Democratic leaders sued, and a Sacramento County Superior Court judge ruled in 2012 that Chiang violated the California Constitution's separation of powers clause.
A three-judge panel of the 3rd District Court of Appeal affirmed the lower court's ruling Friday.
Chiang said he was acting under 2010's Proposition 25 when he decided they had failed to meet the constitution's June 15 deadline for passing a balanced budget and halted lawmakers' pay for 12 days.
"The controller cannot second-guess revenue estimates," the appeals court said in its 11-page ruling, headlining a section in which it ruled Chiang had no power to do his own analysis of whether the budget as passed was, in fact, balanced.
Chiang called the ruling "a setback for important reforms voters made to California's budget process three years ago."
By letting lawmakers alone decide if their budget is balanced, the courts have created "a loophole that undermines the voters' desire to only pay lawmakers when they discharge their most important and fundamental duty: to pass a budget that is both timely and truly balanced," Chiang said in a statement.
A spokesman could not say if he would appeal the ruling.
The appeals court said that while there is no role for the controller, the governor can enforce Proposition 25 by vetoing the budget or using his line-item veto to balance spending with revenue. Indeed, Chiang acted after Gov. Jerry Brown already had vetoed the budget for being imbalanced, forcing lawmakers to pass a new spending plan.
It illustrates that there's still a gray area in Proposition 25. The issue hasn't been tested since 2011 because the Legislature passed balanced budgets in subsequent years.
Senate President Pro Tem Darrell Steinberg, D-Sacramento, and Assembly Speaker John Perez, D-Los Angeles, praised the court's decision while emphasizing that lawmakers are not asking for and will not receive back pay.