California is a Garden of Eden, a paradise to live in or see;

But believe it or not, you won't find is so hot

If you ain't got the do re mi

--Woody Guthrie (1937)

Almost 70 years ago, the American troubadour Woody Guthrie figured out the paradox of the California Dream. The state has long been a victim of its own success. Attracting those in search of a better life, California doesn't always deliver the goods. But despite their initial struggles, the Dust Bowl migrants and their kin subsequently provided the workforce that propelled an impressive economic expansion.

Today the state is experiencing another round of growing pains, and the most debilitating affliction may be its housing market. California is presently a land of high home prices, rising rents and low homeownership rates. If left unchecked and untreated, these trends will certainly jeopardize the state's fiscal, economic and social health for years to come.

The undeniable reality is that California continues to grow and attract new residents. Although the rate of growth slowed in the 1990s, it still outpaced the rest of the nation. The recent and unprecedented out-migration was more than offset by an influx of immigrants and natural increases. Since the 2000 U.S. Census, more than 2 million new residents now call California home, and experts predict an additional 500,000 people a year for the foreseeable future.

The subsequent increase in demand for housing will place ongoing pressure on local housing markets throughout the state. California is already home to nine of the 10 least affordable communities in the country. While housing costs in California have historically exceeded those in other parts of the country, reflecting amenity value and growth pressures, the recent rise is impressive nonetheless. In 1997, the median home price was about 50 percent higher than the national figure. Yet last year, California's median home price hit $388,000, more than twice the national median, and up almost 20 percent from the previous year. Double-digit, year-to-year percent increases in the median home price have become common. This phenomenon is not isolated to a few select regions but is apparent in both high cost (up 30 percent in Orange County) and low cost (up 27 percent in Fresno County) areas of the state. The result is a homeownership rate that is second lowest in the country (58.9 percent), a full 10 points below the national rate that recently topped 69 percent. And unless prices come down, it is not going to get any better. According to the California Association of Realtors, the percentage of households able to afford a median-priced home stood at 18 percent this past August, down 5 points from the previous year.

Housing costs in the rental market pose similar affordability challenges. In the last three years, the state's median monthly rent has increased more than 19 percent, rising from $747 in 2000 to $890 in 2003. Unfortunately, incomes have not kept up. In other parts of the country, lower-and middle-income families opt for homeownership to better manage their housing costs and begin the process of building up equity. But California's high and rising home prices often preclude this alternative and endanger both family well-being and the state's long-term economic development.

When housing costs eat away large portions of household resources, there is less to save, invest and consume. This is true for both renters and homeowners alike. The barriers to home ownership serve as a particularly onerous obstacle for many families as they strive to achieve economic stability. Clearly, success in America today requires not just a job and growing income, but increasingly hinges on the ability to accumulate a wide range of assets. Purchasing a home is often one of the first steps a family takes on the road to building up wealth, and, even then, housing equity remains for many the largest asset in their financial portfolio.

From an economic policy perspective, the state's housing market has the potential to undermine the ability of businesses to attract a competitive workforce. Since 1994, the state has added three jobs for each new unit of housing; at the same time the construction of multi-family housing has plummeted. According to the state's Department of Housing and Community Development, California added only 1.1 million housing units during the 1990s, about half the number that was added during the 1980s. California has not built enough homes to match the demands of its growing workforce and is in danger of exacerbating the situation by falling further behind. It is no surprise that vacancy rates are near historic lows, making it harder for many to live near their places of work. Besides creating additional problems of congestion, long commutes and environmental degradation, the geographic mismatch of housing and jobs is a serious threat to the state's business climate and economic development prospects.

California's housing troubles have been percolating for years and have been the subject of protracted policy debates. The latest response, a $2.1 billion infusion of state funds through Proposition 46, is a start. But given demographic and market trends, this stimulus may be insufficient. Looking forward, experts cite the need to augment the supply of housing by 220,000 units each year for at least the next 10 years. In the current environment, characterized by high prices, a complicated regulatory process, expensive permitting and high land and construction costs, achieving this output will be a difficult task.

Given the local nature of housing markets, the greatest supply and affordability problems are concentrated in regions of the state with the highest growth pressures. That means there isn't one generic policy elixir. What is necessary across the board is for lawmakers to acknowledge that while housing is built and maintained at the local level, it is done so within a regulatory, fiscal and policy environment of their making. And it is this environment, defined by the relationship between the state and local governments, which must be revisited if California is to address its housing woes.

Perhaps most worthy of reform is the state's fiscal policy framework as guided by Proposition 13. Under the current tax system, local property taxes are capped at 1 percent of market values, assessments can increase only 2 percent per year, and 85 percent of property tax revenues are sent to the state. This means that when a locality allows construction of new housing, the incoming residents don't generate enough local resources to cover the service costs required, such as schools, police and sewers. In short, housing creates more costs than it does revenue. Accordingly, municipalities have prioritized attracting commercial development, often in the guise of strip malls, which provides revenue through sales taxes but doesn't burden services. In a state that needs to encourage the production of more housing, the fiscal incentives are all wrong and need to be fixed.

Furthermore, the state is responsible for maintaining a fair distribution of affordable housing, but it depends upon local governments for action. Through its Housing Element Law, California requires localities to make "adequate provision" of housing, which includes identifying housing needs, development constraints, and a set of housing goals. But many municipalities have adopted a range of growth limits. The problem is that the state lacks the authority to force cash-strapped local officials to build the type of housing needed, which is often costly and politically undesirable. Currently, noncompliance with the law must be established in court; historically, this has proven to be a weak deterrent. And even when a path to build housing is cleared, private developers may be wary of making the effort. Not only do they face high regulatory costs, but often they must confront local opposition in the form of anti-sprawl or NIMBY activism. The increased uncertainty lowers the developer's incentive to participate in affordable housing projects that have built-in low margins.

Any viable policy response must focus on reforms that remove the structural barriers to production. Solutions should be market-oriented, but promoted alongside the right mix of incentives and support for both the producers and consumers of housing. In general, cities cannot be expected to keep up with the state's housing construction demand if they are not better supported financially. State and local leadership must come to agreement on a fair means for distribution of affordable housing and enforcement. Developers should be given incentives to build more housing and buyers should be provided assistance to become homeowners.

Here are several specific proposals for the state to consider:

While the outright repeal of Proposition 13 is unlikely, the formula should be revised so that municipalities keep a larger share of their property tax revenue if they commit these resources for affordable housing efforts. The state should authorize a housing bonus, one that could be awarded competitively or contingent upon performance, which would provide an incentive for local government to help fill the state's housing gap. Just as local governments across the country successfully relaxed zoning restrictions in exchange for a high percentage of affordable housing, the state could reward local governments that meet ambitious housing goals. These housing goals don't have to be hard unit counts but can include a range of inclusionary techniques such as lowering development fees, simplifying the permitting process, establishing income targets and creating local housing trust funds. The state can encourage these actions by sanctioning a menu of techniques and actions that would qualify localities for a housing bonus.

Another way to help cities break away from the "fiscalization of land use," one already proposed in legislation (AB 1221), is a revenue swap. This would allow cities to exchange half of their sales tax dollars collected for an equal amount of property tax revenue from the state. Enabling cities to access this funding stream would remove any fiscal bias against housing development, opening up the path for sensible planning deliberations. This swap has the advantage of having a net zero budget impact in the first year, which is good for the state's coffers, but it benefits local governments in the out-years by allowing them to keep the subsequent growth in property tax.

Relieving some of the fiscal pressure on municipalities will only go so far. There must be an expectation that local governments do more. Current law requires that all cities shoulder a share of each region's affordable housing burden. Yet in practice, they fall short. There is a need for fair share fines. Legislation should be supported that puts more teeth into the state law by increasing penalties for noncompliance, such as administrative fines that would involve the payout or withholding of real money. The housing bonus should be the carrot and these penalties the stick.

California voters themselves have also erected barriers to housing production by supporting growth restrictions. The Public Policy Institute of California has documented 389 slowgrowth ballot measures across the state from 1986 to 2000, 60 percent of which passed. Yet opposition to construction is often rooted in unease over its effects on infrastructure and public services rather than hostility to housing per se. Longer commute times make people less amenable to new development. In this sense, California's housing dilemma cannot be separated from the shortfalls in the state's other infrastructural systems. Since growth is a regional issue, the state needs to promote jurisdictional collaboration to devise responsive planning strategies. Local governments that cooperate to meet regional needs should be rewarded for their efforts, through extra bond money or property tax rebates. The Sacramento Area Council of Governments made such a commitment to focus on affordable housing goals, yet legislation that earmarked $1 million in state funds was recently vetoed by the governor. The objection was because it singled out one region. Nevertheless, it's a good idea that should be available to regions throughout the state, and has the potential to save the state money in the long run.

In addition to solving the supply problem, California needs to help augment demand and should implement a vigorous strategy aimed at increasing first-time homeownership. This could be done through the creation of a California home buyers' tax credit, available to qualifying households for the three years after purchasing their first home. This kind of temporary tax relief targets Californians who could raise the state's homeownership rate, families that are capable of buying a home but deterred by the increased financial commitment in succeeding years. Alternatively, California could implement a statewide sweetener to federally-sanctioned Individual Retirement Accounts (IRAs), which can be used for first-time homeownership. These accounts use federal tax incentives to encourage savings but are of little value to lower-income families that don't have a tax liability. The state could create a refundable tax credit, modeled on an extension of the federal Savers' Credit, which would go to qualified taxpayers who contribute to these accounts. Although this would cost money in the short run, benefits will eventually be realized through an expanded tax base. Rounding out the strategy, the state can help facilitate demand by increasing access to housing counseling and financial planning services.

To accommodate its growing population and avoid a revival of the Dust Bowl malaise, California must address the imbalances and inequities of its housing market. There is no doubt that an unprecedented amount of new housing will need to be built in the coming years. Accordingly, the state's economic development strategy must recognize the twin challenges of creating more affordable rental housing located near job centers and providing greater homeownership opportunities. These objectives are not just good for business; they will help seed asset building opportunities for millions of Californians in the decades ahead.