California faces another big budget deficit next year despite increased revenue

California will face a nearly $18 billion budget deficit in the new fiscal year due to higher-than-expected spending, despite an economic boom largely driven by AI enthusiasm and strong revenue, the nonpartisan Legislative Analyst’s Office said Wednesday.

To make things worse, the $17.7 billion shortfall could balloon to an annual $35 billion by fiscal year 2027-28, as spending continues to grow and debts come due, the office warned in its annual fiscal outlook.

The gloomy forecast is a refreshed look at California’s financial future since June, when the state Department of Finance projected a $17.4 billion deficit for the upcoming fiscal year. The widened budget gap could undercut the legacy of Gov. Gavin Newsom, as he will likely be forced to make tough budget choices in his last year as governor.

It also means that for the fourth year in a row in his tenure, California is projected to have a deficit despite revenue growth.

“Today’s fiscal outlook underscores the challenging decisions ahead,” said Assembly budget chair Jesse Gabriel of Encino. He said the committee “remains committed to crafting a responsible budget that prioritizes essential services, uplifts working families and protects our most vulnerable communities.”

But state Sen. Roger Niello of Roseville, the Republican vice chair of the Senate Budget Committee, attributed the structural deficit to Democrats’ “unstoppable spending problems.”

“The state must assess the effectiveness and sustainability of the programs that were created during the surplus and make necessary corrections,” he said in a statement.

Since June, the state has witnessed stronger-than-expected tax revenues, raking in $6 billion more than projected between July and October. But the revenue gains in the new fiscal year will “almost entirely” go toward K-12 schools, community colleges and state reserves by constitutional requirements, the office projected.

Additionally, the fiscal challenges California faces also have persisted, if not deepened, due to steep federal cuts to health care and housing and homelessness services, as well as growing stock market uncertainties driven in part by President Donald Trump’s drastic tariff shifts. It raises a major question as to if, and how, the state can absorb the costs of those federal cuts.

Spending outpacing revenues

The state is projected to spend $6 billion more than previously anticipated next year, including $1.3 billion implementing Trump’s budget bill, which is expected to kick millions of Californians off Medi-Cal, hike health care premiums and shift much of the cost for programs such as food stamps onto the state, the LAO said. The increase is largely because the state must now shoulder a larger share of the cost to continue to provide benefits, said Carolyn Chu, chief deputy analyst with LAO.

The added cost of the federal cuts to health care will grow to $5 billion annually by fiscal year 2029-30, the office projected.

California also stands to lose hundreds of millions of dollars in funding for permanent housing under new policies the Trump administration rolled out last week, just as some counties are starting to see drops in their homeless population. Homelessness agencies warn that thousands of Californians could be kicked out of their subsidized housing and back on the streets.

The loss of federal funding could put more pressure on the state to step in with financial assistance — at a time when Newsom has expressed no interest in releasing more homelessness dollars to cities and counties.

Blaming local officials for stagnant progress on homelessness, Newsom in January proposed zero dollars for the Homeless Housing, Assistance and Prevention program, the main source of homelessness funding for local governments. The Legislature later successfully negotiated a $500 million investment — half what it used to be — and delayed the funds until next year with virtually no guarantee they will continue.

Graham Knaus, CEO of the California State Association of Counties, told CalMatters he expects the state to follow through on its funding commitment.

“We are now facing a federal government that is eviscerating the same funding at the federal level, so we should expect a substantial increase in homelessness,” he said. “And our only chance is for the state to stand with us … and protect those that are the most vulnerable.”

Fourth fiscal year in a row of deficits

The annual forecast by the nonpartisan fiscal adviser is a mere snapshot of California’s fiscal future and can be drastically different from the state finance department’s own projection, which is expected in January. In January 2024, Newsom’s office projected a $38 billion deficit for fiscal year 2024-25 — roughly half the $68 billion budget shortfall the LAO had projected a month before.

Earlier this year, California’s Democratic leaders scrambled to plug a $12 billion budget hole in fiscal year 2025-26, relying on internal borrowing, dipping into state reserves and halting new Medi-Cal enrollment for undocumented immigrants to avoid other deep cuts to social services. They largely blamed Trump for the shortfall, arguing the threat of sweeping tariffs and federal funding loss plunged the state into “deep uncertainty.”

Coffee is among the products facing steep tariffs under the Trump administration.

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Justin Sullivan

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But even before Trump retook office, California already faced a structural money problem, in part due to the state’s heavy reliance on wealthy earners’ income tax and capital gains, which rise and fall with the stock market. The state witnessed a record $97.5 billion surplus in 2022 during an economic boom, followed by an estimated $56 billion deficit over the next two fiscal years.

The state for three years used “temporary fixes,” such as internal borrowing, spending down reserves and suspending tax credits to plug multibillion-dollar budget holes, but now it’s “critical” for state lawmakers to reduce spending, raise revenues or both, the legislative analyst warned.

“California’s budget is undeniably less prepared for downturns,” the analysts noted in their report. “Continuing to use temporary tools — like budgetary borrowing — would only defer the problem and, ultimately, leave the state ill‑equipped to respond to a recession or downturn in the stock market.”

How sustainable is the AI-driven economy?

While all signs point to high uncertainty and low consumer confidence in the state economy, tech companies’ investment in AI has propelled the stock market to a “record high” and boosted tech workers’ income — the “lone bright spot” in the state’s economic outlook, Petek said.

But is it sustainable? Petek is cautious.

The stock market appears to be “overly exuberant,” as some investors are borrowing more to buy high-cost stocks, a sign of a stock market downturn, the report notes. Even if the market holds, lawmakers should treat it as a temporary or unsustainable gain, Petek said.

And there’s no guarantee that revenue gains from the stock market would be enough to fill a deficit of $30 billion to $35 billion, which the state is projected to hit in a few years. Since the state is constitutionally required to spend roughly half of any excess revenue gains on schools and reserves, it would need $60 billion in revenue higher than anticipated to close a budget gap that big, Petek said.

“Our view is that that’s highly unlikely to occur,” he said.

This article was originally published on CalMatters and was republished under the Creative Commons Attribution-NonCommercial-NoDerivatives license.