Tackling Taxophobia

We can't keep pretending tax increases are a fatal disease.
March 1, 2009 AT 3:00 AM
Peter Harkness
By Peter Harkness  |  Founder, Publisher Emeritus

Our new president wants us "to set aside childish things," reverse "our collective failure to make hard choices" and begin "a new era of responsibility." In that case, it's time to take a hard look at our tax system - not just by increasing rates to shore up state and local budgets but by considering serious reform, to assure adequate revenues for the future.

The federal government, in slashing taxes and putting the cost of two wars on its credit card, has nearly doubled the nation's debt in just the past eight years. Now, we are adding substantially to that debt through a stimulus plan that requires even more borrowed money and tax cuts for everyone up and down the income scale. Meanwhile, states and localities are suffering through a wave of budget cuts.

What's missing is serious talk about revenue. It seems to be an article of faith in Washington and across the country that increasing taxes in a recession is a bad idea.

But is that true? If so, why is it that during the last recession, in the wake of the Bush administration's tax cuts in 2001, economic growth was the weakest recorded by any administration in decades? By some indicators, it was the weakest in the 70 years that records have been kept. On the other hand, President Clinton raised taxes in his first year in office, and the economy during his eight-year tenure boomed, with job growth of almost 21 percent compared with only 2 percent for Bush.

Why is it that even during the build-up of the housing and consumer-spending bubbles, business investment in high-technology equipment stalled, leaving computer and telecom orders down nearly 50 percent from previous highs? The Bush years were an economic disappointment, given the amount of stimulus the economy received from a binge in personal, corporate and federal borrowing.

There have to be lessons in this for states and localities, which - unlike the federal government - must balance their budgets and choose between higher taxes and reduced spending when the money runs short. Are spending cuts less harmful than tax increases? The economist who just took over as President Obama's budget director doesn't think so. Eight years ago, Peter Orszag considered that question and concluded that "tax increases would not in general be more harmful to the economy than spending reductions." In the near term, he wrote, "tax increases on higher-income families are the least damaging mechanism for closing state fiscal deficits..." Orszag's argument recently was summarized in a letter signed by 120 economists and sent to New York Governor David Paterson.

Pulling out of the economic muck isn't the only benefit that can stem from rethinking the tax question. States in particular need to modernize their tax structures so they can be assured of adequate revenues down the road. Many states are in structural deficit, even in relatively good times. Their tax codes were written decades ago, when manufacturing, rather than services, was the country's primary economic engine. Not only are many states depending on revenue from industries that no longer generate as much revenue as they used to, but the tax codes themselves are becoming a drag on economic growth.

Obviously, spending all the new federal stimulus money wisely is important, whether it be for infrastructure, alternative energy, or just to shore up Medicaid and other social services under recessionary pressure. The Center on Budget and Policy Priorities estimates that at least 45 states are facing budget deficits for this fiscal year and the next that will reach a combined total of more than $350 billion. Local governments may be in even worse shape. And as states and localities cut services and lay off public employees, the effect on the economy will only get worse.

In any case, there are limits to how much a state can cut. In a revealing analysis of the California budget crisis, the San Jose Mercury News noted recently that if the state, which is facing a combined two-year deficit of $42 billion, were to lay off every one of its 230,000 employees, it wouldn't solve even half the problem. So it's hard to see how the state can cut its way out of this mess. But since a two-thirds vote of the legislature is required to pass a tax increase in California, it's easy for the anti-taxers to block a solution that includes realistic revenue reform.

Only recently has talk of tax increases started creeping into the debate, and it's happening in some rather unlikely places. One of them is Florida. After almost two years of repeated spending cuts, totaling more than $8 billion - and with another $3.5 billion deficit expected - the legislature finally will begin to discuss tax increases this month. The Republican Senate president has ordered a complete review of the state tax system, with a goal of making recommendations for where to find new revenues.

That's more like it. Lotteries, slot machines and casinos on Indian reservations aren't much of an answer. Both Presidents Clinton and George W. Bush, in their first inaugural addresses, called on us to be more responsible. They didn't always follow their own advice. Maybe we can do it this time.

Peter Harkness
Peter Harkness | Founder, Publisher Emeritus | pharkness@governing.com