By Jim Christie

SAN FRANCISCO, Jan 9 (Reuters) - Democrats who control California's legislature expect Gov. Arnold Schwarzenegger to propose a modest increase in spending when he unveils his initial state budget plan -- and they can live with that, the state Assembly speaker said on Tuesday.

The Republican governor's initial budget plan, to be presented on Wednesday, must contend with a forecast shortfall of $5.5 billion and must take into account potential costs from the ambitious health-care agenda he unveiled on Monday, Democratic Assembly Speaker Fabian Nunez told Reuters in a telephone interview.

The budget plan will be revised in May as the state's revenue trend firms, providing Schwarzenegger, who opposes tax increases, and the legislature with the basis for final budget negotiations.

Both sides expect California will not be in a position to be overly generous with its spending.

Schwarzenegger signed a $131.4 billion budget in June, providing California with its first on-time spending plan in six years. That cleared the way for his victorious re-election campaign and for rallying voters behind a $37 billion package of general obligation bond measures for public works on the November ballot.

"We've been working to get our fiscal house in order over the last three budget cycles," Nunez said. "I think the goal for us is to be fiscally prudent with our budget."

"We want a budget that is tightfisted with the people's money but that is also compassionate," Nunez added, noting that Democrats oppose at least one spending cut already proposed by Schwarzenegger and supported by the legislature's Republican minority.

The governor's aides said on Sunday he aims to cut $465 million in welfare spending.

But Nunez said Democrats have generally positive reviews for Schwarzenegger's health-care plan: "Overall we're on the right track."

Schwarzenegger on Monday unveiled a plan to provide health-care insurance to an estimated 6.5 million Californians who lack it. Reaching that goal would include an expansion of existing state health coverage.

"My solution is that everyone in California must have insurance," said Schwarzenegger, inaugurated to a second term on Friday after time in the hospital for a broken leg. "If you can't afford it, the state will help you buy it, but you must be insured."

Because he has vowed to make health care a top priority this year, Schwarzenegger is likely to put forth an initial budget plan with little for Democrats and Republicans to fight over, said Bill Whalen, a Hoover Institution fellow and former speechwriter for former California Gov. Pete Wilson.

"Schwarzenegger wants do an exceptionally complicated thing in reforming health care in California. He doesn't need distractions and a budget deficit and a debate over spending cuts versus tax increases would be the greatest distraction he could have," Whalen said.

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