California's financial free fall is likely to get much worse before it gets better, spreading from the statehouse to every other level of government, including schools, cities, counties and the special districts that fight fires, maintain parks and levees and run libraries.

Gov. Arnold Schwarzenegger and state lawmakers are already grappling with an expected drop in revenue from taxes on personal income, sales and corporate profits. Since they adopted the budget in September, the state's revenue estimate for the current year has dropped by $11 billion, or about 10 percent, with no prospect for a recovery in sight.

But that might be only the beginning of the bad news, according to a new forecast from a private economic consulting group that has consistently – and accurately — sounded a pessimistic note even as others predicted that the downturn would be brief and relatively benign.

The new outlook from Beacon Economics is especially grim because it suggests that property taxes, the most stable revenue source for local government, are about to start declining for the first time in a quarter-century. If that happens, the reversal would have dire implications for local services that so far have not taken the full brunt of the economic slowdown.

Property taxes in California are governed by Proposition 13, the still-controversial 1978 amendment to the state constitution. That measure capped real estate taxes at 1 percent of assessed value and limited assessment growth to 2 percent a year as long as a piece of property did not change hands. When property is sold, it is reassessed at the market value.

Although Proposition 13 triggered a huge, one-time reduction in property tax revenues, since then, property tax collections have only gone up. The limit on assessments has acted like a reserve, slowing down growth in good times but providing a cushion against declines during economic downturns.

To see how this works, consider the case of a property owner who bought a house for $200,000 and saw its market value climb over 20 years to $500,000. Despite the increase in the value of the home, the owner would still be paying tax based on an assessed value of, say, only $300,000. But even if the housing market slowed and the owner sold the house during a downturn for $450,000, the government would still see a revenue bump, because the new owners would be paying far more in property tax based on the new, higher assessment.

That was before the housing bubble. The recent spike and then collapse of housing values is threatening to overwhelm the smoothing effect that Proposition 13 has always provided.

According to the Beacon report, property tax revenue statewide grew from $23 billion in 2000 to an estimated $47 billion in 2008. Since the peak, however, home prices have declined by more than 30 percent, which means many houses that changed hands during the upswing are being reassessed at lower values, not higher values, when they are sold again, often as a result of foreclosures. In addition, people who bought houses during the bubble and are holding onto to them are beginning to take advantage of a provision that allows them to have their assessments – and their tax bills – lowered.

Finally, commercial property values, which held up longer than they did in the housing market, are now moving down, and the state could see a whole new wave of foreclosures and property tax declines in that realm as well.

Beacon projects that all this will lead to an unprecedented 10 percent decline in property tax revenues before the markets find their bottom. The firm sees three straight years of shrinking property tax revenue before collections begin to climb again in 2012. While that is still only a fraction of the associated decline in property values, it would create havoc with local budgets and services that depend heavily on property taxes as a source of revenue.

And even that estimate might be optimistic.

"Much depends on whether the wave of foreclosed properties begins to slow," the report says. "If the economy tips into a deeper recession, and slows or stops the recent increase in purchases in home markets, the situation could be even worse."

There is some glimmer of hope out there. On Monday, reports showed that in San Diego, which has been especially hard hit by the housing crash, foreclosures declined by 37 percent in September. Notices of default, which are a precursor to foreclosure proceedings, declined for the sixth consecutive month.

Some of that drop might be due to new rules requiring lenders to give more notice to delinquent borrowers before moving against them. But to the extent that the changing trend is real and lasting, it is possible that the market might be approaching the bottom.

Even so, much of the damage to property tax rolls has already occurred, and it is just a matter of waiting for the lower values to ripple through the revenue system. Local governments that spent the property tax windfall and did not keep significant reserves on hand are probably going to be in distress for many months, if not years, to come.