California faces $18 billion budget deficit in 2026-27

The Legislative Analyst’s Office released its outlook on the 2026-27 budget, highlighting the state’s weak position and an $18 billion shortfall.

The nonpartisan office releases the report annually to give the Legislature an idea of its starting point before the Assembly and Senate convene each January.

The main causes of the 2026-27 budget problems, the Legislative Analyst’s Office reported, include community college funding established by the passage of Proposition 98, which California voters passed in 1988. Main causes also include debt and reserve deposit requirements, which the state has to pay for in its annual budget, as established by Proposition 2, passed in 2014.

The funds the Legislature would have to allocate to pay for the expenses related to those two propositions would exceed almost all of the $11 billion gain in revenue the state raked in during the last year.

The Legislative Analyst’s Office told The Center Square on Friday that the state’s personal income tax collection is high because many high-income workers in California work in the technology industry, one of the state’s largest and wealthiest industries. Much of that personal wealth for those who work in tech is tied to investment assets, like stocks, according to the office.

With the uptick in the stock market associated with that excitement over artificial intelligence, concerns about that longevity fueled the Legislative Analyst’s Office’s “middle-ground” approach to the budget outlook.

“We’re trying to look at how sustainable that is, and we’re looking at these indicators that are telling us that the stock market is likely overheated,” said Carolyn Chu, chief deputy legislative assistant for the Legislative Analyst's Office.

“The run-up in the stock market is driven by many of these AI or AI-adjacent companies," Chu told The Center Square. "We also look at how the stock market tends to react to major innovations in technology, and often, the stock market overreacts to major innovations in technology, even when that technology can be quite transformative.”

While there is some doubt that the development of AI technology will continue fueling a rise in the stock market long-term, the budget outlook says AI is the one “bright spot” for potential revenue in the coming year. Excitement over AI technology hasn’t just been the main driver of strong income tax collection over the last two years in California, according to the budget outlook, but has also served to increase the stock market by 50% in the last two years.

“Most of these gains come from the meteoric rise in the value of a handful of tech companies that investors believe will be major beneficiaries of recent advances in AI,” the outlook reads. “These companies have made big bets on AI, spending hundreds of billions of dollars on data centers and offering extraordinary pay packages to recruit AI researchers.”

That overheated market has a few key signs, according to the Legislative Analyst’s Office, namely that investors are borrowing more to invest and households are becoming more invested in the stock market than they have been in 70 years.

Higher personal income tax collection in California, because it is tied so closely to the stock market, could also hold the potential to go down if a downturn in the stock market occurs, the Legislative Analyst's Office said. If it does, income tax collection will go down, leading to less revenue for the state to work with in its budget.

Moving ahead in forming a budget while knowing the financial challenges the state faces is imperative, the Legislative Analyst's Office said, especially since it could have implications for programs and services many residents of the state depend on.

“For the legislature to build in some of this insurance against a market turn is important,” Chu told The Center Square. “It is a challenge the legislature faces, because the lion’s share of spending that the legislature has control over does support services that support low-income Californians.”

Some legislators have already spoken out about the Legislative Analyst's Office’s findings in the annual budget outlook, with state Sen. Megan Dahle, R-Bieber, writing in an e-newsletter sent on Friday that the state’s budget outlook “is not an early Christmas present.”

“California has seen booms and busts – and their effect on state budgets – before,” Dahle wrote in the newsletter. “You’ve probably heard of the past few years’ budget deficits‚ which were largely resolved through one-time fixes‚ including internal borrowing and reserves. The state has fewer options left for those solutions‚ which means the coming budget year will demand difficult decisions and hard looks at what state programs are working and getting the taxpayers their money’s worth.”

The nonpartisan California Budget & Policy Center also responded to the release of the budget outlook in a press release on Wednesday, saying that the most affluent Californians are continuing to do well financially, while the majority still struggle to afford basic amenities.

“While these stronger-than-expected returns have boosted state revenues, they reflect a deeply unequal economy: one in which a small number of wealthy investors are doing exceptionally well, even as everyday Californians continue to struggle with rising costs and a weak labor market,” said Scott Graves, the budget director at the California Budget & Policy Center. “Rising costs in health and safety net programs signal that Californians need and value access to affordable health care and other supports, especially as federal funding continues to erode.”

Legislators who sit on budget and fiscal committees were not available on Friday to answer The Center Square's questions. Staff from Gov. Gavin Newsom’s office were also unavailable.