How Should the Government Approach Budget Deficits?

Robert J. Cuomo, Ph.D

Dean of the Girard School of Business and International Commerce

Merrimack College

In my last article, I assessed the impact of a sales tax increase on the Merrimack Valley economy.  I argued that the ultimate impact of the sales tax increase would severely damage Merrimack Valley businesses and that in general raising taxes during a recession is bad economic policy.

The argument put forth to justify a sales tax increase is that additional tax revenues are needed to address the state budget deficit.  Let’s examine this argument.  There are essentially two ways to address budget deficits.  The government can raise taxes and/or reduce spending.  The government has a number of taxes at its disposal that it can increase in order to raise revenue.  The principal taxes usually considered are the the income tax at the federal and state level, the sales and gasoline tax at the state level, and the property tax at the local level.  The government can also increase user fees at both the state and local levels.  At the state level examples are drivers licenses and registration fees, and at the local level user fees such as sport participation fees and music education fees.

Let’s assess the impact of each of these taxes and fees.  My last article addressed the impact of a sales tax increase on the economy.  With regard to the income tax, state government can raise revenue in two ways.  One way is to increase the income tax rate above its current 5.25% and/or to make the income tax rate progressive, i.e. increase the tax rate as a family’s income rises. The revenue raising effect of this will depend upon how Massachusetts residents react to an income tax increase.  Massachusetts residents can react to an income tax increase by working less since they will get to keep less of every dollar earned and/or by moving to a state that imposes a lower income tax burden such as New Hampshire.  The gasoline tax can be increased but it will have a very damaging impact on those households that must travel extensively to get to their jobs.  Also, businesses that rely heavily on transportation to deliver their goods and services to market will be adversely affected.

At the local level, cities and towns can increase the property tax through Proposition 2 ½ overrides.  This will hurt those on fixed incomes such as the elderly.  A controversial way of raising revenues at the local level is to increase user fees.  In operating our public schools cities and towns can increase sports participation fees and/or music education fees.  Opponents of this approach argue that expenses for these programs should be included in school operating budgets and additional fees should not be charged.  Proponents of this initiative argue that these programs although important should not be funded in tight fiscal times so that the burden on all taxpayers can be lessened.

A second way for governments to reduce budget deficits is to reduce spending.  This can be very problematic in that vested interest groups do not want their programs to be cut.  Most taxpayers are in favor of reducing spending in principle but rebel when their program is affected.  Notice what happened when the Massachusetts legislature attempted to cut the Franklin Park Zoo budget by $4million in trying to balance the state budget. Once a program is imbedded into a state or local budget, it is very difficult to execute cuts.  Unions will resist strongly any attempts to cut their benefits and nonprofit organizations will oppose cutting their programs.  There is no doubt that any cuts in spending will be met with very strong resistance on a number of fronts.  This poses a significant problem in that unless difficult spending decisions are made, the lion share of the burden in reducing budget deficits will fall on the taxpayer.

How do we resolve this dilemma?  The choices are clear.  We either continue to raise taxes or user fees to fund whatever we define as our needs, or we limit our spending to what revenue resources we have.  If we do not rein in our spending, then we must constantly raise taxes. There will also be a “crowding out” effect as government borrowing to finance the deficit will lead to higher interest rates. Our children and grandchildren will carry these burdens throughout their lives.  The alternative to deficit spending and its resulting higher taxes and interest rates is to “live within our means”.  This would require our federal, state, and local governments to exercise the same fiscal discipline as households.  Hard decisions would have to be made.  We would not be able to fund every worthy program.

In the final analysis, there is no magic bullet that can solve the budget deficit problem.  We as a society must decide which combination of tax increases and spending constraints we are willing to live with.

Robert J. Cuomo, Ph.D

Dean

Girard School of Business and International Commerce

Merrimack College