A larger deficit, economic uncertainty and unclear revenues: California’s boom turns bust

When Governor Gavin Newsom unveils his revised budget proposal later this week, it will likely include a larger deficit than the $22.5 billion his administration predicted in January.

But even more concerning to his administration than the growing shortfall?

Recent bank failures, climbing interest rates and a high-profile fight over the federal debt limit all pose considerable risks to the economy and California’s revenues.

If the country defaults on its nearly $32 trillion in debt, it would “have a substantial impact on California,” said H.D. Palmer, deputy director of the state Department of Finance.

“The disruption in the financial markets would be dramatic, and that affects us significantly because of the effect that the financial markets have on our revenue stream,” he said. Palmer also pointed to a White House report warning that a default could lead to upwards of 8 million lost jobs.

Silicon Valley Bank, First Republic and Signature Bank “each had a big footprint in California” and their collapses leave risk in the financial sector, Palmer said.

On top of those looming uncertainties, the state still isn’t sure exactly how much money it has to work with this year because of delayed tax filing deadlines. After severe storms caused major damage in counties around the state, the federal government pushed the tax filing deadline for most Californians to Oct. 16. Newsom ordered the same for affected counties.

The state’s Department of Finance estimates about $35 billion in personal income and business tax payments will be delayed until the new deadline.

“By virtue of moving that tax deadline into mid-October, we don't have that cash in hand now,” Palmer said. “So we can’t measure how close those receipts actually came to our forecast.”

That forecast was already grim in January, when the Newsom administration projected a $22.5 billion shortfall. Since then, monthly revenue forecasts have consistently fallen below projections, meaning Newsom and state lawmakers will likely have a larger budget hole to fill.

The governor’s January spending plan included nearly $4 billion in “trigger cuts” to climate and transportation programs — which will now likely take effect — along with more than $7 billion in delayed funding for other initiatives.

Despite the deficit, Newsom has pledged to protect multi-year investments to fund universal pre-kindergarten and health care for all undocumented workers, two of his top social priorities. “I think that's going to be something that you will see in this budget,” Palmer said. “We want to make sure that we protect those core programs.”

California has $23 billion in rainy day reserves, but the governor has hesitated to use those funds unless the economy enters a recession. Legislative leaders including Speaker Anthony Rendon have been more open to dipping into the state’s rainy day fund.

Senate Democrats proposed increasing taxes on large corporations and lowering them for small businesses. Newsom has indicated most tax increases would be a nonstarter, though his January budget includes renewing a tax on Medi-Cal insurers. The governor allowed the Managed Care Organization tax to expire in 2019. If renewed until 2026, It’s expected to bring in more than $6 billion over three years.

California isn’t alone in its financial woes this year, according to Lucy Dadayan, a researcher with Urban Institute’s Tax Policy Center. Other states with budgets that rely disproportionately on high-income earners and capital gains taxes are also looking for ways to fill deficits, including New York and Massachusetts.

That’s partially because wage growth has not kept pace with inflation, Dadayan said.

“The service industry has been recovering and we know that the people employed in the service industry are not major contributors to the tax system because they make less income compared to other high-paying jobs,” she said.

Another significant contributor to California’s treasury is revenue generated through initial public offerings — or companies taken public. After a record year in 2021, IPOs plummeted in 2022.

“Those IPOs generated significant revenues for states” in last year’s budget cycle, Dadayan said. “Especially California — where firms are located — and New York and Connecticut, where deals were brokered.”

The expected deficit is a far cry from the $100 billion surpluses California had in the previous two budget cycles and represents the feast-or-famine reality of California’s progressive tax system.

“Unfortunately, it feels like the revenue boom is over for many states, and [California] should be prepared for much weaker revenue and economic growth in the coming year,” Dadayan said.

Newsom is scheduled to unveil his revised budget proposal on Friday. After that, he and state lawmakers will negotiate over a final spending package. State law requires that a budget pass both chambers of the Legislature by June 15 and be signed by the governor before the new fiscal year begins on July 1.