(Note:Cross posted from Orange County Progressive)

In trying to follow local politics here in Orange County, I’ve been looking very closely at local government budgets, and there’ s one trend that seems to be emerging rapidly. We’re seeing a precipitous decline in local sales tax revenue. And this is not going to be a temporary problem, but rather one with serious long term impacts.

I was absolutely floored by OCTA’s fiscal review that showed a difference over three years, in the projection of revenue from sales tax, that lowered the 2009-2010 projection of sales tax countywide by 19% over their previous projections. (This was a difference between projections, not between actuals, but both current and previous projections were based on solid actual numbers and best case projections).

The decline in sales tax has two components, and one will not recover. What nobody seems to be picking up is the relationship between the mortgage bubble and the collapse in California sales tax.

Calculated Risk has consistently posted graphs and reports that show Mortgage Equity Withdrawal (people taking money out of their houses) as a percentage of disposable income. If you read the Irvine Housing Blog, you’ll see example after example of folks who used their house as an additional income from 2000 to 2007, turning debt into tax-free income, frequently in the range of 50,000 a year. The phenomenon peaked in Q4 2006 when MEW was nine (9)% of disposable income nationwide, and 6% of consumer spending.  A year later, it had only dropped by around 20%. Now it’s essentially cut off because no one will fund the loans anymore, and no one will even fund the credit card debt that was routinely paid off with visits to the house ATM machine.

Because Orange County in particular, and California, in general, have housing prices so much higher than the national average, and because we were at ground zero for the origination of the new mortgage products, my guess is that mortgage equity extraction in the OC may have been as much as  twice the national average as a percent of disposable income, meaning that up to  18% of the county’s disposable income, and 12% of the taxable sales, were coming from MEW.

So sales tax revenue money fell off a cliff in fiscal 08-09, although the  lag in reporting and balancing reports is making that truly apparent only now. Last September  the drop-off was in the six per cent range. Costa Mesa is now reporting a 12% year over year decline in sales tax for 08-09. John Chiang just reported that “sales taxes continue to be hammered by diminished retail spending across the state”, with an 11.8% year to year drop-off in March. (And March sales might have borrowed some high ticket sales in advance of the April 1st sales tax increase!) If you dig down into the details of this  Rockefeller Institute report, you’ll see that a national decrease in retail sales tax reported by the Wall Street Journal is actually a phenomenon driven by the real estate bubble states of CA, FL, and AR. Double digit sales tax losses in those states pull the national “average” loss of 6.2% down to 3.2%.

It’s hard to figure out how much of the decrease is a result of a general economic slowdown, and the huge job losses, and  how much is based on the end of MEW, but my observation is that nobody is even factoring in the disappeared MEW as a part of the problem, and local and state electeds seem to think that normal cyclical patterns will reassert themselves so that retail sales will revert to the mean, Therefore, current assumptions and 2009-2010  budgets at every level may be  underestimating both the current and future drop-off in sales tax revenue.

Instead, it’s more likely that a significant chunk of our retail sales (let’s say 10% when compared to FY 2006-07) are gone forever because of the collapse of MEW, and the jobs in local retail, restaurants and services are following the jobs in finance, real estate, and all the affiliated jobs that supported the refinance industry. There are always lags, especially with small business owners who are reluctant to throw in the towel, but we already have far more retail than we need, and much of it is unprofitable.

Because of the budget preparation cycle, and the lagging revenue information, local budgets for 08-09  were based on retail sales for Q1-Q4 2007, so cities are drawing down reserve general fund balances at a rapid rate, leaving very little flexibility for ensuing years.  Mid-year revisions didn’t cut expenses fast enough, so as budgets are finalized and the retail sales numbers for FY 08-09 receive real visibility, you’re going to see a series of bad choices.

This will hit transit first and hardest, where local transit funds come from a 1/4 cent tax, and we’re looking at devastating impacts in bus and transit systems in Orange County and across the state.

Effects of sales tax collapse varies dramatically from city to city and agency to agency based on the share of property tax that local governments get, which is a bizarre calculation made when prop 13 went into effect, but the overall effects are dire. Property taxes, whose gross receipts had been going up around 6% a year, based on the 2% increase for existing properties, and huge gains for resales. My guess, more pessimistic than most, is that property tax revenue will now be decreasing in the 2% per year range as property values drop by 50% and reappraisals slowly move through the assessors’ systems, with some additional problems with non-payment.  Hotel taxes, which are a big income source for many cities, are plummeting with the general economy. Even stable sources like business license fees, franchise frees, and utility taxes are dropping, so there are no positives to balance out the drop in sales tax.

Given the way that local politics work, and the incredible power of public safety unions, my gut feel is that very few California cities will react quickly enough taking the steps they need to balance their budgets, and that the Vallejo bankruptcy is a precursor to a wave of municipal failures. It’s going to hit hardest, first, in the places where we’re already at depression level unemployment numbers, with no new jobs in sight. Look at  Merced that has a 10 million plus gap in a 40 million dollar budget for next year, after budgeting to dip 4 million into reserves to balance the 08-09 budget. Merced anticipated a 7% drop in sales tax, and saw close to 19% off in the the fourth quarter of annual 2008.  And there are fine points that people don’t get. Merced will not only burn through the reserves that they thought could carry them for five years, but they’ll also lose the $800,000 or so of revenue that they used to make in interest on the reserves.

Merced’s an extreme case, but it’s just a little earlier than a city like Huntington Beach, which is now looking at a shortfall of at least 6 million in revenue for the 2008-2009 fiscal year.

Every local government is going to be facing double-digit cut backs in budgets for 2009-2010, and even worse cutbacks in 2010-11 if their projections are too optimistic, and they get hit with substantial increases in PERS contributions that year.

Obama’s stimulus funds are patching a huge hole in the state budget, but aren’t going to fill the problems with local funding shortfalls.

All of the cities are applying for a part of the ONE BILLION DOLLARS (cue Dr. Evil)  that Obama has pledged to maintain local law enforcement, but that’s divided over three years, and may pay for  5,000 cops nationwide, maybe 500 in California or an average of one for every one of California’s 458 cities  and 58 counties.   Innumeracy reigns at the council dais sometimes when elected officials are grasping at straws.

We’re going to see an extreme makeover of local government. Some revenues will recover very slowly. Other revenue, like the phony money that was coming from the housing ATM, are just not coming back.

Local governments have grown used to steadily increasing revenues, and have planned accordingly. Now they have to hit the reset button.

Extreme makeover time!