Unexpected Tax Revenues Lead to Unexpected Tax Cuts

As Jamelle described yesterday, California just cut its deficit in half, not through dramatic spending cuts but through an unexpected tax windfall, the result of improved economic growth in the state. It’s not unique in experiencing this – Michigan and New Jersey also reported higher-than-expected tax revenues this week. Jamelle rightly says that these windfalls show that the state and federal deficits aren’t the result of rampant government spending in the last two years but were instead generated by lower revenue from flagging tax receipts in the recession (along with the Bush tax cuts and two ongoing unfunded wars).

In Michigan, which was facing a $1.4 billion deficit prior to receiving an unexpected $429 million this week, Republicans are already calling for additional tax cuts to business, which they say will strengthen the state’s nascent economic recovery. State Senate Majority Leader Randy Richardville called for cuts to the taxes that businesses pay on machinery and capital while Rep. Tom McMillin suggested cutting the personal and corporate income tax rates to 4.25 percent from 4.35 percent. This comes only a week after the Legislature passed a $1.7 billion tax cut to businesses.

There are two dangers in these proposals. The first is that they assume tax cuts for business will generate more economic growth than would restoring spending on the social programs cut to deal with the deficit. Michigan cut its unemployment insurance in March to help it deal with its deficit. Unlike businesses, which could potentially stash their tax breaks away in savings accounts, the unemployed can be pretty much guaranteed to inject benefits they get back into the economy, providing a direct stimulus with a multiplier of up to $1.90 for every $1 spent. The state also cut its K-12 education funding by $1.6 billion to deal with its deficit (although some of the funds were redirected toward higher education). If that funding was restored, the better-educated workforce it would generate would have a long-run stimulus effect of up to $13 for every $1 spent.

The other danger is that by lowering tax rates so much, Michigan will set itself up for indefinite deficits in the future. The reason the state received this windfall is that it had a reasonable tax rate. If it cuts business out of its revenue base, the damaging cuts it made to education and elsewhere will become permanent.

It’s great news that states aren’t struggling as much as we once anticipated and that their economies are recovering. As Jamelle said, deficit reduction ultimately comes down to economic growth, and these states would be wise to remember that there are ways to keep the recovery going while also undoing some of the sacrifices they forced on social programs during the budget squeeze.