Revenues Are Above California's 2021 Budget

The recently released California executive budget proposal for fiscal 2022 projects a much brighter fiscal picture, in S&P Global Ratings' view, than when the state enacted its fiscal 2021 budget last June, mostly due to significant one-time revenues and conservative budgeting of expenditures in fiscal 2021, which should support near term credit stability.

Both sales and income taxes have come in much stronger than anticipated. Through November 2020, year-to-date agency revenues have come in 22.7% ahead of fiscal 2021 budgeted amounts. As a result, we believe projected strong revenue growth over the next two years should carry forward significant reserves into the following years.

The state estimates capital gains tax rose to a record 11.4% of total general fund revenues in fiscal 2019 (compared with 3.4% in the 2009 recession year), and should remain near that at 11.3% for both fiscal years 2020 and 2021 based on recent strong stock market returns. In tax year 2018, the top 1% of taxpayers already contributed 46% of California's personal income tax (PIT), while PIT rose in fiscal 2018 to a record 69% of total general fund revenue. We expect that higher unemployment for lower-income residents during the COVID-19 pandemic should further concentrate the contribution of tax revenue among the top taxpayers, who derive a significant amount of their income from capital gains.

California's recent windfall revenue derives from the state's steeply progressive income tax, a strong stock market with its accompanying capital gains taxes, and the ability of upper-income individuals to work at home through the pandemic. In our view, California has the greatest dependence on capital gains tax of all the states (see "Market Volatility Has Varying Impact On U.S. States' Capital Gains Tax Exposure," published March 10, 2020, on RatingsDirect), which exposes it to above-average revenue volatility. There are times, such as now, when this works to the state's advantage, although we believe California also retains above-average revenue risk when capital markets do poorly.

Overall, the state projects general fund revenue will increase $28.2 billion, adjusted to net out transfers from reserves, or 21.7% above conservatively budgeted revenue in fiscal 2021, and will rise a further $3.3 billion, or 2.1% in fiscal 2022 (see table 1). The executive budget estimates the one-time revenue windfall at $15 billion, of which it proposes to use 85% on one-time spending. Due to the one-time nature of the additional revenue, however, we calculate from state projections (without future corrective action) an operating deficit of $8.6 billion in fiscal 2024, netting out beginning balances, or 5.2% of projected expenditures, and $11.3 billion in fiscal 2025, or 6.6%.

This revenue forecast is likely conservative. The executive budget proposal was put together before the most recent federal COVID-19 aid package was enacted, and the governor's May budget revision is expected to include the effect of additional federal aid, which could add significant available revenue.

Tax revenues have been strong enough for the state to project that these revenues will temporarily rise by a modest $102 million over California's constitutional Gann Limit, which was enacted in a 1979 voter referendum, but activated only once since then. Half of the revenue exceeding the limit must be used for taxpayer refunds in fiscal 2022, and half must be spent on schools. The state does not expect to exceed the Gann Limit in succeeding years.

Strong reserves are projected

We calculate from California's projections that general fund and budget stabilization reserves will equal overall a very strong 14.6% of general fund budgetary expenditures at fiscal year-end 2021 (see table 2), and we calculate an estimated 2021 net operating surplus of 1.4% of expenditures, adjusting out transfers to and from reserves, raising the operating surplus to 2.9% if what the state characterizes as one-time expenditures were removed. We calculate the executive budget would produce an adjusted 1.9% operating deficit in fiscal 2022, which would result in an operating surplus of 1.9%, if state-identified one-time expenditures were removed. Under the executive budget proposal, fiscal 2022 would end with reserves equal to a still very strong 13.3% of expenditures. California's new multiyear general fund financial projection cuts the out-year budget gap for fiscal 2024 by more than half from its previous June projection, to what we calculate as a 5.2% operating deficit, leaving reserves equal to 4.5% of expenditures. While the state still projects large out-year deficits (see table 1), these appear more manageable at present.

A breakdown of spending

In the executive budget proposal, general fund spending would break down as follows:

• $59.7 billion, or 36.3% of total general fund expenditures on kindergarten-to-grade 12 (K-12) education;
• $39.4 billion, or 24.0% on health;
• $17.9 billion, or 10.9% on higher education (not including spending offset by federal reimbursements);
• $14.9 billion, or 9.1% on human services;
• $13.1 billion, or 8.0% on corrections;
• $4.6 billion, or 2.8% on natural resources; and
• $15.0 billion, or 9.1% on other expenditures.

How California Will Use The Windfall

The executive budget estimates the state will receive an extraordinary net revenue windfall of $15 billion in fiscal 2021, of which it will spend 85% on one-time spending, including reserves that will help cover a proposed operating deficit in fiscal 2022. Major uses of the windfall revenues include additional spending for health care, higher education, and local school districts, as well as a $3 billion paydown of unfunded pension and retiree health care liabilities in fiscal 2022 required under Proposition 2. This includes a $1.5 billion proposed one-time Proposition 2 paydown of California Public Employees' Retirement System's (CalPERS) unfunded liability and $926 million of pre-funding into the state's health care benefit trust in fiscal 2022.

The governor proposes $5.0 billion of immediate additional fiscal 2021 spending, including $2.0 billion to reopen K-12 schools safely and support in-person instruction for grades K-6. He also proposes an immediate $3.0 billion in direct support for workers and small businesses affected by the pandemic, including $2.4 billion to provide tax refund payments of $600 to low-income residents, for a total of $5.0 billion in additional 2021 spending. Future federal aid might cover some of these payments, which we expect will be reflected in the upcoming proposed May revision to the budget. Overall, the governor is proposing a recovery package to increase general fund spending by $11.2 billion in fiscal 2021, and $2.7 billion in fiscal 2022, to support economic recovery and mitigate effects of the pandemic on California schools.

K-12 school aid

Apart from the proposed immediate $2.0 billion to reopen K-12 schools, the governor also is proposing $4.6 billion to expand learning time to support students that are either one grade level or more behind or credit deficient in core subject matters.

The fiscal 2022 executive budget proposal would use a major portion of the additional revenue to reverse in fiscal 2022 the significant deferrals of school aid that were enacted in fiscal 2021 to balance the budget when California revenues projections were lower. The 2021 budget deferred $12.5 billion of state aid to local schools, representing cash payments to school districts that were not made in fiscal 2021, but that the state promised to make in fiscal 2022 (see table 2).

California is currently arranging a note pool that will allow school districts to borrow in fiscal 2021 against this future fiscal 2022 state aid, and help insulate them from state aid cuts, in what we view as essentially a form of back-door deficit financing. State aid deferrals would normally put pressure on the succeeding year's state budget to defer a like amount of cash payments to avoid a spike in next year's state aid payments when deferred revenue is paid on top of normal formula aid. However, the current revenue windfall is allowing the governor to propose reducing the amount of deferred state aid from fiscal 2022 that would be paid in fiscal 2023 to $4.1 billion, a significant reduction from the $12.5 billion deferred from 2021 into 2022, and representing a large boost in cash payments to school districts in fiscal 2022. The state has no plans to decrease the $12.5 billion of school aid deferrals currently budgeted in fiscal 2021, leaving the schools to rely on the external note financing to largely make them whole in fiscal 2021.

Overall, Proposition 98 school spending would rise to record levels, and the state would subsidize $1.1 billion of school district annual pension contributions in fiscal 2022 outside of Proposition 2's total $3 billion of other state pension paydowns in fiscal 2022. This allocates $830 million in fiscal 2022 to lower the California State Teachers' Retirement System's employer contribution rate to 15.92% from 18.10%, and $330 million to lower the CalPERS school district contribution rate to 23.0% from 24.9%.

Total K-12 spending per pupil from all sources (federal, local taxes, and state) would be $18,837 in fiscal 2021, before falling to $18,000 in 2022, due to the extra allocation of federal funds in 2021. However, ongoing state Proposition 98 K-12 spending would increase by $1,994 to $12,648. Schools would receive a 3.84% cost-of-living adjustment (COLA) under Proposition 98, reflecting a 1.5% adjustment for 2022, as well as an extra make-up adjustment to compensate for having no COLA in 2021.

Higher education gets a boost

The executive budget proposes $1.3 billion of additional general fund spending on higher education, out of total public higher education funding of $36.1 billion from both the general fund and local property taxes, and not including $2.9 billion in the federal COVID-19 relief bill. State general fund spending on higher education alone would be $21.8 billion (including extra general fund expenditures offset by federal grants and reimbursements), including a 3.9% increase in ongoing state general fund funding, and a 5.0% increase in ongoing state funding for the California state university system. Combined state aid and local property taxes for community colleges would increase 3.4%.

Health and human services spending would rise

About one-third of state residents are on Medicaid, and the state projects Medicaid caseloads will increase by 1.6 million in fiscal 2022, to 15.6 million. General fund health and human services spending is projected to rise by 25.6% in fiscal 2022 to $54.4 billion, or 33.0% of proposed total general fund spending. However, significant federal aid has helped fund increased costs during the pandemic. Overall, including spending from federal sources, Medicaid spending would total $122.2 billion in fiscal 2022. The executive budget proposes to reverse $2 billion of various health services suspended in the enacted 2021 budget.

Zero emission vehicle mandate could result in $1 billion bond issue

The governor earlier issued an executive order mandating that all new passenger vehicles sold in the state be zero emission by 2035, and all trucks by 2045 (see "California's Order Requiring Zero-Emission Vehicles Poses Challenge To Gasoline Taxes," published Oct. 21, 2020). As part of that order, the executive budget proposes extending motor vehicle registration fees and issuing up to $1 billion of bonds against this revenue to help implement the governor's zero emission executive order. We expect to see more regarding the governor's plan to transition to all zero-emission vehicles in the upcoming May budget revision and expect future implementation studies to be released by the state.

California's 2022 Budget Proposal Could Be Modified After The May Budget Revision

The governor's 2022 budget proposal was put together before the most recent federal COVID-19 aid package was enacted, and another potential federal aid package could result in additional revenue. The revenue picture also remains more uncertain than usual because of the ongoing pandemic. As a result, there could be significant modifications to the governor's plan when California releases its May budget revision following the tabulation of April income tax returns.

Table 1

Table 2