California budget volatility continues to complicate efforts to close its deficits

California legislators are facing a fifth straight budget where spending would outstrip its revenues, amid warnings of multibillion-dollar deficits stretching well into the future unless they either reduce outlays or increase income.

Legislative analyst Gabe Petek, in his overview of Gov. Gavin Newsom’s proposed $349 billion 2026-27 budget, says the deficits totaled $125 billion over the last four years and “have persisted even as the state’s economy and revenues have grown, underscoring that the problem is structural rather than cyclical. Taken together, these trends raise serious concerns about the state’s fiscal sustainability.”

The proposed budget projects $227 billion in general fund revenues and $248 billion in general fund spending. Newsom has promised that when the budget — his last as governor — is revised in May, it will close not only its deficit but address the ongoing deficits. Petek and Newsom’s Department of Finance project them in the range of $20 billion to $35 billion a year.

How Newsom would do that while opposing major tax increases is still to be revealed. Meanwhile initial hearings in both legislative houses featured speculation from members on how the budget could be balanced, including sharp spending cuts and tax increases.

The hearings also saw renewed interest in another factor from years past: volatility.

Sen. Jerry McNerney, a Stockton Democrat who chairs the Senate Revenue and Taxation Committee, noted that the state’s major revenue source of personal income taxes can vary widely from year to year, making them difficult to reliably project.

“I think it’s time for a statewide discussion about how to even out this volatility, even though those are difficult conversations — it’s been noted, it’s been tried before,” McNerney said.

The proposed budget estimates that personal income taxes will supply 68% of general fund revenues, and high-income taxpayers will pay the bulk of those taxes. Wealthy Californians derive much of their income from capital gains, which can vary widely year to year depending on how their investments fare.

The volatility factor has its greatest effect on the budget during periods of economic uncertainty, when investment earnings swing widely. During past recessions, California has experienced as much as 20% revenue declines.

California’s budgets became dependent on a relatively few high-income taxpayers over the last four decades, as income taxes surpassed sales taxes to become the most important revenue source.

Income taxes exceeded sales taxes for the first time in 1983. The gap has steadily increased since then, as a detailed chart in the budget’s addendum reveals. The progressive structure of the income tax system ensures that high-income taxpayers supply most of its revenue.

The Great Recession that struck California in 2007 drove the volatility factor home. Then-Gov. Arnold Schwarzenegger and legislative leaders created a blue ribbon commission to recommend steps to make revenues more predictable. Months of hearings ensued and a sharply divided commission finally recommended lowering the state’s dependence on income taxes and substituting a revised sales tax that would extend to more transactions.

The report was never seriously considered. When Jerry Brown succeeded Schwarzenegger in 2011, he championed “rainy day” reserves that would, he said, cushion volatility’s impacts during economic downturns.

However, during the last four years of chronic deficits, Newsom and legislators have tapped those reserves to cover the gaps, even though there’s been no recession, breaking promises to preserve them.

“We’re not touching these reserves,” Newsom said three years ago. “We’re in a very volatile moment.”

Petek has warned of a possible downturn — with big revenue declines — if the artificial intelligence stock market boom fades. It happened in 2000 when the dot-com tech boom imploded.