Newsom faces an $18 billion deficit despite higher revenue

from Yue Stella YuCalMatters

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

To make matters worse, the $17.7 billion shortfall could grow to $35 billion a year by the 2027-28 fiscal year as spending continues to rise and debts become callable, the service 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 predicted A deficit of $17.4 trillion for the upcoming fiscal year. The widening budget hole could undermine Gov. Gavin Newsom’s legacy as he likely will be forced to make tough budget choices in his final year as governor.

It also means that for the fourth year in a row in his term, California is expected to run a deficit despite revenue growth.

“Today’s fiscal outlook highlights the challenging decisions ahead,” said the Assembly Budget Speaker Jesse Gabriel from Encino. He said the committee “remains committed to crafting a responsible budget that prioritizes essential services, lifts up working families and protects our most vulnerable communities.”

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

“The state must evaluate the effectiveness and sustainability of programs created during the surplus and make the necessary adjustments,” he said in a statement.

Since June, the state has seen higher-than-expected tax revenue, accumulated $6 billion more than forecast between July and October. But revenue gains in the new fiscal year will “almost entirely” go to K-12 schools, community colleges and state reserves as constitutionally required, the office predicted.

In addition, the fiscal challenges facing California also continue, if not worsen, due to steep federal cuts to healthcare and housing and homeless servicesas it grows stock market uncertainty driven in part by Trump’s sweeping tariff changes. This raises a fundamental question of whether and how the state can absorb the costs of these policies.

Expenses outpace income

The state is projected to spend $6 billion more than projected next year, including $1.3 billion to implement Trump’s budget, which is expected to kick millions of Californians out of Medi-Cal, raise health care premiums and shift much of the cost of programs like food stamps to the state, the LAO said. The increase is largely because the state now has to shoulder a larger share of the costs to continue providing benefits, said Carolyn Chu, LAO deputy principal analyst.

The added costs of federal health care cuts will rise to $5 billion a year by the 2029-30 fiscal year, the service predicts.

California also could lose hundreds of millions of dollars in permanent housing funding under new policies the Trump administration introduced last week, just as some counties are beginning to see a decline in their homeless population. Homeless agencies are warning that thousands of Californians could be forced out of their subsidized housing and back onto the streets.

The loss of federal funding could put more pressure on the state to step in with financial aid — at a time when Newsom has expressed no interest in allocating more homeless 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 primary source of homelessness funding for local governments. The Legislature later successfully negotiated a $500 million investment— half of what it was — and delayed the funds until next year with virtually no guarantee that they would continue.

Graham Knauss, CEO of the California State Association of Counties, told CalMatters he expects the state to meet its funding commitment.

“Now we’re faced with a federal government gutting the same funding at the federal level, so we should expect a significant increase in homelessness,” he said. “And our only chance is for the state to stand by us … and protect those who are most vulnerable.”

Fourth consecutive fiscal year of deficit

The nonpartisan fiscal adviser’s annual forecast is merely a snapshot of California’s fiscal future and could differ dramatically from the state finance department’s own forecast due in January. In January 2024, Newsom’s office projected a $38 trillion deficit for the 2024-25 fiscal year — roughly half the $68 billion budget deficit the LAO projected a month earlier.

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

But even before Trump took office again, California was already facing a structural money problem, in part because of the state’s heavy reliance on wealthy people. income tax and capital gainswhich rise and fall with the stock market.

The last time California faced a $35 billion cash problem was in 2011, when then-Gov. Jerry Brown announced a “wall of debt” consisting of loans and deferred payments. But that was when California was recovering from the Great Recession, said legislative analyst Gabriel Petek.

“This wall of debt (today) is building up in the absence of a recession,” he told reporters at a news conference on Wednesday.

The state has for three years used “temporary fixes” such as domestic borrowing, draining reserves and suspending tax credits to plug multibillion-dollar budget holes, but it is now “critical” for state lawmakers to cut spending, raise revenue or both, a legislative analyst warned.

“California’s budget is clearly less prepared for downturns,” the analysts noted in their report.

“Continuing to use temporary tools – such as budget borrowing – would only delay the problem and ultimately leave the state unprepared to respond to a recession or stock market decline.”

How sustainable is the AI-driven economy?

While all signs point to high uncertainty and low consumer confidence in the state’s economy, tech companies’ investments in AI have shot the stock market to a “record high” and boosted incomes for tech workers — the “one bright spot” in the state’s economic outlook, Petek said.

But how sustainable will it be? Friday is cautious.

The stock market appears “overly bullish” as some investors borrow more to buy high-priced stocks, a sign of a stock market slump, the report noted. Even if the market holds, lawmakers should treat it as a temporary or unsustainable gain, Petek said.

And there’s no guarantee that stock market revenue will be enough to fill the $30 billion to $35 billion deficit the state is expected to hit in a few years. Because the state is constitutionally required to spend roughly half of all excess revenue gains on schools and reservations, it would need $60 billion more in revenue than expected to fill such a large budget hole, Petek said.

“Our view is that this is very unlikely to happen,” he said.

This article was originally published on CalMatters and is republished under Creative Commons Attribution-NonCommercial-No Derivatives license.