home
economics and welfare pages
Revised October 31, 2001
States are suffering substantial fiscal stress as a result of the recent economic slowdown. Mississippi, Ohio and South Carolina enacted broad-based spending cuts and eight states raised taxes in enacting their fiscal year 2002 budgets. A number of states are slated to consider additional budget cuts in special legislative sessions that have been called for that purpose, and several governors -- including those in Colorado, Georgia, Iowa, Maryland, North Carolina, and Vermont -- have used their executive authority to reduce budgets. A much larger number of states are expected to initiate budget cuts when state legislatures reconvene this winter and confront budgets that have fallen out of balance as a result of the downturn.(2) In all states except Vermont, some form of balanced budget rule forces such counter-productive fiscal policies: When the state enters a recession, revenue naturally falls and expenditures rise. The balanced budget rules then force the state to reduce spending, raise taxes, or some combination thereof, which is counter-productive since it exacerbates the economic slowdown.
Some state policy-makers apparently believe that from a macroeconomic perspective, reducing spending is preferable to raising taxes. For example, members of the Connecticut Economic Conference Board apparently have argued that, "The worst action the state could take would be to raise taxes during a recession; the best course would be to cut spending."(3) Similarly, media reports have suggested that in Florida, "Gov. Jeb Bush, while insisting he prefers to avoid deep cuts in education or health care, says the only thing off the table at this point is a tax increase. Gov. Bush says he believes raising taxes only would exacerbate economic woes by damping consumer and business spending."(4)
Despite these claims, economic analysis suggests that tax increases would not be more harmful to the economy than spending reductions. Indeed, in the short run (which is the period of concern during a downturn), the adverse impact of a tax increase on the economy may, if anything, be smaller than the adverse impact of a spending reduction, because some of the tax increase would result in reduced saving rather than reduced consumption. For example, if taxes increase by $1, consumption may fall by 90 cents and saving may fall by 10 cents. Since a tax increase does not reduce consumption on a dollar-for-dollar basis, its negative impact on the economy is attenuated in the short run. Some types of spending reductions, however, would reduce demand in the economy on a dollar-for-dollar basis and therefore would be more harmful to the economy than a tax increase.
In analyzing the economic impact of spending reductions, it is important to draw a distinction between transfer programs (such as unemployment insurance and Social Security) and direct government spending on goods and services (such as purchasing military equipment or building roads). Basic economy theory suggests that direct spending reductions will generate more adverse consequences for the economy in the short run than either a tax increase or a transfer program reduction. The reason is that some of any tax increase or transfer payment reduction would reduce saving rather than consumption, lessening its impact on the economy in the short run, whereas the full amount of government spending on goods and services would directly reduce consumption.
A reduction in government spending on goods and services is thus likely to be more harmful to the economy in the short run than an increase in taxes or a reduction in transfer program spending. Within the sphere of changes to taxes and transfer programs, the impact on the economy depends primarily on the propensity to consume -- that is, on how much of an additional dollar of income is spent rather than saved -- among those who receive the transfer payments or pay the taxes. The more that the tax increases or transfer reductions are focused on those with lower propensities to consume (that is, on those who spend less and save more of each additional dollar of income), the less damage is done to the weakened economy.(5) 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.(6) 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 spending on goods and services.
For states interested in the impact only on their own economy rather than the national economy, the arguments made above are likely to be strengthened. In particular, direct government spending is often concentrated among local businesses - which can cause distortions in the long run, but bolsters the positive impact on the local economy in the short run. The broader spending patterns that would be affected by tax increases, on the other hand, are often less concentrated among local producers. More of the demand reduction from tax increases would therefore fall on out-of-state goods (relative to in-state goods), mitigating the adverse impact on the local economy. Reductions in direct spending could thus have a disproportionately adverse impact on the state economy, relative to tax increases that have a stronger negative impact on out-of-state goods and services.
In addition, higher-income families appear to consume relatively more goods and services produced in other regions.(7) In other words, relative to lower-income families, higher-income families have much lower propensities to consume local goods - both because they have lower propensities to consume overall and because locally produced goods are a smaller share of their consumption. Therefore, a tax increase concentrated on higher-income families may have a smaller adverse impact on the state economy than other alternatives. Similarly, a reduction in transfer payments to lower-income families would have a larger adverse impact on the local economy than a tax increase for higher-income residents.
One other point is worth noting. Opponents of tax increases typically worry about adverse incentive effects. Whatever the validity of such "supply-side" concerns in the longer run, it is important to emphasize that the focus of concern during a slowdown is demand, not supply. Indeed, tax increases (such as an increase in the estate tax) that induce people to spend more (by effectively providing a tax break for consuming) may actually strengthen the economy in the short run.
The conclusion is that, if anything, tax increases on higher-income families are the least damaging mechanism for closing state fiscal deficits in the short run. Reductions in government spending on goods and services, or reductions in transfer payments to lower-income families, are likely to be more damaging to the economy in the short run than tax increases focused on higher-income families. In any case, in terms of how counter-productive they are, there is no automatic preference for spending reductions rather than tax increases.
It is worth emphasizing that any state spending reductions or tax increases are counter-productive at this time: they restrain the economy at a time when it is already slowing. Given the existence of balanced budget rules at the state level, some form of federal revenue sharing is therefore warranted.(8)
1. Peter Orszag is the Joseph A. Pechman Senior Fellow in Tax and Fiscal Policy at the Brookings Institution. Joseph Stiglitz is Professor of Economics at Columbia University and one of the recipients of the 2001 Nobel Prize in Economics.
2. Iris Lav, "State Fiscal Problems Could Weaken Federal Stimulus Efforts," Center on Budget and Policy Priorities, October 4, 2001.
3. Hartford Courant, October 7th.
4. Wall Street Journal, October 24th.
5. This point is likely to be even more important in the context of temporary changes in tax or transfer programs. Lower-income families are more likely to be liquidity constrained -- that is, forced to consume only out of income, rather than out of their assets or by borrowing -- than higher-income families. A temporary reduction in transfer programs (which disproportionately affect lower-income families) would therefore reduce consumption by more than a temporary increase in taxes for high-income families, which would have little effect on their lifetime income and could thus have little effect on their consumption (since they could temporarily offset the impact of the higher taxes by borrowing or by consuming some of their assets).
6. Dynan, Skinner and Zeldes (2001) show that, in several different data sets, average propensities to consume out of current and permanent income fall as those income measures rise. Parker (1999) uses data from the Consumer Expenditure Survey and finds that the marginal propensity to consume out of transitory income at low levels of resources (which for most low-income households is effectively current income) is much higher than the marginal propensity to consume out of transitory income for very high-income households. McCarthy (1995) uses data from the Panel Survey of Income Dynamics and shows that the marginal propensity to consume out of idiosyncratic income shocks is larger for low-wealth households than for high-wealth households. The weight of the evidence suggests that lower- and middle-income households do have higher propensities to consume out of available resources. See Karen E. Dynan, Jonathan Skinner, and Stephen P. Zeldes, "Do the Rich Save More?" NBER Working Paper 7906, National Bureau of Economic Research, September 2000; Jonathan Parker, "The Consumption Function Re-estimated," mimeo, August 1999; and Jonathan McCarthy, "Imperfect Insurance and Differing Propensities to Consume Across Households," Journal of Monetary Economics, November 1995, pages 301-27.
7. More precisely, less of the value-added embodied in the goods and services consumed by higher-income families occurs in the local area relative to the goods and services consumed by lower-income families. See, for example, Andrew Bernat and Thomas Johnson, "Distributional Effects of Household Linkages," American Journal of Agricultural Economics, 73(2) May 1991.
8. See Iris Lav, "State Fiscal Problems Could Weaken Federal Stimulus Efforts," Center on Budget and Policy Priorities, October 4, 2001, and Peter R. Orszag, "Evaluating Economic Stimulus Proposals,"Testimony before the Committee on the Budget, United States Senate, October 25, 2001.
Reprinted in The Jackson Progressive, http://www.jacksonprogressive.com by the kind permission of the Center on Budget and Policy Priorities, 820 First Street, NE, Suite 510 Washington, DCÊ 20002, Ph: (202) 408-1080. Fax: (202) 408-1056