California is preparing to confront an $18 billion budget deficit next year, marking the fourth consecutive cycle in which state spending is projected to outpace incoming revenue. The estimate comes from the Legislative Analyst’s Office (LAO), which released its annual fiscal outlook and projected that the situation will remain difficult for several years ahead. The LAO’s latest figures show the deficit is about $5 billion worse than previous expectations from June, reflecting updated revenue and cost projections that have shifted since mid-year updates.

In the coming months, lawmakers and the governor will begin the formal budgeting process for the 2026–27 fiscal year, which must be finalized by July. The governor’s initial proposal is expected in January and will serve as the starting point for negotiations with the Legislature. Analysts note that the latest projection signals a continuation of broader financial pressures rather than a sudden downturn. The LAO report describes the state’s fiscal condition as “relatively weak,” even though tax collections have recently risen due to strong performance in specific sectors .

Drivers of the projected deficit

The report outlines several factors contributing to the gap. Mandatory spending formulas established under Proposition 98 and Proposition 2 will absorb much of the state’s recent revenue gains, leaving limited flexibility to close the shortfall. According to the LAO, spending obligations in education and reserve requirements will “almost entirely offset revenue gains,” even as income tax collections increase .

Rising program costs further widen the imbalance. The state expects to spend roughly $6 billion more than previously anticipated next year, driven in part by changes at the federal level. Updated federal health care and food assistance policies will require California to cover roughly $1.3 billion in additional annual Medi-Cal and CalFresh costs, with those obligations expected to grow in subsequent years .

Economic trends have also shaped the LAO’s forecast. While California has benefited from significant increases in personal income tax revenue, much of that growth is tied to the stock market and the surge of investment surrounding artificial intelligence. Legislative analysts cautioned that these gains may be temporary. The report points to several indicators that suggest the market may be overheating, including elevated valuations and increased investor leverage, and warns that similar patterns have preceded downturns in the past .

Structural pressures and long-term risks

Beyond the immediate shortfall, the LAO warns that California may face much larger structural deficits in the years ahead. Current projections show potential annual deficits of around $35 billion beginning in 2027 if spending continues to outpace revenue. Analysts note that even if income tax growth remains strong, constitutional spending requirements limit the state’s ability to use extra revenue to close the gap. The report describes this dynamic as a significant long-term challenge for state leaders .

The LAO also emphasizes that the state is running low on temporary measures that have been used in recent years to balance budgets without implementing broad cuts. Lawmakers have previously relied on internal borrowing, delaying expenditures, and drawing from state reserves to cover multi-year shortfalls. Those strategies, the report notes, are finite. California currently has about $14 billion remaining in its reserves, roughly half of its peak in earlier years, and these funds are not sufficient to resolve the underlying structural issues .

Additional federal policies add another layer of uncertainty. The LAO highlights ongoing tariff changes and federal spending adjustments that influence corporate tax receipts and overall economic performance. Analysts noted weaker job growth and flat sales tax revenues as signs of a less robust state economy, despite isolated areas of strength in the technology sector. These mixed signals underscore the challenge of forecasting revenue with precision in the near term.

Political and policy responses underway

As the governor prepares his January proposal, administration officials have acknowledged the scale of the fiscal challenge. The Department of Finance has stated that its own forecast anticipated a deficit of approximately $17 billion, closely aligning with the LAO’s figures. The department also cited federal uncertainty, market volatility, and rising caseloads in major programs as continuing pressures on the state’s finances .

Lawmakers have begun outlining their positions ahead of the budget process. Some legislative leaders have emphasized the importance of safeguarding essential services, while others argue that the state must re-evaluate programs expanded during years of surplus. The LAO’s report does not propose specific spending reductions or tax increases but stresses that balancing the budget will require either new revenue or reductions in ongoing commitments. Analysts described the action as “critical,” citing the cumulative effect of multi-year deficits and the exhaustion of temporary fixes .

The upcoming budget cycle occurs during the final years of the governor’s term, adding political implications to the fiscal decisions ahead. State officials are expected to scrutinize both short-term solutions and longer-term adjustments as they attempt to stabilize California’s fiscal position. The balancing act will involve assessing major programs, evaluating revenue options, and determining whether the state’s economic outlook provides enough stability to support any new commitments.

Outlook for the year ahead

California’s fiscal environment remains complex heading into next year. While the state continues to generate significant tax revenue—especially from sectors tied to technology—the broader economic picture is mixed, and the state’s expenses continue to rise. The LAO’s report underscores that the projected $18 billion shortfall is not the result of a single policy change or economic swing but reflects cumulative pressures: constitutional spending requirements, rising program costs, federal shifts, and the volatility of revenue sources tied to financial markets.

The next several months will determine how lawmakers and the governor choose to address the projected deficit and whether they opt for shorter-term adjustments or longer-term structural reforms. With major decisions expected in the first half of the year, state leaders will be navigating one of the most challenging budget cycles California has faced in recent years, guided closely by the constraints and projections outlined by the Legislative Analyst’s Office.