California has more expenses than revenue. And that's causing a fiscal headache for Gov. Arnold Schwarzenegger, who is seeking approval of his 2008-2009 budget. State lawmakers were supposed to have approved the budget by July 1, but as of mid-August, they had failed to do so — as they have all but four times over the past two decades.

The Golden State, boasting the largest population in the United States with 36.4 million residents, has a whopping budget deficit of $22.2 billion — the largest in the nation in terms of both total dollars and amount per taxpayer. New Jersey is a distant second with a proposed budget deficit of $3.5 billion.

In an effort to reduce expenses and prod state lawmakers to quickly approve the budget, Schwarzenegger ordered his administration to lay off thousands of part-time employees and temporarily slash the pay of most full-time staff. He also imposed a hiring freeze and restricted overtime pay.

More than 10,000 government employees have lost their jobs and nearly 200,000 employees could have their pay cut to $6.55 per hour, the federal minimum wage, until a budget is signed. As of mid-August, the pay cuts had not taken place and Schwarzenegger has filed a lawsuit to force cuts in state workers' salaries each time legislators miss their deadline.

While the budget brouhaha takes center stage in the state's capital, outside of Sacramento, Californians are more concerned about the underlying cause of the budget deficit rather than the impact of the government job cuts and pay reductions.

California Credit Union League (CCUL) economist and a former economist with the U.S. Department of Labor Terrin Griffiths doesn't expect Schwarzenegger's cuts to have a tremendous impact on the economy because we've been hit so hard by the housing slowdown. “There are bigger issues at play here — the housing crisis and the national economy,” says Jeffrey Neustadt, president of Portfolio Development Partners LLC, a Walnut Creek, Calif.-based shopping center developer. “Retailers and retail developers are making their decisions based on those things, rather than the budget and the job cuts the governor is proposing.”

Declining revenues

The economic forecast underlying Schwarzenegger's budget assumes California will feel the effects of the economic slowdown more than the rest of the nation, according to the Legislative Analyst's Office, a nonpartisan group that evaluates the state's budget. The administration says the state's economy will slow this year and there will be a slight loss in jobs while personal income will rise 4.5 percent. As a result, economists argue that the state has already tilted into a full-fledged recession. “There are no strong markets in California — there are only less weak markets,” says Christopher Thornberg, principal of Beacon Economics, a Los Angeles-based consulting firm.

The firm, which specializes in analyzing the national and local economies, noted most of California's economic woes can be directly tied to the housing slowdown. California had some of the highest appreciation in home values during the boom. Over the past two years, home prices have fallen by as much as 40 percent in some parts of California, according to Thornberg.

The falling home prices have a direct correlation to the region's gross product, notes Norm Miller, an economist and director of academic programs at the Burnham-Moores Center for Real Estate at the University of San Diego. For every 10 percent decline in home values, the gross metro product (GMP) decreases by about one percent. And, every one percent decrease in GMP translates into a drop in retail sales of about seven cents per dollar.

The housing crisis has also contributed to decreased property tax revenues, Miller says. And, since construction has slowed, local governments are seeing decreasing development impact fees, which range from $45,000 to $185,000 per housing unit.

Meanwhile, in July the state's unemployment rate rose to 7.4 percent compared to 5.4 percent the same month a year ago;. It was 4.9 percent in July 2006, according to the U.S. Bureau of Labor Statistics. As a result, from July 2006 to July 2008, income tax revenue in the state fell $1.3 billion, according to the California Department of Finance.

Weakening consumer spending

Beyond income and property taxes, the biggest decline in the state's revenues comes from shrinking consumer spending. Even consumers who still have jobs and the ability to pay their bills are spending less. “For a lot of Californians, their decision to spend less is completely psychological,” says Mark Schurgin, president of the Festival Cos., a Los Angeles-based shopping center owner and developer. “They don't feel confident enough to spend money, so they're saving it.”

While there are no statistics for retail sales in the state, it does monitor sales taxes. Looking at those numbers a drop is apparent. Sales tax receipts for the state were $81 million below the expected $2.04 billion estimate for July, according to the California Department of Finance. Year to date, sales and use tax receipts are down more than 4 percent.

Festival is closely monitoring its retailers' monthly sales figures looking for any signs of weakness. A recent company report shows sales are off 5 percent to 8 percent and the decline is most severe at its suburban properties in the Inland Empire and the Central Valley.

Nevertheless, many retailers are still expanding in the state. “I think most of them see California as a bright spot with good strong population growth and intrinsic disposable income,” says Steve Cutter, president of Lockehouse Retail Group Inc., a Burlingame, Calif.-based brokerage firm.

Weingarten Realty Investors however, has experienced a growing number of requests from retailers for rent reductions or early lease terminations, says Neil Soskin, vice president and director of leasing for the REIT's western region. Occupancy at the Houston-based company's California portfolio of more than 25 properties comprising four million square feet, is 95 percent today; down one percent from a year ago.

With a half dozen projects on its plate, Weingarten is expected to take a break from development and work on leasing its existing centers. Also taking a more reserved approach to development is Portfolio Development Partners. “We are approaching deals the way we used to — we're now doing all the work up front including the entitlements, leasing and financing before we buy the land,” Neustadt says.

The solution

In the past, California's lawmakers have tried to solve the state's budget deficits by cutting expenses. That strategy might not work this time around, says the California Budget Project, a nonprofit organization that provides expertise on state fiscal and economic policy issues.

A recent report by the organization says every dollar the state cuts in spending reduces consumption by the same amount. The dollar-for-dollar reduction occurs because state spending cuts disproportionately impact lower-income Californians, who typically spend all their income.

A better solution, economists say, is for California to find additional sources of revenue, which usually means increasing taxes. Most states would choose to increase property taxes, but that's not really an option in California because of Proposition 13, which limits taxes on both commercial and residential property. Some lawmakers have suggested exempting commercial property from Prop 13 but that does not have strong support.

Instead, there has been talk of raising taxes. A Democratic Party-backed budget plan, voted down last month, included $6.6 billion in increases. It would have boosted the income tax rate for families earning more than $321,000 to 10 percent from 9 percent, and for those earning more than $642,000 to 11 percent from 10 percent. The proposal also would have raised the corporate income tax rate to 9.30 percent from 8.84 percent.

In the interim, Schwarzenegger has proposed a temporary one-cent sales tax increase to be assessed in 2009. It hasn't received much support, says Griffiths, since those taxes fall disproportionately on low-income residents.