An unexpected surge in tax revenue from the artificial intelligence-driven stock market masks a persistent structural budget deficit in California, the Legislative Analyst's Office warned in a report following the governor's May revise budget proposal.
"Despite booming revenues, the budget position is overextended, reflecting: a structurally higher spending base, diminished reserves, an already accumulated wall of debt, and an operating deficit,"
A revenue shock could be coming, according to the LAO, because the state's revenue outlook rests disproportionately on AI-driven equity valuations that are trading at highs last seen at the peak of the dot-com bubble.
California lawmakers and Gov. Gavin Newsom are now negotiating the details of the state's 2026-27 budget.
Newsom released his
Compared to the current budget, the governor's revised revenue outlook across the three-year budget window is higher by roughly $16 billion, the LAO said.
This financial boost is disproportionately tied to personal income tax collections fed by the stock market, which is largely fueled by AI-related stocks.
Overall state income tax withholding from stock pay at California technology companies represented about 10% of total income tax withholding, the
California's tech companies make up more than 60% of the total value of the Nasdaq 100 index, a list of the 100 most valuable companies listed on the Nasdaq stock exchange, the LAO said.
The LAO described the state's fiscal situation as "genuinely unprecedented" and cautioned that the AI-fueled exuberance is "not safe to bet" on being sustainable.
The LAO views the revenue recovery as temporary, rooted in an unsustainable stock market similar to the peak of the dot-com bubble.
Despite the current revenue boom, the state faces a structural budget imbalance, meaning ongoing revenues cannot support ongoing expenditures.
"Periods of elevated revenues, such as the current cycle of strong personal income tax receipts, are typically when the state should be strengthening its fiscal position," the LAO wrote. "Instead, the May Revision draws it down — relying on roughly $20 billion in reserve withdrawals and suspended deposits, as well as $4 billion in borrowing (on top tens of billions of dollars of existing borrowing), to achieve budget balance."
In November, the
Though there is more revenue to work with now, the LAO said this month that the administration's estimates still show operating deficits of roughly $10 billion annually from 2026‑27 through 2029‑30
This imbalance is compounded by a structurally higher spending base, diminished reserves, and an accumulated $30 billion "Wall of Debt" from budgetary borrowing, the LAO wrote.
Newsom claimed the state has eliminated its structural deficit through July 2028 and is maintaining nearly $30 billion in reserves.
The LAO's takeaway was that structural deficits persist, while future deficits have come down substantially, but the state is ill-prepared for a slip in revenues.
"This upgrade is almost entirely attributable to expectations for income tax collections, which are being driven by enthusiasm around artificial intelligence and the related stock market boom," the LAO wrote. "This improves the budget's bottom line."
The governor's May revision tax revenue estimates in the current year represent over 30% growth from three years ago, according to the LAO, which said the governor's estimates largely agree with its own.
"Much of this growth is driven by the personal income tax, which is up nearly 50% during that same period," the LAO report said.
Adding to the fiscal concerns, state data shows a disconnect between revenue gains and job creation: while AI enthusiasm propels the market, California tech employment has dropped off since 2022 and job growth in the sector is not yet apparent, according to the UCLA Anderson Forecast March report.
Led by the industry's hyperscalers, projected capital expenditures on AI will climb to
This represents approximately 2% of GDP, a scale of investment that firmly positions the AI revolution alongside history's most significant technological buildouts, including the railroads, the Interstate highway system, and the telecommunications boom, he said.
But 2026 may also mark the point where this expansion begins to moderate as these staggering investment announcements are no longer receiving the warm reception they once did on Wall Street, Bohr said. Instead, rising expenditures have recently correlated with falling stock valuations, signaling that investors are beginning to question the limits of future revenue-generating capacity, even in an era of financial exuberance, he said.
Plus, Bohr said, physical constraints related to energy availability and grid transmission are starting to bind. This combined with the rapid depreciation of AI chips will become a costly source of perpetual expenditure, forcing the hyperscalers to reinvest continuously just to maintain their current capabilities, he said.
Newsom and President Donald Trump drew headlines in recent days for executive orders around AI regulation. Trump
"California has never sat back and watched as the future happened to us — and we won't start now," Newsom said in a statement. "Today is just the first step as we rewrite policy and direction, creating a future of work that works for all."
Newsom
Trump's abrupt reversal highlighted a fundamental schism within the administration, as officials struggled to
