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The projected budget deficits come less than a year after Governor Gavin Newsom signed into law a record $308 billion budget that included a projected surplus of nearly $97.5 billion along with a variety of new spending initiatives. (see Record Surpluses Show Need for Tax Reform) In October 2022, Fitch Ratings projected California as the only state with year-over-year tax revenue declines, and in November 2022, the LAO projected California’s budget deficit at $24 billion projected for the 2023-24 budget year. In January, Newsom introduced a $297 billion budget for the 2023-24 fiscal year with a projected $22.5 billion deficit due to sharp declines in tax revenues. Newsom plans to cover the deficit by shifting funds, delaying some spending, and some spending cuts.

Budget Problem Likely Larger in May 2023

The LAO reports that the state likely faces a budget problem in 2023‑24 due to deteriorating revenue relative to expectations from June 2022. The LAO calls the governor’s budget revenue estimates “reasonable” but “likely a bit too high.” The LAO estimates a 66% chance that state revenue will be lower than the governor’s budget estimates for 2022‑23 and 2023‑24 and estimates that it will be approximately $10 billion for those years. This implies a budget problem about $7 billion larger than the governor’s estimate. Nonetheless, anticipated revenues for 2023‑24 are still projected to be about 20% higher than before the pandemic.

Projected State Spending Likely to be Unaffordable

The governor’s office projects operating deficits of $9 billion in 2024‑25, $9 billion in 2025‑26, and $4 billion in 2026‑27. The LAO states that given California’s constitutional spending requirements, revenues would need to be higher “by more than these amounts for the state to be able to afford the spending level currently proposed.” The LAO concludes that such a level of revenue is unlikely, leading to a 20% chance that the state can afford current projected spending levels.

Baseline Budget Likely to be Affordable

The report, however, notes that the state has a much higher likelihood of covering its “baseline budget,” which is the spending level after removing reserves deposits and one‑time and temporary spending currently authorized or planned. In fact, the LAO projects an even chance that revenue would be sufficient for the state to pay for all of its baseline programs.

States Should Not Use Reserves Now

The LAO notes that state revenues are not consistent with recessionary levels and advises to hold off on using reserves. The LAO cautions that using reserves now to maintain the recent spending peak would mean the state would have less reserves available to pay for its core services if revenues declined further or in the event of a recession. The LAO recommends that the legislature hold off on using reserves unless revenues decline by more than $10 billion through 2023‑24, as that would reflect levels below historical averages and could impact the state’s core spending level.

LAO Recommends other Actions for Addressing Budget Problem

The LAO identified a variety of other actions the legislature can take to address the additional shortfalls. These include: (1) suspending deposits into the state’s rainy‑day fund (requires action by the governor); (2) reducing more one‑time and temporary spending; (3) shifting more costs than currently proposed by the governor; and/or (4) increasing revenues, for example, on a temporary basis.

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The LAO warned that general economic conditions will hurt revenues. The longer inflation persists and the higher the Federal Reserve increases interest rates in response, the greater the risk to the economy, it said. “Reflecting the threat of a recession, our revenue estimates represent the weakest performance the state has experienced since the Great Recession,” the LAO stated.

The LAO attributes the projected budget deficit mainly to revenue estimates that are $41 billion lower than budget act projections from 2021‑2022 through 2023‑2024. The report noted that the estimate understates the actual budget problem in inflation adjusted terms. The LAO also projected annual deficits to decline from $17 billion to $8 billion over the subsequent years of the forecast.

The LAO reported that the $24 billion budget deficit is roughly equivalent to the amount of general‑purpose reserves that the legislature could have available to allocate to General Fund programs. The LAO, however, stated that revenues could be $30 billion to $50 billion below the revenue outlook if there is a recession.

The LAO estimated that the state has $38 billion in discretionary state funds to allocate in the 2021‑22 budget process. The LAO attributes the differences between its figure and the governor’s figure to “differing definitions.” The LAO stated that the “Governor’s estimate includes constitutionally required spending on schools and community colleges, reserves, and debt payments. We do not consider these spending amounts part of the surplus because they must be allocated to specified purposes.”

The LAO also recommended that the legislature “restore budget resilience” and criticized the use of “$12 billion in reserve withdrawals and borrowing to increase spending.” The LAO said the state “will need these tools to respond to future challenges, when federal assistance might not be as significant. We urge the Legislature not to take a step back from its track record of prudent budget management.”

The LAO also noted the 400 proposals in Newsom's revised budget and recommended allocating the surplus “in a more targeted manner that reflect its top priorities” and delaying some funding decisions.

The governor’s office believes the direct payments satisfy the Gann Limit, which requires the government to refund taxpayers tax revenue that exceeds a formula based on 1978-79 appropriations limits but adjusted for inflation and other economic factors.

The budget outlook is a dramatic turnaround from a year ago, when the state projected a $54 billion budget deficit. In another contrast to a year ago, the budget proposal does not include any tax increases. “When you are enjoying a $76-plus billion, and growing, operating surplus, I don’t think it’s time for new tax increases,” Newsom said.

Dee Dee Myers, director of the Governor’s Office of Business and Economic Development, said in April that tax increases were not on the agenda. “The governor’s made clear, he’s not going to raise taxes. There will be no increase in income tax, no California wealth tax, not interested in raising corporate taxes or capital gains taxes,” she said. “You know, taxes haven’t been increased in California since 2012, when it was done by ballot initiative.”

Proposition 4, which established an appropriations limit in Article XIIIB of the state constitution, requires that if the state has revenues above the limit over two consecutive years it must divide the excess between taxpayer rebates and additional spending on schools. The state has estimated excess revenues of about $100 million between 2018‑19 and 2019‑20 and about $500 million between 2019‑20 and 2020‑21.

The LAO anticipates that the state will either need to reduce taxes or issue refunds to taxpayers and make additional payments to schools in these amounts. The report also notes that without significant budget changes, the state likely does not have the capacity for new services or program expansions.

The report cited two primary reasons that room under the limit has diminished: the growth in personal income tax revenue and constitutionally required spending. The LAO reports that the growth in personal income tax revenue has exceeded the growth rate of the state appropriations limit because the personal income tax is the state’s largest revenue source and there has been faster income growth among high‑income earners. The LAO also reports that constitutionally required school spending has been driven by faster state revenue growth and has increased faster than school limits. “Because the state absorbs appropriations above school limits, this trend has resulted in diminished room for the state,” the report notes.

The LAO outlined five options for the legislature to consider in response: (1) issue tax refunds and allocate excess revenues to schools, (2) increase spending on excluded purposes, (3) reduce proceeds of taxes and spending, (4) make statutory changes to the state appropriations limit, and (5) go to the voters.

Payments to individuals

SB 88 provides one-time payments of $600 to taxpayers who qualified for the state Earned Income Tax Credit in 2020 (usually incomes of less than $30,000), and taxpayers who file their tax returns using federal Individual Tax Identification Numbers (ITINs), earn less than $75,000 a year, and did not receive the most recent federal stimulus checks December due to their immigration status. Taxpayers who qualify for both categories would receive $1,200.

The program will also provide one-time payments of $600 to lower-income households enrolled in the California Work Opportunity and Responsibility to Kids Act (CalWORKS), Cash Assistance Program for Aged, Blind, and Disabled Legal Immigrants (CAPI), and the Supplemental Security Income/State Supplemental Program (SSI/SSP).

Grants for small businesses

SB 87 provides an additional $2 billion for grants of up to $25,000 for businesses with annual revenues between $1,000 and $2.5 million in 2019 income that have been impacted by the pandemic. The agreement is an increase from the current $500 million in grants. The bill reserves $50 million of this for nonprofit cultural institutions. To distribute the grants, the bill establishes the California Small Business COVID-19 Relief Grant Program in the newly established Office of Small Business Advocate (CalOSBA).

Eligible recipients are sole proprietors, independent contractors, 1099 employees, C-corporations, S-corporations, cooperatives, limited liability companies, partnerships, limited partnerships, and nonprofits. The organization must have begun operations prior to June 1, 2019, be currently active and operating, or have a clear plan to reopen when the state permits reopening of the business.

The bill prioritizes grants according to geographic distribution based on COVID-19 health and safety restrictions; industry sectors most impacted by the pandemic; nonprofit mission services most impacted by the pandemic; underserved small business groups that have faced historic barriers to access to capital and networks, and are defined as businesses majority owned and operated on a daily basis by women, minorities or persons of color, and veterans, or businesses in rural and low-wealth communities; and disadvantaged communities. The grants would not be subject to state income tax.

In May, the economic fallout from the COVID-19 pandemic confronted the state with a projected $54 billion deficit, the largest in the state’s history. Governor Gavin Newsom declared a budget emergency in June, allowing him to use the state’s rainy day fun, and the governor and legislature reportedly agreed to use about $16 billion from the rainy day fund over the next three years. A cash shortage did not occur, however.

The LAO explained the dramatic turnaround in tax revenue by noting that revenue did not drop as anticipated during the pandemic because high-income taxpayers did much better than expected and much better than lower-income taxpayers. The taxpayers had fewer job losses and benefited from a strong stock market. Additionally, by October, California had also regained nearly 44 percent of the more than 2 million jobs lost during March and April.

The projected tax revenue windfall is not all good news, as the LAO projected long-term fiscal deficits. The surplus also demonstrates California’s notorious volatility in tax revenue from a tax structure that receives most of its revenue from the personal income tax, which is dependent on the state’s highest earners.