Revamping California's education finance system: education leaders need to understand how the state got into this budget mess in order to craft long-term solutions that provide school districts with greater stability

Leadership, March-April, 2003 by Brett McFadden

California's budget crisis is topic No. 1 in Sacramento and throughout the golden state. The complexity and enormity of the problem has engulfed virtually every aspect of public policy discourse. Hardly a day goes by without a newspaper article or television broadcast focusing on the state's budget woes and its impact on individuals, programs or specific locales.

And why not? California's economy and budget have been on a roller-coaster ride. Over the past three years, California has gone from record level budget surpluses to unprecedented budget deficits. It was not too long ago that our state's economy was riding the wave of the dot-com and high-tech craze, and reaping the benefits of their economic windfalls. As dramatically as the economic boom began, it ended, sending the state's revenues and budget into a multi-year tailspin.

How and why did this occur? How did it get so bad, so fast? These are important questions fin anyone affected by the state budget. For K-12 educators, it is imperative that we understand how we got into this mess in order to craft policies to get ourselves of it.

More importantly, understanding the characteristics of California's tax and revenue structure is key to designing long-term solutions that provide school districts greater stability and freedom from the state's economic ups and downs.

This article will focus on why California's budget condition went from boom to bust in such a short time. Attention will be given to how the state's revenue structure contributed to the problem, and what impact it has had on education finance. Finally, possible solutions and options for the K-12 education community and individual school districts will be explored.

How did we get into this mess?

When you consider the state went from a $13 billion budget surplus in 1999-00 to an estimated $36.4 billion deficit for 2003-04, that's a good question to ask. The culprits behind this problem have been the nature of the economic downturn and our state's revenue structure--particularly the types of revenues we rely on to pay for public services.

Revenue volatility has long been a characteristic of California budget making. Tax receipts rise during good economic times and fall during periods of decreased economic activity. Such volatility should not come as a surprise when you consider the dynamic nature of California's economy and the fact that a majority of our state taxes are closely linked to cyclical variations in the economy.

In recent years, however, the cyclical nature of the state's revenues has become exacerbated due to changes in the California economy and the revenues that are derived from it. During much of the 1990s, the high tech sectors of the economy realized significant growth and development. California realized a higher benefit from this growth, since a large percentage of high tech firms and businesses are located in the state.

Job growth and salary/benefit compensations within this sector were some of the highest of any segment of-the economy. As a result, personal income and the related economic activity associated with higher incomes increased dramatically throughout the last half of the 1990s.

The impact of these economic changes increased exponentially due to California's progressive personal income tax structure. Under this structure, higher income levels are subjected to higher tax rates. As a result, revenues have a tendency to grow faster than income during economic expansions, and decline more than income during periods of economic recession.

Although revenue volatility has always been around, it increased in the late 1990s. Year over year revenues increased by 23 percent in 1999-00, but then fell to 14 percent in 2001-02 (LAO, 2002, p. 38). Such fluctuations had not been seen since the early 1960s.

Over-reliance on personal income tax

With recent changes in California's economy came changes in the types of revenues the state receives. Most notably has been the growing reliance on PIT (personal income tax) as a major portion of state revenues. In 1980-81, PIT represented approximately 35 percent of the state's General Fund. By 2000-01, that figure jumped to nearly 58 percent (LAO, 2002, p. 39).

The growth in PIT reliance occurred because PIT revenues grew at a quicker pace than the state's economy, while other revenue sources (sales and corporate taxes) grew more slowly. In addition, the elimination of the state inheritance tax as well as other factors contributed to the increased budgetary reliance on PIT.

The problem with PIT is that it has become highly volatile and concentrated among high-income earners. Higher income earners typically have larger percentages of volatile income sources (stock options, capital gains and business earnings). The amount of total income from the top 5 percent of taxpayers went from 22 percent in 1980 to nearly 42 percent in 2000 (Hill, 2002). In other words, the bulk of PIT revenues now" come from the very rich, who in turn have a higher percentage of volatile income sources.