The 2025-26 Budget: Initial Comments on the Governor's May Revision

2025-26 BUDGET The 2025-26 Budget: Initial Comments on the Governor’s May Revision GABRIEL PETEK | LEGISLATIVE ANALYST | MAY 2025 KEY TAKEAWAYS A Budget Problem Has Emerged Since January. Overall, our assessment of the state’s budget condition for 2025-26 is very similar to that of the administration’s assessment—namely, since January, when the budget was roughly balanced, a budget problem has emerged. We estimate the administration solved a $14 billion budget problem (similar to the $12 billion budget problem cited by the Governor). This budget problem is driven by two key factors: higher baseline spending, most notably in Medi-Cal, and lower revenues, reflecting diminished expectations for both the personal income tax and the corporation tax. The Governor Mainly Proposes Addressing the Budget Problem With Spending Solutions. The May Revision proposes $9.5 billion in spending solutions, including about $5 billion in spending reductions. A significant share of these spending solutions are ongoing and grow to $17.5 billion by the last year of the administration’s forecast—helping to address, but not fully solve, the state’s persistent multiyear deficits. Notably, the administration does not propose using any more in reserves to address this new budget problem, which is prudent. Recommend Legislature Maintain Overall May Revision Structure. We recommend the Legislature address the budget shortfall with a similar approach that the administration took, namely adopting solutions that primarily put the state on more solid fiscal footing, rather than those that delay or exacerbate future problems. Moreover, we recommend avoiding committing to new activities. Finally, although we have not previously recommended the Legislature take decisive action to address the structural deficits, the state’s persistent fiscal imbalance and the added downside risks—particularly from potential federal actions— suggest a need for a more proactive approach. As such, we view the Governor’s focus on reducing multiyear spending as a reasonable and appropriate step. That said, the Legislature could allocate the mix of solutions differently, for example, by changing the types of programs, types of reductions, or mix of spending and revenue solutions adopted. INTRODUCTION On May 14, 2025, Governor Newsom presented coming days, we will analyze the plan in more a revised state budget proposal to the Legislature. detail, provide additional comments in hearing This annual proposed revised budget is referred testimony, and update our multiyear forecast of the to as the May Revision. In this brief, we provide a budget’s condition using our own projections and summary of and comments on this revised budget, estimates. (The information presented in this brief is focusing on the Governor’s proposals for and the based on our understanding of the administration’s overall condition of the state General Fund—the proposals as of May 15, 2025. In many areas, budget’s main operating account. At this time, our understanding of the proposals will continue our assessment is based on the administration’s to evolve.) revenue projections and spending estimates. In the www.lao.ca.gov 1 2025-26 BUDGET THE BUDGET PROBLEM In this section, we present our estimates of the creates a “settle-up” obligation that will need to be budget problem that the Governor addressed in the paid in a future year if 2024-25 revenues remain May Revision, focusing on the three-year budget unchanged. Smaller proposals, such as shifting window under consideration: 2023-24 to 2025-26. nearly $300 million in General Fund spending to the We begin by reviewing the evolution of the budget Proposition 4 (2024) climate bond, account for the condition, detailing how the outlook deteriorated remaining difference. from roughly balanced in January to a deficit today. Absent Proactive Choices Last Year, Budget Then, we summarize the proposals the Governor Problem Would Be Significantly Larger. In puts forward to address the budget problem. June 2024, the Legislature not only addressed the What Is a Budget Problem? A budget 2024-25 budget problem, but also took proactive problem—also called a deficit—arises when steps to mitigate the anticipated 2025-26 budget resources for the upcoming budget are insufficient challenge. The June 2024 budget package included to cover the costs of currently authorized services. $28 billion in budget solutions for 2025-26, A budget problem is inherently a point-in-time although savings from some of these actions have estimate that reflects information available at the since diminished. We provided further detail and time of development, forecasts of future revenues updated estimates of these solutions in our January and spending, and assumptions about the extent report, The 2025-26 Budget: Overview of the to which changes in costs are due to current Governor’s Budget (see Appendix 1). Without this policy (that is, whether or not they are “baseline legislative action, the current budget problem would changes”). When changes in costs do not occur be substantially larger. automatically under current policy, we count them as budget solutions or augmentations. We take HOW HAS THE BUDGET PICTURE this approach in order to provide the Legislature CHANGED SINCE JANUARY? visibility into the full scope of the administration’s In January, both our office and the administration choices. The remainder of this section walks assessed the budget as roughly balanced. Since through the sources of our differences with the then, the outlook has weakened, and we now administration and how those differences impact estimate the state faces a $14 billion budget the budget problem estimate. problem. This section outlines the major factors We Estimate Governor Addressed a contributing to that change. $14 Billion Budget Problem. Overall, our Revenues Lower by About $5 Billion. The assessment of the state’s budget condition for May Revision downgrades the administration’s 2025-26 is similar to that of the administration. revenue estimates by $5 billion. Revenues for While we estimate the administration addressed prior and current years are up a total of $6 billion, a $14 billion budget problem, the Governor primarily reflecting stronger-than-expect personal cited a figure of $12 billion. The reason for this income tax collections which are running $4 billion difference is mainly that the May Revision includes ahead of prior projections as of April. In contrast, a number of proposals that generate budget the administration’s forecast for the budget savings that our office considers budget solutions, year is down $11 billion, reflecting diminished but the administration would count as workload expectations for both the personal income tax and budget changes. Most of these are related to the corporation tax. proposals made in the January Governor’s General Fund Spending on Schools and budget. For example, this includes a proposal to Community Colleges Lower by $3.9 Billion. provide $1.3 billion less in total funding for schools Proposition 98 (1998) sets a minimum funding and community colleges than the estimated requirement for schools and community colleges constitutional minimum for 2024-25. This yields based on formulas in the State Constitution. one-time General Fund savings in that year but 2 LEGISLATIVE ANALYST’S OFFICE 2025-26 BUDGET Compared with the Governor’s budget, the General tax credit, and adds new proposals that bring the Fund portion of this requirement is down $3.9 billion total to nearly $2 billion—$1.6 billion in spending across 2024-25 and 2025-26. As we discuss and around $150 million in revenue reductions. later in this brief, the May Revision maintains These measures require additional budget solutions a cost-of-living adjustment (COLA) and other to maintain budget balance and include: spending increases for schools and community • Partially Reversing Funding Reductions colleges despite the drop in funding. for the University of California (UC) and Baseline Spending Higher by $12 Billion. California State University (CSU). The Baseline spending reflects the projected cost of largest May Revision discretionary proposal continuing existing services under current law and relates to the base funding cuts for UC and policy, prior to the adoption of any new budget CSU. The May Revision reduces planned solutions. Compared to the Governor’s January base cuts from 7.95 percent, as agreed to in budget, the administration now estimates baseline last year’s budget, to 3 percent. This change spending (excluding Proposition 98 spending on increases ongoing General Fund costs by schools and community colleges) is higher by $267 million for UC and $231 million for CSU. $12 billion. This represents an unusually large • Rebenching Proposition 98 for revision. For context, the comparable revisions Wildfire-Related Property Tax Losses. in the prior two budget cycles were $2 billion The May Revision proposes rebenching the (2023-24) and $2.7 billion (2022-23). The increase Proposition 98 minimum funding guarantee is primarily driven by higher costs in the Medi-Cal to account for property tax revenue losses program, which are projected to exceed January resulting from the January 2025 Los Angeles estimates by $10 billion over the three-year budget wildfires. This policy decision increases window: roughly $2 billion in 2024-25 and $8 billion the Proposition 98 guarantee, requiring in 2025-26. According to the administration, this an additional $172 million in General Fund growth is largely due to higher-than-anticipated resources over the budget window to offset per-enrollee costs, which reflects a range of factors those losses. like greater utilization of services, increased prices for medical care, and expanded use of high-cost In addition, the administration includes roughly specialty drugs. While these cost increases 70 other proposals, each with an estimated cost of affect all enrollee groups, the administration less than $100 million. (Appendix 3, forthcoming, attributes a significant share of the growth to provides a full listing of these items.) higher costs associated with individuals lacking All Other Changes Improve Budget Bottom satisfactory immigration status. In addition to Line by $2 Billion. Across the rest of the budget, Medi-Cal, the other main driver of increased costs the administration estimates a net improvement is higher-than-expected costs in the In-Home of $2 billion to the General Fund bottom line. Supportive Services (IHSS) program, related to both The largest component is a $1.5 billion upward higher caseload and hours per case. revision to the entering fund balance, primarily New Discretionary Spending and Revenue driven by higher-than-expected reversions of Proposals Total Nearly $2 Billion. The unspent funds and lower required Proposition 2 January budget included about $700 million in (2014) debt payments. The lower debt payments discretionary spending and revenue reductions. reflect weaker projected revenues in 2025-26, The May Revision retains most January proposals, which reduce constitutionally required transfers. including the Governor’s plan to expand the film www.lao.ca.gov 3 2025-26 BUDGET HOW DOES THE GOVERNOR $4.9 billion in such reductions. Key proposals include limiting provider overtime and travel hours PROPOSE ADDRESSING THE in the IHSS program (about $700 million, growing to BUDGET PROBLEM? nearly $900 million), reducing Medi-Cal payments Figure 1 summarizes the budget solutions to clinics that serve patients with unsatisfactory described in this section. The May Revision immigration status ($450 million, growing to primarily addresses the budget problem through $1.1 billion), and eliminating certain long-term spending-related solutions—totaling $9.5 billion— care facility benefits for this population (about which include reductions ($4.9 billion), fund $300 million, growing to $800 million). shifts ($3.2 billion), and delays ($1.3 billion). Fund Shifts. Fund shifts occur when the state A significant share of these spending solutions uses alternative fund sources—such as special are ongoing and grow to $17.5 billion by 2028-29 funds—to pay for costs typically borne by the in the administration’s forecast. In addition, the General Fund. These actions reduce General May Revision includes $4.1 billion in cost shifts Fund spending while displacing spending that and $330 million in revenue-related solutions. otherwise would have been supported by the Online Appendices 1 and 2 (forthcoming) provide a special funds. Because fund shifts typically result complete list of solutions by program area. in lower overall state spending, we categorize them as spending-related solutions. The May Spending-Related Solutions Revision includes an estimated $3.2 billion in fund Reductions. Under our definition, a spending shifts. Major proposals include shifting $1.5 billion reduction occurs when the Governor proposes in California Department of Forestry and Fire spending less than what is required under Protection operational costs to the Greenhouse Gas current law or policy—more commonly referred Reduction Fund, using $1.3 billion in Proposition 35 to as a spending cut. The May Revision includes (2024) revenues to support base growth in Medi-Cal, and Figure 1 moving roughly $300 million in climate-related project costs to How the May Revision Addresses the the Proposition 4 climate bond $14 Billion Budget Problem (about $270 million of which was initially proposed in January). These actions reduce the availability of these fund sources for other purposes. Delays. We define a delay as a proposal that reduces expenditures Cost Shifts within the budget window (2023-24 Reductions through 2025-26) but shifts those costs to a future year in the multiyear period (2026-27 through 2028-29). In effect, the Governor proposes to defer, rather than Revenue-Related Solutions eliminate, the spending. The May Fund Shifts Delays Revision includes about $1.3 billion in such delays, reflecting the administration’s proposed Spending-Related Proposition 98 settle-up payment. Solutions As a result, associated spending is likely to be higher in the out-years. 4 LEGISLATIVE ANALYST’S OFFICE 2025-26 BUDGET Revenue-Related Solutions Fund to cover unanticipated cost increases in Medi-Cal. While this payment has been made The Governor’s May Revision maintains a on a cash basis, the May Revision proposes January proposal to change the rules about that the state not recognize it in the budget how taxable profits are determined for financial this year (instead, it would be recognized institutions. The administration estimates this over multiple years and fully reflected by change would increase revenues on an ongoing 2034). This maneuver essentially creates basis by around $300 million per year. a loan from the state’s cash resources, Cost Shifts and a future obligation that is repaid when The May Revision includes about $4 billion in the state recognizes the payment that was cost shifts. We define cost shifts as budget actions already made. It conceptually similar to the that achieve savings in the present, but result in a Proposition 98 funding maneuver used in binding obligation or higher cost for the state in a last year’s budget—for more information on future year. In that way, these actions can be similar how these types of budget solutions work, to borrowing, but are often not explicitly structured see our report: The 2024-25 Budget: The as such. For example, major categories of cost Proposition 98 Funding Maneuver. shifts include: • Special Fund Loans. The May Revision also proposes using special fund loans, a • Medi-Cal Maneuver. Under state law, the more traditional form of borrowing, to help administration can transfer funds to the balance the budget. These loans are made on Medical Provider Interim Payment (MPIP) Fund a budgetary basis from borrowable special to help cover an appropriation deficiency funds with unspent balances. There are in Medi-Cal. These transfers are capped proposals for two new special fund loans: as a percent of Medi-Cal’s appropriation. $150 million from the Unfair Competition Law On March 12, the administration notified Fund and $400 million from the Labor and the Joint Legislative Budget Committee it Workforce Development Fund. had transferred $3.4 billion General Fund (around the maximum allowed) to the MPIP BUDGET CONDITION Figure 2 In this section, we describe the overall condition of the General Fund budget after accounting for General Fund Condition Summary the May Revision proposals and solutions. We also (In Millions) describe the condition of the school and community college budget. 2023-24 2024-25 2025-26 Revised Revised Proposed General Fund Budget Prior-year fund balance $51,769 $41,886 $34,321 Figure 2 shows the General Fund condition Revenues and transfers 195,879 225,673 214,558 under the May Revision. The state would end Expenditures 205,762 233,238 226,376 2025-26 with $4.5 billion in the Special Fund Ending fund balance $41,886 $34,321 $22,504 for Economic Uncertainties (SFEU). The SFEU Encumbrances $18,001 $18,001 $18,001 is the state’s operating reserve and essentially SFEU balance $23,885 $16,320 $4,503 functions like an end-of-year balance. The State Reserves Constitution’s balanced budget provision prohibits BSA $23,194 $18,292 $11,192 the state from enacting a negative SFEU balance SFEU 23,885 16,320 4,503 for the upcoming fiscal year, in this case, 2025-26. Safety net 900 — — Total Reserves $47,979 $34,612 $15,695 SFEU = Special Fund for Economic Uncertainties and BSA = Budget Stabilization Account. www.lao.ca.gov 5 2025-26 BUDGET While historically the state mostly has enacted School and Community College Budget SFEU balances between $1 billion and $4 billion, Overall Proposition 98 funding across 2024-25 the Legislature can choose to set the balance at any and 2025-26 is $4.6 billion below the January level above zero. estimate. This change consists of a $3.9 billion Under May Revision, Reserves Would decrease in the General Fund portion of the Total Nearly $16 Billion at End of 2025-26. funding requirement and a $753 million decrease in Legislative action taken last year planned for a local property tax revenue. Despite this drop, the $7 billion withdrawal from the Budget Stabilization May Revision continues to fund a COLA for existing Account (BSA) this year. The Governor’s May school and community college programs (revised Revision maintains that action, but does not down from 2.43 percent in January to 2.3 percent in propose using additional reserves relative to this May) and maintains most of the January spending action. (The budget also includes formula-driven proposals. To cover the drop in Proposition 98 adjustments to prior-year deposits, primarily in funding, the Governor proposes four main actions: 2023-24, resulting in about $200 million more • Deferring school and community college deposited into reserves.) All told, under the payments from the end of 2025-26 to the May Revision estimates and proposals, the state beginning of 2026-27 ($2.4 billion). would end 2025-26 with nearly $16 billion in total • Zeroing out the Proposition 98 Reserve reserves, including $11 billion in the BSA and by withdrawing deposits that are no $4.5 billion in the SFEU. longer required or were previously Multiyear Budget Deficits Persist Under the discretionary ($1.5 billion). Administration’s Estimates and Proposals. • Withdrawing or reducing several community According to the administration’s estimates and college proposals mainly involving information assumptions, budget deficits are projected to technology projects ($400 million). persist in future years, with operating deficits of approximately $15 billion to $20 billion annually • Accelerating a settle-up payment related to the through the outlook period (see Figure 3). These Proposition 98 requirement in 2024-25, which deficits would accumulate, resulting in a negative makes more funding available for school and $42 billion balance in the SFEU community college programs ($250 million). by 2028-29. As a result, these operating deficits represent future Figure 3 budget challenges the Legislature State Faces Future Budget Deficits would need to address. The Under the Administration's Estimates and Proposals budget outlook will differ under our (In Billions) revenue and spending projections, however. We plan to provide a more detailed analysis of the multiyear 2026-27 2027-28 2028-29 budget condition under our own projections in an upcoming report, -$5 The 2025-26 Budget: Multiyear -10 Budget Outlook. -15 -20 -25 6 LEGISLATIVE ANALYST’S OFFICE 2025-26 BUDGET COMMENTS Budget Structure more proactive approach. As such, we view the Governor’s focus on reducing multiyear spending as Governor’s Revenue Estimates Reasonable. a reasonable and appropriate step. We recommend We generally agree with the administration’s the Legislature adopt a similar level of ongoing assessment of the revenue outlook. Recent budget solutions in its final budget package. collection trends support its upgrade in prior- and current-year revenues. Meanwhile, mounting risks Maintaining Remaining Reserve Prudent. suggest its revenue downgrade in the budget year In the May Revision, the Governor chose not to is warranted. A turbulent federal policy environment draw additional funds from the state’s reserves poses significant risks to both the state’s already to address the budget shortfall that has emerged stagnant economy and a potentially overheated since January. Maintaining the state’s reserves stock market that is prone to volatility. This in this way would preserve them to be used for confluence of factors suggests there are limited future deficits, or as a flexible funding source to prospects for continued revenue growth in the avoid sudden disruption to services should there coming year. be midyear federal spending changes. For this reason, we recommend the Legislature maintain Focus on Solutions That Do Not Delay or this approach in the final budget package. Further, Exacerbate Budget Problems. Both our office and the May Revision maintains a January proposal to the administration have revised down our forecasts put certain changes to the state’s reserve policy for the budget position since January, reflecting before voters. This issue continues to deserve the more downside risk in the economy and revenues, Legislature’s attention and we have provided an and significantly higher-than-anticipated costs in analysis of this proposal in our report: Rethinking key programs, most notably Medi-Cal. Given these California’s Reserves. factors and the uncertainty about decisions by the federal government that could reduce funding to Budget Choices the state, we recommend the Legislature address Absent New Proposals, Fewer Budget the shortfall with a similar approach that the Solutions Would Be Required. The Governor’s administration took, namely adopting solutions that May Revision includes nearly $2 billion in new primarily put the state on more solid fiscal footing, discretionary spending and revenue proposals, rather than those that delay or exacerbate future including about $900 million in new ongoing problems. Moreover, we recommend avoiding spending and $300 million in ongoing revenue committing to new activities. reductions. Without these proposals, the state’s Governor’s Multiyear Spending Reductions budget problem would be smaller, requiring fewer Appropriate. Both our office and the administration budget solutions now and in the future. While the have forecasted significant out-year budget Legislature may support the Governor’s priorities, deficits in recent years, ranging from $10 billion to accepting these proposals involves trade-offs. nearly $30 billion annually. In addition, our most We recommend the Legislature carefully evaluate recent forecast showed that projected spending each new proposal to determine if it warrants growth exceeds both projected revenue growth inclusion given the state’s fiscal challenges. A high and historical patterns of spending increases. bar should be applied to new proposals, with even Although we have not previously recommended the greater scrutiny for ongoing commitments, to Legislature take decisive action to address these ensure only the highest-priority items are adopted structural issues, the state’s persistent imbalance in the final budget. and the added downside risks—particularly from potential federal actions—suggest a need for a www.lao.ca.gov 7 2025-26 BUDGET Governor’s Out-Year Spending Solutions Largely Focus on Large, Fastest Figure 4 Growing Health and Human Growth in Major State Programs From 2018-19 to 2024-25 Services (HHS) Programs. General Fund and Special Fund Of the total $9.5 billion in K-12 and Community Colleges Includes Local Property Taxes proposed spending solutions in the May Revision, $5.3 billion Average Growth Rate are proposed in the health and human services area. (Under the administration’s K-12 Education estimates, these solutions grow to $13.6 billion by 2028-29.) In Education general, we understand that in putting together this proposed budget, the administration CSAC focused on the state’s largest and fastest-growing Community Colleges programs—specifically Medi-Cal, IHSS, and the Department UC of Developmental Services CSU DSH (DDS). Figure 4 shows growth rates across the state’s largest DPH programs over the last decade. SSI/SSP Medi-Cal HHS Reductions Largely Health and Human Services Child Care Achieved Through Limiting Access to Programs. Ongoing IHSS reductions to Medi-Cal, IHSS, Environmental Resources and DDS largely are achieved DDS by limiting access in three CalRecycle CalFire CARB CPUC SWRCB ways: eligibility, benefits, and administrative requirements. Debt Related Retiree Health The largest eligibility-related GO Bonds solution is the freezing of the Medi-Cal enrollment for Criminal Justice CDCR individuals 19 and older with Judicial Branch unsatisfactory immigration status. The proposed solution Caltrans would mean adults with DMV Transportation unsatisfactory immigration CHP status not currently in the program could not enroll in the -15 -10 -5 5 10 15 20 25 30 35% future. The May Revision also CSAC = California Student Aid Commission; DSH = Department of State Hospitals; DPH = Department of Public Health; proposes to limit benefits for IHSS = In-Home Supportive Services; DDS = Department of Developmental Services; CARB = California Air Resources Board; this population by terminating CalRecycle = California's Department of Resources Recycling and Recovery; CPUC = California Public Utilities Commission; CalFire = California Department of Forestry and Fire Protection; SWRCB = State Water Resources Control Board; dental, IHSS, and certain CDCR = California Department of Corrections and Rehabilitation; DMV = Department of Motor Vehicles; and CHP = California Highway Patrol. long-term care coverage. Lastly, the May Revision includes a few solutions that would increase 8 LEGISLATIVE ANALYST’S OFFICE 2025-26 BUDGET administrative requirements. These include consider reductions in longer-standing program reinstating a complex asset limit test for Medi-Cal areas that may no longer be meeting legislative eligibility and limiting enrollment in the IHSS goals. Lastly, the Legislature could consider residual program, which could create administrative increasing revenues either through limiting or challenges for re-enrolling recipients who lose eliminating tax expenditures or increasing rates. access to IHSS services due to a loss of Medi-Cal We discuss ways to consider identifying these eligibility. While these proposed solutions would alternative solutions in our post Undertaking have different impacts, they ultimately would limit Fiscal Oversight. access to services. Encourage Legislature to Focus on Fiscal Legislature Can Choose Another Approach. Picture, Leave Other Policy Issues for Later. While we recommend the Legislature maintain the The Legislature has a few weeks to review same amount of ongoing solutions as proposed the May Revision and develop its own budget in the May Revision—both in the short and long plan. Finalizing this year’s budget plan involves term—the Legislature could allocate the mix challenging trade-offs that likely will impact of these solutions differently. For example, the service levels provided to Californians. As such, Legislature could adopt proposals over a broader we recommend the Legislature defer—without set of program areas. The May Revision does not prejudice—the policy-driven May Revision include major solutions in a few program areas that proposals that have limited budget implications received larger augmentations in recent years like to later in the year (or beyond). These include the child care, student aid, or public health (although administration’s proposals related to streamlining some of these programs received reductions in housing production, accelerating Delta conveyance the June 2024 budget package). The Legislature projects, changing requirements for state water also could consider alternative variations of quality control plans, regulating pharmacy benefit the administration’s proposals, such as limiting managers, and creating new state agencies for Medi-Cal enrollment for adults with unsatisfactory housing and consumer protection. This would allow immigration status based on populations of priority, the Legislature more time and capacity for sufficient like those with the lowest income, instead of timing consideration of the potential benefits, implications, of enrollment. Alternatively, the Legislature could and trade-offs associated with these proposals. www.lao.ca.gov 9 2025-26 BUDGET 10 LEGISLATIVE ANALYST’S OFFICE 2025-26 BUDGET www.lao.ca.gov 11 2025-26 BUDGET LAO PUBLICATIONS This report was prepared by Ann Hollingshead with contributions from staff 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. 12 LEGISLATIVE ANALYST’S OFFICE