SAN FRANCISCO — If there’s anyplace in the country where rising tax rates should choke off an economic recovery, it’s California. On top of the federal tax hikes that kicked in last month, the state has just raised income taxes on its wealthiest residents to the highest levels in the nation, a move that conservatives warn will drive millionaires and their companies to other states, taking jobs and growth with them.
The increases come as California’s economy continues a remarkable turnaround. A year ago, the state was a mess, with double-digit unemployment, a bottoming-out housing market and scary budget deficits. Now, hiring is up faster than the national average, and the housing market is regaining strength. Even the state budget is back in the black.
What happens to the economy here over the next year will be a case study for policymakers in Washington, who are paralyzed by similar questions of taxation and growth. The early indications, in California, point toward an outcome you might not expect.
The tax increases approved in November are a big reason the state isn’t staring down another huge budget shortfall or the prospect of issuing IOUs to fill it. They include bumping up the sales tax slightly and raising the top income tax rate to 13.3 percent, which is four percentage points higher than the District of Columbia’s and more than double the rate in Virginia or Maryland.
Yet many economists and some young executives in the state say they don’t worry about that high rate chilling growth. Other factors loom much larger for California’s business and economic health, they say, including whether the state can maintain deep pools of highly skilled talent and, in complicated but important ways, the renewed upward march of housing prices in the Bay Area and beyond.
“I don’t think we should be surprised that the state is growing, nor that California is growing faster than the national economy,” said Christopher Thornberg, an economist and the founding partner of Beacon Economics.
Thornberg gives forecasting presentations to private and civic groups around the state. He projects that even with the tax increases, the state is poised for strong growth in the coming year and is poised to add, not lose, job creators. “In a couple of years in California,” he said, “we’re going to have the problem that we don’t have enough housing, and housing’s too expensive.”
California has the largest state economy; if it were its own country, the state would rank among the world’s top 10. The state often fares worse in recessions than the rest of the nation, and the Great Recession fit the pattern. Housing prices collapsed in the Central Valley and Southern California’s Inland Empire, leaving hundreds of thousands of families in foreclosure and millions owing more on their mortgages than their homes were worth. The state lost more than a third of its construction jobs. Unemployment peaked above 12 percent.
Unemployment is still 9.8 percent in California, two percentage points above the national rate. But by all indications, the state economy has improved rapidly in the past year. California’s unemployment fell by 1.4 percentage points in 2012, compared with a 0.7-point drop for the country as a whole.
The state’s recovery has two drivers, economists say. The innovative engines of growth along the Pacific Coast have roared back to life. Also, the state’s housing market is no longer the anchor on growth that it was for several years: Prices bottomed out in 2012 and began to rise, construction permits are up, and contractor hiring is accelerating.
Rising home prices don’t just help the economy by driving new construction. They also free up more consumer spending and seed small-business growth, as entrepreneurs borrow against the value of their homes.
You can see all those factors at work in the Bay Area, where high-tech start-ups are increasingly sprouting and expanding across San Francisco and bulldozers are rolling again in the millionaire bedroom communities east of Oakland.
The region and the state are flush with venture capital, which is financing the growth of companies such as Sifteo, a next-generation video-game maker of sorts housed in a converted warehouse on the south end of San Francisco.
Sifteo co-founders Dave Merrill and Jeevan Kalanithi created a gaming system consisting of small cubes that players shake, touch and bump together to complete puzzles. The company sells its system online and in stores for about $130 for a set of three cubes; its staff of 27 has overgrown its office, where commuting bikes hang on the walls and electronic components spill over desks.
Merrill and Kalanithi hold PhDs from the MIT Media Lab. They’ve secured nearly $14 million in funding from investors since 2009. They hired 10 people last year and plan to add five more this year. They just acquired more office space to house their growing team. It was a fight for the space — the building is nearly full of companies — but Merrill says nowhere in the country would be a better home for Sifteo because of the concentration of engineering talent in the Bay Area.
Ask Merrill what he worries might disrupt his business in the next year, and he ticks off a list: Political changes in China that might raise the cost of manufacturing products there. A plunge in consumer confidence in America. A rapid decline of big-box retailers that stock his products.
He does not worry, he says, about tax increases.
Standard economic models hold that tax increases reduce growth. Some Republican governors are hoping that California’s hikes will drive companies and wealthy people to other states. Texas Gov. Rick Perry has openly courted California firms, and Ohio Gov. John Kasich just announced plans to do the same.
But many Golden State economists say the tax hikes won’t drive away companies. A Stanford University study last year found no link between tax rates and wealthy Californians’ decisions to leave the state, and the state has a history of tax increases not affecting growth, including under a Republican governor — Ronald Reagan.
“The evidence is, from past tax increases, that it makes very little difference,” said Jerry Nickelsburg, a senior economist at the UCLA Anderson Forecast, who predicts only a slight scrape to state growth from the new rate increases. Since 1967, he added, tax hikes and cuts in the state have had a “second-order effect” on growth.
The bigger threat, other economists say, might be another run-up of housing prices, especially where the innovators live.
Housing prices are a much bigger factor in most people’s budgets than state tax rates, said Jed Kolko, chief economist for the online real estate site Trulia. If home prices rise quickly, he said, they constrain growth more than taxes do: “The skilled workforce that California presents as an advantage,” Kolko said, “is also threatened by higher housing prices.”
Data suggest the threat is growing. Trulia reports homes sold for 10 percent more in California in January than they did the year before, with San Jose and Oakland the two hottest markets. That was double the rate of increase for the nation as a whole.