* Revenue, spending mostly in balance
* Economic expansion, tax hikes seen boosting revenue
* Credit rating could be raised
By Jim Christie
SAN FRANCISCO, Jan 14 (Reuters) - California's budget watchdog largely commended the first projected surplus in years unveiled by Governor Jerry Brown, saying in a report on Monday that the state's spending and revenue in his budget plan were now "roughly in balance."
That compares with previous budget plans that had to tackle often massive budget gaps, the Legislative Analyst's Office said in its report.
"Over the past several years, each January Governor's budget has included billions of dollars in proposed solutions - expenditure reductions, revenue increases, borrowing and other actions - in order to close budget shortfalls," the report said.
The Legislative Analyst's Office only in November had predicted a nearly $2 billion deficit.
The Democratic governor on Thursday delivered some rare good news in his spending plan for the state's fiscal year beginning in July, saying California's budget deficit is gone after years of financial troubles, allowing for increased spending on education and healthcare.
Supported by a state economy expanding quicker than the rest of the nation and new revenue from tax increases, Brown's plan includes a surplus of $851 million, in addition to a projected $785 million surplus for the current fiscal year, which ends in June.
The report by the Legislative Analyst's office struck an optimistic tone about California's finances, which the recession, housing crash and financial crisis roiled in recent years by opening massive budget gaps.
California, where deep deficits were also common before the 2007-2009 recession, has the nation's lowest credit rating: A-minus by Standard & Poor's. But the rating agency has a positive outlook on California and sees the potential for an upgrade if the state maintains fiscal discipline.
The office's report on Monday applauded Brown's vow to hold down most state spending and suggested caution.
Some Democrats would like to see more funds going to social services after years of steep cuts and hope to increase spending now that they have a supermajority of seats in the legislature.
"The governor's emphasis on fiscal discipline ... is commendable, especially in light of the risks and pressures that the state still faces," the report said.
The report added that there are "still considerable risks to revenue estimates given uncertainty surrounding federal fiscal policy and the volatility inherent in our revenue system."
Brown said California has to hold down most of its spending due to uncertainty about the direction of talks in Washington over the federal budget and the economic recovery. He also is concerned about potential increases in healthcare costs and lawsuits that could block parts of the state budget.
Brown is correct to stress fiscal discipline given the potential risks to the state's revenue, especially risks from moves in Washington that could hurt the economy, State Controller John Chiang told Reuters on Monday.
"We still have Washington that has to make some very critical decisions," Chiang said.
Under Brown's budget plan, spending in the upcoming year is set to rise $4.7 billion from the current 2012-13 budget. Schools and universities will get a $4 billion boost, health spending will rise $1.2 billion, while transfers to local governments will drop $2.1 billion.
Brown also wants to put $1 billion in a rainy-day fund, pay down internal loans used to help close budget gaps over the past decade and put the state in a position where it can post surpluses in future fiscal years.
While California's finances appear to be stabilizing, in part thanks to tax increases approved by voters in November, the state will still face serious budget challenges, the Legislative Analyst's Office said in its report.
The office pointed to "huge unfunded liabilities associated with the teachers' retirement system and state retiree health benefits."
"As such, the state faces daunting budget choices even in a much-improved fiscal environment," the report said.
HJ Sims analyst Dick Larkin has concerns that California's revenue may not meet the Brown's administration's forecast. But he said the governor's budget plan is reasonable and that if a shortfall reappears it will be manageable thanks to more money flowing into California's coffers.
Larkin expects the state will see its general obligation bond rating raised one notch before the end of this year. "It looks like California has finally turned the corner on credit risk," he said, adding that rating agencies "have just been waiting to bring California out of the basement."