Why California Can Spend a Fortune One Year and Be Broke the Next
One year, California is sitting on a $97 billion surplus and Gavin Newsom is talking about expanding everything from free school meals to universal health care. The next year, budget analysts are warning of a $45 billion deficit and Sacramento is suddenly very interested in "fiscal restraint." Same state. Same tax code. Roughly the same economy. So what on earth is going on?
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The answer is something called the "volatility problem," and it is baked so deep into how California funds itself that no governor, no legislature, and no ballot measure has ever fully fixed it. Understanding it explains a lot about why California politics can feel so manic, why big promises sometimes evaporate, and why the state that has the fifth-largest economy on the planet still occasionally can't pay its bills on time.
It starts with who California actually taxes.
The State Runs on a Handful of People
California's general fund, the main pot of money that pays for schools, universities, prisons, Medi-Cal, and most everything else, is funded overwhelmingly by the personal income tax. That tax brings in roughly two-thirds of general fund revenue, depending on the year. And a disproportionate slice of that comes from a very small number of high earners.
The top 1 percent of California taxpayers routinely account for close to half of all income tax receipts. The top 5 percent account for even more. This is not a quirk or a rounding error. It is the structural foundation of the state's finances, and it has enormous consequences.
Rich Californians don't just earn salaries. They earn capital gains: profits from selling stocks, real estate, and business stakes. California taxes capital gains as ordinary income, at rates that top out above 13 percent, the highest state rate in the country. When the stock market is up and tech valuations are soaring, those gains pour into Sacramento. When the market drops, they evaporate almost overnight.
This is the core of the volatility problem. The state's revenue doesn't track the broad economy in a smooth, predictable line. It tracks the portfolio balances of a few hundred thousand wealthy taxpayers, and those balances can swing by tens of billions of dollars in a single year.
The Boom-Bust Cycle, Explained in Plain Numbers
When Silicon Valley has a good run, stock options get exercised, IPOs close, and capital gains flow. State coffers fill up faster than budget analysts can model. Lawmakers, facing genuine surpluses, fund new programs. Sometimes those programs come with ongoing spending commitments. Schools get more money, counts get locked in, formulas get set.
Then the market corrects. The capital gains disappear. But the ongoing spending commitments don't. Prop. 98, the voter-approved formula that guarantees a minimum share of the budget to K-12 schools, means education funding is legally protected and hard to cut. Medi-Cal enrollment tends to rise in downturns, when people lose jobs and insurance, precisely when revenue is falling. The mismatch between sticky spending and volatile revenue is where deficits are born.
It's not hypothetical. California burned through a massive surplus in the early 2000s dot-com bust and ended up with a structural deficit that took years to close. It happened again after 2008. And after the COVID-era tech boom pushed revenues to historic highs, the correction that followed produced one of the largest projected deficits in state history within just a couple of years. The pattern is almost mechanically reliable.
The Rainy Day Fund: Good Idea, Limited Fix
California voters approved a strengthened rainy day fund in 2014, officially called the Budget Stabilization Account. The idea is simple: when capital gains revenues spike above a certain level, a chunk of the excess gets automatically diverted into a reserve instead of spent. When revenues drop, the state can draw it back down to cushion the blow.
It works, up to a point. The fund has helped California manage downturns without as many brutal mid-year cuts as in past cycles. But it has limits. There's a cap on how large the reserve can grow. The fund can be raided under certain conditions. And when deficits are measured in the tens of billions, even a well-stocked rainy day account only buys time, not a real fix.
The deeper problem is that the fund smooths the peaks and valleys a little, but it doesn't change the underlying structure. California is still fundamentally dependent on a narrow, volatile tax base, and no amount of reserve-fund engineering changes that without changing who and what the state taxes.
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Why Nobody Just Fixes It
The obvious solution, at least on paper, is diversification. Tax more types of income more consistently. Rely less on capital gains. Maybe look at a broader sales tax base, or a wealth tax, or a split-roll property tax. California has debated all of these. Some have passed in modified forms, some have failed at the ballot, and some keep coming back.
But every structural fix has a political cost. Lowering the top income tax rate to reduce volatility means less revenue from the state's wealthiest taxpayers, which is a genuinely hard sell in a state that funds its social programs heavily off those taxpayers. Expanding the sales tax to cover services is deeply unpopular with business groups. A wealth tax has constitutional and enforcement problems that aren't trivially solved.
And there's a darker irony at work. The same voters who approve new spending programs in flush years are also the ones who passed Prop. 13 in 1978, which locked property tax increases to a strict formula and took the most stable, predictable revenue source off the table as a growth engine. The state has been improvising around that constraint ever since.
What This Means Every Time You Hear a Budget Number
When Sacramento announces a surplus, the honest question is: where did it come from, and how permanent is it? If the answer is a great year for capital gains, treat it like a good hand in poker rather than a raise at work. It might not be there next year.
Likewise, when a deficit hits the headlines and the finger-pointing starts, it usually isn't because someone raided the treasury or made a catastrophic error. It's because the revenue model collapsed faster than the spending commitments could be unwound. That's a structural problem, and structural problems don't have villains. They have architects, and in California's case, some of them have been dead for decades.
The state has the economic firepower of a major nation and a government finance model that sometimes runs like a casino that only takes bets on one table. Until that changes, the boom-bust cycle will keep coming. Bank on it.