What Is California’s Budget Deficit and Why It Persists

California’s budget deficit for the 2026-27 fiscal year is projected at roughly $18 billion before the Governor and Legislature apply spending cuts, new revenue, and reserve draws to close it. That estimate comes from the nonpartisan Legislative Analyst’s Office and is about $5 billion larger than the administration anticipated just months earlier. The outlook worsens further out: structural deficits could reach $35 billion a year by 2027-28 as spending growth continues to outpace revenue.¹ The state isn’t in free fall. It’s working through a prolonged fiscal hangover from years when revenues dropped sharply and the commitments made during flush years didn’t shrink with them.

How Big the Gap Is

The LAO pegs the 2026-27 budget problem at almost $18 billion, driven by two forces: revenues that fell significantly in 2022-23 and never recovered to prior projections, and a level of ongoing state services that was never fully scaled back to match that new reality.¹ The Governor’s May Revision proposes a package of solutions that produces a balanced spending plan on paper, with a $4.5 billion operating reserve in 2026-27 and $2.1 billion in 2027-28.² That doesn’t mean the structural mismatch has gone away. It means the administration found enough one-time maneuvers and new revenue to paper over it for now.

Looking further out, both the LAO and the administration project deficits ranging from $20 billion to $35 billion annually in the years beyond 2026-27.³ The gap between ongoing revenue and ongoing spending is the definition of a structural deficit, and it doesn’t resolve itself without permanent spending reductions or permanent revenue increases. One-time fixes buy time and push the problem forward.

Federal trade policy made the picture worse. Broad-based tariffs imposed by the federal government slowed economic growth across the state and forced a downgrade to both economic and revenue forecasts at the 2025-26 May Revision. Combined with higher-than-expected costs in programs like Medi-Cal, tariff-driven economic weakness contributed to an $11.8 billion General Fund shortfall in the 2025-26 fiscal year alone.⁴ Trade-sensitive industries like agriculture, manufacturing, and technology sit at the heart of California’s economy, so federal tariff decisions ripple through the state’s tax base quickly.

Why California’s Revenue Keeps Swinging

The General Fund leans heavily on personal income taxes, which makes it uniquely sensitive to the financial fortunes of the highest earners. For the 2022 tax year, the top one percent of filers paid nearly 39 percent of all personal income tax revenue.⁵ That share has been even higher in boom years; in 2012 it topped 50 percent.⁶ When stock markets rally and capital gains pour in, Sacramento’s coffers overflow. When markets cool or tech valuations slide, the revenue drop is fast and steep.

Capital gains are especially volatile. The Governor’s 2026-27 revenue forecast attributes $21.2 billion in upgraded personal income tax projections mainly to higher capital gains realizations, while warning that capital gains growth is expected to slow beginning in 2026 as those elevated levels normalize.⁷ This is the recurring pattern. A windfall year tempts lawmakers into expanding programs, and the correction year that follows leaves those programs underfunded.

Natural-disaster-related filing extensions from the IRS and Franchise Tax Board have delayed billions in expected payments by months in recent years. When tax receipts arrive late, the state has less time to react to a shortfall, and policymakers end up making spending decisions on incomplete data.

Where the Money Goes

The Governor’s proposed 2026-27 budget totals roughly $248 billion in General Fund spending. Two categories dominate: Health and Human Services at about $93.7 billion (roughly 38 percent), and K-12 education at $88.6 billion (about 36 percent). Higher education adds another $26 billion, and Corrections and Rehabilitation accounts for about $14 billion.⁸ Together those four categories consume over 89 percent of the General Fund, leaving a thin slice for everything else. That concentration explains why closing a deficit is hard: the biggest line items are either locked in by federal rules, constitutionally protected, or politically immovable.

Medi-Cal Is the Fastest-Growing Pressure

Estimated Medi-Cal spending for 2026-27 is $49 billion in General Fund dollars and $222 billion in total funds when federal matching dollars are included.⁹ The LAO identifies per-enrollee cost increases as the primary driver of spending growth over the past decade, fueled by greater use of services, higher service costs, and recent state benefit expansions. Caseload growth plays a smaller role. These costs are largely non-discretionary. The state cannot simply decide to spend less without cutting benefits, tightening eligibility, or securing federal waivers.

Education Funding Is Constitutionally Protected

Proposition 98 sets a minimum funding guarantee for K-12 schools and community colleges based on a formula tied to state revenue and enrollment. When revenues drop the guarantee falls too, but it creates a floor lawmakers cannot dip below without extraordinary action. The Governor’s 2026-27 budget proposes delaying a $5.6 billion payment associated with a higher estimate of the 2025-26 Proposition 98 guarantee, essentially pushing costs into a future year when the state would need to settle up.¹⁰ The LAO has warned that such deferrals can worsen future deficits.

How the State Plans to Close the Gap

The Governor’s May Revision uses a layered approach because no single tool is large enough on its own.

A Surplus Holding Account, created in 2024, receives $9.7 billion in the 2026-27 budget to support the 2027-28 fiscal year, providing a cushion against overcommitting before revenues are finalized.²
Revenue measures permanently limit business tax credit use to $5 million or 50 percent of tax liability (raising $850 million), extend taxation to digital software and software-as-a-service ($450 million), and implement a managed care organization tax ($575 million).²
Fund shifts move spending from the General Fund to special funds. The Behavioral Health Services Fund alone provides $211.9 million in 2026-27 budget solutions.
Medi-Cal program adjustments include asset test limits ($278.3 million in savings) and increased monthly premiums of $50 for certain adults.
A $5.6 billion Proposition 98 payment is deferred, shifting current obligations into future budgets.¹⁰

Each tool has tradeoffs. Revenue measures face political resistance and can dampen business investment. Deferrals push costs forward. Fund shifts are available only once. The budget allocates $1.9 billion to retire payment deferrals from prior years, a reminder that yesterday’s one-time fixes eventually come due.¹⁰

The Rainy Day Fund Isn’t a Solution

California’s Budget Stabilization Account, strengthened by voters through Proposition 2 in 2014, requires an annual transfer equal to 1.5 percent of estimated General Fund revenues. Through the 2029-30 fiscal year, half of that transfer goes into the reserve and half toward paying down state debts. In years when capital gains tax revenue exceeds 8 percent of total General Fund tax revenue, the excess is split the same way. The reserve is capped at roughly 10 percent of estimated General Fund revenues.

As of the 2026-27 May Revision, the account balance stands at $15.1 billion, up from $11.2 billion under the 2025 Budget Act.² That sounds like a lot of money until you compare it to a structural deficit the LAO estimates at $35 billion a year. The reserve buys about five months of breathing room, not a permanent fix.

Long-Term Liabilities Behind the Annual Number

The annual gap gets the headlines, but California carries long-term obligations that dwarf any single year’s shortfall. The California Public Employees’ Retirement System reported an unfunded liability of $186.8 billion as of June 30, 2023.¹¹ That’s the gap between what the system has promised to pay retirees and what it currently holds. The state’s annual contributions chip away at it but consume General Fund dollars that might otherwise go to current services.

Retiree health care benefits add more pressure. California state and local governments collectively face an estimated $187 billion in unfunded liabilities for post-employment benefits beyond pensions, including medical, dental, and vision coverage for retired workers. These obligations don’t appear as line items in the annual deficit conversation, but they are binding commitments that will compete with everything else for General Fund dollars for decades.

The Rules That Shape the Choices

California’s Constitution doesn’t let the state simply run a deficit indefinitely. Article IV, Section 12 requires the Governor to submit a budget with itemized spending recommendations and revenue estimates every January, and if recommended spending exceeds estimated revenues, the Governor must identify where additional revenue should come from.¹² The same provision prohibits the Legislature from sending the Governor a budget bill that appropriates more from the General Fund than estimated revenues for that year, effectively requiring a balanced budget on paper.

A separate constraint, Article XIII B of the California Constitution, caps how much the state can appropriate in any given year. Known as the Gann Limit, this spending ceiling was established by voters in 1979 and modified by Proposition 98 in 1988. When revenues exceed the limit, the excess must be returned to taxpayers or directed toward education.¹³ The Gann Limit hasn’t been the binding constraint in recent deficit years, but during surpluses it can force rebate checks instead of reserve-building.

Raising taxes to close a deficit faces its own barrier. The Legislature needs a two-thirds supermajority vote in both chambers to enact any state tax increase, which gives the minority party significant leverage in budget negotiations. That’s why Governor’s budget proposals tend to lean on fee adjustments, fund shifts, and spending cuts rather than straightforward tax hikes.

What It Means for Residents

The practical effect of these deficits is slower investment in infrastructure, deferred school payments, tighter eligibility for public programs, and the ongoing possibility of new fees or taxes. California isn’t facing insolvency. It is making tradeoffs that affect service quality in ways that won’t show up in a single headline number, and the pattern will keep repeating as long as the state’s commitments outrun what its volatile tax base can reliably produce.

1
Legislative Analyst’s Office. The 2026-27 Budget: California’s Fiscal Outlook
2
California Department of Finance. May Revision 2026-27
3
Legislative Analyst’s Office. The 2026-27 Budget: Overview of the Governor’s Budget
4
California Department of Finance. 2025-26 Enactment Budget Summary
5
California Department of Finance. Governor’s Budget Summary – Revenue Estimates
6
Legislative Analyst’s Office. “Top 1 Percent” Pays Half of State Income Taxes
7
California Department of Finance. Governor’s Budget Summary – Revenue Estimates
8
California Senate Budget and Fiscal Review Committee. Summary of the Governor’s Proposed 2026-27 Budget
9
Legislative Analyst’s Office. The 2026-27 Budget: Medi-Cal Analysis
10
Legislative Analyst’s Office. The 2026-27 Budget: Proposition 98 Guarantee and K-12 Spending Plan
11
CalPERS. 2024 Annual Review of Funding Levels and Risks
12
Justia. California Constitution Article IV – Legislative – Section 12
13
Justia. California Constitution Article XIII B Section 8 – Government Spending Limitation