UPDATE 2-California faces smaller deficit, potential surplus
* "Promising moment" for state's finances
* Revenue seen improving after election
* State still needs to restrain spending
By Jim Christie
SAN FRANCISCO, Nov 14 (Reuters) - California faces a $1.9 billion budget gap for its next fiscal year, a much smaller deficit than in prior years due to the economic recovery, spending cuts and new revenue from tax hikes approved last week by voters, the state's budget watchdog said on Wednesday.
"Our economic and budgetary forecast indicates that California's leaders face a dramatically smaller budget problem in 2013-14 compared to recent years," the report by the Legislative Analyst's Office said.
California has reached a "promising moment: the possible end of a decade of acute state budget challenges," the report added, noting that there also is a "strong possibility of multibillion-dollar operating surpluses within a few years."
California could have an operating surplus in its 2014-2015 fiscal year of more than $1 billion, which could grow to more than $9 billion in the 2017-2018 year, according to the report.
But the office cautioned that its forecast depends on a number of factors, including steady economic growth, rising stock prices and state leaders holding down spending.
"These estimates mean that the new Legislature and the Governor will need to address a $1.9 billion budget problem in order to pass a balanced budget in June 2013 for the next fiscal year," the report added.
Voters last week also gave Democrats a super majority in the state legislature. That allows them to bypass a Republican minority that previously had enough votes to block bills to increase taxes and to overturn vetoes by Governor Jerry Brown if necessary. The governor has been in conflict with fellow Democrats in the legislature reluctant to cut spending.
"We also assume - as the state's recent economic forecasts have - that federal officials take actions to avoid the near-term economic problems associated with the so-called 'fiscal cliff,'" the report said.
California's main source of revenue is personal income taxes, and it relies heavily on its wealthiest residents for that money.
They will face higher income tax rates after voters last week approved tax measure put to them by Brown. The measure raises the state sales tax by a quarter-cent for four years and increases income tax rates for seven years for individuals who earn more than $250,000 a year.
USES FOR NEW REVENUE
The Legislative Analyst's Office in its report urged that California's government use budget surpluses to build a reserve and to tackle outstanding pension liabilities, particularly for the state's teachers pension fund.
Surplus funds could also be tapped to "selectively" restore recent spending cuts, particularly for cuts affecting schools, or to invest in the state's infrastructure, the report said.
Standard & Poor's Ratings Services analyst Gabriel Petek said the report's outlook is in line with his agency's view of California's finances, which have been improving in recent years.
Brown in January projected at a budget gap of more than $9 billion for the current fiscal year ending June 30, 2013, compared with the $25 billion shortfall the state's leaders faced in the prior year.
Petek said S&P would keep a close eye on any moves by lawmakers to dramatically increase spending: "It could undercut the progress they've made were they to accelerate their spending significantly ... They need to be as prudent as possible."
S&P analysts in a note last week said California's credit quality looks to improve after voters approved Brown's tax measure. S&P rates California A-minus - the lowest rating for any state - with a positive outlook.
"The measure does more than temporarily increase operating revenues and, in our view, is the linchpin to the governor's broader, multi-year strategy for reversing the state's negative budget position," the note said.
"By providing a temporary but significant boost in tax revenues and permanently lowering its general fund spending baseline, we believe Proposition 30 helps alleviate the state's chronic fiscal strain," the note added.
S&P's analysts see the potential for revenue raised by the measure to help California pay down three-quarters of its approximately $34 billion in off-balance-sheet obligations from budget liabilities and payment deferrals over the past decade.
Revenue from the measure could also help pay for Brown's "realignment" initiatives, according to S&P's analysts. The efforts involve handing responsibility for some state programs such as jailing low-level criminals to local officials.
One concern for S&P over the tax measure is that it could increase revenue volatility that has plagued California over the past decade because 80 percent of the revenue it raises will come from high-income taxpayers, according to S&P.