The Risks of Future Budget Deficits Are Worse Than They Appear
Newsom claims that this new spending is fiscally responsible because the FY2026-27 budget is not in deficit, but this is a state constitutional requirement. Doing the requirements of your job is not an exceptional achievement.
He also crows that there will be no deficit next year. But this claim is based, in part, on surging income tax revenues from the rich – the top 1 percent of income earners provide around 50 percent of the state’s total income tax revenues. This year, surging AI stock valuations have inflated state income tax revenues. These revenue surges represent the sugar-high period of the state’s notoriously volatile tax system.
Like all sugar highs, the revenue crash eventually comes, often sooner than politicians plan. Should there be a speculative AI bubble, or AI valuations simply plateau, the projected future income tax revenue growth will disappoint causing a huge budget deficit that the next governor will need to solve.
Conclusion: The Seeds of California’s Next Budget Crisis Have Been Planted
As we have been documenting in our Spending Watch analyses, there is an impending fiscal cliff that is clear to anyone willing to see it. For the honor of paying the 8th highest per capita tax burden in the country and enduring one of the least competitive tax systems (the 3rd worst), Californians receive terrible public services. Our schools underperform; our roads are the second worst in the country; and nearly one-quarter of the nation’s homeless population live in California.
Longer-term, the prospects become bleaker. Even CalPERS admits, that the pension fund is only 79 percent funded as of the end of FY2025 even though investment returns were a strong 11.6 percent. This creates a $265 billion budget hole, which will worsen should the market underperform.
The time to address the state’s fundamental imbalances was yesterday. Working against these solutions are the same fundamental problems. First, as Newsom’s last budget amply demonstrates, state leaders believe that more state spending is the solution to every problem – especially those created by previous state policies or programs.
Second, California’s budget process is riddled with voter-approved spending requirements, constitutional formulas, and federal mandates that reduce the state’s ability to effectively budget.
The voter approved Prop 98, for instance, mandates that a pre-determined portion of the General Fund revenues – around 40% – must be dedicated toward K – 14 programs. Prop 55, which increased personal income tax rates, also mandates those revenues be spent on K – 12 and community college programs. Voters will be asked to make these taxes permanent in the November 2026 election.
The bullet train boondoggle gets its guaranteed appropriation from the cap-and-trade fund. Even Medi-Cal spending is biased upward. Should the state try to economize on its healthcare spending, the resulting loss in matching federal revenues would create even larger holes in the budget.
Cutting pork programs is also problematic as every seemingly wasteful program has advocates. The benefits from these programs are concentrated in these groups of course. Because the costs for each individual program are relatively small and dispersed over millions of taxpayers, eliminating waste is much harder than identifying it.
Overcoming these obstacles is exceptionally hard. The best way to avoid a troubling fate is to change course well before the budget crashes into economic reality. The latest budget does not remotely recognize these problems which is why, the FY2026-27 budget is another fiscal failure.
