Chancellors Budget Workshop State Economic and Fiscal Forecast Presented by: Michelle McKay Underwood Director, Legislative Services School Services of California, Inc.

© 2013 School Services of California, Inc. 1 Overview This is going to be a good year for the State Budget The economy is moving in the right direction, albeit slowly Passage of Proposition 30 provides additional revenues, which benefit education Helped Governor Jerry Brown tackle the Budget problems that have dogged the state for the past decade The State Budget is legitimately balanced for the first time since 2002 and has the first real reserve in years Substantial progress is made toward reducing the states wall of debt But not all of the states problems are behind us The feds are all over the state on prison overcrowding Interest rate increases or international events could derail the recovery

© 2013 School Services of California, Inc. 2 State Budget Sets Low Bar revenues have come in $2.1 billion above the amount that was forecast just two months ago Governor Browns May Revision lowered the revenue outlook by $1.3 billion Strong revenue performance of the last two months more than makes up for the downward revenue adjustment Using the Governors estimates, the State Budget likely understates revenues The Legislative Analysts Office (LAO) and other independent economists estimate that revenues will actually come in more than $3 billion higher That portends greater flexibility in future funding and potential additional one-time funds to Proposition 98

© 2013 School Services of California, Inc. 3 The National Economy The U.S. economy is continuing its slow recovery: UCLA economists indicate the country would need 6% growth over the next five years to catch up to a normal 3% rate of growth in our current economic recovery Moderate strength is attributed to: Historically low interest rates Housing recovery well underway – housing starts roughly double what they were a year ago Increased from depression-era level to recession level – Still a ways to go – it is expected that housing will not fully recover for two more years Increasing auto sales, with the vehicle fleet the oldest on record Federal stimulus and monetary policy increase spending and investment

© 2013 School Services of California, Inc. 4 The National Economy Recovery is fragile: While imports have increased, driven primarily by consumer spending, exports have slowed: Recessions in Europe and Japan Slower growth in China First quarter Gross Domestic Product (GDP) growth revised downward at second look from 2.4% to 1.8% Federal sequestration in both and particularly in has reduced spending and investment Higher payroll and income taxes and Affordable Care Act (ACA) implementation has left many consumers uncertain about the future However, many states are reporting improvements in the job market Optimism is building as personal consumption rates improve

© 2013 School Services of California, Inc. 5 U.S. Economic Outlook

© 2013 School Services of California, Inc. 6 The California Economy California has followed an uneven path to economic recovery Job growth is greater than any other state in the nation, with the exception of Utah Some sectors like leisure and hospitality and construction are increasing, while state and local government are on the decline Median home prices in the state have increased by 32% in the last year Inflation-adjusted personal income is expected to increase 1.6% in 2013 and 3.6% in 2014 By 2014, the California unemployment rate is expected to fall to 8.1%, one percentage point higher than the 2014 projected U.S. rate – still very high Of concern, however, is the bifurcated path of the state economy The inland regions are characterized by continuing high unemployment and ailing housing markets The coastal regions enjoy relatively low unemployment, improving housing markets, and higher average incomes

© 2013 School Services of California, Inc. 7 Californias Unemployment Rate

© 2013 School Services of California, Inc. 8 Californias Unemployment Rate vs. Other States Source: Bureau of Labor Statistics, July 2013

© 2013 School Services of California, Inc. 9 California Personal Income Forecast

© 2013 School Services of California, Inc. 10 Slower Revenue Growth in As a result of the drag that the federal tax hikes and spending cuts will have on the economy, the Department of Finance (DOF) lowered the outlook for California personal income growth in 2013 from 4.3% in January to 2.1% in the May Revision We think this is overly pessimistic – more on that later This slowdown in the economic outlook in turn lowers the revenue forecast assumed in the State Budget Total General Fund revenue drops $1.3 billion from the January estimate to $97.1 billion in the May Revision Each of the three major taxes are revised downward A rebound, however, is forecast to begin in , with the three major taxes combined expected to grow 9.3% in that year and 6.7% in Recent studies still rank Californias business environment as nearly last in the nation Source: CNBCs Annual Top States for Business Rankings, July 10, 2013

© 2013 School Services of California, Inc. 11 Budget Risks Are Few in Compared to prior years, the proposed State Budget faces considerably less risk Unlike the spending plan, it is not dependent upon voter approval of a major tax initiative Proposition 30 provides both sales tax and income tax revenues Unlike the State Budget, it is not dependent upon an unrealistic revenue projection The plan does not rely on an infusion of federal funds to maintain programs It is not reliant on unrealistic operational efficiencies in state programs However, the recent changes in the business climate mentioned earlier could affect state revenues (such as the reductions in export revenues) tempering the state recovery

© 2013 School Services of California, Inc. 12 General Fund Revenues in Source: State Budget Summary, page 6

© 2013 School Services of California, Inc. 13 General Fund Budget Summary Revenues and transfers drop $1.1 billion in , or -1.1% Expenditures increase $616 million, or 0.6% The reserve is 1.1% of revenues and transfers Source: State Budget, page 6

© 2013 School Services of California, Inc. 14 The Administrations Revenue Forecast Recall that the Governors May Revision lowered the revenue outlook for by $1.3 billion from the January Budget Proposal forecast because of the expected drag that federal budget policy would have on the economy Sequestration cuts would reduce federal spending Higher tax rates for high-income earners and the expiration of the federal payroll tax holiday would depress consumer spending The LAO offered a contrary view – the overall economy was gaining strength compared to the January forecast Revenues were forecast to exceed the May Revision by $3.2 billion The Legislature initially adopted the LAO forecast, but the Governor ultimately prevailed, with the State Budget Act based on the lower revenue estimate

© 2013 School Services of California, Inc. 15 DOF Forecast Through Source: Governors May Revision

© 2013 School Services of California, Inc. 16 Is the Forecast Reasonable? In order to assess the risks of the DOFs revenue forecast, not just for but through , School Services of California, Inc., (SSC) commissioned Capitol Matrix Consulting (CMC) to perform an independent analysis of the DOF forecast Brad Williams, a partner with CMC, served as the LAOs senior economist for 12 years and was recognized by the Wall Street Journal as the most accurate California forecaster of the 1990s The SSC/CMC analysis finds that the DOF forecast is reasonable, with greater upside potential than downside risks We assume that: The U.S. expansion will continue at a moderate pace for several years California personal income will rise from 3.4% in to an annual average pace of 5.5% through Payroll jobs will grow at an annual average rate of about 2.2%

© 2013 School Services of California, Inc. 17 DOF vs. SSC/CMC Forecast Source: General Fund Revenues and Proposition 98 Forecast, CMC, July 2013

© 2013 School Services of California, Inc. 18 Measuring Risk of the Forecast All forecasts are ultimately proven wrong Actual revenues are either above or below the forecast level, but almost never exactly as projected The more important question: What are the risks to the forecast and how can these risks be measured? The forecast risks include: The economic impact of the federal ACA and how it will affect employment The Federal Reserves plan to retreat from quantitative easing and the effect of higher interest rates on the stock market, housing sales, and business investment The weakness of the European and Asian economies and their impact on U.S. and California exports

© 2013 School Services of California, Inc. 19 Confidence Intervals and Forecasting One method of quantifying forecast risk is to establish a confidence interval around the forecast The SSC/CMC analysis examined historical General Fund revenue growth rates over a 30-year period, establishing standard deviations around the growth rates for one-year through five-year sub-periods Flashback to Statistics 101: A standard deviation (SD) measures the average variation from the mean growth rate – For normally distributed variables, about two-thirds of the observations fall within one SD of the mean Using +/- 1 SD from the forecast, there is a one-sixth chance that revenues will fall below the confidence interval and a one-sixth chance that revenues will exceed the confidence interval

© 2013 School Services of California, Inc. 20 Confidence Intervals and the Forecasts Source: General Fund Revenues and Proposition 98 Forecast, CMC, July 2013

© 2013 School Services of California, Inc. 21 Conclusions About the DOF Forecast Based on the independent analysis conducted by CMC, the DOF forecast is reasonable and falls within the +/- 1 SD confidence interval There is more upside potential that actual revenues exceed the Administrations forecast than downside risks that revenues will fall short The Administrations General Fund revenue forecast, therefore, provides a reasonable basis to project Proposition 98 revenues

© 2013 School Services of California, Inc. 22 Proposition 98 Funding Guarantee Proposition 98 sets the minimum funding level for K-14 education, based on the prior-year funding level and changes in workload (as measured by K-12 average daily attendance [ADA]) and inflation (as measured by the lesser of per-capita personal income or per-capita General Fund revenues) Adopted by state voters in 1988, this is a constitutional guarantee The measure specifies only the minimum funding level, it does not determine what programs will be funded For , the state fully funds Proposition 98 at $55.3 billion, a decline of $941 million from There are no manipulations or reinterpretations of the constitutional guarantee as there have been in prior years The guarantee declines about 2% because of the lower General Fund revenue forecast in the May Revision

© 2013 School Services of California, Inc. 23 Proposition 98 Forecast

© 2013 School Services of California, Inc. 24 Who Will Benefit from Stronger Revenues? No other area of the State Budget gets increased as significantly as education: Up to $120 million in additional funds to counties to accommodate new workload associated with implementing the ACA $206 million for mental health An increase of $143 million for California Work Opportunity and Responsibility to Kids (CalWORKs) employment services $34 million to begin providing preventative adult dental benefits in May 2014 $60 million augmentation to support trial courts to increase public access Demand for new revenues from other areas of the State Budget will be strong going forward Source: State Budget, DOF

Thank you © 2013 School Services of California, Inc.