LAO Warns of Fiscal Challenges in Out-Years

This week, California Legislative Analyst Gabriel Petek issued a post warning of potential state budget problems in coming years despite California’s persistent strong state tax collections. The LAO recently conducted a fiscal analysis of 10,000 possible revenue scenarios, finding that in 95 percent of its simulations, the state encountered a budget problem at fiscal year 2025-26. Notably, the likelihood of a budget of a budget problem is unaffected by the future trajectory of state tax revenues.

The LAO notes that continued revenue growth could increase the state’s constitutional funding obligations enough to cause large recurring deficits. With the state reaching the state appropriations limit (SAL), each additional dollar of revenue must be allocated consistent with SAL requirements, generally making them unavailable to fund baseline expenditures.

Additionally, the state must also continue to spend required amounts on education and reserve and debt payments. Combined, the LAO estimates that for every dollar of tax revenue above the SAL, the state faces approximately $1.60 in constitutional funding obligations. Based on scenario analysis, if revenues exceeded median expected growth, SAL requirements could reach $20 billion to $45 billion by 2025-26. Therefore, each additional dollar of revenue above the limit worsens the state budget outlook.

In response to this outlook, the LAO recommends that the Legislature consider rejecting the bulk of the Governor’s $10 billion in non-SAL-excludable budget proposals. The LAO further notes that rejecting proposed spending alone, even in favor of SAL-excludable outlays, likely would be insufficient since constitutional obligations would accumulate faster than incoming revenue in future years. Therefore, the LAO suggests that the Legislature hold unspent funds in reserve to help pay for the state’s anticipated SAL-related obligations. Longer-term, lawmakers will likely need to weigh fundamental questions about the size of state government and whether to seek a voter-approved amendment to Proposition 4, which enacted the SAL.

The LAO offers commentary on economic conditions in California and the country, ultimately calling for budget resilience-enhancing actions in the immediate term. The LAO notes that the Governor’s budget plan is “not a fiscally sustainable starting point” considering Department of Finance (DOF) estimates indicating negative balances in state discretionary reserves from 2023-24 through 2025-26.

The full post from the LAO is available here.