EOS Backgrounder on Deferrals
30 June 2020
$11 billion dollars of debt – “deferrals” – is buried at the heart of this year’s education budget. Maintaining last year’s spending levels in the face of dramatically lower state general-fund revenue means accepting IOUs instead of cash. The impact of IOUs will be felt first in districts in low-property-value counties like Fresno, Kings, Imperial, and Tulare. Those districts will need to borrow extensively to fund ongoing operations, with the IOUs as collateral.
By June 2021, the impact of $11B of debt will be felt across the education spectrum. This debt will need to be redeemed – rolling it over drags the state’s credit rating down, its borrowing costs up, and puts a tremendous strain on cash flow. Redeeming it has historically meant raising new tax revenues and/or cutting back future spending. Like it or not, the cost of maintaining spending next year is that finding the $11B has landed squarely, again, on the backs of education.
Every year the governor and legislature are constitutionally required to agree upon a budget that balances the state’s expected revenues with planned expenditures. In good times, the tension is between undertaking new programs, expanding existing ones, and setting money aside as a cushion against bad times. In downturns, the hard decision is between which programs to cut, what reserves to use, and how much to borrow.
Spending on public school K-12 education plays an outsize roll in this decision for two reasons. First, K-12 schools constitute the largest single area of state expenditure, typically consuming just under 40% of the General Fund. (1) Second, there is an absolute floor below which combined spending on schools and community colleges constitutionally cannot go. Known as the “Proposition 98 Minimum Guarantee,” this restriction controls about 38% of the General Fund.
The state’s expenditure combines with local and federal money to fund our schools. Compared with other states (2), California’s state contribution is unusually high. The state generally pays around 58% of all K-12 costs, significantly higher than the 47% national average.
The unusual reason for this is that the state has redirected schools’ primary local resource (property tax) to satisfy its own obligations to city and county governments as well as to fund redevelopment activity. Backing out the schools’ share of the $9 billion diversion for the state’s vehicle-license-fee sharing obligation (3) and the $4 billion of remaining redevelopment debts (4), the state’s actual contribution to schools is similar to other states’, at 47.8% vs 47.3% (5).
The decisions in 2004 and 1979 that led to these diversions are long forgotten, hence the ongoing lament about ‘how much’ Sacramento devotes to schools.
Because K-12 education represents a large part of the state budget, it is always the focus of attention in an economic downturn. It is a great temptation to insist that schools take their “fair share” of any budget cuts – which would be a very big share, indeed. Economic assistance, health and human services issues are also at the forefront of people’s minds in times of trouble.
Unfortunately, the “minimum guarantee” turns out to be a triple-edged sword at these times.
- On the one hand, it sets a floor that provides education funding some security. It is the first number that budget staff calculates -- to see what flexibility they have to maintain spending elsewhere.
- Because of that calculation, the minimum guarantee also rapidly becomes a ceiling. It becomes the “voter-approved guarantee,” as if voters had set it as their target.
- Finally, the terms of the proposition constrain future year reductions in the guarantee. Conservative financial management dictates keeping it low and spending any additional available revenue ‘outside the guarantee’ when times are good (6).
Deferrals – The IOU Stopgap
One budget-balancing approach that has emerged in recent recessions is known as “deferrals.” This practice began decades ago, outside of education, when the state delayed its June 30th payroll for one day – to July 1st, over the end of the fiscal year. Effectively an accounting ruse, this reduced nominal current-year personnel spending (and the current-year deficit) without having to make actual program cuts. On the flip side, it also increased the following year’s spending, which necessitated repeating the process until a fiscal year when revenues turned out especially strong. Then the semi-monthly payroll date was moved back to June 30th.
Deferrals are particularly attractive when economic conditions change rapidly and revenues fall, reducing both cash-on-hand and the Proposition 98 Guarantee.
During the financial crises in 2002 and 2008, the state deferred amounts it owed to K-12 school districts. At first, it was just their June apportionment – $1-2B – that was shifted a few days into July. Then, as the 2008 recession deepened, the total grew to $9.4B as all the spring month apportionments were added. This meant shifts in income receipts up to five months long. While originally a budget-balancing maneuver, deferrals had become a cash-flow tool – a necessity since the state usually didn’t have the cash to make five months of payments in July.
When the state defers payments to schools, it is reducing its own current-year spending while allowing school districts to continue to operate without being required to cut programs. This is usually politically expeditious, since districts have to notify any individual teachers subject to impending layoffs no later than mid-March. Since critical indicators of upcoming fiscal year balances are not filed until April – notably, income tax returns and payments – deferrals sidestep dramatic end-of-year reductions.
Furthermore, the state is able to lower the overall Proposition 98 Guarantee in Test 1 down years to reduce pressure on the General Fund when the economy improves. Thus, the administration and legislature give themselves the option to fund above the minimum guarantee in future Test 2 years, but are not constrained to the higher level that direct spending would have created.
The Cost of Deferrals
At the district level, funding ongoing spending with IOUs may require borrowing when the deferral amount is more than a single month’s state aid or when the term of a deferral stretches beyond a month. This has a financial cost as well as consuming administrative time and attention. For 2011-12, the payback stretched into September 2012. In 2012-13, an improving economy and passage of Proposition 30 tightened this up to receiving March and April in late August, but that year’s April, May and June didn’t arrive until mid-July. The 2020-21 budget shows deferrals that run as late as November. Districts in wealthier counties can sometimes file their state IOUs with the county treasurer, then simply run an overdraft. But in poorer counties, that option isn’t necessarily available, so districts have to issue Tax Anticipation Notes individually or as part of a county or state consortium.
Furthermore, because only state-aid funding that is owed to a district may be deferred, deferrals disproportionately burden less advantaged districts. Although statewide an average of 54% of LCFF funding comes from state aid, it ranges by county from 11% - 77%. The ten counties in the top range – above 65% -- tend to have low county-wide property tax per capita. This hits their school districts with a triple whammy.
- First, lower incoming property tax to schools means more state aid to begin with.
- Second, the state’s school funding formula includes supplementary and concentration grants that raise the amount of funding for disadvantaged districts. But this means that the total dollar amount that is deferred is greater -- while requirements for the use of that funding don’t abate.
- Third, more education-allocated property tax is taken to cover the vehicle license fee obligation (mentioned above). It is a transfer of school districts’ property tax to other local governments on a per-capita basis, so more is taken away in populous areas.
Thus, some of the hardest hit districts are in counties like Kings, Fresno, Imperial, Tulare, San Bernardino, Kern and Riverside.
Most importantly, the day of reckoning comes when the crisis is over.
Deferrals are very much like a parent buying a much-needed present for a college-age child – and putting it on the child’s credit card. At the end of the day, there is a debt, which has to be redeemed. And the college student, not the parent, often finds himself on the hook to repay it. Here, since the obligation shows up in education, it becomes education’s job to get it repaid.
This was very evident in 2012, when the governor’s May and June budgets stated clearly that there would be $5.5B of cuts to K-12 education unless a new tax measure were passed to pay back the “Wall of Debt” to schools and set the General Fund on a stronger course. This became Proposition 30 on the November ballot. Just a week before it passed, Governor Brown expressed strong reservations about the likelihood of its passage – suggesting that education was very close to having to swallow the cost of the deferrals it had accepted.
Holding spending steady for a year in a downturn requires not merely a recovery to normal next year but an equal and opposite surplus to repay those IOUs.
Going forward from 2021, this will be further complicated by two issues. First, Proposition 30’s six-year term was extended by Proposition 55 (2016), so the next effort will be additive again to that. Proposition 30 also removed $6B a year of sales tax income from the General Fund Revenue calculation on which the Prop 98 base is calculated.
Second, Proposition 2 (2014) created a Rainy Day Fund along with mandatory payments towards old debts and the pension overhang. New debts will not qualify for this funding, so in good times the equal-and-opposite uptick will have to be even greater before deferrals can be repaid from ongoing revenue streams. Furthermore, there are requirements for funding the separate School Stabilization Fund, which count towards the Prop 98 guarantee.
One brighter light is the possibility that the Federal Government will step in with additional aid to education. To the extent that this is targeted specifically for education (rather than general state support), burying deferrals in K-14 schools allows California to maintain the non-K-12 side of the budget. And the Federal aid would sidestep issues like mandatory pension payments and contributions to the Rainy Day Fund.
The Bottom Line
Deferrals allow California school districts to live on borrowed time – on their own borrowed money. Aside from the immediate debt problem faced by the lowest-resourced districts, education as a whole has to figure out where to find the unfunded $11B being spent this year … and, unless revenues miraculously rebound another $11B next year.
Let’s make good use of the borrowed time.
(2) Rankings of the States 2018 and Estimates of School Statistics 2019, NEA Research, April 2019. Table F-2. Of total funding of $100.6B in 2018-19, $58.1B came from state funds. Nationally, states contribute $345B of $730B. Excluding California – the largest state in the nation for education funding, the national average is 45.6% (286.9/628.9). The California data is corroborated by the LAO at https://lao.ca.gov/Education/EdBudget/Details/388.
(3) http://www.ebudget.ca.gov/budget/publication/#/e/2019-20/FinancialInfo, download Schedule 13, Prop 98 Certification. And from http://www.ebudget.ca.gov/budget/publication/#/p/2018-19/BudgetSummary , download Revenue Estimates, which show $8.5B of property tax removed for VLF Swap (p. 171), with $29B continuing to go to K-14 schools incl. $1.6B from redevelopment dissolution. Splitting the VLF Swap between K-12 and community colleges is difficult, because it is taken first from their common pool of indirect funding, the Educational Revenue Augmentation Fund, in each county, then if that is insufficient, from their direct property tax allocation. Classically, this is split 89%-11%, so I have reduced the state share by 89% of $8.5B = $7.565B. The state contribution becomes $50.6B or 50% of the total, much closer to the average of the rest of the states. Add to that the redevelopment costs still buried in education, $2.4 B, and the state contribution drops to $48.2B or 47.9%. Note: the reason I characterize these as ‘unusual’ is that, in other states, property tax is directly levied by or directed to local services. When Proposition 13 (1978) capped the levy at 1% total for all services without laying out a structure for reallocating shares of that 1%, it set up a titanic battle between cities, counties, special districts, the state and schools. Schools, with 53% of all property taxes going in, have tended to be the loser in that battle. Less than 40% of the general levy now actually gets to their doors.
(4) From the 2017-2018 Governor’s Budget summary, Housing and Local Government section, $10.4B had been returned to cities, counties, special districts and K-14 education from redevelopment agency dissolution. $5.9B of this was returned to (had come from) K-14 education, about 57%. See Redevelopment sheet, showing $7.61B of total tax increment from SCO, less $2.81 estimated overall distribution = $4.8B still flowing to RDAs x 57% to K-14 x 89% to schools = $2.4B
(5) California’s per capita property tax is literally identical to the national average. So, although there are good arguments for why more property tax could and should be flowing to schools, this does not explain why the state devotes a larger proportion of its General Fund to education.
(6) The enacted 2019-20 budget noted that per-pupil Proposition 98 spending would be $12,000 – while spending from all sources (state, federal, and local) would be $17,400. (Typically, about $1,000 of that would be federal revenue, with the remainder local parcel taxes, excess property tax, donations, etc., and finally non-Prop 98 state funding.)