California’s Strong Revenue Trends Mask Looming Budget Risk

History suggests that fiscal risks can build during times when they are easiest to ignore. In California, periods of extraordinary revenue growth, often fueled by booming asset markets, tend to obscure underlying budget problems only to reveal them later under far more difficult circumstances. The current discrepancy over the size of the state’s budget deficit—$18 billion under the Legislative Analyst’s Office estimate versus $3 billion in the Governor’s budget—fits squarely within that pattern. The disagreement is not about whether revenues are currently strong or even whether the market conditions giving rise to them are susceptible to a downturn. Rather, the issue is whether a wait-and-see approach suffices or whether this long-standing risk to California’s finances should be incorporated into the state’s budget assumptions from the start.

Unpacking this question calls for revisiting what is driving the state’s current revenue boom. As we described in our November Fiscal Outlook, the recent stronger-than-expected revenue trends are almost entirely explained by the personal income tax (PIT), which has seen double digit growth this year. Rather than broad-based economic growth, PIT strength has been fueled by a very bullish stock market. Whereas California’s labor market has stagnated over the last two years, the S&P 500 stock index has appreciated roughly 50 percent over the same period. And most of this increase has come from skyrocketing share prices among a handful firms associated with innovations in Artificial Intelligence (AI). These firms have invested heavily in building out data centers and on extraordinary pay packages for their key employees. This spending, along with gains to investors, has turbo-charged state income tax receipts.

This dynamic has happened before. Throughout the mid-to-late 1990s, the stock market boomed over optimism around the Internet and dot-com start-ups. Strong tax revenue trends from this boom generated large budget surpluses that ultimately gave way to serious deficits once the bubble burst and PIT revenues declined nearly 30 percent. The Internet obviously has been a transformative innovation for society and the economy, but early on, financial markets valued dot-com and Internet firms above what their revenue-generating capacity warranted at the time. There are signs of similar market overexuberance related to AI happening now. At this point, stock prices are trading at a rich premium relative to corporate profits. Moreover, investors have been aggressive in taking on high levels of margin debt (borrowing to buy stocks), which has reached approximately three times the historical norm. These and other indicators are at levels previously only seen at times when the market was approaching a peak before entering a period of retrenchment.

Despite our view that there is a strong possibility of a market downturn, however, our revenue forecast does not assume one will occur. Rather, we’ve incorporated the elevated risk of a downturn into our estimates. To do this, we add a stock market indicator to our forecast models alongside other the economic variables. The added risk variable weighs on the range of revenue outcomes that we view as most plausible. The middle of the range, which becomes our main revenue forecast, is thus lower than if we did not include the stock market risk indicator. In this way, our approach represents a hedge; estimated revenues are not as low as they would be in an outright downturn, nor are they as high as is possible if there is no downturn. This differs from the approach taken by the Governor. While the Governor’s budget describes the financial markets as a leading risk to the budget and assumes that stock market appreciation slows, it does not explicitly factor the risk of a market downturn into its revenue estimates. Because of how sensitive California’s revenues are to stock market performance, the Governor’s approach yields a revenue estimate that is $30 billion above that of our office.

Regardless of the revenue assumption used in the 2026-27 budget, both our office and the Governor’s Department of Finance (DOF) agree that the state faces large structural deficits. Although the strong current-year tax collections mask it, there are at least two notable indications of an underlying fiscal problem. First, despite a $42 billion upgraded revenue estimate, the Governor’s proposal nevertheless cited a $3 billion deficit under DOF assumptions. Second, the Governor proposed suspending a $2.8 billion true-up deposit to the state’s reserve that otherwise would be required. This proposal helps balance the budget but runs counter to the basic fiscal logic that stronger-than-expected revenues should be used to build reserves. In short, although the economy is not in recession and the stock market has been booming, the budget is only precariously balanced.

The large structural deficit, which both our office and DOF agree exists, is a major concern. We have noted how following the dot-com bust and 2001 recession, California relied mostly on short-term solutions rather than realigning its structural imbalance. Consequently, the state went into the Great Recession a few years later with a structural deficit (and virtually no budget reserves), which greatly exacerbated the severity of the fiscal crisis that ensued. Given the strong possibility of an equity market downturn over the next year, the risk of repeating a painful experience looms. This historical context argues for incorporating revenue risk up-front and adjusting the budget accordingly.

But even if the stock market boom persists for longer and revenues ultimately exceed our forecast, the solutions adopted to balance the budget using more cautious revenue assumptions should not be viewed as unnecessary. In fact, they could help narrow the structural deficit that both our office and DOF agree is sizable and persistent. Given that this deficit is estimated to range from $20 billion to $35 billion in the years ahead, addressing it gradually, rather than all at once, reduces fiscal disruption and more readily provides for legislative input and flexibility. Moreover, these deficit estimates do not account for a downturn. Were the markets to drop considerably, budget problems would be tens of billions of dollars larger, necessitating even deeper cuts and/or tax increases. These challenges would not be short-lived either. After the dot-com bust and the Great Recession, it took four and five years, respectively, for revenues to recover. Incorporating revenue risk into the budget now, therefore, reflects prudence, not pessimism.