California faces a looming $18 billion budget gap even as AI-fueled tax gains mask deeper fiscal strains.

The nonpartisan Legislative Analyst's Office is warning that AI-driven tax windfalls may be disguising serious budget risks.

In its November 2025 fiscal outlook, the office said the state's economy remains under strain and recent revenue strength may not last.

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Economy & Tax Collections

The office noted that both California and U.S. economies face major headwinds.

Borrowing costs remain elevated and new import tariffs are squeezing business and consumer budgets.

Despite weak hiring and flat sales tax growth, the state's income tax collections surged in recent months.

The LAO attributes that strength to exuberance around artificial intelligence, which pushed tech-sector compensation and stock market gains to new highs.

Revenue Outlook & Risk

The report explains that while the revenue forecast incorporates a modest upgrade based on strong income tax trends, it also builds in caution.

The LAO assumes some of the gains are tied to a potentially overheated stock market and therefore reverses the boost beginning in 2026–27. That hedge, it says, gives the state some protection if markets turn.

Budget Gap Widens

Under the LAO's current estimates, California now faces nearly an $18 billion budget shortfall in 2026–27 -- about $5 billion more than projected earlier.

The increase stems in part from mandatory spending growth under Proposition 98 (1988) and Proposition 2 (2014), which absorb nearly all revenue improvements, as well as $6 billion in unexpected cost growth in other programs.

Structural Deficit Threat

The outlook warns that starting in 2027–28 the state may confront annual structural deficits of around $35 billion if spending continues to outpace revenue.

The LAO urges lawmakers to adopt ongoing spending reductions and/or revenue enhancements now, because the state has already used many of its emergency tools and built-in resilience is low.

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