Some state workers have already seen their pay and hours cut
The US state of California is on the brink of issuing IOUs instead of making direct payments, after lawmakers failed to agree on ways to balance the budget.
State senators in Sacramento wrangled into the night as the start of the new fiscal year on 1 July approached.
California faces a budget shortfall of some $24.3bn (£14.5bn), but lawmakers are at odds over how to tackle it.
With tax revenues slumping amid the economic slowdown, several US states are facing a budget crunch.
California struggles to balance its budget every year, but this year has been particularly difficult.
And the size of the Californian economy - it generates nearly 13% of US gross domestic product - means what happens there matters.
Amid at times heated debate on Tuesday, the Californian Senate failed to agree on Democratic proposals to shave $3.3bn from education and other programmes as a stopgap measure to address the shortfall.
Gov Schwarzenegger says painful cuts are necessary
Democrats believe cuts should not slash vital social programmes.
"We have that duty to make sure that no one starves," Sen Jenny Oropeza said.
The Republicans argue that much deeper spending cuts are needed to balance the budget.
They and Gov Arnold Schwarzenegger, who has pushed for moves to address the entire deficit, have also ruled out tax increases.
"No-one wants to see IOUs issued but equally important no one wants to see us continue to avoid the problem," said Senate Minority Leader Dennis Hollingsworth.
California's State Controller John Chiang said he would be forced to begin issuing IOUs from Thursday to contractors and vendors, local agencies overseeing health programmes, as well as some people who receive state aid.
"The general obligation bonds will be paid," Mr Chiang told Reuters. "California has never defaulted on its debt obligation and we don't plan to do so."
For many US states, 30 June heralds the end of the fiscal year, but several were facing crucial decisions to balance the books as the deadline neared.
Many of the states are legally required to have a balanced budget, which can mean cutting services and firing workers.