THE GOVERNOR’S 2007 PROPOSED BUDGET CHANGES

Making the most of short-term gains, giving a break to working Virginians.

Executive Summary

• Governor Tim Kaine’s recommended changes to the state’s current budget would increase general fund spending by $1.2 billion, or 3.3 percent compared with the enacted budget. Fortunately for the Governor, a continued strong economy in Virginia provides significant new revenue to address a number of issues facing the state.
• The proposed amendments give priority to targeted investments in certain key areas: continuing to fund core services, improving tax fairness, and maintaining the state’s financial stability.
• The proposals include a Working Virginians Tax Cut that will eliminate state income taxes for an estimated 323,000 working people in the state. The proposal would raise the filing threshold on the state income tax from $7,000 to $12,000 for an individual and from $14,000 to $24,000 for a married couple.
• Transportation spending would increase $485 million ($339 million leftover from last year’s budget agreement, and $146 million in additional funds), but the Governor argues that even that amount is insufficient to meet current needs. He promises to follow up these budget amendments with separate legislation to provide “long-term, sustainable revenue” for transportation.
• Pilot programs are proposed to test expanding state support for pre-K education. The state already provides funds for needy children’s pre-K education through the Virginia Preschool Initiative. The ideas being tested here could be used to expand state support to include all pre-K kids in the state.
• Under the Governor’s budget amendments, public school employees would receive a 3 percent salary increase. This makes good on the current budget’s promise to provide this pay increase.
• In addition to the pay raise, further proposed spending in education (both K-12 and higher education) bring the total increase in this area to over $200 million.
• The spending plan also proposes topping off the state’s rainy day fund with an additional $153 million, bringing the Revenue Stabilization Fund to its legal limit.
• Over $130 million in general fund revenues are proposed for various programs in health and human resources mostly to backfill federal dollars that are disappearing due to a variety of changes in federal social service-related programs.

Overview

The Governor’s budget reflects enviable developments in the Virginia economy. Virginia’s state government continues to see revenue growth for the fifth straight year. Although revenue growth began to slow as expected in 2006, the trends are still positive as reflected in the projected surplus in the general fund. The key drivers of these increased revenues are strong job growth in Virginia and strong consumer spending. However, the budget also shows some of the difficulties in allocating these resources to critical programs since most of the sources of revenue fueling the growth are volatile and unpredictable. This Budget Brief by The Commonwealth Institute for Fiscal Analysis examines the major components of the Governor’s proposed budget changes and discusses the likely impact of the proposals on low- and moderate-income Virginians.

Background: What is all the fuss about?

Virginia operates under a two year budget cycle. In even numbered years, during a long legislative session, the General Assembly enacts a budget that governs spending for the state across the next two years (called the biennial budget). In odd numbered years, during a short session, the legislature considers amendments to change that enacted budget. In good economic times, those changes to the budget are fueled by new funds available from updated revenue estimates and actual receipts from the first year of the budget cycle.

The money available to the state falls into two categories: general funds and non-general funds. General fund money comes from general taxes paid by individuals and businesses, such as income taxes. It is not dedicated to a particular purpose, so can be used to fund a wide array of state programs. The Governor and General Assembly have the greatest discretion in deciding how to spend the money in the general fund.

Over half of the state budget, however, comes from non-general fund sources. These are funds for a specific purpose. For example, college tuition money that the state receives goes to support higher education. Federal grant money is only for the specific activities outlined by the grants. Although an important segment of the state budget, the Governor and General Assembly have less control over how to allocate these funds.

The current budget for the 2006-2008 biennium was adopted by the General Assembly after a memorable marathon session in the spring, which went right up to the opening days of the fiscal year. A stalemate occurred over how to fund transportation programs in the state. Apart from disagreements on that key issue, though, the enacted budget was generally a responsible spending plan. As the Chairman of the Senate Finance Committee characterized it:

“For the first time in many years, we passed a real biennial budget that recognized all our known obligations and left no large second year “holes” for the short session.”
Senator John H. Chichester at the Senate Retreat, November 16, 2006.

In addition to trying to recognize known future costs in the original budget, the General Assembly appears serious about trying to maintain “structural balance” in the budget. That is, matching revenues and spending year-to-year, without relying on year-end balances. At the House Appropriations Committee retreat in November, the Committee reported that it was going to try and “avoid the ‘double-up to catch-up’ spending [so that] FY 2007 revenues in excess of the forecast should not be carried into FY 2008 and spent on on-going programs. [Doing so] would have the effect of doubling up spending that can not be supported within the revenue framework.”

Virginia’s Revenues: Continued Growth – Especially One-Time Funds

The economy in Virginia has performed well in recent years. The Governor projects continued economic growth, although slower than in the last few years. Among key measures like employment, personal income, unemployment, and wages/salaries, Virginia is expected to outpace the rest of the nation. For example, unemployment is forecast to be only 3.5 percent in Virginia, while the U.S. average is forecast to be 5.0 percent. In addition, wages and salaries are forecasted to grow 6.1 percent in Virginia, but only 4.6 percent in the U.S. as a whole. The strong economy has meant that Virginia has exceeded historical averages in these key measures of economic growth.

However, the economic outlook contained in the Governor’s spending plan anticipates a slowing of that growth and forecasts several key measures being closer to their long-term trends. For example, the Governor notes that the forecast for employment and wage and salary growth is essentially unchanged as compared to last year’s official estimate. Revenue to the state is closely linked to these key measures since important sources of money like sales taxes and withholding taxes basically follow salary and wage as well as personal income growth or contractions. Changes in these areas give you a good sense of where state revenues will be going.

This year, extra cash from end of the last fiscal year is not particularly significant since the legislature stayed in session right up until the beginning of the two year budget. As a result, revenue estimates were already updated and most of the available revenue already spent in the budget that was enacted in June (2006 revenues ended within one percent of what was predicted and actual revenue exceeded what was forecasted by only $19 million). Strong economic times do provide some additional revenue in 2007 and 2008, though.

The revisions to the revenue forecast reflect growth in two of the most volatile revenue sources: corporate and non-withholding taxes. Corporate taxes are now estimated to provide an additional $114 million in 2007, and an additional $14.5 million in 2008. Non-withholding taxes (generally estimated taxes paid by businesses) are now forecast to be $303 million more in 2007 and $334 million in 2008. Overall, revenues are estimated to grow 5.4 percent in 2007 and 4 percent in 2008. All in all, good news for the Commonwealth.

There are some notes of caution that go along with this good news. As the Virginia Senate Finance Committee reports, non-withholding and corporate income taxes are highly correlated since most taxpayers making estimated payments are small business owners, and strong business profits translate into compensation increases for employees which then play into how much in taxes those employees pay. As it turns out, these sources are also the hardest to predict since they are driven by investment decisions and other aspects of taxpayer behavior that are not always clear to forecasters. For example, corporations do things like carry back losses on their taxes and taxpayers can choose when to realize capital gains.

Taxes like these that are subject to wildly fluctuating revenues from year to year are less dependable than more consistent sources of taxes. An unanticipated downturn results in less money and the possibility of having to cut services and programs or raise taxes in order to meet the state’s requirement of a balanced budget.

Also of note, the slowing housing market in the state has meant that revenue forecasts have been revised downwards in some key areas. Sales tax projections have been reduced from last year’s official forecast. In addition, recordation tax receipts are expected to continue declining. They fell 22 percent through the first five months of the current fiscal year, the Governor notes.

The Governor’s budget does make allowances for the fact that much of the surplus is one-time in nature since 73 percent of the proposed new spending is also described as one-time in nature. Items include: $226.5 million for capital projects, $161.5 for transportation, and $152.7 million for the rainy day fund.

Matching one-time expenditures with one-time surpluses is a sound management practice that the state has not always adopted. During the last economic expansion in the late 1990s, Virginia enacted a series of tax cuts, most notably the elimination of the car tax that totaled $1.5 billion a year. When the recession hit, the state was thrown into a significant budget crisis. A downside of limiting the use of one-time surpluses to one-time expenditures, however, is that many of the most pressing needs facing the state such as poverty and access to healthcare are not going to be solved with one-time infusions of funds. Rather, consistent funding over time is needed.

Virginia’s Spending and Tax Cuts: Also Growing at a Good Clip

Not only have state revenues been rising, but so have state expenditures. The National Association of State Budget Officers reports that in fiscal year 2006, Virginia expenditures grew 9.7 percent (the national average was 8.7 percent) and in FY 2007 they are projected to increase 15.4 percent. The national average is projected to be 7.0 percent).

The state has also enacted a number of tax cuts in recent years which generally benefit the wealthiest segment of the population and corporations. The Estate Tax was repealed which will take $105 million out of revenues in 2008, and $120 million out each year after that. Corporate tax cuts were also provided through an expanded coal tax credit that is costing $14.5 million in 2007. Other recent tax cuts include a new credit for the purchase of long-term care (cost: $4.9 million) and a back to school tax holiday (cost: $2.5 million).

Working Virginians Tax Cut

Among the most exciting items within the Governor’s budget (it was the only proposal that received applause during his December 15 speech) is the Working Virginians Tax Cut. This proposal increases the state’s filing threshold for individual income taxes as follows:

• From $7,000 to $12,000 for individuals
• From $14,000 to $24,000 for married couples

According to the Governor (using data from the 2004 tax year), this change would mean that 176,000 working Virginians who now have to file the paperwork to prove that they owe no taxes would no longer have to file. In addition, it is estimated that another 147,000 working Virginians would no longer have to pay any state income taxes. It is estimated that slightly less than 10 percent of all returns will be eliminated. The revenue impact of this proposal is modest. Estimates are that it will reduce revenues by $13.8 million in 2008, $27.4 million in 2009, and $24.9 million in 2010.

The Working Virginians Tax Cut will help address some of the unfairness in the state’s tax system. As noted in the Governor’s budget speech, Virginia has a reputation for being a low tax state. However, low-income Virginians pay a disproportionate share of state and local taxes. According to the Institute on Taxation and Economic Policy, the poorest 20 percent of Virginia households (those earning less than $16,000 per year in 2002) paid 9 percent of their income on state income, sales, excise and property taxes. The richest 1 percent of households paid only 4.8 percent. One of the key reasons for this kind of disparity is because Virginia has not updated fundamental parts of its tax system in decades. As a result, wages below the poverty level are taxed in Virginia and inflation is allowed to eat away at the purchasing power of working people.

It is important to note that Virginia is implementing a new Earned Income Tax Credit (EITC) for the first time in 2006. The state EITC program would allow eligible working Virginians to claim a credit of 20 percent of any Federal EITC they have earned. Initial estimates indicate that this new EITC program will already eliminate the tax liability for a number of the same families (especially married couples with two or more children) affected by the Governor’s proposal. The Commonwealth Institute will be conducting more research on the impacts of the proposal to highlight its effects and interactions with other critical tax programs like the EITC.

The Transportation Knot

The Governor’s budget changes propose some additional funds for transportation, although not much. Transportation spending would increase $485 million ($339 million leftover from last year’s budget agreement, and $146 million in additional funds), but the Governor argues that even that amount is insufficient to meet current needs. He promises to follow up these budget amendments with separate legislation to provide “long-term, sustainable revenue” for transportation.

His budget notes that transportation revenues are expected to decline by almost 42 percent in 2007 and over 51 percent in 2008. The key sources of this significant decline are drops in gas tax revenue and motor vehicle sales and use taxes. The Governor also reports that costs are rising for all projects (existing and planned) because of inflation in the markets for materials like steel and concrete. The result is a loss of purchasing power for the unspent $339 million from last year and fewer funds for future needs because of declining revenue.

By his own admission, Governor Kaine does not propose to fund many key projects in this budget or to address a reported $450 million “annual maintenance deficit.” The stark nature of his description of the state of Virginia transportation combined with his promise to submit separate legislation on the issue of increase revenue for this function make it clear the debate here is far from over.

The Spending Plan – New Money and Treading Water

The following sections describe the recommended spending changes to the budget that will most heavily impact low- and moderate-income Virginians.

Health and Human Resources. In his budget, the Governor recommends a 1.7 percent increase in general funds for health and human resources spending. In general, his spending changes are aimed at filling holes in the different programs’ funding created by reductions in other sources of funding. For example, federal actions in reducing TANF block grant funds and other human services related program funding, means that Governor Kaine is proposing general fund increases to these programs of $73.3 million. Although commendable that this budget addresses this reduction in federal assistance, it does not mean that any additional new resources overall are going into these programs.

In addition, the governor proposes to add $58.2 million in general funds to the Health Care Fund to cover a shortfall in revenue due to lower tobacco taxes and reduced payments from the Master Settlement agreement with tobacco companies.

Other proposals include (funding from general fund):

• Pediatric Physician Services ($5.2 million increase) – This increase in general fund money matched with $5.8 million in non-general fund money would allow Virginia to increase the amount of money it pays to doctors who treat children enrolled in Medicaid by a total of 15 percent instead of 8 percent as is currently planned. If payment rates are too low, doctors will often not accept Medicaid patients thus limiting access to care for the poorest Virginians. This proposal is aimed at helping improve access by making it more cost effective for doctors to treat these patients.
• Prenatal Coverage ($2.6 million increase) – These funds when matched with $4.8 million in non-general fund money would be used to expand Medicaid eligibility for prenatal coverage of women from 166 to 200 percent of the federal poverty level. In 2005, Virginia’s child health program began to cover prenatal care for women in order to improve birth outcomes. This proposal would align the eligibility requirements for the expectant mothers with those for the child so that the mothers will be more likely to receive prenatal care.
• At-Risk Youth and Children ($9.1 million net increase) – This increase would provide additional money to localities for foster care services some of which are now ineligible for Medicaid reimbursement.
• Payments to foster care families ($3 million increase) – This funding (along with $3 million in matching funds) would increase the money that the state pays to foster homes in order to try and encourage the use of these family-based programs. If more placements can be made with families, then the program can avoid placing kids in the more costly residential facilities that the state runs.
• Pre-K pilot program ($2.9 million increase) – These funds would be used to pilot programs as part of the Governor’s new initiative on pre-school education. Early childhood education programs would agree to participate in a voluntary quality rating system to assess the quality of the education provided. Although the state already provides funds for early childhood education of needy kids under the Virginia Preschool Initiative program, the Governor is looking into possibly expanding that funding support to other families in the state.
• TANF work requirements ($26 million increase) – Along with $4.2 million in matching funds, this proposal would provide funding to meet federal work participation requirements under the recently reauthorized welfare reform act.
• Meals on Wheels ($700,000 increase) – This funding would allow Virginia’s 25 Area Agencies on Aging (AAAs) to provide an additional 135,000 meals per year. This increase addresses only about one-tenth of what advocates in this area have requested (using existing waiting list data) in order to provide needed meals.

Education

The K-12 education budget is reduced by $43.4 million in 2007 and increased by $26.9 million in 2008. Most of these changes are the net result of technical updates to the funding formulas that govern the level of state funding for public education based on overall enrollment and the size of the needy student population. The following are the most significant proposed changes included in the Governor’s amendments:

• Public school employee pay increases ($63.9 million increase) – By far the biggest item in the budget, this increase would provide the state’s share of a 3 percent salary increase for all public school employees, including all instructional and support staff.
• Pre-K pilot program ($4.6 million increase) -- This funding would launch “Strong Start” pilot programs for an estimated 1,250 students.
• Early Reading ($4.1 million increase) – This money would provide additional at-risk students with the services necessary to improve their reading skills.
• Algebra Readiness Program ($3.9 million increase) – These funds would expand this program to include sixth grade students. Currently it is only for seventh and eighth grades. This initiative is aimed at helping to address the recent drop in SOL math test scores.

The funding for higher education is also increased by a total of $40.4 million. Highlights include:

• Financial Aid ($13.7 million increase) – This increase would provide additional need-based financial assistance to help offset the recent tuition increases at the state’s colleges and universities.
• Base Adequacy Funds ($15.3 million) -- This increase would provide additional money to colleges and universities to help meet basic operations as determined by the state’s base adequacy funding formula.

Public Safety

The Governor’s proposed amendments would increase public safety funding by $68.1 million. The following noteworthy increases are included in his plan:

• Indigent criminal defense attorneys ($9 million increase) – This funding would be used to increase the compensation in 2008 for court-appointed attorneys who serve indigent Virginians in criminal cases.
• Indigent Defense Commission ($3.6 million increase) – This increase would provide additional personnel and higher salaries for the Commission in order to fulfill its statutory mandates to provide representation to indigent criminal defendants and to improve the offices staff who deal with capital cases.
• Legal aid ($400,000 increase) – This proposal would increase funding for civil legal aid for the poor. Legal aid programs operate out of 37 offices serving every jurisdiction in the state.

Housing

The Governor proposes some housing-related changes of note:

• Virginia Housing Partnership Revolving Fund ($2 million increase) – This increase would provide funds to help address affordable housing needs in the state. This amount is well below the amounts sought by affordable housing advocates for the problem of affordable housing. Their proposal, the Housing Trust Fund, would be a dedicated revenue source stemming from recordation taxes (not general fund revenues).
• Indoor Plumbing Rehabilitation ($1.6 million increase) – Coupled with $10 million in non-general funds, this proposal would accelerate the state’s efforts to improve living conditions of low-income Virginians in economically distressed areas by providing indoor plumbing.
• TANF Housing Grant (no new funds) – Unlike many of the other TANF-related programs where the Governor proposes to backfill reduced federal money with state general funds, the $5 million TANF grant to the Department of Housing and Community Development for continuum of housing services for low-income families appears in tact.

Conclusion

Thanks to continued strong revenues to the state treasury, Governor Kaine’s recommended budget can afford to provide the Working Virginians Tax Cut, replenish the rainy day fund, and invest more money in his key priorities. Despite this appealing combination of proposals, there will still be significant issues over which the General Assembly will disagree. The unresolved transportation debate will likely be replayed. It is an election year, too, so with legislators facing the voters in November, pressures will be on to both pass legislation on which to campaign and to complete their work on time.