The Legislative Analyst’s Office (LAO) released an updated revenue outlook reflecting the recent state tax collections that have come in significantly above the Governor’s January budget assumptions. Specifically, the LAO’s revised estimates show that General Fund revenues could be approximately $5 billion higher across the 2025-26 and 2026-27 budget window, driven primarily by stronger-than-expected personal income tax payments tied to capital gains and stock market performance. Importantly, however, all the increase they see is concentrated in the current fiscal year (2025-26), while they project weaker revenue in 2026-27 than the Governor assumed. As a result, the LAO advises the Legislature to treat this revenue improvement cautiously and avoid committing it to large, ongoing new spending obligations. Details of the LAO revenue analysis are available here.

The LAO has also released its review of the Governor’s major Proposition 98 spending proposals. In it, they continue a central message of caution: while the Governor proposes significant new funding, much of it relies on volatile revenue assumptions tied to capital gains and stock market performance. Consistent with their view on revenues, the LAO advises the Legislature to prioritize one-time investments and avoid creating large new ongoing commitments that could prove unsustainable if revenues decline.  A link to the full LAO analysis of the Governor’s K-12 proposals is here.

Below is a summary of the LAO’s review of Governor Newsom’s Proposition 98 proposals:

Overall Fiscal Guidance

The LAO emphasizes that recent revenue growth is largely driven by capital gains and other volatile sources, which could reverse quickly in an economic downturn. As a result, the LAO recommends prioritizing one-time spending over ongoing commitments.

Proposals the LAO Supports

COLA and Special Education Augmentation

The LAO recommends adopting the statutory COLA and increasing special education funding, although it notes that the Legislature may wish to revisit the specific cost estimates. The LAO views these adjustments as appropriate responses to cost pressures rather than expansions of programmatic commitments. This suggests COLA and special education augmentations are among the most secure elements of the Governor’s proposal.

Discretionary Block Grant ($2.8B one-time)

The LAO supports providing discretionary one-time funding to school districts, recognizing that flexible funding allows local leaders to address the most pressing cost pressures in their communities. However, the LAO notes the Legislature could adjust the amount based on updated revenue estimates.

Deferral Paydown ($1.9B one-time)

The LAO recommends adopting the Governor’s proposal to pay down existing Proposition 98 payment deferrals. The LAO views deferral paydowns as a fiscally prudent use of one-time funds because they improve the state’s budget structure and reduce the risk of future payment delays to school districts. Reducing deferrals strengthens the reliability and predictability of district cash flow.

Learning Recovery Block Grant ($757M one-time)

The LAO supports this proposal as a reasonable use of one-time funding to address student learning needs that emerged or worsened during the pandemic. Because the funding is one-time in nature, the LAO considers it consistent with prudent fiscal management given the uncertainty of ongoing revenues.

Proposals the LAO Recommends Modifying or Rejecting

$5.6 Billion Prop 98 Underfunding (Governor’s proposal to delay payment)

The LAO recommends rejecting the Governor’s proposal to underfund the Prop 98 Guarantee in 2025-26 and thereby create a new $5.6 billion Prop 98 payment obligation in a future budget. The LAO finds that while this delay in satisfying the Prop 98 Guarantee may provide short-term relief on the non-Prop 98 side of the budget, it creates both significant fiscal risk to future budgets and cash flow challenges for school districts. The LAO notes the state currently has sufficient resources to avoid this gimmick and argues that it would reverse recent progress made in improving school funding stability.

Community Schools ($1B ongoing)

The LAO recommends against establishing a large new ongoing community schools funding commitment at this time. The LAO does not reject the concept but finds that creating a major new ongoing obligation carries significant risk given the uncertain revenue outlook. Instead, the LAO suggests the Legislature consider more limited or one-time approaches.

Expanded Learning Opportunities Program (ELOP) Rate Increase

The LAO supports establishing a fixed Tier 2 rate but recommends setting it at the current Tier 2 rate of $1,579 rather than the $1,800 proposed by the Governor. The LAO concludes that existing funding levels are sufficient to sustain the program and that increasing the ongoing funding rate would create additional long-term fiscal obligations at a time of uncertainty.

Necessary Small Schools Funding Increase

The LAO finds merit in increasing Necessary Small Schools funding but recommends modifying the proposal because the Governor’s proposed 20 percent increase is not based on a detailed cost analysis. The LAO encourages the Legislature to revisit the methodology and determine an appropriate funding level based on documented needs – including a potential increase for all small districts. This suggests some increase may occur, but the final amount and structure may differ from the Governor’s proposal.

Differentiated Assistance Changes

The LAO recommends rejecting the Governor’s proposed changes to differentiated assistance funding at this time. The LAO finds that the state’s accountability system is still undergoing changes and that modifying the differentiated assistance structure before those changes are complete would be premature.

What’s Next?

Budget Subcommittee hearings will continue for the next few weeks and months. Expect the LAO to continue signaling that the Governor is being too optimistic, despite December and January revenues exceeding estimates in the Governor‘s January Budget by nearly $7 Billion.

Watch for them to continue urging the Legislature to adopt a scaled-back, more conservative posture on program expansion (advocating deferral buydowns, no new programs/commitments, use of one-time funds, etc.). They are implicitly questioning any new “categorical” funding and prioritizing district cash flow stability as a core objective. If the Legislature agrees with the LAO, the revenue upgrade improves the likelihood of additional one-time Proposition 98 funding beyond what the Governor has so far proposed, but does not strengthen the case for major ongoing program expansions.