ACAX2 1 Assembly Constitutional Amendment, 2nd Ext. Session

BILL ANALYSIS ï¿½

ACA 1 X2
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Date of Hearing: April 28, 2014

ASSEMBLY COMMITTEE ON BUDGET
Skinner, Nancy, Chair
ACA 1 X2 (John A. Pï¿½rez) - 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.

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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

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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.

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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.

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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

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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

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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.

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REGISTERED SUPPORT / OPPOSITION :

Support

Governor Jerry Brown

Opposition

None on file.

Analysis Prepared by : Christian Griffith / BUDGET / (916)
319-2099