Dec 5 - The State of California's progress in recovering from the severe fiscal challenges of recent years could receive an additional boost thanks to the outcome of the Nov. 6 election, according to Fitch Ratings. The state's fiscal recovery is incomplete and challenges remain, but continued economic improvement, a demonstrated commitment to more sustainable budgetary operations and progress on reducing budgetary debt would be viewed positively by Fitch. On Nov. 6, voters authorized two measures that will increase state general fund tax receipts. Proposition 30 temporarily raises the top marginal personal income tax (PIT) rates on high income filers for seven years, through 2018, and the statewide sales tax for four years, through 2016. Proposition 39 changes the method by which multistate corporations calculate their income tax liability. The state Legislative Analyst's Office (LAO) estimates that in fiscal 2013 Proposition 30 will generate $6 billion higher PIT and sales tax receipts, while Proposition 39 will generate an additional $500 million in corporate income tax receipts for the general fund. California's financial performance for more than two decades has been marked by volatile revenue swings and periodic, severe fiscal and cash flow crises. The state's ability to respond effectively to these challenges has been hindered by numerous restrictive voter initiatives and by a highly partisan policymaking environment. These factors have offset the state's exceptional economic attributes and a moderate debt burden, resulting in a general obligation credit rating currently at 'A-', which is below the level of other Fitch-rated states. Fitch recognizes, however, that California has made notable progress since the recession and fiscal crisis of 2008 and 2009. The state has benefitted from modest but steady economic and revenue gains. Employment has grown in California for 27 months through October 2012, most recently well in excess of the national rate, and the unemployment rate, despite remaining elevated compared to the nation's, has fallen sharply from previous levels. Housing market indicators are likewise improving. More importantly, the state has also benefited from incremental improvements in fiscal management. In a departure from longstanding budgeting practice, with its focus on stop-gap measures, the fiscal 2012 and fiscal 2013 adopted budgets implemented deep, recurring spending cuts, significantly lowering the state's longstanding structural imbalance. Several recently-passed voter initiatives have facilitated more effective budgeting, most notably Proposition 25, which passed in November 2010 and allows a simple legislative majority (rather than a supermajority) to adopt the state's spending plan. Various statutory and administrative changes since early 2009 have augmented the power of the state's comptroller, treasurer and budget office to effectively manage state cash resources and avert cash flow crises. Fitch believes that the passage of Propositions 30 and 39 last month is a continuation of these positive trends. However, while materially enlarging general fund resources, in Fitch's view the key credit consideration will be how California responds to the prospect of expanded revenue flexibility. The governor has prudently emphasized the need to prioritize repayment of approximately $34 billion in budgetary borrowing accumulated during the last two fiscal crises and estimated that the adopted fiscal 2013 budget, assuming passage of Proposition 30, would enable the state to lower budgetary borrowing to $8.9 billion in fiscal 2016. The state faces other near-term fiscal uncertainties. These include the familiar challenge of an emerging general fund budget gap estimated by LAO at a cumulative $1.9 billion through June 30, 2014 (although at a level far below the gaps confronted by the state in recent years). The LAO forecast noted both revenue underperformance and the state's inability to fully realize budgeted solutions in the new gap estimate. Likewise, the potential 'fiscal cliff' and federal deficit reduction negotiations in general pose economic and budgetary uncertainty to California and other state governments. In Fitch's view the temporarily elevated marginal PIT rates for high earners approved by voters through Proposition 30 will likely expose the general fund to greater volatility in revenue collections prior to their sunset in fiscal 2018-19. The prospect of greater future volatility highlights the importance of using temporarily higher revenue resources to reduce past budgetary obligations and rebuild flexibility; the state's budget stabilization fund last carried a balance in fiscal 2008. Past fiscal recoveries in California have been marked by big cyclical revenue gains being absorbed by expanded, recurring state expenditures, setting the stage for even larger budget gaps when cyclical revenues invariably fall. With the deep structural cuts of recent years, budget makers may face a similar temptation to restore cuts going forward. As development of the fiscal 2014 budget begins, Fitch will closely monitor the state's economic and fiscal progress, including steps toward more sustainable budgetary operations. Additional information is available at 'www.fitchratings.com'.