Q&A: What Does the Budget Shortfall Mean for California? (2024)

Building a just and equitable California for every person no matter their race, ethnicity, gender, age, or zip code requires investments to create health, housing, economic, and educational opportunities. The foundation for these investments is the state budget, through which policymakers can commit the funding needed to build a California where everyone can be healthy and thrive. But sustaining and expanding the state’s investments in individuals and communities becomes more challenging when revenues fall short of projections and lead to a state budget shortfall — as is the case this year.

This Q&A:

• looks at the size of the state budget shortfall and why it emerged,
• notes that state revenues could come in higher or lower than expected,
• outlines state leaders’ options for addressing the budget gap, including raising revenues and using reserves, and
• describes how advocates can work, even in a tough budget year, to advance their priorities and lay the groundwork for building a more equitable California.

What is the size of the budget shortfall?

California faces a budget shortfall — also known as a “budget problem,” “deficit,” or “gap” — of tens of billions of dollars. The shortfall is based on estimates of revenues and spending across three fiscal years: 2022-23 (the prior year), 2023-24 (the current year), and 2024-25 (the fiscal year that begins on July 1, 2024). This three-year period is known as the “budget window.”

Policymakers must close the deficit by June 2024 as part of the 2024-25 budget process by taking actions that apply to all three fiscal years. (Potential budget actions are described in later sections of this Q&A.)

There is no single, agreed-upon estimate of the current size of the budget shortfall. Estimates involve making assumptions about economic conditions, revenue collections, and the needs of California communities in the future. The governor’s administration and the Legislative Analyst’s Office (LAO) independently produce estimates of revenue collections and the state’s overall fiscal condition for the three-year budget window, and their assumptions are often different.

For the current budget window (July 2022 through June 2025):

• Governor Newsom’s proposed budget, released on January 10, estimates a shortfall of $38 billion.
• However, the actions the governor proposes to take to close the deficit add up to $58 billion, according to the LAO. This means the governor has actually identified a $58 billion budget problem, based on the LAO’s analysis, even though his “headline” number — $38 billion — is much smaller. The reason why there are two different numbers is that the governor and the LAO disagree about how to categorize some spending actions in the governor’s proposed budget.
• The LAO’s own estimate of the budget shortfall is $68 billion.

In short, the governor solves for a smaller budget shortfall ($58 billion) than the LAO projects ($68 billion). This difference is largely due to the governor’s more optimistic state revenue forecast. The governor currently assumes that revenues will be about $15 billion higher over the three-year budget window compared to the LAO’s projections.

Estimates of the budget shortfall will be updated in May as more information becomes available. The key takeaway is that the state has a sizable budget problem to address in this year’s budget process.

Why is California facing a budget problem this year?

The main reason for the budget problem is that state revenue collections have been coming in much lower than previously projected, and forecasts for future revenues have also been adjusted downward as a result. This occurs after several years of strong revenue growth that produced budget surpluses and made possible new spending commitments.

A large portion of the problem is related to state revenues for the 2022 tax year, which are estimated to be about $25 billion lower than policymakers expected when they adopted the budget for the current fiscal year last summer.

One major factor leading to the lackluster revenue performance in 2022 was the impact of the Federal Reserve’s interest rate hikes, which decreased investment, slowed economic activity, and contributed to a steep stock market decline. The stock market drop negatively impacted personal income tax collections from high-income earners, whose income is disproportionately made up of capital gains and stock-based compensation.

The extent of the 2022 revenue shortfall only became clear in late 2023 due to the extension of tax filing deadlines for 2022 taxes to November 2023. Because of this delay, state leaders had to finalize the 2023-24 budget last June with much less complete revenue information than usual, and they enacted a budget assuming significantly more revenue for the 2022 tax year than actually materialized.

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

The estimated budget shortfall is just that — an estimate. In May, the governor’s Department of Finance and the Legislative Analyst’s Office will release updated projections of the size of the budget gap. These new numbers will take into account the most recent information available on the economy, revenues, and spending needs.

The governor’s updated estimates will be unveiled in his revised budget (the “May Revision”), which must be released by May 14. The May Revision will set the stage for negotiations between the governor and legislative leaders in June over the key outlines of the 2024-25 budget package.

At that point, the state will have mostly complete information on 2023 tax receipts since the April tax deadline will have passed. Policymakers also will have some information on 2024 tax collections from quarterly estimated tax payments by businesses and high-income individuals. However, the revenues assumed in the 2024-25 budget, when enacted this summer, will involve some projections. In other words, it is still possible that actual revenues for the 2022-23 through 2024-25 period (the “budget window”) will be higher or lower than expected.

If revenues come in higher than anticipated, state leaders could revisit some of the spending reductions, spending delays, and/or other “budget solutions” that they decide to adopt in June. Alternatively, if revenues were to come in significantly lower, state leaders would need to take additional actions, potentially including more spending solutions, although such actions would likely not occur until early to mid-2025 as part of the 2025-26 budget cycle.

What revenue-raising options do state leaders have to balance the budget?

Policymakers have many options to increase state revenues and make the state’s tax system more fair. These options should be seriously considered, not just to address the current budget problem, but also to strengthen state services on an ongoing basis and create a more equitable state.

State leaders consistently fail to examine the tens of billions of dollars that the state loses to tax breaks each year as part of the annual budget process. Many of the largest tax breaks primarily benefit wealthy corporations and high-income individuals. Eliminating or scaling back ineffective or inequitable tax breaks would provide additional revenue to support Californians struggling with the basic costs of living while also increasing tax fairness.

For example, the state is estimated to lose around $4 billion a year to a tax break called the “water’s edge election.” This break incentivizes corporations to avoid taxes by using foreign tax havens. Policymakers should ensure that corporations are sufficiently contributing to state revenues by reexamining this and other corporate tax breaks.

Policymakers can also restructure corporate tax rates so that the small number of immensely profitable corporations — which receive the majority of profits in the state — are subject to a higher tax rate than less profitable corporations.

Wealthy corporations can afford to pay their fair share in state taxes. Corporate profits are near record highs, yet corporations contribute a smaller share of their profits toward state taxes than they did a generation ago due to tax cuts and tax breaks approved by state policymakers. Increasing corporate taxes would only affect businesses that report profits, so it would not impact businesses’ ability to pay their workers and cover their other expenses.

The governor did put forth modest revenue solutions in his proposed 2024-25 state budget, but they make up less than 1% of the overall package of solutions — a package that also includes substantial spending cuts that would negatively impact Californians facing the most disadvantages. Policymakers could avoid painful cuts by growing state revenues instead of focusing mainly on spending solutions as the governor has proposed.

What other options do policymakers have to balance the state budget?

Aside from increasing revenues, policymakers have several additional tools to close the budget shortfall in a way that minimizes the impact on public services — particularly services that reduce poverty and prioritize economic opportunities, well-being, and the overall improvement of Californians’ lives.

One option is to use the state’s General Fund reserves. 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 bolster programs that 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 state revenues are expected to 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 borrow from state special funds. Many 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 that are typically supported with General Fund dollars. The borrowed funds are later repaid with interest when General Fund revenues rebound. However, policymakers should avoid borrowing from a special fund if doing so would compromise the state’s ability to achieve the policy goal for which the fund was created.

Another option is to shift General Fund costs onto another fund source, such as a special fund. In this case, the dollars are not borrowed. Instead, the General Fund cost displaces spending that the special fund would otherwise have paid for. This would include, for example, shifting climate-related costs from the General Fund to the Greenhouse Gas Reduction Fund or paying for the state’s typical costs for Medi-Cal with revenues from the managed care organization (MCO) tax. The governor has proposed both of these actions as part of his 2024-25 spending plan.

Borrowing from and/or shifting costs onto special funds is a reasonable and prudent 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.

Policymakers also can revert, delay, and/or reduce appropriations to help close a budget gap.

• A reversion means returning unspent funds to the General Fund when state costs come in “below budgeted amounts.” Funds are typically reverted after three years, but reversions can be accelerated.
• A delay means moving an expenditure to a later period when revenues may be more robust.
• A reduction means providing less funding than “what has been established under current law or policy.” This could involve either partially or entirely eliminating the expenditure.

Spending reductions should be used with caution and especially should avoid targeting services that support Californians’ health and well-being — things like cash aid, food assistance, child care, and health care. Services like these are lifelines for individuals and families, and cutting them would disproportionately impact low-income communities and Californians of color.

Instead, if spending reductions are needed to help balance the budget, they should target ineffective spending, such as poorly targeted tax breaks as well as the billions of dollars that annually fund the state’s costly and inequitable prison system.

How much does the state have in budget reserves, and when can those funds be used?

California policymakers’ prudent decisions to set aside funds for a rainy day mean the state has significant resources to address a budget shortfall.

At the end of January 2024, California held a total of more than $25 billion in four state budget reserves:

• the Budget Stabilization Account (BSA),
• the Public School System Stabilization Account (PSSSA),
• the Safety Net Reserve, and
• the Special Fund for Economic Uncertainties (SFEU).

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, Safety Net Reserve, and SFEU 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.

First Look: Understanding the governor’s 2024-25 state budget proposal

Learn about the key pieces of the 2024-25 California budget proposal, and explore how the governor prioritized spending and determined cuts amid a sizable projected state budget shortfall.

Read Report

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.

State law specifies that funds in the Safety Net Reserve are intended to support CalWORKs and Medi-Cal benefits and services during an economic downturn. However, the Legislature may allocate these funds for other purposes if the governor signs a bill to do so.

Governor Newsom’s 2024-25 budget proposes withdrawing the entire Safety Net Reserve while also making cuts to the CalWORKs program. These proposals likely run counter to the intent of the Legislature when it created a reserve fund to support families with the greatest need. Moreover, draining the Safety Net Reserve would leave no funds to support CalWORKs and Medi-Cal benefits and services if economic conditions worsen.

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 much greater scrutiny — and significantly higher hurdles — compared to years when state revenues are stronger. But advocates still have options for navigating a tough budget year.

Advocates can push for new revenues and a fairer tax system. Revenues are a key tool in the budget-balancing toolbox and can prevent harmful spending cuts when there’s a budget shortfall. For example, advocates can encourage state leaders to examine the tens of billions of dollars that the state loses to tax breaks each year as part of the annual budget process.

Ensuring that our state has adequate revenues to support robust public services should be a top long-term priority regardless of the state’s fiscal condition. New revenues are needed to continue making progress toward an equitable state where everyone can be healthy and thrive, and advocates can make that case even in a tough budget year.

Advocates can also urge policymakers to protect recent policy gains and funding commitments, particularly investments that help to create a more equitable state. These include investments in child care, housing, health care, assistance for older adults and people with disabilities, and other critical services. Many recent investments could be at risk if the governor’s May Revision identifies a much larger budget gap than currently anticipated, so advocates will need to make a strong case for protecting recent gains and urge policymakers to exhaust alternatives to cuts to vital services.

Furthermore, advocates can plan for the future by continuing to make the case for additional state investments that prioritize the overall improvement of Californians’ lives. Advocates can 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. Educating policymakers today can lay the groundwork for policy wins and expanded funding when the revenue situation improves.

In some cases, state leaders may be open to adopting a policy change, while delaying implementation until funding is provided in a subsequent state 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. However, given the significant budget challenges the state is facing, policymakers may be reluctant to commit now to a future expansion of services, even if it’s only “on paper.”

Finally, advocates should keep in mind that the budget is never truly final when the governor signs the budget package into law each June. State leaders always return to the budget later in the summer, making minor and sometimes substantial changes. For example, the Legislature may pass amendments that change the spending levels in the Budget Act. Lawmakers also may pass additional trailer bills, thus increasing the size and scope of the original budget package.

Unexpected opportunities can always emerge — so advocates should be prepared to advance their priorities through the budget process year-round.