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2021-22 Budget, State Revenues & the Ongoing Needs of Californians

May 2021 | By California Budget & Policy Center

Introduction

Policymakers are preparing to make decisions on the 2021-22 state budget — and just as there are signs the pandemic is starting to ease in California. Still, data and experience show the economic and health effects of the recession will linger on for Californians, especially people in low-wage jobs, families in low-income households, and Californians of color. How can policymakers address the challenges and barriers for Californians now and meet their ongoing needs, look beyond this budget year to equitably allocate the state’s resources, and confront the widening wealth and income inequality in our state? 

Our new Q&A shares key information to keep in mind as policymakers make decisions on behalf of Californians and our local communities.

1. Governor Newsom will soon release his “May Revision” budget proposals. What is the May Revision, why is it important, and how does it relate to the 2021-22 state budget that the Legislature will pass in June?

State law requires California governors to revise their proposed budget for the upcoming fiscal year by May 14. This update, known as the “May Revision,” is a key part of the annual state budget process that determines policy priorities and the allocation of resources to support Californians and local communities. Governors use the May Revision to unveil new proposals or to amend or withdraw the policy recommendations they advanced in January as part of their initial proposed spending plan. In addition, the May Revision:

  • Updates the governor’s revenue forecast, which estimates the amount of funding that state leaders will have to invest in public services and systems;
  • Adjusts key budget-related estimates, such as the projected number of K-12 students and the number of people who are expected to receive health care services through Medi-Cal;
  • Revises spending estimates across a broad range of programs and systems, from K-12 schools and higher education to health and human services and the state prison system.

The May Revision gives governors a high-profile opportunity to influence budget and policy decisions by promoting their own priorities for California just weeks before the Legislature’s June 15 deadline to pass the budget bill. The May Revision also sets the stage for budget negotiations in late May and early June between the governor and the leaders of the state Senate and Assembly (collectively known as the “Big 3”), who must reach an agreement on the contours of the final budget. While the 2021-22 state budget will incorporate many of Governor Newsom’s May Revision proposals, it will also reflect many of the Legislature’s own spending and policy priorities.

2. State revenues have been coming in ahead of projections for several months now, despite the pandemic and the recession. Why is that? Who is continuing to do well during this devastating public health emergency, and who has been left behind?

The state’s main revenue sources, the personal income tax, sales tax, and corporation tax, have all performed better than expected for a few main reasons. First, Californians with high incomes — who contribute a large share of personal income taxes due to the state’s progressive income tax system — have largely been shielded from job and income losses during the pandemic and have benefited from the strong growth in the stock market. Additionally, the federal relief to individuals and businesses has buoyed consumer spending and business investment and, in turn, sales tax revenues. Finally, many large corporations have been able to weather the crisis and some have even seen large profit increases.

Meanwhile, Californians in low-paying jobs, and particularly Black and Latinx Californians and women, have borne the brunt of the job and income losses and other hardships. For example, about 3 in 5 Black and Latinx households lost earnings during the pandemic, compared to less than half of white and Asian households. More than 1 in 3 California women lived in households that struggled to pay the bills last fall, and Black and Latinx women were the most likely to live in households that struggled to pay the bills, stay current with their rent or mortgage, and afford enough food.

3. Earlier this year, the governor projected a $15 billion budget “windfall,” and since then state revenues have continued to surge. The federal American Rescue Plan also will bring in another $26 billion in direct fiscal aid to the state. How should the state spend these funds?

In January, Governor Newsom proposed a $165 billion spending plan that included a $15 billion budget “windfall.” Moreover, in recent months state revenues have continued to outpace projections by billions of dollars. These gains are the result of stronger-than-expected economic conditions, the state’s progressive tax system, and the fact that state leaders underestimated revenues in this year’s budget. This also means that state spending is trending back to where it might be expected to be in a normal year. But, this is clearly not a normal period for California and, while economic projections are for continued growth, the state is facing significant needs stemming from the public health and economic effects of COVID-19.

In addition, the American Rescue Plan will deliver $26 billion in direct fiscal aid to the state. These funds are one-time and can be spent over multiple years. 

State policymakers should use unanticipated state revenues and the new federal aid to:

  • Continue to address the ongoing public health crisis;
  • Provide assistance to the households and organizations harmed by the pandemic, particularly people of color that were disproportionately affected;
  • Fill gaps in federal assistance, particularly for people who are undocumented and have been excluded from federal aid;
  • Invest one-time dollars in ways that achieve longer-term impact, such as capacity-building and infrastructure investments in child care, behavioral health, housing, and homelessness, as well as capitalized operating reserves that can support future investments; and 
  • Restructure vital state supports so that they include the people previously excluded because of ableist, ageist, racist, sexist, and classist policies that have blocked Californians’ access to benefits, security, and opportunity.

4. The governor’s January proposal included a lot of “one-time” investments. California is also receiving substantial federal “one-time” funding. Yet, the state and Californians had significant ongoing needs pre-COVID, and the pandemic exposed and created a set of greater needs. What are some key ongoing needs and investments that state leaders need to address?

One-time spending is not adequate to support Californians who struggled to meet their basic health, housing, and child care needs even before the pandemic, with an inequitable burden on Black and brown Californians and those with low incomes. Nor is one-time spending adequate to support critical systems and service providers that face ongoing operating costs and need long-term funding commitments to responsibly budget and plan. Clear needs for boosted ongoing state support include:

  • Investing in local efforts to address homelessness through reliable, flexible state funding at a scale that responds to the scale of the crisis.
  • Addressing housing affordability by focusing on the needs of California’s low-income renters — through direct assistance, robust legal aid and enforcement, and affordable housing production.
  • Expanding comprehensive Medi-Cal coverage to all undocumented Californians who are otherwise eligible, with special urgency to cover seniors, and ensuring that all income-eligible Californians have access to nutrition assistance regardless of immigration status.
  • Providing ongoing funding for local public health departments to ensure they can respond to COVID-19 and other threats to population health.
  • Bolstering funding for mental health care and substance use treatment and expanding the behavioral health workforce.
  • Addressing the long-standing underfunding of subsidized child care to ensure all families have access to affordable care and providers are paid fair rates.

State leaders need to be bolder in committing to ongoing support — while also boosting support to a level that meets the scale of need — for the systems and services Californians rely on to meet basic needs and that are vital to public health and well-being. State leaders should seek to increase revenues in equitable ways and make structural changes to revenue and budget policies to ensure ongoing investments can be made to support Californians.

5. California is home to tremendous wealth yet the needs of Californians in low- and middle-income households are vast and Californians of color have been blocked from economic and health opportunities for generations. Why has there been so little urgency among state policymakers to consider new revenues to address ongoing needs and confront the widening wealth and income inequality that preceded and was exacerbated by the pandemic?

Raising new state revenues to support ongoing investments is often an uphill battle, even when there are significant needs for Californians and communities. This year, several factors are further dampening the sense of urgency among policymakers for new revenues. The better-than-expected revenues the state has been receiving — largely due to the continued prosperity of wealthy households — and the influx of federal relief funds have given state leaders more options to balance the budget for the upcoming fiscal year. In subsequent years, options may be more limited to balance the budget, and policymakers may need to consider how to increase revenues, reduce spending, or a combination of these and other strategies. Additionally, the strong revenue growth has raised concerns that revenues are approaching the state’s constitutional spending limit, known as the “Gann Limit.” If this limit is exceeded, policymakers must spend revenue over that limit in specific ways, so they lose the flexibility to spend those funds to best address the needs of Californians. The looming gubernatorial recall likely creates even more hesitancy among state leaders to advance tax policy changes. 

These factors combine to create an especially challenging year for the prospect of raising revenue. However, many of the needs faced by Californians — particularly for Californians of color, who have been disproportionately affected by the health and economic consequences of the pandemic — existed long before this crisis and will exist long after if the state does not make the investments required to address those needs. State policymakers can take steps that raise revenues to support those investments and make the tax and revenue system more equitable for all Californians, not just the wealthy few.

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When Governor Gavin Newsom released his proposed 2019-20 budget this past January, one of the biggest surprises was that he did not include a proposal to extend California’s tax on health insurance plans — or  “managed care organizations” (MCOs) — which expires on July 1. (An extension of this tax would require federal approval.) The Governor’s position is puzzling because the MCO tax package generates a net state General Fund benefit of roughly $1.5 billion each year. If the MCO tax goes away, so does this General Fund benefit, thus reducing the capacity of the state budget to support public services and systems, such as child care for working families and higher education.

The Governor has expressed concern that pursuing a reauthorization of the MCO tax could conflict with the state’s efforts to renegotiate, with the federal government, two Medi-Cal “waivers” that will expire in 2020. (Waivers help to determine how services are delivered in Medi-Cal, our state’s Medicaid program.) However, the nonpartisan Legislative Analyst’s Office (LAO) has evaluated this concern and concluded that the Newsom Administration “has not laid out a convincing rationale” for letting the MCO tax package lapse. Furthermore, the LAO notes that “California’s prospects of receiving federal approval of a reauthorized MCO tax are strong.”

In order to help shed light on a critical policy issue that has major implications for the state budget but has largely been flying under the radar, here are five key facts about California’s current MCO tax package:

1. The current MCO tax package took effect in 2016 following more than a year of intense lobbying by the Brown Administration.

The current MCO tax package was approved by the Legislature on a bipartisan vote in early 2016, following over a year of all-hands-on-deck lobbying by Governor Brown and his administration. Due to new federal rules, California’s then-current MCO tax no longer complied with federal guidelines and needed to be revised. Ultimately, Governor Brown called the Legislature into special session with the goal of creating a new MCO tax that would adhere to federal rules while also generating substantial General Fund savings. In addition to a revamped MCO tax, the final tax package included offsetting state tax cuts for the health insurance industry that were designed to ensure that the industry, as a whole, would be no worse off financially as a result of the revised MCO tax. The final tax package won broad support, including from health plans, and took effect on July 1, 2016.

2. The MCO tax package reduces — or “offsets” — state General Fund spending on Medi-Cal by well over $1 billion per year, freeing up these dollars to support other state priorities.

This General Fund offset results from a complex financing arrangement. (See this LAO report for an overview of how it works.) Essentially, California taxes MCOs and uses the proceeds to leverage federal funds to support Medi-Cal, our state’s Medicaid program. The MCO tax package frees up around $1.5 billion in General Fund revenues each year that would otherwise go to Medi-Cal. These freed-up funds support an array of public services and systems that are funded through the state budget.

3. By leveraging federal dollars for Medi-Cal — at no cost to the state’s General Fund — the MCO tax allows California to come closer to claiming its fair share of federal Medicaid funding.

It’s long been known that the main formula for determining how much federal funding states receive for their Medicaid programs is flawed, and in a way that puts California at a financial disadvantage. (This formula is officially known as the “FMAP.”) For California, the key problem is that the state “receives a low federal matching rate despite its relatively low ability to fund [Medi-Cal] program services,” according to the US Government Accountability Office (GAO). By providing another way for California to tap federal Medicaid funds — at no cost to the General Fund — the MCO tax helps to lessen the inequities that are built into the FMAP formula by boosting federal support for Medi-Cal.

4. If the MCO tax were allowed to expire, state General Fund costs for Medi-Cal would ultimately increase by more than $1 billion per year, but without any additional benefit to the Medi-Cal program.

If the MCO tax expires, policymakers would have to replace the lost MCO tax revenues with state General Fund dollars in order to maintain current federal Medicaid matching funds and keep the Medi-Cal program whole. In fact, this is what Governor Newsom’s proposed 2019-20 budget assumes — that the General Fund will backfill the foregone MCO tax revenues. This, in turn, would reduce the amount of state funds available to support other key public services and systems.

5. Alternatively, extending the MCO tax would free up General Fund dollars that could be used to expand key services beginning in the 2019-20 fiscal year, which starts on July 1.

As noted above, Governor Newsom assumes that state General Fund spending on Medi-Cal will rise beginning in 2019-20 due to the (presumed) expiration of the MCO tax — an assumption that is built into his proposed state budget. Alternatively, if the MCO tax were extended, this General Fund “backfill” for Medi-Cal would not be necessary. As a result, these General Fund dollars, ultimately reaching around $1.5 billion per year, would be newly available — relative to the Governor’s current multi-year budget forecast — to pay for other state priorities. For example, these freed-up dollars could help to move California closer to universal health coverage. Key policy options here include improving and expanding Medi-Cal and creating new state subsidies to reduce the cost of coverage for low- and moderate-income Californians who purchase health insurance on the individual market.

Conclusion

The current MCO tax package leverages federal funds for Medi-Cal, leaves the health insurance industry no worse off financially, and provides a net annual state General Fund benefit of roughly $1.5 billion, with these freed-up dollars supporting critical public services and systems. It’s not too late for the Newsom Administration to reverse course and work with state lawmakers to craft an updated MCO tax package that can win federal approval this year.

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Does California need significant new investments in its transportation infrastructure? Given our state’s deteriorating highways, roads, bridges, and other transportation infrastructure, not to mention billions of dollars in deferred maintenance, the answer should clearly be “yes.”

Governor Brown and state legislative leaders agree. They recently enacted Senate Bill 1, the Road Repair and Accountability Act of 2017, allocating $54 billion over the next 10 years in a transportation package that is split equally between state and local investments. This transportation package provides funding for highway and road maintenance and rehabilitation, public transit, improving conditions for pedestrians and bicyclists, and facilitating goods movement. The revenue to pay for these investments comes from a 12-cent increase in the state excise tax on gasoline (the “gas tax”), increased diesel fuel taxes, and new transportation improvement fees.

The new transportation package seeks to address billions of dollars in deferred maintenance and represents the culmination of deliberations that started in 2015, with an initial proposal from the Governor and a special legislative session on transportation funding that ran from June 2015 to December 2016.

While the overriding question should be whether California needs these transportation investments and improvements, much of the attention leading up to and following the enactment of the package has focused on questions about the fairness of the gas tax, whether the funds actually will be spent on transportation improvements, and whether the package was hastily passed without sufficient debate. After briefly recapping what the package actually includes — on both the spending and revenue sides — we examine each of these questions, in part by adding some much-needed context.

How Will the Money Be Spent?

The funds from the $54 billion package will be split equally between state and local transportation programs.

Major state-level allocations include:

  • $15 billion for highway repairs.
  • $4 billion in bridge repairs.
  • $3 billion to improve trade corridors.
  • $2.5 billion to reduce congestion on major commute corridors.

Major local-level allocations include:

  • $15 billion for local road repairs.
  • $8 billion for public transit and intercity rail.
  • $2 billion for local “self-help” communities that are making their own investments in transportation improvements.
  • $1 billion for active transportation projects to better link travelers to transit facilities.

How Will the Money Be Generated?

The package generates $54 billion in new revenues over 10 years from a series of tax and fee increases:

  • $24.4 billion from a 12-cent increase in the base gas excise tax starting November 1, 2017.
  • $10.8 billion from a 20-cent increase in the diesel fuel base excise tax and a 5.75-cent increase in the diesel fuel sales tax starting November 1, 2017.
  • $16.3 billion from a new annual transportation improvement fee that will take effect on January 1, 2018. This fee will range from $25 to $175 per vehicle based on the value of the vehicle. For instance, a vehicle valued at less than $5,000 would incur a fee of $25, while a vehicle valued at $60,000 or more would incur a $175 fee.
  • $200 million from a new annual fee of $100 on all zero-emission vehicles starting on July 1, 2020.

In addition, the base gas and diesel fuel excise taxes, the new transportation improvement fee, and the new zero emissions vehicle fee will be annually adjusted for inflation starting in 2020-21. Further, the base gas and diesel fuel excise taxes and new transportation improvement fee will be annually adjusted for inflation starting on July 1, 2020. The new road improvement fee will be annually adjusted for inflation starting on July 1, 2021.

The Question of Fairness: Gas Taxes and Vehicle Fees Are How We Fund Transportation

Whenever increases in the gas tax are considered, issues are raised about the fairness of the tax. As noted in our primer on California’s tax system, there are different ways to assess the fairness of taxes. Most people agree that a fair tax system asks taxpayers to contribute to the cost of public services based on their ability to pay. When lower-income households spend a larger share of their budgets on taxes than higher-income people do, we refer to those taxes as regressive. Conversely, taxes that require higher-income people to spend a larger share of their budgets on taxes are considered progressive. Lower-income households spend more of their incomes on daily necessities, such as basic transportation. In this respect, gas taxes are regressive.

However, this critique of the gas tax as a way to fund transportation improvements would be more concerning if we had other, more progressive ways of funding these improvements. The reality is that transportation funding in California, and nationally, primarily relies on a set of usage-based excise taxes and fees — taxes and fees that people pay to use highways, roads, transit facilities, ports and airports, and so on. While usage-based taxes and fees may be mostly regressive, they are fair in that they are paid as the cost of using the service. Even alternatives in transportation funding — toll roads and charges based on vehicle miles traveled (VMT), for instance — still raise revenues based on people’s use of highways and roads, and not with regard to users’ incomes. Another potential alternative, the carbon tax — a tax imposed on the burning of carbon-based fuels such as coal, oil, and gas — would still generate revenues based on the demand for and use of those fuels.

Some people contend that transportation should be funded from the state’s General Fund, or by general obligation (GO) bonds where the service on the debt is paid out of the General Fund, because the General Fund in California is largely reliant upon the state’s progressive income tax. However, this raises a major concern: Using General Fund dollars would put transportation investments in competition with other vital programs and services for limited state funding. General Fund dollars should be reserved for services for which lower-income households are especially burdened by the cost of the service (e.g., health insurance) or programs from which the entire society benefits and which we want to encourage (e.g., K-12 education).

Usage-based taxes and fees also make sense as a source of transportation funding because they can be structured in ways that meet other policy goals. For instance, because driving creates emissions that are harmful to the environment, taxes and fees can be designed to encourage alternative forms of transportation. Further, concerns about the impacts on lower-income individuals can be addressed by providing offsets. For instance, California could expand its Earned Income Tax Credit (EITC) — a refundable credit for low-income Californians — as a means of offsetting increased gas costs.

There is another factor to consider as to the wisdom of the recently enacted increase in California’s gas tax: our state’s gas taxes have not been increased in 23 years. Since the state last increased the rate, the real (inflation-adjusted) buying power of the gas tax per mile driven has dropped significantly. (Miles driven is a good proxy for the deterioration of roads.) There are a few reasons for this. One is that the tax is not indexed to inflation. Second, it is imposed as a fixed amount per gallon, not a percentage of the sales price of gasoline, so it does not increase as gasoline prices increase. Finally, because cars are more fuel-efficient than years ago, drivers pay less per mile driven than they did in 1994, when the gas tax last rose. When gas tax revenues fail to keep up with both inflation and wear and tear, less money is available to maintain and build streets and highways, and a backlog of deferred maintenance accumulates. The cost of addressing the deferred maintenance on the state’s transportation assets (not even including local roads) is now $57 billion. The relatively large 12-cent-per-gallon increase in the gas tax, which represents an approximate 4 percent increase in the overall cost of gasoline, is partly the result of 23 years of no increases. Furthermore, since the new package starts to adjust the gas tax rate for inflation in 2020, it will result in much more gradual annual changes in the rate, in turn helping ensure that revenues keep up with ongoing needs.

Lastly, it is important to put the gas tax in the broader context of the transportation package overall. State leaders structured the transportation improvement fee on vehicles — another key piece of the package’s revenue mix — so that it is based more on people’s abilities to pay, with the fee increasing relative to the value of the vehicle.

One of the other critiques offered about the new package is that the funds are not assured to go toward transportation improvements.

This critique is simply not based in fact. As noted in our quick summary above, the funds are all earmarked for state and local transportation investments. In addition, the package includes a set of accountability provisions designed to ensure that the revenues are spent as intended. Among these is a constitutional amendment (ACA 5) that will require voter approval on the June 2018 ballot. ACA 5 would 1) prohibit spending the funds on anything other than transportation and 2) create a state transportation inspector general within the California Department of Transportation (Caltrans) to ensure both that funds are spent as intended and that this spending complies with state and federal requirements.

The Question of Timing: State Leaders Have Been Working on a Transportation Package for Over Two Years

Opponents of the package have also charged that the package was “rammed through,” without enough opportunity for deliberation.

This simply is not the case. Governor Brown initially proposed a similar package in early 2015 and called a special legislative session that ran from June 2015 through the end of 2016, without resolution. The Governor then outlined the contours of a new package in his proposed budget for 2017-18, released in January, and state legislative leaders crafted alternative proposals in the weeks that followed. So, at a minimum, the new transportation package represents deliberations that had been underway for more than two years. And, given that the state has not increased the gas tax in 23 years, while billions of dollars in deferred maintenance has mounted, enacting a new transportation funding package was long overdue.

Ultimately, the most important question is whether California needs to invest more in its transportation infrastructure, improving its highways, roads, public transit and other alternative transportation options, and its ability to move people and goods efficiently. Years of neglect and billions of dollars in deferred maintenance, exacerbated by a lack of political will to increase taxes and fees, mean that the answer to that question is clearly “yes,” and that the recently enacted transportation package is a significant advance for California.

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