01/16/2009 05:12 am ET Updated May 25, 2011

In a Recession, Should States Raise Taxes Or Slash Spending?

I appeared on Your World with Neil Cavuto yesterday to talk taxes. This follows my recent CNBC debate with Grover Norquist on the same issue just a few weeks ago. Cavuto, of course, was much less partisan than Norquist - and yesterday's conversation was pretty substantive.

The question of our discussion was whether states, facing deficits, should raise taxes? Cavuto voiced the standard line that raising taxes could hurt the economy. I countered by pointing out that states - unlike the federal government - are legally unable to go into deficit, and so the choice is not whether to raise taxes in a vacuum, but whether to raise taxes OR cut spending? Because at the state level, you have to do one or the other during deficit-inducing recessions. Faced with that choice, it's clear the better policy is the former, not the latter.

Almost every single economist agrees, the last thing we want to do in a recession is slash government spending. We want, in fact, to increase that spending so that it is a counter-cyclical force to a deteriorating economy. So the question, then, is how to most safely generate the revenue to maintain or increase that spending. By "most safely" I mean how to raise the revenue in a way that will minimize any negative economic impact. And the answer comes from Joseph Stiglitz:

"[T]ax increases on higher-income families are the least damaging mechanism for closing state fiscal deficits in the short run. Reductions in government spending on goods and services, or reductions in transfer payments to lower-income families, are likely to be more damaging to the economy in the short run than tax increases focused on higher-income families."

So, first and foremost, you don't want dramatic spending cuts (beyond the usual rooting out of waste/fraud) and you don't want to raise taxes on middle- and lower-income citizens who both need the money for necessities, and are the demographics that will most quickly spend money in a stimulative way. That leaves taxes on the super-rich, and Stiglitz - unlike anti-tax ideologues - has actual data to make his case. We know Bill Clinton raised top marginal tax rates in a hobbled economy in 1993, and the economy then boomed. We also know the results of a recent Princeton University study, which looked at states that had raised taxes on the very wealthy during the post-9/11 recession. The analysis found that the tax increases were both the most reliable revenue generator and the safest in terms of minimizing any negative economic impact. Indeed, the states that pursued this course of action saw a net job growth, and almost no tax flight (ie. people fleeing the state because of the tax increase).

This is why I don't subscribe to the notion that Barack Obama must give up or postpone his proposed tax increases on the richest citizens or corporations - because while many have presented grandiose theories, no one has presented any compelling evidence that raising taxes on the very wealthy hurts the economy.

The difference for Obama, of course, is that the federal government can run up deficits, while states cannot. So he has far more leeway. States, on the other hand, have to make the hard choices - and unfortunately, one of the biggest states is making bad ones.

As you'll see in the Cavuto clip, Cavuto starts our discussion with the news that New York Gov. David Paterson is proposing a mix of spending cuts and regressive tax and fee increases on the middle class (a sales tax, a tuition tax increase, etc.) to deal with his state's huge budget deficit. That's right, in one of the most unequal states in the country - in a state that domiciles some of the richest financial industry fat cats in the country - the governor is against even a slight increase in income taxes on the highest earners. Somehow, he thinks it will be better to punish his state's working-class with the double-whammy of service cuts and tax increases.

Paterson will be pushed, though, by grassroots groups such as the Working Families Party, which is championing a millionaire's tax - one that a new poll shows 75 percent of the New York public broadly supports. The battle promises to be an epic one, pitting the Empire State's fat cats and unelected governor against the rest of the state. And it is a battle that will likely commence in states all over the country. If progressives lose, the end result will be tax and budget policies that both hammer an already teetering middle class and further weaken the macro economy.