The 2025-26 Budget: California's Fiscal Outlook

2025-26 BUDGET The 2025-26 Budget: California’s Fiscal Outlook GABRIEL PETEK LEGISLATIVE ANALYST NOVEMBER 2024 www.lao.ca.gov 1 2025-26 BUDGET 2 LEGISLATIVE ANALYST’S OFFICE 2025-26 BUDGET Executive Summary The Fiscal Outlook gives the Legislature our independent estimates and analysis of the state’s budget condition for the 2025-26 budget process. We evaluate the budget condition based on current law and policy at both the state and federal level. This means we are assessing the state’s spending and revenues assuming no new laws or policies are enacted. This is not a prediction of what will happen—state and federal laws and policies will change in the coming years—but rather serves as a baseline to help the Legislature understand its starting place. Further, while changes in federal policy are being actively discussed, we cannot predict which changes may be enacted and therefore cannot estimate the effects on California’s budget. Legislative Action Last Year Addressed Anticipated Budget Problem Proactively. In the 2024-25 budget process, the Legislature not only addressed the budget problem for that fiscal year, but also made proactive decisions to address the anticipated budget problem for 2025-26. These choices included about $11 billion in spending-related solutions and $15 billion in all other solutions, including $5.5 billion in temporary revenue increases and a $7 billion withdrawal from the state’s rainy-day fund. After these solutions, the spending plan assumed the 2025-26 budget would be balanced. Revenues Running Ahead of Broader Economy. Despite softness in the state’s labor market and consumer spending, earnings of high-income Californians have surged in recent months. Income tax collections have seen a similar bounce. This recovery in income tax revenues is being driven by the recent stock market rally, which calls into question its sustainability in the absence of improvements to the state’s broader economy. Revenue Improvement Offset by Higher Costs, 2025-26 Budget Remains Roughly Balanced. Although revenues are running ahead of budget act assumptions, those improvements are roughly offset by spending increases across the budget. On net, our assessment finds the state has a small deficit of $2 billion. Given the size and unpredictability of the state budget, we view this to mean the budget is roughly balanced. If a budget problem of this magnitude were to materialize by the end of the budget process in June, relatively minor budget solutions would be needed. Revenues Are Unlikely to Grow Fast Enough to Catch Up to Atypically High Spending Growth. While the budget picture is fair for the upcoming year, our outlook suggests that the state faces double-digit operating deficits in the years to come. By historical standards, spending growth in this year’s outlook is high. Our estimate of annual, total spending growth across the forecast period—from 2025-26 to 2028-29—is 5.8 percent compared to an average of 3.5 percent in other recent outlooks. Meanwhile, revenue growth over the outlook window is just above 4 percent—lower than its historical average largely due to policy choices that end during the forecast window. Taken together, we view it as unlikely that revenue growth will be fast enough to catch up to ongoing spending. No Capacity for New Commitments. While out-year estimates are highly uncertain, we anticipate the Legislature likely will need to address deficits in the future, for example by reducing spending or increasing taxes. In our view, this year’s budget does not have capacity for new commitments, particularly ones that are ongoing. www.lao.ca.gov 3 2025-26 BUDGET INTRODUCTION Every year, our office publishes the Fiscal tax revenues is being driven by the recent Outlook in anticipation of the upcoming budget stock market rally, which calls into question its season. This report gives the Legislature our sustainability in the absence of improvements independent estimates and analysis of the state’s to the state’s broader economy. budget condition with the goal of helping lawmakers • 2025-26 Budget Roughly Balanced. In the prepare for the 2025-26 budget process. As always, 2024-25 budget process, the Legislature not our Fiscal Outlook evaluates the budget’s condition only addressed the budget problem for that based on current law and policy at both the state fiscal year, but also made proactive decisions and federal level. This means we are assessing to address the anticipated budget problem the state’s spending and revenues assuming no for 2025-26. Although revenues are running new laws or policies are enacted. This is not a ahead of budget act assumptions, those prediction of what will happen—state and federal improvements are roughly offset by spending laws and policies will change in the coming increases across the budget. This means the years—but rather serves as a baseline to help the budget is roughly balanced this year. Legislature understand its starting place. Further, • No Capacity for New Commitments. While while changes in federal policy are being actively the budget picture is fair for the upcoming discussed, we cannot predict which changes may year, our outlook suggests that the state be enacted and therefore cannot estimate the faces double-digit operating deficits in the effects on California’s budget. years to come. While these out-year estimates This year, our report has three takeaways: are highly uncertain, this is an indication • Revenues Running Ahead of Broader that the Legislature might need to address Economy. Despite softness in the state’s labor deficits in the future, for example, by reducing market and consumer spending, earnings spending or increasing taxes. In our view, of high-income Californians have surged in this year’s budget does not have capacity recent months. Income tax collections have for new commitments, particularly ones that seen a similar bounce. This recovery in income are ongoing. REVENUES RUN AHEAD OF BROADER ECONOMY State’s Job Market and Consumer Spending …And Yet Incomes Are Growing Rapidly Remain Lackluster… California’s economy has for High-Income Californians. Alongside these been in an extended slowdown for the better downbeat trends, a bright spot has emerged: part of two years, characterized by a soft labor strong growth in total pay to California workers. market and weak consumer spending. While this Total pay grew at a well above-average rate in the slowdown has been gradual and the severity first half of 2024. The first quarter was especially milder than a recession, a look at recent economic strong, with 17 percent annualized growth in total data—as in Figure 1—paints a picture of a sluggish pay, among the sharpest quarterly growth rates economy. Outside of government and health on record. Income tax receipts have followed suit, care, the state has added no jobs in a year and a with withholding collections nearing 10 percent half. Similarly, the number of Californians who are growth so far this year. Yet this pay bounce does unemployed is 25 percent higher than during the not appear to be connected to the hourly wages strong labor markets of 2019 and 2022. Consumer and salaries that most workers receive. Estimates spending (measured by inflation-adjusted retail suggest pay from these traditional forms grew sales and taxable sales) has continued to decline at an annualized rate of only a few percentage throughout 2024. points in the first quarter. Instead, much of the 4 LEGISLATIVE ANALYST’S OFFICE 2025-26 BUDGET Figure 1 Most Economic Metrics Running Below Average Each dot represents the annual growth rate in the specified economic category in each quarter between 1982 Q1 and 2024 Q2. The purple dots show the first two quarters of 2024. The orange dot shows the historical average. (Income and sales data adjusted for inflation.) Total Pay to Workers -15 -10 -5 5 10 15% Business Owner Income -30 -20 -10 10 20 30% Payroll Jobs -15 -10 -5 5 10 15% Unemployed Workers -90 -60 -30 30 60 90% Taxable Sales -21 -14 -7 7 14 21% www.lao.ca.gov 5 2025-26 BUDGET bounce appears to be tied to special forms of pay any confidence what the stock market will do next. for high-income workers, such as bonuses and Still, some cautionary observations are warranted. stock compensation. Current stock prices relative to companies’ past earnings (a common measure of how “expensive” Booming Stock Market Driving Income stocks are) are at levels rivaled only by the transitory Growth. The recent run-up in the stock market, booms of 1999 and 2021. Furthermore, a single which appears tied to optimism surrounding company (Nvidia) accounts for about one-third of artificial intelligence, is a primary driver of the the total gains in the S&P 500 stock index over the rapid growth in pay to high-income workers. last year. Overall, without more positive signs from Stock compensation has become an increasingly the broader California economy, it is difficult to be important form of pay among California’s highly confident in the recent revenue recovery. high-income workers, especially those at major technology companies. In the first half of Possible Paths to a Broader Economic 2024, stock pay alone at four major technology Recovery. Over the coming months, if California’s companies accounted for almost 10 percent of labor market and consumers begin to show signs the state’s total income tax withholding. Because of a broadening recovery, the state’s fiscal position this form of compensation is tied to the company’s is likely to be on better footing. It remains to be stock price, it rises when stock prices rise. Other seen whether this will occur, but there are some forms of pay, such as bonuses to workers in the conceivable paths toward broader improvements. financial sector, also tend to rise when financial One path is falling interest rates and expansion markets are doing well. Early evidence suggests of money available for lending and investment. this has been the case in 2024 as well. A key driver of California’s economic slump over the last two years has been the Federal Reserve’s Without Broader Economic Improvements, efforts to tamp down inflation by raising interest Recent Gains Are on Shaky Ground. With a rates and shrinking how much money is available boost from the booming stock market, our forecast for lending and investment. As inflation has eased, puts tax collections on track to beat expectations the Federal Reserve recently has reversed course. by $7 billion over the budget window (that is, from Should inflation remain subdued and the Federal 2023-24 through 2025-26). This is entirely due to Reserve continue down its path toward looser improving income tax collections, which would, money, California’s economy could be lifted. under our forecast, end the current year 20 percent Another potential path is continued strength in higher than two years ago. That being said, the the stock market. Should enthusiasm around ultimate outcome is highly uncertain. It is entirely artificial intelligence prove warranted, stocks plausible for revenues to end up above or below could solidify around current high levels. The our estimates by $30 billion across the budget solidification of this new wealth could encourage window. Contributing to the uncertainty this year is Californians to consume more and businesses to the fact that a recovery built on a stock market rally hire more workers. is especially precarious. We cannot predict with 2025-26 BUDGET ROUGHLY BALANCED Legislative Action Last Year Addressed in spending-related solutions and $15 billion in all Anticipated Budget Problem Proactively. other solutions, including $5.5 billion in temporary In the 2024-25 budget process, the Legislature revenue increases and a $7 billion withdrawal from not only addressed the budget problem for that the state’s rainy-day fund, the Budget Stabilization fiscal year, but also made proactive decisions Account (BSA). After these solutions, the spending to address the anticipated budget problem for plan assumed the 2025-26 budget would 2025-26. These choices included about $11 billion be balanced. 6 LEGISLATIVE ANALYST’S OFFICE 2025-26 BUDGET We estimate the 2025-26 budget remains roughly • Spending on Schools and Community balanced this year. On a technical basis, the budget Colleges Higher by $2.5 Billion. bottom line condition is the accumulated change Proposition 98 (1988) establishes a minimum in General Fund revenues and spending across annual funding requirement for schools and the three fiscal years in the budget window—this community colleges, met with state General year, 2023-24 through 2025-26—and reflected Fund and local property tax revenue. When in the ending balance in the Special Fund for General Fund revenue increases, the minimum Economic Uncertainties (SFEU) in 2025-26 in requirement usually grows in tandem. Higher Figure 2. On net, our assessment of the budget revenues, especially in 2024-25, result in condition finds the state would have a small deficit a higher spending requirement on schools of $2 billion. Given the size and unpredictability of and community colleges. The box on page 9 the state budget, we view this to mean the budget describes overall spending on K-14 education is roughly balanced. If a budget problem of this under our outlook. magnitude were to materialize by the end of the • All Other Spending Higher by $8 Billion. budget process in June, relatively minor budget We estimate spending across the rest of the solutions would be needed. budget will be higher than the administration’s Higher Revenues Offset by Higher Costs. June 2024 projections by about $8 billion over Our assessment reflects some key assumptions, the budget window. The largest contributors which we describe in the box on the next page. At a include: the fiscal effects of recently passed higher level, there are a few factors, some offsetting, that result in the Figure 2 roughly balanced budget. These General Fund Condition Under Fiscal Outlook are shown in Figure 3 and include: (In Millions) • Small End Balance for 2025-26. The starting place 2023-24 2024-25 2025-26 for this year’s budget is Prior-year fund balance $47,119 $15,875 $13,881 the planned spending and Revenues and transfers 191,536 215,951 217,970 Expenditures 222,781 217,944 223,303 revenue level established Ending fund balance $15,875 $13,881 $8,549 by last year’s budget Encumbrances $10,569 $10,569 $10,569 package. In this case, the SFEU balance $5,306 $3,312 -$2,020 June 2024 budget package Reserves planned for a small balance BSA balance $22,796 $17,870 $10,770 in the SFEU—$1.5 billion—for Safety Net Reserve 900 — — the end of 2025-26. SFEU = Special Fund for Economic Uncertainties. • Revenues Exceed Budget Act Projections by Figure 3 $7 Billion. Collections data to date show Higher Revenues Offset by stronger-than-anticipated revenue growth Higher Costs across 2023-24 and 2024-25, although our (In Billions) forecast for 2025-26 is mostly flat. Overall, our revenue projections are up by about $7 billion End Balance Assumed in 2024 Spending Plan $1.5 relative to the June 2024 estimates with more than half of that total attributable to the Revenues Higher $7.1 School and Community College Spending Higher -2.5 current year. All Other Spending Higher -7.9 Rainy Day Fund Deposit Higher -0.2 Budget Problem at LAO Fiscal Outlook -$2.0 Note: Positive values improve the budget condition. Negative values erode the budget bottom line. www.lao.ca.gov 7 2025-26 BUDGET Key Assumptions Underlining This Outlook How We Reflect Current Law and Policy. Our Fiscal Outlook uses a current law and policy baseline so as to give the Legislature a clear understanding of the budget’s condition based on its most recent set of actions. Typically, our definition of “current law and policy” includes: (1) enacted law and (2) policies the Legislature has a track record of repeatedly enacting, including those to maintain current services. (So, our outlook does not reflect recent proposals by the Governor, like the expansion of the film tax credit.) In recent years, we have expanded this definition to include the costs associated with legislative intent language, as long as it meets certain conditions. This expansion was warranted due to the multiyear plans adopted by the Legislature when the state anticipated significant surpluses. Specifically, we include intent language when: (1) the Legislature voted on and approved the policy, (2) the policy is referred to in budget-related statutes (for example, in trailer bill) that have force of law, and (3) the policy as described in statute is specific and implementable. In addition, we include intent reflected in floor reports of the adopted budget when they include specific information regarding planned spending. This year, our expanded approach applies to legislative choices made for 2025-26 to proactively address the deficit anticipated for that year. Includes Fiscal Effects of Recently Passed Ballot Measures. Our outlook reflects the fiscal effects of propositions approved by voters on the November 5, 2024 ballot. In particular, we have incorporated cost estimates for the two bond measures—one for school facilities and one for climate-related projects—Proposition 35, which extends the tax on managed care plans, and Proposition 36, which increases penalties for certain theft and drug crimes. Under our estimates, these measures together result in nearly $3 billion in added costs over the budget window, which are nearly exclusively due to increased costs as a result of Proposition 35. Assumes Administration Does Not End Limitations on Deductions and Credits. The 2024-25 budget package enacted a temporary increase in corporation tax revenues by not allowing: (1) any businesses to use tax credits to reduce their taxes by more than $5 million and (2) businesses with $1 million or more in income to use net operating loss deductions. These limits apply to tax years 2024, 2025, and 2026; however, statute also gives the Department of Finance the discretion to trigger off these temporary limitations in the event the budget has the capacity to do so. Our projections indicate the budget does not have this capacity, so we have assumed these limitations remain in place. Under our estimates, this results in around $5 billion in revenue in 2025-26. After 2025-26, Assumes Budget Stabilization Account (BSA) Deposits Are Not Suspended. As noted earlier, our outlook reflects the legislative decision to suspend BSA deposits and instead withdraw funds from the account in 2024-25 and 2025-26. However, our outlook does not assume that the state continues to suspend BSA deposits in 2026-27 and later. Suspending those deposits would result in an improvement in the budget bottom line condition by about $3 billion per year. Does Not Account for Future Disasters. Our outlook accounts for higher costs associated with fighting forest fires as the state’s fire season has become longer and more severe. However, we do not attempt to predict the occurrence of unanticipated, major disasters, for example, an earthquake, pandemic, or fire involving significant destruction of many buildings and other structures. In recent years, the state has experienced disasters—including the COVID-19 pandemic—that involved historically significant losses of life and carried increased budgetary costs. State costs associated with these and other major disasters are mostly offset by federal funds, although the level of funding for this purpose is contingent on decisions made by the federal government. 8 LEGISLATIVE ANALYST’S OFFICE 2025-26 BUDGET Funding for Schools and Community Colleges Proposition 98 Creates School and Community College Budget Within Broader State Budget. By requiring the state to set aside certain amounts of funding each year, Proposition 98 (1988) creates a budget for schools and community colleges within the state’s larger budget. The minimum size of this budget—the “minimum guarantee”—is determined by a set of constitutional formulas. Individual school and community college programs, in turn, represent the costs paid out of this budget. This budget also has its own reserve account earmarked exclusively for schools and community colleges. The state must deposit funding into this account when it receives high levels of capital gains revenue and the minimum guarantee is growing quickly relative to inflation. Proposition 98 Guarantee Revised Up in 2024-25, Nearly All of the Increase Deposited Into Reserve. Compared with the estimates in the June 2024 budget, our estimate of the minimum guarantee is up $3 billion (2.6 percent) in 2024-25 (see figure below). Most of this increase reflects our higher estimates of General Fund revenue, but faster growth in local property tax revenue also contributes. Due to our higher estimate of capital gains revenue, nearly all of the growth in the guarantee must be deposited into the Proposition 98 Reserve. The balance in the reserve by the end of 2024-25 would be $3.7 billion. Growth in School and Community College Funding (Dollars in Millions) 2024-25 2025-26 Change From Change 2024-25 Enacted Enacted LAO LAO Budget Estimates Amount Percent Estimates Amount Percent Minimum Guarantee $115,283 $118,255 $2,973 2.58% $116,799 $1,516 1.3% General Fund $82,612 $84,796 $2,183 2.64% $81,747 -$866 -1.0% Local property tax 32,670 33,460 789 2.42 35,052 2,382 7.3 Proposition 98 Guarantee Grows Modestly in 2025-26. We estimate the guarantee in 2025-26 is $116.8 billion, an increase of $1.5 billion (1.3 percent) from the 2024-25 enacted budget level. Growth in General Fund revenue and local property tax revenue both contribute to the higher guarantee. An additional contributing factor is the expansion of transitional kindergarten. The June 2021 budget established a plan to expand this program to all four-year old children by 2025-26. The Legislature and Governor also agreed to adjust the guarantee upward for the additional students enrolling in the program each year. This adjustment accounts for nearly $800 million of the increase in the guarantee in 2025-26. Legislature Would Have $2.8 Billion Available for New Commitments in 2025-26. Separate from the growth in the guarantee, $3.7 billion in existing Proposition 98 funding becomes freed-up in 2025-26. This adjustment is due to the expiration of one-time spending and several other offsetting changes. After accounting for the freed-up funding and the cost of providing a 2.46 percent statutory cost-of-living adjustment for existing programs, we estimate that $2.8 billion is available for new commitments. The Legislature could allocate this funding for any combination of one-time or ongoing school and community college priorities. For example, the Legislature could use a portion to eliminate the payment deferrals it enacted in the June 2024 budget. www.lao.ca.gov 9 2025-26 BUDGET propositions, higher-than-expected caseload • Will State Operations Efficiencies in Medi-Cal and In-Home Supportive Services Materialize? The 2024-25 budget package (IHSS), an assumption that the state does directed the Department of Finance (DOF) not achieve all of the state operations to: (1) reduce General Fund state operations savings planned in the 2024 budget, and expenditures by $2.2 billion ongoing beginning higher-than-expected costs for fighting fires. in 2024-25 and (2) revert $763 million to the • BSA Deposit Slightly Higher. The State General Fund associated with vacant positions Constitution typically requires the state to in 2024-25 (this action was made ongoing deposit funds into the BSA when revenues through permanent reductions of state are higher. Consistent with legislative positions starting in 2025-26). To date, we choices from last year, we assume the state have not been able to obtain any information suspends deposits into the BSA in 2024-25 from DOF about the implementation of and 2025-26, which means that changes in these reductions among state departments. revenues for those years have no effect on As such, it is not clear to us how much of the BSA. In 2023-24, a small upward revenue these cost savings will materialize. While revision results in an additional deposit for our outlook assumes the state is able to that year. score some savings associated with each of these actions, the extent of those savings Revenue Uncertainty Always Present in is still unknown. Ultimately, action by the Our Budget Outlook. Our Fiscal Outlooks are administration could improve or erode those always highly uncertain. The main source of that savings relative to our assumptions. uncertainty is our revenue forecast. As mentioned • How Much Will the Healthcare Minimum earlier, in the budget window alone, revenues Wage Ultimately Increase Costs? Late could easily end up above or below our estimates last year, the Legislature passed a bill to by $30 billion. Further, as shown in Figure 4, increase the minimum wage for many health uncertainty only grows into the future. care workers, and those increases took A Few Key Spending Uncertainties Impact effect in October of this year. The timing and Budget Bottom Line. In addition to revenue magnitude of the costs associated with these uncertainty, the state faces some key uncertainties wage increases—and in particular the costs in the spending estimates: to the Medi-Cal program—are uncertain. Estimates of the General Fund share of this cost Figure 4 have ranged from the low Revenues Are Highly Uncertain hundreds of millions of dollars to the low billions of dollars. Total General Fund Revenue (In Billions) Our outlook assumes a figure $300 in between these estimates, The shaded area shows how far revenues could but actual costs could be 280 deviate from our main forecast. Outcomes beyond the shaded area are possible, but significantly lower or higher 260 revenues most likely will fall in the shaded area. than this. 240 • Why Is the Senior Medi-Cal 220 Population Growing Rapidly? In the first seven 200 months of 2024, the senior 180 caseload in Medi-Cal has 160 increased sharply. The 2022-23 2023-24 2024-25 2025-26 2026-27 2027-28 2028-29 average monthly growth of 14,500 senior enrollees 10 LEGISLATIVE ANALYST’S OFFICE 2025-26 BUDGET during this period is about nine times faster Further Improvements in Budget Condition than in the prior six-month period. We believe Depend on Revenue Timing. Further that the key driver of this caseload surge is improvements in revenues are possible, but this the recent full elimination of the asset limit year, those improvements have a complicated effect test—a condition of Medi-Cal eligibility for on the budget’s condition. Typically, as a rule of seniors that existed to some degree through thumb, we say that when revenues improve by $1, December 2023. (In addition, IHSS enrollment the budget bottom line improves by $0.50 to $0.60. recently has accelerated, however, readily This is due to the state’s constitutional formulas, available data do not specify whether the mainly Proposition 98, which typically requires increased enrollment is concentrated to the state to spend an additional $0.40 on schools seniors.) The surge also aligns with the and community colleges for each $1 of additional implementation of additional federal flexibilities revenue. This year, however, the dynamic is more meant to limit the impacts of eligibility complicated due to “maintenance factor,” which is redeterminations being conducted by counties created when the state has provided less growth for the first time since the beginning of the in K-14 funding than the growth in the economy. pandemic. We assume that the elevated As a result of maintenance factor, all else equal, senior caseload continues for a three-year improvements in revenues in 2024-25 could result in period, roughly in line with the phase-in of past a near dollar-for-dollar increase in school spending eligibility expansions. However, given only in that year with minimal benefit to the budget several months of data, projecting the exact bottom line. Upward revisions in 2025-26, however, trend is subject to uncertainty. To the extent would have the typical effect of $0.50 to $0.60 in that events play out differently, costs could overall budget improvement for each dollar of new differ significantly from those reflected in our revenue. These dynamics are explained further in outlook, particularly in 2025-26. our report, The 2025-26 Budget: Fiscal Outlook for Schools and Community Colleges. www.lao.ca.gov 11 2025-26 BUDGET NO CAPACITY FOR NEW COMMITMENTS State Faces Annual Multiyear Deficits of Around $20 Billion. Figure 5 Figure 5 shows our forecast of the multiyear condition of the State Faces Growing Multiyear Deficits budget. While the budget is (In Billions) roughly balanced in the upcoming fiscal year, the state faces annual operating deficits beginning in 2025-26 -5 2026-27—growing from about -10 $20 billion to about $30 billion. Although highly uncertain, these -15 represent additional budget -20 problems the Legislature would 2026-27 -25 need to address in the coming 2027-28 years, for example by reducing -30 2028-29 Budget Problem Operating Deficits spending, increasing taxes, shifting -$35 costs, or using more reserves. The magnitude of these deficits also indicates that, without other changes to spending or revenues, the state does not have capacity for total annual spending growth rate was 3.5 percent new commitments. and only 3 percent for spending excluding K-14 education. While there are always idiosyncrasies in Remaining Reserves Could Cover Much of spending patterns that can influence these growth Deficit in 2026-27. The state has faced significant rates—for example, the timing of one-time spending budget problems over the last two years—by our reductions or anomalies in federal funding—the estimate, a $27 billion deficit in 2023-23 and a increase in this growth is contributing to the state’s $55 billion deficit in 2024-25 (excluding early action multiyear deficits. taken this year). Yet, over this time, the Legislature did not use much of the state’s reserves. Under our Spending Growth Driven by Past Program outlook, even assuming the state uses $7 billion Expansions and Underlying Growth. Figure 6 in reserves in 2025-26, nearly $11 billion would shows some of the programs that are key drivers of remain in the BSA. Assuming the Legislature also the growth in spending. In some cases, for example suspended the otherwise required deposit in IHSS and developmental services, faster growth 2026-27, the state could cover about two-thirds of is standard and largely due to underlying trends in that year’s budget problem with reserves alone. caseload, utilization, and price. However, recent However, in years thereafter, the state would need ongoing program expansions are also contributing to make other changes to address the shortfalls. factors. This includes, for example, the expansion of services, eligibility, and rates in Medi-Cal; an Faster Than Normal Spending Growth expansion of child care, including an increase Contributing to Deficits. One reason the state in slots; and several other expansions to human faces operating deficits is growth in spending. services programs. (For context, our handout, Our estimate of annual total spending growth How Program Spending Grew in Recent Years, across the forecast period—from 2025-26 to provides more information on augmentations, 2028-29—is 5.8 percent (6.3 percent excluding K-14 including those that are ongoing, in recent budgets.) education). By historical standards, this is high. For example, in our last five Fiscal Outlooks, the 12 LEGISLATIVE ANALYST’S OFFICE 2025-26 BUDGET Revenues Are Unlikely to Grow Figure 6 Fast Enough to Catch Up to Spending. The state typically faces Forecasted Growth in Major Programs a deficit when spending exceeds Average Annual Growth, 2024-25 to 2028-29 revenues in the budget window and an operating deficit when spending exceeds revenue in future years. Education An operating deficit—like the ones Schools and we currently anticipate—can arise Community Colleges either because of a difference in the levels of revenues and CSU spending (a stable gap over time) Student Aid Preschool or a difference in growth rates (a gap that grows over time). Both UC are an issue currently, as seen in Figure 7. Our forecasted spending Health and Human Services In-Home Developmental Services growth is about 6 percent over Supportive Services the forecast period—a growth rate CalWORKsa that is high by historical outlook SSI/SSP Medi-Cal Child Welfare standards and slightly above what we consider to be long-term Public Safety Child Care revenue growth. Meanwhile, Corrections and revenue growth over the outlook Rehabilitationb window is just above 4 percent— Courts this is lower than its historical average largely due to policy choices, namely the limitations on GO Bonds Other CalFire Unemployment Insurancec deductions and credits that end during the forecast window. Taken -10 -5 0 5 10 15 20 25% together, we view it as unlikely that a Year-over-year General Fund growth in CalWORKs largely reflects a shift in the availability of federal funds. Year-over-year total fund growth for the program is closer to 1 percent. revenue growth will be fast enough b Excludes growth in employee compensation. to catch up to ongoing spending. c Mainly, costs to repay federal loan to the state's UI program. This means that although the state Note: Size of the bubble represents the size of the program in 2024-25. does not face much of a budget GO = general obligation; CalFire = California Department of Forestry and Fire Protection; and UI = Unemployment Insurance. problem this year, in the coming years, legislative action could be necessary to close this gap. Figure 7 Oversight Key to Budget Revenues Not on Track to Grow Fast Management. Understanding Enough to Catch Up to Ongoing Spending which programs are working well (In Billions) and those which are in need of $300 adjustment is a key starting place Expenditures 250 for considering future budget solutions. As we anticipate 200 Revenues Excluding BSA Transfer future budget problems are more 150 likely than not, we recommend 100 the Legislature conduct robust 50 oversight of programs this 2020-21 2021-22 2022-23 2023-24 2024-25 2025-26 2026-27 2027-28 2028-29 BSA = Budget Stabilization Account. www.lao.ca.gov 13 2025-26 BUDGET budget season. Doing so can provide the years and the state’s constrained fiscal capacity, Legislature necessary insight for whether the the Legislature now has a key opportunity—if not a administration is implementing programs according necessity—to assess the efficiency, effectiveness, to legislative intent as well as whether programs equity, and priority of some of its recent are achieving the desired outcomes. Particularly augmentations and longer-standing programs. given the significant program expansions in recent 14 LEGISLATIVE ANALYST’S OFFICE 2025-26 BUDGET APPENDIX Appendix Figure 1 General Fund Spending by Agency Through 2028-29 (Dollars in Billions) Average Annual Agency 2023-24 2024-25 2025-26 2026-27 2027-28 2028-29 Growthb Legislative, Executive $9.2 $4.4 $4.3 $3.3 $3.3 $2.7 -14.3% Courts 3.4 3.2 3.5 3.6 3.8 3.9 4.2 Business, Consumer Services, and Housing 3.5 1.3 0.3 0.2 0.2 0.2 -8.6 Transportation 0.7 0.2 0.1 — — — -43.6 Natural Resources 10.3 4.1 3.7 3.8 3.9 4.0 3.2 Environmental Protection 2.3 0.2 0.1 0.1 0.1 0.1 -0.1 Health and Human Services 73.4 74.2 78.7 82.8 93.6 100.7 8.5 Corrections and Rehabilitation 14.9 13.9 13.4 13.4 13.5 13.5 0.2 Education 20.6 20.2 19.5 20.7 22.0 22.3 4.6 Labor and Workforce Development 1.4 0.9 0.9 1.2 1.3 1.3 12.2 Government Operations 4.6 2.5 4.5 4.0 3.0 5.3 5.7 General Government Non-Agency Departments 2.8 1.3 1.2 1.2 1.7 1.2 -0.7 Tax Relief/Local Government 0.6 0.7 0.7 0.7 0.8 0.8 3.8 Statewide Expenditures 2.0 -0.4 4.4 5.3 6.6 7.0 16.9 Capital Outlay 0.8 0.6 — 0.1 — 0.1 32.3 Debt Service 5.3 5.9 6.1 6.3 6.5 6.8 3.7 Non-98 Spending Total $155.7 $133.1 $141.6 $146.9 $160.5 $170.1 6.3% Proposition 98a $67.1 $84.8 $81.7 $85.2 $89.7 $94.1 4.8% Proposition 2 Infrastructure 0.7 — — — — — — Total Forecasted Spending $222.8 $217.9 $223.3 $232.1 $250.3 $264.2 5.8% a Reflects General Fund component of the Proposition 98 minimum guarantee. b From 2025-26 to 2028-29. www.lao.ca.gov 15 2025-26 BUDGET LAO PUBLICATIONS This report was prepared by Ann Hollingshead, with contributions from others across the office, and reviewed by Carolyn Chu. The Legislative Analyst’s Office (LAO) is a nonpartisan office that provides fiscal and policy information and advice to the Legislature. To request publications call (916) 445-4656. This report and others, as well as an e-mail subscription service, are available on the LAO’s website at www.lao.ca.gov. The LAO is located at 925 L Street, Suite 1000, Sacramento, California 95814. 16 LEGISLATIVE ANALYST’S OFFICE