Senate Budget And Fiscal Review Committee

Before we begin, let me ask my vice chair if he has any opening comments. Yeah, I do. So I'm looking forward to more detailed presentation. What I know of it so far is probably superficial. I have to say, though, all due respect, I'm not overly excited. It's kind of like washing your hands with gloves on, if I could make that comparison. I've been thinking about that one for a while.

Yeah, you don't get your hands clean. My point is, it's just not exciting enough.

It's just not a particularly exciting proposal for what we really need for a reserve. I continue to believe that the only approach that would keep us from the feast and famine that we continue to experience over the years that we have all experienced is to limit spending based upon a rolling average of revenues over a five to seven year period. We can't change the tax base, but we can change how we use it to make it equivalent to that. And if we had had a system like that in 2020-21 and 21-22, we would have built up significantly more reserves and we would be in nowhere near the difficult position that we are right now. And I continue to believe, although I don't get much traction on it, that that's the only approach that would really permanently keep us from the intense feast and famine that we continue to experience. Thank you.

Thank you, Chair, Vice Chair, and members. My name is Carolyn Chu from the LAO. This afternoon, I've been asked to give an overview of Proposition 2 to set the context for the changes that would be made under ACA 20. So you should have a handout in front of you that I will walk through. The first two pages of this handout should be pretty familiar to this committee. The first one just lays out how reserves work and what reserves are intended to achieve, which both the chair and vice chair have highlighted. California's revenues are volatile, and reserves allow the state to sustain a level of core spending over time by capturing surging revenues when they are high and then using those resources when revenues decline again. On the second page of my handout it goes through a little bit of the history of state reserves The bottom line essentially being that since the 1980s the state did not have very significant reserves until the passage of Proposition 2 in 2014 So you can see on the right-hand side of the figure, tracking the line for the Special Fund for Economic Uncertainties, really there was not very much set aside in terms of state budget reserves. And then once Proposition 2 passed in 2014, the state has built up pretty good-sized reserves over the last decade or so. Turning to page 3, this figure lays out how Proposition 2 works. And essentially, Proposition 2, if you look at the constitutional provisions, they are really laying out a set of formulas that set aside a pot of money. And that part of money is split into between putting money away in the budget stabilization account and paying down additional debts, particularly pension and state retiree health liabilities. Proposition 2, I should note, also has provisions as they relate to school reserves. However, the measure does not directly affect anything on school reserves, so I won't highlight those components unless there are questions about them. So quickly walking through that formula in Proposition 2, what it says is that 1.5% of all general fund revenues are put into that set-aside pot. And then in addition, when revenues are performing pretty well, the state sets aside any amount above 8% of capital gains taxes, when capital gains tax revenues exceed 8% of general fund revenues. So that's generally when revenues are performing pretty well, and we call this amount the amount of excess capital gains. So the state puts those two pieces together, divides them in half, half goes into the budget stabilization account, the other half goes towards paying down those long-term liabilities. On page four, I'll highlight a couple of other features of Proposition 2. So those required deposits that I just walked through on the prior page are required until the budget stabilization account reaches 10% of general fund revenue. After that point, the state can make discretionary deposits, but required deposits no longer have to be made. The Proposition 2 also requires that there is a declaration of a budget emergency in order to withdraw funds from the BSA, and the legislature must approve of those withdrawals with a majority vote. Same thing goes for suspension. So suspending the deposits into the BSA requires a declaration of a budget emergency as well as approval by the legislature. And Proposition 2 lays out what constitutes a budget emergency, which I can go over if the committee has questions. And then lastly on the reserves, under the requirements of Proposition 4 or the GAN limit, deposits into the budget stabilization account count towards the GAN limit. However, when those monies are withdrawn, they do not count. They are excluded from the GAN limit or the state appropriations limit. On the debt requirements, the debt payments are required until 2030, so the state is approaching the expiration of those debt requirements, but the legislature would have the option of continuing them if it so chose. And as I already mentioned, only certain kinds of debts are eligible. In general, under Proposition 2, the debts that are being paid are over and above what the state is already required to pay each year against its outstanding debts. And what essentially is required now are supplemental payments towards pension and retiree health liabilities. So turning to the last page this lays out the changes that would be made under ACA 20 and was already highlighted by the chair Essentially the changes made under ACA 20 would build more reserves as well as require extra debt payments for an additional 10 years So how does it achieve the increase in reserves? There are two main facets. The first of which is to create what we informally call super excess capital gains. So when capital gains exceed 10% of general fund revenues, the measure would require 150% of those revenues be deposited into the BSA, as well as maintain the existing excess capital gains revenue requirement of that 8% to 10%. So that would set aside more, and it would set aside more both for the budget stabilization account as well as the debt payments. The other changes it makes to reserves is to increase the threshold on the budget stabilization account to 20%, so essentially doubling the size and therefore requiring that the state make deposits into that account for a longer period of time. It would also change the treatment of deposits when it comes to the GAN limit. That is specifically essentially flip-flopping the way it works now, which is to exclude deposits into the state appropriations limit, but then to count those monies towards the GAN limit when they are withdrawn from the fund. In terms of debt, as I already mentioned, the measure would extend the debt payment requirements through 2040. And then in addition, the measure expands the type of eligible debts. So it expands it to include Proposition 98 settle-up payments, budgetary borrowing, and payments towards the state's outstanding unemployment insurance liability with the federal government. The other allowed debt payments also would remain. Lastly, the ACA 20 would also extend the change in treatment under the GAN limit to the temporary surplus holding account. This committee will be familiar with that account, which was recreated in the last couple years to set aside surplus funds. And under the measure, deposits into the temporary surplus holding account would be excluded from the GAN limit on deposit and then count towards the GAN limit when they were withdrawn. This exclusion, however, would be limited to 10% of general fund revenue, so it couldn't be an uncapped exclusion. So with that, I'm happy to answer questions.

Good afternoon. Lisa Merzinski with the Department of Finance. I don't have much more to add than to give you an overview of that, but I do want to let you know that the administration fully supports the provisions in this measure, And we believe it does a lot to improve proposition to and kind of correct some of the issues that we found we had in putting more money into the state reserve during 2021 and 22. Thank you.

And the assembly had a fairly confusing discussion about this. And one of the assembly members asked if excluding deposits from the state appropriations limit means we can send more or even spend more. And it's my understanding that this creates an incentive and the GAN limit requires that something be counted everywhere and this just works. would count it in a different place.

Sure. So our office has suggested that this change in the treatment of reserve deposits in terms of the state appropriations limit be considered. And to your point, this sort of stepping back, the state appropriations limit wants spending to be counted somewhere. So it requires that either the money is counted as spending at the state level or at the local level. So when the state gives money to local governments, it has to count there. And similarly with the treatment of reserves today, the state counts them against the deposit but then doesn't count them when they are withdrawn. The state is really only likely to run up against the state appropriations limit when revenues are really surging. And even right now, when the state really has very healthy revenue collections, the state still has, I think, roughly $30 billion in room under the state appropriations limit. So it's not that the state appropriations limit isn't a constraint on spending. It certainly wasn't in 2021-22, but it is not a common occurrence. And by allowing the state to exclude those deposits when they are made, it does enable the state to potentially save more in those particularly revenue-surging years.

I think we've got to explain all of this to our constituents. And if there's anything that's difficult to explain to constituents, it's our budget, our spending. And, of course, now we're talking about the rainy day fund. But my question is, is it mandated? Is that what we're trying to do? Because I think anyone who's running a household, they need to pay their bills. They need to pay the requirements, tuition, and whatever on the list of items. in your home, right? Whether it be groceries, car payments, tuition, whatever it is. And whatever is left over, a family should wisely say, well, let's put this into the future of the kids because of tuition and college. Let's put this one in account because of the fact that just in case the car breaks down or roof leaks and so this is maintenance and overall situation. but it's usually up to the family to make that decision. Are we going to be mandated that we need to have this budget go from 10% to 20% and that's what we do first and then we pay our bills? How is that looking for the future?

But again, the question is we need to mandate the fact that we have to make that deposit. But if there's a difference on this emergency or the deposit, this emergency outweigh the deposit?

Okay.

Thank you. Hope that works with everybody that asks questions. Yeah. Thank you. We'll go to Senator Blakespear, and Senator Richardson is on deck.

So in terms of how much would be paid down, that is a decision for the legislature and the governor in the future to make if the proposition is approved. What the measure simply says is that the unemployment insurance loan is a allowed use of the debt payment. So under the current rules of proposition to the debt payments range from usually they're around $2 billion per year. And right now they're typically paying down outstanding unfunded liabilities for the state's CalPERS obligations and state retiree health. And so if the measure passes, the legislature would have additional choices to make about what debts to pay down with those monies, and the UI loan could be one of them. So it would be a budget decision ultimately. I believe the outstanding debt to the federal government is around $20 billion.

Correct. So in every Budget Act, there is an allocation of the Proposition 2 debt payments among the allowable uses. And really the two remaining allowable uses are predominantly making supplemental payments to the state's unfunded CalPERS liability and paying down the state's state retiree health liability. and so that is where the preponderance of those payments in recent years have gone. When the measure first passed, budgetary debt that had been accumulated during the Great Recession was an eligible debt and that is where the monies largely went in the early years of these debt payments Okay And so the cap has been 10 but now it will be 20 And so how did we settle on 20%? How did we come up with that amount being the right amount? I would defer to my Department of Finance colleague.

Okay. So when you were answering the chair's question and you ended with you said this will allow us to – I think it was to spend more. But I think the question was on to save more. It wasn't your question. You used both words, right, spend and save. But what you ended with wasn't what I expected, so I wanted to circle back to that.

Okay. So that all leads back to the question of the concern about the appropriations limit will lead us to spend more I don think it depends It really fundamentally depends on the choices of a future legislature

Right. So just one last thing, Chair, if you don't mind. So I think one of my interests is in the state budget when we do have surging revenues that we don't expand our programs that are ongoing in such a way that it's unsustainable and we end up over-promising and then having to make painful cuts. And so the idea of basically living within our means. And so when we do have surging revenue, the idea that we would put it in a rainy day fund makes a lot of sense. And so can you just address how you think this is going to help achieve that goal? Because it's a requirement that it go into the rainy day fund instead of it being discretionary that we can expand in such a way that we wouldn't be able to sustain that when the revenues come back down.

You meant 2020?

I'm sorry, 2019-20.

I'm glad my spouse is at Washington because he'd say, you were there, you can correct her.

Yes, yes, sorry. As I was thinking, 100 years ago.

We operate so differently. It was the greatest. Okay. Yes, you're interested.

Something we all could grasp.

Okay. Okay.

Thank you.

Thank you, Mr. Chairman. If I could follow up on what you were discussing, would the deposit that we now have made this year be considered an extra discretionary deposit?

Correct. Okay. And then I have a question. I had a little mini-debate discussion with the vice chair, and he was stating, you know, we had a spending problem, and I'll let him make his own comments, which I'm sure he's prepared to do.

Not more. I've got a lot more to do. So I want to be... Hold on what you were saying with the state appropriations limit, and you said, or the state appropriations, what we spend, and you said it's based upon inflation and population.

Okay. And so what happens when now we are beginning in California? I know, I thought I had heard this due to redistricting, that our actual, our population is decreasing, but the type of our population is changing. And that was the argument I was making with Mr. Nilo, that even though our population may decrease, If we have more seniors who normally with an older age comes in increased cost of health care, that's just one example of how our population is changing. Does the current formula adapt for that? Because at some point I would think our population, isn't our population currently decreasing or no?

Do you think at some point we should, given the influx of what we anticipate with the baby boomers and what that cost will be?

My next question is, could you repeat again What were the things currently we pay for in the debt payments?

Okay, and now we're going to be adding some things that could be paid.

So how do we compare to other states when it comes to paying outstanding debt and our reserve fund? How would you rate us with comparable cities like New York?

And could you – so Mr. Nilo doesn't use that. Could you clarify, though, are those states that are comparable to us? Because I sure some states you know Rhode Island I mean or something they might I mean but that very different from California Well I was going to ask a follow question and it might address that

Which was the chairman's point. And one other follow-up that's really random. You said some of the states that really rely on resource extraction have a whole different thing. And I know when I represented the governor at Western Governors and went to Wyoming, 70 percent of their revenue comes from, I think, oil and coal extraction. And they want us to know that every single school had been built because of revenues from that. Do they have to be careful because of the fluctuating market for those resources, and that's why they have to do a reserve? Because gas prices might tank, and therefore their revenues tank equivalently?

Thank you for indulging me.

I just had one comment and one question. Am I understanding correctly that Prop 2 is being extended to 2040?

Okay. I have one comment and one question left. My comment to the chair in this committee, I'm very encouraged to see that this will allow us to begin to make payments to the UI, which is a very serious issue. I know I have read the LAO reports on potential solutions that we could consider. So I just want to commend the chairman with the negotiations, the third-party negotiations, that at least we're beginning to put the state's UI situation on the table of paying more or figuring out something that we need to begin to do And I think that really a challenge of us over these next couple years is to really figure out that it you know I realize it the debate of whether we just keep paying you know interest and all of that, but I think at some point we really do need to seriously think about a strategy to address that, the $20 billion that is our outstanding debt. So I'm encouraged to see that it's now in this section. The last thing I would say is this is called ACA 20. And for those of us who are legislators, if you were to describe what this does in a couple sentences, could you help us with some talking points for members that, you know, I'll take a stab at it. ACA 20 can assist us in being more fiscally responsible, you know, helping us to pay down our debt, which in turn makes our state more stronger and whatever. But if you could just take a stab at helping us of how would you describe it? Because I think it would be very helpful to us as members when we get questions from our colleagues, when we get questions from the committee, to be able to really articulate how monumental this is, how important it is, and how it really is setting a new direction for us.

Okay. Thank you. That's it. Thank you.

Just a follow-up, infrastructure, because our schools, you know, we have a set budget, 98. It has to, we have to adhere to that cost and so on. But then there's deterioration in some. So infrastructure and our roads and this, that, and the other. Is that going to be affected that we will, again, have to fill that mandatory 20% up to 20% versus taking care of infrastructure or hospitals and everything else?

It may not be all at once. That's my point.

Okay. Thank you, Mr. Chair.

Thank you, Mr. Chair, and I appreciate the conversation and discussion, and I do appreciate the efforts to strengthen our reserves to better prepare our state for downturn and moments like these when we facing national hostilities and having to figure out ways to cover all of our bills I am wondering about the proposal especially in this moment because one of the things that I've sort of experienced being here these last few years is the fluctuation in our revenue and our projections and what we think is coming in and then what doesn't come in or then what does come in and suddenly we, you know, we have a deficit and then we have revenue. And I feel this is a moment where we could see a huge fluctuation as we just saw what happened with Elon Musk and his public offerings. Anthropic, I think, is next on deck. Open AI. I'm just curious how we're looking at these targeted valuations and what is the potential opportunity for California as these IPOs could hit before the end of the year. And to me, I just wonder, do we think that the doubling of the rainy day fund cap is truly sufficient for what we could expect to be happening over the next few months in the state? And I support savings. My question is, and I support the fiscal discipline, but we have so many challenges, too, that we're facing. So I'm just curious how we think, how we're preparing for that.

Oh, yes, I'm sorry. Yes, Brian Euler with the Legislative Analyst's Office. I think, unfortunately, we don't have a very satisfying answer, really, on what kind of revenue to expect from the forthcoming IPOs. I mean, I think what we can say is that, you know, historically, these major IPOs, you know, in California, primarily associated with these large tech companies, have resulted in significant state tax revenue in the past. The example that's most often brought up is Facebook, and the state did receive a few billion dollars in revenue from that IPO. And there's certainly the potential that these fourth-cut, or while the SpaceX IPO happened, Anthropic and OpenAI, similarly there's potential for significant revenue gains in line with those Facebook and some of those past tech IPOs. A challenge with these IPOs is that the – Sort of the specifics of how those IPOs work and how the stock options and stock awards that have been provided to the employees and early investors are different than with some of those past IPOs and in a way that makes it much more unpredictable for us to determine beforehand or in real time how much the state is going to benefit. So there's a lot of potential there, but it really depends a lot on just sort of behavioral decisions by those employees and early investors and executives are holding those stock in terms of when they decide to sell or when they decide to exercise some of their options on stock options that they have. And so those things are, you know, very hard for us to predict beforehand. We'll be able to see it when it does come in the tax data, but that, you know, that won't be for months or years. So there is a lot of potential there, but it's just too unpredictable for us at this moment.

Thank you. Colby White, Department of Finance. So just briefly, when we're talking about in the context of ACA 20 here, I think really part of what it's trying to do is improve upon Proposition 2. And one of the ways it will improve upon it is by how my colleagues referenced the super excess capital gains. And those are the types of things that potentially can occur when you do have these supersized IPOs. They're very unpredictable, and how it plays out this time is not known, as my colleague mentioned. But there is the potential there if, you know, the Anthropic follows and OpenAI, and these are large. And then if there is those windfall-type capital gains, ACA 20, by having the changes that are made in ACA 20, the improvements over Proposition 2 will better enable the state to reserve some of the additional gains and not commit those to ongoing purposes.

So the debt payments under the changes for ACA 20 would be larger in the years of super excess capital gains. They would be larger than they are today. So they fluctuate today, but they're often around $2 billion. And they would be larger than that in those super excess capital gains years. The relative savings associated with making those extra payments through the debt payments would really depend on which liabilities the legislature opted to pay down. So different liabilities have different interest rates. So budgetary loans typically are incurring an interest rate equivalent to the pooled money investment account rate, which hovers around three-ish. the pension liabilities have a discount rate of closer to 7%. So paying those down while there is less immediate benefit to the state budget, there is a longer term savings. And then when it comes to the unemployment insurance loan, the state is paying the interest on that loan, which I think is also around 3%. But the state is not paying down the principal, as I'm sure you are aware, that is the employers that are paying down the principal.

Senator Niello.

host a town hall with the sole purpose of explaining this budget reserve proposal and to see exactly how it could be done. Because here, this is very complicated. Proposition 2 was very complicated. I happen to like the KISS principle, and that's why I continue to say, to very little success, that the only way that we going to over time recover from our feast and famine because of our revenue stream Again we not going to change that We not going to lower taxes on the upper people and raise them on the lower people That is politically obviously not possible. But we can do it on the use side, and that is to limit spending based upon a rolling five to seven years average of revenue. And I say five to seven years because that's about the time frame we go from feast to famine and then back again. And there could be some additional qualifications in there in terms of a base amount, maybe some limitation of uses, but it would really allow much more flexibility for budget writers. All of the excess would go to revenues, and when the revenues dropped down, all of the reserve would come back in. That's pretty simple and easy to understand. So that's the first point I wanted to make. The other point I want to make, and I've been sitting here saying, do I really want to do this because I'm going to correct something that you said, and I'm loathe to correct LAO. I don't really feel that my knowledge or intellect rises to that level, but nonetheless, I have to because I've had some other conversations about the GAN limit, and there continues to be misunderstanding on that. The original GAN limit was Proposition 4, I think, in 1979. And it did establish the limit at population growth and inflation defined as the CPI, Consumer Price Index. And it set the base limit at that year. But during the 1980s, people discovered that really is a limit. we're not going to be able to spend as much money as we want to spend we've got to change that so they did Proposition 111 I think it was in 1990 and it changed the definition of inflation if I understand the wording of it correctly because I think you're right to say it's inflation but it changed the definition of inflation to the change in personal income and also reset the base year to 1986-87 or something like that. So it ratcheted up the base year to a decade later. Now, the thing that's ironic about personal income as a limitation on the ability to spend the revenue you make is almost nonsensical because it's personal income that's driving the increase in revenue. So I have maintained for years the GAN limit, not because of Paul Gann, but because of those that discovered that what Paul Gann did really was a limitation on the ability to spend money, they made the Gann limit virtually meaningless, which is why we haven't talked about it ever since then until just recently. And even at this point, it's not a significant factor on our budget setting. So another thing it did, too, is it imposed a two-year average on that, which virtually eliminated. That made it even less meaningful. So we basically neutered the GAN limit. And I think it's important to make that point because it really is not a limitation on spending. So my two points are simplicity I wish we could be much more simple I would hate to have a town hall and try to I have you come and do it We happy to do so Oh, that's a mistake. We serve the legislature. And then also the simplicity of the way I would rather look at this myself. Okay, before we go to public comment, I just have three comments on some of the debate. The first is, I inadvertently have responded to the vice chair's challenge every two years for 20 years. I have a town hall meeting in my hometown and go through every single proposition and explain it to the public. I have done that continuously. What it does, who supports it and oppose it, who's contributing money, you know, et cetera. So I've already set the date. I will make sure I don't let the vice chair know. So he does not drive to Santa Cruz in a tent. And then in response to Senator Richardson's question, I would say something like we have a very volatile revenue system, And we need to save more in good times and not spend it in order to not have to cut more in bad times. And that's what this does. I would be clear about that. And then the third thing to note is that Paul Gann, the very Paul Gann, supported publicly while he was still alive, excluding deposits and counting withdrawals from the Rainy Day Fund. So he actually supported the general principle that we are going at with ACA 20. So those three comments. Now, this is the opportunity for public comment. It would not be. Yeah, this does not. Erwin, please move to the microphone. Welcome to the committee. Welcome back to the Senate. And if there's anybody else, you can be ready to speak after Erwin. All right.

I'm sure everybody at home knows who you are. So thank you for doing that. All right.

Okay.

We appreciate your comments. Is there anybody else to address the committee and public comment? Seeing none, normally we bring it back and we have a debate over a motion, but we're not taking action today. And I believe that we had a good conversation with everybody and that, except for Senator Ochoa Bogue, who got here late, everybody had a chance to talk or ask a question.

Yes.

Well, let me recognize you, Senator Richardson.

My comment, not in any way, meant a criticism.

Well, thank you. Well, let me appreciate everybody for participating in this hearing. I think it was a good airing of the situation. We will consider this on the floor of the Senate tomorrow. And seeing no further business, the Committee on Budget and Fiscal Review will stand adjourned. Thank you.