What assumptions drive the LAO’s $18 billion deficit projection for 2026–27?
Executive summary
The LAO’s $18 billion shortfall for 2026–27 rests on a set of interlocking assumptions: a more conservative revenue outlook that explicitly incorporates a high risk of a stock‑market downturn (and falling income and capital‑gains receipts), larger constitutionally‑driven education and reserve triggers that absorb revenue gains, and higher projected costs in health care, employee pay and other programs—plus one‑time “true up” reserve and debt‑service obligations that raise near‑term cash needs (LAO analysis summarized) [1] [2] [3].
1. Revenue prudence: the LAO assumes market risk and weaker capital gains
A central driver of the LAO’s estimate is its revenue forecast, which deliberately tempers recent windfalls by incorporating “the strong risk of a stock market downturn,” and therefore projects declines in income and capital gains receipts in 2026–27—revenues that have been inflated by recent tech and AI‑related gains (the LAO contrasts this with the administration’s rosier view) [1] [4] [5].
2. The administration’s higher revenue view is the mirror image
The LAO stresses that the governor’s revenue estimate is considerably higher because it does not build in the same market‑downturn risk; that gap in revenue assumptions—almost $30 billion across the budget window in LAO’s calculation—is the single largest reason LAO’s deficit estimate exceeds the administration’s [1] [5].
3. Constitutional spending rules—Proposition 98 and Prop 2—eat gains
Even where revenues are stronger, constitutional commitments limit flexibility: LAO estimates Proposition 98 school funding and Proposition 2 reserve rules “almost entirely offset” revenue improvements, requiring roughly $5.1 billion more General Fund Proposition 98 spending over 2024‑25 through 2026‑27 compared with June projections and constraining the ability to use growth to close the gap [3] [2].
4. Higher program costs beyond schools: roughly $6 billion more
LAO estimates spending for “other programs” is about $6 billion higher than the administration assumed—driven in part by rising Medi‑Cal caseload and costs and pay raises for state workers—so even with improved revenue collections the outlays rise materially, widening the shortfall [2] [4] [3].
5. One‑time timing, reserve “true ups” and debt payments raise 2026–27 needs
Beyond structural drivers, LAO flags near‑term timing items: although it assumes Proposition 2 deposits would be suspended in 2026‑27 because of the shortfall, prior revenue improvements force $2.8 billion in “true up” reserve deposits and roughly $600 million in additional debt payments relative to budget‑act assumptions—both add to the 2026‑27 budget problem [2].
6. Structural versus cyclical framing: why this is bigger than a one‑year gap
LAO ties the $18 billion in 2026‑27 to a larger structural imbalance: even after near‑term adjustments, it projects deficits growing to about $35 billion annually starting in 2027‑28 because spending growth—largely for health, education, and ongoing commitments—continues to outpace revenue growth absent policy change [2] [3].
7. Politics, prior fixes and implicit assumptions about reserves
LAO warns the state has already relied heavily on resiliency tools—reserve draws, deferrals and bonds—to cover prior shortfalls; its outlook assumes limited capacity to repeat that approach and treats some prior fixes as exhausted, which makes the 2026–27 shortfall less bridgeable without new revenue or cuts [6] [7].
8. Alternative views and key uncertainties
The administration and some advocates disagree: Newsom’s team uses higher revenue projections (no explicit market downturn), producing a far smaller near‑term gap, while progressive groups stress protecting programs and propose revenue solutions rather than cuts; LAO explicitly frames its assumptions as cautious, not prophetic, and says outcomes could shift substantially by the January budget and next June [1] [8] [9].