Authored by Tom Ozimek via The Epoch Times,

California is staring at another major budget shortfall, as the state’s nonpartisan Legislative Analyst’s Office (LAO) has projected that next year’s deficit will hit nearly $18 billion and described the state’s budget position as “relatively weak.”

The LAO report, released on Nov. 19, is an early look at the 2026–2027 budget. It paints a picture of a state with growing obligations, slowing economic momentum, and fewer tools left to steady itself as it faces the prospect of the fourth straight year of operating in the red.

The forecast points to a widening imbalance between the state’s spending commitments and the revenue needed to support them, even as a surge in personal-income tax collections from the artificial intelligence (AI) boom has lifted California’s finances in the short term.

“The budget condition right now has become relatively weak,” legislative analyst Gabriel Petek told reporters during a Nov. 19 briefing, noting that although tax receipts remain strong, virtually every other indicator reflects a slowing state economy.

AI Windfall Comes With Big Risks

One reason revenues look better than expected is the extraordinary strength of the stock market, driven largely by investor enthusiasm in AI and massive spending by tech companies on data centers and specialized talent. Income-tax collections have grown at double-digit percentages, and compensation for workers in AI-related fields has sharply increased taxable income.

But the LAO warns the surge may not last. The report highlights several signs that the market could be overheating—high valuations, rising investor leverage, and historically elevated household exposure to equities—all of which echo past periods of unsustainable growth.

Analysts at LAO cautioned that assuming continued gains would be risky, especially given the potential for a stock-market correction that could sharply reduce tax revenues.

“In the past, these patterns have been a sign that a stock market downturn will occur in the next couple of years,” the report states.

“There certainly is some chance that this time is different and such a downturn is not forthcoming. Nonetheless, the risk appears strong enough—and the potential consequences for the state budget dire enough—that we think it should be incorporated in the state’s revenue outlook.”

Even if income-tax receipts continue to outperform expectations, the state cannot use most of the additional money to plug next year’s deficit. Under the California Constitution, stronger revenues automatically drive higher spending for public schools and community colleges through Proposition 98.

The LAO estimates that more than 60 percent of new revenue—about $7 billion—must be directed to education funding formulas, including mandatory adjustments for prior-year underfunding.

Other constitutional requirements under Proposition 2 require increased deposits into reserves and additional debt payments, consuming much of what remains and leaving very little discretionary revenue to address the broader shortfall.

Costs Rising Faster Than Expected

Projected statewide spending continues to climb. The LAO estimates that expenditures will exceed earlier expectations by nearly $6 billion in 2026–2027. Part of the increase stems from higher statewide costs for pensions, retiree health care, and administration.

Another important driver is the federal One Big Beautiful Bill Act, which shifts more financial responsibility for Medi-Cal and CalFresh onto states. The LAO estimates the changes will add roughly $1.3 billion in new Medi-Cal and CalFresh costs for California next year, and those obligations are expected to grow over time.

Just before the LAO report was finalized, federal officials issued preliminary guidance indicating that California may also need to adjust certain provider taxes beginning in July 2026—a change that could drive state costs even higher and is not included in the LAO’s current estimates.

With revenue gains largely restricted and operating costs rising, the LAO projects even deeper trouble ahead.

Beginning in 2027, California could face annual structural deficits of about $35 billion as ongoing spending continues to outpace ongoing revenue—an outlook made more difficult by the state’s heavy reliance on one-time fixes in recent years.

Lawmakers filled earlier gaps by borrowing internally, delaying spending, or withdrawing billions of dollars from reserves. Those strategies are now mostly exhausted, the LAO warns, leaving far fewer tools to rely on if the economy slows or markets cool.

“As it stands—with larger forecasted deficits and many fewer tools available to address them—California’s budget is undeniably less prepared for downturns,” the report cautions.

The widening gap means California Gov. Gavin Newsom, whose second term ends in 2027, faces a challenging path as he prepares to release his final budget proposal in January.