Gov. Gavin Newsom’s office on Friday forecast a “modest shortfall” of $2.9 billion for the upcoming fiscal year, down sharply from previous estimates in a nearly $349 billion budget proposal that relies heavily on continued windfalls from tech and AI stocks.

The governor’s 2026-27 budget proposal projects $9 billion more in revenue than anticipated, banking on the AI-driven economy to last. It’s significantly rosier than the grim outlook by the nonpartisan Legislative Analyst’s Office, which in November projected an $18 billion deficit.

“A downturn in the market is one of the top risks,” said state Department of Finance Director Joe Stephenshaw.

The projected deficit could balloon to $22 billion in fiscal year 2027-28, a problem the governor will address in an updated fiscal forecast in May, Stephenshaw said. Newsom’s proposal is the opening salvo in months of budget negotiations that begin in earnest in June.

The abysmal outlook means the Legislature must begin to look for ways to tackle the long-term problem, perhaps by allowing the state to deposit more into its rainy day fund in good years, said Sen. John Laird, a Santa Cruz Democrat who chairs the Senate Budget Committee. He said he’s concerned the AI-driven revenue cannot be maintained.

“We don’t know if there’s an economic downturn and how long it will last,” Laird told CalMatters. “If there’s not an economic downturn, we need to reduce the future deficits as much as possible in anticipation (of one).”

But Newsom’s proposal for next year calls for spending nearly $30 billion more than this year. It includes $248.3 billion in the general fund, the primary account for state operations, up by $18 billion.

The spike is primarily in education and health care, partly driven by the need to implement federal cuts to the Medi-Cal program and constitutional requirements to deposit portions of higher-than-expected revenue into education and state reserves.

Medi-Cal, for example, is expected to cost the state $2 billion more in the current fiscal year and $2.4 billion more next year, with $1.1 billion just to cover the added costs under President Donald Trump’s budget bill, according to Guadalupe Manriquez, the Department of Finance’s health budget manager.

Other departments would see lower funding next year, although Stephenshaw said the budget proposes no major cuts and the apparent decreases are from the loss of one-time allocations.

Newsom wants to spend $1.3 billion less on housing and homelessness next year, slashing the department’s budget by more than half as one-time allocations run dry. He also cut nearly $15 billion in funding for climate programs to bolster coastal resilience as sea levels rise, prepare for wildfires, ensure water security and develop solar and wind energy projects, but preserved an annual $1 billion from the renewed cap-and-invest program for high-speed rail.

Newsom’s budget proposal “dodges the harsh realities” of the federal cuts and doesn’t go far enough to counter them, said California Budget and Policy Center executive director Chris Hoene in a statement.

“Gov. Newsom’s reluctance to propose meaningful revenue solutions to help blunt the harm of federal cuts undermines his posture to counter the Trump administration,” he said. “The proposal will leave many Californians without food assistance and health care coverage.”

Republican lawmakers blasted Newsom’s proposal as kicking the can down the road.

“This is more of the same from a lame-duck governor content on leaving the rest of us to pick up the financial pieces when he leaves office,” said Senate Minority Leader Brian Jones of San Diego.

Bolstering the rainy day fund

Nodding to “long-term structural challenge,” Newsom wants to deposit $3 billion into the state’s rainy day fund Budget Stabilization Account, as well as $8.6 billion into two other reserve accounts. He also proposed spending $11.8 billion over the next four years, including $3 billion this upcoming year, to pay down the state’s pension liabilities.

“There are encouraging signs in the California economy,” Newsom said in a written statement accompanying the budget. “Yet history teaches us that prosperity, if taken for granted, can vanish as quickly as it arrives. California’s responsibility is to act with steady hands and anticipate future instability.”

Newsom did not attend Friday’s budget presentation. He painted a rosy picture of California’s fiscal future during his State of the State address Thursday. Flashing top-line numbers, the Democratic governor touted billions of  dollars more in revenue, proposed new investments in education and pledged more toward the state’s reserves and pension debt.

Education wins under Newsom’s plan

Newsom’s budget calls for $350 million more for the University of California and $365 million more for the California State University system, fulfilling Newsom’s 2022 promise to increase that spending by 5% annually for five years.

It’s a far better position for the systems compared to last year, when Newsom sought to reduce funding for the UC and CSU by nearly $800 million combined. The systems fought off those cuts.

The funding from Newsom’s promise has helped the UC increase the number of California resident students it enrolls by a total of 10,000 undergraduates since 2021.

California would also spend more on financial aid, which would benefit hundreds of thousands of students eligible for tuition waivers as well as scholarships for the middle class.

He also proposed no cuts to K-12 schools and preserved many existing programs, increasing per-pupil spending slightly to $27,400. The proposal also includes a $509 million increase in special education funding.

Newsom wants to fully fund the state’s universal transitional kindergarten program and provide universal before and after-school programs at elementary schools. The TK program will cost $1.9 billion annually, according to his proposal. Another $1 billion will go toward adding high-needs community schools.

Immigrants to take a hit in Medi-Cal

Beginning October 2026, the federal government will cut federal Medi-Cal funding for certain immigrants including refugees, asylees and survivors of trafficking. In response, California’s budget proposal would transition this group — approximately 200,000 immigrants in the state — to a restricted program that covers emergencies and pregnancy care only.

This would essentially divide immigrants into different levels of care. California currently offers state-funded, full-scope Medi-Cal to undocumented immigrants. Asked about the confusion it would cause to offer different coverage, finance officials blamed the federal government for the change.

Stephenshaw on Friday said the state couldn’t afford the $786 million it would cost in 2026-27 to provide full benefits for this group, a cost that would rise to $1.1 billion in future years.

Health advocates say they had assumed some immigrants would move into state-funded comprehensive coverage, like other immigrants in the state.

“You can imagine for the population that we’re talking about, we’re talking about someone who has arrived as a victim of trafficking who desperately needs a spectrum of health care services,” said Kiran Savage-Sangwan, executive director of the California Pan-Ethnic Health Network. “The state is now saying … ‘We are not going to treat them the same as other immigrants with unsatisfactory immigration status, we’re going to treat them differently.’”

New federal guidelines will also limit the amount of tax revenues the state can collect from Medi-Cal insurance providers, causing the state to lose at least $2 billion in revenue a year starting June 30.

Newsom’s budget proposal assumes, however, that the new policy wouldn’t take effect until Dec. 31 as the administration asks the federal government for an extension. If the June deadline holds, the state could lose $1.1 billion more in tax revenue, Manriquez said.

Less funding for housing, homelessness

Newsom’s budget proposal this year represents a significant pull back of state spending on affordable housing. Every year since 2020, the state has tacked on an additional $500 million in spending to pad the federally funded Low Income Housing Tax Credit, the country’s premier funding source for affordable housing construction. This year’s spending plan includes no such proposal.

Newsom’s budget also slashes what had been a $1 billion infusion in spending for cities and counties to fund housing and services for homeless Californians to $500 million, “contingent on enhanced accountability and performance requirements” for local governments.

That all adds up to a more than 56% cut in overall spending for housing and homelessness.

“Not much in the way of good housing news,” said Ray Pearl, executive director of the California Housing Consortium, in a text message, though he stressed this was the first step in a half-year-long process.

In prior years, Newsom’s preliminary budget proposals have jettisoned such spending programs, only for the Legislature to add them back. Stephenshaw hinted as much in his presentation: “We’ll obviously have conversations with the Legislature on what the appropriate level will be as we work through this process.”

The California State Association of Counties is hoping those conversations will lead to an increase in homelessness funding before the budget becomes final.

“We know it works,” said CEO Graham Knaus during a media briefing. “We know it has led to a significant reduction in homelessness in communities across California. And without those resources, that success that we have had is going to go away.”

Newsom has tussled with counties over homelessness funding for years as political pressure to resolve the state’s homeless crisis continues to mount. Newsom has blamed counties for failing to deliver results despite his $24 billion investment. Only a portion of the funding goes to county agencies and there is no dedicated annual funding to fight homelessness.

Newsom on Thursday proposed moving $1 billion in Proposition 1 funding from mental health services to housing and treating homeless people, which startled county behavioral health service providers who rely on Prop. 1 for services.

“While these one-time bricks and mortar investments are promising, the $1 billion in funding for ongoing housing subsidies under Proposition 1 comes at the expense of redirected mental health treatment and prevention programs,” said Michelle Doty Cabrera, executive director of the County Behavioral Health Directors Association.

 Yue Stella Yu is a reporter with CalMatters. CalMatters’ Ben Christopher, Ana B. Ibarra, Carolyn Jones, Marissa Kendall, Jeanne Kuang, Alejandro Lazo, Maya Miller and Mikhail Zinshteyn contributed to this report.