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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.

Comments to “Let’s tax and spend smarter

  1. Sorry Californiality…That is a dumb idea. We really need to reverse to 40 years ago. Then you would see a financial healing in CA.

  2. What would happen, ultimately, if California shocked the world by ending the state income tax? In the long run, we might end up with more businesses, increased spending, and a higher investment in California. A positive psychological

  3. Taxing the richer is the reaction many governments are considering in the recession to slowly close the deficit. This is bolstered by wider social support from some of the lower earning parts of society that have been affected by the recession. A higher tax for high earners has already been implemented in the UK. However, leaving taxes as they are for the upper quartile of earners attracts high-quality talent to a region, economic progress and ultimately spending. The main issue for any state’s tax collection is that of tax havens.

  4. Well, for starters, California will need to recover all the lost revenue of those people who fled the state in the last 10 years. Billions of dollars of lost tax revenue left our state when people moved to Arizona, Washington, Oregon and Colorado.

    How can that revenue be recovered? It can’t be, so the people who are living in poverty in California need to be helped to become people who generate more income and more tax revenue for the state.

  5. I agree with the modest increase in gasoline tax, as long as a subsidy is given to public transit agencies. That way, they will not be forced to raise fares to offset the increase in fuel. More lower income citizens use public transit.

    A fixed tax rate can be installed for homeowners over the age of 67 and has an income of less than $50K per year. Prop 13 needs to be rescinded. I grew up experiencing the cuts to public schools and local life-enrichment programs. It has been to the detriment of Oakland. Prior to Prop 13, there were far more youth programs available and summer work and vocational training for high schoolers. Now the only thing available is adding to the statistics of high crime, drop-out rate, teen pregnancy and drug offenses.

  6. What would happen, ultimately, if California shocked the world by ending the state income tax? In the long run, we might end up with more businesses, increased spending, and a higher investment in California. A positive psychological social virus could reverse the effects of what the collective media has exacerbated lately. I’m no economic genius, but all ideas should be on the table… even the ‘dumb’ ideas!

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