Proposition 2 Asks Voters to Require the State to Pay Down Budgetary Debt for the Next 15 Years

This is the second in a series of blog posts highlighting the CBP’s analysis of Proposition 2, which will appear on the November 4, 2014 statewide ballot.

Proposition 2 is often casually referred to as a “rainy day fund” measure because it would significantly change the state’s budget reserve policies.

As we noted in our blog post last week, “setting aside funds in good economic times to help meet the challenges that arise during economic downturns is a sound budgeting practice. Budget reserves — also known as rainy day funds — are critical because they can help policymakers limit the need for deep cuts to vital public systems and services when tax revenues decline.”

In addition to changing the state’s rainy day fund policies, Proposition 2 would require the state to pay down “budgetary debt” over the next 15 years and, unlike with the deposits into the rainy day fund, would not permit policymakers to suspend these payments in times of fiscal emergency.

Our analysis of Proposition 2 raises concerns about not allowing for the temporary suspension of these debt payments. Policymakers often need flexibility in adapting to unexpected changes in economic and fiscal conditions, such as when state revenues are dramatically lower than had been anticipated.

Nevertheless, paying down budgetary debt that the state accumulated during and before the Great Recession — such as borrowing from special funds or underfunding pension liabilities — is necessary to ensure that the state has the capacity to fund vital programs and services in the future.

Budgetary debt is different than debt incurred to build capital projects. The usual way that state and local governments incur debt is to issue bonds to build capital projects, such as the Proposition 1 water bond that will also appear on the November ballot. These bonds finance capital assets, such as K-12 schools, colleges and universities, transportation facilities, prisons, and water projects. The bonds come in two forms: general obligation bonds that require voter approval and lease-revenue bonds that are approved by the Legislature. The bonds are sold to investors who are repaid, with interest, according to a fixed schedule over a term of 20 to 30 years.

The purpose of using capital debt is to spread the costs across the life of the assets. For example, if a school will be in service for 30 years it is not fair for taxpayers in the year it is built to bear the full cost of building the school. Spreading the costs to taxpayers over the 30-year life of the asset ensures that taxpayers today and in the future are paying proportionate shares.

As of June 30, 2014, the state had a responsibility to repay $87 billion of capital debt bonds from its General Fund, at a cost of $7.6 billion in 2014-15 in debt service payments. The state Constitution prioritizes repaying these bonds and provides little flexibility to alter the timing and amount of debt service payments.

Recognizing the distinction between capital debt and budgetary debt is important to understanding why paying down budgetary debt is required in Proposition 2. Proposition 2 would require paying down the following types of budgetary debt:

  • Making certain payments that were owed to K-12 schools and community colleges as of July 1, 2014;
  • Repaying dollars that were borrowed — prior to 2014 — from various state funds and used to pay for services typically supported with General Fund dollars;
  • Reimbursing local governments for state-mandated services that they provided prior to 2004-05, but for which the state has not yet provided payment;
  • Reducing unfunded liabilities associated with state-level pension plans; and
  • Prefunding other retirement benefits, such as retiree health care.

These liabilities are different from the capital debt described above. First, whereas the state repays capital debt to investors, budgetary debt is repaid to school districts, local governments, and branches of state government, or is the dollars set aside to pay for pension and health benefits for retired state workers and teachers.

Second, whereas capital debt buys long-living assets that provide benefits in future years, the budgetary debt targeted by Proposition 2 was incurred in prior years, for services already provided. In other words, this is debt that requires taxpayers in the future to pay for services delivered in the past.

Carrying large amounts of budgetary debt threatens the ability of the state to support vital public services and systems in future years. For example, the state provides many of its retirees with health benefits. Generally, the state does not set aside money for (or “pre-fund”) this cost as employees earn it. Each year, the state pays the medical bills of retirees out of current year General Fund revenues. In 2014-15, this is expected to exceed $1.8 billion. If the state had pre-funded these benefits, today’s state budget would have additional funds to spend on public services and systems such as schools, health care, human services, and higher education.

The Department of Finance reported earlier this year that the total unfunded retiree pension and health benefits owed by the state were $218 billion — much larger than the amount of General Fund-supported capital debt that the state must repay.

Proposition 2’s requirement that budgetary debt be paid down more quickly would mean that the state will free up significant funds in future years. But, getting there will cost more in the near term in order to avoid even larger payments and painful service cuts down the road.

— Chris Hoene