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Income Tax Increase: the Right Approach to Budget Deficit

October 28, 2010 By Jeff Van Wychen, Fellow and Director of Tax Policy & Analysis

Whether or not they admit it, all three of Minnesota’s major gubernatorial candidates are presenting budget balancing strategies that involve tax increases. One strategy focuses on sales tax increases, one on property tax increases, and one on income tax increases.

Property and sales taxes are both regressive, meaning they shift a disproportionate share of the tax load to those households with the least ability to pay. The income tax is a progressive tax, meaning that it places a larger share of the tax load on higher income households. The progressive nature of the income tax makes it the best fit for the current economic times. An income tax increase is the right choice because it is the best way to address the most serious problem facing the state and national economies: weak consumer demand for goods and services.

In a recent interview on Minnesota Public Radio, former secretary of labor and professor of public policy at the University of California-Berkeley Robert Reich notes that “The reason we are seeing only 64,000 [new U.S.] jobs in September, the reason we’re having such a hard time getting out of the gravitational pull of the great recession is that so many Americans just don’t have the ability any longer to buy and we’re going to continue to be in the gravitational pull of this terrible recession until Americans have more money in their pockets.”

While Reich is talking about the national economy, his comments are relevant to the states. What economists call “aggregate demand”--that is, total demand for goods and services--is weak. While the great recession is technically over, job growth is also weak. According to Reich, “There are not going to be many new jobs in America until the vast American middle class, working class, poor--basically, the rest of America--has more money in its pockets.”

States are limited in the extent to which they can stimulate aggregate demand, particularly when they are confronting large budget deficits, as Minnesota currently is. In fact, the two options open to states in balancing their budgets--tax increases and spending cuts--both tend to further harm the economy by reducing aggregate demand. In resolving a budget deficit, the task for state policymakers is to choose the approach which is least harmful.

Nobel Laureate Joseph Stiglitz concludes that in the short term, tax increases are less harmful to a state’s economy than direct expenditure cuts because nearly every dollar cut from direct government spending for infrastructure, education, public safety, and so forth represents a dollar less that is spent within the state’s economy. However, a dollar increase in taxes results in less than a dollar decline in spending within the state because (1) a significant portion of the decline in discretionary income resulting from the tax increase would have been saved, not spent, and (2) of the portion that would have been spent, a significant portion would have been spent outside of the state’s economy, thereby providing relatively little stimulus within the state. Stiglitz’s conclusions are summarized in more detail in a 2009 Minnesota 2020 article.

In the current situation, where weak aggregate demand is stifling recovery, we should rely more on tax increases than on spending cuts to balance the state’s budget. But which taxes do we increase?

The three major taxes in Minnesota are the sales tax, the property tax, and the income tax. All three have advantages and disadvantages, but in the state’s current economic situation, the primary thrust of state budget policy must be geared toward bolstering--or at least avoid further diminishing--aggregate demand. The income tax best accomplishes this.

As noted above, the property tax and the sales tax are both regressive, falling most heavily on low- and middle-income households. These are the same households that tend to spend a larger portion of their income and tend to spend more within the state and local economy. Increasing taxes on these households would have the most detrimental impact on aggregate demand.

Of the three major taxes, only the income tax is progressive. By relying on an income tax increase to balance the state budget--especially an increase that is targeted toward high income households--we are protecting the purchasing power of low- and moderate-income families that tend to spend a higher percentage of their income and spend it within the state and local economy. This is clearly the best way to avoid further harming aggregate demand. Relative to the income tax, property and sales tax increases more heavily erode middle- and low- income purchasing power.

The wrong thing to do right now is to give more untargeted tax breaks to corporations. As noted in the Reich interview, U.S. businesses currently sit on $2 trillion in capital, yet most are not using this money to create jobs and increase production. Why not? Because aggregate demand is weak. Business expansion and job growth will not occur until consumers have the ability to purchase the goods and services businesses produce.

That’s why trying to stimulate the economy through untargeted business tax breaks is like trying to push a rope. The only thing that will stimulate economic expansion and job growth is growth in aggregate demand. We will increase aggregate demand not by throwing more tax breaks at businesses that are already sitting on tons of capital, but by protecting and promoting the purchasing power of middle-class families.

Progressives have long promoted increased dependence on the income tax, since it alone of the three major taxes is based on the ability to pay. This is a laudable goal, but now there is a more practical, hardnosed rationale for an income tax increase. It is the best way to balance the state’s budget without reducing the aggregate demand necessary for a sustained economic recovery.

While the ability of state tax policy to influence aggregate demand should not be overemphasized, neither should it be totally ignored.

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  • Mike Gude says:

    November 8, 2010 at 6:23 pm

    Well written, Jeff, and well said.  Thanks for this analysis.