In economic terms, raising taxes better than budget cuts”

Published in The News Tribune, March 9, 2010

Peter Callaghan noted in his column (“Instead of guessing, we could ask our economist about tax increases”, 2/21/10) that elected officials in Olympia are throwing out dueling claims over the effect new state taxes will have on the economy.  He asks “Would it cripple a halting economic recovery? Would deeper budget cuts do the same?”

The truth is, neither cuts in public spending nor tax increases are ideal in a recession as both reduce demand for goods and services (and hence employment) in the economy. However unlike the federal government – which can rely on deficit spending during recessions – the state government must choose cuts, new taxes, or a combination of both.  Given this choice, deeper cuts in spending on investments to education, health care and infrastructure improvements would be the worst option.

The reason is that tax increases are not likely to slow economic growth and employment as much as cuts. Think of cuts in education that lead to more layoffs. Or cuts in assistance to people who are temporarily disabled. Or cuts in child care that result in parents not being able to go to work. Those directly take money out of citizen’s hands and thus affect employment levels and the state’s economy.

Of course tax increases do the same thing, which is why ideally we wouldn’t do that either.  But individuals, especially those with higher incomes, are unlikely to reduce consumption by the full amount of the tax increase.  Rather, some reduction will occur to savings, which plays a smaller role in stimulating the economy than does consumption.

It’s for this reason that Nobel Prize winning economist Joseph Stiglitz and Peter Orszag, director of the federal Office of Management and Budget, have said, “The adverse impact of a tax increase on the economy may be smaller than the adverse impact of a spending reduction because some of the tax increase would result in reduced saving rather than reduced consumption”.  But last year, instead of coupling cuts with tax increases, we took a largely all-cuts approach in filling the state’s $9 billion budget deficit. This year, due to the continuing effects of the recession, the state faces a $2.8 billion deficit, which lawmakers are now trying to fill.

Proposals laid out by the Governor, the House and the Senate call for meeting this deficit largely through additional budget cuts. But in the short term, more cuts are likely to be worse than new taxes; moreover, they are likely to affect  the people who are most in need of the sorts of goods and services that the state government provides – education, health care, and social services in particular.

Callaghan is right to question the logic of the new taxes that Governor Gregoire is proposing, however.  Taxing gum and bottled water does sound both desperate and (imagine!) politically motivated.  But the problem lies in our tax base which leaves us few options for raising needed revenue in a fair and efficient manner.  The B&O tax is unfair, so it isn’t a good candidate.  The sales tax is regressive and exempts way too many things, so scratch that.   In an ideal world we would have an income tax, and we would raise revenue through this tax.

Given that we live in the real and not the ideal world, Governor Gregoire and the Legislature aren’t left with many good options.  Probably the best option available is to raise real sin taxes on gasoline and cigarettes, which unfortunately are regressive and so fall disproportionately on those least able to afford them.   To this end, the state could couple this with funding for the Working Families Tax Rebate which mitigates the impact of higher taxes on those already hit hardest in this downturn.

So while Callaghan is right to question the logic of the specific taxes that Governor Gregoire is proposing, in the end raising revenue is the right tactic, particularly if it is done in a way that shifts the burden of new taxes to those among us best able to afford it.