BILL ANALYSIS Ó ACA 1 X2 Page 1 Date of Hearing: April 28, 2014 ASSEMBLY COMMITTEE ON BUDGET Skinner, Nancy, Chair ACA 1 X2 (John A. Pérez) - As Amended: April 24, 2014 SUBJECT : State Budget Reserve SUMMARY : Makes changes to the State's budget reserve policy. Specifically, this measure : 1) Doubles the size of the Budget Stabilization Account from five percent of the General Fund (or $8 billion, whichever is greater) to 10 percent of the General Fund. 2) Dedicates certain General Fund revenues derived from taxes on Capital Gains as the funding source for the Budget Stabilization Account (also referred to as the Rainy Day Fund). In specific: a. Any capital gains revenue that total more than 6.5 percent of total General Fund revenues - and that are not required to go toward Prop 98 - would be transferred into the Budget Stabilization Account. b. The measure includes a "true up" provision to adjust the amount of the transfer to accurate reflect the amount of capital gains revenue collected for the previous two fiscal years.. c. Specifies that the transfer of revenue to the Budget Stabilization Account would take place on October 1st. 1) In lieu of deposit into the reserve, funds can be used to repay debts or be used to substitute voter approved bond funds for projects to avoid incurring debt. 2) Changes the rules for withdrawing funds from the Budget Stabilization Account. Specifically: a. Requires the declaration of a fiscal emergency by the Governor and a statute passed by the Legislature for funds to be transferred from the Budget Stabilization Account to the General Fund. ACA 1 X2 Page 2 b. Restricts the amount of funding that can be transferred from the Budget Stabilization Account to the General Fund to 50 percent of the Account's balance, unless a transfer was made in the prior year. 3) Once the reserve reaches 10 percent, restricts the use of any revenue above the reserve cap to infrastructure, including deferred maintenance or to pay down obligations or to avoid debts.4) Creates a Proposition 98 Reserve, called the Public School System Stabilization Account, which would capture certain revenues derived from taxes Capital Gains and attributed to Proposition 98 purposes in very specific circumstances: a. The State must have repaid and allocated the entire Proposition 98 Maintenance Factor amount before a transfer could be made. b. The State must be in a Test 1 level of Proposition 98 and the transfer can be no more than the difference between the Test 1 and Test 2 levels of Proposition 98. c. The State cannot be accruing Proposition 98 Maintenance Factor or be suspended in a year when the transfer is made. d. If these conditions are met, Proposition 98's share of revenues derived from capital gains that are above 6.5 percent of total General Fund are transferred into the Proposition 98 reserve. e. These funds would be used to fund Proposition 98 Growth and Cost of Living Adjustments in years when there is a decline in Proposition 98. f. Transferred funds would be considered part of the Proposition 98 calculation. 5) Conforms transfers to the Budget Stabilization Account ACA 1 X2 Page 3 to reflect the new mandatory funding source. In particular: a. Deletes the existing optional 3 percent transfer of overall General Fund revenues into the Budget Stabilization Account, which can be suspended by the Governor. b. Removes ACA 4 (Gatto) from the 2009-10 Sessions from the ballot. 6) Requires the Department of Finance to submit five-year General Fund revenue and expenditure projections as part the budget submission. This places a current statutory requirement into the State Constitution. 7) Requires the display of the calculations for this measure and the overall balance of the Budget Stabilization Account in the Budget Act. EXISTING LAW Article XVI of the State Constitution includes language related to Proposition 58 which established the Budget Stabilization Act and includes and optional transfer of 3 percent of overall General Fund revenues, which can be suspended by the Governor. This language caps the size of the Budget Stabilization Account at five percent of the General Fund (or $8 billion, whichever is greater). FISCAL EFFECT : This measure would provide a dedicated funding source for the Budget Stabilization Account. According to the five-year forecast published by the Department of Finance in January of 2014, this measure would transfer an estimated $3 billion to the Budget Stabilization Account by 2017-18 COMMENTS : Assembly Constitutional Amendment 1 X2 responds to two critical problems that have plagued California's budget for decades: 1. Revenue Volatility. California's revenue system is notoriously volatile. This results in large part from reliance on income tax. While income tax rates are not dramatically progressive, the incomes of wealthy Californians do fluctuate and therefore their income taxes they pay also fluctuate. ACA 1 X2 Page 4 2. Inadequate Reserves. Long term forecasts are always difficult. At times forecasts show balanced budgets as far as the eye can see, but reality often proves different. Without strong reserves, unpredicted economic down turns have ravished the state budget and caused draconian cuts to programs and painful middle class tax increases. ACA 1 X2 addresses these problems with the following: 1. Stabilizes Spending. ACA 1 X2 separates state spending from the rollercoaster of revenue volatility. Short term spikes in revenues are taken off the table rather than being used for unsustainable permanent tax cuts or ongoing programs. The spiking revenues are then put into the Rainy Day Fund to be withdrawn during economic downturns to avoid program cuts and middle class tax increases. 2. Increases the Reserve. ACA 1 X2 doubles the size of the Constitutional Reserve to 10%, which will provide increased protection against draconian cuts to programs and painful middle class tax increases during economic down turns. The challenge in crafting a policy which sets aside funds for a future year is that it is hard to find the right balance that sets aside unexpected revenues for a rainy day, but does not overreach and constrain the entire budget. The proposed Rainy Day Fund contained in this measure reflects the current thinking on how to address this problem-by pairing the solution to the cause of the problem. This proposal pairs the source of the volatility, capital gains, with the solution for funding the Rainy Day Fund. It recognizes that spikes in capital gains-related tax revenues, derived from stocks and asset sales, are a major cause of the State's revenue volatility problem. For example, in 2007 California residents earned $132 billion of capital gains, which contracted by almost 80 percent to only $29 billion of total capital gains in 2009. This measure would target spikes in this capital gains revenues and deposit any revenue attributed to capital gains and not required for use by Proposition 98 that constitute more than the 6.5 percent of total General Fund into the Budget Stabilization Account. This would create a cyclically-aligned mandatory revenue source for the Rainy Day Fund. ACA 1 X2 Page 5 Once in effect, this measure would double the size of the existing Rainy Day Fund, as it recognizes that, given the depth of the last three recessions, a 5 percent reserve would be insufficient to fully buffer against a future downturn. When the budget is adopted in June it is based upon a projection of future revenues, and actual revenues can differ from projections. As such, the measure also includes a "true-up" mechanism, which adjusts the amount of funding deposited in the Rainy Day fund over two fiscal years, so that Rainy Day Fund captures the accurate level of revenues. In addition, the measure creates a Proposition 98 Rainy Day Fund. This fund would mirror the structure of the unrestricted General Fund reserve by capturing certain unanticipated revenues from capital gains. However this fund would be subject to very strict limitations that would tightly limit when funding could be deposited. No funding would be set aside in the Proposition 98 Reserve until after the Maintenance Factor is fully allocated. Currently, the Department of Finance projects a $4.5 billion maintenance factor remaining at the end of 2014-15, which is not expected to be fully repaid until 2019-20. In addition, revenue would only be diverted in years when the Proposition 98 was in a Test 1 funding level, this has only occurred three times and normally expected in very robust revenue years. Finally, revenues could not be allocated to the Proposition 98 Reserve if Proposition 98 was suspended. Finally, this measure includes language that allows the funds in Budget Stabilization Account to be used for debt avoidance and reduction. This provision recognizes that the State continues to have fiscal liabilities which accrue interest. It may not be prudent to accumulate cash in a low interest accruing account at the State level while more expensive liabilities remain on the State's balance sheet. This provision provides the State flexibility to consider these trade-offs and make fiscal decisions that serve the best use of state funds. The approach taken by ACA 1 X2 has advantages over other approaches to buffering the State budget against the revenue volatility which has driven recent budget challenges. As the majority of benefits of economic growth have been concentrated within a small group of the richest individuals in the world, California's revenues have followed a volatile rollercoaster of the equities market peaks and Initial Public Offerings. The State has no way to forecast these episodic increases and three solutions have emerged to reduce this ACA 1 X2 Page 6 volatility : 1) reduce taxes on higher-income earners who are benefiting the most from the current economy and levy additional taxes on the middle class, with the logic that it's less possible to predict the gains the most wealthy will have in a given year; 2) contain spending in some type of autopilot mechanism, to keep overall spending much lower than revenues so the State cannot have an imbalance or; (3) isolate the revenue sources with the most volatility and devise an approach to stream these into a Rainy Day Fund. This measure intends to use the third approach, a targeted set aside of volatile revenue, to fund a durable and ongoing Rainy Day Fund. Two other approaches have been suggested to address revenue volatility: 1. Tax Reform to End Revenue Volatility Proposals have been made to "reform" the tax system to address revenue volatility, most notably the report by the Commission on the 21st Century Economy, suggested reducing taxes on the wealthy and either reducing or eliminating corporate taxes and shifting the corresponding tax burden to the middle income earners. Such a shift would dramatically reduce the volatility in the tax system, but would increase the burden on the middle class. But the drawback of this proposal is that would further reinforce increasing income inequity. California's middle class has seen no income growth over the last three decades, while the wealthy have seen significant gains in overall income. According to a 2011 study "The Great Recession and Distribution of Income in California" by the Public Policy Institute of California, the inflation-adjusted median income of Californians declined by 1 percent between 1980 and 2010. However, earners at the 90th percentile of income earners were making 34 percent more in 2010 than in 1980. Additional proposals include the expansion of consumption taxes, such as a sales taxes or a value-added tax in lieu of a sales tax. Such regressive measures would not just impact middle-income earners, but also hit the poorest Californians, who have already seen a dramatic drop in their income. The PPIC study found that lowest ten percent of earners had incomes roughly 24 percent lower in 2010 than in 1980. 2. ACA 4 of 2010, Limits Amount Available for Expenditure ACA 1 X2 Page 7 An alternative approach is provided in ACA 4 of the 2009-2010 Session, which uses a linear regression based upon past revenues to "forecast" the amount of revenue that can be appropriated in a given year. Any revenue above this forecast amount must be deposited into a Rainy Day Fund. This essentially limits spending, as the available revenue is set by a regression line that auto-pilots the overall structure of the budget. Overall, ACA 4 treats the State's revenues like a flood control project, damming up all of the revenue and letting a control trickle of revenue through the gates each year. However, unlike most flood control projects, the flow of revenue would be controlled automatically and robotically, regardless of whether it was needed or not. This means that even in good times, the State could be faced with insufficient revenues to cover its costs, as the forecast revenues have no relation to actual revenues received by the State. In fact, if this measure was adopted in the Fall of 2014 it is possible that this regression may produce a revenue number in 2015-16 which is lower than the current revenue levels and require the State to renew budget reductions so that existing revenues can be used for a Rainy Day Fund. In addition to subjugating the State's budget decisions to a strict mathematic equation, this approach has two major technical shortcomings-1) it would misread the some of the typical revenue increases that accompany the recovery from a recession as unanticipated revenue rather than a recovery and 2) if inflation were to increase beyond the historically low levels of the last several years, the forecast may misread an inflation-driven increase in revenues which may not be a gain in real terms. This measure also has strict rules which limit the State's ability to use the reserve funds to pay off liabilities, which means the State could have piles of cash sitting in low-interest Rainy Day Accounts and also a large balance of higher costs liabilities on the books. er from a recession as unanticipated revenue rather than a recovery and 2) if inflation were to increase beyond the historically low levels of the last several years, the forecast may misread an inflationary driven-increase in revenues which may not be a gain in real terms. This measure also has strict rules which limit the State's ability to use the reserve funds to pay off liabilities, which means the State could have piles of cash sitting in low-interest Rainy Day Accounts and also a large balance of higher costs liabilities on the books. ACA 1 X2 Page 8 REGISTERED SUPPORT / OPPOSITION : Support Governor Jerry Brown Opposition None on file. Analysis Prepared by : Christian Griffith / BUDGET / (916) 319-2099