The ‘nightmare’ Budget Scenario Looming Over California — And Gavin Newsom

SACRAMENTO, California — Two emerging threats are looming over California’s future — the prospect of an AI slowdown colliding with an aggressive wealth tax proposal that has already driven a handful of high-profile billionaires to flee the state.

California’s artificial intelligence boom isn’t sustainable and could fade as soon as this year, budget experts are warning. Meanwhile, departures driven by the wealth tax proposal could cut deeply into state revenues.

For Gavin Newsom, the timing could hardly be worse.

"If there's an AI crash, that would be very difficult to navigate through,” said Darry Sragow, a longtime Democratic strategist in the state. “And it's hard to imagine this ballot measure having a positive impact on much of anything."

Newsom, a likely 2028 presidential contender, has for years counted on tech industry innovation and taxes from California’s wealthiest residents to finance his biggest progressive projects, projecting California as an economic powerhouse. But now in his final year as governor, he is suddenly confronting the twin threats of a billionaire exodus and a potential slowdown in AI growth that could upend both California’s reputation as a tech behemoth and the state’s fragile revenue stream.

Together, they represent a major political liability for the high-profile Democrat, who is laboring to position California as a model worth replicating on a national stage.

“Investment in AI and data centers and all of the build out we've seen cannot indefinitely continue,” warned Matt Mahan, the Democratic San Jose mayor who is considering his own run for governor. “And I don't currently believe that Sacramento is properly positioned for an inevitable slowdown in the economy."

And though Mahan, leader of Silicon Valley’s most populous city, is a frequent critic of the governor, he is far from the only Democrat who sees liability for Newsom.

"It does put the governor in a tough situation, because he is trying to do this last year where he can go around touting accomplishments,” said Andrew Acosta, a Democratic political consultant in Sacramento. “If the next governor comes in and says, 'We’ve got to clean up the mess that the last governor made,' that's not going to be helpful for him."

Newsom this month pitched a brighter version of California’s financial picture than independent experts at the Legislative Analyst’s Office, the state’s nonpartisan budget watchdog. His office projected a relatively small, $2.9 billion deficit buoyed by AI industry revenues, compared to the $18 billion gap the LAO anticipated in its own estimates last November.

“Every year, it’s the same kabuki,” Newsom told reporters last week. “I don’t think there’s been a lot of evidence since they put out their first forecast that we’re wrong.”

State Finance Department spokesperson H.D. Palmer said the governor’s plan identifies an AI downturn as a budget risk but doesn’t “assume a recession” will happen this year, as the LAO did.

“If we could project with relative certainty the specific time point when a market downturn could occur, we should be playing the Sportsbook in Vegas,” Palmer said.

But even Newsom acknowledged last week that “something could happen, a ‘black swan’ event … Don’t think for a second I’m static, looking at the budget, assuming anything. We game all this stuff out.”

Newsom, who has railed against the wealth tax, told POLITICO last week that he’s been working quietly to reach a compromise before the initiative qualifies for California’s November ballot, including meeting with a top labor union official spearheading the effort.

Still, the possibility that it might go forward threatens to accelerate the exodus of uber-wealthy magnates and the business activity they fuel. Last month, the Legislative Analyst’s Office and the Finance Department projected the wealth tax could reduce state revenue by hundreds of millions of dollars a year in the “likely” scenario that some billionaires leave California and take their income with them.

That would dramatically eclipse tens of billions of dollars that the agency said the state would “probably” collect from the tax, which would target five percent of billionaire assets. Meanwhile, tax loopholes and the volatile stock market make the exact amount hard to predict.

“If a lot of billionaires left, all those things combined could certainly then have a really negative impact on the state's budget,” said Chris Hoene, executive director of the nonpartisan California Budget and Policy Center.

Or as Michael Genest, who was top financial adviser to Republican former Gov. Arnold Schwarzenegger in the lead-up to the Great Recession, put it: "Of the two big pictures — one, stock market crash, two, billionaires leaving — either one by itself would be catastrophic for the California state budget."

He said, “Our budget is heavily, heavily reliant on the upper income people in the state and on the stock market.”

California’s dependence on the fortunes of a few top earners has led to several massive budget gyrations since the turn of the century, with downturns following the so-called “dot-com bubble” in the early 2000s and the Great Recession later that decade.

Facing deficit budgets in the last three years, Newsom has proposed tough cuts, including a measure last year to curb access to Medi-Cal for some undocumented immigrants. But he’s ramped up spending overall, from $208 billion in his first fiscal year as governor to a proposed $349 billion starting in July. To offset recent funding shortfalls, California’s relied on its booming AI industry.

But budget analysts point to high rates of investor borrowing and sluggish job growth as evidence that the sector is a “bubble” that’s at risk of popping. Even AI titans like Mark Zuckerberg and Sam Altman have suggested their industry’s rapid growth isn’t sustainable.

“California and Silicon Valley in particular, was built on bubbles,” said Larry Stone, a Democratic donor and longtime Silicon Valley investor who served 30 years as a county assessor in the region. “What's happening now with AI is, in fact, kind of classic.”

On top of that, Newsom is contending with a Trump administration that has scrambled world markets with tariff threats while targeting blue states, especially California, with federal funding cuts to health care, food aid, and other programs. Those cuts have blown holes in the state’s budget even as AI revenues pour in.

“The stars are aligned for a nightmare scenario,” said Steve Maviglio, a longtime Democratic political consultant in Sacramento and frequent critic of the governor.

Last week, the LAO slammed Newsom’s budget for painting what it argued was an overly optimistic financial picture that disregarded the possibility of a stock market downturn tied to AI. Agency staff wrote that the risks were “severe enough that not incorporating them into this year’s budget, as the Governor proposes, would put the state on precarious footing.”

California’s progressive tax system relies heavily on personal income and capital gains taxes from high-income earners, many of whom work in tech. The state has raked in cash as firms like Nvidia, Meta and Google offer top AI talent lucrative pay packages that often include stock options.

It also means the state is more exposed if AI stocks tumble.

If billionaires leave and the AI boom recedes, said Senate Budget Committee Vice Chair Roger Niello, a Republican, “that would be a real double whammy. There's no doubt about that — and a pretty serious one.”

AI industry leaders are bullish, saying the sector will furnish California’s coffers with billions of dollars in future tax revenue, a major boon for the state economy. ChatGPT-maker OpenAI estimated in its own economic report from last July that the company and its employees will contribute nearly $200 million in state taxes this year — and will contribute around $6 billion in total economic impact in 2030.

Yet those figures assume an AI bubble does not “pop” between now and the end of the decade. They also rely on continued high-tech chip research powering AI systems and a breakneck pace for data center construction, even as Democrats propose AI regulations to safeguard against spiking utility bills.

If those trends don’t hold and AI companies fail to show signs of turning a profit this year, experts say the firms risk souring their standing with investors, which could discourage new investment in the sector.

Still, Hoene said “it's also important to recognize that we don't know a downturn is coming.”

Yet the potential for a downturn is causing even some lawmakers in Newsom’s party to pour cold water on Newsom’s more optimistic outlook. Assemblymember Nick Schultz, a Democrat from Burbank, said during a legislative hearing this week that while he wants to “share the optimism of the administration,” he agrees with the LAO’s more conservative numbers over “concerns about the health of the stock market and how that might impact revenues."

“We're banking our budget on an economy fueled by AI, for all intents and purposes,” added state Sen. Laura Richardson, a Los Angeles Democrat.

Newsom, for his part, has taken counter-measures to guard against a budget crisis. He’s shielded the AI industry from state Democrats’ most aggressive proposals to regulate the emerging technology, while state Attorney General Rob Bonta last year approved OpenAI’s high-stakes corporate restructuring after getting concessions from the company, which had begun to hint it might move out of state along with its billions if it didn’t get its way.

The state has built up its reserves in the years since the Great Recession, allowing it to weather shocks such as the economic effects of the Covid-19 pandemic and inflation better than prior decades. Newsom’s latest budget proposal contains $23 billion in reserves, and the state can borrow money from other funds as long as it is repaid.

Even some Republicans admit the state’s in a better spot under Newsom.

“We have more in reserves. Our cash position is much healthier,” Niello said, comparing the state’s situation to 2008. But he added: “If we'd have put all that surplus away in the reserves, we wouldn't be anywhere near the problem we have right now.”

There’s a chance that the AI math works out in Newsom’s favor. If industry giants keep booming and California rakes in more tax revenue than expected, it would put California in an even stronger position a year from now. And as proponents behind the wealth tax struggle to win over other labor unions, a mass exodus of billionaires could peter out.

If both issues go his way and state revenues keep climbing, Newsom could leave office on a high note, able to boast that he kept the world’s fourth-largest economy humming while ushering in a wave of progressive policies.

“Governors have to tell the story of their state. That's how they get nominated to be the candidate.” said Doug Herman, a Democratic strategist in Los Angeles who was a lead mail strategist for Barack Obama’s 2008 and 2012 campaigns. “You have to leave the place cleaned up and in good order.”

Recently, Newsom has also closed budget gaps primarily through deferrals and borrowing from reserves, helping to avoid tax hikes while still spending more to create programs that funded housing construction and established universal pre-K for four-year-olds, among other priorities.

Those moves, however, were made with the hope that California’s economic outlook would improve in future years.

“The gimmicks, one-time stuff, borrowing the use of your reserves — those things all come back to bite you,” Genest said.

Chase DiFeliciantonio contributed to this report.