October 29, 2008

What’s on the Special Session Agenda and How Big Is the Deficit?

Governor Schwarzenegger has called for a special session commencing on November 5 to deal with the state’s fiscal problems.  As indicated in our prior update, while a lame duck session may have more political flexibility than would the new Legislature elected on November 4, the political dynamics may stay the same with the Republicans urging no tax increases and the Democrats unwilling to make deep cuts because they believe they will have a better chance to implement their policies in January. 

According to my estimate, the budget deficit is approaching $6-8 billion resulting from a combination of lower than anticipated tax revenues and higher than anticipated expenditures.  Whenever the state and national economies move into recession, the claims for government services (such as unemployment insurance, Medi-Cal, and other programs) increase significantly.  A significant claims expenditure increase was not built into the budget when it was passed in September.

The corporate tax, sales tax and personal income tax revenues all will be reduced during a true recession.  Economists define a recession as two consecutive quarters of negative economic growth.  At this point we have not had negative economic growth for at least eight years.   It is expected that the third and fourth quarters of 2008 (July 1 – Dec. 31) will be negative.  I also expect that the first quarter of 2009 will have negative growth. 

Expect the special session to partially address the currently estimated revenue and expenditure gap.  The special session probably will not address the full gap for two reasons: 1) to allow looking at bridging into the 2009-10 budget for an 18-month resolution; and 2) to hope for federal government action that could reduce the state’s liabilities for Medi-Cal and unemployment insurance costs.  The second federal economic stimulus package could include support for unemployment insurance, discretionary funds for states with budget deficits, and support for increased Medi-Cal costs.  Federal funds from the stimulus package could result in $3-4 billion to help close the budget gap.  Because of the possibility of such federal action, it would be practical for the lame duck session to address part, but not all, of the current gap.

Because school funding and the Proposition 98 guarantee is based on state General Fund revenue from the proceeds of taxes, education funding will be on the table during the special session.  Even if the federal government were to provide $3-4 billion to California as part of an economic stimulus package, this would not help the Proposition 98 guarantee calculation.  Additional federal funds are not counted in the calculation.  My expectation is that the Proposition 98 guarantee will be lowered by approximately $2 billion.  This reduction could be covered through a variety of manipulations in anticipated revenue and allocation of expenditures along with reductions in categorical aid and the possible deletion of the revenue limit Cost-of-Living-Adjustment. 

While it is too early to determine how the Legislature and Governor will respond to the special session, it is not too early for schools to start planning to control their expenditures to build their reserves.

~Dave Walrath

dwalrath@m-w-h.com