The 2026-27 Budget: Initial Comments on the Governor's May Revision

analysis full 2026-27 BUDGET The 2026-27 Budget: Initial Comments on the Governor’s May Revision GABRIEL PETEK LEGISLATIVE ANALYST MAY 2026 www.lao.ca.gov 1 analysis full 2026-27 BUDGET 2 LEGISLATIVE ANALYST’S OFFICE analysis full 2026-27 BUDGET Executive Summary Despite Revenue Boom, Budget Architecture Relies on $20 Billion in Reserves. The May Revision’s estimate of tax revenues in the current year represents over 30 percent growth from three years ago. Much of this growth is driven by the personal income tax, which is up nearly 50 percent during that same period. Periods of elevated revenues like these are typically when the state should be strengthening its fiscal position. Instead, the May Revision draws it down—relying on roughly $20 billion in reserve withdrawals and suspended deposits, as well as $4 billion in borrowing (on top of tens of billions of dollars in existing borrowing), to achieve budget balance. Structural Problem Is Now Upon the State. For several years, we have cautioned that structural deficits were emerging and would soon require corrective action. Despite the current revenue boom, the state now faces a structural budget imbalance—meaning ongoing revenues are insufficient to support ongoing expenditures. Structural Deficits Persist Future Deficits (In Billions) Have Come Down Substantially, but 2026-27a 2027-28a 2028-29 2029-30 State Ill-Prepared for -$2 a Slip Up in Revenues. -4 In January, we noted that our office and the -6 administration estimated -8 the state faced future -10 deficits between $20 billion -12 and $30 billion per year. -14 DOF Operating Deficits Adjusted for LAO Revenue Estimate Due to a combination of -16 DOF Estimate of Operating Deficits higher revenue estimates, -18 lower baseline spending, a Excludes transfers to the Temporary Surplus Holding Account (TSHA). and ongoing proposals DOF = Department of Finance. (which both raise revenue and reduce spending), the May Revision cuts these future deficits in half. Despite this progress, the underlying budget condition is not sound. First, the existence of any operating deficits during a revenue boom of this magnitude is itself a warning sign. Further, given the state’s diminished reserves and already accumulated wall of debt, California is ill-prepared for even a slip up in revenues. Even just a repeat of the 2022 market declines, which were mild by historical standards, could quickly push the budget into deep deficits. Alarmingly, given current market conditions, the dot-com bust probably is a better parallel. If such scenario were to repeat, the revenue hole could be $100 billion. Recommendations. The state’s current fiscal situation is genuinely unprecedented. Despite booming revenues, the budget position is overextended, reflecting: a structurally higher spending base, diminished reserves, an already accumulated wall of debt, and an operating deficit. www.lao.ca.gov 3 analysis full 2026-27 BUDGET As such, we recommend the Legislature take action to put the budget on sound fiscal footing, including: • Maintaining Amount of Ongoing Solutions Proposed by Governor. We recommend the Legislature maintain at least the amount of ongoing solutions included in the May Revision. • Making a $20 Billion Discretionary Reserve Deposit. In light of current revenue conditions, we recommend the Legislature make a $20 billion discretionary deposit into the Budget Stabilization Account (BSA) this year. This would make notable progress toward the administration’s proposal that the state raise BSA reserves to 20 percent of General Fund tax revenues. • Setting Aside $4 Billion for Potential Settle-Up Obligation. We recommend the Legislature set aside $4 billion to pre-fund this likely obligation. Taken together, these recommendations require the state to identify roughly $24 billion in new budget capacity—or solutions—relative to the Governor’s May Revision. The Legislature could make significant progress toward this total by rejecting the proposals to set aside nearly $10 billion for next year and about $1 billion in new discretionary spending. 4 LEGISLATIVE ANALYST’S OFFICE analysis full 2026-27 BUDGET INTRODUCTION On May 14, 2026, Governor Newsom will analyze the plan in more detail and provide presented a revised state budget proposal to additional comments in hearing testimony. the Legislature. This annual proposed revised (The information presented in this brief is based budget is referred to as the May Revision. In this on our understanding of the administration’s report, we provide a summary of and comments proposals as of May 15, 2026. In many areas, on this revised budget, focusing on the overall our understanding of the proposals will continue condition of the state General Fund—the budget’s to evolve.) main operating account. In the coming days, we MAY REVISION BALANCED ON HIGHER REVENUES AND RESERVES Higher Revenues Improve Budget Higher Spending Somewhat Offsets Higher Condition. Relative to the Governor’s budget, the Revenues. Under two initiatives, the State administration’s May Revision estimate of revenues Constitution requires the state to set aside a share across the budget window (2024-25 to 2026-27) are of revenues for schools and community colleges higher by about $16 billion. This upgrade is almost (Proposition 98, 1988) and debt payments and entirely attributable to expectations for income tax reserve deposits (Proposition 2, 2014). In line with collections, which are being driven by enthusiasm the administration’s higher revenue estimates, around artificial intelligence (AI) and the related both these requirements are also up. Across the stock market boom. This improves the budget’s rest of the budget, however, spending is slightly bottom line. lower, largely reflecting updated estimates of state employee pension costs, which are driven by a technical correction. SOLUTIONS AND DISCRETIONARY CHOICES IN MAY REVISION SOLUTIONS Revenue-Related Solutions The May Revision includes $14 billion in solutions Proposes Larger Managed Care Organization in 2025-26 and 2026-27 as shown Figure 1 (MCO) Tax. The MCO tax is a specific tax on health on the next page. This includes: $2 billion in plans (such as Kaiser Permanente and Anthem revenue-related proposals, nearly $3 billion in Blue Cross) that helps pay for Medi-Cal. It currently spending-related solutions (including spending provides around $7 billion to $8 billion annually. It is reductions and fund shifts), $4 billion in new set to expire at the end of 2026. The Governor’s borrowing, and suspended reserve deposits of budget assumed renewal of the tax in 2027, but at more than $5 billion. These solutions reflect all a much lower level—just tens of millions of dollars of those included in the May Revision, as well as in annual revenue. The expected sizable reduction those originally proposed in January. The remainder reflected the administration’s understanding of of this section walks through each of these recent federal and state policy changes. The components in more detail. administration now believes it can pursue a larger www.lao.ca.gov 5 analysis full 2026-27 BUDGET to apply the state’s sales tax to Figure 1 prewritten software delivered in other ways—such as downloads $14 Billion in Budget Solutions in the May Revision and remote access—beginning in 2027. Custom software would Spending remain exempt. The administration Solutions Reduce Spending estimates that this would raise General Fund revenue by $450 million and local sales tax Fund Shifts revenue by $560 million in 2026-27, growing to $900 million General Suspended Fund and $1.1 billion local revenue Reserve Deposits in 2027-28. Raise Revenues Spending-Related Solutions Additional Borrowing Expands Package of Medi-Cal Solutions. The May Revision includes additional spending-related budget solutions Note: Figure excludes about $100 million in reversions also included in the May Revision. in Medi-Cal relative to the Governor’s budget. In 2026-27, tax and remain legally compliant. Accordingly, the additional savings would be the May Revision proposes a 2027 MCO tax that $1.8 billion, mostly from a limited-term proposal provides around $2 billion annually. The Governor to use more funding from Proposition 35 (2024) proposes using all of the revenue to offset General to help pay for Medi-Cal provider rate increases. Fund costs in Medi-Cal, resulting in annual savings The May Revision also includes several new of $575 million in 2026-27 and around $2 billion in ongoing solutions, including proposals to lower the subsequent years. asset limit for seniors and persons with disabilities Proposes Permanent Limit on Business Tax and to increase the monthly premium charged Credits. California allows corporations to claim a to adults with unsatisfactory immigration status. variety of tax credits that reduce their tax liability Including proposals from January, the May Revision on a dollar-for-dollar basis. Taxpayers that have solutions associated with Medi-Cal are $2.2 billion enough credits are allowed to reduce their tax bill in 2026-27, including $400 million in reductions and down to $800. Under the May Revision, beginning $1.8 billion in fund shifts. in 2027, businesses would only be allowed to use All Other Spending-Related Solutions Total tax credits to reduce their corporation tax liability $500 Million. Across the rest of the budget, by 50 percent or $5 million, whichever is greater. the May Revision includes $500 million in other In contrast to recent limits on business credits, this spending-related solutions (including both change would be permanent. The administration proposals that persist from January and new estimates this would increase corporation tax proposals in May). These are relatively evenly revenues by $850 million in 2026-27 and $1.7 billion split between spending reductions and fund in 2027-28. shifts. For example, other spending-related Apply Sales Tax to Retail Sales of Digital solutions include: about $200 million in behavioral Prewritten Software. Software not customized health offsets across a variety of departments, for a particular client is called prewritten software. $50 million in savings to align In-Home Supportive The state’s sales tax currently applies to prewritten Services eligibility with Medi-Cal, and $50 million software delivered on tangible media but not to in a reduction in the cost-of-living adjustment for other sales of software. The May Revision proposes child care. 6 LEGISLATIVE ANALYST’S OFFICE analysis full 2026-27 BUDGET Borrowing administration’s revenue estimates, an additional $5.4 billion true-up deposit is now required for that May Revision Includes $4 Billion “Settle-Up” year. The May Revision proposes the state suspend Obligation. The May Revision generates a this entire true-up deposit. $4 billion settle-up payment by providing less than the constitutionally required funding level NEW COMMITMENTS for schools and community colleges in 2025-26. (The Governor’s budget had proposed a larger Revenue and Spending Commitments settle-up payment of nearly $6 billion.) Settle up gives the state more budget capacity this year, New Discretionary Proposals of $1.3 Billion. but if revenues meet expectations for 2025-26 The May Revision includes $1.3 billion in new it would eventually require the state to make a discretionary proposals (some of which were payment of this amount to schools and community proposed at Governor’s budget). These use budget college districts. (Conversely, if revenues fall short capacity and mean that more solutions are required of their projections, the state’s settle-up obligation to balance the budget. This entire amount is driven would decline.) We understand this proposal is almost exclusively by many small proposals rather intended, in part, to acknowledge revenue risks than a few larger proposals. For example, some of and avoid unintentionally spending more than the the largest of these items are: $76 million for utility minimum requirement if revenues decline and the replacement and site improvements at Exposition requirement drops. Park; a $68 million reappropriation for broadband last-mile infrastructure; and $56 million for a May Revision Would Bring Total Borrowing disaster rebuilding program. The remainder of the Close to $30 Billion. Recent budgets have relied list includes about 100 proposals, mostly less than on over $25 billion in budgetary borrowing to close $20 million. (This also includes $25 million for one budget gaps. These are amounts that will need to new revenue-related proposal in 2026-27 which be repaid in the coming years—most of which will grows to $100 million in 2027-28.) add to the state’s existing structural deficits. We call this budgetary borrowing the state’s new “wall Discretionary Reserves and Set-Asides of debt,” in line with a Great Recession era term Sets Discretionary Reserve Balance to that described budgetary borrowing accumulated $4.5 Billion. The Special Fund for Economic to partially address the state’s persistent budget Uncertainties (SFEU) is a general-purpose problems. The May Revision proposal to create reserve commonly used to provide capacity for nearly $4 billion in settle up would add to the wall unanticipated expenditures, including state costs of debt by that amount. (The May Revision also associated with disasters and other emergencies. reflects some repayments of certain debts.) On a technical basis, it can be thought of as the Suspended Reserve Deposits end balance of the state’s General Fund—the money that remains after accounting for all of the Suspends Budget Stabilization Account (BSA) state’s expected revenues and spending. The State True-Up Deposit of $5.4 Billion. Proposition 2 Constitution has a balanced budget requirement, outlines the formulas by which the state must, which means the balance of the SFEU must be set each year, make deposits into the BSA, unless above zero for the upcoming fiscal year (2026-27). those requirements are suspended under a budget Any level above that is up to the discretion of emergency. Proposition 2 also requires the state to the Legislature. As a result, we consider the revisit—or “true up”—its estimates of BSA deposits entire balance of the SFEU to be a discretionary twice: once in each subsequent fiscal year. These choice. That said, recent budgets have set the true-ups are required even if the initial deposit was SFEU between $3.5 billion and $4.5 billion, so the suspended; however, true-ups can themselves be Governor’s budget proposal to set the balance to suspended, as well. The state already suspended $4.5 billion is in line with recent policy. a $1.6 billion initial deposit for 2025-26. Under the www.lao.ca.gov 7 analysis full 2026-27 BUDGET Deposits $10 Billion Into Temporary Surplus surging. That said, although revenues are currently Holding Account (TSHA). The May Revision surging, by our count, there is no “surplus” to proposes a first-time deposit of nearly $10 billion overcommit. The nearby box describes this account into the TSHA—an account created to help the state and proposal in more detail. avoid overcommitting a surplus when revenues are What Is the Temporary Surplus Holding Account (TSHA)? Revenues Are Both Volatile and Uncertain. State revenues are volatile—they can grow or shrink rapidly from year to year, particularly because California’s tax system relies heavily high-income taxpayers. This means that, in some years, the state will collect significantly less in tax revenue than it has in spending commitments—resulting in large budget problems. Relatedly, there is significant uncertainty about near-term revenue estimates—that is, even for the upcoming fiscal year, revenues can come in significantly above or below projections, resulting in large forecasting errors. This is especially common when revenues are growing or shrinking rapidly. Reserves can help address both challenges—volatility and uncertainty. Historically, however, the state’s reserves have primarily been used to manage revenue volatility across economic cycles rather than short-term uncertainty in forecasting. TSHA Was Set Up to Avoid Overspending a Surplus. In 2024, the Legislature created the TSHA as a tool intended to manage near-term revenue uncertainty. As we understand it, the account was designed for periods when the state is experiencing surpluses during rapid revenue growth and might otherwise risk committing to new spending based on uncertain revenue estimates that might not materialize. The Legislature initially considered establishing formulas or rules governing deposits into the account. Ultimately, however, the TSHA was enacted as a flexible and largely discretionary mechanism. Governor Proposes Using TSHA for First Time in May Revision. The May Revision proposes depositing $9.7 billion into the TSHA in 2026-27 and withdrawing the same amount in 2027-28. We understand the administration derived this amount from the remaining resources available after accounting for baseline costs, budget solutions, and new proposals, including a Special Fund for Economic Uncertainties balance of $4.5 billion. In effect, the TSHA proposal uses anticipated resources from 2026-27 to help balance the budget in 2027-28. BUDGET CONDITION Budget Condition This Year Under May Revision, Reserves Would Total Nearly $20 Billion at End of 2026-27. Under Figure 2 shows the General Fund condition the Governor’s May Revision proposals and under the May Revision. The state would end assumptions, general-purpose reserves would 2026-27 with $4.5 billion in the SFEU. The SFEU total nearly $20 billion by the end of 2026-27. is the state’s operating reserve and essentially This includes an SFEU balance of $4.5 billion and functions like an end-of-year balance. The State about $15 billion in the state’s main constitutional Constitution prohibits the state from enacting a reserve, the BSA. These balances would be negative SFEU for the upcoming fiscal year, in this available to mitigate a future budget problem. case 2026-27. 8 LEGISLATIVE ANALYST’S OFFICE analysis full 2026-27 BUDGET Multiyear Budget Condition Figure 2 Budget Is Balanced in 2026-27 and 2027-28. General Fund Condition Summary The State Constitution requires the budget be (In Millions) “balanced” for the upcoming fiscal year. This means that cumulative resources available must 2024-25 2025-26 2026-27 Revised Revised Proposed not exceed cumulative expenditures across the budget window. In other words, the estimated SFEU Prior-year fund balance $54,124 $56,576 $56,190 for the budget year—in this case 2026-27—must Revenues and transfers 233,639 245,442 222,875 Expenditures 231,187 245,828 246,566 be greater than zero. (This was shown in Figure 2.) Ending fund balance $56,576 $56,190 $32,498 The administration also makes proposals that would Encumbrances $27,998 $27,998 $27,998 result in a balanced budget in 2027-28. The May SFEU Balance $28,578 $28,192 $4,500 Revision achieves this by relying on one-time resources. These include unspent money from Reserves BSA $18,596 $11,497 $15,075 prior years, use of reserves, and the TSHA-related SFEU 28,578 28,192 4,500 deposit and withdrawal. Safety net — — — However, Structural Deficits Persist Under Total Reserves $47,174 $39,689 $19,575 the Administration’s Estimates and Proposals. SFEU = Special Fund for Economic Uncertainties and BSA = Budget Stabilization Account. A budget is structurally balanced when revenues collected in a given fiscal year are sufficient to cover expenditures planned for that same year. (In addition, the state would have about $10 billion On this basis, the administration’s estimates show in the Proposition 98 Reserve, available only for operating deficits of roughly $10 billion annually school and community college programs.) from 2026-27 through 2029-30, as shown in Budget Relies on Use of $20 Billion in Figure 3. Beginning in 2027-28, these deficits Reserves From BSA. One major factor allowing represent the ongoing gap that would need to be the budget to achieve balance in Figure 2 is the use addressed in future budgets. of roughly $20 billion from the BSA. This amount reflects a combination Figure 3 of reserve withdrawals and the suspension of otherwise required Structural Deficits Persist deposits. Many of these actions (In Billions) were adopted in prior budgets. As a result, we treat most of them as 2026-27a 2027-28a 2028-29 2029-30 part of the “baseline” budget rather than as budget solutions. That -$2 said, in total, the $20 billion reserve -4 use consists of: (1) a $1.5 billion -6 suspension of the initially required -8 BSA deposit in 2024-25, (2) a -10 $5 billion BSA withdrawal in -12 2024-25, (3) a $7 billion suspension -14 of the initially required BSA deposit DOF Operating Deficits Adjusted for LAO Revenue Estimate -16 and true-up now required for DOF Estimate of Operating Deficits -18 2025-26, and (4) a $7 billion BSA withdrawal in 2025-26. a Excludes transfers to the Temporary Surplus Holding Account (TSHA). DOF = Department of Finance. www.lao.ca.gov 9 analysis full 2026-27 BUDGET Using Our Revenue Estimates Does Not May Revision Deposits $6.2 Billion Into Substantively Change the Picture. Figure 3 also Proposition 98 Reserve. The Proposition 98 shows the state’s operating deficits assuming Reserve is a statewide account earmarked our revenue estimates. (This shows our estimate exclusively for schools and community colleges. of revenues and revenue-driven spending, such The May Revision makes a $4.6 billion mandatory as for Proposition 98 and Proposition 2, but deposit into this reserve triggered by increased takes the administration’s estimate of all other capital gains revenue. It also makes a $1.6 billion spending.) As the figure shows, the picture of the discretionary deposit. The total reserve balance budget condition is essentially the same under our would grow to $10.3 billion, which equates revenue estimates. to 8.3 percent of the Proposition 98 funding requirement in 2026-27. Schools and Community Colleges May Revision Contains $6.9 Billion in New Budget Spending. After accounting for changes in the This section describes the May Revision Proposition 98 requirement, baseline costs, and spending and proposals for schools and community reserve deposits, among other adjustments, the colleges. The information presented in this section May Revision has $6.9 billion for new school and is relative to the administration’s January proposals. community college spending. This amount is in Proposition 98 Funding Requirement addition to the $10.9 billion in new spending from Revised Up Significantly. Proposition 98 sets the January budget. The Governor proposes a minimum funding requirement for schools and allocating most of the $6.9 billion for discretionary community colleges based on formulas in the State grants and augmentations to existing programs. Constitution. Compared with the January budget, Specifically, the May Revision prioritizes five the May Revision estimates that this requirement main areas: has increased by $6.4 billion over the 2024-25 • A significantly larger one-time discretionary through 2026-27 period. This increase reflects grant for schools ($2.3 billion). higher General Fund revenue estimates, partially • A major ongoing increase in special education offset by lower local property tax estimates. funding ($1.8 billion). Other Adjustments Make Additional Funding • A larger ongoing cost-of-living adjustment Available. Separate from the higher minimum for school and community college programs requirement, roughly $3.8 billion is freed up by ($1.5 billion). lower baseline costs in the state’s main school • Additional one-time funding for community funding formula over the 2024-25 through 2026-27 schools, including grants for planning, period. The Governor also scales back his January implementation, and technical support proposal to delay some Proposition 98 funding ($485 million). to future years, making an additional $1.6 billion • Additional one-time funding for literacy available in this year’s budget. Additionally, coaches that would support existing grant $807 million in unspent funds from previous recipients through 2030-31 ($440 million). budgets is available for reallocation. COMMENTS Budget Window this growth is driven by the personal income tax, which is up nearly 50 percent during that same Revenues Are Booming, but Estimates Are period. The May Revision anticipates these elevated Reasonable. The May Revision’s estimate of revenues will be sustained in the budget year, albeit tax revenues in the current year represents over with only modest growth. These assumptions are 30 percent growth from three years ago. Much of 10 LEGISLATIVE ANALYST’S OFFICE analysis full 2026-27 BUDGET roughly in line with our latest revenue forecast Multiyear and reflect the reality of extraordinary income Future Deficits Have Come Down tax collections in recent months and a booming Substantively… In January, we noted that our stock market. office and the administration estimated the state Despite Revenue Boom, Budget Architecture faced future deficits between $20 billion and Relies on $20 Billion in Reserves. Periods of $30 billion per year. Due to a combination of higher elevated revenues, such as the current cycle of revenue estimates, lower baseline spending, and strong personal income tax receipts, are typically ongoing proposals (which both raise revenue and when the state should be strengthening its fiscal reduce spending), the May Revision cuts these position. Instead, the May Revision draws it down— future deficits in half. As a result, under the May relying on roughly $20 billion in reserve withdrawals Revision, projected deficits are now closer to and suspended deposits, as well as $4 billion $10 billion per year. This is substantive progress in borrowing (on top tens of billions of dollars of and in line with our guidance in January. existing borrowing), to achieve budget balance. …But State Ill-Prepared for a Slip Up. Despite These actions should be reserved for addressing this progress, the underlying budget condition is revenue shortfalls in downturns, not to balance the not sound. First, the existence of any operating budget during a revenue boom. deficits during a revenue boom of this magnitude Structural Problem Is Now Upon the State. is itself a warning sign. Further, given the state’s For several years, we have cautioned that structural diminished reserves and an already accumulated deficits were emerging and would soon require wall of debt, California is ill prepared for even a corrective action. Despite the current revenue slip up in revenues. Stock market runs like the boom, the state now faces a structural budget one seen in the last three years almost always imbalance—meaning ongoing revenues are end in a dramatic reversal. Many classic warning insufficient to support ongoing expenditures. signs suggest this market run may be nearing its This condition is present in both 2025-26 and end. Should the stock market reverse course, tax 2026-27. The administration reports a structural revenues would decline significantly. Even just a deficit of $400 million in 2025-26 and $14 billion repeat of the 2022 market declines, which were in 2026-27. (In 2025-26, a one-time withdrawal mild by historical standards, could quickly push from the BSA reduces the operating deficit, the budget into deep deficits. Specifically, income but excluding that withdrawal—which is more tax revenues across 2022-23 and 2023-24 fell consistent with measuring ongoing budget $65 billion below 2022-23 Budget Act estimates. conditions—would result in a structural deficit of Alarmingly, given current market conditions, the about $7.5 billion in that year.) dot-com bust probably is a better parallel. If such scenario were to repeat, the revenue hole could be $100 billion. Using this year’s budget to build resilience would allow the state to weather this kind of shock without immediately needing to turn to tax hikes or cuts to ongoing services. www.lao.ca.gov 11 analysis full 2026-27 BUDGET RECOMMENDATIONS Maintain Amount of Ongoing Solutions Set Aside $4 Billion for Potential Settle-Up Proposed by Governor. In January, we Obligation. The administration’s settle-up proposal recommended the Legislature reduce the structural has merit in that it protects the budget from the risk deficit by at least half. The May Revision effectively of revenues coming in lower than anticipated and achieves that goal. We therefore recommend that— obligating the state to a spending level that is higher in the final budget—the Legislature maintain at least than constitutionally required. However, if revenues the amount of ongoing solutions included in the come in at or above the level currently anticipated May Revision. for 2025-26, the state will owe an additional Make a $20 Billion Discretionary Reserve $4 billion to schools and community colleges in Deposit. While the Governor has made progress a future year. In effect, this proposal allows the in addressing the state’s future budget problem, state to support more spending in the near-term the May Revision relies on reserves to support by creating a future obligation. We recommend near-term budget balance despite booming the Legislature set aside $4 billion in a reserve to revenues. The timing of these budget decisions pre-fund this likely obligation. matters. Near-term revenues are much more $24 Billion in Solutions Necessary to certain than those projected in later years, where Achieve Recommendations. Taken together, the uncertainty compounds. As a result, building recommendations above require the state to identify budget resilience now is just as important—if not roughly $24 billion in new budget capacity—or more so—than addressing structural deficits. solutions—relative to the Governor’s May Revision. In light of current revenue conditions, we Redirecting the transfer to the TSHA and rejecting recommend the Legislature make a $20 billion all of the Governor’s discretionary proposals discretionary deposit into the BSA this year, would yield about $11 billion in capacity—making reversing the reserve reliance described above. significant progress toward our recommended (There is no cap on discretionary deposits into the total. In addition, we recommend that any BSA. As such, under this recommendation, total potential upward revisions to revenue estimates reserves would reach 17 percent of General Fund between now and the budget enactment be used tax revenues, while also allowing for additional for additional reserve deposits. Even with these mandatory deposits into the BSA under the actions, however, the Legislature would still need to constitutional rules. This would make notable identify roughly $10 billion in additional solutions, progress toward the administration’s proposal including both revenues and spending, and which that the state raise BSA reserves to 20 percent of could either be ongoing or one-time. General Fund tax revenues.) 12 LEGISLATIVE ANALYST’S OFFICE analysis full 2026-27 BUDGET CONCLUSION The state’s current fiscal situation is genuinely not represent a sustainable long-term baseline unprecedented. Despite booming revenues, the for the budget. It also means aligning ongoing budget position is overextended, reflecting: a spending commitments more closely with the structurally higher spending base, diminished state’s long-run revenue capacity, prioritizing reserves, an already accumulated wall of debt, rebuilding reserves—even at the expense of and an operating deficit. Meanwhile, a revenue additional spending cuts or revenue increases— shock could be coming, as the state’s revenue and planning explicitly for downside scenarios. outlook rests disproportionately on AI-driven equity Should a significant revenue correction occur, the valuations that are trading at highs last seen at the state may require many of the same fiscal tools— peak of the dot-com bubble. reserves, borrowing, and budget flexibility—that These conditions warrant a disciplined and are currently being used to manage the existing cautious fiscal approach. In our view, this means structural imbalance. recognizing that recent revenue performance may www.lao.ca.gov 13 analysis full 2026-27 BUDGET 14 LEGISLATIVE ANALYST’S OFFICE analysis full 2026-27 BUDGET www.lao.ca.gov 15 analysis full 2026-27 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. 16 LEGISLATIVE ANALYST’S OFFICE