California Forward submitted written testimony to the Senate Budget and Fiscal Review Committee in support of the Rainy Day Fund.
Testimony Submitted to the Senate Budget and Fiscal Review Committee
February 27, 2014
State Budget Reserve Funds: Requirements and Alternatives
Seeking a balance
An important element of the Governor’s 2014-15 budget is a proposal to capture “spikes” in revenue and use that revenue to pay down debt and create a reserve. The objective of the reserve is to soften the effects of economic downturns on vital state-funded programs. Both elements are part of an effort to move away from boom-and-bust budgeting, the primary cause of the state’s recent fiscal instability. Although a measure on the November 2014 ballot proposes to capture “non-recurring” revenue and establish a new “Rainy Day Fund,” the Governor believes the proposal is too complex. The Governor proposed a simpler system for dealing with the same problem.
Much of California’s recent fiscal instability has been aggravated by short-term decisions that led to boom-and-bust budgeting. In good years, programs receive an infusion of additional resources only to have those funds taken away when the economy slows. This revenue instability is largely due to the state’s tax structure. The personal income tax is heavily dependent upon a small number of higher income earners whose income and tax burden grow dramatically in high-growth years. To a lesser extent, the sales tax contributes to this volatility because it is applied narrowly to goods rather than broadly to services and goods.
In the past, lawmakers have spent revenue that was the result of the state’s volatile revenue structure, primarily spikes in revenue from capital gains realizations, to fund new ongoing commitments, such as education and health and social services. When capital gains revenues dropped, major spending cuts followed. A decade ago, state spending jumped $22 billion over a three-year period after the “dot.com” boom drove up income tax revenues. Within two years, spending fell by about $15 billion, even with temporary taxes put in place to soften the blow. Meanwhile the state’s high-priority programs – K-12 education, higher education and health and social services – struggled.
Some have advocated restructuring taxes to reduce volatility. But most options require broadening the tax base, which would involve taxing something not currently taxed, or shifting the tax burden to the middle class. Both avenues are politically treacherous.
While restructuring taxes should be pursued over the long term for a variety of sound economic and financial reasons, the effects of revenue volatility can be swiftly and effectively managed on the spending side of the ledger. Even if tax reform was politically possible – and it reduced revenue volatility – the need to bolster reserves to cushion the effects of recessions would remain.
Governor Schwarzenegger and the Legislature crafted a budgetary reserve requirement in 2010 that would limit spending based on a complicated formula. The formula would attempt to limit spending based on the growth in revenue over the previous 20 years, along with numerous other factors. The constitutional provision was placed on the 2012 ballot, but the Legislature moved it to the 2014 ballot.
With the economy recovering, lawmakers are once again under pressure to take advantage of the state’s financial recovery – a set of operating surpluses projected to climb to nearly $10 billion by 2018. There is no telling when the next recession will come, however. The average length of economic expansions in California is almost five years. The longest recent expansion lasted ten years. The current recovery, meanwhile, is four and a half years old.
The Governor’s proposal:
The Governor’s proposed 2014-15 budget, complying with the rules of Proposition 58 (2004), would make the first annual transfer of funds into the state’s existing Budget Stabilization Fund since 2007. It puts aside 3 percent of the General Fund, half of it to pay down debt and half to the reserve.
The budget also proposes an alternative to ACA 4. In his budget, the Governor concludes: “[ACA 4] would be a clear improvement over the existing structure – tightening the rules on when deposits should be made and when withdrawals are allowable. Yet, it does not give the state the option to pay off its liabilities, does nothing to address the sharp ups and downs of Proposition 98, and bases deposits on revenues from the past 20 years rather than on spikes in capital gains.”
Principles that should govern the solution:
An effective fiscal control and reserve requirement should satisfy three requirements:
1. Capture revenue spikes to avoid boom and bust budgeting. To effectively avoid boom and bust budgets, the fiscal control must capture spikes in revenue that are largely the result of above average capital gains and limit the use of those funds to one-time purposes that do not decrease revenue or increase spending in future years. Those one-time uses could include paying down debt, pay-as-you go infrastructure or technology projects, funding reserves, or tax rebates.
2. Provide an adequate reserve and appropriately manage the use of those funds. The primary objective of a reserve is to maintain fiscal stability when revenues do not grow as fast as the current service budget, or worse, when they decline year over year. A reserve is particularly important to social and income-support programs that experience an increase in demand during periods of high unemployment. But all programs will benefit from the stability that allows managers and employees to make steady improvements and increases the confidence of clients and customers.
3. Make the requirement transparent so everyone knows how it works. Given the high level of public distrust and the enormous political pressures in play, policymakers need a simple and transparent mechanism for identifying spikes that will be limited to one-time spending and building the reserve. The formula contained in ACA 4 was intended to prevent public officials from manipulating the calculation. But the formula is so complex, it raises public trust issues, as well as concerns about the formula’s unintended consequences under unpredictable economic situations. California should enact a mechanism that is simple and clear enough for the public to hold elected leaders accountable for following the law.
What does the public think?
In 2010, CA Fwd was the lead partner in a statewide Deliberative Poll that engaged a random, scientific sample of 412 Californians over a weekend of deliberations on a series of important public policy topics. One of the issues discussed was the appropriate method for improving fiscal stability. The Deliberative Poll’s relevant findings:
- 68 percent of participants supported increasing the size of the rainy day fund.
- 80 percent of participants supported limiting the use of one-time revenue “spikes” to one-time expenditures, starting with paying down state debt and filling the state rainy day fund. (After being presented with more details on the proposal, as well as several alternatives, 84 percent of participants supported this approach.)
The deliberations – along with traditional polling – have documented that a broad cross section of Californians view this as a litmus test issue. Whether state leaders balance the budget contributes to their trust or distrust in government.
The Governor’s proposed reserve requirements could substantially advance each of the three requirements of an effective fiscal control, and it also offers specific improvements to the approach advanced by ACA 4. As the specific language is developed, analyses and discussions are needed to ensure that there is an understandable and transparent mechanism for establishing the amount of one-time revenues, the amount that should be put in reserve and the appropriate limitations on one-time spending.