1. Structuring a Functional Reserve: Lessons from California
National Tax Association
2014 Annual Conference on Taxation
Santa Fe, New Mexico
November 2014

2. The Big Picture Issues
State budget relies on tax revenue sources of which some components can be quite volatile.
Unanticipated, unbudgeted General Fund expenditures—because of court decisions, emergencies, federal law changes—are not unusual.
Proposition 98, the state’s complex funding formula for K-14 education, is a major factor in state spending decisions and budget flexibility.
California has had a generally weak track record on setting aside money in reserves during good economic times.

3. General Fund Revenues and Capital Gains Component ($000s)

4. State Reserve Proposal
With the January budget, Governor proposed to replace ACA 4 (currently on the ballot) with a new constitutional “rainy day” fund/reserve measure, for the November 2014 ballot.
ACA 4, the budget reserve/spending cap measure passed in in 2010, was set for the November 2014 ballot. It was originally scheduled for the June 2012 ballot but was later moved to November 2014.
Either measure, if approved by the voters, would replace the existing state budget reserve requirements.

5. The Recent Situation
The state has always had it’s normal, “prudent,” budget reserve, technically known as the Special Fund for Economic Uncertainties (SFEU).
Typically, the SFEU—which has usually been at least $1 billion when the Budget Act is passed in the summer— has paid for garden-variety of needs to keep the budget in balance.
More significant economic downturns typically exhaust the SFEU, and require additional action by the Legislature to bring the budget back into balance.

6. The Recent Situation
Proposition 58, approved by voters in the March election, established a secondary reserve known as the Budget Stabilization Account (BSA).
The BSA was a companion measure to Prop. 57, the Economic Recovery Bond (ERB) measure.
In addition to establishing the BSA, Proposition 58 also established in the state constitution new “balanced budget” requirements and established new mechanisms to deal with mid-year “fiscal emergencies.”

7. BSA Mechanism
Requires 3% of estimated annual General Fund revenues to be transferred to BSA until the balance in the BSA is $8 billion, or equal to 5% of total General Fund revenue, whichever is greater.
Half of each annual transfer is used to pay down the ERB debt faster, until it is paid off. After that, all the entire 3% goes to the BSA.
Governor proposed and Legislature approved the full transfer this year (equivalent to $3.2 billion), with $1.6 billion going to ERB debt (and pay them off), and the remaining $1.6 billion deposited to the BSA.

8. BSA Mechanism
Governor has power, by executive order, to suspend the transfer.
Given state’s difficult fiscal situation, this has regularly been done annually (except for 2007).
Governor proposed and Legislature approved the transfer in 2014.
Funds can be transferred out of the BSA, and back to the General Fund, by majority vote of the Legislature.
The BSA process simple and straightforward. Some—including the Governor—question whether it is strong enough.

9. Proposed ACA 4
Approved for ballot in October 2010 (during state’s longest budget delay). Significantly tightened up the BSA mechanisms.
Limited the ability of the Governor to suspend the 3% annual transfer to the BSA.
Increased the reserve target amount from the current BSA’s 5% of total revenues, to 10% of total revenues.
Divided evenly the 3% transfer into the BSA and a “supplemental” BSA for use in capital and debt service payoff.
Limited the use of “unanticipated” revenues to Proposition 98 education obligations and for BSA.

10. Proposed ACA 4
Restricted withdrawal from the BSA to emergencies and years of defined insufficient revenues.
Limited withdrawals to no more than 50% of the balance of the fund in any one year.
Provided a limited menu of uses of revenues that are received over the total cap in the fund, thus acting as a spending cap.
Required the estimation of linear regression (time trend) to establish what is ‘unanticipated’ revenue, accounting for any tax policy changes in order to exclude these effects.

11. Governor’s January Proposal
Largely built off the existing BSA enacted by Proposition 58. Provided that deposits to the BSA would be based on General Fund revenues attributable to capital gains that are above 6.5% of total General Fund tax revenues.
Created a new Proposition 98 reserve whereby spikes in funding would be retained for future years of decline, to smooth spending. Mechanism was similarly based on spiking capital gain revenues.

12. Governor’s January Proposal
Limited withdrawals from BSA to not more than 50% of the balance, except in a year following a withdrawal.
Provided for a “true-up” mechanism used at two points in time to add to or remove prior deposits, based on updated capital gains taxes calculations.
Overall, less complex than ACA 4, but significantly more complex and effects much more uncertainty than existing Proposition 58 BSA mechanism.

13. Critiques of the Governor’s Proposal
Added new elements of complexity to already complex budget process—and inserted more complexity in the State Constitution.
Basing deposits on capital gains would be problematic.
Estimates require much subjective judgment.
Capital gains definition and tax rates may change—along with underlying economics.
True-up mechanism would likely be clumsy.
Remainder of state’s revenue structure is also volatile—not just revenues from capital gains.
Provided substantial new power to the Executive Branch.
Proposition 98 reserve provisions could also create substantial uncertainty and budgetary complications.

14. Legislative Reserve Fund Proposal
Deposits to the Reserve 1.5% of total annual General Fund revenues.
Current law Proposition 58 is 3%.
Plus, revenues attributable to capital gains that are above 8% of General Fund tax revenue projections, after accounting for Proposition 98 impacts.
Governor’s original proposal was based on 6.5% threshold.
Half of total deposit would have to go to pay down debt for at least the next 15 years.
Debt includes “Wall of Debt” payments (loans, local government mandates, etc.), and unfunded pension liabilities.

15. Legislative Reserve Fund Proposal
Same two-year “true-up” provisions for capital gains deposits as Governor’s original proposal.
Given higher capital gains threshold, “true-up” provisions less likely to have significant impacts.
Deposits can be suspended or reduced, pursuant to a Governor proclamation, during a budget emergency.
Proposition 98 reserve had no changes.
Reserve deposits only occur when all of current Maintenance Factor repaid, and Prop. 98 is in Test 1 year.
Deposits not likely to begin for several years, and then not too often.

16. Legislative Reserve Fund Proposal
Funds can be withdrawn when money is needed to fund expenses to a level that is up to the highest amount of previous three enacted budgets, adjusted for inflation and population.
Modified from Governor’s proposal, taking multi-year recessions into better account.
Funds can also be withdrawn during a natural disaster emergency.
No change to Governor’s original proposal.
Up to half of the balance in the Rainy Day Fund can be withdrawn in a single year.

17. Observations
Simplicity, predictability, and flexibility are virtues for a budget reserve...but any mechanism will place some restriction on the Legislature’s appropriation authority.
Ensured that at least half of deposits will go to pay down debt for at least 15 years, freeing-up General Fund for other purposes.
Diminished the importance of capital gains in the calculation.
Reduced difficulties associated with estimating issues, potential of “gaming” the numbers, and “true-up” surprises.
Reduced reliance on capital gains also minimizes potential negative interactions with federal tax actions.

18. Change in General Fund Revenues and Capital Gains Component

19. Observations
Requiring 1.5% annual deposit takes money off the table for spending.
But potentially much less than under current Proposition 58 or ACA 4.
Ensures that half is used for debt, freeing up General Fund.
Will likely result in balance in the fund to draw upon during an economic downturn.
Withdrawal provisions are workable.
Ensure that money is available during multi-year downturn.
Three year look-back facilitates recovery to pre-recession spending levels and reduces the chance of locking-in artificially depressed spending.

20. Estimated Reserve Fund Deposits
New Reserve Policy at 2014 Budget Act
(Dollars in Millions)
1.5% under Prop 58 1
General Fund Revenues and Transfers
$113,265
$118,129
$123,379 2
Prop 58 Transfer (1.5% of General Fund Revenues & Transfers)
$1,699
$1,772
$1,851
Capital Gain Revenues 3
General Fund Tax Proceeds
$113,011
$117,803
$122,706 4
Personal Income Taxes from Capital Gains
$9,409
$9,933
$10,471 5
% of General Fund Tax Proceeds
8.3%
8.4%
8.5% 6
8% of General Funds Tax Proceeds
$9,041
$9,424
$9,816 7
Personal Income Taxes from Capital Gains in Excess of 8% General Fund Tax Proceeds
$368
$509
$655 8
Prop 98 Share of Capital Gains Tax Revenue above 8%
$194
$276
$314 9
Non 98 Share of Capital Gain Tax Revenue above 8%
$174
$233
$341 10
Total Available for Rainy Day (Lines 2 and 9)
$1,873
$2,005
$2,191 11
Debt Repayment (50%)
$937
$1,002
$1,096 12
Deposit to Rainy Day Fund (50%)
Cumulative Balance in Rainy Day Fund 1/
$2,543
$3,545
$4,641