While unemployment, falling house prices and businesses staggering from recession are the reflections of California's fiscal crisis, its population, industry and market base, technology and innovation rates of development are still going strong.

California is in its third year of a state budget and fiscal crisis exacerbated by a global economic crisis, according to Al Hyde, professor in the department of Public Administration at SF State.

The fiscal condition includes declining revenues from tax sources, increasing costs from public programs for services and salaries and interest costs from state borrowing.

Despite its high growth status, California was not prepared for the national-global economic downturn proportions manifested in 2008.

Historically, there has been a repeating pattern of boom and bust budgeting over the past 25 years.

"The state of California 'overspent' when economic times were good and cut back dramatically during recessions and overspent when economic growth returned, trying to catch up in terms of financing state programs," said Hyde.

Another contributing factor to the fiscal crisis was the passage of Proposition 13, which changed the fiscal relationship between state and local levels of governance, he said.

In 1978, Californians approved Proposition 13 to diversify the state and local tax systems. State and local levels share expenses for some public services. The state, because of its larger base of resources, supplements and supports basic services like education and social services.

"Local governments have been bereft ever since Proposition 13 took away their property tax base. The state tries to make it up, using sales taxes and taxes on capital gains, but these are particularly volatile in recessions," said Richard A. Walker, geography professor at University of California Berkeley.

California has a public fiscal crisis primarily because it has a state budget, Hyde said. Local budgets are highly dependent upon it and built on a highly elastic and progressive revenue base that easily gets out of sync when spending decisions aren't linked to it.

There are two sets of political factors that contributed to the crisis, according to Hyde.

First, the political process of the state budget requires a two-thirds vote of the legislature to pass the budget. Which means that some part of the minority party must approve the budget -- if the Republican Party does not accept any tax increases, the budget will only pass if spending does not exceed revenues. This sounds right, but this process works in low-stress, positive economic times, not during recessions, when revenues fall, stated Hyde.

Second, the standard for passing a voter referendum in California is low. This means it is relatively easy to get the petition signatures to put things on the ballot and with some advertising and low voter turnouts, passage is relatively easy, Hyde said. In this way voter referendums can omit funding for programs and incorporate some degree of popular control in the budgeting process that can override fiscal discipline.

On the economic side, according to Hyde, there were three factors that created the California budget crisis: the collapse of the housing bubble, increased unemployment and the progressive income tax structure.

During the collapse of the housing bubble for the upper end, housing prices fell by more than one third. At the lower end, foreclosures escalated dramatically. California, with the largest population and housing stock, had over 25 percent foreclosures. This factor caused tax revenues from property tax, building start fees and sales tax on home improvement to fall.

Property taxes are usually seen as stable sources of revenue for local governments. But economically, "Property taxes are highly variable because they depend upon the real estate value. For years, California benefited from a high real estate market," Hyde said. In late 2008 the state's Department of Equalization reported that annual change in revenues fell from +12.55 percent in 2006 to 4.8 percent in 2008 to -6 percent projected for 2009 and are expected to become positive in 2012. This represents almost 20 percent shift in revenue.

Second, the rise in the unemployment meant a decline on income and sales tax revenues, and state costs for unemployment benefits increased.

California Unemployment Rate (%)
Through Peak Change
Dec-79 6.17 Sep-80 7.23 1.07
Jul-81 7.03 Dec-82 10.97 3.93
Jul-90 5.13 Nov-92 9.87 4.73
Mar-01 4.73 May-02 6.73 2.00
NA Sep-08* 7.70

*Current Estimate by Beacon Economics
Source: California Employment Development Department (EDD)

The third factor, and most damaging one, was the state's rapidly progressive income tax structure augmented by the state's dependency to capital gains and stock options used as sources of revenue, said Hyde. In 2007, the last year of the high economy during this decade 2000-2009, these two tax sources accounted for nearly $15 billion in revenues constituting just under 15 percent of the General Fund. If the state had treated capital gains and stock options differently, more like "windfall profits" tax and not as a free source of revenue, the state's fiscal decline would have been less considerable, he said.

The state has relied pronouncedly on personal income tax as a main source of income. Approximately $90 billion, over half of the state's annual revenues, was attained mainly from the top 1 percent earners in the fiscal year 2009.

Forecast of Personal Income, Sales and Corporate Taxes (Billions)

Fiscal Total Tax Total Change from

Year Revenues Previous Year

2008-09 87.3 -4.0

2009-10 81.6 -5.7

2010-11 85.0 3.3

2011-12 94.6 9.6

*Forecasts by Beacon Economics

Besides the income tax revenue there is also a very significant share of income tax revenues derived from capital gains and stock option taxes. As the center of the new high-tech economy, California received $16 billion in 2000 from tax gains, a big contrast with $2.8 billion in 1995. At its highest point, over 20 percent of California's revenues came from taxes paid on stock gains and stock options cashed in, allowing the state to accumulate endless budget surpluses without fiscal effort or spending discipline. Therefore, the state relied on income tax, an intrinsically volatile source of revenue, said Hyde.

Everyone shares different levels of responsibility for the fiscal crisis, stated Hyde. Governors for not coming up with revenue and spending coordinated budgets but claiming fiscal waste, unions, and large program costs as the cause. Legislators and their parties using either their majority or minority polar positions to refuse to balance the budget by making changes on both spending and revenue. Also responsible, he said, are interest groups and organized groups who push their own agendas at the expense of the overall budget; and the public, voters who support spending for selected programs or future investments while capping or reducing taxes at the same time.

In California, the Legislative Analyst's Office is responsible for monitoring and analyzing the state's fiscal affairs, providing regular forecasts of revenues and budget deficit projections which significantly under-estimated the fall of revenues over the past year.

At federal level, the National Office of Management and Budget and Congressional Budget Office also missed the severity of the downturn and over estimated the recovery, according Hyde. And economists by and large were equally off in tracking and forecasting the economic crisis.

"What needs to be done is to put back in place a reasonable property tax on commercial property and housing, with safety features for elderly homeowners" said Walker. "We also need to restore corporate taxes and raise high-income tax rates further," he said, adding that "we have more rich people than any other state." Walker believes there also needs to be additional oil lease fees.

But there is hope because despite its 11 percent unemployment and a collapsing housing market, California is still the 8th largest economy in the world, said Hyde. "We may never get to be politically wiser as a state when it counts to budgets- but economically, California is only going to get bigger and stronger," he said.