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Let’s tax and spend smarter

Ben Hermalin, professor of economics and finance | October 10, 2009

Macroeconomics is all about feedback mechanisms and how they cause shocks to the system to be amplified or dampened.  One unfortunate mechanism is the relation between state tax revenues and tax spending.  Much of the revenues of a state such as California come from revenue sources that are tightly tied to overall economic activity.  A downturn means less income—so less income tax—and, correspondingly less consumer spending—so less sales tax.  Most states have prohibitions on deficit spending, so a consequence of a downturn in revenues is a downturn in state spending.  And, as my colleague David Levine, among others, have noted, a downturn in state spending is precisely the last thing you want in a recession.  Less state spending, means layoffs of state employees and less state purchasing, which lowers spending, leading firms to cut back on production and, thus, on private employment.  All of which means less state tax revenue, thereby keeping this harmful cycle rolling.

California and the nation are going to continue to suffer as long as the states cutback on their spending.  One  solution is for the federal government to help the states directly, something I strongly favor.  Another could be for the states to relax their prohibitions on deficit spending—recognizing that incurring a fiscal deficit today might be worth it to avoid a growth deficit tomorrow. But another, perhaps longer run solution, is for the states to get smarter about how they raise revenue.  First, let’s put more of the tax burden on things that are less volatile, specifically property and expenditures on certain goods, such as gasoline.  Second, raise the tax rates on those who tend to have more stable employment, which are the folks in the upper tax brackets.  Third, let’s be more sensible about “negative” taxes (otherwise known as subsidies).

Less revenue volatility seems a goal that both liberals and conservatives can embrace.  Liberals because this helps protect the most vulnerable people at precisely the time they are most vulnerable, namely during a recession.  Conservatives because this means that state governments won’t suddenly find themselves flush with cash during boom times; cash that tends to burn a hole in their pockets.  (Yes, true, governments could follow the patriarch Joseph by saving during the seven years of plenty, to spend in the seven lean years, but experience suggests that today’s politicians lack such discipline—just look at what happened to the Clinton surpluses.)

Although property values do fluctuate, they generally fluctuate less than income.  Moreover, if we are truly worried about little old ladies losing their houses due to rising property taxes, we can establish a means of directly aiding the old or poor with their property-tax bills.  We don’t need to essentially eliminate the property tax, as Proposition 13 did, to keep the old and poor in their homes.  A rough estimate indicates that we Californians use about 16 billion gallons of gasoline per year.  A modest tax increase of 50 cents per gallon would, thus,  eliminate approximately half of the recent revenue shortfall.  Moreover, a gasoline tax would have the added benefit of charging people for the harm they create by driving (e.g., pollution, congestion, greater accident risks, etc.).  A basic rule in economics is if you don’t charge people for the harm they do, they do too much harm.

Higher marginal tax rates on the highest income earners would create little disincentive for those earners to cut back on their working or spending.  It would, however, make the income component of state revenues less volatile.  Moreover, because the higher earners get a disproportionate share of many state and local expenditures (e.g., they are more likely to use the airports, highways, state parks, state universities, etc.), greater progressivity in the tax code hardly seems like too unfair a burden to put on those who are doing the best.  (Such advocacy is not, I assure you, motivated by self interest—any such increase in tax rates would lead to me paying a lot more in taxes.)  In the same way, I’m not sure why we should provide so many subsidies for these benefits:  People should pay to use the roads (another reason for raising the gas tax) and parks.  Why the rich should face the same tuition rates as the poor seems a curious way to operate—surely, it would be better to raise the tuition to the state’s colleges and universities and provide more generous financial aid to those who need it.  That the state’s business schools charge less than market rates is especially curious—whose bright idea was it that we should subsidize the future investment bankers of America?

I’m not naïve, there is no hope in the near term that a government as dysfunctional as California’s will deal with any of these issues (at least not sensibly).  And once the crisis is over and we’re in boom times, it’s hard to see politicians reforming how the state taxes if that means reducing the, then, revenue it has.  As Paul Romer said, “A crisis is a terrible thing to waste.”  But waste it we will, I expect.