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Challenging Conservative Conventional Wisdom

January 06, 2009 By Jeff Van Wychen, Fellow and Director of Tax Policy & Analysis

During a budget crisis, raising taxes does less harm than slashing budgets.

With a $5.5 billion state budget deficit projected for the 2010-11 budget cycle, state leaders are scrambling to deal with the crisis. Spending reductions, including large cuts in county and city aid, have already happened. With the budget deficit's bulk still looming before state policymakers during the 2009 session, it is clear that Governor Pawlenty and other anti-investment politicians have bought into the right-wing conventional wisdom regarding budget balancing: avoid tax increases at all costs.

However, Nobel Prize winning economist Joseph Stiglitz and Brookings Institute Senior Tax and Fiscal Policy Fellow Peter Orszag have offered a systematic and thoughtful rebuttal to this conventional wisdom.  They put forth a forceful case that in the short run, prudently designed tax increases are less harmful than spending cuts.

Less than 100 percent of every dollar of household disposable income is consumed (i.e., spent on goods and services), while the remainder is saved; thus, by reducing household disposal income by $1, a tax increase produces a reduction in consumption of less than $1.  However, a dollar reduction in direct government spending generally represents a full dollar decline in consumption.  Therefore, the decline in consumption and the corresponding short term negative impact on a state's economy is likely to be less if there is a tax increase as opposed to an identical cut in direct government spending.

Stiglitz and Orszag go on to note that cuts in direct government spending are more likely to have an adverse impact on the state economy, since these dollars tend to be spent within the state.  For example, expenditures for roads and bridges are spent within the state and therefore all or nearly all the stimulus stays in the state economy.  Individual and business spending, on the other hand, is not necessary concentrated within the state.  For example, the purchase of a Chinese-made television is likely to have a relatively small state stimulus.  For this reason, the reduction in individual and business spending from a tax increase is likely to have a less severe impact on a state's economy than a reduction in direct government spending.

Stiglitz and Orszag are careful to distinguish between "direct government spending on goods and services," such as infrastructure investments, and "transfer payments," such as unemployment insurance.  Cuts in direct government spending are likely to have a more adverse immediate impact on the economy than cuts in transfer payments, since 100 percent of direct spending is "consumed," whereas a portion of transfer payments is presumably saved.

Regarding transfer payments versus tax increases, the adverse impact of each relative to the other depends on the portion of each that is consumed, as opposed to saved.  Stiglitz and Orszag conclude that:

Since higher-income families tend to have lower propensities to consume than lower-income families, the least damaging approach in the short run involves tax increases concentrated on higher-income families.  Reductions in transfer payments to lower-income families would generally be more harmful to the economy than increases in taxes on higher-income families, since lower-income families are more likely to spend any additional income than higher-income families.  Indeed, since the recipients of transfer payments typically spend virtually their entire income, the negative impact of reductions in transfer payments is likely to be nearly as great as a reduction in direct government spending on goods and services.

Furthermore, Stiglitz and Orszag note that "higher-income families appear to consume relatively more goods and services produced in other regions of the county (or abroad) than lower-income families do."  Thus, reductions in transfer payments to low-income households are likely to have a more severe impact on a state's economy than tax increases on high income households.

Stiglitz and Orszag make a strong case that cuts in direct government spending have the most severe immediate impact on a state's economy, while cuts in transfer payments have a somewhat less severe effect.  Least damaging to a state's economy are tax increases focused on high income households.

In balancing Minnesota's budget, Stiglitz and Orszag's analysis suggests that the approach that would be least harmful to the state's economy in the short term would be to increase taxes on high-income households.  Such a tax increase could take the form of an income tax rate increase for the third tier or the creation of a new fourth tier for the wealthiest Minnesotans with a higher income tax rate than the current third tier.

In tackling the state budget deficit, policymakers should stay open minded.  Revenue increases-especially increases in the individual income tax focused on the highest income households-most certainly should be among the options on the table when attempting to fill the state's $5.5 billion hole.

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