Wednesday, November 20 the Legislative Analyst’s Office (LAO) released its Fiscal Outlook for the 2025-26 State Budget and a separate Fiscal Outlook for Schools and Community Colleges. The news is positive for the 2025-26 state budget and for school funding, with some cautions about potential deficits in future years. The bottom-line for schools and community colleges is that Proposition 98 funding is higher throughout the the three-year budget period than anticipated in the 2024 Budget Act, which could mean:
- There will be sufficient Prop. 98 funding in the 2025-26 budget to cover an estimated 2.46% COLA and to support an additional $2.8 billion for new commitments.
- The Prop. 98 Reserve will grow – increased capital gains revenue in prior and current fiscal years will require a fairly large $3.7 billion deposit into the Prop. 98 Reserve (recall that the Reserve was emptied in 2023-24 to deal with the budget shortfall).
- Due to faster year-over-year revenue growth, an additional $761 million in maintenance factor would be paid in 2024-25, leaving a balance of $3.3 billion at the end of that year – under current revenue projections, no maintenance factor would be paid in 2025-26.
As we all know, the LAO offers its independent assessment of California fiscal and budgetary condition to the Legislature, while the Department of Finance (DOF) provides its assessment to the Governor. We will have to wait and see what DOF numbers and assumptions are contained in the Governor’s January Budget Proposal, but these LAO reports, along with consistently good revenue collection reports for the first quarter of fiscal year 2025 (which could suggest revenues are even higher than estimated by the LAO), are good news for the next state budget. We all need to be aware, however, that there is a great deal of uncertainty about economic conditions over the next few years.
We will get into much greater detail regarding various projections by the LAO and DOF and what they mean for the next state budget at our January Budget Perspectives Workshops. You can register here.
State Budget Condition
Without going into a lot of detail that is not directly relevant to funding for schools and community colleges, the LAO concludes that the overall fiscal condition for the state is fairly solid for 2025-26 with some concerns for future years. While revenue collection to date might seem to suggest we are in an even stronger position, the LAO notes that costs are also significantly higher than anticipated in the 2024 Budget Act.
Following are the highlights regarding the overall state budget:
- In the 2024-25 budget process, the Legislature and Governor proactively addressed an anticipated budget problem for 2025-26. Decisions to withdraw funds from the state’s rainy day fund, temporarily increase some revenues, and make several spending adjustments put the state in a much better position going into the budget process this year.
- While revenue collections are strong and higher than anticipated in the 2024 Budget Act, the LAO believes that revenues are running ahead of the broader economy in a way that is not sustainable. The LAO notes that revenue collections have surged despite a softness in the state’s labor market and consumer spending, largely due to revenue from high-income earners and the stock market rally. The sustainability of this higher than anticipated revenue is questionable without an improvement in the broader state economy.
- Almost all of the higher revenues are offset by higher costs, leaving the 2025-26 budget largely balanced. Remember, for purposes of the overall state budget, increased Prop. 98 spending is accounted for as a cost. In addition to Prop. 98 spending, the LAO notes that spending (this is spending attributable to higher costs, not new policies) is growing annually by almost 6% compared to an average growth of about 3.5%.
- The LAO concludes, then, that there is no capacity for the state to make new budget commitments in future years, and that the Legislature should be prepared to deal with operating deficits after 2025-26.
Schools and Community College Funding
The main takeaway for schools and community colleges is that the latest estimates put Prop. 98 funding moderately up in both 2024-25 and 2025-26 compared to assumptions in the 2024 Budget Act. The larger increase of about $3 billion is in 2024-25, with a more modest $1.5 billion increase in 2025-26. Note that this smaller increase in 2025-26 is based on the LAO’s assumption that revenue growth in 2025-26 will be weak despite current strong revenue collections, as explained above in the section on the broader state budget. If revenues increase considerably more than projected by the LAO in 2025-26, schools and community colleges could receive significantly more funding due to triggering of higher maintenance factor payments.
Taking fiscal year 2024-25 first, almost all of the $3 billion increase in Prop. 98 funding will be directed toward the Prop. 98 Reserve. The 2024 Budget Act assumed a deposit of about $1.1 billion into the Reserve, but under these assumptions that deposit would increase to $3.7 billion. The rest of the increased Prop. 98 revenue is accounted for by increased cost estimates for LCFF and other programs.
For 2025-26, the Prop. 98 funding increase is about $1.5 billion. Recall from one of our previous updates that some one-time costs in 2024-25 were paid for with on-going resources, meaning in 2025-26 those resources are freed up for new commitments. Those freed up resources add another $3.7 billion of spending power in 2025-26. The LAO estimates that enough 2025-26 Prop. 98 funding is available to cover an estimated 2.46% COLA (a cost of about $2.4 billion) and still provide $2.8 billion in funding for new commitments.
Because of concerns about future year deficits, the LAO urges caution with regard to new commitments. They suggest that the $2.8 billion could be used to eliminate the payment deferrals proposed in the 2024 Budget Act, and any remaining funds could be used for one-time spending to create a buffer for ongoing programs in case funding is lower than expected in future years.
The Budget Process
These reports from the LAO are helpful indicators of the resources likely available for the next state budget, but as we all know we will need to wait to see what numbers and assumptions the Governor will utilize in his January Budget Proposal. The LAO’s independent assessments typically will play a role in how the Legislature negotiates with the Governor as they work to finalize a budget between the May Revision and June 30th. We look forward to seeing you at our budget workshops for a more in-depth discussion.
Please reach out to any of us at Capitol Advisors if we can provide any additional information.
Best,
Abe
Abe Hajela
Partner | Capitol Advisors Group