Is California in financial trouble? Not in the way that phrase usually implies. The state runs the fourth-largest economy in the world, holds roughly $23 billion in combined reserves, and carries investment-grade credit ratings from all three major agencies.1State Treasurer’s Office. California’s Current Credit Ratings But it does face a real and persistent budget deficit, projected structural shortfalls of about $35 billion a year starting in 2027–28, and long-term pension and retiree health obligations approaching $360 billion.2Legislative Analyst’s Office. The 2026-27 Budget: California’s Fiscal Outlook The state is not going broke. It is, however, spending more than it reliably collects, and the tools it used to hide that gap in recent years are largely gone.
The Deficit That’s Driving the Worry
The Legislative Analyst’s Office pegged California’s 2026–27 shortfall at nearly $18 billion in its November 2025 outlook, about $5 billion worse than the administration had anticipated months earlier.2Legislative Analyst’s Office. The 2026-27 Budget: California’s Fiscal Outlook The Governor’s January budget used more optimistic revenue assumptions and put the gap closer to $2.9 billion, proposing around $9 billion in solutions to balance the books.3Legislative Analyst’s Office. The 2026-27 Budget: Overview of the Governor’s Budget Both offices agree the problem exists and will persist. Beginning in 2027–28, the LAO projects structural deficits averaging roughly $35 billion per year.
California’s constitution requires a balanced budget each year, so officials close these gaps through a mix of spending cuts, delayed projects, internal borrowing between state funds, and reserve withdrawals. The LAO has noted that most of the recent fixes have been temporary rather than permanent adjustments to the spending base. The state has already used over $20 billion in such one-time measures, and many of those tools are now exhausted.2Legislative Analyst’s Office. The 2026-27 Budget: California’s Fiscal Outlook
The underlying cause is structural. Spending growth continues to outpace revenue growth. Revenues dropped sharply in 2022–23 and haven’t returned to their projected trajectory, yet ongoing service commitments haven’t been fully adjusted to that reduced capacity.
Why Revenues Swing So Hard
California’s tax structure practically guarantees volatility. The personal income tax supplies about 60 percent of General Fund revenues, with rates from 1 percent on low incomes up to 13.3 percent on taxable income above $1 million for single filers, including a 1 percent surcharge under the Mental Health Services Act.4Franchise Tax Board. Tax Calculator, Tables, Rates The top 5 percent of filers contribute roughly 60 percent of all personal income tax collections. That ties the state’s fiscal health directly to the fortunes of its wealthiest residents.
A large share of that high-end income comes from capital gains: stock sales, startup exits, and investment returns tied to financial markets and the technology sector. When markets surge, the treasury overflows. When they correct, receipts can drop by tens of billions within a single year. That is how California went from record surpluses in 2020–21 and 2021–22 to significant deficits in a remarkably short time. New spending commitments were built during the boom. When markets cooled, the revenue vanished and the commitments remained.
What’s Already Promised Before Lawmakers Spend a Dollar
A large share of the budget is locked in by voter-approved formulas. Proposition 98 guarantees a minimum funding level for K–12 schools and community colleges. For 2026–27, that minimum sits at approximately $125.5 billion, about 39 percent of General Fund revenues under the Governor’s budget.5Legislative Analyst’s Office. Proposition 98 Guarantee and K-12 Spending Plan That money is constitutionally allocated before any discretionary debate begins.
Proposition 2, passed in 2014, adds another mandatory set-aside, requiring the state to deposit 1.5 percent of General Fund revenues into the Budget Stabilization Account each year, plus additional deposits when capital gains receipts exceed 8 percent of General Fund revenue.6Justia. California Constitution Article XVI Section 20 – Public Finance The Gann Limit, established by Proposition 4 in 1979, separately caps total state and local government spending at 1978–79 levels adjusted for population growth and inflation. Together, these formulas mean a significant share of incoming revenue is spoken for even in boom years.
The Cushion, and How Hard It Is to Tap
California’s primary financial cushion is the Budget Stabilization Account, the rainy day fund created by Proposition 58 and restructured by Proposition 2. The 2025–26 budget placed the BSA balance at roughly $11.2 billion.7CA.gov. California State Budget 2025-26 Combined with the Special Fund for Economic Uncertainties ($4.5 billion) and the Public School System Stabilization Account ($4.1 billion), total reserves for 2026–27 come to approximately $23 billion.8CA.gov. 2026-27 GB Budget Summary
That’s substantial compared with where the state stood before the 2008 recession, when reserves were effectively zero. But the LAO has cautioned that reserves are now at roughly half their recent peak, leaving the budget less prepared for a downturn than it was just a few years ago.2Legislative Analyst’s Office. The 2026-27 Budget: California’s Fiscal Outlook
Accessing the BSA is not simple. Under Proposition 2, the Governor must first declare a budget emergency, and the Legislature must authorize a withdrawal by majority vote. Even then, no more than half the account can be drawn in the first year. Only in a second consecutive year of declared emergency can the Legislature authorize a full liquidation.6Justia. California Constitution Article XVI Section 20 – Public Finance
The Bigger Long-Term Weight
The annual deficit gets the headlines. The long-term liabilities are heavier. As of June 30, 2025, California had approximately $72.8 billion in outstanding general obligation bonds, with total General Fund–supported debt including lease revenue bonds reaching about $80.8 billion.9State Treasurer’s Office. State of California Debt Affordability Report October 2025 These bonds fund infrastructure and are repaid over decades. Voters approve them, and they carry the state’s full faith and credit pledge.
Pensions are the larger concern. The California Public Employees’ Retirement System reported an unfunded liability of $186.8 billion as of its June 30, 2023, valuation.10CalPERS. 2024 Annual Review of Funding Levels and Risks The California State Teachers’ Retirement System added another $88.7 billion in unfunded obligations as of June 30, 2024. California courts have historically treated those benefits as vested contractual rights that can’t be easily reduced.
On top of pensions, the state carries an $82.4 billion net liability for retiree health and dental benefits — known as Other Post-Employment Benefits — as of June 30, 2022.11California State Controller’s Office. Controller Cohen Updates State Retiree Health Care Liability Combined long-term unfunded obligations for pensions and retiree healthcare approach $360 billion. These aren’t bills due tomorrow. They will be paid over the next three to four decades. But they constrain every future budget, because the state must increase contributions each year to close the gap.
How Markets See It
Despite the deficit headlines, financial markets still view California as a strong borrower. Its general obligation bonds carry ratings of AA from Fitch, Aa2 from Moody’s, and AA- from Standard & Poor’s.1State Treasurer’s Office. California’s Current Credit Ratings Those are solidly investment-grade — not the top tier, but well above any threshold that would signal distress.
Ratings directly affect what California pays to borrow. Higher-rated bonds carry lower interest rates, saving taxpayers on every infrastructure project financed through debt. California’s GO bonds currently yield around 3.6 percent to maturity, consistent with its rating tier. So far, the agencies have held steady, weighing the state’s economic size, revenue capacity, and reserves against the structural deficit they flag as a concern.
The Federal Funding Exposure
One risk that rarely enters the state budget debate is how much California depends on federal money. For 2026–27, the Governor’s budget projects roughly $190 billion in federal fund expenditures out of a total budget of about $349 billion, meaning federal dollars support more than half of state spending.8CA.gov. 2026-27 GB Budget Summary The bulk flows to health and human services programs, particularly Medi-Cal, which would face enormous funding gaps without its federal match.
Federal policy changes — spending caps, block grant conversions, or targeted funding reductions — could open a hole in California’s budget that no state-level tax increase or reserve withdrawal could easily fill. A sustained cut to federal health care funding would force the state to either backfill billions from the General Fund or reduce services. State budget documents rarely frame federal funding as a risk factor in the way they discuss revenue volatility, but the exposure is enormous.
The Economy Backing It All Up
Every commitment above is backed by the private economy generating the tax revenue to pay for it. In April 2025, Governor Newsom announced that California had officially overtaken Japan to become the world’s fourth-largest economy, with a nominal GDP of $4.1 trillion based on International Monetary Fund and Bureau of Economic Analysis data.12Governor of California. California Is Now the 4th Largest Economy in the World Only the United States as a whole, China, and Germany rank higher.
That base spans technology, aerospace, agriculture, entertainment, biotech, and renewable energy. No single sector’s downturn would sink the whole. The question isn’t whether California’s economy can support its obligations. It clearly can. The question is whether the political process will match spending commitments to the revenue the economy reliably produces, rather than the revenue it produces in its best years.
High-income taxpayer migration, often cited as a threat, has had a modest net effect so far. Franchise Tax Board data shows that people leaving and people arriving pay roughly comparable amounts in taxes, with the net annual revenue reduction averaging about 0.2 percent of total personal income tax collections.13Franchise Tax Board. The Impact of Migration on California Income Tax Revenues That’s a rounding error against a budget this size.
Bottom Line
California is not in financial trouble in the way a household that can’t make rent is in trouble. It has a massive economy, substantial reserves, and the legal authority to raise taxes or cut spending to close any gap. What it does have is a structural mismatch between what it has committed to spend and what it expects to collect, projected at roughly $35 billion a year if nothing changes. The temporary fixes that papered over recent shortfalls are largely used up, reserves have been drawn down to about half their peak, and long-term obligations exceeding $350 billion will demand growing annual contributions for decades.
The honest read is that California has a spending problem more than a revenue problem. Its economy generates enormous wealth, and tax collections during strong market years are staggering. The difficulty is that the state tends to build permanent programs on top of temporary windfalls, then scrambles when markets cool. Until ongoing spending is aligned with sustainable revenue rather than peak revenue, the cycle of surpluses followed by deficits will continue.