Federal Spending in California FY 1994
($ billions)
Balancing the federal budget without changing taxes in FY 2002 will require that the federal government cut its spending by $228 billion, about 11 percent, that year.[1] Because the aggregate number of federal dollars flowing into California will be less (than if the deficit is allowed to continue), state tax revenues would be reduced about $2.7 billion. The impact on the state's budget will also depend on whether federal grants to the state are decreased. California now receives about $46 billion in federal support for programs operated by the state, and any reduction in federal spending is likely to include some cuts in support for the state's programs.
How the federal government goes about eliminating its deficit--where federal spending is cut and whether mandates are relaxed in the process--will determine the range of state spending options. Without relief from federal mandates, these decreases will force the California state government to sharply reduce spending on higher education and on other government services. With mandate relief, the state would still face difficult tradeoffs between cuts in spending on various areas, but state decisionmakers would have more options if they could partially close its budget gap by cutting spending on health and welfare.
We review current federal and state spending in California. We then estimate state revenues and expenditures, by spending category, in FY 2002, assuming present trends and patterns in federal taxes and spending. Next, we review the cuts in federal spending that would be required to balance the federal budget by FY 2002 and estimate the implications of those cuts for federal spending in California.[2] Because the extent to which power will be devolved to the states is not now clear, we consider the impact of cuts in federal spending on broad categories of state spending under alternative assumptions of state decisionmakers' flexibility in responding to decreases in federal spending. We develop several scenarios regarding how the state is affected by, and responds to, those cuts. In each scenario, we estimate state revenues and expenditures by category and compare the expenditure estimates to our baseline estimates of what expenditures would be if present trends in federal spending continue. Finally, we identify the implications of alternative federal deficit reduction policies, and alternative state responses, for state revenues and spending.
This analysis focuses on the short-term effects of federal spending cuts on the California state budget. Eliminating the federal deficit could have a dramatic effect on the California economy. A balanced budget might stimulate lower real interest rates and more-robust economic growth, and improve the balance of trade. These effects, in turn, could generate significant increases in state tax revenues. Conversely, significant spending cuts could plunge the economy into a recession and result in significant decreases in state tax revenues. However, the effects of balancing the budget on aggregate economic activity, positive or negative, are likely to be realized over time. In the short term, cuts in federal spending would reduce the resources available to state decisionmakers. We examine the potential dimensions of that problem here.
We neglect other federal policy initiatives under discussion that could affect state finances. Reducing unfunded or partially funded mandates on states and easing the restrictions on the implementation of programs could dramatically affect state spending patterns. Because the state's income tax structure is based on the federal system, major changes in the federal tax laws--for example, moves toward a flat tax or a consumption-based tax--could affect California state revenues and, consequently, expenditures. Assessing the effects of these proposals is beyond the scope of this study.
Federal Spending in California FY 1994
($ billions)
Table 2 shows the expenditures from each fund in FY 1994. It also shows the local school districts' and community college districts' local property tax revenues.
California State Spending by Source, FY 1994
($
billions)
Although the legislature has discretion over General Fund spending, much of that spending is effectively determined before the governor or legislature even begins to consider each year's budget. Propositions 98 and 111 define a minimum funding level for K-14 education depending on K-12 enrollments, growth in personal income, and prior-year spending. They also require that state support for K-14 education be at least enough to achieve the specified minimum funding level when added to K-14's local property tax revenues. Given local property tax revenues, Propositions 98 and 111 effectively define minimum state support for public elementary and secondary education and community colleges.[5] Mandated sentencing laws and state and federal court decisions regarding the treatment of prisoners largely determine the amounts the state must spend for prison construction and operation. Federal mandates determine much of California's spending on health and welfare. The state of California has provided benefits in some programs at levels higher than those required by the federal government. But the courts have rebuffed attempts to scale back the level of state support. Only spending on higher education and other programs, $6.7 billion, about 17 percent of General Fund spending and 8 percent of total state spending, is truly discretionary.
Special fund spending is entirely nondiscretionary in that the uses of the money paid into a special fund are specified in the law that establishes the fund and permits raising the money. If changes in economic conditions or other relevant factors affect the magnitude of special fund collections, spending on the functions they support will change along with them.
The federal funds shown in Table 2 are spending that flows through the state. The table does not include spending that goes directly to private entities either through benefit programs (e.g., Social Security), direct federal employment, or federal contracts. More than half of federal funds in the state budget support federally mandated health and welfare programs. Note that federal funds in the state accounts include all federal dollars flowing through a state agency. For example, the University of California operates the Lawrence Livermore Laboratories under a contract with the Department of Energy. Because the University of California is a state agency, these funds appear in the federal funds accounts in the state budget. The federal accounts (Table 1) place these funds under procurement.
Table 2 also shows property tax revenues to K-14 education, although they are not formally state revenues or expenditures. Because each additional dollar of local property tax paid to a local school district or to a community college district reduces the state's minimum obligation to the support of K-14 education, local K-14 property taxes are essentially substitutes for state revenues.
We estimate that if current trends in state and federal spending continue through FY 2002, the total funds available for functions carried out by the state of California in that year would be about $124 billion, including about $62 billion in General Fund revenues. The state will have to make sharp cuts in discretionary spending: State General Fund spending on higher education and on other government activities will have to fall about 14 percent in nominal dollars. At a 3 percent annual inflation rate, this would imply a 32 percent decline in real expenditures in these areas.
General Fund Revenues, FY 1994
California Personal Income and General Fund Revenues, FYs 1970-
1994
($ billions)
We used the projected income distribution and California's income tax laws to project the amount of personal income tax that will be collected in 2002. We took into account the expiration of the higher rate on the highest-income taxpayers in the state that went into effect this year, but did not include the governor's proposed income tax cuts. Sales taxes, bank and corporation taxes, other taxes, and transfers from special funds were also projected using the personal income projections as a base. The revenue projections for 2002 are shown in Table 5.
Projected California General Fund Revenues, FY 2002
($
billions)
Medi-Cal is California's Medicaid program (labeled "medical assistance program" in the state budget). It provides medical assistance to low-income people, and a substantial portion goes to elderly, low-income people to supplement their Medicare assistance. (The federal Medicare program is for elderly people of all incomes; federal Medicare payments are not reported in California's budget.) Aid to Families with Dependent Children goes primarily to single-parent households; a small proportion goes to households with two adults who are both unemployed. Supplemental Security Income (SSI) provides assistance to low-income aged, blind, and disabled individuals. California supplements the federal SSI program with an additional State Supplemental Program (SSP) payment. The federal SSI payments are not reported in the California state budget, but the state's SSP payments, which come from the General Fund, are.
California's spending on health and welfare programs has been resistant to economic trends. For example, in the last recovery there was no marked decrease in the percentage of Californians on assistance. Accordingly, in projecting future expenditures for each program, we assume that participation rates--the fraction of the population in each age group who will obtain support from the program--will be constant over the next decade. We also assume that benefit levels in each program will keep pace with inflation. In sum, we assume program growth will come from population growth. For each program, we apply the participation rates by age group to the demographic projections and sum over age groups to estimate the numbers of people who will receive benefits from the program. We then multiply the participation estimates by estimated future benefit levels, assuming a 3 percent annual inflation rate.
We assumed state General Fund spending for all other health and welfare programs and for the operations of the relevant state agencies would grow at the same rate as the sum of state spending for the three major programs discussed above.
FY 1994 actual spending levels and our projections for FY 2002 are shown in Table 6.
Health and Welfare Spending: FY 1994 and 2002
($
billions)
The state's share of support for K-14 education is determined by a complex formula that became part of California's state constitution in 1988 with the passage of Proposition 98; it was altered in 1990 by Proposition 111.[10] The propositions essentially require that total support for elementary and secondary education and community colleges be the larger of (a) a specified share of the General Fund or (b) the previous year's level of support, adjusted for changes in per-capita personal income and K-12 enrollments. K-14 education's local property tax revenues are determined by Proposition 13, which limits the property tax rate, and a series of state laws that determine how the property taxes raised in a county are to be divided among local governments, school districts, community college districts, and special districts. Given the local property revenues provided K-14 education, the state is required to provide at least enough support to bring K-14 funding to the minimum specified by Propositions 98 and 111.
We modeled the formulas specified in Propositions 98 and 111. We used the Department of Finance's estimates of future K-12 enrollments and our estimates of future personal income per capita to compute the minimum funding requirements for K-14 education.
We assumed that nominal annual growth rates in local property tax revenues will remain at their current low levels for two more years, then, beginning in 1997, increase but still remain below the rates experienced in the 1980s. We assumed the FY 1994 local property tax allocations among local agencies would continue, and we estimatedK-14 education's local property revenues through FY 2002.
Finally, we subtracted our estimates of K-14 local property tax revenues from our estimates of Proposition 98/111 minimum spending requirements to obtain estimates of the minimum level of state spending for K-14 education in FY 2002. We assume that state General Fund spending for other education programs and for the operations of the state Department of Education will grow at the same rate as the Proposition 98/111 funding requirement.
Methods for Projecting Federal Spending in the 2001-2002 California Budget
California State Budget, FY 2002, Baseline Projection
($
billions)
What if the federal government relaxed its spending mandates? While there has been considerable interest in the notion of merging federal health and welfare programs into block grants, the debate over federal policy does not appear to contemplate the removal of all constraints on the uses of federal funds. Thus, even if states are given block grants for the support of health and welfare programs, they would likely be constrained to use those funds for health and welfare purposes and not given the right to allocate those monies to, say, transportation. Special funds would still have to be spent in accordance with the laws that established them and the state would still have to meet the requirements imposed by Propositions 98, 111, and 184. Hence, the state would be free to divert some of its General Fund revenues from health and welfare to other spending categories. The line labeled B in Figure 1 shows the range of alternatives open to the state in terms of the allocation of spending between health and welfare, shown on the horizontal axis, and higher education and other government activities, shown on the vertical axis. The point marked x on line B corresponds to the spending allocation shown in Table 8.
Figure 1--Baseline Options for Health and Welfare and Higher Education and Other Spending
Estimates of Federal Government Outlays, Revenues, and the
Deficit
($ billions)
Figure 2--Deficit Under Options Considered by the Federal Government
If the federal government were to balance its budget in FY 2002, we would expect to see about $59.9 billion in California General Fund revenues, compared to the baseline projection of $62.1 billion. Elimination of the federal deficit would reduce special fund revenues from the baseline projection of $16.1 billion to $15.6 billion that year.
Total federal spending in California in 1994 was $155 billion. A decrease of 11 percent would have been $17 billion. If we assume an income multiplier of 1.5, a $17 billion cut in federal spending translates into a $25 billion decrease in personal incomes. Total 1994 California personal income was $683 billion. A $25 billion decrease in personal income would have been about 3.5 percent.
State General Fund revenues have been a relatively constant portion of personal income. We assume that General Fund revenues would fall in proportion to a decrease in personal income. We projected state General Fund revenues of $62.1 billion in FY 2002. A 3.5 percent cut in personal incomes in that year would thus reduce projected FY 2002 General Fund revenues by about $2.2 billion, to $59.9 billion. We assume this level of General Fund revenues in all scenarios.
We assume that special fund revenues will also drop in proportion to decreases in personal incomes. For example, we assume that a 3.5 percent reduction in aggregate California personal incomes would result in a 3.5 percent reduction in special funds for higher education, from the baseline projection of $701 million to $677 million--and so on for the special funds in each of the other major budget categories. Overall, special fund spending in FY 2002 would be about $15.6 billion if the federal budget were balanced, compared to $16.1 billion in the baseline. We assume this level of special fund revenues in all scenarios.
We consider several scenarios regarding the nature of federal spending cuts, beginning with two extreme cases: In the first, all cuts in federal spending are in areas other than support for the state. Federal grants to the state for every category of state spending are maintained at the baseline levels. In the second, federal spending cuts are entirely in support for the state. Reductions in expected grants to state governments would be about $17 billion if all of the reductions came from those areas.
Realistically, federal budget cuts are likely to affect all areas of federal spending. If both federal support to the state and all other areas of federal spending were cut proportionately, federal grants to California would be reduced from $46.1 billion to about $41 billion. We consider several scenarios in which federal spending cuts in support for the state are proportional to total reductions in federal spending.
In all the scenarios we initially assume that current health and welfare spending mandates are retained and then consider the effects of relaxing these mandates.
In all cases, we assume that spending for K-14 education and for corrections must satisfy the California constitutional requirements imposed by Propositions 98, 111, and 184. Because the baseline projections assumed that spending in these areas would be no greater that what those laws required, cuts in federal support will not reduce spending for either K-14 education or for corrections below the baseline spending projections. Because property tax collections are slow to respond to changes in personal income, we assume that they will be unchanged in all scenarios.
Table 10 shows the state's budget in this scenario, assuming that the required spending cuts are proportionately divided between higher education and other government services.
California State Budget, FY 2002, No Cuts in Support to the
State
($ billions)
Figure 3--Options for California Spending Choices for Health and Welfare and Higher Education and Other Spending
How state health and welfare spending would be affected in this scenario is highly uncertain because federal support for health and welfare programs would have to be cut substantially. Would the federal government continue to mandate state spending in these areas at the same level despite significant reductions in the federal role? Would there be substantial pressures for the state to step up its support to make up for some of the reductions in federal support?
We initially assume the state maintains its support for health and welfare programs at the baseline level. The federal government might require that the state maintain spending for health and welfare, despite the cuts in federal spending in this area. Or the state might decide that it must continue to meet the needs of those benefited by these programs. In any case, we assume the state neither matches nor attempts to make up for cuts in federal support for health and welfare. Higher education and other government services must absorb the entire $2.7 billion decrease in state revenues. Table 11 shows the state's budget in this scenario, assuming that the required cuts in state spending are proportionately divided between these two categories.
California State Budget, FY 2002, Deficit Eliminated Through Cuts
in Support to the State
($ billions)
The effects of proportional cuts in the federal budget on the state's spending pattern would depend, in part, on whether federal health and welfare support and spending mandates would be modified as federal grants to the state were cut. Table 12 shows California's budget, assuming that neither federal support for health and welfare nor federal mandates for state spending in this area were changed from the baseline. Although the decrease in total funds available for services that appear in the state budget decreases by less than 8 percent, truly discretionary functions bear the brunt of the change in available resources.
California State Budget, FY 2002, Proportional Cuts; Health and
Welfare Held Harmless
($ billions)
California State Budget, FY 2002, Proportional Cuts in Federal
Spending; State Spending on Health and Welfare Continues
($
billions)
California State Budget, FY 2002, Proportional Cuts in Federal
Spending, State Maintains Total Support for Health and
Welfare
($ billions)
Propositions 98, 111, and 184 impose minimum state spending requirements for K-14 education and for corrections. Thus, the state will have to respond to cuts in its tax revenues by cutting spending in other areas. Moreover, federal mandates now preclude significant cuts in state spending for health and welfare. Unless those mandates are relaxed, the state will have to concentrate its spending cuts in those areas over which it has discretion--higher education and other government services.
In sum, how the federal government goes about eliminating its deficit--where federal spending is cut and whether mandates are relaxed in the process--will determine the range of spending options available to the state. Without relief from federal mandates, these decreases will force the California state government to sharply reduce spending on higher education and on other government services. With mandate relief, we would probably still see sharp cuts in state spending in these areas. But they could be somewhat less sharp if the state chose to partially close its budget gap by cutting spending on health and welfare.
California Statistical Abstract, 1995.
Governor's Budget Summary, 1994-1995, submitted by the Governor, State of California, to the California Legislature, 1993-1994 regular session.
Greenwood, Peter, C. Peter Rydell, Allan F. Abrahamse, Jonathan P. Caulkins, James Chiesa, Karyn E. Model, and Stephen P. Klein, Three Strikes and You're Out: Estimated Benefits and Costs of California's New Mandatory Sentencing Law, RAND, MR-509-RC, 1994.
U.S Department of Commerce, Federal Expenditures by State for Fiscal Year 1994, March 1995.
[2] Because cuts in federal taxes are still under debate, we only consider the spending cuts needed to balance the federal budget given current federal tax policies.
[3] U.S Department of Commerce, Federal Expenditures by State for Fiscal Year 1994, March 1995.
[4] California Statistical Abstract, 1995.
[5] The legislature does control the distribution of the Proposition 98/111 guarantee between elementary and secondary districts and community college districts.
[6] Stephen Carroll, Eugene Bryton, C. Peter Rydell, and Michael A. Shires, Projecting California's Fiscal Future, RAND, MR-570, 1995, provides a detailed discussion of the methods and data used to project General Fund revenues.
[7] The demographic projections used in this report were produced from a specially run statewide summary table of the Department of Finance's June 1993 projections.
[8] Carroll et al. (1995) provides a detailed discussion of the methods and data used to project General Fund expenditures.
[9] Peter Greenwood, C. Peter Rydell, Allan F. Abrahamse, Jonathan P. Caulkins, James Chiesa, Karyn E. Model, and Stephen P. Klein, Three Strikes and You're Out: Estimated Benefits and Costs of California's New Mandatory Sentencing Law, RAND, MR-509-RC, 1994.
[10] If federal budget cuts in 2001 reduce the 2001 state budget below our base case, then the Proposition 98 required minimum--which depends in part on the 2001 spending level--would be somewhat lower, decreasing the required state spending on K-14 in 2002.
[11] Congressional Budget Office, December 1995.
[12] If progress is made between 1996 and 2001 in reducing the deficit, the aggregate size of the debt will be less than under the worst case scenario and interest cost will be somewhat less, reducing the magnitude of the required cuts.
[13] Over the longer term, balancing the federal budget could stimulate increases in economic activity that would more than compensate for the decrease in federal spending. We assume the economy will react to the elimination of the deficit only over a period of time and, consequently, will not respond during the year that the budget is balanced. If balancing the budget does not stimulate California's economy over the long term, the fiscal picture could become much worse than shown here.