SACRAMENTO – Gov. Gavin Newsom reached an agreement Friday with legislative leaders on a $351.7 billion state budget in his final year as governor, a spending plan that uses tax incentives to avoid major cuts and reduce California’s chronic deficit for years to come.
The deal provides nearly $2 billion in state revenue next year through increased corporate taxes, new software sales taxes and a renewed tax on health care organizations. Lawmakers and the governor continue major investments in education, health care and have agreed to increase spending on subsidized child care and affordable housing.
“We don’t want to leave the next governor with not just a balanced budget, but a structurally sound budget, and we’re going to get that done,” Newsom said in an interview Friday. “We were very cautious about spending new money,”
The agreement ends weeks of lobbying and negotiations between lawmakers and the governor at the state Capitol over how to handle an increase in income taxes collected on stock market gains related to artificial intelligence.
Forecasts at the time last June showed a $12.6 billion shortfall in 2026-27, according to the California Department of Finance. Revised forecasts now suggest the state will end the year with more than $4.5 billion in revenue.
Democrats, following Newsom’s lead, cut $6.4 billion for next year, allowing the governor to reduce the deficit projected for 2027-28 and reduce criticism of his spending style.
But economists say the recovery and rising incomes are likely to be temporary.
Spending in California has generally outpaced revenue growth during Newsom’s tenure as governor, creating chronic deficits. Without additional funds, the budget continues to rely on reserves, currency swaps, borrowing and debt servicing to balance government spending.
The Legislative Analyst’s Office, an independent financial adviser to lawmakers, has warned of an estimated $10-billion gap between government spending and spending, which could widen if the stock market pulls back. The LAO said the existence of any operating deficit at a time of profit growth is a red flag and that the state is “ill-prepared” for even a slight contraction.
Christopher Thornberg, an economist and founder of consulting firm Beacon Economics, said it’s business as usual in Sacramento.
“They like increased spending. But it seems politically impossible to go the other way,” said Thornberg. “We have seen this game played many times.”
Lawmakers and the governor offered a different view and argued that their decision to put $6.4 billion in a temporary savings account, called the Projected Surplus Temporary Holding Account, and ask voters to allow them to keep more money in the rainy day fund are examples of smart budgeting.
“You see us saving a lot and you see us trying to address the immediate needs of our community, but also the structural budget that we may be waiting for,” Senate President Pro Tem Monique Limón (D-Goleta) said in an interview. “We are predicting a time when we will need to deal with these problems and we want to start now to think about the future as well.”
Under a progressive tax framework, the government’s budget depends on income taxes paid by the wealthiest people on the highest income from capital gains. The setup leaves California vulnerable to the unpredictable nature of the stock market, dramatic fluctuations in income and, in recent years, dependent on bad forecasts.
Negotiations at the state Capitol included a deal on a constitutional amendment aimed at lowering the income tax.
If approved by voters in the statewide election in November, the amendment would increase the limit on the mandatory lump sum in the rainy day fund from 10% to 20% of the general fund’s income. The measure would also allow lawmakers to exempt money they put in a rainy day fund and temporary holding account from federal spending limits.
Under existing state appropriations limits, also known as the Gann Limit, lawmakers cannot spend more than an amount determined by a formula that takes into account annual tax revenue, changes in population and the cost of living. Tax revenues in excess of the limit must be divided between schools and refunds to taxpayers.
With few exceptions, the limit applies to most allocations of tax revenue, including where lawmakers put money into a rainy day fund and other reserves.
Newsom said the change will leave the state in a better position to deal with volatility. While calls for tax reform remain in California, the governor said being able to put more money into savings could eventually solve the state’s budget challenges.
“The one thing that’s missing is the one thing that I think we finally got there, which is a change in the reserves,” Newsom said. “It changes the political dynamics, where now you don’t have to exchange the important things in the package.”
Republicans criticized the proposed constitutional amendment, which passed the budget bill this week, for failing to require more money to pay off the $22 billion in unemployment insurance debt.
State Sen. Tony Strickland (R-Huntington Beach) called it a missed opportunity.
“It doesn’t take a debt settlement to go into UI debt,” Strickland said. “It facilitates more spending, freeing up deposits from the government’s spending limit.”
As part of the negotiations, lawmakers agreed to roll back some health care cuts that would have required monthly premiums for immigrants and eliminated dental care. The agreement adopted a Medi-Cal asset assessment of $21,000 on July 1, 2027, instead of $2,000.
The budget deal includes a provision that requires California’s next governor to make options to reduce taxpayer subsidies for companies with employees who receive state-sponsored health care through Medi-Cal instead of a company health plan. The program is intended to raise revenue to offset state cuts that are expected to leave millions of Californians without access to health care.
The California Department of Finance said state cash reserves are expected to reach $28.8 billion under the 2026-27 budget.
