Tomorrow the Legislature will gavel in a special session — called by Governor Jerry Brown — on California’s rainy day fund. In convening this session, the Governor released details of his own rainy day fund proposal, which would restructure the state’s existing rainy day fund, the Budget Stabilization Account (BSA). An alternative proposal known as ACA 4 — a constitutional amendment approved by the Legislature in 2010 and subject to voter approval — is currently scheduled to appear on the statewide ballot in November. The Governor is asking the Legislature for the two-thirds vote needed to replace ACA 4 on the ballot with his rainy day fund proposal. If then approved by voters, the Governor’s approach would be codified in the state Constitution.
As policymakers and others assess the Governor’s proposal, two basic questions are paramount: What problems are we trying to solve? And does the Governor’s approach successfully address them?
The Governor has identified the central problem as California’s “boom and bust” approach to budgeting: the tendency during times of strong revenues to allocate all available funds — via tax cuts or spending commitments — rather than putting some funds aside for times of weaker revenues. The result is that periods of weaker revenues in California generally mean sizable budget shortfalls and, in turn, deep spending cuts.
Wide fluctuations in state revenues are partly due to ups and downs in California’s economy, but they also result from how the state’s tax system is designed. California’s economy is characterized by a number of very-high-growth sectors that tend to expand rapidly during upswings, and the state’s tax system is structured to capture a share of this growth. This is done through higher personal income tax rates for wealthier earners as well as through taxes on capital gains and other types of income that increase during periods of economic growth.
That the Governor proposes to address “boom and bust” budgeting by way of a rainy day fund is to his credit. This is because the chief alternative would be to reduce fluctuations in revenue by changing the state’s tax structure: specifically, taxing low- and middle-income Californians more and, in turn, sacrificing longer-term revenue growth by not effectively capturing economic gains. In other words, the alternative would involve making the revenue system less fair and less capable of providing sufficient support for essential public systems and services — outcomes that are both far worse than any that are likely to result from budgeting for the ups and downs of economic cycles.
The key question in the upcoming special session is whether the Governor’s rainy day fund proposal amounts to a better mechanism — compared to the rainy day fund now in place and the model provided for in ACA 4 — for ensuring that California is positioned to withstand periods of decreased revenues without having to resort to deep cuts in public investment.
The BSA — California’s current rainy day fund — was put into the state Constitution by voter approval of Proposition 58 in 2004. Proposition 58 requires that the state deposit 3 percent of General Fund revenues into the BSA each year — regardless of economic conditions — until the fund reaches certain thresholds. However, BSA deposits can be suspended or reduced in any given year by an executive order issued by the Governor — without approval from the Legislature — and there are no restrictions on how much of the funds can be withdrawn from the BSA in a given year. Deposits to the BSA have been suspended since 2008-09, and all BSA funds went to help cover budget shortfalls that emerged during the Great Recession. The Governor’s budget proposal for 2014-15 calls for a deposit to the BSA of $3.2 billion.
ACA 4 would require that the state deposit 3 percent of General Fund revenues into a budget reserve each year. However, half of those revenues would be used to fund infrastructure or pay debt service on bonds and thus would not be available to help support state services during an economic downturn. In addition, ACA 4 would impose a cap on state spending that would, over time, severely limit the state’s ability to invest in services outside the Proposition 98 minimum school funding guarantee, including health care, higher education (CSU and UC), and assistance for seniors and people with disabilities. It would do this by establishing a complex method for identifying “unanticipated revenues,” with these revenues — subject to availability — first used to fund any required increase in the Proposition 98 guarantee and then used to further build the budget reserve, fund various obligations, and implement other policies, such as a one-time tax cut or a one-time boost in infrastructure spending. As a result, it is likely that spending for key public systems and services funded outside of Proposition 98 — including health and human services and CSU and UC — would decline as a share of the state budget, since relatively fewer General Fund dollars would be directed toward those services.
We think that the Governor’s proposal provides a couple of important improvements on the state’s rainy day fund:
- Paying down debts and liabilities. The Governor’s rainy day fund proposal allows for making payments to cover certain budgetary debts and other liabilities — such as funding for the state’s retirement systems and unfunded obligations from prior fiscal years — instead of making the required rainy day fund deposits. This provision gives state policymakers the flexibility to retire existing debts instead of — or in addition to — saving for a rainy day.
- Placing limits on the amount of rainy day funds that may be withdrawn in the initial year of a downturn. The Governor’s proposal limits withdrawals from the rainy day fund to 50 percent of the total funds in the first year of a downturn in an effort to ensure that policymakers do not rely too heavily on the reserve at the outset of a recession as a means of bolstering the state budget.
These are both notable improvements that would strengthen California’s budget reserve and its ability to help foster good fiscal management over the long term. Yet at the same time, there are certain provisions in the Governor’s proposal that raise concerns and merit special attention from legislators as they take up the Governor’s proposal in the special session.
- Deposits based on capital gains revenues. The Governor’s proposal bases rainy day fund deposits on General Fund revenues from capital gains — rather than on General Fund revenues overall, as in the current BSA — on the grounds that capital gains revenues are “the state’s most volatile source of revenue.” Specifically, the proposal requires that capital gains revenues that exceed 6.5 percent of total General Fund tax revenues in any year be deposited into the rainy day fund.
Basing deposits on capital gains revenues sounds good in theory, but it presents serious challenges in practice. First, capital gains revenues are among the most difficult revenues to accurately estimate at a given point in time. The state typically is unable to provide an accurate accounting of capital gains revenues until a couple of years after the fact. As a result, rainy day fund deposits could be subject to significant corrections in later years. State leaders would have to “true up” prior years’ capital gains revenue estimates and make changes to prior years’ rainy day fund contributions — further complicating the state’s budget process.
A second challenge is that the unpredictability of capital gains revenues may result in required deposits to the rainy day fund during periods immediately following a recession — at which point it might still be desirable to boost state spending rather than the state’s reserve. For instance, capital gains revenues recovered quickly following the end of the Great Recession, and by 2012-13 they significantly exceeded 6.5 percent of General Fund tax revenues. So, had the Governor’s proposal been in place during this period, capital gains deposits likely would have been required even though the state budget was still far from recovering from the impact of the recession. Fortunately, this challenge has an available fix: a provision could be added that would allow for deposits to be suspended until the state reaches certain thresholds that signal a post-recession recovery (for example, certain targets in tax collections and/or employment), an idea supported by experts on the design of state budget reserves.
- An increase in the maximum size of the rainy day fund to 10 percent. The Governor’s proposal increases the cap on the rainy day fund from 5 percent of General Fund revenues (under the current BSA) to 10 percent. While experts on strengthening rainy day funds support increases in the caps on rainy day funds, these same policy experts underscore that building back adequate funding for core public programs — such as education, health care, and other services that meet residents’ basic needs — should take precedence over deposits into the rainy day fund. California’s total General Fund revenues in the Governor’s proposed 2014-15 budget would be $106 billion. Consider a state budget cycle a few years into the future — with this 10 percent cap having been in place — that has General Fund revenues at a hypothetical $120 billion. A maxed-out rainy day fund would mean $12 billion set aside for a rainy day, juxtaposed against significant program needs across an array of state services that could potentially still be operating at diminished levels compared to where they were prior to the Great Recession. An effective rainy day fund, in contrast, would allow state policymakers some leeway in directing funds to public services and systems — in lieu of making deposits into the reserve — based on changes in caseload, persistent economic challenges, and other statewide and community needs.
- Creation of a separate rainy day fund for schools. The Governor’s proposal creates a separate reserve within the state’s General Fund for K-14 schools and community colleges, with the goal of making school spending more predictable. While making annual school revenues more predictable is a desirable goal, the formulas the Governor proposes to reach it would add greater complexity to the formula that the state uses to determine annual education spending. Moreover, our initial analysis suggests that deposits to the reserve for school spending would be rare and likely not to occur until at least the end of the decade.
- Restrictions on suspending or reducing deposits. The Governor’s proposal significantly restricts policymakers’ ability to suspend or reduce the required rainy day fund deposit. The deposit could be suspended or reduced if the Governor and the Legislature — by majority vote — agree to do so. However, the Governor first would have to declare a “budget emergency,” which is narrowly defined as (1) a disaster (natural or otherwise), (2) a “substantial” budget gap, or (3) insufficient revenues to provide “adequate” funding for most state services (those funded outside of Proposition 98) in the coming fiscal year. The Governor’s proposal defines “adequate” as spending equal to that in the current fiscal year adjusted for changes in inflation and population. In other words, if annual inflation is running at about 2 percent and the state’s population grows by well below 1 percent — California’s post-Great Recession conditions — state funding for most services could rise by less than 3 percent and still be considered “adequate,” even though far more funding may be needed to sufficiently reinvest in programs cut during an economic downturn. Under this scenario, unless the Governor could point to a disaster or a substantial budget shortfall, there would be no basis for declaring a “budget emergency,” and the required transfer from the General Fund to the rainy day fund would have to go forward, leaving fewer dollars to support public systems and services.
In sum, while the Governor’s rainy day fund proposal includes some notable improvements, it also includes a number of provisions that raise questions about how the rainy day fund would operate — especially at times when the state is coming out of an economic downturn. The proposal includes provisions that add to the complexity of the state budget process, thereby increasing the likelihood of unintended consequences. Some key provisions in the Governor’s proposal, while well-intentioned in terms of sound fiscal stewardship, have the potential for requiring state leaders to put aside funds for a rainy day while the state is still struggling to recover from economic downturns and facing a significant need to reinvest in core public systems and services.
With the special session soon getting underway, it’s important to underscore that policymakers have available a number of alternative paths forward — their choices aren’t limited to the current rainy day fund, the model under ACA 4, and the Governor’s proposal. Ultimately, while strengthening the state’s rainy day fund is a laudable objective, the state’s leaders should be careful to balance priorities — paying down debts and liabilities, saving for a rainy day, and ensuring that the state is positioned to adequately invest in programs and services that contribute to economic growth and broadly shared prosperity.
— Chris Hoene