California Faces Moderate Current Year Budget Shortfall Which Could Grow in Future Years

served as Editor to this alert.

Last week, following California Governor Gavin Newsom’s final State of the State address, his Department of Finance Director, Joe Stephenshaw, unveiled the Governor’s January budget proposal. Stephenshaw noted that, despite optimistic economic forecasts, the Newsom Administration is not proposing any significant new spending. Despite increased revenue collections (forecasted to be $42 billion higher over three budget years), the state still faces a $2.9 billion shortfall in the current budget year, a projected $22 billion shortfall in next year’s budget and shortfalls exceeding $20 billion the two years following.

Consequently, the Governor is proposing an overall state budget of $348.9 billion, with a $248.3 billion General Fund that includes $23 billion in total reserves with no “significant new cuts,” according to Stephenshaw. Additionally, while some members of the state’s Legislature are outspoken in their desire to adopt new taxes and revenues, the Governor’s proposal does not include any significant new taxes.

Despite these increased revenue projections, why does the state face projected shortfalls? First, the state faces constitutionally required spending through Prop 2 (the state’s “Rainy Day Fund” reserve) and Prop 98 (school funding for TK-12 and community colleges) when revenues increase. As a result, the Governor touted the increase to education funding during his address, calling it “the most significant investments in education in history”.

Another driver in the state’s potential budget shortfalls is increased program costs, such as those found in the state’s Medicaid program, driven in part by the impacts of House of Representatives (H.R.) 1 of 2025 (a.k.a., the “Big Beautiful Bill”). The Newsom Administration projects that these changes will result in costs of $1.4 billion General Fund in 2026–27 and escalate over the coming years.

The Administration also notes the risks that a stock market or economic downturn would have on their forecasts:

“If a market downturn of more than 20 percent—comparable to the decline in 2022—were to occur in 2026 and be sustained through the end of the year, revenue could be $25 billion to $30 billion below forecast within the budget window, even if there were no economic recession. If coupled with an economic recession, revenue would be even lower.”

Such a downturn would essentially wipe away all the forecasted revenue increases.

What Comes Next?

By mid-January, the Legislative Analyst’s Office will release its review of the Governor’s budget plan. This sets the stage for late January, when the legislative budget committees are scheduled to commence their hearings. 

As part of this process, the Governor’s budget, along with Budget Change Proposals and related budget trailer bills, will be introduced as legislation. These bills encompass both the budgetary framework and specific policy initiatives that will guide authorized program spending.

No later than May 15, the Governor will present an updated budget plan, known as the “May Revise,” that will reflect the most current revenue estimates and potentially adjust budgetary allocations and priorities accordingly. The Legislature then has a crucial deadline of June 15 to send a balanced budget to the Governor—a requirement tied to their compensation. Finally, the process culminates with a July 1 deadline for Newsom and the legislature to approve the final spending plan for the fiscal years 2026 and 2027, with work continuing on trailer bills throughout the end of session.