California Faces Second Straight Year With a Multibillion-Dollar Deficit

On January 10, for the second straight year, Governor Newsom released a budget proposal that seeks to close a multibillion-dollar deficit. The projected size of that deficit depends on the source of the analysis — the governor’s proposed budget for 2024-2025 offers a more optimistic view than California’s Legislative Analyst Office (LAO). As described by the head of the California Department of Finance, Joe Stephenshaw, the difference largely lies in the governor’s budget having a more optimistic view of the short term. Additionally, the administration adjusted the 2023 baseline spending with a US$15 billion reduction to school and community college spending. As a result, the governor’s budget predicts a US$37.9 billion deficit — in sharp contrast to the LAO’s US$68 billion deficit projection from December 2023, although the LAO has since revised that figure to US$73 billion in light of recent revenue figures (namely, personal income taxes) that came in below expectations.

It is worth noting that two straight years of historically large deficits come after similarly historic surpluses — California had a nearly US$100 billion surplus as recently as 2022. The swing is at least in part due to higher than expected tax receipts following the COVID-19 recession, which drove the surplus projection, and, by contrast, a decline in revenues due to the stock market decline since the middle of 2022 and IRS tax deadline delays in 2023 for nearly all California counties to accommodate recovery from last year’s floods. The collection delays were particularly impactful because last year’s May revision of the budget could not be informed by April tax collections — state revenue data did not arrive until the end of 2023. As a result, the January proposed budget includes “baseline changes” to make the corrections, typically done in May following April tax collections, which, as pointed out by the LAO, results in a lower deficit projection.

The budget deficit projected this year — not to mention administration and LAO projections of significant budget deficits for the next three years — will have a great impact on state business, including the legislature’s consideration of more than 2,000 pieces of proposed legislation, implementation of new laws, and the progress of a variety of state-funded programs.

In that context, the governor’s US$209 billion General Fund budget proposal released in January intends to close this year’s budget gap with spending controls including a combination of cuts, delays, fund shifts, and a withdrawal from reserves — the last of which requires the governor to declare a fiscal emergency. The governor has stated he does not intend to raise income taxes and specifically reiterated he would not support a “wealth tax.”

The Mechanics

In closing the Department of Finance-projected US$37.9 billion-dollar deficit, the governor’s proposed budget includes approximately US$13.1 billion in withdrawals from reserves. That includes US$10.4 billion withdrawn from the Mandatory Budget Stabilization Account; US$1.8 billion withdrawn from the Discretionary Budget Stabilization Account; and US$900 million withdrawn from the Safety Net Reserve. Even after all of these proposed withdrawals, the state’s reserves remain robust with US$18.4 billion remaining in the coffers.

The other mechanics can be categorized into four types: reductions, delays, fund shifts, and reversions. Nearly all of the governor’s spending‑related solutions are one‑time. The US$8.5 billion in reductions include US$2.9 billion from climate programs, US$1.2 billion to housing programs, a US$800 million reduction to state departments’ operating budgets, about US$500 million in savings to continue an existing two‑week delay in Medi‑Cal payments, a US$500 million reduction to the school facilities aid program, and a reversion of legislative requests in the amount of US$350 million. Other programs impacted include the School Facilities Aid program, Student Housing Revolving Loan Fund program, and the Middle Class Scholarship program, as well as the UCLA Institute of Immunology and Immunotherapy.

Several budget items, worth US$5.1 billion and spread across a three-year period, are being delayed beginning in 2025-2026. This includes the Transit and Intercity Rail Capital Program; full implementation of the Department of Departmental Services (DDS) Service Provider Rate Reform; Clean Energy Reliability Investment Plan; Vulnerable Community Toxic Clean Up; Behavioral Health Bridge Housing Program; and Preschool, Transitional Kindergarten and Full-Day Kindergarten Facilities Grant Program.

The budget also proposes US$5.5 billion in fund shifts (borrowing) and deferrals. The fund shifts move certain expenditures from the General Fund to other funds — including the Greenhouse Gas Reduction Fund. The deferrals defer specific obligations to the 2025-2026 fiscal year — the most notable of which is the funding increase for the University of California and California State University systems.

While not including income tax increases, the budget does propose revenue of US$5.7 billion through increasing the Managed Care Organization Tax Support for Medi-Cal for an estimated US$3.8 billion, as well as borrowing internally from special funds. The governor proposes narrowing businesses’ ability to reduce their tax bill by counting previous losses against their current income. This would generate about US$300 million in additional revenue in 2024‑2025.

Climate Change

Although California has long seen itself as a climate leader — and the governor himself as a climate champion — the deficit will impact the state’s climate programs. The governor’s proposed budget includes about US$2.9 billion in reductions, US$1.9 billion in delays of expenditures to future years, and US$1.8 billion in fund shifts related to climate programs. The administration intends to instead pursue federal climate funding, including from the Inflation Reduction Act and Infrastructure Investment and Jobs Act, to backfill some of this funding.

The reductions to California’s climate programs are not significantly deep in any singular category, but they are broad and impact nearly all climate programs. Zero-emission vehicle, transportation, nature-based solutions, extreme heat, community resilience, coastal resilience, and sustainable agriculture programs all see reductions, shifts, and/or delays as well. Of all of the climate-related programs, water programs and energy investments see the biggest reductions — each seeing more than US$1 billion in previously committed funds reduced or delayed in the proposed budget (based on the 2022 Budget Act commitments). Impacted water programs include watershed climate resilience, water recycling, PFAS-related support, dam safety, and state water efficiency. A notable exception among the water programs, robust funding for flood protection, remains. Affected energy programs include CPUC capacity building grants, carbon removal innovation, residential solar and storage, incentives for long-duration storage, equitable building decarbonization, and hydrogen grants.

Of the climate related programs, wildfire and forest resilience programming sees the most limited reductions: US$2.7 billion out of previously committed US$2.8 billion in funding is maintained. This is not surprising as the state is experiencing insurance coverage problems due to the wildfire risk. The governor’s proposed budget also seeks to bolster fire protection in natural resources and environmental protection funding areas, as discussed in the next section.

Natural Resources and Environmental Protection

The governor’s proposed budget includes increases in certain natural resources and environmental protection programs (non-climate related) and reductions in others. The Department of Forestry and Fire Protection includes funding increases to support the new CalFire 66-hour workweek, a new training center, and resources for air bases and fire stations to combat wildfires. Water quality and habitat programs do see reductions and delays. The proposed budget includes a funding delay for the Cleanup in Vulnerable Communities Initiative, funding returns for various urban waterfront projects, and a loan from the California Beverage Container Recycling Fund to the General Fund.

Health and Human Services

The California Health and Human Services Agency (CHHSA) oversees 12 departments in charge of the state’s health and social services programs, with the largest being the Department of Health Care Services (DHCS), Department of Public Health, Department of Healthcare Access and Information (HCAI), Department of State Hospitals, Department of Developmental Services, and Department of Social Services (DSS). The governor’s budget maintains the same funding as last year, with US$253.4 billion (US$73.9 billion General Fund) for all health and human services programs in 2024-2025. There have been a number of investments over the last couple of years, including California Advancing and Innovating Medi-Cal (CalAIM) which moved Medi-Cal to a more whole-person care model, developing a Master Plan in Aging, improving the behavioral health continuum, providing additional assistance for subsidized childcare slots, and improving the public health infrastructure. Despite the forecasted budget deficit, the governor has maintained the investment of providing Medi-Cal for all, irrespective of immigration status, which includes US$3.4 billion (US$2.9 billion General Fund) in 2024-2025 and approximately US$3.7 billion (US$3.2 billion General Fund) ongoing, inclusive of In-Home Supportive Services costs. This program, which began last year, has been pointed to as one of the avenues to deliver “healthcare for all” without going to a full single-payer system.

DHCS oversees Medi-Cal, the state’s Medicaid program, county-operated community mental health and substance use disorder programs, California Children’s Services, and the Primary and Rural Health programs. It occupies the largest share of CHHS’ budget. As noted above, the budget maintains the expansion of eligibility for Medi-Cal benefits. The overall Medi-Cal budget includes US$157.5 billion in 2023-2024 and US$156.6 billion in 2024-2025. The budget provides funding to cover approximately 14.8 million Californians in 2023-2024 and 13.8 million in 2024-2025, which is more than one-third of the state’s population.

CalAIM is slated to maintain approximately US$2.4 billion (US$811.1 million General Fund) in 2024-2025 to continue the changes designed to provide a more comprehensive and preventative health care, which includes mental health, substance abuse, and social factors that impact health (like housing). The budget also maintains US$24.7 million in 2025-2026 increasing to US$197.9 million to allow up to six months of rent or temporary housing to eligible individuals experiencing homelessness or at risk of homelessness transitioning out of institutional care, a correctional facility, the child welfare system, or other transitional housing settings.

The most significant budget solution is an early increase in the California’s Managed Care Organization Provider Tax (MCO Tax), which, after being approved by the federal government, was effective April 1, 2023. The budget would have the legislature request the federal government to approve an amendment increasing this tax to provide US$20.9 billion in funding to the state, an increase of US$1.5 billion compared to the rate previously approved. The budget proposes US$12.9 billion to support the Medi-Cal program and maintain a balanced budget, and US$8 billion for targeted rate increases and investments from the MCO Tax. This funding shores up and supports safety net programs including increased childcare slots and rate increases for Medi-Cal providers. As mentioned above, there was a baseline adjustment from last year’s budget on Medi-Cal readjustment which showed an increase in costs from last year, however there is a forecast of less enrollment after 2024. There is US$323 million in funding delays across several programs, including HCAI workforce infrastructure development, Behavioral Health Infrastructure Program and Bridge Housing, rate increases to providers in DDS, and housing supports in DSS. Additionally, there are fund shifts from a variety of programs.

One additional notable item is the governor may be seeking delays and potential changes in legislation he signed in October, Senate Bill 525 by Senator Durazo, which increased the minimum wage for a broadly defined class of “health care workers.”

Safety: Criminal Justice, Courts, CalOES

Criminal justice remains a top priority for voters, the legislature, and the administration. The budget relies on net General Fund savings of US$87.8 million from Proposition 47, which requires misdemeanor rather than felony sentencing for certain property and drug crimes and permits incarcerated persons previously sentenced for these reclassified crimes to petition for resentencing. This provision has been under attack in relation to the onslaught of retail thefts, and there will be a number of legislative measures on this point.

There is a proposed total funding of approximately US$1.3 billion, including US$487 million General Fund, to support the California Department of Justice, which provides litigation services on behalf of the people of California; acts as legal counsel to state agencies; provides oversight, enforcement, and regulation of firearms laws; provides evaluation and analysis of physical evidence; and supports the criminal statistics and data, including the Controlled Substance Utilization Review and Evaluation System. There is a proposed increase from $9 to $15 on licensees, private clinics, or providers prescribing controlled substances annually as of April 1, 2015.

The California Judicial Branch maintains its funding of current initiatives with a total funding of US$5.2 billion in 2024-2025, of which US$3 billion is provided to support trial court operations. This includes supporting technology innovations to modernize court operations, including technology enhancements to support remote access to courtroom proceedings by providing a publicly accessible audio stream in California trial courts.

Notably, there is a proposed increase of US$30 million General Fund (US$15 million in 2024-2025 and US$15 million in 2025-2026) to expand the California Military Department’s existing drug interdiction efforts to prevent drug trafficking by criminal organizations, with a particular focus on assisting federal, state, local, and tribal law enforcement agencies in combatting fentanyl. On the other side, due to the deficit, there is a number of delays or reductions in grants for several programs.

The prison population continues to decline, and the administration has ended its reliance on contract prison capacity. California Department of Corrections and Rehabilitation (CDCR) estimates savings of US$156 million General Fund annually beginning in 2024-2025. CDCR also announced in December 2022 the planned closure of Chuckawalla Valley State Prison by March 2025. This closure is estimated to generate savings of US$148 million General Fund annually beginning in 2025-2026 with additional administrative savings predicted. The budget includes US$11.4 million General Fund in 2024-2025 and growing to increase community correctional reentry center contract rates corresponding with recent inflationary trends for contracts expiring in 2024-2025. Budget solutions include reversion of monies from COVID-19-related activities and related work compensation savings, reversion from parolee county of release workload, delays in technology for surveillance, other baseline adjustments, and a budgetary loan of US$100 million from the Cannabis Tax Fund to the General Fund.

California Office of Emergency Services is allocated US$3 billion (US$530.3 million General Fund) and 1,909 positions for Cal OES to oversee and coordinate emergency preparedness, response, recovery, and homeland security activities. To address budget shortfalls, the budget proposes a delay in funding for Flexible Cash Assistance for Survivors of Crime and reversion of money from community hardening and seismic retrofitting for soft-story multifamily housing.

Labor and Workforce Development Agency

The agency is in charge of safe and fair workplaces, helping to deliver critical worker benefits, and promoting good jobs for all. The agency oversees seven departments, boards, and panels that serve California employers and workers, which include the Agricultural Labor Relations Board, Department of Industrial Relations, Employment Development Department (EDD), Worker’s Compensation Appeals Board, Public Employment Relations Board, Unemployment Insurance Appeals Board, and Workforce Development Board. Notably, there will be a one-time US$331 million payment for the annual interest payment on the state’s Unemployment Insurance loan, half of which will come from the Employment Training Fund. This is notable because Senate Bill 1116, which would provide unemployment insurance benefits to striking workers, was reintroduced this year, despite being vetoed last year.

EDD is designated to receive one-time funding of US$362.8 million to continue to upgrade and modernize systems, US$12 million for additional 71 positions to be phased in to address workload, US$2.8 million from the Worker’s Compensation Administration Revolving Fund for 13 positions to be phased in and clarify time periods; additional resources will be directed to other department modernization projects.

K-12 and Higher Education

Taxpayers decided long ago to ensure that funding for schools was somewhat protected. Funding for K-12 schools and community college was guaranteed in a formula commencing in 1988-1989 under Proposition 98. Multiple factors are included, such as the level of funding in 1986-1987, General Fund revenues, per capita personal income, and school attendance growth or decline. This year’s budget calls for maintaining and covering all current levels of funding and existing commitments for new and expanded programs, with an additional less than 1% cost-of-living increase for the year.

Revised estimates of the General Fund since 2023 have significant impact, with a downward revision of a US$15.2 billion reduction in required funding. This is offset by an increase in local property tax, but overall, Governor Newsom wants to maintain current programs, including funding for community schools, universal school meals, expanded learning opportunities, education workforce, and continued implementation of universal transitional kindergarten. Instead, within the school and community college spending plan budget is an undefined reduction of US$8 billion in 2022‑2023 funding. The January 10 proposal includes total funding of US$126.8 billion (US$76.4 billion General Fund and US$50.4 billion other funds) for all K-12 education programs. K-12 per-pupil funding totals $17,653 from the Proposition 98 General Fund and $23,519 per pupil when accounting for all funding sources. The budget also includes US$53.7 million from the General Fund to help fund the state’s Universal Prekindergarten initiative.

Governor Newsom is proposing to delay the promised 5% increases in revenue to the University of California and California State University systems. Both would borrow funding this year to cover the cost and will be reimbursed the following year.

Community colleges and schools will be protected by drawing US$7 billion from the US$10.8 billion Transitional Kindergarten 2014 rainy-day fund to cover this year’s shortcomings. The state won’t seek reimbursement for what turned out to be funding above the minimum Proposition 98 obligation for the prior two years.

In collaboration with the California Legislative Black Caucus, Governor Newsom is preserving an additional US$300 million for the state’s poorest schools. Other areas of funding include US$6 million to research hybrid and remote learning methods to produce new models. US$20 million will be included for a new math framework adopted by the State Board of Education last July, US$5 million to increase support for the California Cradle-to-Career Data System, and US$122 million to increase funding for universal school meals. The state has launched a goal to add 146,000 new slots for subsidized childcare with US$2 billion to support the effort.

Homelessness and Housing

The governor’s budget maintains US$3.4 billion General Fund dollars to tackle homelessness and includes US$400 million for a third round of grants to address encampments that have become a prominent sight throughout the state. An additional US$1 billion will be available for a fifth round of Homeless Housing, Assistance and Prevention grants.

To address the deficit, US$1.2 billion is expected to be cut from housing programs. The cuts include US$300 million from the regional planning grants, US$250 million less for building and preserving multifamily homes, and an additional US$250 million from a program to acquire and rehabilitate properties that are at risk for potential foreclosures. There also will be a delay of the US$260 million General Fund Homeless Housing, Assistance and Prevention Program.

Transportation and Infrastructure

The governor intends to put a US$180 billion investment over the next 10 years in infrastructure. With the current budget deficit, this year’s allocation will be on immediate critical projects in the state’s core functions. A five-year plan on infrastructure required under the law proposes US$53.3 billion in a combination of the General Fund, a special fund, and federal funding.

The proposed budget offsets most of the reduction in General Fund dollars (US$1.1 billion) for transportation programs with Greenhouse Gas Reduction Fund money (US$791 million). As a result, significant funding for high priority transit and rail infrastructure, Active Transportation Program projects, port terminal improvements, and the Zero Emission Transit Capital Program is maintained.

Additionally, the governor’s proposed budget maintains nearly all of the funding for transportation programs (US$13.6 billion out of US$13.8 billion) associated with California’s climate goals.

Work in Progress

As mentioned in the beginning, the January budget proposal is just the first step of what will eventually become California’s budget for 2024-2025. The legislature is beginning budget hearings, with input from the Legislative Analyst’s Office, stakeholders, and the administration’s various agencies and departments. There will be another proposal released in May — the May Revise — which will take into account tax collections due in April, and the final budget will be voted upon on June 15, as required by state law. Adjustments will continue to be made in the details of the budget through the legislative session in the form of trailer bills until August 31, when the legislature adjourns the end of the two-year session.

© Arnold & Porter Kaye Scholer LLP 2024 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.