California's budget continues to be a sore point as the state prepares to issue just over $1 billion of general obligation bonds in a competitive deal on Thursday.

Revenues this year have been coming in stronger than anticipated in the budget adopted in June, but the state engaged in billions of dollars in interfund borrowing to close a $12 billion deficit when it approved the fiscal 2025-26 budget.

General fund revenues from July through September outpaced forecasts by $4.5 billion, driven largely by personal income tax collections that exceeded estimates by nearly $4 billion, according to State Controller Malia Cohen's monthly cash report released Sept. 30.

Fiscal year-to-date expenditures also came in higher than budget act estimates by $2.1 billion.

"California is through the first quarter of its fiscal year with revenues ahead of budget expectations," Cohen said in a statement. "While this is welcome news, the state still faces a structural deficit amidst global economic uncertainty. The best course of action leaders can take for current and future generations is to limit the accumulation of budgetary debt and hold on to reserves for moments of true economic hardship."

In its annual review of California's budget, the nonpartisan Legislative Analyst's Office devoted an entire section of the Oct. 16 report to interfund borrowing, which it described as the state's "wall of debt."

That phrase was a favorite of former Gov. Jerry Brown, a Democrat, who used it to describe money the state government used to cover deficits through vehicles like interfund borrowing or deferring payments owed to lower levels of government like local school districts.

The LAO report says the 2025-26 spending plan includes $10 billion more of such maneuvering, increasing outstanding budgetary borrowing from $12 billion to $21.6 billion.

"We define 'borrowing' as budget actions that achieve savings in the present, but result in an obligation or higher cost for the state in a future year," the LAO said in its review.

That includes a $1.6 billion payroll deferral, $6.4 billion in cash borrowing from Proposition 98 reserves for K-12 education funding, and $4.4 billion in cash borrowing from Medi-Cal, the state's Medicaid program.

The state had $85.1 billion in unused borrowable resources as of Sept. 30, according to the controller. These resources are from internal funds outside of the general fund and can be used by the state controller's office to manage daily and monthly cash deficits when revenue collections are lower than expenditures.

But Cohen said she cautions against the use of special fund borrowing for budgetary purposes as it may increase future debts and deplete reserves, limiting the state's ability in an economic downturn to avoid harsh spending cuts.

The LAO isn't trying to say anything specific by using the phrase "wall of debt," said Ann Hollingshead, the LAO's principal fiscal & policy analyst and lead writer on the report. "It's just a colloquial phrase, and it wasn't meant to be interpreted more broadly than that."

The state is projecting deficits of $15 billion to $25 billion through fiscal 2028-2029, according to the LAO's report; Hollingshead said the state has a structural deficit, which simply means the state is spending more than it brings in through revenues.

"What we said in the May budget revise report is that the state has made progress in solving the structural deficits, but there is still work to be done," Hollingshead said.

Revenues have come in stronger than what was expected when the budget was approved in June and the LAO will revise the forecast upward when it releases its annual fiscal outlook on Nov. 19, Hollingshead said.

"There is some possibility of the projected deficits attenuating to some extent, given the better than expected revenues," she said.

In its August outlook, the LAO's office updated its expectations for the state's three largest revenue sources: income, corporation and sales tax. The report attributed the upgraded outlook primarily to expectations of higher income tax collections based on enthusiasm around artificial intelligence, which had pushed the stock market to record highs and boosted compensation among the state's technology sector.

Moody's Ratings affirmed its Aa2 rating and S&P Global Ratings affirmed its AA-minus rating for the state ahead of its plans to issue $1 billion in general obligation bonds. The competitive deal Thursday will be a split of $700 million in tax-exempt and $300 million of federally taxable bonds.

"The rating reflects our expectation that California will continue to manage its budget through multifaceted actions as it encounters various physical events, as well as evolving economic and federal policy developments," S&P analysts said.

S&P said it will continue to assess if any potential policy changes in the federal-state relationship, such as Medicaid funding are resulting in direct state budgetary pressure, but "even in the face of economic uncertainties of changing tariffs and federal tightening on immigration policy, the state's economy is slowing, but still growing."

California currently has a gross domestic product of $4.2 trillion, the highest among the states and the fourth largest in the world, S&P analysts noted.

The information in the LAO's budget report is consistent with what the LAO put out in response to the May revision, said Matthew Butler, a Moody's vice president and senior credit officer.

The interfund borrowing is not a major concern for Moody's, relative to the size of the state's resources, Butler said; but a reduction in spending would be a sign of stronger fiscal health, given the looming deficits. Plus, he said, in prior eras when the state engaged in internal borrowing, the country was in an economic downturn.

"Relative to other states, cost pressures are manifesting to a greater degree in California," Butler said. "California is using the tools it has to deal with it, but they are pushing it off into the future by borrowing from other funds."

The situation of having 7% of general fund revenues in its reserves is strong, but relative to other states California is trending in a leaner direction, Butler said.

Fitch Ratings affirmed its AA rating and stable outlook on Sept. 17 ahead of a $2.4 billion GOs deal later that month.

Total reserves are $15.7 billion in the budget stabilization account and special fund for economic uncertainties, the LAO's Hollingshead said. That's down from more than $48 billion in 2023-2024.

California leads all states in total debt outstanding with $100 billion across its government activities, as of June 30, 2024, Moody's said in a Sept. 17 credit opinion report. But it's scaled to the resources of the state and its revenue base, Butler said. On that measure, California is close to the median of all states, he said.

The bulk of the state's debt consists of $70.7 billion of GOs, according to the State Treasurer's Office, but the state also carries lease revenue debt, appropriation-backed debt and special tax debt. As of Oct. 1, California had $42.5 billion in authorized, but unissued GO debt, according to the treasurer's office.

One of the challenges for the state is its expansion of the number of people on Medi-Cal puts it more at risk from cuts to that program at the federal level, Butler said.

Medicaid cuts are coming as part of the Republican One Big Beautiful Bill Act President Trump signed in July.

California Gov. Gavin Newsom touted the state's strengths and economic challenges in a press briefing following a fireside chat he had with Dee Dee Myers, director of the governor's Office of Business and Economic Development, Wednesday at think tank California Forward's annual economic summit in Stockton.

Events like the economic summit are important, Newsom said, so the state can reinforce its own strategies even as the Trump administration enacts policies that are harmful to California.

"I am mindful of the vandalism that the president of the United States is doing to the economy," Newsom said. "Mindful of the fact we are currently experiencing one of the largest tax increases in American history with tariff rates that are higher than they have been since the 1930s. This state is disproportionately impacted by the errant policies of this administration."

Newsom described federal grant cuts to the National Institute of Health, National Science Foundation and universities and other actions by the Trump administration as code red from an economic perspective.

"I know the markets are holding up – and perhaps the only scorecard the president cares about is the bond market," Newsom said. "But I can assure you there is a lot of anxiety out there, not just across this state, but across the country about the president's economic policies and that's why it was so important today to reinforce our own strategies and reinvigorate our economic engines."