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The Case for Tax Cuts

No matter how bad things are, raising taxes now will hurt in the long run, argues one tax expert.


Penelope Lemov

Penelope Lemov is a GOVERNING correspondent. She was GOVERNING's health columnist and was senior editor for several award-winning features.

For many states, budgeting for fiscal 2010 came down to the wire -- and beyond it. In what is probably the worst recession for states in the past 50 years, most legislatures balanced budgets by cutting spending and using federal fiscal funds. Some also raised taxes: According to a tally by the Tax Foundation, as of July 31 seven states had hiked personal income tax rates, four had increased sales tax rates, and nearly a dozen had upped "sin taxes" to haul in additional revenue. Three states went in another direction: They actually cut personal income taxes.

When the recession ends, states need to have the right policies in place to promote economic growth and maintain revenue stability. The question is, are tax increases or tax cuts the best way to end up in good shape. Last month, Nicholas Johnson of the Center on Budget and Policy Priorities made the case that states that raise taxes in a recession -- to avoid deep spending cuts -- end up in better shape in the long run. This month, Joseph Henchman, director of state projects at the Tax Foundation, argues that raising taxes is not the best answer and that raising rates for high-income citizens isn't productive in the long run. Here's an edited version of our conversation:

Joseph D. Henchman

Should states cut taxes in a recession like this one?

It depends. Different states have different situations. Some states -- California, for instance -- ran up their spending beyond anything sustainable during the boom years. So, in their case, cutting spending is preferable to cutting taxes. There may be example on the other side where cutting spending would cut into bone.

Can you cut spending and taxes in times like these?

It would be tough to get political support for that, but there's no inherent reason you couldn't do it. The idea behind cutting taxes or spending is that you don't do it for the sake of doing it. You cut so that spending will go down and you can reduce the involvement of government in society. It's a means to an end.

Given the states' desperate need for revenue, why isn't raising taxes a sound idea?

There are distortions created by high taxes that are true any time. Higher taxes mean less incentive for productive activity, and you need to have incentives whether or not you're in a recession. The Keynesian view is that you cut taxes and increase spending in a recession and do the reverse in good times. So there is that school of thought.

Several states that have raised income taxes have targeted the highest brackets, passing so-called "millionaire taxes," the idea being that it doesn't effect spending the way a tax increase on lower income people would. What's your take on the millionaire tax?

It's bad public policy for a couple of different reasons. First, there's the long-term picture. The tax increase may be effective at raising revenue this year or next, but what it does is reduce incentives to earn over time. To get a short-term benefit, you're imposing long-term harm. We saw that with New Jersey. That state has had a millionaire tax for a while. When they imposed it, revenue went up but the economic performance of the people who were taxed went down. I expected that to happen, but people acted surprised when it did. Maryland also has a millionaire tax, but there's not been a study done there -- the tax passed only a year or two ago -- but anecdotal evidence is that the same thing is happening there.

The other big problem is fairness: You're providing programs that benefit everyone, but you're funding them from a small group of people. That undermines support for these programs. When there's a downturn, you find taxpayers unwilling to keep these programs going. California relied so heavily on high earnings, such as personal income and capital gains that were soaring in good times. When the recession hit, those revenues dropped off. The money to pay for these programs dried up and now people are saying, "We're not going to pay for it anymore." So it makes support for these programs very shallow. We'll see what happens on the federal level if we fund health care reform with a millionaire surtax.

Some states have begun to talk seriously about extending the sales tax to services. What's your reaction to that?

Politically, that's harder to pass than other solutions because there are vested lobbies that benefit from a zero sales tax on their services. The base of service taxes would be legal, medical and real estate. These are the things that, if you wanted to raise real money, you would have to extend the tax to those things. But they have strong lobbies and they fight hard. The net result is what we've seen in many states: A plan starts out broad and services get picked out one by one and you end up with a couple of services and that doesn't raise much money. In 2007, Maryland started with a long list and ended up with only computer services, which then felt singled out for an attack. That got repealed.

It's unfortunate. Services should properly be subject to sales tax. The idea is to expand the base and lower the rate.

As parents get their kids ready to go back to school, many states -- nearly a third of them -- have sales tax holidays. How good an idea are those?

Sales tax holidays are a political gimmick. They don't provide significant tax relief. They are not an effective way to help low-income consumers or consumers generally. They are a way for politicians to pretend they care about tax cuts without doing anything about them. Historically, the holidays have been favored by high-tax states. Their consumers go to another state to buy, so the holidays are used to try to keep consumers shopping in-state. That's why New York and Massachusetts adopted theirs (though Massachusetts dropped their holiday this year). The holidays kind of work on that level, but as more states adopt the holidays, they becomes less effective. The real problem, though, is high sales taxes.

In the tax-versus-spending continuum, how do you see things shaping up for states in the coming year?

This past fiscal year, it was a question of how states used the federal stimulus money. Some used it to keep their current level of service, hoping for the best. Some used it to reorganize services or pay down debt, but in the process created structural balance. Indiana did that. The serious problems for those that used it to pad the budget and keep current services levels is that this coming year, they'll face structural deficits.

A lot of states have exhausted rainy-day funds -- that's how severe this recession is and how serious spending constraints are. We're seeing a lot of states go through their spending column by column to find things to cut. That's the first I've heard of states doing that. When times are good, they don't spend time making sure all their spending is right.

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