12-6-02 Proposition 98--Worst Case/Best Case Scenarios are Both Unlikely

Volume 15 For Publication Date: December 6, 2002 No. 24

Proposition 98—Worst Case/
Best Case Scenarios are Both Unlikely
An Analysis and Commentary

The recent report by the state’s Legislative Analyst’s Office (LAO) that the state has a $21.1 billion budget shortfall is based only on current law and makes no attempt to forecast what corrective action the state may take. This article looks at the worst possible outcome for Proposition 98 funding and contrasts that to the best possible outcome. While we usually don’t like to give away the ending, our conclusion is that both of these extreme scenarios are so unlikely that the truth almost assuredly will lie somewhere in between.

So Why Did This Occur?

Usually, in a “Test 2” year (such as 2002-03), state revenues have no impact on the Proposition 98 funding level until revenues drop to the point where “Test 3” kicks in.

But this year, because of the significance of the Maintenance Factor restoration, current-year drops in state General Fund revenues have a big impact. The 2002-03 State Budget was built on the estimate that schools would receive $3.2 billion out of a total of a $3.9 billion restoration IOU. However, the required level of this restoration payment is according to a formula that is very sensitive to General Fund revenues.

For the current budget year, the Proposition 98 restoration payment plunges by $600 million for every $1 billion drop in state General Fund revenues. These cuts in restoration payments don’t really kick in this year until after the first billion-dollar drop in revenues, because of the unexpected drop in state taxes last May and June and the Governor’s Budget vetoes ($143 million).

So, the LAO on November 14, 2002 , projected a $4.1 billion shortfall in current-year state General Fund revenues—this translates into a $1.9 billion drop in the minimum restoration payment.

In turn, this opens the state to the option of cutting school funding by $1.8 billion. However, to put this in context, it would cover less than one-third of the state’s current-year Budget hole.

Worst-Case Scenario

The worst-case scenario is, of course, that the state reduces Proposition 98 funding to the constitutionally required minimum, and also repeals a provision of current law that requires the state to fully restore the “Maintenance Factor” in 2003-04. Under this scenario:

· The state will reduce Proposition 98 funding to the minimum in 2002-03. Based on the LAO forecast, this would require that $1.8 billion in funding already appropriated to school agencies be deferred and/or cut. [Note that while the LAO report talked about the Proposition 98 minimum dropping by $1.9 billion in 2002-03, the Governor had previously set aside $143 million that the LAO had considered to be appropriated, so this amount is really part of the LAO’s $1.9 billion total.] After this action, the amount remaining to eventually be paid on the Proposition 98 “Maintenance Factor”—that is, the amount that current-year funding is below the historic “Test 2” level—would jump from just under $700 million to almost $2.6 billion.

· Under the LAO forecast, state tax revenues are now projected to grow so slowly in 2003‑04 as to require no formulaic restoration of the “Maintenance Factor.” But Section 54 of AB 2781 (Chapter 1167/2002) currently requires that the state fully restore the Maintenance Factor in 2003-04, regardless of how fast state tax revenues grow—or how serious the State Budget shortfall is. Under this worst-case scenario, however, the state would repeal this requirement. And since the Maintenance Factor itself grows by the Proposition 98 COLA and growth factors, this would leave Proposition 98 funding some $2.7 billion below the historic “Test 2” level in 2003-04.

Under the LAO Forecast based upon current law (i.e., including full restoration of the Maintenance Factor in 2003-04), there is enough funding available in 2003-04 to pay for statutory COLA and growth and the $681 million in funding already deferred into next year, meet all current provisions of law, including the $203 million appropriated for equalization aid, and have about $1 billion left over. The worst-case scenario not only reduces available funding in 2003-04 below prior estimates by $2.7 billion, but the state would also have to pay for any additional amounts deferred into 2003-04. Seemingly, the only option would be for the state to again defer billions of dollars in program funding into 2004-05, creating major cash flow and accounting problems, plus reducing the real funding available in 2004-05 to pay for that year’s programs. Continuing to have this type of rolling deferral would result in Proposition 98 funding shortfalls potentially for years to come.

In total, this worst-case scenario would save the state $4.6 billion between 2002-03 and 2003-04. However, given the devastating impact on school funding, it seems unlikely that this scenario would be realized. In particular, our guess is that the state will need to enact some form of a tax increase to bridge the $21 billion state budget shortfall, and, at a minimum, the restoration formulas under Proposition 98 would require at least partial restoration of the Maintenance Factor in 2003-04.

Best-Case Scenario

The best-case scenario is for the state to make no changes affecting Proposition 98. Under this scenario, there would be no cuts or deferrals affecting 2002-03, and the state would honor the current-law requirement that the Maintenance Factor be fully restored in 2003-04.

Some people might say that a real “best case” scenario would also include the state appropriating the $143 million that the Governor set aside, or for that matter, even funding the Maintenance Factor of almost $700 million in 2002-03. But if we were to include that as part of our best-case scenario, we would probably be accused of using hallucinogens.

This best-case scenario results in the entire budget shortfall having to be resolved by tax increases and/or cuts to the non-Proposition 98 side of the budget. This, too, seems unlikely.

Middle Ground

Our crystal ball is somewhat cloudy these days. Frankly, we were shocked by the size of the State Budget shortfall forecast by the LAO. We were hoping to see a much smaller reduction in current-year state tax revenues, and therefore a much smaller drop in the Proposition 98 minimum.

Given the overall magnitude of the shortfall, coupled with the fact that the relatively painless fixes were used to close the current year’s estimated budget shortfall—such as internal borrowing and the securitization of the tobacco settlement—we fully expect to see a combination of billions of dollars in State Budget cuts and billions of dollars in revenue enhancements (doesn’t that sound so much less painful that “tax increases”?). And we don’t expect that education will completely escape the budget axe.

At this point, the only semi-bloodless exit strategy for education from this scenario would be for either: (1) the Republicans to agree to significant revenue enhancements and/or (2) the Democrats to refuse to make the education funding cuts that have become suddenly available due to the plummeting Proposition 98 guarantee. [Note that one Democrat—the Governor—could unilaterally stop or reduce any cuts, and his commitment to education funding may be tested again.]

Fortunately, education is a high priority for both political parties. We certainly recognize that any level of cuts or additional deferrals are not welcome news. But we need to be prepared for both, given the overall shortfall that the state is facing.

—Paul Goldfinger and Bob Blattner