The economic outlook for California retailers and manufacturers is taking a steep dive.

The latest blow came when Gov. Arnold Schwarzenegger declared a fiscal emergency on Monday, predicting that the state would go broke by February or March unless the legislature approves higher taxes, including a 1.5 percent increase in the sales levy to 8.75 percent for three years, and makes deep cuts in public services to reduce spending. The governor’s declaration mandates that lawmakers break their political gridlock and act within 45 days to close an expected $11.2 billion shortfall — or face a potential standstill in state government. The deficit could balloon to $28 billion by mid-2010.

A tax boost, which requires approval by a two-thirds majority of lawmakers, was blocked by the Republican minority during a three-week special session last month.

Because cities and counties also tax sales, an increase in the state levy would push the overall sales tax in some jurisdictions, including San Francisco and Oakland, to 10 percent or more.

Schwarzenegger said Monday that “without immediate action, our state is heading for fiscal disaster,” leaving many Golden State merchants and manufacturers more disheartened than ever.

“Increasing sales taxes would be ill conceived when consumers are already struggling with the idea of spending,” said Wilkes Bashford, owner of four namesake high-end women’s and men’s fashion stores in Northern California.

During 42 years in business, Bashford said the current economic downturn is the worst his firm has experienced. “It also seems that a sales tax increase would work at cross purposes to any government economic stimulus being planned,” he said.

With higher sales taxes, “Californians will suddenly shop in Nevada or another tax-free or lower-tax state,” said Mark Werts, owner of fashion denim retailer American Rag Cie, with locations in Los Angeles, San Francisco and Newport Beach.

However, Max Azria, designer, chairman and chief executive officer of the BCBG Max Azria Group based in Los Angeles, said he backs Schwarzenegger’s efforts.

“We fully support the governor on the tax hike,” Azria said. “Perhaps as a counterbalance California could institute a two-day-per-year sales tax holiday like New York.”

As the largest U.S. market with a gross domestic product of $1.7 trillion — about equal to that of Italy — California has seen state tax revenues dwindle as business revenues have fallen along with housing values. Home foreclosures are at record highs, consumer spending is down, mall vacancies are up and the state’s jobless rate increased to 8.2 percent in October from 7.7 percent a month earlier, well above the worsening 6.5 percent national rate.

“You can just sense the fear in L.A., and the last couple of months have been worse than ever,” said Lisa Kline, who owns five namesake Los Angeles contemporary boutiques, noting a sales tax hike could further damage independent retailers already hurt by the recession.

Scott Manson, senior vice president and general merchandise manager at Fresno, Calif.-based regional department store Gottschalks, said the biggest obstacle for consumers is the precipitous decline in home values, which have fallen 34 percent against a year ago, according to San Diego-based MDA DataQuick.

“The key issue in California is the rebound of real estate values,” Manson said. “Until people feel that they have income to spend, there will be this cycle of fear, the save-and-not-spend that further stalls the economy.”

The lobbying arm of the state’s retail industry, the California Retailers Association, is backing Schwarzenegger’s call for a sales tax rise.

“We don’t like sales tax increases, but you have to balance that with the need to do something about this crisis,” said Bill Dombrowski, president and ceo of the retailers association.

Dombrowski said the group is supporting an economic stimulus package and caps on state spending during flush economic times to help offset a tax hike.

Jeff Silver, chief operating officer of Jerry Leigh Inc., an apparel manufacturer in Van Nuys with 600 workers, said an increase in the sales tax would add to an already difficult business climate, although it probably wouldn’t drive consumers to lower-tax states to shop. In lieu of raising the sales tax, Silver proposed increasing levies on gas, liquor and cigarettes.

Dick Kern, owner of Churchill Jewelers in Santa Barbara, in business since 1918, is concerned a sales tax boost will send shoppers to the Internet, where most commerce is tax-free. “There are a lot of [other] places that the state could go” to raise taxes, Kern said, citing gasoline as an alternative.

Shawn Tavakoli, ceo of Beauty Collection, a three-store chain based in Van Nuys, suggested the state focus on jobs programs instead of raising the sales tax. “If people have jobs, they will spend money,” he said.

A month ago, Schwarzenegger urged raising the sales tax along with several other taxes, including a 5 cent levy on each alcoholic drink and imposing sales and use taxes for the first time on services such as veterinary care, vehicle and furniture repairs, golfing fees and tickets for sports events.

The governor also proposed a 9.9 percent tax per barrel of oil extracted from wells in California. However, of the $4.7 billion that would be raised in the first year from all proposed tax hikes, increasing the sales tax would be the biggest immediate revenue generator, raising$3.5 billion by the end of next year.

Along with his tax agenda, Schwarzenegger wants legislators to consider economic stimulus proposals such as a 90-day stay on home foreclosures, incentives for mortgage companies to renegotiate loans and a boost in funding for the state’s unemployment insurance fund.

Schwarzenegger’s plan also calls for $4.5 billion in 2009 budget cutbacks, including $2.5 billion from public education and a state employee furlough of one day a month, as well as eliminating two state holidays, for a $320 million savings. He is said to be planning for layoffs of state workers.

California is not alone in its predicament. During a meeting of the National Governors Association Tuesday in Philadelphia, President-elect Barack Obama said 41 states face the likelihood of budget deficits this year and in 2009 “forcing you to choose between reining in spending and raising taxes.…Meanwhile, virtually all of you are facing the additional challenge of a state constitution that requires you to balance your budget.”

Obama said resolving the crisis “means passing an economic recovery plan for both Wall Street and Main Street that jump-starts our economy.”

But California doesn’t have the luxury of time and the political winds are not blowing in the state’s favor. Democrats are still six votes short of the necessary two-thirds majority in the Senate and the Assembly that is needed to boost taxes.

“Unfortunately, the governor [a Republican] doesn’t have the political clout needed to get his own party to raise taxes,” said John Elwood, a public policy professor at the University of California, Berkeley.

Elwood noted the irony that Schwarzenegger is facing a budget crisis similar to the one that resulted in the ouster of his predecessor, Democrat Gray Davis, and Schwarzenegger’s own rise to power. Davis was recalled by voters in 2003 over the issue. In his victorious campaign over Davis, Schwarzenegger pledged to fix the state’s fiscal mess.

Jon Haveman, an economist with Beacon Economics in Los Angeles, said some kind of tax boost will have to be part of the state’s short-term budget fix. He doesn’t foresee too much of a negative drain on consumer spending if sales levies increase. However, beyond the immediate crisis, he doesn’t see lawmakers coming to grips with the long-term changes in how state government is funded.

“The real structural problems aren’t likely to be solved in the next 45 days, meaning that next year we’ll probably be right back in the same place,” Haveman said.

The Golden State’s budget shortfall comprises almost half of the total $24.3 billion deficits of all the states for the 2009 fiscal year, according to the Center on Budget and Policy Priorities, a think tank based in Washington, D.C.

“California just needs more revenues,” said Nicholas Johnson, director of the center’s state fiscal project. “The situation is pretty bad. The end result will be some public employees will likely lose their jobs and that means teachers, cops and firefighters. A lot of schools will have to cut back.”

Dale Achabal, executive director of the Retail Management Institute at Santa Clara University in Silicon Valley, said the state has few alternatives to higher taxes.

“It’s not going to solve the problem, but the industry recognizes we’re all in this together and we’ll have to contribute to get through this difficult period,” he said.

Peter Kim, president and ceo of Hudson Jeans, said he was uncertain about the impact of a higher sales tax on his City of Commerce, Calif.-based premium denim brand. One move that he vehemently opposes is an increase in the business tax. Like many companies that are trying to control expenses ranging from inventory to shipping, he suggested that the state government do the same to trim waste.

“As we’re looking at our business, we have to cut and be as efficient and tight as possible,” he said. “We’re doing that. The government should be doing that.”

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