LAO releases Fiscal Outlook report for 2018; Congress votes on Tax Reform

By Sara C. Bachez and Elizabeth Munguia, Governmental Relations; Special Report by Bob Canavan
Monday, November 20, 2017

Every fall, the Legislative Analyst Office (LAO) publishes the Fiscal Outlook to provide the Legislature with an assessment of the state’s budget conditions as they prepare for deliberations for the upcoming fiscal year. The LAO also provides a separate Proposition 98 Outlook report. 

This article provides a summary of both reports and a federal update on Congress’ action on tax reform legislation. 

The Economy        

The LAO establishes the near-term outlook based on a September 2017 forecast of the U.S. economy using Moody’s Analytics, which projects continuing expansion of the nation’s economy. For California, the projections indicate a slower job growth through 2019, while wage growth will continue to climb due to: 1) the implementation of minimum wage increases ($11 per hour in 2018, $12 per hour in 2019, and $15 per hour by 2022) and 2) employers seeking to recruit and retain employees.

California’s state budget depends on three major revenue sources: personal income tax, corporate tax, and sales and use tax. Since 2008-09, these three sources have increased by $34 billion. Personal income tax has increased significantly because of voter approved initiatives, Proposition 30 (2012) and Proposition 55 (2016), which increased the tax rate on high-income earners. However, the stock market plays a critical role in the revenues generated from income tax on capital gains. Stock prices have risen since 2016, but projections show that this growth will not continue beyond mid-2018. Should the federal government enact tax changes in this area, revenues generated from capital gains will fluctuate based on higher or lower stock prices.  

The near-term outlook is positive, with continuing signs of growth in personal income tax with modest increases in sales and use tax and corporate tax.


Proposition 98

The LAO estimates that the 2017-18 Proposition 98 Minimum Guarantee will increase by $651 million from the enacted 2017-18 Budget Act and the 2018-19 Proposition 98 Minimum Guarantee will increase by $2.6 billion over the revised 2017-18 funding level. It is projected that $5.3 billion will be uncommitted funding to allocate in 2018-19, of which $2.7 billion can be provided to fully implement the Local Control Funding Formula and $228 million for cost of living adjustments to select K-14 programs. 

The LAO acknowledges in their report of the notable increases in pension contributions, and suggests the Legislature consider providing relief to help local educational agencies manage various cost pressures. 

The LAO assumes that the minimum guarantee will grow from $75.2 billion in 2017-18 to $77.7 billion in 2018-19. Test 2 will be operative, with the change in the guarantee created due to an increase in per capita personal income and modest decline in K-12 attendance. Of the $77.7 billion projected for the 2018-19 year, the LAO estimates that $5.3 billion will be available. These funds have been freed up due to the following changes:   

  • $1 billion for one-time funding in 2017-18. 
  • Declining K-12 enrollment, reducing LCFF costs by more than $500 million. 
  • Proposition 39 funding requirements expire in 2018-19, freeing up $423 million. 

The state could reach full implementation of the Local Control Funding Formula in 2018-19, by allocating $2.7 billion to close the gap. The state would have $2.6 billion for other Proposition 98 priorities, such as funding: 

  • Cost of Living Adjustments at 1.8 percent: $228 million 
  • State Preschool Program: $34 million
  • California Community College Program: $31 million 

Looking Beyond

The LAO describes two possible economic scenarios through 2021-22, a growth scenario and a recession scenario, as illustrative examples, not predictions, about the future direction of our state’s economy. 

  • Growth Scenario. Should the minimum guarantee continue to rise, the average annual increase is 3.8 percent, which would allow the state to fund a modest COLA for school and community college programs and provide about $2 billion per year to address cost pressures or enhance programs. 
  • Recession Scenario. The minimum guarantee declines under the recession scenario by $5 billion in 2019-20, and $2.4 billion in 2020-21. Test 1 is operative for the last three years of the period, with the guarantee receiving about 40 percent of General Fund revenue. Recent practice indicates that the state would not create any maintenance factor in Test 1 periods, and the state would have to consider reductions to ongoing programs.

The report ends with section on Key Trends that highlights six issues that will continue to impact school and community college funding, such as declining enrollment, pension cost increases, a depreciated cost of living adjustment around 1 percent, and staffing and benefit cost increases. 

The LAO’s Fiscal Outlook is a great indicator of the information the Legislature will need to analyze and assess prior to responding to Governor Brown’s January Budget Proposals. We will keep you informed of those developed in January 2018. 

                                                               Congress votes on Tax Reform 

Last Thursday, the House voted 227-205 to pass H.R.1: The Tax Cut and Jobs Act.   Among its many provisions, the bill terminates tax credit bonds such as Qualified Zone Academy Bonds (QZABs) and advanced refunding and private activity bonds. These programs have previously helped finance California school facilities. The bill also limits deductions for mortgage interest and state and local property taxes.  Three California Republican House Members voted No (Congressmen Darrell Issa, Tom McClintock, and Dana Rohrabacher). All California Democrats voted No.

A Senate version of the Tax Cut and Jobs bill approved 14-12 by the Finance Committee on a straight party line vote does not address tax credit bonds or private activity bonds but does end advanced refunding effective December 31, 2017.   The Senate bill would repeal state and local property tax deductions.  The Senate Committee bill also revives the health care debate by proposing to repeal the Affordable Care Act individual mandate.

House passage of their tax proposal and Senate consideration of tax cuts may delay action on FY 2018 appropriations for education programs, such as Title I and Individuals with Disabilities Education Act (IDEA), when the current Continuing Resolution expires on December 8. House and Senate Republican leaders are continuing bipartisan budget talks to raise Fiscal Year 2018 budget caps as they try to complete tax cut legislation before Christmas. Raising Fiscal Year 2018 budget caps for defense and non-defense programs is critical so appropriations committees can complete 2018 funding bills without sequestration cuts.

We will keep you updated on future developments.