February 15, 2021

The case for COLA caution

From School Services of California (SSC)

Rest assured that when we published our 2021–22 Governor’s Budget Dartboard with our out-year cost-of-living-adjustment (COLA) estimates that are lower than those of the Department of Finance (DOF), we were cognizant of the impact it would have on our K–12 and community college clients, which are in the throes of budget development and multiyear projections (MYP). Publishing alternative estimates is not something we do regularly nor without great and careful deliberation.

Since the publication of our Dartboard, we have received many inquiries about our COLA estimates and why they are significantly different from DOF’s official out-year estimates. We know these questions come to us from public education agencies that not only need to meet their Assembly Bill 1200 obligations demonstrating fiscal soundness, but that are also in the midst of (or anticipate imminent) negotiations with their local labor partners. So, “getting it right” is of paramount importance.

The Composition of COLA

COLAs for K–12 and community college agencies are derived from a specific index—the federal Implicit Price Deflator for state and local governments—embedded in the laws for K–14 general apportionments. The index is comprised of a basket of goods and services consumed by local and state government entities across the nation, adjusted annually (up or down) to reflect their aggregate costs. The idea, of course, is to maintain the purchasing power of public dollars year-over-year to ensure that public agencies, such as school districts and community colleges, can maintain the current level of educational services.

In other words, the Implicit Price Deflator is the public agency version of the better-known Consumer Price Index (CPI). But because governments spend their resources differently from private citizens, it is important to track the change in the cost of goods and services specifically for them.

While we use the same index the DOF uses for our out-year COLA estimates, some of our cost assumptions for factors in the index differ markedly from the DOF’s assumptions.

It is no secret that state and local governments have borne a significant cost burden to address and mitigate the health and economic effects of COVID-19. Last May (2020), Governor Gavin Newsom warned that California was staring down a $54 billion budget shortfall after starting off the new year celebrating an anticipated surplus. And California, unlike most of the nation, is lucky. While one of 50 states in the union, California is unique. We have the Silicon Valley—home to some of the most innovative and wealthiest companies and owners in the world. And perhaps second only to New York, California has one of the most aggressive and progressive tax structures in the United States—meaning, we aggressively tax our highest income earners (the “one-percenters”) the most. The combination of housing some of the world’s most advanced technology companies and our progressive tax system has cushioned state coffers—and by extension, education funding—from a dreaded COVID-19 recession. Others have not been so lucky.

COLA: Recent History

Although crux of this publication unpacks the differences in future statutory COLA estimates, we would be remiss if we did not acknowledge an equally important trend related to the statutory COLA. This is that the statutory COLA does not always equate to what the state funds. Looking at the current and two prior years, the statutory and funded COLA have been congruent only once. 2018–19 was the year of the “Super COLA”, while 2020–21 is the year of the “No COLA”. If you consider the “Catch-up COLA” in 2021–22, that will make three out of four consecutive years in which the statutory COLA is different from the funded COLA. This dynamic creates additional risks to the assumptions public education agencies use in budget development and MYP.

COLA: The Near- and Medium-Term View

Importantly, the Implicit Price Deflator accounts for the economic conditions of all local and state public agencies across the nation. Nearly 60% of the index is related to the wages of local and state government workers, while the remainder is tied to transportation and other operational costs.

Although the final statutory COLA will be based on actual changes in state and local government spending, the figures are still largely unknown. We currently have seven of eight data points needed to calculate the 2021–22 statutory COLA, only three of eight data points for the 2022–23 statutory COLA, and none of the data points for 2023–24.

The horizon paints a sobering picture with respect to the wages of public employees. Because of budgetary impact of COVID-19 on public agencies, it is difficult to imagine anything but small wage increases over the coming years. In fact, the State of California imposed a 10% furlough on its employees last June, which has yet to be restored even though the state’s economy and General Fund picture have rebounded beyond anyone’s wildest dreams. Moreover, debate continues in Washington, D.C. over the need to provide local and state governments additional stimulus funds, so their fiscal recovery is anything but certain.

Similarly, with respect to non-wage costs, price increases (i.e., petroleum costs) are moderate now with downward pressure looking into the future. For example, the surplus of commercial property vacated because of stay-at-home orders or choices by private companies will surely drive down lease payments.

The combination of these factors influences School Services of California Inc.’s COLA estimates for the coming years and suggest nominal to moderate increases in the near and medium term. Consequently, we urge caution on behalf of our clients.

Assess Your Risk Tolerance

Ultimately, the assumptions each public education agency uses to build its budgets and MYP depends on its unique tolerances for risk. Agencies with healthy reserves and plans to address known cost increases, may tolerate more risks to their budgets. However, there are factors that every agency should consider when conducting a risk assessment. This includes student enrollment trends (namely, declining enrollment), which will drive state apportionments, and the awareness that the recent hold harmless provisions included in the 2020 Budget Act will likely expire at the end of this fiscal year to be felt most acutely in 2022–23. It also includes rising pension obligations when similar Budget Act benefits to buy down employer contribution rates fade away the same year.

If public education agencies do not properly account for these out-year cost pressures when considering which COLA assumptions to apply, it could create very difficult local conditions in the near and medium term. Consequently, we counsel our clients to evaluate their out-year risks carefully to determine the COLA assumptions they can afford to use.

By John Gray, Patti Herrera, Dave Heckler, and Matt Phillips

https://www.sscal.com/publications/fiscal-reports/case-cola-caution