With potential recession looming, California estimates $25-billion deficit next year

SACRAMENTO —  Driven by high inflation and the threat of a recession, the state faces a potential $25-billion budget deficit next year that could at minimum curb some recent spending increases for essential safety-net programs that help Californians most in need.

The state’s Legislative Analyst’s Office, which advises lawmakers on California’s fiscal outlook, delivered the sober news Wednesday. It comes months after an estimated historic budget surplus provided Gov. Gavin Newsom and the Democratic-led Legislature with an abundance of riches to expand government assistance.

The previous projection — a $97-billion surplus — led to the expansion of Medi-Cal eligibility to all immigrants in 2024, paid family leave, free preschool for 4-year-olds and a boost in the earned income tax credit.

Newsom and lawmakers in June also approved a $17-billion relief package to help families, seniors, low-income Californians and small businesses — including $9.5 billion in stimulus payments to Californians struggling with high gasoline prices and increased inflation.

The LAO forecast stated that a sizable portion of the projected revenue shortfall could be offset by lowering spending, including for transportation and housing. With lower enrollment in public schools, education spending could also decrease.

The forecast also warned, however, that the drop in state revenue — and need to reduce spending — could be substantially worse if a significant recession envelops the country.

Along with state spending, the outlook is being driven largely by economic undercurrents affecting the nation — namely the steep rise in inflation and subsequent increase in interest rates.

“The longer inflation persists and the higher the Federal Reserve increases interest rates in response, the greater the risk to the economy,” the Legislative Analyst’s Office said in its forecast. “The chances that the Federal Reserve can tame inflation without inducing a recession are narrow.

“Reflecting the threat of a recession, our revenue estimates represent the weakest performance the state has experienced since the Great Recession” in 2008 and 2009.

H.D. Palmer, a spokesperson for the state Department of Finance, called the estimated shortfall a “realistic and reasonable assessment of the work that lies ahead.” He said the Newsom administration anticipated the economic slowdown and planned accordingly, putting California in a good position to weather the impact.

“This is precisely why the governor made clear that the state had to be smart with the surplus — which we’ve done,” Palmer said. “Using it to build up our budget reserves, pay down debt, and target the balance on one-time spending — like the $9.5 billion in inflation relief payments that continue to be delivered to millions of Californians — and not building up higher ongoing spending that can’t be sustained.”

The governor and Legislature may still face difficult decisions to close the budget gap, especially if economic conditions worsen, he said. All of that is being considered as Newsom prepares his budget proposal, which will probably be released in January.

Republican Assembly Leader James Gallagher of Yuba City blamed the state’s financial circumstances on Democratic leaders, who he said “overtaxed Californians and grew government while ignoring investments in critical infrastructure like new water storage.”

He said the Legislature should focus on policies that will help the economy grow and lower costs for Californians.

The state is expected to have $22 billion in general reserves by the end of the 2023-24 fiscal year to address budget shortfalls, and legislative leaders Wednesday emphasized that in recent years the state has devoted most of its surplus revenue to one-time spending, rather than creating or expanding costly programs that require funding annually.

“Thanks to our responsible approach, we are confident that we can protect our progress and craft a state budget without ongoing cuts to schools and other core programs or taxing middle class families,” Senate President Pro Tem Toni Atkins (D-San Diego) said in a written statement. “The bottom line is simple: We are prepared to hold onto the gains we’ve made and continue where we left off once our economy and revenues rebound.”

Still, under state law, education funding is automatically tied to state budget revenue, which means Wednesday’s report put public schools and community colleges on high alert.

Only months after celebrating record high education funding, the LAO’s latest analysis lays out a plan for the governor and Legislature to work with potentially billions of dollars less.

Despite an estimated decline of more than $2 billion in required funding, the state could still fully fund schools by making some adjustments, according to the LAO, and schools are better off than other programs if a recession hits. The state Constitution guarantees that they typically receive about a 40% chunk of the total budget.

Maintaining normalcy will be possible, in part, by reducing some spending to reflect dips in student attendance and by making withdrawals from a rainy-day fund specifically created for education — reserves that have grown because of required deposits thanks to the state’s good fortune in recent years.

Any school funding shortfalls could be small and short term, according to the LAO, and “by historical standards, the school funding picture remains strong.”

But the report also warns of “precarious” school budget balancing in the coming years, depending on economic health.

The report comes a week after voters overwhelmingly approved Proposition 28, which designates nearly $1 billion to music and arts education starting next year.

Expect teachers unions and school advocates to fight for more than just the required minimum for schools even in a recession, said Kevin Gordon, a Sacramento education lobbyist.

“The notion of following a year of spectacular new investments in education, to see circumstances that might undermine some of those really important investments, it’s disappointing but a reality we have to grapple with,” Gordon said.

The California Teachers Assn. said in a statement that it is optimistic, thanks to “collaborative budgeting and healthy reserves.”

“The state remains in a strong position to continue prioritizing equitable teaching and learning conditions and addressing the critical educator shortage,” said union spokesperson Lisa Gardiner.