Q&A: What Does the Projected Budget Shortfall Mean for California?

This Q&A explains why California faces a budget problem, highlights the challenges with estimating revenues this year, outlines state leaders’ options for addressing the budget gap — including using reserves — and describes how advocates can advance their policy priorities and lay the groundwork for building a more equitable California even in a tough budget year.

Why is California facing a budget problem this year?

While California experienced extremely strong revenue growth in recent years, state forecasters are now estimating that revenues will come in significantly below expectations for the three-year “budget window” ending in fiscal year 2023-24. Specifically, the governor’s budget proposal assumes that revenues over this budget window will be $29.5 billion lower than estimated in the 2022 Budget Act, before accounting for required transfers into the state’s rainy day fund.

The Legislative Analyst’s Office (LAO) has projected a larger shortfall, noting that the governor’s revenue estimate is $13.6 billion higher than the LAO’s estimate. Revenues are expected to fall short primarily due to lower current-year personal income tax withholding and estimated payments, a weaker stock market, and the risk of an economic slowdown resulting from high inflation and interest rate hikes intended to combat inflation.

Under these lower revenue estimates, the state would not have enough resources to support currently authorized services. The governor’s proposed spending plan assumes the state will face a $22.5 billion budget shortfall, or deficit, without taking actions to balance the budget. Because the state Constitution requires the budget to be balanced, the governor proposes a combination of solutions to address the budget shortfall, including delays or reductions in previously planned spending, and cost shifts, but not the use of the state’s substantial reserves.

Could state revenues come in higher — or lower — than current projections?

The estimated budget shortfall is just that — an estimate. A lot can change in the economy between now and May, when the governor’s Department of Finance and the Legislative Analyst’s Office will update their revenue estimates based on the most recent information. The governor’s revised budget (the “May Revision”) will adjust his January budget proposals to reflect the administration’s updated revenue estimates, and state leaders will negotiate the 2023-24 budget package using the most current revenue numbers (either the governor’s or the LAO’s).

However, there will be additional uncertainty in the May revenue estimates this year.  The governor has extended income tax payment deadlines for individuals and businesses affected by the winter storms that battered much of the state in early January.

The filing deadline for personal income taxes — the state’s largest revenue source — as well as the January and April estimated tax payment deadlines will be pushed to May 15 this year for filers in counties that were declared as disaster areas. This means that forecasters will have limited information when updating their revenue estimates. Since January and April are two of the most important tax collection months, the filing extension will create considerable uncertainty and make the process of  balancing the budget more difficult for policymakers.

What options do policymakers have to balance the state budget?

Policymakers have several tools to close the budget shortfall in a way that minimizes the impact on public services — particularly those that reduce poverty and help Californians with low incomes make ends meet. One option is to use the state’s General Fund reserves to address a budget shortfall. In fact, the state has built up substantial reserves precisely to help support critical services when revenues fall short.

State leaders especially should use reserve funds to help Californians meet basic needs like food, health care, housing, and child care. However, reserves should be used prudently. Reserve funds may be needed over multiple fiscal years, particularly if the economy slides into a recession and revenues decline over an extended period. (See below for more on the state’s General Fund reserves and how they may be used.)

Policymakers also could shift costs from the General Fund to state special funds that have the capacity to support additional services. For example, some of the state’s 500+ special funds may have large balances that aren’t immediately needed. The state could borrow these excess revenues and use them to temporarily support services typically paid for with General Fund dollars.

Any money borrowed from special funds would later be repaid with interest when General Fund revenues rebound. Shifting costs across funds is a reasonable budgeting practice. This approach can help to close a state budget gap in a way that minimizes the need for cuts to critical public services without compromising the state’s fiscal health.

Another option for balancing the budget while protecting core services is to raise revenues from corporations and the wealthy, the beneficiaries of windfall gains and profits in recent years. Corporations contribute a smaller share of their profits toward state taxes than they did a generation ago, partly due to tax cuts approved by state policymakers. More broadly, the state loses around $70 billion each year to corporate and individual tax breaks, many of which largely benefit profitable corporations and high-income households. These include wasteful tax breaks like the film tax credit.

Carefully targeted tax increases are a compelling option for closing a budget shortfall. Boosting the corporate tax rate, for example, would only affect businesses that report profits. Moreover, raising taxes on higher-income households would minimize the impact on the economy because the wealthy are more likely to reduce their savings rather than their spending in response to a tax increase.

Policymakers also can delay or reduce spending to help close a budget gap. Delaying an expenditure moves it to a later period when revenues may be more robust. In contrast, a reduction eliminates a previously approved expenditure. Spending reductions should be used with caution. In particular, any cuts should avoid eroding services that help families and individuals make ends meet and support their health — things like cash aid, food assistance, and child care. Instead, policymakers should eliminate ineffective expenditures, such as poorly targeted tax breaks as well as the billions of dollars that annually fund the state’s bloated, costly, and inequitable prison system.

How big are the state’s budget reserves, and when can those funds be used?

California policymakers’ prudent decisions to set aside funds for a rainy day mean the state is well prepared to address a potential budget shortfall. At the end of 2022, California held a total of $37.7 billion in four state budget reserves:

California’s Constitution and state law govern when funds may be withdrawn from these reserves, the amount that can be withdrawn, and how funds may be used. For example, the state Constitution only allows withdrawals from the BSA and PSSSA if the governor declares a budget emergency and the Legislature passes a bill, by majority vote, that approves the withdrawal. In contrast, state law allows the Legislature to withdraw funds from the Safety Net Reserve or the SFEU at any time by majority vote.

All of the funds in the PSSSA, SFEU, and Safety Net Reserve may be withdrawn in one year. However, a withdrawal from the BSA is limited to the lower of the amount needed to address the budget emergency or 50% of the BSA balance, unless funds had been withdrawn in the previous fiscal year in which case all of the funds remaining in the BSA may be accessed.

The PSSSA is the only reserve with strict limits on the use of its funds, which must be provided to support K-12 schools and community colleges. On the other hand, the Legislature may use funds from the BSA and the SFEU for any purpose. In addition, while Safety Net Reserve funds are intended to support CalWORKs and Medi-Cal benefits and services during an economic downturn, the Legislature may allocate these funds for other purposes if the governor signs a bill to do so.

What should advocates keep in mind when advancing their policy priorities this year?

Advocating for policies and the funding to support them is clearly more challenging when the state faces a budget shortfall, like it does this year. In particular, proposals that call for new spending will face greater scrutiny — and higher hurdles — compared to years when state revenues are stronger.

One option for advocates in a tough budget year is to focus on protecting recent policy gains and funding commitments. These include investments in child care, housing, health care, assistance for older adults and people with disabilities, and many other critical services — any of which could be at risk if the budget gap grows. State leaders also have prioritized several policies for implementation in 2024-25 — if revenues are sufficient to support them. These policies include boosting CalWORKs grants and cutting red tape in the Medi-Cal program so that young kids can be continuously enrolled in health coverage. These pending policies could be threatened if revenues further weaken over the coming months.

Furthermore, advocates can continue to make the case for new state investments to help Californians be healthy and thrive. Advocates should educate state leaders about Californians’ ongoing needs, highlight policy solutions, and seek allies to help advance their proposals — using both the policy bill process and the budget process. These actions can lay the groundwork for policy wins and expanded funding when revenues rebound.

Faster progress also is possible. For example, state leaders may be open to adopting an ambitious policy change, but may also delay implementation until funding is provided in a future budget. This approach keeps the issue on the state’s “front burner” and puts advocates in a good position to argue for the needed resources in a future state budget cycle.

Finally, advocates should keep in mind that state budget decisions won’t end in June when the 2023-24 budget package is signed into law. Policymakers always make changes to the budget in August, revising the policies and funding levels approved in June. If the state’s revenue situation improves during the summer, advocates would have another opportunity to advance their policy priorities through the state budget process this year.