Key Takeaways

• Surplus-to-outsized budget gaps highlight California's volatile revenue cycles, adding pressure to the near-term budget outlook.
• The governor's proposed corrective measures, which assume improved revenue relative to fiscal 2023, expose the state to a wider budget gap should revenue growth fail to materialize.
• The build-up of reserves in recent years should help cushion budgetary pressure and balance the proposed budget.
• We forecast deceleration in macroeconomic growth, which could leave limited room for upside but should allow for sufficient momentum for a positive outcome.

What We're Watching

With a softer revenue outlook, the administration's efforts to re-align expectations and limit spending will be tested as the legislature irons out the details of the state's next budget. To the extent that California continues to rely on volatile revenues without a corresponding structural realignment--such as a new recurring revenue stream or an equivalent expenditure reduction--long-term structural balance will remain difficult to achieve, most acutely in periods of economic contraction. Although the state has demonstrated discipline in maintaining strong reserves, limiting the growth of new programs--opting instead for one-time investments, and remaining committed to keeping long-term liabilities manageable--shifts in policy can result in magnified challenges beyond the next budget cycle. With a more optimistic revenue outlook than the Legislative Analyst's Office (LAO) revenue forecast, certain initiatives and overall spending may ultimately need to be reined in should the administration's revenue outlook miss its mark. Attention now turns to the state's response cast against an evolving economic environment with lingering uncertainty.

The Fiscal 2025 Budget Proposal Overview

California's high-flying budgetary performance is now a distant memory, and the question now is whether revenue has stabilized at cruising speed or is susceptible to further turbulence. The governor's fiscal 2025 budget proposal captures the effects of the revenue underperformance in fiscal 2023, which was unknown until late November 2023 due to the prolonged income tax filing delay that overlapped fiscal years 2023 and 2024. The state's conformity to the Internal Revenue Service's postponed tax filing to November from April 2023, stemmed from the severe winter storms which affected 55 of the state's 58 counties. The current event appears less far-reaching, but could challenge the state's planning and compound the budget problems.

The Department of Finance's (DOF) preliminary estimates reflect fiscal 2023 general fund revenue (excluding transfers) of $25.1 billion, or 12.2% short of forecast. General fund revenue in the current fiscal year (2024) is now forecast to be $10.3 billion, or 5% lower than forecast at budget adoption. The administration forecasts fiscal 2025 general fund revenue (excluding transfers) to be $7 billion, or 3.3% lower than assumed when the fiscal 2024 budget was adopted. Over the collective budget window, excluding solutions, transfers, or loans, general fund revenue is $42.45 billion lower than forecast less than a year ago. Adjusting for solutions and transfers, the revenue revision narrows by about $15 billion to $28.9 billion.

Table 1

As proposed, the state's fiscal 2025 general fund budget of approximately $201 billion is balanced with the help of a mix of budgetary maneuvers, including shifts, reductions, deferrals, and the use of reserves. The administration estimates that these solutions help fill a $38 billion gap, with reserves accounting for slightly over one-third of the solutions, or 5.8% of expenditures. In contrast, the LAO estimates revenue for fiscal 2023 was nearly $26 billion lower than budget act projections, and will be down by slightly more than $19.5 billion, or 9.4%, in the current fiscal year relative to those projections. The cumulative knock-on effect results in a nearly $68 billion negative balance to end the fiscal 2025, assuming no changes in current law and policy. S&P Global Ratings notes that the administration estimates total expenditure in fiscal 2023 was 15% lower than what the budget act for the current fiscal year had assumed, coupled with a larger prior-year balance, resulting in a higher beginning balance to start the current fiscal year.

Table 2

Proposed budget expenditures for fiscal 2025 are approximately 10% lower than fiscal 2024, with non-Proposition 98 expenditures revised 15% lower when balanced against a modest 3% increase in Proposition 98 outlays. The proposal maintains reserves at adequate levels with the budget stabilization account representing 5.3% of expenditures, though it comes in at a stronger 8.8% of expenditures when including the public school system stabilization account and Special Fund for Economic Uncertainties. DOF will release an updated revenue forecast and budget proposal in May after receiving key April income tax collections.

Risks To The Budget

Revenue (under)performance

Although the administration's forecast reflects a moderation of expectations anchored in reasonable assumptions (including positive economic momentum, even albeit muted), the balance of risk leans toward downside, in our view. Even if general fund revenues (excluding transfers) were to rebound 4% over 2023 levels--roughly half of the forecast growth--the budget gap would grow nearly $7.4 billion, or 3.2% of forecast expenditures in the current plan, compounding into the next budget absent solutions. As a result, in our view, this diminishes California's fiscal capacity to assume new commitments--or even to sustain those already made.

As a backdrop, without question, the state began its fiscal 2024 budget with elevated uncertainty given the delayed income tax filing deadline that overlapped fiscal years. Although most other revenue had largely come in as expected, personal income taxes missed their forecast by an exceptional margin. As indicated in the state controller's office's cash receipt report from November--when taxes were finally collected--personal income tax collections alone were $19.4 billion, or 29% short of estimates year to date. In its latest report (December), the controller's office reports general fund receipts are 22.2% below estimates year to date.

Although the new revenue forecast reflects general fund revenue regaining its footing in the current and next fiscal years, given the propensity for revenue volatility, California's budget position is always susceptible to being undermined by a revenue plunge often precipitated in part by a stock market selloff, as was the case most recently. As always, a key vulnerability to the state's revenue performance stems from California's tax revenue derived from its highest-income taxpayers' capital gains income. The budget assumes capital gains-related taxes will equal 8.3% of general fund tax revenue in fiscal 2024 and 8.7% in fiscal 2025, well off the peak 13.5% and 13.3%, in fiscal years 2021 and 2022, respectively. Although a surprise to the upside is possible, in our view, the administration's downward revision in capital gain realizations should help mitigate further forecast revenue volatility should those realizations fail to rebound; nevertheless, they could still prove too optimistic. Fortunately, barring any tax deadline extensions, the state will have greater visibility regarding the pace of its revenue recovery by late April, in time for the administration's May Revision before budget adoption.

Modest Economic Growth With Limited Upside

For 2024, S&P Global Market Intelligence (data compiled as of December 2023) forecasts California's economic growth will largely mirror the national level of about 1.7% (real gross state product, annual) and slightly exceed it at 1.6% in 2025, compared with the U.S. level of 1.5%. S&P Global Ratings' baseline forecasts sufficient macroeconomic momentum to support economic growth in the coming year, but cautions that subdued business investment--alone or together with a consumer spending pullback--could soften broader economic growth. (For additional information, see "Economic Outlook U.S. Q1 2024: Cooling Off But Not Breaking," published Nov. 27, 2023, and "Credit Conditions North America Q1 2024: A Cluster of Stresses," published Nov. 28, 2023, both on RatingsDirect.) Similar to S&P Global Ratings' baseline U.S. outlook, the DOF's forecast is built on the assumption of continued gradual economic expansion, with real U.S. GDP growth of 1.6% in 2024 and 1.2% in 2025. Unemployment remains above the national level in 2024 and 2025 at 5.1% and 5.2%, respectively, under DOF's forecast, which is in line with S&P Global Market Intelligence's forecast.

Table 3

While the state's economic outlook aligns with our own, the risk remains that broader economic growth fails to provide a sufficient spark to ignite revenue growth as forecast. For example, while economic output remained positive in 2022, with 0.7% annual growth relative to 2021, it fell well short of the national level of 1.9% (real GDP), and indeed contracted in three of four quarters (quarters one, two, and four each showed percentage change from the preceding period annualized), as reported by the Bureau of Economic Analysis. S&P Global Ratings believes that California's limited economic momentum over this period, coupled with an equity bear market and anemic initial public offering activity, contributed in part to weak revenue collections. As economic conditions continue to evolve, it is possible that the state's revenue proves more sensitive to broader macroeconomic trends than previously, which could necessitate a recalibration of assumptions.