May 17, 2002

May 17, 2002 | WebMemo on Taxes

Tax Policy in Response to Budget Shortfalls - A State-LevelPerspective


The economic climate over the last couple of years has not been friendly to state budgets. Prior to September 11, 2001, as a result of the recession, several states already faced budget deficits and, since 9/11, those deficits have grown and have been more widely felt. In short:

  • Prior to September 11, 2001, nineteen states reduced their enacted budgets by a total of about $1.9 billion in order to compensate for revenue deficits.
  • Since 9/11, an additional sixteen states have made cuts to FY02 enacted budgets, or have been faced with cutting FY03 budgets, in addition to other measures, to close deficits.
The seriousness of this news, however, is tempered by the fact that 47 out of 50 states averaged greater than 4 percent increases in spending from FY99-01. And most states, presumably with this realization in mind, have made budget cuts their main policy for deficit reduction. In many cases, of course, budget cuts alone have not produced the necessary savings and, as a result, a number of states have enacted tax increases of various kinds. Specifically:
  • Thirteen out of 42 states with budget deficits chose to address their deficits at least in part through tax increases.
  • Eight of those thirteen have chosen to impose income tax increases (personal and/or corporate) in additional to sales taxes and/or user fees, and two more states are proposing such increases.

While both income and consumption-type (i.e. sales) taxes do raise revenue, they have very different economic effects. While sales taxes dampen short-term consumer demand, they will not discourage savings and investment since they don't tax interest or dividend income or capital gains. Income taxes will not only discourage consumption (as people have less money), they will also discourage savings and investment. This is important from the consumer end in that people will buy fewer stocks and put less money in taxable savings accounts (i.e. IRA's), and more important from the business end in that businesses will not invest in new plant and products (or jobs). Furthermore, the economic growth that would result from keeping taxes low, or reducing them, would in fact increase the tax base such that tax revenues actually increase, thereby reducing deficits. Thus, state income tax increases will most likely prove an inhibitor to economic recovery and growth. Those states that have imposed only consumption and use taxes will most likely have faster recoveries. Interestingly, 28 states have either not changed taxes or have reduced taxes.

Ethan Baker is a former research assistant in the Center for Data Analysis.

The Fiscal Survey of States: December 2001, (, The National Association of State Budget Officers (NASBO), December 2001.

State Budgets--Updates (,%202002.htm), NASBO, January 2002.

2000 State Expenditure Report, table 1, 'Total State Expenditures- Capital Inclusive' FY99-01, NASBO, Summer 2001.

State Budgets--Updates (,%202002.htm), NASBO, January 2002.

Kotlikoff, Laurence J., "Saving and Consumption Taxation: The Federal Retail Sales Tax Example" in Frontiers of Tax Reform, Michael J. Boskin, ed., Hoover Institution Press, Stanford, CA, 1996.

Bartlett, Bruce, "Why Tax Cuts are Needed," Detroit News, April 3, 1995 (

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