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Why Most States Have Rejected a Cuts-Only Approach

Today’s Wall Street Journal editorial (“Virginia Is for Surpluses”) trumpets Virginia’s $400 million surplus for fiscal year 2010 and praises Governor McDonnell for closing the state’s large budget shortfall without raising revenues. But both parts of this argument have serious flaws.

First, as I explained earlier today, the state fiscal crisis is far from over despite the surpluses that Virginia and some other states are reporting. Virginia’s surplus, for example, mostly reflects the fact that revenues — which have plummeted by about 20 percent in inflation-adjusted terms since the recession started — fell by less than expected in 2010. States are forecasting more large shortfalls for next year.

Second, there are sound reasons why most states have rejected a cuts-only approach to closing budget shortfalls in favor of a

that includes revenue increases as well as spending cuts:

A cuts-only approach is bad for a slow economy. As a 2008 letter from 120 economists to New York Governor Paterson stated,

[I]t is economically preferable to raise taxes on those with high incomes than to cut state expenditures.

The reasoning is straightforward: 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. Budget cuts reduce the level of total spending Raising taxes on high income households also will reduce spending, but by much less than the amount of the tax increase since those with plenty of income typically spend only a fraction of their income.

By contrast, almost every dollar of state and local government spending on transfer payments to the needy and for the salaries of public servants providing vital services to our communities enters the local economy right away, generating a greater economic impact.

An earlier paper by Columbia University professor and Nobel Prize winner Joseph Stiglitz and former Office of Management and Budget director Peter Orszag (then a scholar at the Brookings Institution) made the same points.

Raising taxes won’t hurt the recovery. The available data don’t support claims that tax increases during a downturn will slow a state’s economic recovery. Twenty-nine states raised taxes between 2002 and 2004 to help close large shortfalls stemming from the 2001 recession. During the subsequent recovery (from 2004 through 2007), these states fared about as well economically as those that didn’t raise taxes, as the table below shows.

Annual Economic Growth by Various Indicators 2004-2007
Indicator States That Increased Taxes Significantly States Without Significant Tax Increases
Personal Income 6.0% 6.2%
Employment 1.6% 1.8%
Median Wage 3.1% 3.1%

Relying solely on cuts imposes unnecessary hardships on the most vulnerable members of society. States’ shortfalls have been so large that even though most states have raised taxes, states have also cut health coverage for low-income children, medical services for the elderly and people with disabilities, and assistance for homeless families, among other things. Closing shortfalls entirely through spending cuts would force these vulnerable groups to bear an even larger share of the burden.