California LAO Report Shows $18 Billion Shortfall

AENN

From the LAO Report:

"2026-2027 BUDGET LEGISLATIVE ANALYST’S OFFICE 2 22026-27 BUDGET "

2026-27_Fiscal_Outlook_111925.pdf

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Executive Summary Not Safe to Bet Artificial Intelligence (AI) Fueled Exuberance Is Sustainable. Both the California and U.S. economies currently face significant headwinds. Borrowing costs, a key factor in business expansions and major consumer purchases, remain high. New tariffs on imports into the U.S. are creating cost pressures for businesses and consumers. Despite this, income tax collections have been strong in recent months, growing at double-digit rates. These strong income tax collections are being driven by enthusiasm around AI, which has pushed the stock market to record highs and boosted compensation among the state’s tech workers. With so much exuberance surrounding AI, it now appears time to take seriously the notion that the stock market has become overheated.

History suggests that the stock market is prone to overreact to major technological advances, even if the technology itself turns out to be revolutionary. Our Revenue Outlook Builds in Some Insurance Against a Stock Market Downturn. Reflecting concerns about the potential effects of tariffs, the budget act enacted in June assumed revenues would decline in 2025-26 and grow modestly in 2026-27. Looking primarily at strong trends in income tax collections since June would suggest a significant upgrade to budget act revenues is warranted. However, our Fiscal Outlook revenue forecast reflects a smaller, temporary upgrade which reverses beginning in 2026-27.

This is because our forecast incorporates the strong risk that recent income tax gains are tied to an unsustainable stock market. This does not mean our forecast assumes a stock market downturn will definitely happen. Instead, our forecast includes income tax collections that are somewhat weaker than suggested by cash trends, but still tens of billions of dollars above where they would be if stocks actually drop significantly. This middle-ground approach offers the state some insurance against revenue declines, resulting in smaller budget corrections should a market downturn actually occur. 2026-27 Budget Problem Now Larger Than Anticipated. Under our revenue and spending estimates, the Legislature faces an almost $18 billion budget problem in 2026-27. This is about $5 billion larger than the budget problem anticipated by the administration in June, despite improvements in revenue. This is because constitutional spending requirements under Proposition 98 (1988) and Proposition 2 (2014) almost entirely offset revenue gains.

Moreover, we estimate costs in other programs to be about $6 billion higher than anticipated. Starting in 2027-28, we estimate structural deficits to grow to about $35 billion annually due to spending growth continuing to outstrip revenue growth. Budget Position Is Weak. We advise the Legislature to address the budget problem through a combination of ongoing solutions—namely, achievable spending reductions and/or revenue increases. There are three reasons these actions are now critical.

First, the budget problem is now larger than anticipated, despite improvements in revenue, and the structural deficits are significant and growing. Second, while our revenue estimates hedge against a market downturn, they do not reflect the revenue declines the state would experience in a recession. Third, the state has used most of its budget resiliency tools to address prior deficits. If our estimates hold, the Legislature will face a fourth consecutive year of budget problems—all during a period of overall revenue growth. As it stands—with larger forecasted deficits and many fewer tools available to address them—California’s budget is undeniably less prepared for downturns".