California roars back, but there's a 'dark side'

California was hit hardest by the recession, but the Golden State has come roaring back with a vengeance. A new tech boom, the housing recovery and a temporary tax increase approved by voters under Proposition 30 have led California out of a deficit and into a budget surplus. Unemployment has fallen from a peak of 12.4 percent to 6.1 percent.

Now for the bad news.

"There is a dark side for the jobs and the budget," writes economist Bill Watkins, who runs the Center for Economic Research and Forecasting at California Lutheran University. The dark side, in Watkins' mind, is the state's continuing reliance on the fortunes of its richest residents, especially since capital gains in California are taxed as regular income. "With recent stock market losses, California's major taxpayers will likely have a bad year," said Watkins. "Look for California's surplus to disappear quickly."

Under Prop 30, the highest tax bracket in the state moved to 13.3 percent, and capital gains are taxed as regular income. The state says an estimated 10 percent of total personal income tax revenue comes from capital gains, or about $12 billion this year.

"So far we have not seen a big drop (in tax revenues), but there's a real risk," said Jerry Nickelsburg, senior economist for the UCLA Anderson Forecast. He added that the risk could increase if Prop 30 is extended past its 2018 expiration date, "because it extends this extraordinary dependence that we have on high-income earners."

H.D. Palmer of the state Department of Finance said tax revenues in the fiscal year that started July 1 are "so far, so good." However, he is keeping an eye on the stock market: "Just 1 percent — about 150,000 of the returns — are responsible for more than 45 percent of all the personal incomes taxes paid in California."

However, Palmer pointed out that, unlike during the recession, California now has a rainy day fund. Any capital gains tax revenues above 8 percent go into that fund as a sort of hedge against the markets. "We know that the economic expansion that California has enjoyed is going to come to an end at some point," said Palmer. "We just don't know exactly when that's going to be."

The good news is that California can expect to see more people earning more money. The Los Angeles Economic Development Corp. predicts the state will add over 386,000 jobs this year "with the biggest gains coming in administrative and support services, professional, scientific and technical services, and leisure and hospitality." California contributes 13 percent to U.S. GDP, with an estimated output of $2.3 trillion last year. The UCLA Anderson Forecast predicts the state will see employment grow 2.7 percent this year, before starting to slow.

As hiring slows, however, housing prices will continue to accelerate. The median price for a home in San Francisco is now $1.25 million, up 18 percent in a year, according to CoreLogic. Prices have topped $1 million across the bay in Berkeley. In Los Angeles, median prices are closing in on $500,000. "Affordability has become a real issue," reports the UCLA forecast, which added that California's drought in affordability will only get worse over the next two years.

This is bleeding over into higher rents. According to UCLA's Nickelsburg, the percentage of renters spending at least 30 percent of their incomes on rent has grown from 40 percent to 46 percent. H.D. Palmer in the state's finance department said California continues to see a greater increase in construction of apartment buildings over single-family homes. "That's a trend we've seen for a number of months."

As if that isn't enough, Watkins at CLU threw in one more worry: "China … is a major concern."

There is a silver lining, though, just not in the economic forecast. It's in the weather forecast.

Rain is coming: storm clouds, which California will welcome after four years of drought. Whether it rains or not, Watkins points out the state's massive agriculture industry has been adapting for years, boosting production with less water. "This is a story of fabulous innovation," he writes, "one that producers in other industries can look to for inspiration."