CA Budget: Legislative Analyst says ‘State is Ill-Prepared if Revenues Drop’

Last week California Governor Gavin Newsom released his May budget revise, and blamed the President’s policies–especially tariffs– for contributing to a worsened budget outlook.

And then he claimed his final May budget revise is “miraculously balanced.”

The California Legislative Analyst’s Office disagreed with him last January, and disagrees now.

As we reported, Newsom proposed roughly $322 billion in total spending and about $226 billion General Fund spending. His budget revise projected a $12 billion deficit for 2025-26.

It is important to note that the Legislative Analyst’s Office (LAO) warns, “deficits have persisted even as the state’s economy and revenues have grown, underscoring that the problem is structural rather than cyclical.”

They maintain that position. The Legislative Analyst’s Office released today its initial response to Gov. Newsom’s final proposed state spending plan:

Despite Revenue Boom, Budget Architecture Relies on $20 Billion in Reserves. The May Revision’s estimate of tax revenues in the current year represents over 30 percent growth from three years ago. Much of this growth is driven by the personal income tax, which is up nearly 50 percent during that same period. Periods of elevated revenues like these are typically when the state should be strengthening its fiscal position. Instead, the May Revision draws it down—relying on roughly $20 billion in reserve withdrawals and suspended deposits, as well as $4 billion in borrowing (on top of tens of billions of dollars in existing borrowing), to achieve budget balance.

Structural Problem Is Now Upon the State. For several years, we have cautioned that structural deficits were emerging and would soon require corrective action. Despite the current revenue boom, the state now faces a structural budget imbalance—meaning ongoing revenues are insufficient to support ongoing expenditures.

And the LAO included this graph for the visual learners:

Gov. Newsom boasted last week zero deficits:

California’s fiscal future is on a stronger footing for the years to come.

$0 deficit THIS budget year.

$0 deficit NEXT budget year.

$0 structural deficit through July 2028.

Long-term deficit: Cut by more than half.

The LAO directly highlighted large multiyear deficits in its January 2026 analysis of Governor Newsom’s proposed 2026-27 budget.

Now, the LAO tells Gov. Newsom, “Not so fast:”

Future Deficits Have Come Down Substantially, but State Ill‑Prepared for a Slip Up in Revenues. In January, we noted that our office and the administration estimated the state faced future deficits between $20 billion and $30 billion per year. Due to a combination of higher revenue estimates, lower baseline spending, and ongoing proposals (which both raise revenue and reduce spending), the May Revision cuts these future deficits in half. Despite this progress, the underlying budget condition is not sound. First, the existence of any operating deficits during a revenue boom of this magnitude is itself a warning sign. Further, given the state’s diminished reserves and already accumulated wall of debt, California is ill‑prepared for even a slip up in revenues. Even just a repeat of the 2022 market declines, which were mild by historical standards, could quickly push the budget into deep deficits. Alarmingly, given current market conditions, the dot‑com bust probably is a better parallel. If such scenario were to repeat, the revenue hole could be $100 billion.

The Legislative Analyst’s Office says, “despite booming revenues, the budget position is overextended, reflecting: a structurally higher spending base, diminished reserves, an already accumulated wall of debt, and an operating deficit.”

Note: “Reduce Spending” is the smallest sliver of the pie.

Recommendations: we recommend the Legislature take action to put the budget on sound fiscal footing, including:

• Maintaining Amount of Ongoing Solutions Proposed by Governor. We recommend the Legislature maintain at least the amount of ongoing solutions included in the May Revision.
• Making a $20 Billion Discretionary Reserve Deposit. In light of current revenue conditions, we recommend the Legislature make a $20 billion discretionary deposit into the Budget Stabilization Account (BSA) this year. This would make notable progress toward the administration’s proposal that the state raise BSA reserves to 20 percent of General Fund tax revenues.
• Setting Aside $4 Billion for Potential Settle‑Up Obligation. We recommend the Legislature set aside $4 billion to pre‑fund this likely obligation.

Make a $20 Billion Discretionary Reserve Deposit. While the Governor has made progress in addressing the state’s future budget problem, the May Revision relies on reserves to support near‑term budget balance despite booming revenues. The timing of these budget decisions matters. Near‑term revenues are much more certain than those projected in later years, where uncertainty compounds. As a result, building budget resilience now is just as important—if not more so—than addressing structural deficits. In light of current revenue conditions, we recommend the Legislature make a $20 billion discretionary deposit into the BSA this year, reversing the reserve reliance described above. (There is no cap on discretionary deposits into the BSA. As such, under this recommendation, total reserves would reach 17 percent of General Fund tax revenues, while also allowing for additional mandatory deposits into the BSA under the constitutional rules. This would make notable progress toward the administration’s proposal that the state raise BSA reserves to 20 percent of General Fund tax revenues.)

The LAO acknowledges that “Future Deficits Have Come Down Substantively” but “Despite this progress, the underlying budget condition is not sound. First, the existence of anyoperating deficits during a revenue boom of this magnitude is itself a warning sign. Further, given the state’s diminished reserves and an already accumulated wall of debt, California is ill prepared for even a slip up in revenues. Stock market runs like the one seen in the last three years almost always end in a dramatic reversal. Many classic warning signs suggest this market run may be nearing its end. Should the stock market reverse course, tax revenues would decline significantly.”

The LAO concludes:

The state’s current fiscal situation is genuinely unprecedented. Despite booming revenues, the budget position is overextended, reflecting: a structurally higher spending base, diminished reserves, an already accumulated wall of debt, and an operating deficit. Meanwhile, a revenue shock could be coming, as the state’s revenue outlook rests disproportionately on AI‑driven equity valuations that are trading at highs last seen at the peak of the dot‑com bubble.

These conditions warrant a disciplined and cautious fiscal approach. In our view, this means recognizing that recent revenue performance may not represent a sustainable long‑term baseline for the budget.

Here is the LAO initial May Budget Revise report.