Ten years ago, there were numerous articles written about the poor financial state of California during the governorship of Gray Davis and, later, Arnold Schwarzenegger. The State’s financial position deteriorated to the point that bond rating agency Moody’s downgraded the state to the ‘BBB’ range, or just above ‘junk bond status’. This was the first time in the post-Great Depression era that a US state was assigned such a low rating. Since that time, the State has raised taxes to stabilize its finances, and Illinois’ poor financial position has become the topic of conversation. However, California still faces some obstacles going forward, which are primarily driven by its massive Medicaid system (estimates suggest that one in three Californians are enrolled in the Medicaid system) and the State’s reliance on capital gains taxes.

California’s Current Financial Position

I’m sure this is so battered because it’s been used a lot…

As of the end of the 2016 fiscal year, the State boasted a positive General Fund balance. This is the first time that the State has recorded a positive fund balance in more than ten years and represents a marked improvement from the State’s weakest financial position in fiscal year 2012, when it held a General Fund balance representing negative 26% of total revenue.

The State’s largest source of revenue is its personal income tax which represents 46% of total revenues. Intergovernmental revenue, which is primarily revenue provided by the federal government (mainly Medicaid funding), represents 42% of total revenue and sales taxes represents 12% of total revenue. For the current fiscal year, the State forecasts a slight increase in sales tax receipts and no growth for income tax and intergovernmental revenues. Those projections are 2% lower than previous estimates.

The State’s largest expenditure is Health and Human Services (Medicaid) which represents 52% of total expenditures. Education represents 32% of total expenditures and is the State’s second largest expenditure. For the current fiscal year the State now forecasts total expenditures to grow by 2.5% over previous projections, including 4% growth for Medicaid and 2% growth for education.

The State’s largest pension system, the State Teacher’s Retirement System, is 63% funded. Total pension, other post-employment benefits, and debt service costs account for 10% of total State expenditures, which is an average fixed cost. Due to recently passed legislation, the State, local communities, and school districts will face increased pension contributions going forward. At 3.2%, the State’s debt levels, in comparison to other states, are above average.

Current and Projected Deficits

Deficit projections for the current fiscal year come in between $400 million to $1.6 billion (representing roughly 1% of total revenues). Additionally, budget estimates for the upcoming fiscal year are forecasting another deficit. The projected imbalances are being driven by the above-referenced flat to possibly declining income tax revenues coupled with growth in the State’s Medicaid system.

Declining income tax revenues are driven primarily by declines in the State’s capital gains tax (which accounts for 10% of the State’s revenue). Over the past two years capital gains revenue has dropped more than 7%. California’s reliance on capital gains taxes has long made the state susceptible to the variability of market conditions and any economic downturn is expected to negatively impact the State’s overall revenues.

Spending reduction is for chumps

Growth in State expenditures is largely being driven by tremendous growth in the State’s Medicaid system. After the passage of federal healthcare reform in 2010 California’s Medicaid system has seen substantial enrollment growth, including a 14% increase in enrollment between 2013 and 2016. Current estimates suggest that one in three Californians are enrolled in the State Medicaid system. Any federal funding reductions to Medicaid would have a substantial negative impact on the State’s financial position.

To address these budget imbalances Governor Brown has proposed reductions in State revenues for local school districts and state universities. In the past, the State has pursued a similar strategy to address budget deficits. The reductions in State revenue are expected to have a disproportionate impact on school districts that rely heavily on state funding and are already financially weak. These school districts likely will face state funding reductions combined with state mandated increases in pension payments.


The State’s financial position remains adequate, though some financial deterioration may occur in the near term. Local California governments that would be most impacted by reduced state funding would be local school districts that are already reliant on state support and have already been experiencing financial strain. Proposed federal funding reductions for the State Medicaid system would pose a significant challenge for California and would further exacerbate expected deficits.

If no federal reductions in Medicaid occurs, the State’s financial position is expected to remain adequate, but deficits are likely in the near term. Local school districts (which are heavily reliant on state funding) are most likely to be effected by any State deficits going forward.