Highlights Of The Proposal
- The May Budget Revision proposes large reserve drawdowns, but fiscal 2021 would still end with budgetary fund balances we would consider strong, despite large projected revenue drops.
- One-time budget adjustments would total a large $19.3 billion in fiscal 2021, or 14% of expenditures, indicating a large structural gap will still need to be addressed in the fiscal 2022 budget, and reserves may be drawn down to low levels before recovery takes place.
- Large one-month one-time deferrals of school aid may close fiscal 2020 and 2021 budget gaps and prop up year-end 2021 budgetary fund balances, but they lower general fund liquidity when 'double month' school payments are made in July, and can create a continuing need for ongoing deferrals in following years.
- About $14 billion of proposed spending cuts would not go into effect if the federal government provides by July 1 additional aid for lost tax revenue due to pandemic restrictions.
- The budget bill currently pending in the state senate, compared to the governor's May budget revision proposal, contains more spending, more optimistic Medicaid projections, some additional money from managed care providers, and if additional federal aid is not received, a later Oct. 1 'trigger date' that would produce lower reserves and larger one-month one-time school aid deferrals in July.
Our Rating Incorporates An Expectation Of Cyclicality
Our current 'AA-/Stable' rating incorporates our view that California is subject to above average revenue cyclicality, and could come close to fully drawing down its currently strong reserves before recovering. We view the current drop in revenue as a more sudden version of the state's historical swings. The stable outlook reflects our expectation that California will have adequate liquidity to ride out the current recession, and that the state's economy will at least partially bounce back after pandemic restrictions are lifted. Before the current recession, the state had achieved structural balance (with recurring revenues sufficient to fund California's legally required ongoing expenditure base), albeit at a high point in the economic cycle, and we believe the state will make upcoming adjustments to its fiscal 2021 budget to enable it withstand the recession, although with potentially large drawdowns in its substantial budget stabilization account (BSA). We believe that the use of the BSA, spending cuts, and access to large internally borrowable non-general fund cash will enable the state to avoid severe liquidity pressure until the state is able to restore structural budget balance.
Overview Of The Governor's May Revision
The governor's recent May revision to his January fiscal 2021 budget proposal projects substantially lower revenue, large reserve drawdowns, and large expenditure cuts, which would be partially reversed if additional federal aid is received for pandemic related tax revenue losses. Such federal aid is not in current federal legislation, and seems unlikely to be received by July 1. However, even without additional federal aid, the May revision projects fiscal 2021 would end with what we would view as still strong total general fund reserves equal to 8.0% of expenditures, on a budgetary basis of accounting.
The pace of expected reserve drawdowns from peak total reserves equaling 16.2% expenditures at fiscal end 2018 (see table 1) to a projected 8.0% in 2021, however, demonstrates, in our view, the above average cyclicality of California tax revenues and the severity of the current downturn. We view California's tax revenue as particularly cyclical due to its dependence on income tax for about 69% of general fund revenue, and the large proportion of income tax derived from top taxpayers and their cyclical capital gains. In 2018, the state estimates about 46% of income tax came from the top 1% of taxpayers.
The state forecasts about a 6% baseline drop in fiscal 2020 general fund tax revenue and a 22% baseline drop in 2021 revenue, compared to the governor's January budget proposal, before proposed revenue enhancements.
In actual dollar terms, the state projects general fund tax revenue will drop $9.4 billion, or 6.8%, from revised fiscal 2020 tax revenue to revised fiscal 2021, including the positive effect of $4.4 billion of corporate revenue enhancements, primarily from temporarily suspending certain corporate tax losses and limiting certain corporate deductions. Projections of capital gains tax realizations were reduced from the state's January forecast to $119 billion from $151 billion for calendar 2020, to $70 billion from $147 billion in 2021, and to $84 billion from $144 billion in 2022.
Total K-12 general fund spending would decline a large $6.9 billion, or by 12.6%, including a Proposition 98 K-14 local school aid spending cut ($7.5 billion in fiscal 2021, about a 14.2% decrease)—not surprising as Proposition 98 K-14 spending makes up about 38% of total general fund spending. The state would make a one-month school aid deferral of about $1.9 billion of school aid from June 2020 to July 2020 (into the next fiscal year), and add on top of that another $3.4 deferral in the next 2021 fiscal year, for a total one-month deferral of school aid payments from June 2021 into July 2021 (into fiscal 2022) of $5.3 billion. The pending senate budget bill would increase this one-month school aid deferral in June 2021 by an extra $3.7 billion, from the $5.3 billion cumulative deferral in the governor's plan to $9.0 billion, if additional federal aid is not received, according to the California Legislative Analyst's Office (LAO), as part of total senate deferrals of $10 billion.
The LAO calculates that K-12 funding would be held essentially flat in fiscal 2021, if one-time federal and other aid and deferrals are also included in funding contributions. Since statewide enrollment is declining, that translates into a small increase in per pupil funding, although rising pension and other costs also continue to squeeze local school districts.
Draft Senate Budget Bill
If additional federal aid is not received, the pending state senate budget bill could raise school deferrals further to $9.0 billion (compared to $5.3 billion in the governor's plan), as part of total deferrals of all types of $10.8 billion. The draft senate bill would not make cuts until Oct. 1, as opposed to a July 1 trigger under the governor's proposal, and if additional aid were not received it would lower reserves further to about 5% of its proposed higher expenditures, than the 8% total reserve level in the governor's proposal. Under the draft senate bill, if no additional federal aid was received, fiscal end 2021 total budgetary reserves would equal less than the cash deferrals.
According to the LAO, the senate bill also assumes $3.6 billion less in Medicaid costs than in the May revision proposal; spends about $4.2 billion more; provides about $1.0 billion in extra revenue from managed care organizations; and without the additional federal aid would draw down total general fund reserves to about 5.5% of expenditures, compared to the governor's proposal to draw down reserves to 8.0% of expenditures. In the senate's current plan, without additional federal aid, one-month school funding deferrals would total more than the fiscal end 2021 total budgetary general fund reserves, indicating a need for internal cash flow borrowing and a potential substantial structural deficit that might need to be addressed in fiscal 2022.
If something close to the senate bill passes, S&P Global Ratings will evaluate the impact on credit of potentially larger structural gaps that may need to be closed when the fiscal 2022 budget is adopted next year.
Structural Imbalance In The Governor's Proposed May Revision
The rapid projected drawdown in total general fund reserves in the governor's May budget revision indicates that the state may need to make substantial additional cuts in fiscal 2022. While currently strong reserves allow the state some time to right the ship, maintenance of credit quality will depend on how well the state can arrive at structural balance when reserves run out and cash liquidity may not be as strong as at present.
The state projects that general fund revenues for the combined two fiscal years 2020 and 2021 will decrease about $41 billion compared to the state's January revenue forecast, and estimates that without implementation of the proposals recommended in the May budget revision, out-year budget gaps would be about $45 billion annually, instead of the $16 billion gap now projected in 2024.
Compared to the January budget proposal, which assumed both higher revenue and higher spending than the year before, the state now projects a budget gap difference of $54 billion for remaining fiscal 2020 and all of fiscal 2021, including extra COVID-19 related costs and lower revenue estimates.
The governor proposes to meet the $54 billion gap from the January budget proposal by:
- Cancelling about $6.1 billion in program expansions and spending increases, including some that were of a one-time nature.
- Redirecting $2.4 billion in expected one-time extra CALPERS pension liability pay downs to instead pay regular annual pension contributions.
- Drawing down $450 million in fiscal 2020 from a Safety Net Reserve in fiscal 2020, and drawing down $8.3 billion of reserves in fiscal 2021, including $7.8 billion from the BSA.
- Borrow and transfer $4.1 billion from special funds.
- Raise $4.4 billion of additional revenue, primarily from limiting corporate tax credits for research and development, and temporarily suspending net operating losses.
- Use of $8.3 billion enacted one-time federal Coronavirus Aid, Relief, and Economic Security Act funds for additional COVID-19 related expenditures. These include $4.4 billion to address learning loss for local school closures, which must be spent by Dec. 31, 2020.
- Implement $14.0 billion of other cuts if additional federal aid is not received by July 1 to compensate for lost revenue due to the pandemic. These include a 10%, or $6.5 billion reduction to the K-12 education local control funding formula, including elimination of a cost-of-living adjustment; $1.4 billion of general fund savings from yet to be negotiated 10% cuts in employee pay-- the state says it will impose reductions if it cannot reach an agreement; a 10% cut to higher education; cuts in pre-school funding; child care cuts; certain social service cuts; and various other cuts, such as in trial court funding.
The governor proposes to help local school districts by redirecting $2.3 billion of previously allocated money for extra pension liability pay downs of CALSTRS and school CALPERS liabilities to allow school districts to use the money for regular annual pension contributions. The governor proposes to increase mandated Proposition 98 spending in out-years by up to $4.6 billion in fiscal 2024—this would be a permanent constitutional requirement to increase K-14 spending as a percent of the state's general fund, from about 38% of general fund spending to about 40%, under Proposition 98's "test 2", which allows for increases as a percent of general fund spending, but never a decrease. As a result, it would permanently increase the state's fixed costs in the out-years. Scheduled increases in state contribution rates to CALSTRS would be put on hold for three years.
The estimated fiscal 2021 budgetary balance may paint an overly optimistic picture since it does not include $5.3 billion in one-month K-12 school aid deferrals from June 2021 to July 2021, creating a one-time deferral into fiscal 2022 that does not show up in the fiscal 2021 budgetary balances. Schools would receive a "double" monthly payment in July, which does not affect the budgetary ending balance, but reduces state liquidity until the following June, when the next year's deferral is made.
The state's multi-year financial projection, made as part of the May revision, estimates that about $2.4 billion of fiscal 2020 budget adjustments are of a one-time nature (1.7% of expenditures), and a large $19.3 billion of proposed fiscal 2021 budget adjustments are one-time (14.4% of projected expenditures) (see table 2). The $19.3 billion of one-time budget adjustments in fiscal 2021 include $8.3 billion of combined reserve drawdowns, $5.3 billion one-time school aid deferrals from June to July, over $1 billion of federal Medicaid assistance program savings, $975 million for CALPERS pension liability pay downs re-directed to replace annual pension contributions, and additional aid for additional one-time COVID-19 related expenses.
A $6.5 billion projected budget gap in fiscal 2022--about 4.7% of projected 2022 expenditures, after use of $5.4 billion of BSA reserves--will remain and need to be closed. However, total combined reserves, including the BSA, would turn negative in fiscal 2022 without further budget adjustments. The projected out-year fiscal 2024 out-year gap rises higher to $16.2 billion (10.8% of expenditures) without future budget adjustments, although this includes the governor's proposal to add $4.6 billion in additional Proposition 98 guarantee spending not in current law (see table 2).
The state is currently projecting that the pace of its economic recovery will be similar to its slow recovery coming out of the Great Recession, which may be too pessimistic. IHS Markit currently projects California real gross state product will fall 6.9% in calendar 2020, and rise 5.4% in 2021, and 4.6% in 2022, while personal income will fall 0.8% in calendar 2020, and rise 3.0% in 2021, and 4.05 in 2022. To the extent economic recovery exceeds the state's long term projections, the projected out-year gaps could diminish.
We believe California's cash position is currently quite strong, although the cash position could diminish over the next several years.
At the end of April 2020, the state controller still reported that the state still had $44.4 billion of month-end unused internally borrowable resources, even though one-month April 2020 general fund cash receipts fell 30.0% below the same one-month April period in 2019. (Cumulative revenue through April 30 was up 1.9% over the prior year period, and only 3.6% below the adopted fiscal 2020 budget forecast).
A strong April end cash position is notable, because of lost April income tax due to the extension of the income tax filing period to July. The state estimates that the extension of the April income tax filing deadline to July will shift about $15.6 billion of fiscal 2020 income tax collections into fiscal 2021, and shift temporarily about $4.4 billion of corporate tax into fiscal 2021.
The governor proposes, in fiscal 2021, $4.1 billion of general fund borrowing from special funds. While this helps support the general fund, it will result in a small drawdown in total internally borrowable resources.
To the extent that the state implements deferrals of school spending from June into July, it will correspondingly decrease state liquidity while leaving budgetary fund balances unchanged. The draft senate budget bill could lead to $10.8 billion of total deferrals at fiscal end 2021 (according to the LAO), if additional federal aid is not received by Oct. 1—greater than projected general fund reserves.
The state's proposed solution to tax revenue losses leans heavily upon its large existing reserves and deferring substantial amounts of school aid to July from June, similar to the deferrals made during the Great Recession. These earlier school aid deferrals were eliminated during the subsequent economic recovery and have now become available for use again as a sort of extra reserve. The substantial $19.3 billion one-time budget solutions proposed in fiscal 2021 will lead to a large structural budget gap that will need to be closed in fiscal 2022, when one-time resources may not be as robust. The one-time budget adjustments proposed in fiscal 2021 equal about 14% of projected expenditures, indicating balancing the fiscal 2022 budget may be difficult. Future credit quality will depend to a large degree on how well the state can come up with structural budget solutions in the out-years.
|California General Fund Financial Results--Budgetary Basis|
|--Fiscal year-end June 30--|
|Governor's May Budget Revision Proposal|
|Budgetary basis results||2021P||2020P||2019E||2018||2017||2016|
|Net as percentage of expenditures||(6.7)||(3.9)||1.8||9.2||2.7||4.2|
|Net transfers (to)/from other funds and other additions||12,550||(3,998)||(4,426)||(3,673)||(4,003)||(3,031)|
|Unreserved-undesignated plus SFEU||(1,556)||1,960||6,353||9,231||1,934||3,071|
|Safety net reserve||450||900||900||200||0||0|
|Public school system stabilization account||0||0||0||0||0||0|
|Budget Stabilization Account (BSA)||8,350||16,156||13,968||10,798||6,713||3,529|
|Combined BSA and other general fund reserves||10,760||15,501||21,221||20,229||8,647||6,600|
|Reserves and stabilization account as a percentage of expenditures- May revise||8.0||10.6||15.0||16.2||7.2||5.8|
|Proposition 98 school cash payments deferred into July 2022- May revise||5,300||1,900|
|Senate Budget Proposal|
|Combined BSA and other general fund reserves (assumes no additional federal aid- if full additional federal aid is received, reserves would be $500 million more than the governor's May revision)||7,600|
|Reserves and stabilization account as a percentage of expenditures- Senate budget||5.5|
|Senate Budget Proposal Proposition 98 school deferrals (assuming no additional federal aid)||9,000|
|SFEU--Special fund for economic uncertainty. P-projected in governor's May 2020 budget revision proposal. E-Revenue estimate from May revise proposal; 2019 expenditure and fund balance estimates from January 2020 budget proposal. Sources: Governor's May Revision Proposal; Governor's January Budget Proposal; California Legislative Analyst's Office|
|General Fund Multi-Year Forecast 2020-2021 May Revision|
|Combined revenues and non-BSA transfers||138,997||129,611||123,821||128,055||134,218|
|Transfer (to) from Budget Stabilization Fund||(2,160)||7,806||5,405||2,945||0|
|Total Resources- combined prior balances/transfers/revenues||148,117||139,037||134,361||129,652||121,031|
|Proposition 98 school expenditures||52,352||44,872||45,734||47,871||50,222|
|Proposition 98 additional proposed supplemental payment||0||0||1,806||3,697||4,624|
|Non-Proposition 98 expenditures||94,145||89,030||88,169||91,270||95,619|
|Budget Stabilization Account||16,156||8,350||2,945||0||0|
|Revenues/Transfers minus Expenditures, exluding BSA transfer||(7,500)||(4,291)||(11,888)||(14,783)||(16,247)|
|Source: California Department of Finance|
This report does not constitute a rating action.
|Primary Credit Analyst:||David G Hitchcock, New York (1) 212-438-2022;|
|Secondary Contact:||Oscar Padilla, Farmers Branch (1) 214-871-1405;|
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