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Created: Wed Jul 23 12:04:48 2008

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policy points
JULY 2008
JUNE 2005

BUDGET CUTS OR TAX INCREASES: WHICH ARE PREFERABLE
DURING AN ECONOMIC DOWNTURN?
C
alifornia faces a large budget gap, while at the same time unemployment is rising and the state and national economies

are struggling.1 Governor Arnold Schwarzenegger has proposed closing the budget gap primarily by cutting state

spending.2 However, economic research suggests that policymakers should consider a more balanced approach � one that

includes raising additional revenues. Basic economics demonstrates that carefully chosen tax increases are a better option than

spending cuts when the economy is weak. In addition, research suggests that even large tax increases have little impact on

economic performance: The economies of states that substantially raised taxes in recent years performed as well as or better

than those of states that did not increase taxes. Nobel Prize-winning economist Joseph Stiglitz recently wrote that when the

economy is weak: "Economic theory and evidence gives a clear and unambiguous answer: It is economically preferable to raise

taxes on those with high incomes than to cut state expenditures."3

K E Y F A C T S

State spending reductions could Consumers buy less and businesses produce less when the economy is weak. Therefore,
further exacerbate the weak the key to promoting the state's economic growth in the short run is to encourage
economy. spending on goods and services.4 Stiglitz writes: "In a recession, you want to raise (or not
decrease) the level of total spending � by households, businesses and government � in
the economy. That keeps people employed and buying things, and makes it more likely
that businesses will want to invest to serve that consumer demand."5 However, state
spending reductions have the opposite effect: Each dollar less that the state spends
generally reduces consumption by the same amount.6 This dollar-for-dollar reduction in
consumption tends to occur because state spending cuts disproportionately affect lower-
income Californians, who typically spend all of their incomes. For example, every dollar of
cash payments to low-income families that the state cuts would reduce the money that
these families have to spend on rent, groceries, and other goods and services by an equal
amount.

1107 9th Street, Suite 310 Sacramento, CA 95814 P: (916) 444-0500 www.cbp.org
Personal income tax increases are Personal income tax increases have less of an impact on consumption than state spending
a better option than spending cuts cuts because they affect higher-income Californians � who are more likely to save than
because they have a lesser impact to spend their incomes � to a greater extent. The more that tax increases are targeted to
on consumption. higher-income taxpayers, the less those increases will affect consumption. For instance,
if high-income taxpayers spend, on average, 90 percent of their incomes and save 10
percent, then each dollar of a tax increase imposed on high-income taxpayers would
reduce spending by 90 cents rather than by one dollar. For this reason, Stiglitz and Peter
Orszag, currently the director of the Congressional Budget Office, conclude: "Tax increases
on higher-income families are the least damaging mechanism for closing state fiscal
deficits in the short run."7

Personal income tax increases are According to Stiglitz:
a better option than spending cuts
because they have a lesser impact "Every dollar of state and local government spending enters the local
on local economies. economy right away, generating a greater economic impact. The impact is
especially large when the money goes for salaries of teachers, policemen
and firemen, doctors and nurses and others that provide vital services to
our communities." In contrast, "raising taxes on high income households
also will reduce spending, but by less than the amount of the tax increase
since those with plenty of income typically spend only a fraction of their
income � and some of what they spend is spent on luxury goods made
abroad."8

Furthermore, lower-income families tend to spend more of their incomes locally than
higher-income families.9 For example, lower-income families spend a greater percentage
of their incomes on housing � a local expenditure � than higher-income families.10
Therefore, because state spending reductions would disproportionately affect lower-
income Californians, they would have a greater impact on local economies than personal
income tax increases, which would affect lower-income Californians to a lesser extent.

The economies of states that States that enacted large tax increases between 2002 and 2004 � increasing state
substantially increased taxes in revenues by at least 5 percent � subsequently experienced stronger average growth in
recent years performed as well as or personal income than states that did not increase taxes at all.11 Additionally, average job
better than those of states that did and wage growth was essentially the same for states that increased taxes the most during
not. this period as it was for states that did not increase taxes. Moreover, states that raised
taxes substantially are considerably less likely to face budget shortfalls this year than are
states that did not.12

The Economies of States That Increased Taxes in the Early 2000s Performed
as Well as or Better Than Those of States That Did Not
Average for States That:
Percent Change, 2004 to 2006 Increased Taxes Substantially Did Not Increase Taxes
Median Wage 5.7% 5.9%
Number of Jobs 3.5% 3.4%
Personal Income 10.6% 9.7%
Note: States that increased taxes substantially are those that enacted tax increases between 2002 and 2004
that resulted in a cumulative increase in state revenues of at least 5 percent.
Source: Center on Budget and Policy Priorities

2
The economies of states that enacted States that enacted large tax cuts between 1994 and 2001 � reducing revenue by at least
large tax cuts in the late 1990s and 7 percent � subsequently experienced weaker growth in jobs and personal income and
early 2000s performed worse than larger increases in the unemployment rate, on average, than other states.13 Furthermore,
those of other states. the states that enacted large tax cuts faced larger budget shortfalls when their economies
weakened.

Public services are critical to a Research suggests that the quantity and quality of public services may play a more
healthy business climate. important role in business location decisions than state and local taxes.14 This finding
reflects the fact that state and local taxes tend to make up a very small share of business
costs.15 Moreover, public services can reduce the cost of doing business. For example,
high-quality infrastructure can reduce transportation and shipping costs, and high-quality
public education can reduce workforce training costs. Given this finding, it is not surprising
that most of California's business executives favor increasing funding for the state's public
schools.16

Alissa Anderson prepared this Policy Points. The California Budget Project (CBP) was founded in 1994 to provide Californians with a source of timely, objective, and
accessible expertise on state fiscal and economic policy issues. The CBP engages in independent fiscal and policy analysis and public education with the goal of
improving public policies affecting the economic and social well-being of low- and middle-income Californians. General operating support for the CBP is provided
by foundation grants, individual donations, and subscriptions. Please visit the CBP's website at www.cbp.org.

ENDNOTES
1 California's economy has weakened considerably. For an overview of key economic indicators, see California Budget Project, The Economic Slowdown Is Bad News for
California's Workers and Their Families (March 2008).
2 In January, the Governor proposed closing the budget deficit primarily by reducing support for public services. In February, the Legislature passed, and the Governor
signed into law, a series of spending reductions that affect a broad range of public services. With the exception of relatively modest fee proposals, the Governor's May
Revision to his Proposed 2008-09 Budget maintained his "all cuts" approach to balancing the budget.
3 Joseph E. Stiglitz, letter to New York Governor David A. Paterson, New York Senate Majority Leader Joseph L. Bruno, and New York State Assembly Speaker Sheldon
Silver (March 27, 2008), p. 1.
4 See Peter Orszag and Joseph E. Stiglitz, Biting the Budget Bullet: Why Raising Taxes Is the Least Painful Way out of the State's Fiscal Crisis (Tax Policy Center: April 27,
2003).
5 Joseph E. Stiglitz, letter to New York Governor David A. Paterson, New York Senate Majority Leader Joseph L. Bruno, and New York State Assembly Speaker Sheldon
Silver (March 27, 2008), p. 1.
6 See Peter Orszag and Joseph Stiglitz, Budget Cuts vs. Tax Increases at the State Level: Is One More Counter-Productive Than the Other During a Recession? (Center on
Budget and Policy Priorities: Revised November 6, 2001).
7 Peter Orszag and Joseph Stiglitz, Budget Cuts vs. Tax Increases at the State Level: Is One More Counter-Productive Than the Other During a Recession? (Center on
Budget and Policy Priorities: Revised November 6, 2001), p. 2. According to Stiglitz and Orszag, "A much better approach [than spending cuts] would close more of
the budget gap by levying an income-tax surcharge on higher-income families ... while leaving the current rate ... in place for others." See Peter Orszag and Joseph
E. Stiglitz, Biting the Budget Bullet: Why Raising Taxes Is the Least Painful Way out of the State's Fiscal Crisis (Tax Policy Center: April 27, 2003), p. 3. An income-tax
surcharge � an additional rate added on top of the existing rate structure � can raise a substantial amount of revenue with a relatively small increase in current tax
rates. Moreover, state taxpayers would not bear the full cost of an income-tax surcharge because state income taxes reduce federal income taxes for taxpayers who
itemize their deductions. Because most high-income taxpayers itemize, part of the cost of an income tax surcharge targeted to high-income taxpayers would be offset
by reduced federal income taxes. See Elizabeth C. McNichol and Andrew C. Nicholas, Using Income Taxes To Address State Budget Shortfalls (Center on Budget and
Policy Priorities: February 21, 2008).
8 Joseph E. Stiglitz, letter to New York Governor David A. Paterson, New York Senate Majority Leader Joseph L. Bruno, and New York State Assembly Speaker Sheldon
Silver (March 27, 2008), pp. 1 and 2.
9 Peter Orszag and Joseph Stiglitz, Budget Cuts vs. Tax Increases at the State Level: Is One More Counter-Productive Than the Other During a Recession? (Center on
Budget and Policy Priorities: Revised November 6, 2001), p. 2.
10 US Bureau of Labor Statistics, Consumer Expenditures in 2005 (February 2007), Table 1.
11 Center on Budget and Policy Priorities. A total of 17 states enacted large tax increases between 2002 and 2004, resulting in cumulative revenue increases of between
5.1 percent and 15.7 percent. Six states did not enact any tax increases during this period.
12 Seven out of 17 states (41 percent) that enacted tax increases resulting in increased revenues of 5 percent or more faced budget shortfalls this year, compared to all six
of the states that did not increase taxes at all.

3
13 Nicholas Johnson and Brian Filipowich, Tax Cuts and Continued Consequences: States That Cut Taxes the Most During the 1990s Still Lag Behind (Center on Budget
and Policy Priorities: December 19, 2006). Sixteen states enacted large tax cuts between 1994 and 2001 that reduced revenue by at least 7 percent. The change in the
number of jobs and in personal income represents the average annual percent change between 2001 and 2006. The change in the unemployment rate represents the
percentage point change between 2001 and 2006.
14 "Hundreds of surveys have found that tax incentives play little role in investment decisions, [which is] particularly remarkable given that survey respondents may have
a strong interest in exaggerating the importance of tax incentives they could receive." Moreover, "statistical and econometric studies are nearly unanimous in concluding
that state and local tax incentives fail to attract a significant number of new businesses, create numerous jobs, or substantially enhance state economic performance."
See Robert G. Lynch, Rethinking Growth Strategies: How State and Local Taxes and Services Affect Economic Development (Economic Policy Institute: March 2004), pp.
21 and 25.
15 By one estimate, state and local taxes accounted for approximately 1 percent of the cost of doing business in 2000. See Robert G. Lynch, Rethinking Growth Strategies:
How State and Local Taxes and Services Affect Economic Development (Economic Policy Institute: March 2004), p. 4.
16 Greenberg Quinlan Rosner Research and California Foundation for Commerce & Education, Selected Survey Results: Business Executives' Attitudes on California
Education Conducted for the California Foundation for Commerce and Education (March 2007), downloaded from http://www.calchamber.com/CC/News/
Archive/2007/03122007PR.htm on March 6, 2008. This survey of a representative sample of more than 1,300 business executives was conducted in early 2007.