After 2 years of massive surplus, California is facing a $24B budget deficit

Updated, Jan. 10, 2023: This story has been updated to note that the LAO revised the forecasted deficit to $24 billion after discovering an error in its analysis. 

California’s state budget might be facing a deficit of $24 billion next year in what could be the state’s weakest performance since the Great Recession, according to a report by the nonpartisan Legislative Analyst’s Office released on Wednesday.

The forecast does not reflect a recession — just the threat of one — but it notes that the longer inflation persists, the more likely a national recession becomes.

The shortfall is driven mostly by declines in income tax revenue and drop-offs in the stock market, though analysts noted job losses in the tech sector may also contribute to deepened revenue deficits.

"It’s not insignificant, but it’s also manageable,” Legislative Analyst Gabe Petek said in a briefing with reporters. “We don’t think of this as a budget crisis, we just think of it as a notable budget problem.”

California has about $37 billion in several different savings accounts, about $23 billion of which lawmakers could dip into for next year’s budget. But the LAO recommends lawmakers save the money in case of a recession.

“Based on historical experience, should a recession occur soon, revenues could be $30 billion to $50 billion below our revenue outlook in the budget window,” the report states. In that case, the state may need to draw from its rainy day fund. 

Analysts also say spending cuts could be avoided if lawmakers instead pause or delay some funding that was allocated in previous years.

Petek pointed to certain climate programs as an example of funding that could wait until revenues are more stable. 

“We’re not saying they shouldn't still be done, but it's a matter of timing,” he said.  “They could adjust the timing of the roll out of the funding to help manage the near-term budget pressure.”

A new chapter in California’s boom-and-bust cycle?

The announcement underscores California’s volatile tax revenue system, which has whiplashed between record deficits and surpluses since the COVID-19 pandemic struck in 2020. That year, the state legislature cut spending to fill a $54 billion deficit in what lawmakers and analysts now acknowledge was an overcorrection.

In 2021 and 2022, lawmakers had close to $100 billion in surplus funds and federal aid, which they used to boost spending on education, homelessness, health care for undocumented residents and more. The budget also included a $17 billion inflation relief package with rebates between $200 and $1,050 for middle and low-income taxpayers. 

The state’s revenue collections rely heavily on its top 1% of earners, who provide nearly half of all income tax revenue through a progressive income tax and capital gains taxes on stock and property sales. While higher earners did well during the past few years, an economic slowdown will mean reduced revenues for the state.

Democratic Lawmakers, Newsom stress budget resilience

State lawmakers and Governor Gavin Newsom have stressed that the vast majority of surplus funds from recent years have been spent on one-time allocations.

But the report notes a small number of ongoing expenditures are expected to grow in the coming years, placing new pressure on the budget.

Democratic leaders in the Legislature say they are committed to protecting new investments in areas including education while budgeting responsibly – the California Constitution requires lawmakers to pass a balanced budget annually. 

State Senate leader Toni Atkins (D-San Diego) said thanks to using previous surplus funds to pay down debts and boost reserves, “we are confident that we can protect our progress and craft a state budget without ongoing cuts to schools and other core programs or taxing middle class families.”

“We can and will protect the progress of recent years’ budgets,” said Assembly Speaker Anthony Rendon. “In particular, the Assembly will protect California’s historic school funding gains, as districts must continue to invest in retaining and recruiting staff to help kids advance and recover from the pandemic.”

Earlier this fall, Newsom vetoed dozens of bills that would have put the state on the hook for new, unbudgeted spending, citing lower-than-expected revenues. 

A spokesperson for the Department of Finance said in September the combination of a shrinking unemployment rate and declining income tax revenues likely means the state is feeling the effects of job losses in higher-earning industries such as tech. Those job losses will likely have a disproportionate impact on state revenues.

Legislative analysts acknowledged recent layoffs at Twitter, Meta and Amazon could lead to further impacts to California’s budget. 

Assembly Republican leader James Gallagher (R-Yuba City) said the minority party has fought Democrats who control the Legislature on increased government spending. 

“We overtaxed Californians and grew government while ignoring investments in critical infrastructure like new water storage,” Gallagher said in a statement. “It's not too late to focus our spending on the fundamental priorities, save for the rainy day to come, and pursue policies that will grow the economy and lower everyday costs for Californians.”

Newsom will present a proposed budget in January, which will outline his priorities for the next fiscal year.