How Does California Make Money: Income Tax, Sales Tax, and Grants

California’s state government takes in roughly $227 billion a year through its General Fund, and most of that money comes from three taxes: the personal income tax, the sales and use tax, and the corporation tax. So how does California make money beyond those three? Federal grants, payroll taxes, excise taxes on things like gasoline and cannabis, property taxes (which fund local governments more than the state), lottery sales, and a long list of fees fill out the rest. The personal income tax alone covers about 63 percent of General Fund revenue, which is why Sacramento’s budget rises and falls with the fortunes of California’s highest earners.¹

Personal Income Tax

The personal income tax is the single largest source of state revenue, projected to bring in about $142 billion in the 2026–27 fiscal year.² It runs on a progressive scale with nine brackets. Rates start at 1 percent on the first few thousand dollars of taxable income and climb to a top rate of 12.3 percent. Anyone earning more than $1 million pays an additional 1 percent surcharge created by the Mental Health Services Act, which voters approved in 2004 to fund county mental health programs.³ That brings the effective top rate to 13.3 percent, the highest state income tax rate in the country.

One quirk sets California apart from federal rules: the state taxes capital gains as ordinary income. There is no reduced long-term rate. Profits from selling stocks, real estate, or other assets stack on top of wages and get taxed at the same progressive rates. When markets are strong, that produces enormous surpluses. When markets fall, revenue drops fast, and the state can swing into deficit within a single year. The Franchise Tax Board handles collection, audits, and enforcement.

Sales and Use Tax

The statewide base sales tax rate is 7.25 percent, applied to most purchases of physical goods such as electronics, furniture, clothing, and vehicles.⁴ Cities and counties add their own local rates for transportation, public safety, and other services, which pushes the total above 10 percent in some areas. The portion directed to the General Fund generates roughly $35 billion a year.²

Not every purchase gets taxed. Most unprepared groceries and prescription medications are exempt, which softens the burden on lower-income households. Services and digital goods are generally outside the tax base. The use tax is a companion rule: if you buy something from an out-of-state or online seller that doesn’t collect California sales tax, you owe use tax at the same rate on that purchase. The California Department of Tax and Fee Administration oversees both.

Corporation Tax

Businesses operating in California pay a franchise tax on their net income, projected to generate about $43.5 billion in the 2026–27 fiscal year.² General corporations pay a flat 8.84 percent on California-source net income. Banks and financial corporations pay a higher 10.84 percent. Revenue and Taxation Code Section 23151 sets those rates.⁵

Even corporations that lose money owe an $800 minimum franchise tax. Corporations formed on or after January 1, 2020, are exempt from the minimum in their first taxable year, but after that, the $800 floor applies regardless of profitability.⁶ California uses market-based sourcing to determine how much of a multistate company’s income is taxable here, meaning the state looks at where customers are rather than where the company has offices or employees.

Federal Grants

Federal money is not something California collects as a tax, but it funds a huge portion of state operations. The largest chunk pays for Medi-Cal, California’s Medicaid program.⁷ About 60 percent of all federal funding sent to California goes to Medicaid, totaling roughly $96.7 billion annually. The state and federal government split the cost roughly evenly, so any cut in federal contributions would hit the state budget almost immediately. Education grants and highway funds make up the next largest categories, each carrying federal strings in the form of program standards, matching requirements, and detailed reporting.

Payroll Taxes

California runs its own payroll tax system on top of federal Social Security and Medicare withholdings. Two programs dominate.

State Disability Insurance covers workers who cannot do their jobs because of a non-work-related illness, injury, or pregnancy. For 2026, employees pay a 1.3 percent withholding rate on all wages, with no cap on taxable earnings.⁸ California’s Paid Family Leave program is funded through the same withholding.

Unemployment Insurance is paid by employers. Businesses pay UI taxes on the first $7,000 of each employee’s annual wages, at rates ranging from 1.5 percent to 6.2 percent depending on the employer’s layoff history and the current rate schedule.⁹ The Employment Development Department administers both programs.

Excise and Specialized Taxes

California also imposes targeted taxes on specific products and industries. These typically flow into dedicated funds rather than the General Fund.

Motor fuel: The gasoline excise tax for July 2025 through June 2026 is $0.612 per gallon, funding highway maintenance, road construction, and other transportation projects. The rate is adjusted periodically for inflation, which is why it is among the highest in the country.¹⁰
Cannabis: Licensed retailers pay a 15 percent state excise tax on sales, a rate locked in through 2028 after legislation reversed what would have been a 25 percent rate. Revenue supports youth drug treatment, environmental cleanup of illegal grow sites, and community reinvestment.¹¹
Insurance premiums: Insurance companies pay a gross premiums tax of roughly 2.35 percent on the premiums they collect, one of the state’s older revenue streams and worth billions annually.¹²
Alcohol and tobacco: Per-unit excise taxes apply to beer, wine, spirits, and cigarettes. The rates have not changed in decades and generate comparatively modest revenue dedicated to public health programs.

Property Tax

Property taxes are the largest revenue source for local governments in California, but very little of that money reaches the state’s General Fund. Proposition 13, passed by voters in 1978, capped the general property tax rate at 1 percent of assessed value and limited annual assessment increases to 2 percent. A property is reassessed to full market value only when it changes hands or undergoes new construction, which is why two identical homes on the same street can carry very different tax bills.

Counties collect property taxes and distribute them to cities, school districts, and special districts. The state’s involvement is indirect but significant: because Prop 13 constrained local school funding, Sacramento now sends billions each year from the General Fund to make up the difference. Proposition 98, passed in 1988, formalized that obligation by guaranteeing a minimum share of state revenue for K–12 schools and community colleges.¹³ So while property tax is not a state revenue stream in a direct sense, it shapes how a large chunk of state income tax dollars get spent.

Lottery, Fees, and Investment Earnings

The California State Lottery has generated more than $48 billion for public education since it launched in 1985, including about $1.9 billion in the 2024–25 fiscal year.¹⁴ Nearly 80 percent of those distributions go to K–12 schools, with community colleges and the university systems splitting the rest. Lottery money is supplemental by design and covers only about 1 percent of total K–12 spending.¹⁵

Fees touch almost every interaction with state government. Motor vehicle registration fees fund highway patrols and road maintenance.¹⁶ Professional licensing fees cover the cost of regulating doctors, contractors, real estate agents, and other licensed occupations. Court filing fees, park entrance fees, and environmental permit fees each feed their respective programs. No single fee rivals the big tax streams, but together they add billions to state operations.

When the state has surplus cash on hand, the Treasurer invests it in low-risk securities. The interest earned flows back to the treasury, providing a steady trickle of non-tax revenue that helps bridge the gap between when taxes are collected and when bills come due.

1
California Department of Finance. California’s Budget Process
2
CA.gov: Governor’s Budget Summary. Governor’s Budget Summary 2026-27
3
Legislative Analyst’s Office. Proposition 63 – Mental Health Services Expansion and Funding
4
California Department of Tax and Fee Administration. California City and County Sales and Use Tax Rate Information
5
California Legislative Information. California Revenue and Taxation Code Section 23151
6
Franchise Tax Board. Corporations
7
DHCS.ca.gov. Medi-Cal Overview
8
Employment Development Department. Contribution Rates, Withholding Schedules, and Meals and Lodging Values
9
Employment Development Department. Tax-Rated Employers
10
California Department of Tax and Fee Administration. Sales Tax Rates for Fuels
11
Governor of California. Governor Newsom Signs Legislation Cutting Taxes on Cannabis
12
California Department of Tax and Fee Administration. Insurance Tax Total Assessments
13
Legislative Analyst’s Office. The 2026-27 Budget – Proposition 98 Guarantee and K-12 Spending Plan
14
California State Lottery. Who Benefits
15
California Department of Education. Lottery – CalEdFacts
16
California Department of Motor Vehicles. Registration Fees