Just one month after the passage of the latest budget in California’s history, the non-partisan Legislative Analyst’s (LAO) Office finds that California state government faces a whopping $25 billion budget deficit. This is comprised of a $6 billion deficit ending June 30, 2011, and then a $19 billion gap between revenues and expenditures in the 2011-12 fiscal year beginning July 1, 2011.

Despite California’s constitutional requirement for the enactment of a balanced budget, California finds itself in serious fiscal straights again. This is because $12 billion of the $18 billion in “solutions” in the last budget were temporary or “onetime” in nature. Add to that the sunset of $8 billion in tax increases that were agreed to two years ago but which go away by June of 2011, and finally, updated expenditure information that shows the state spending $4.5 billion more than anticipated just one month ago. This all adds up to a new $25 billion headache. The gap between ongoing revenues and expenditures is now approaching 23 percent of the General Fund.

So, what can we expect out of Sacramento with a new legislature and governor taking office in January?

Newly-minted Governor Brown will be constitutionally required to introduce a state budget on January 10, 2011, just one week after being sworn into office. This does not give him and his transition team much time to work out the details of a new fiscal recovery plan. It is likely that one of the governor’s first official acts will be to declare a “fiscal emergency” and compel the Legislature to take early action on his budget proposals.

The LAO is recommending a multi-year approach to solving the problem, with a combination of permanent and one-time solutions in year one and then gradually solving the entire problem over four years. The LAO is also recommending permanent revenue increases (higher taxes) as part of any solution. We believe the most likely scenario is that any tax increase would be an “extension” of the tax increases that are scheduled to sunset next year: sales tax, personal income tax and vehicle license taxes totaling about $8 billion. However, there are likely to be calls for elimination of corporate tax breaks like R&D credits, net operating loss carry forward and back, single sales factor apportionment and related provisions.

Passing a tax increase, including keeping the temporary tax increases in place, will not be any easy task. California still requires a two-thirds vote of the Legislature to increase a tax and the Democrats’ majorities fall two seats short of that threshold in the 40-member Senate and two seats short in the 80-member Assembly. Some legislators have suggested asking voters to approve an extension of the 2010 tax increases in a special statewide election, but that course is filled with risk if the Legislature defers spending cuts and voters ultimately reject extending the higher tax rates.

Governor-elect Brown may follow his last two predecessors and call for a special tax commission to review and recommend ways to reduce California’s volatile tax revenue system. Both Republicans and Democrats agree on the need to broaden the state tax system so that California doesn’t have such a small number of wealthy households paying most of the taxes (the top one percent of taxpayers in the state pay almost 50 percent of the personal income tax). This makes state tax revenue very vulnerable to future changes in capital gains and related types of volatile income.

Although there is far-reaching agreement on the need to broaden the base, there is much controversy over how to achieve it. For example, some argue for lowering the state sales tax rate but spreading it to services that are now exempt. Others argue for widening the tax brackets and ensuring that all income levels pay some tax. These ideas would reduce volatility but are also quite controversial. Governor Schwarzenegger’s tax commission, led by political insider Gerald Parske, proposed to reduce state income, sales, and corporation taxes and offset the revenue loss with a “business net receipts tax” (BNRT). This proposal did not gain any traction in the Capitol.

Finding a long-term solution to California’s persistent budget shortfalls is further complicated by voter decisions on three initiative measures on the November ballot. While voters passed a measure reducing the legislative vote threshold to pass a budget bill to a simple majority from two-thirds, they simultaneously made passing a budget more difficult by approving revenue-limiting measures that prevent future borrowing from local governments and impose a two-thirds vote to pass fees on businesses to mitigate any alleged social or environmental harm associated with the use of a company’s products or services.

On November 11, Governor Schwarzenegger announced that he will call a special budget session starting December 6, that focuses on resolving the $6 billion current-year deficit. The Governor said that, "While California's economy appears to be showing signs of stabilizing, our job creation, and revenues are still lagging," and "Changes in Congress and passage of Proposition 22 also present significant new challenges to balancing our budget." This announcement comes just one day after the LAO report.

Jerry Brown enjoyed a brief honeymoon after being elected to his first term as governor in 1974, but there will be no honeymoon as he begins his reprise as California’s 39th governor on January 3.