reduce Other One Time Spending. We estimate the state has at least $8 billion in one time and temporary spending in 202425 that could be pulled back to help address the budget problem. In addition, there are potentially billions of dollars more in spending from prior years that has been committed but not yet distributed, and therefore also could be reduced to help address the budget problem.
- Identify Other Solutions. Even after using most or all these solutions, the Legislature still would need to find more solutions to address the remainder of the budget problem. Other options include additional cost shifts (such as more loans from special funds), revenue solutions, and ongoing spending reductions.
Withdraw Reserves
State Could Withdraw Up to $24 Billion in General Purpose Reserves. As shown in Figure 3, the state has $23 billion in the BSA under our estimates, plus about $1 billion in the Safety Net Reserve, to address the budget problem. The Safety Net Reserve is available to fund program costs in HHS programs, like Medi-Cal, while the BSA can only be accessed in a budget emergency, as described below.
Budget Emergency Available Under Our Estimates. The Legislature can only suspend mandatory deposits or make withdrawals from either of its two constitutional reserves—the BSA and the Proposition 98 Reserve— if the Governor declares a budget emergency. The Governor may declare a budget emergency in two cases: (1) if estimated resources in the current or upcoming fiscal year are insufficient to keep spending at the level of the highest of the prior three budgets, adjusted for inflation and population (a “fiscal budget emergency”), or (2) in response to a natural or man-made disaster. Under our forecast, a fiscal emergency would be available both in 202324 and 202425. In the case of a fiscal budget emergency, the Legislature only can withdraw the lesser of: (1) the amount of the budget emergency, or (2) 50 percent of the BSA balance (in each year). As of this writing, the Governor has not called a fiscal budget emergency for 202324 or 202425.
Reduce Proposition 98 Spending
Spending Reductions Would Help Balance the Budget but Involve Trade-Offs. If the Legislature reduced school spending to the constitutional minimum allowed by Proposition 98, it would address up to $16.7 billion of the budget problem. To obtain these savings, the state would have to reduce spending it previously approved in 202223 and 202324. In previous downturns, the state relied heavily on two main approaches for implementing such reductions: (1) across-the-board reductions to per pupil allocations and (2) payment deferrals. These options, however, tend to be disruptive for school operations, particularly when the state announces them on short notice. In addition, the state’s options for reductions in 202223 are limited because the state has allocated most of the funding attributable to the prior year already. Before resorting to cuts or deferrals, however, the state could reduce spending in other ways that would be less disruptive for schools.
Proposition 98 Reserve Could Cover Spending Above the Minimum Requirement in 2022-23. Based on deposits the state made in 202021 and2021=-22, the Proposition 98 Reserve currently holds a balance of $8.1 billion. (This amount excludes the additional deposits the state had anticipated making in 2022=-23 and 2023-24 prior to our lower revenue estimates.) The state could use up to $7.7 billion of this balance to cover school spending that exceeds the Proposition 98 minimum requirement in 2022-23. Using the Proposition 98 Reserve in this way would allow the state to lower General Fund spending to the constitutional minimum level in the prior year without reducing the funding allocations it previously approved. From an accounting perspective, Proposition 98 Reserve withdrawals also do not count as spending for the purpose of determining the minimum funding requirement in future years. This means using the Proposition 98 Reserve for 2022-23 would also reduce the constitutional minimum requirements in 202324 and 202425. (The formulas governing the Proposition 98 Reserve would require the state to withdraw the remaining amount in the reserve—about $450 million—in 2023-24.)
The State Could Make Reductions to Programs with Unallocated Funds. Although the Proposition 98 Reserve could allow the state to reduce General Fund spending with minimal disruption to school programs, the reserve balance is not large enough to obtain $16.7 billion in savings by itself. If the state wanted to obtain the maximum possible savings, it would need to make additional reductions. One option is to reduce program funding that has not yet been allocated to schools. For example, the state previously approved $1.1 billion for grants to community schools that count as spending in 202223 but have not yet been awarded. (This funding is in addition to the roughly $3 billion in funding for community schools that the state approved prior to 202223.) In addition, several hundreds of millions of dollars in State Preschool funding provided in 202223 and 202324 is currently not obligated for any specific purpose. Over the coming months, the state will be able to identify additional grants and programs with unspent funds. Reducing grants that have not yet been allocated to schools could allow the state to reduce General Fund spending while minimizing reductions to funding that schools were already planning to receive. As we explain in the Appendix, if the Legislature took these actions, Proposition 98 funding would be sufficient to cover all but $1 billion of ongoing program costs in 202425.
Reduce One Time Spending
Pulling Back One Time and Temporary Spending Could Provide More Than $10 Billion in Solutions. We estimate the state has $8.6 billion in one time and temporary spending slated for 202425 that can be reduced entirely to address the serious budget problem. This includes spending of $2.2 billion on transportation, $1.9 billion on natural resources and environment, and $1.8 billion on various education programs. In addition, the Legislature has committed tens of billions of dollars in previous years to onetime and temporary purposes, including billions of dollars in the current year. Some of these funds could be withdrawn to address the deficit, but the Legislature would need to request more information from the administration to know the precise amounts that could be feasibly reduced. To maximize flexibility and mitigate disruption, some of these pullbacks could merit early action in 2024.
Identify Other Solutions
State Might Have Some Cost Shift Options Remaining. Cost shifts occur when the state moves costs between fund sources or entities— for example, shifting spending from the General Fund to special funds or, as has been done in prior budgets, shifting costs from the state to local governments. The state used about $10 billion in cost shifts to address last year’s budget problem and could have some additional capacity to shift additional costs again this year. For example, we think the state would have more capacity to make loans from special funds if those loans were made on a pooled basis, rather than on an individual fund basis.
State Has Used Revenue Increases to Address Past Budget Problems. For example, in 202021, the state temporarily suspended net operating loss (NOL) deductions, preventing corporations with net income over $1 million from using NOLs. The state also limited businesses from claiming more than $5 million in tax credits. The state also has increased broad based taxes on a temporary and permanent basis in similar revenue downturns.
Other Spending Reductions. Given the extent of the deficit, the state might also have to reduce other spending—including cuts into its core service level—in order to balance the budget. In facing budget problems of similar magnitudes, the state in the past has made reductions in employee compensation and lowered spending on higher education and the judicial branch. The Legislature also could explore using more of the state’s recently reauthorized tax on managed care organization to offset the General Fund costs of MediCal, rather than for other costs, such as increasing provider rates.
State Has Used Revenue Increases to Address Past Budget Problems. For example, in 202021, the state temporarily suspended net operating loss (NOL) deductions, preventing corporations with net income over $1 million from using NOLs. The state also limited businesses from claiming more than $5 million in tax credits. The state also has increased broad based taxes on a temporary and permanent basis in similar revenue downturns.
Other Spending Reductions. Given the extent of the deficit, the state might also have to reduce other spending—including cuts into its core service level—in order to balance the budget. In facing budget problems of similar magnitudes, the state in the past has made reductions in employee compensation and lowered spending on higher education and the judicial branch. The Legislature also could explore using more of the state’s recently reauthorized tax on managed care organization to offset the General Fund costs of MediCal, rather than for other costs, such as increasing provider rates.
