California faces a $68 billion budget deficit in the near term and a $155 billion deficit in the long term, a gap so serious it could compel Gov. Gavin Newsom (D) to declare a fiscal state of emergency and lawmakers to make painful cuts to infrastructure projects, school programs and other services next year.
The deficit estimates were released Thursday by the Legislative Analyst’s Office, a nonpartisan agency that advises the California legislature.
“We do think that the state does have a lot of options, at this time, for dealing with [the deficit],” Legislative Analyst Gabriel Petek said during a media call discussing the report. “But even with all of these, there probably will be some difficult choices to come down the road.”
California lawmakers must find a way to eliminate the $68 billion gap — which encompasses last fiscal year, this year and the next — in the state’s Fiscal Year 2025 budget. FY 2025 starts on July 1, 2024. Gov. Gavin Newsom (D) signed off on spending $311 billion to run state government this year, not including federal funds.
State leaders should be able to close most of that gap by pulling money from California’s emergency funds, scouring the budget for one-time money that has been approved but not yet spent, and approving accounting maneuvers that lower FY 2023 and FY 2024 school spending to the constitutional minimum, the Legislative Analyst’s Office report found.
“We can get to $68 billion without having to make reductions to ongoing programs,” Petek said. Addressing deficits projected for future years will be more challenging.
Lawmakers will fight to avoid cutting funding for key programs such as education next year, Assembly Budget Chair Jesse Gabriel (D) told Pluribus News.
“What we’re going to look to avoid at all costs are cuts to social programs for the most vulnerable Californians,” Gabriel said. “We want to protect education funding. We want to protect the progress that we’ve made in recent years.”
Lawmakers in several other states, such as Arizona and New York, also will have to close budget gaps when they meet next year.
But California’s swing from multi-billion dollar surpluses in FY 2021 and 2022 to deficits in FY 2023 and 2024 has been particularly dramatic, reflecting the volatility of the state’s tax structure and the disproportionate impact tech companies have on the state economy.
California relies on taxing the incomes of ultra-wealthy people, whose earnings tend to fluctuate with capital markets. The stock market boomed in 2021, but market losses in 2022 depressed capital gains revenue last fiscal year, the LAO found.
Meanwhile, technology companies that enjoyed soaring valuations in 2021 have struggled since the Federal Reserve last year began raising interest rates to combat inflation.
The interest rate hikes “seem to have an outsized effect on California’s economy, in particular our high-tech sector,” Petek told reporters. “We’ve seen a pretty steep drop-off in investment in venture capital, a very steep reduction in the initial public offering activities that really generate a lot of tax revenue from California.”
Although the U.S. economy is still growing, the LAO estimates that California entered an economic downturn in 2022 and is now in a recession.
California’s deficit is also unusual because it spans FY 2023, which ended months ago. That’s because of a timing problem: due to natural disasters, the federal government gave California taxpayers six extra months to file returns this year.
With payments coming in late, state officials only recently learned that FY 2023 tax revenues had dropped by 20%, a plunge comparable to California’s experience in the Great Recession.
“In a normal year … we would have found out about the revenue drop in the spring, and it would have been the obligation, the constitutional requirement, of the legislature to solve for the problem in May and June,” Petek said.
Based on the revenue outlook and current spending plans, the state not only faces a $68 billion deficit in FY 2025 but about $30 billion annual deficits in the three years after that.
The good news is that California is better prepared to balance its budget now than it was when the Great Recession hit, Petek said.
State leaders have in recent years socked away money in emergency accounts, which now hold some $37.8 billion. They also chose to spend billions of surplus dollars on one-time projects, some of which could now be pulled back.
Given the size of the projected deficit, state leaders may need to tap into the state’s rainy-day savings to balance the budget. But Petek advised lawmakers not to spend down the savings right away.
“Our high-level suggestion to the legislature is to just to be judicious about the use of reserves, for example,” he said, “because there’s a lot of uncertainty ahead.”