SACRAMENTO — In just a few weeks, California is expected to begin issuing state refunds to more than 10 million taxpayers — a welcome injection of cash into the ailing economy.

There's just one catch: The state may delay the checks or issue IOUs instead.

California, the most populous state in the nation, is running out of cash with a $41.6 billion deficit that Gov. Arnold Schwarzenegger and lawmakers have thus far been unable to resolve despite more than two months of negotiations.

The situation is so dire that the state controller has warned he will have to delay payments to taxpayers, businesses, social service programs and student aid to conserve money in the state's checking account. Finance officials project the state will run out of cash in late February, but the state controller will have to make a decision by Feb. 1.

It would be the second time the state has issued IOUs on tax refunds since the Great Depression but the first time it would be felt widely because the delay comes in the middle of tax season.

For residents such as Cheryl Hubbard, 62, a home care worker from Pasadena, a missing tax refund would throw another wrench in her already tight budget. She said her schedule at her $8-an-hour job already has been slashed by half because of the budget crisis.

"I feel bad because we always end up using it to pay bills," said the grandmother, who is planning to use her refund this year to fix her car. "At one time, people looked forward to their taxes for things they wanted. Now they use it for things they need. If we can't get our tax refunds, we can't pay our bills."

According to the Franchise Tax Board, the state returned $10.7 billion to individuals and businesses last year. The average state refund was $853 for individuals and $13,284 for businesses.

The state normally borrows cash to cover operating expenses until tax revenues come in at the second half of the fiscal year. But this year, the state is collecting billions of dollars less in sales, income and business taxes while it has struggled to obtain loans in a tight credit market.

To slow the bleeding, the state last month froze financing on thousands of infrastructure projects in California, halting nearly $4 billion in loans for everything from freeway interchanges and carpool lanes to classrooms. A state panel is scheduled to decide Friday which critical projects to save.

Mac Taylor, the Legislature's nonpartisan analyst, released a report Wednesday ahead of the governor's annual State of the State address. It signaled California would fall into a cash abyss unless elected leaders act quickly.

"If the massive budget gap is not addressed promptly, the state's insolvency may significantly erode for years to come the confidence of the public — as well as investors — in state government itself," Taylor wrote.

State Controller John Chiang has not said whether he will delay or issue IOUs on tax refunds. But Taylor noted that IOUs could bear as much as 5 percent in interest costs to the state.

Beth Mills, a spokeswoman for the California Bankers Association, said banks have not made a decision on whether they would accept IOUs. Mills said the organization has asked the controller's office to clarify a number of questions, including what the IOUs would look like, when banks could cash them and how much interest the state would pay.

"Right now, there's really a lot of unanswered questions," Mills said.

The last time the state issued IOUs was for two months in the summer of 1992, when many banks cashed the registered warrants for a short time to cover state tax refunds, vendor payments and other expenses, according to the legislative analyst.

State employees who received IOUs sued and won on the argument that it violated the federal Fair Labor Standards Act. However, few taxpayers felt the pinch of that because it happened in July, months after the majority of residents file their income taxes.

This time, though, the state must continue to make payments to schools, debt, state employees' wages, Medi-Cal claims and court-ordered obligations.

John Eastman, dean of the law school at Chapman University and an attorney who has represented anti-tax groups, said issuing IOUs also could invite lawsuits from individual taxpayers.

Lon Sobel, a professor at Southwestern Law School, said it's best for people expecting refunds to file early, but a recent federal extension on Form 1099 income statements from Jan. 31 to Feb. 15 could hamper their ability to do so.

"When taxpayers are late paying their taxes, the state of California charges and collects interest," Sobel said. "I don't know whether the interest goes in the other direction."