California's fiscal issues mount as governor prepares May budget revisions

California Governor's Office

California Gov. Gavin Newsom is set to release his budget revisions Wednesday as the state wrestles with homegrown challenges magnified by tariffs, federal grant cuts and federal layoffs.

The state's Legislative Analyst's Office forecast in Wednesday that state general fund tax revenues for the past two fiscal years, 2023-2025, are $5 billion over estimates in the governor's proposed January budget, but 2025-26 revenues are expected to be $7.8 billion below January projections.

The legislative analysts characterized their outlook as "strong growth this year, muted expectations moving forward," adding, their revenue forecast as the state moves into the fiscal 2025-26 budget year is "essentially flat, reflecting mounting risks and headwinds."

"Total collections across the budget window (2023-24 and 2025-26) roughly match the assumptions in the January governor's budget," according to the LAO's revenue outlook. "The timing of those collections, however, is somewhat different, with more revenue attributed to the prior and current years and less revenue expected in the budget year."

State income tax collections for the current fiscal year ending June 30 are up almost 20% from two years ago, which the LAO said would normally indicate a positive revenue outlook. But the outlook is dampened by the state's stagnant economy, the stock market's questionable sustainability and the potential impacts of expanded tariffs, legislative analysts said.

The LAO said the state's economy has been in a slowdown for over two years, but the stock market had been propping up income tax collections.

"The risks posed by California's stagnant economy and a potentially overheated stock market have been magnified by recent policy actions," the LAO said, pointing to the uncertainty around tariffs and the likelihood they will increase costs for consumers and businesses and likely place some drag on the economy. 

During a press conference in mid-April, in which Newsom announced he challenged President Donald Trump's proposed tariffs in court, the governor said the president's actions have "significantly downgraded the gross domestic product projections for the state of California"

Trump's announced 10% tariffs on all of the nation's trading partners on April 2, but then put a 90-pause on the increases except for the 125% tariff imposed on China, which caused a stock market dive and a sell-off in the bond markets.

California is heavily dependent on capital gains from the state's high earners for state revenues, a factor often cited by the rating agencies as a challenge for the state.

The state also engaged in $675 billion in two-way trade last year and stands to lose billions if international commerce declines, Newsom said in April.

Newsom's January budget was introduced as wildfires driven by hurricane-force winds devastated homes nestled in Los Angeles County's west-side and east-side mountain ranges.

The state already had to add more than $5 billion to the budget to help cover Los Angeles wildfire costs and an unexpected increase in Medi-Cal costs. Plus, the state and federal government gave Los Angeles County residents a six-month delay on filing income taxes, which makes revenue estimates murky.

The governor usually revises his proposed budget in May with solid income tax figures in hand from April. It starts the state budget process in earnest, leading to its signing by the governor on July 1.

California entered the year with revenues at break-even to slightly negative before Trump's actions that have many economists predicting a recession. 

The UCLA Anderson Forecast has had the country on "recession watch," since March; they are anticipating a slowdown could come in a year or two.

The administration's "purportedly desired policies would impose, each in their own way, a significant contraction on different sectors of the economy," said UCLA Anderson Forecast's chief economist Clement Bohr.