California vs. Texas

It’s hard not to compare California and Texas against each other. Both states are geographically large, coastal, resource-rich, ethnically diverse, and are the #1 and #2 states in both population and GDP. However, the states differ greatly in culture, government, and political and business climate.

Much has been made throughout the Great Recession of the strength of Texas over California. Texans have been crowing about the strength of their economy in comparison to California’s weaknesses. Even though California has been adding jobs lately, its 9.8 percent unemployment rate is sharply higher than Texas’s 6.1 percent rate (that disparity has been true before and through the recession). The Texas economy slid just 1.5 percent in 2009 – the depth of the recession – while California’s dropped 2.2 percent and continued to struggle up to this year. Many would put the blame on California’s “anti-business” attitude.

But a closer look at the two economies shows that in a number of ways, California has been performing well, ranging from long-term economic growth to venture capital investments. A study this last quarter (Q412) by UCLA’s Anderson Forecast said that what separated the two states during the Great Recession was not their business climates, but their mix of businesses. The UCLA economists suggests that Texas’s strength during the recession has largely come from its close ties to the oil industry, which has led the state into both booms and busts throughout the past century, while California’s downfall came primarily because of its reliance on construction and real estate as its key job engine in the last decade. This analyst does not fully agree with this assessment.

California was once a powerful draw for Americans on the move. It was a state where everything could be better. But that California is no more. Around 1990, after decades of spectacular postwar growth, California began sending more people to other states than it got in return. Since that shift, its population has continued to grow (at a rate near the national average) only because of foreign immigration and a relatively high birthrate. Immigration from other nations, though, is declining, and it is likely that the state’s growth rate may soon fall behind that of the U.S. as a whole.

The state now pushes out where it once pulled in. California is a far more populous state than it was in 1960, when it was second to New York in population size with 15,717,204 people. Since then, the state has grown 137 percent, to 37,253,956 in 2010. For comparison, consider New York, which grew by only 15 percent during that same period. On the other hand, Texas has grown faster over these 50 years—by 262 percent. As we’ll see below, though, it’s significant that Texas’s record reflects a recent sprint. Until 2000, its growth matched California’s rather than surpassing it.

So why have job markets in the two states diverged so sharply?

Between 2000 and 2006, California and Texas — the two largest economies in the nation — had virtually the same unemployment rates, tracking within tenths of a percentage of each other. But when the housing bubble popped, the states dramatically diverged. California construction firms, real estate offices and mortgage brokerages shed tens of thousands of workers, bringing the rest of the economy into recession.

Texas, besides the energy and technology industries, excels at factories producing autos, fabricated metals, and other durable goods. But that’s largely because of a shift of manufacturing from the Midwest to factories in northeastern Mexico and Latin America, south of the Texas border. This area has also been the benefactor of rising wages and costs in China, which has shifted more manufacturing back to North America. A diverse mix of industries helped to insulate the Texas economy from the recession.

So what changed California from a “pull” to a “push” state? There is no simple answer to that question. But we do know that several trends converged around that time to sap the state’s economic vitality.

One was the recession of 1990. The state’s unemployment rate, which had tracked the U.S. rate closely through most of the 1980s, surpassed the national average after 1990. By 1993, in fact, the California rate was 2.6 percentage points above the country’s overall rate. Whenever California’s unemployment is higher than the U.S. rate, migration into the state tends to fall and emigration rises. In most years since 1960, California’s unemployment rate has been above the national average.

The early 1990s were the most dramatic demonstration we know of this effect. In those years, California had a sharp and prolonged recession while the rest of the nation was going through a relatively mild and brief downturn. The state’s hard fall was due in part to its dependence on the defense sector which had thrived during the Reagan-era arms buildup of the 1980, and then shriveled with the end of the Cold War. California’s number of aerospace jobs shrunk from 337,000 in 1990 to 191,000 in 1994.

As is to be expected in a recession, construction also took a dive. The number of new residential building permits, which had peaked at nearly 315,000 in 1986, was under 85,000 in 1993 and didn’t exceed 100,000 again until 1997. To put that peak-to-trough drop of 230,000 in perspective, it was greater than the total number of permits issued in any year of the 2000s building boom.

In the same period Texas was coming out of its toughest recession fueled by an energy economy that was not broadly based and created:
• A boom environment. Back then, Texas had been in a long building boom fueled by rising oil prices. Housing prices had risen nicely for years. Many Texans who had started with next to nothing were enjoying a new feeling of wealth as they moved from one appreciating house to another. Sound familiar?

• A finance frenzy. Back then, the savings and loans industry (particularly in Texas) was encouraged by changed accounting rules to make big development loans, booking unearned profits. The end result is that industry is no longer around. Back then, Texas home buyers were advised to put as little as possible down because Texas laws prohibited borrowing equity out of your house. Many people put only 5 percent down — an amount that would be wiped out by selling costs.

• Low, adjustable ‘teaser’ interest rates. Back then, builders and sellers marketed houses by “buying down” mortgage interest rates for a year or two as well as picking up closing costs. In working with production builders back then, it was nothing for the builder to pay 10 basis points to help the buyer ‘afford’ the home. Although ‘buy downs’ were not as giving due to stricter requirements, there was some of this going on in the pre-recession boom. After that, interest rates and monthly payments rose. Many saw their payments rise as the value of their houses fell.

• Employment growth. Back then, construction, oil, real estate, finance and banking employment loomed large in Texas. When the employment growth stops, so does the economy.

California’s population exodus began in the early 90’s, with eventually a net migration of 3.4 million people out of California since 1990. Many of the people “voting with their feet” are the wealthy and productive classes that states and cities compete for.

So what happened to California since the 1990’s that hurt their competiveness?

One of the factors that may have hurt California’s economic competitiveness at the end of the 1980s was that decade’s dramatic spike in real estate prices. Home values increased in most states during the 1980s, but in California they rose far more. According to Census data, the state’s median home values were consistently above national averages in 1940, 1950, 1960, and 1970 but never by more than 36 percent. By 1980, they were 79 percent higher. By 1990, they were 147 percent higher. This was a boon to those Californians who wanted to cash out on their expensive homes and move to cheaper locales. But many consumers saw their homes and real estate investments as an ATM. They could pull equity out of their real estate, spend it in almost any way they wanted, and the surging real estate market would give them a 40+% annual return. It’s shocking, but appreciation on a annual basis in California was running about that according to the Office of Federal Housing Enterprise Oversight (OFHEO), which tracked mortgages and managed FNMA, FHA and FMAC. But for employers looking to fill positions in California, it added to the cost of labor there in comparison with other states. The Texas median home price in 1990, for instance, was less than one-third of California’s.

Looking back on the population surge of the 1980s in California, it’s easy to see why housing prices soared. They were obeying the law of supply and demand, with a boost from the sharp reduction in property taxes brought about by Proposition 13 (then, as now, property taxes were capped at 1 percent of a home’s purchase price, plus an adjustment of no more than 2 percent per year). During the 1980s, the state gained 6,092,257 residents, and builders struggled to keep up by adding 1,903,841 housing units, or less than one for every three new Californians; in the previous decade, the ratio had been one-to-1.6.

Added to sheer demand for housing was the fact that California was growing short on buildable land. This was due both to geography and policy. The most desirable parts of the state are near the coast, where land use was becoming increasingly restrictive. Cities and counties imposed growth controls which continue today, and more and more land was placed off-limits as permanent public open space or preserved farmland. We recognize that many factors go into the price of homes, so it is impossible to determine how much of the California premium was due to building restrictions, land-use rules, land scarcity, demand for housing, or tax policy. We can only note that all these factors played a role and that their combined effect was to make housing far more costly in California than in most other states.

By comparison, housing was a relatively unimportant factor in job growth in Texas as the recession hit, with most new jobs being created in diverse professional fields such as accounting, law, and security services. The more diverse Texas economy also benefited from its interaction with the oil and natural gas industry, which are an important part of the tax base. But in the early 2000’s these were not high growth industries.

Apologists for the Golden State frequently point to Texas’s flourishing oil and gas industry as the reason for its success. Texas does lead the nation in proven oil reserves, but California ranks third. The real difference isn’t in geology but in public policy: Californians have decided to make it difficult to extract the oil under their feet, as well as having a history of passing higher tax burdens to individuals and corporations.
However one of the chief reasons California remains slow coming out of the recession and Texas skirted is fairly obvious. California’s major industries were more directly tied to the causes of the recession, resulting in steeper job loss when the recession hit. California experienced a more acute housing bubble than most states, including Texas. California lost more jobs than many other states because it was the center of the sub-prime mortgage finance industry, and housing was a major employer. In addition, California was also hit harder than most by the slowdown in Asia, which meant that fewer manufacturing goods were being moved to and from its important ports.

All this took a toll on the state budget and forced a financial crisis. This crisis has forced the state to look at harsh realities of new tax revenues. Last November the state passed Proposition 30 (California’s Millionaire Tax to Restore Funding for Education and Essential Services Act of 2012), which increases the tax rate for taxpayers earning more than $1 million by three percent and taxpayers earning over $2 million by five percent, making California’s highest tax bracket 15.3 percent. The tax increases would last for 12 years. The passage of this proposition moved California’s highest tax bracket to the highest in the country (formerly 10.3 percent, above Hawaii, who had the highest tax bracket at 11 percent.) All this took effect January 1, 2013.
The revenue generated from these additional taxes will be used to fund public schools as well as senior and social services.

This 15.3 percent income tax rate, in addition to the proposed highest Federal income tax rate, 39.6 percent, could subject California high-net worth taxpayers to an income tax rate of 54.9 percent on any income over $2 million. (No wonder golfer Phil Mickelson and others have stated publicly that they are thinking of moving out of the state.)

Both the Federal and California tax income progressively, meaning that not all income a taxpayer earns is taxed at the highest rate. For all taxpayers, the first portion of income is taxed at the lowest rate and then higher rates are applied for additional income. For this reason, only income over $2 million would be subject to a 54.9 percent income tax rate. For example, under the current Federal and state tax rates a person earning $2 million dollars would pay $677,314 for Federal taxes and $191,295 in California taxes, without any credits, deductions, or exemptions. That is a total of $868,609 on $2 million or a tax rate of 43.4 percent.

Many of the new California tax laws are aimed at taxing wealthy entrepreneurs. California and Texas have always led the nation in intellectual capital (patents). Lots of these patents were done by entrepreneurs at startup companies. Entrepreneurs are job creators, risk takers, and innovators who generate new wealth. We know that small businesses generate nearly two out of three new jobs in the U.S., and we also know California is suffering greatly with the second-highest unemployment rate in the nation, yet one of the highest tax burdens for individuals and corporations.

As pointed out by our state and local chambers, California’s harsher regulations and continued increased tax burden will continue to push more individuals and corporations to look at more cost effective business environments. Texas and its metros are at the top of the list.

There are many more reasons for the population exodus from California to Texas. We will explore more in the coming weeks.