NEW YORK - The release of Governor Jerry Brown's revised fiscal year 2013 budget proposal reveals that California's estimated deficit has increased to $15.7 billion from the $9.2 billion that the state had forecast in January. The estimated deficit is now 16% of the proposed $91.4 billion general fund budget. Of the cumulative deficit, about $8 billion is attributable to each of fiscal years 2012 and 2013.

Despite the significantly larger deficit, Standard & Poor's Ratings Services' A-minus rating and positive outlook remain unchanged. When revising the outlook to positive, Standard & Poor's cited the state's more structural approach to budgeting and changed budget process as potentially helping to strengthen its credit quality. However, if lawmakers are unable to agree upon solutions to the state's budget deficit that Standard & Poor's viewd as credible, it may revise the outlook back to stable. Furthermore, it could change the outlook to negative or lower the rating if the state's credit quality weakens through the budget process.

Prior to 2011, California required a two-thirds majority to pass its annual budget. As a result of this requirement in our view, the state experienced protracted budget stalemates resulting in liquidity crises. Despite the larger budget deficit, the change to a simple majority vote for budget approval increases the likelihood that California will avoid liquidity crises stemming from very late budget enactment. The state's pursuit of a budget with improved alignment between ongoing revenues and expenditures, which began in 2011 when the governor cited structural balance as a priority in his fiscal year 2012 budget proposal, has the potential to benefit its credit quality.

However, the governor's updated and more cautious economic and revenue forecast, pressure on required education spending, and some unrealized spending reductions from fiscal year 2012 contribute to an increased projected budget shortfall, which may threaten to undermine the state's potential for credit improvement. Bringing the state's spending plan into alignment with available revenues, even if taxes are increased by voters in November, will likely necessitate significant policy choices in a short time frame on the part of the legislature.

Although a majority of the state legislature has the authority – and, therefore, greater political accountability – to pass a budget, most tax and fee increases still require two-thirds agreement of the legislature. Therefore, the legislature's discretion over fiscal policy effectively amounts to deciding how to allocate spending cuts. From a policy perspective, the legislature's task is made more difficult by the fact that any budget cuts enacted for fiscal year 2013 will come on top of the deep spending cuts it has already made in recent years. The previously enacted cuts have proved important because the state's projected budget shortfall increased by $6.5 billion in the past five months.

On a more positive note and despite the recent fiscal erosion, the state's structural budget deficit is still approximately 50% smaller than it was as of the governor's January 2011 budget proposal.

Major budget solutions in the May revision include cuts (50% of solutions), increased revenues (mostly via the governor's tax initiative) for 35% of the solution, and a smaller set of less structural measures (15%), such as internal loan repayment extensions and special fund transfers.

The tax initiative is outside of the legislature's control and requires voter approval. The state estimates it would generate $8.5 billion – $2.9 billion of which would flow to kindergarten through grade 14 (K-14) education as mandated by the state constitution under Proposition 98. This leaves $5.58 billion to benefit the general fund if approved by voters. Assuming voters approve the tax initiative, the governor has laid out $8.3 billion in cuts, including about $2.9 billion to various social service programs that benefit low income residents.

Among the largest of these cuts are $1.2 billion to Medi-Cal, the state's Medicaid program, and $880 million to CalWORKs, the state's welfare program. Unlike in fiscal year 2012, aside from a change of about $83 million, the federal consents required for most proposed fiscal year 2013 reductions to the Medi-Cal program are routine in nature, according to the state. This should improve the rate of actual realized savings from these reductions, should they be enacted.

If voters reject the tax initiative, the governor proposes pre-approving an additional $6.1 billion in cuts, $5.5 billion of which would hit K-14 education. But even if voters approve the tax increase, the governor's plan would use the $2.9 billion in Proposition 98-related higher tax revenue to begin to reduce the state's backlog of school deferrals (now at $10.4 billion) instead of increasing programmatic education funding.

Total general fund spending would grow by 5.6% in fiscal year 2013 under the governor's plan, but this includes constitutionally required spending increases of $5.2 billion under Proposition 98 and the retirement of $2.1 billion in debt from a 2009 loan made to the state from local governments. Adjusting for these outlays, total general fund expenditures would decline by 4.5%.

Overall, the Department of Finance estimates that 51% of the $16.7 billion in deficit solutions are recurring, and based on the assumptions in the budget, would result in a small, $1.05 billion ending reserve. This reserve level is low but important considering that the potential Facebook initial public offering-related income tax revenue is especially difficult to forecast.

The state's recognition of the larger estimated shortfall signals the governor's approach of realistically assessing the state's fiscal challenges by assuming a more modestly paced economic recovery. For example, the updated forecast for total personal income growth in the state of 3.4% in 2013 is down from the 4.1% it had assumed in January. Similarly, the state reduced its assumed increase in capital gains income in 2011 to 5% from 15%.

This latter adjustment was somewhat offset by recognizing $1.48 billion in new personal income tax revenue anticipated to flow from the Facebook initial public offering (not assuming approval of the tax initiative). As a result of the more sober assessment of the economy and tax revenues, there are improved chances for actual budget performance to live up to the assumptions on which it is based.

This will be important because the automatic trigger cuts included in the final fiscal year 2013 budget will likely serve a different purpose than they did for 2012. Whereas the purpose of the midyear trigger cuts in fiscal year 2012 was to partially offset the risk associated with optimistic revenue assumptions, in fiscal year 2013 the trigger cuts will be designed to mitigate the potential for voters to reject the governor's tax initiative.

Despite the increased deficit, the legislature and governor could still agree on a budget package that may enable the state to retain a good ability to finance its intrayear cash flow deficits. If this occurs, and if the state averts a liquidity shortfall, S&P could raise the rating within the two-year time frame of the outlook horizon. However, if lawmakers are unable to agree upon solutions to the state's budget deficit that it views as credible, S&P may revise the outlook back to stable.

Among other factors, it will consider whether the state's ability to finance any expected intrayear misalignment in the state's cash flows can withstand the potential for voters to reject the governor's tax initiative in November. The increased projected deficit makes this a more difficult task but does not eliminate the possibility of the state enacting a budget with structural improvement.

In S&P’s opinion, a budget with fiscal provisions resembling the governor's plan could help strengthen the state's finances, but the plan's austerity also has public policy implications. And, while the legislature's political accountability for the budget may provide it an incentive to reach an agreement, it remains to be seen whether this will be sufficient for them to follow the governor's lead.

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