State Spending Cuts Make Recessions Worse

Amy Traub

State Spending Cuts Make Recessions Worse

Ready for a Halloween scare? New York State predicts a deficit of $47 billion over the next four years. Many states have been smacked by the economic downturn’s one-two punch of declining revenues and rising need for public services, but in New York, home to the devastated financial services industry, is really in the soup. Governor Paterson’s answer? “bold and aggressive action to reduce state spending.” As he told Congress on Wednesday, "any taxation right now would only exacerbate the problem."

With all due respect, the Governor needs to put down his Ayn Rand novels and consider what real economists are saying about state budget choices during periods of economic decline.

The evidence suggests that both spending cuts and tax increases can exacerbate an economic downturn, since both can reduce business and households’ propensity to spend. The best stimulus is for the federal government to engage in deficit spending. So Gov. Paterson is right to ask the feds for cash. But chances are, it won’t be enough for NY. Yet running deficits is not an option for New York or most other states, which need to balance their budgets each year. So what should state policymakers be doing when federal aid isn’t enough?

An analysis by Nobel Prize winning economist Joseph Stiglitz and Peter Orzag (currently Director of the non-partisan Congressional Budget Office) suggests spending cuts are actually a worse option than raising taxes:

A reduction in government spending on goods and services is thus likely to be more harmful to the economy in the short run than an increase in taxes or a reduction in transfer program spending. Within the sphere of changes to taxes and transfer programs, the impact on the economy depends primarily on the propensity to consume — that is, on how much of an additional dollar of income is spent rather than saved — among those who receive the transfer payments or pay the taxes. The more that the tax increases or transfer reductions are focused on those with lower propensities to consume (that is, on those who spend less and save more of each additional dollar of income), the less damage is done to the weakened economy. Since higher-income families tend to have lower propensities to consume than lower-income families, the least damaging approach in the short run involves tax increases concentrated on higher-income families. Reductions in transfer payments to lower-income families would generally be more harmful to the economy than increases in taxes on higher-income families, since lower-income families are more likely to spend any additional income than higher income families. Indeed, since the recipients of transfer payments typically spend virtually their entire income, the negative impact of reductions in transfer payments is likely to be nearly as great as a reduction in direct government spending on goods and services… The conclusion is that, if anything, tax increases on higher-income families are the least damaging mechanism for closing state fiscal deficits in the short run.”

Take heed, Governor!