Besides the welfare and social service reforms, education funding is one of the key negotiating points. Lawmakers are trying to decide whether it can be cut and, if so, by how much. Funding for K-12 schools and community colleges accounts for roughly half of annual state spending.

The possibility of a breakthrough in resolving California's mammoth budget shortfall comes a week after the state began issuing IOUs to thousands of vendors as a cash-saving move. State workers also have begun taking three days off a month without pay, cutting the salaries of more than 200,000 government employees by 14 percent.

The state's fiscal picture has become progressively worse since Schwarzenegger and lawmakers passed the budget for the current fiscal year last February during an unusual midyear session.

Personal income taxes declined 34 percent during the first five months of the year, a slide that has accelerated as the recession continues to strangle California's economy.

On Friday, the state controller's office reported the state had spent $10.4 billion more than it collected in the fiscal year that ended June 30. It is now without sufficient cash to cover all of its payment obligations.

If the budget isn't balanced by late August, the state will have to defer payments to its pension funds and may issue IOUs instead of paychecks to state employees.

The unprecedented drop in tax revenue is forcing Schwarzenegger and lawmakers to make difficult choices, with deep cuts proposed to education, health and social service programs.

At the same time, Schwarzenegger and Republican lawmakers are standing fast against additional tax increases, limiting lawmakers' options for closing the deficit.

The two-year budget package approved in February increased sales, personal income and vehicle license taxes, and Republicans say the state's economy cannot absorb additional tax hikes.

While the governor and lawmakers try to reach a compromise, some of the state contractors who are being issued IOUs will have to start scrambling to find banks that will cash the warrants. Bank of America Corp. and other major banks said Friday was the last day they would honor the IOUs, which cannot be redeemed until Oct. 2.