updated 1:08 a.m. PT, Sat., July 18, 2009

SACRAMENTO, Calif. - A deal to solve California's $26.3 billion budget deficit could come as early as this weekend after legislators and Gov. Arnold Schwarzenegger made "huge progress" during hours of closed-door negotiations, state lawmakers said.

"This thing is coming to an end sooner than later," Senate President Pro Tem Darrell Steinberg, D-Sacramento, said Friday. He said an agreement could come as soon as Sunday night, when talks are scheduled to resume.

Democratic Assembly Speaker Karen Bass said late Friday that she was optimistic they would reach a deal soon, adding that both sides "made huge progress today."

Hours before lawmakers and Schwarzenegger began their latest round of talks, the U.S. Department of Labor reported that California's unemployment rate remained at a record high of 11.6 percent, underscoring the challenges facing the state's economy.

Income tax revenue to the state has plunged 34 percent during the first five months of the year, leading to a massive imbalance between the state's income and its spending obligations.

It's that imbalance the governor and lawmakers are trying to fix in a budget that was passed in February.

'We still have a ways to go'
Despite the renewed sense of optimism, negotiators still have not resolved the main points of disagreement that have prevented a deal so far, including whether to repay billions of dollars to public schools for money that was cut from earlier budgets and whether the state should maintain a reserve fund for emergencies.

"We are closer than we have been, but we still have a ways to go," said Aaron McLear, Schwarzenegger's spokesman.

Schwarzenegger, a Republican, disagrees with the Legislature's two Democratic leaders over how the state should guarantee that schools will always get back what is cut during lean budget years. Both parties agree schools should be repaid about $11 billion from recent budget cuts, but Democrats want a written guarantee enshrined in the state's complex education funding formula that schools will always get such repayments.

The administration believes such a change would require voter approval.

Education advocates prefer to make repayment permanent because they feel the governor hasn't always made good on his past promises. In 2005, the administration agreed to repay $2.9 billion to public education after the state's largest teachers union accused Schwarzenegger in a lawsuit of taking school funding and refusing to pay it back.

Another negotiating point was over whether to take money from city and county governments, many of which have experienced steep declines in tax revenue and are being forced to lay off workers, including law enforcement officers and firefighters.

"Folks are gathered across the street right now to talk about how to take money from our schools, from our cities and our counties," San Mateo County Supervisor Rich Gordon said Friday during a conference of about 500 local government officials to discuss Schwarzenegger's proposals to take billions of dollars from local treasuries.

The crowd across from the state Capitol responded with hisses, boos and shouts of "No way!"

Some local government groups have threatened to sue if the state tries to pry away their tax money. Republican lawmakers, some of whom are needed to reach the two-thirds threshold for passing a budget in the state Legislature, have been cool to the idea of raiding local coffers.

The resumption of talks came on a day that state government offices closed for the second time this month and as a health program for low-income children stopped accepting new applicants for the first time in its 12-year history.

Healthy Families, which offers reduced-cost medical coverage to low-income children, began putting new applicants on a waiting list because of a projected shortfall of at least $90 million. Advocates fear as many as 570,000 children would be denied access to health coverage, but program officials pegged the figure around 400,000 if the freeze were imposed for an entire year.

"I understand there's no money, but the kids, they deserve to have some health insurance, some coverage. We don't have enough income to pay for their medical bills," 26-year-old Pa Lor said as she signed up for the waiting list at a Sacramento County Healthy Families contract provider.

The effects of California's fiscal crisis are being felt throughout the state, with IOUs going out to thousands of state vendors, state government employees forced to take three days off a month without pay, teachers uncertain about whether they will be called back to work as the school year approaches and the state's credit rating in the tank.

In an early glimmer of good news, Citibank announced Friday it was extending the period it will accept IOUs, which the state began issuing this month to preserve cash. That will provide temporary relief for vendors who have been issued the warrants instead of payments for providing staffing, cleaning office supplies and other services to the state.