Honorable Calvin K.Y. Say

Speaker, House of Representatives

Twenty-First State Legislature

Regular Session of 2002

State of Hawaii

Sir:

Your Committee on Finance, to which was referred H.B. No. 1800 entitled:

begs leave to report as follows:

The purpose of this bill is to amend the General Appropriations Act of 2001 (Act 259, Session Laws of Hawaii 2001), which appropriated funds for the operating and capital improvement costs of the Executive branch for the fiscal biennium July 1, 2001, through June 30, 2003 (FB 2001-2003).

In deliberating on this bill and other bills that affect state finances, your Committee faced a number of major policy issues that limited its ability to fund the priority items of the House of Representatives. Although economic indicators suggest that the economy is growing and revenues are increasing, nevertheless your Committee took a prudent approach in developing this supplemental budget.

When the FB 2001-2003 budget was prepared, government resources had increased slightly, and general revenues from tax collections for the first eight months of fiscal year (FY) 2000-2001 had grown at a rate of 7.8 percent, exceeding the Council of Revenues' (COR) projection of a 6 percent increase. The Federal Reserve had lowered interest rates several times, spurring growth in mortgage lending, mortgage refinancing, and construction activities. All indications pointed to the strength of Hawaii's economic recovery.

Last year, the chief economist for the Bank of Hawaii stated before your Committee that "Hawaii’s aggregate income – personal income or gross state product – achieved a real, or inflation adjusted growth rate in the neighborhood of 3 percent during 2000. This is the highest growth rate since economic momentum began building in 1997."

Mixed with this optimism was the reality of dealing with the increasing drain on the State’s resources. The State was obligated to fund substantial fixed costs including health fund premiums for State employees, debt service payments, pension accumulation payments to the Employees' Retirement System (ERS), Social Security and Medicare insurance payments, and costs associated with the Felix Consent Decree. Additionally, fixed costs increased even more as bargaining agreements were reached with the Hawaii State Teachers Association, University of Hawaii Professional Assembly, Hawaii Government Employees Association, and the United Public Workers.

The terrorist attacks of September 11^th, stalled the momentum of Hawaii's economy. The unprecedented grounding of all air travel in the United States following the attacks dealt a direct blow to Hawaii's tourist industry. The state unemployment office was flooded with new claims as 7,000 jobs were lost, and organizations providing services to the hungry and homeless were suddenly overwhelmed by requests for assistance.

The Legislature immediately responded in an emergency Special Session by passing measures to address the most immediate and pressing needs of Hawaii's citizens. Emergency food and housing assistance, extended unemployment benefits, and temporary health insurance were provided to assist individuals and families. Tax relief and waivers of assessments were provided to businesses suffering from the effects of September 11^th. In addition, funds were appropriated to stimulate economic growth by increasing government capital improvements program (CIP) project spending and promoting Hawaii as a visitor destination.

As a result of September 11^th, on November 14^th the COR reduced its September 5^th estimate of general fund revenues from 4.1 percent growth for FY 2001-2002, to a 0.7 percent decline in the same period, a reduction of almost 5 percent. This revision resulted in an approximate $315 million drop in projected revenues for the current biennium. In addition, the COR projected an average annual growth rate for fiscal years 2003-2008 of 5 percent. On March 14^th the COR reaffirmed its November projection and held to the strong out-year growth estimates.

The immediate and dramatic shock to the economy arguably resulted in the worst budget shortfall to face the State. Your Committee responded with openness and inclusion in finding solutions to our predicament. Ideas and input were solicited and welcomed from all sectors, including House majority and minority members, the Senate, the Administration, social service agencies, concerned individuals, and many other segments of the community.

To this end, your Committee held joint hearings with the Senate Committee on Ways and Means at various locations across the State. Public informational briefings were also held that focused on strategies to balance the budget, including across-the-board cuts for all state departments, eliminating vacant government positions through attrition, deferring the State's pension contributions to the ERS, and authorizing the issuance of general obligation (G.O.) bonds for CIP projects to stimulate the economy.

Your Committee has dedicated considerable effort to find ways to free up resources to provide funds for high priority items while reducing the overall budget. Toward this end, your Committee seriously entertained the policy of attrition. This policy is based on the idea that vacant positions and funding can be eliminated, and the workload can be redistributed to the remaining employees. The assertion that large budget reductions can be realized through this policy is based on three assumptions: first, that positions are non-essential, and that the workload of newly vacant positions can be redistributed among remaining employees; second, that payroll costs for all authorized positions are provided for in the budget, and third, that fringe benefits are budgeted for all positions regardless if they are vacant or filled. Based on the testimony presented at the two hearings on this subject, your Committee concludes that attrition is an ill-conceived policy that leaves implementation to chance.

The assumption that responsibilities can be redistributed among employees is unrealistic. It is simply not prudent public policy to blindly or naively assume that positions that become vacant are not essential and can, therefore, be eliminated. Many services provided by the State require 24-hour support, such as public safety, or require specialized skills, such as all health services, education, engineering, and law enforcement. Furthermore, it should be noted that despite perceptions to the contrary, the Executive workforce has clearly been reduced in recent years. In 1994, there were 45,604 civil service and exempt full-time equivalent positions. By 2001, the workforce had dropped to 43,327. This reduction of 2,277 positions is particularly significant in light of the State's growing population, expansion of numerous programs in response to federal mandates, and few public services being eliminated during this period. In addition, the net reduction of 2,277 positions was accomplished while the Department of Education's (DOE) workforce increased by 3,106. Clearly, the measured use of redistributing responsibilities has been utilized.

The assumption that large budget cuts can be made by eliminating vacant positions is flawed. The State already budgets its payroll under the assumption that all positions will not be filled all the time, and addresses this through the budget. Payroll for all general funded positions is currently underbudgeted by $49 million to account for vacancies that inevitably occur throughout the course of the fiscal year. Over the years, the level of underfunding has increased with vacancy or turnover "savings" imposed by the Legislature. This budget imposes another $6.2 million for "vacancy savings", which will force agencies to further delay the filling of positions in FY 2002-2003.

Your Committee's review of the general funded vacancies indicates that a large percentage is tied to core programs in the Departments of Education, Health, Human Services, Public Safety, and the University of Hawaii (UH). Furthermore, many of these positions are not being filled in order to meet turnover savings assessments, as well as unbudgeted accrued vacation payouts, unbudgeted payroll for workers’ compensation claimants, and filling of essential positions with emergency hires until qualified applicants can be found.

Your Committee found it to be an erroneous assumption that the fringe benefits budget could be reduced with the implementation of an attrition policy. Because the costs associated with the public employees’ health fund are based on actual enrollments rather than the total number of authorized positions, eliminating vacant positions will not translate into reductions in the budget. Furthermore, the State’s obligations for the ERS are based on actuarially established projections, which take into account all existing retirees and current employees and not vacant positions. Therefore, eliminating existing vacant positions will also not translate into fringe benefit savings.

In the aftermath of the attacks of September 11^th, the ripple effect through our economy brought tremendous financial hardships to local families, and triggered a marked increase in the need for both public and private social services on every island. Homelessness and unemployment rose sharply as thousands of workers were displaced and an even greater number experienced reduced working hours.

The challenge of continuing to provide essential government services with a $315 million shortfall is immediate. Throughout its deliberations, your Committee's priority has been to develop a balanced budget that protects the most vulnerable and fragile of our population from the devastation of hunger, homelessness, and hardship.

Accordingly, your Committee will continue the work this body began during the Third Special Session of 2001 by providing the means to fund the most basic and essential health and human services to those most in need of such services. It is also the intent of your Committee to keep intact as many programs as possible that benefit and enrich the educational experience for our elementary, secondary, and high school students. At the same time, your Committee is committed to ensuring that short-term, adverse economic circumstances do not impair the long-term vision of the University of Hawaii and the community colleges.

In addition to the constitutional requirement to maintain a balanced budget, your Committee is restricted by numerous cost items that must be funded regardless of the State's economic situation. These are items that the State is either mandated to pay or must be funded due to their critical importance.

A fixed cost item that must always be paid before any other in the budget is the debt service owed to those who have purchased G.O. bonds. Debt service funding requirements for FY 2002-2003 are $433.6 million, representing a $16.5 million increase from FY 2001-2002. The ERS funding requirement for FY 2002-2003 is $295.9 million, representing a $45.7 million increase from FY 2001-2002. The public employees’ health fund requirements for FY 2002-2003 are $279.8 million, representing an increase of $19.7 million. The State is obligated to pay for these benefits for its employees every year, and they also must be accounted for before other state expenditures.

Other critical items that cannot be left out of this year's budget are those required by federal courts including: adult mental health services and adolescent mental health at $182 million, representing a $5.3 million increase from FY 2001-2002; special education at $228 million, representing a $6.9 million increase from FY 2001-2002; and Healthy Start at $27.3 million, representing a $3.5 million increase from FY 2001-2002. Other general fund increases for core services include an operating subsidy of $15 million for the Hawaii Health Systems Corporation, representing a $13 million increase from FY 2001-2002; and child placement board and related payments for adoption and foster care at $26.3 million, representing a $2.7 million increase from FY 2001-2002.

These required expenditures total $1.488 billion, representing a $113.3 million increase from FY 2001-2002, which constitute a serious budgetary obligation that must be taken into account.

In meeting the constitutional requirement for a balanced budget, your Committee has reduced the $3.63 billion Executive general fund budget by $144 million for FY 2002-2003. The reductions are widespread, and impact even core services such as education, health, and public safety.

After careful deliberation, your Committee finds that in order to maintain essential services while acting within our budgetary constraints, we must not only look toward reducing expenditures, but also toward expanding our resources. By identifying innovative ways to reduce the deficit, the State will be able to lessen the budget cuts and mitigate the effects of the current revenue shortfall. In turn, this will preserve essential core programs whose elimination will only result in more severe monetary and human costs in the long run.

A key measure in providing additional resources for essential services follows the Governor’s proposal to transfer funds from the Hawaii Hurricane Relief Fund (HHRF) to the general fund. H.B. No. 2654, H.D. 2, will allow for continued funding of numerous programs and services that would otherwise face certain elimination.

H.B. No. 2654, H.D. 2, restores $34.5 million to the DOE's budget, including funding for:

• Vocational Training programs ($3 million);

• Hawaii Content and Performance Standards ($1.1 million);

• Preventive Educational programs ($1.4 million); and

• The K-2 student-teacher ratio at 20 to 1 ($9.4 million).

In addition, vital programs relating to health promotion were provided for through the transfer of hurricane relief trust funds, including:

• STD/AIDS Prevention Services ($5.3 million); and,

• Substance Abuse programs ($2.2 million).

The public safety of Hawaii's citizens will also be preserved with the restoration of $10 million for the leasing of 535 prison beds in mainland and federal facilities. Other items that are deleted from this budget but are restored using HHRF funds include $2.5 million to subsidize rural health centers in the most underserved areas of Hawaii, such as Hana, Molokai, Waianae, and Kahuku, and $454,000 for the County Prosecutors’ Victim Assistance programs.

Despite initiatives used to identify additional resources for essential services, reductions in the budget were necessary. Even with the successful passage and enactment of H.B. No. 2654, H.D. 2, a net general fund reduction of $66 million is necessary to balance the budget. Some of the reductions that are incorporated in the budget and not restored using HHRF funds include:

• $6.2 million in job vacancies;
• $5.1 million for Department of Health's (DOH) Developmentally Disabilities Program;
• $4.2 million in health fund premium costs;
• $3.6 million for DOE's Computer Education Program;
• $1.7 million for DHS’s Aged, Blind, and Disabled Program;
• $1.5 million for various exempt positions;
• $1.3 million for the Oahu Community Correctional Center’s J-Block expansion;
• $1 million for the Hawaii Health Systems Corporation;
• $1 million for the General Assistance program for the Department of Human Services (DHS);
• $908,076 for the Natural Energy Laboratory of Hawaii’s operating subsidy;
• $657,000 for leasing (20) Federal Detention Facility prison beds;
• $271,660 for the State Health Planning and Development Agency;
• $199,500 for various purchase of service contracts for the Office of Community Services;
• $50,000 for extended hour ambulance service for Kula, Maui;
• $46,369 for the County Prosecutors’ Career Criminal and Victim Assistance Programs;
• $44,486 for overtime for the Office of Elections; and,
• $35,000 for the State Fire Council.

In addition, $28 million in new requests for general funds were denied including:

• $1.9 million for (100) out-of-state prison beds;
• $1.7 million for the Kapolei Public Library;
• $1.2 million for DHS’s adoption and foster homes program;
• $1 million for UH’s computer science academic initiative;
• $1 million for the DOH’s Family Guidance Centers;
• $403,000 for lifeguard service for Kaena Point and Hapuna State Park;
• $395,586 for additional security at the State Capitol and Downtown Civic Center;
• $250,000 for invasive species rapid response capability;
• $169,240 for Office of Elections voter education and election worker stipend increase; and,
• $58,744 for maintenance of the No. 1 Capitol District Building;

Many of these reductions may negatively impact services and programs currently provided by state agencies. However, to address the current fiscal realities in a prudent and judicious manner, these cuts are unavoidable.

Throughout this process, your Committee has been driven by the belief that a combination of alternative funding and responsible budget reductions will provide the necessary means to maintain essential services for the people of Hawaii through this temporary crisis and ensure them a future with a brighter economic outlook.

The supplemental budget also contains a limited number of new appropriations for high priority programs and services. Due to the lack of resources, funding for these were secured from a reassessment of priorities as well as from reviews that identified where efficiencies could be achieved. The appropriations below represent the most critical new budget items.

In response to the tragedy of September 11, an additional $10 million in special funds was allocated to the Department of Transportation (DOT) for airport security. This appropriation will strengthen the security of our air transportation system.

Affirming our commitment to invest in education, this budget appropriates an additional $8 million to the DOE for additional costs associated with the Felix Consent Decree. Acknowledging the potential of charter schools, an additional $6.1 million is earmarked for 23 new charter schools.

To support higher education, an additional $5 million is appropriated to UH, including funds for the following: Medical School restructuring ($983,000); Hilo High Technology Center ($400,000); and Office of Mauna Kea Management ($1 million).

UH-Hilo received an additional $297,000 for increased utility costs and $500,000 for distance learning programs, which are particularly necessary for geographically isolated schools throughout Hawaii. Your Committee also recognized the valuable role that community colleges play in educating Hawaii’s residents by offering open access to academic and vocational programs. Therefore, your Committee has provided an additional $1 million for instructional expenses and $773,000 for the maintenance of new facilities.

Your Committee strengthens public safety by providing $3.2 million to the Department of Public Safety to lease 150 additional prison beds on the mainland. In addition, your Committee has provided $215,000 for sex offender rehabilitation programs.

To assist some of Hawaii's less fortunate residents, the budget provides an additional $2 million to the DHS for the State's adoption and foster home program, and $3.5 million to the DOH for its adult mental health program. In recognition of the pressing need to preserve and protect Hawaii's natural environment, the bill also allocates an additional $250,000 to the Department of Land and Natural Resources for additional funding of invasive species control programs.

Provisions for other crucial programs include:

• $15.8 million in additional federal-funding authorization for various programs, including those in Department of Transportation, Department of Human Services, Department of Health, and Department of Defense;

• $7.4 million in additional trust fund authorization for capacity-building grants and project awards from the rental housing trust fund;

• $5.8 million in additional special fund authorization for the University of Hawaii tuition and fees special fund; and,

• $2.7 million in additional revolving-fund ceiling increases for risk-management costs.

Moreover, authorization for a substantial number of positions in core areas--education, higher education, public safety, and human services--is being added to the budget. The net increase is 1,461 positions (including the 78 positions funded through H.B. No. 2654, H.D. 2). The increase includes the addition of:

• 1,449 positions in DOE, the majority of which are related to the Felix Consent Decree;

• 32 positions for various programs at UH;

• 36 deputy sheriffs needed for new posts at Honolulu International Airport for enhanced security; and

• 11 positions for the DHS child welfare services program.

The Administration proposed a plan authorizing an additional $900 million in new construction spending for FY 2002–2003 in an attempt to stimulate the economy. Being mindful of the State's ability to manage its debt and the resiliency demonstrated by the local economy, your Committee chose instead to reduce that amount to $340 million. Despite the reduced level of funding, this increase in construction spending will still have a very positive impact on the State's economy.

Of the additional $340 million in spending, an emphasis has been placed on education. With prior years’ budget reductions, repair and maintenance of our public schools has been regularly postponed, resulting in a backlog of these projects. An additional $156 million was provided for public schools to address the growing repair and maintenance needs of Hawaii's aging public schools and to provide new classrooms across the State to alleviate overcrowding. Your Committee has also provided an additional $44 million in G.O. bonds to the UH system for repairs and upgrades of its facilities statewide.

While balancing the budget this year has proven to be a difficult job, your Committee is optimistic about the Hawaii's future economic prospects. While the COR predicted a shortfall this year, it also forecasted revenue projections at an average increase of 5 percent each year over the next four years. There are positive signs that Hawaii's economy is recovering quickly and will continue to do so over the next few years. Domestic as well as international arrivals have shown strong improvement since the event of September 11^th, returning to near pre-attack levels. Domestic arrivals for September 2001 were 28 percent lower than the previous year, while domestic arrivals to date for March 2002 are only 1.9 percent lower than the previous year. Total arrivals for September 2001 were 34 percent lower than the previous year, while total arrivals to date for March 2002 are only 4.4 percent less than the previous year. Increased bookings at the Hawaii Convention Center for 2003 and 2004, the influx in cruise ship visitors with the arrival of the Norwegian Star, and stable home-buying and construction figures are further positive signs that Hawaii’s economy is in recovery.

The number of unemployment benefit claims has also fallen since the beginning of 2002, and are considerably less than what was originally forecast in analyses immediately following the attacks. The state unemployment rate is now down to 4.6 percent, from a high of 5.6 percent immediately after the attack, another sign of the rapid economic recovery.

Your Committee believes that these signs of our economic recovery are testaments to the Legislature's farsightedness in passing several measures in recent years, to set the stage for a broad-based economy. Tax reductions and government streamlining measures are the key to stimulating the economy while increasing the efficiency of State agencies.

While many other states are considering the suspension or repeal of tax reductions enacted during periods of rapid economic expansion in order to cover current budget shortfalls, your Committee has made a conscious decision to maintain these tax reductions. While the following previously implemented tax breaks negatively impact current tax revenues, they are also keys to the State's financial recovery.

These two measures will stimulate the economy by saving businesses $22 million in FY 2001-2002; and $21 million in FY 2002-2003:

• Act 353, SLH 1997, mitigated the pyramiding aspect of the 4.0 percent general excise tax (GET) paid on subleased real property by reducing this rate by 0.5 percent per year. By 2004, all subleases will be subject to a 0.5 percent GET rate.

• Act 71, SLH 1999, further assisted businesses by reducing the pyramiding effect of the 4.0 percent GET on all intermediary services over a seven-year period, again, by reducing the rate by 0.5 percent per year. By 2006, this rate will be 0.5 percent, similar to the GET rate on wholesale goods.

These tax credits were designed to reduce the negative impact to the construction industry by assuring that projects with potential cash flow problems as a result of the economic shock to Hawaii will be able to continue:

• Act 8, Third Special Session of 2001, adjusted tax filing thresholds for over 48,000 businesses, to allow them to pay taxes at a later date, which saved them over $17 million in FY 2001-2002.

• Act 10, Third Special Session of 2001, established a residential construction and remodeling income tax credit of 4 percent and increased the hotel renovation income tax credit from 4 percent to 10 percent.

This tax measure directly helps all the people in Hawaii. This current year represents the final year of the income tax reduction – a reduction that will put an additional $30 million back into the pockets of Hawaii's residents in FY 2001-2002; and an additional $41 million in FY 2002-2003:

• Act 157, SLH 1998, provided the largest personal income tax cut in State history by lowering the rates and restructuring the tax brackets.

These tax breaks represent long term reductions in government revenues that will be accompanied by the need to limit expenditures and programs while improving services that are provided to the citizens of Hawaii.

H.B. No. 2840 prepares for the difficult task of resolving competing claims on government revenues, by providing a mechanism to classify core government functions and programs. The Core Government Functions Advisory Commission will provide a long term planning tool that will streamline services and allow a redistribution of valuable government resources.

Given these steps toward recovery, your Committee finds that the economic crisis from the September terrorists attack appears to be temporary in nature. Nevertheless, we must remain prudent. It dictates an extension of the mindset established during the Third Special Session of 2001: We are all in this together and we must persevere to address the immediate and essential needs while protecting the long-term fiscal integrity of the State.

Your Committee believes it has developed such a budget. The passage of this budget represents a major step in our efforts to rebuild our community following the September 11^th tragedy. There is still much work to be done, and your Committee stands ready to cooperate with the Senate to produce a fair and equitable supplemental budget.

As affirmed by the record of votes of the members of your Committee on Finance that is attached to this report, your Committee is in accord with the intent and purpose of H.B. No. 1800, as amended herein, and recommends that it pass Second Reading in the form attached hereto as H.B. No. 1800, H.D. 1, and be placed on the calendar for Third Reading.