Is California in a Deficit? Budget, Impact, and Risks

Yes, California is in a deficit. The state faces a projected budget shortfall for fiscal year 2026-27, though the size depends on who is doing the math. The Governor’s budget pegs the gap at roughly $2.9 billion, while the nonpartisan Legislative Analyst’s Office puts it closer to $18 billion.¹² Both offices expect ongoing annual deficits in the range of $20 billion to $35 billion over the next several years. The current shortfall is smaller than the massive gaps of 2024 and 2025, but the pattern of volatile revenue and expanding program costs has not gone away.

What the 2026-27 Budget Looks Like

The Governor’s proposed 2026-27 budget identified a $2.9 billion deficit and laid out solutions to close it. After those adjustments, estimated General Fund spending for 2026-27 stands at roughly $246.6 billion. The budget contains no new tax increases, relying instead on spending reductions, fund shifts, and internal borrowing to close the gap.¹

The LAO’s November 2025 Fiscal Outlook sees a much bigger problem. The difference between the two numbers comes almost entirely from revenue projections: the administration’s estimate of incoming tax receipts exceeds the LAO’s by nearly $30 billion across the budget window.² If the LAO’s more cautious forecast proves accurate, lawmakers will have to find billions more in cuts or new revenue before the fiscal year ends.

This is a smaller gap than Californians have seen recently. The 2024-25 fiscal year brought a projected shortfall of approximately $44.9 billion under the Governor’s estimate, or as much as $73 billion under the LAO’s calculation.³⁴ The 2025-26 budget carried an $11.8 billion General Fund shortfall driven largely by Medi-Cal caseload growth, which lawmakers closed through about $2.8 billion in program reductions, $7.8 billion in internal borrowing and revenue measures, and $1.2 billion in fund shifts.⁵

Why the Two Deficit Numbers Disagree

The gap between the Governor’s $2.9 billion estimate and the LAO’s $18 billion figure is not unusual. These two offices consistently disagree, sometimes by enormous margins. The Department of Finance, which produces the Governor’s budget, tends to use more optimistic assumptions about job growth, consumer spending, and stock market performance. The LAO, operating independently of the executive branch, typically builds in more downside risk.

Neither is guessing. They are using different models with different assumptions about the same uncertain future, and small differences in projected revenue compound into large differences in the estimated deficit. Timing matters too. Tax filing deadlines shift, federal extensions push data collection into later months, and a single quarter of stock market returns can move billions in capital gains estimates. A deficit projection released in January can look very different from one released in May, even within the same fiscal year.

Why California’s Revenue Is So Volatile

California’s General Fund depends on personal income tax for more than two-thirds of its revenue. The rate structure has nine brackets topping out at 12.3 percent, plus a 1 percent surcharge on income above $1 million that funds mental health services. That combination produces a top marginal rate of 13.3 percent, the highest of any state.⁶ The system collects enormous sums during good years and plummets when high earners have a bad one.

Capital gains drive most of the swings. When markets surge, capital gains tax receipts flood the treasury. When they stall, those receipts can drop by tens of billions in a single year. The top 1 percent of earners generate a disproportionate share of income tax revenue, so a single rough year for tech IPOs, venture capital exits, or stock option exercises can blow a hole in the budget that ordinary wage growth cannot fill.

Higher interest rates have compounded the problem. Expensive borrowing cools corporate investment, slows the real estate market, and reduces the deals that generate taxable gains. Inflation has pushed up the cost of state-provided services at the same time, squeezing the budget from both sides. The whiplash is dramatic: in 2022, Governor Newsom announced a record $97.5 billion surplus. By the next year it had evaporated, and the commitments made during the boom became obligations that persist long after the revenue is gone.

How the Deficit Affects Residents

Schools

Proposition 98, the 1988 constitutional amendment that sets a minimum funding guarantee for K-12 schools and community colleges, is calculated using three formulas tied to General Fund revenue, personal income growth, and student attendance. In most years, the operative formula links school funding to a minimum share of General Fund revenue, so when revenue drops, the guarantee drops with it.⁷

The Legislature can suspend the guarantee with a two-thirds vote in each house, but doing so creates a legal obligation called “maintenance factor” that must be repaid when revenues recover.⁸ Education cuts during a deficit are effectively borrowed against future budgets.

Medi-Cal and Social Services

Medi-Cal is the single largest pressure point. Caseloads have grown steadily, and recent federal policy changes have reduced the federal match rate for certain populations, forcing the state to pick up more of the cost. The 2026-27 May Revision proposes significant cuts, including reinstating asset limits for seniors and adults with disabilities at $2,000 for individuals and $3,000 for couples, which the administration estimates will reduce General Fund costs by $278.3 million.¹

Other proposed reductions include transitioning certain Medi-Cal members from managed care to fee-for-service, saving roughly $583.8 million in General Fund costs, and adding utilization management requirements for behavioral analysis and transportation services. Enhanced care management and community support programs also face eligibility refinements worth tens of millions in annual savings.¹ For residents who rely on these programs, the deficit determines whether their coverage and services continue.

Businesses

California has suspended the net operating loss deduction for taxable years 2024 through 2026. Businesses and individuals with more than $1 million in income cannot use NOL deductions to offset their tax liability during this period, though they can still calculate and carry over losses for use in future years. The carryover period extends by one year for each year of suspension. Taxpayers earning under $1 million are exempt, and disaster losses are unaffected.⁹ The suspension raises revenue in the short term but increases the tax burden on companies that are already losing money.

What Could Make It Worse

The LAO has warned that federal tariffs on imports are creating cost pressures for businesses and consumers. The enacted 2025-26 budget already assumed revenues would decline that year and grow only modestly in 2026-27, partly reflecting tariff concerns.¹⁰ A broader trade disruption could reduce corporate profits, suppress capital gains, and push the deficit well beyond current projections.

A recession is the scenario that worries budget analysts most. California’s revenue system amplifies economic swings in both directions. The LAO has noted that while its estimates hedge against a market downturn, they do not fully account for the revenue declines the state would experience in an actual recession.²

The state’s rainy day fund offers some protection but not much. As of the 2026-27 May Revision, the Budget Stabilization Account balance stands at approximately $15.1 billion, up from $11.2 billion at the 2025 Budget Act level.¹ That sounds comfortable until compared with deficits that have recently reached $44 billion or more. The Governor can only tap the fund by declaring a budget emergency, and the state already planned a roughly $7 billion withdrawal as part of the prior year’s budget deal.¹¹ If a downturn arrives, the cushion covers only a fraction of what a recession-driven revenue collapse would cost.

1
California Department of Finance. May Revision 2026-27 Budget Summary
2
Legislative Analyst’s Office. The 2026-27 Budget: Overview of the Governor’s Budget
3
California Department of Finance. May Revision 2024-25 Budget Summary
4
Legislative Analyst’s Office. The 2024-25 Budget: Deficit Update
5
California Department of Finance. California State Budget 2025-26
6
California Franchise Tax Board. 2025 California Tax Rate Schedules
7
Legislative Analyst’s Office. Proposition 98 Guarantee and K-12 Spending Plan
8
Legislative Analyst’s Office. The 2025-26 California Spending Plan: Proposition 98 and K-12 Education
9
Franchise Tax Board. Net Operating Loss
10
Legislative Analyst’s Office. The 2026-27 Budget: California’s Fiscal Outlook
11
Legislative Analyst’s Office. The 2025-26 Budget: Overview of the Governor’s Budget