Wall Street Journal 6/3/09

Revenues to state and local governments are sensitive to economic conditions. Sales taxes are tied to purchases, of course. Income tax revenue is often more problematic. If a state, like Oregon or California, has a progressive income tax structure (higher income citizens pay a higher tax rate) then when incomes drop not only do taxes go down but they go down even faster as people fall into lower tax brackets. Oregon is particularly vulnerable because it does not have a sales tax. California has been buffeted by this phenomenon – seeing wide swings in revenue as economic cycles pass through.

On the costs side economic recessions increase demand for state and local services and programs. These are part of automatic stabilizers, and help a bit with increasing aggregate demand. They cost money, however.

And yet, unlike the federal government most state and local governments are prohibited from running or planning a deficit. They must operate in the black, even in the face of seriously declining revenue and increasing costs.

Not a pretty picture.

Every so often, history serves up an analogy that’s uncomfortable, a little distracting and yet still very relevant.

In the summer of 1933, just as they will do on Thursday, heads of government and their finance ministers met in London to talk about a global economic crisis. They accomplished little and went home to battle the crisis in their own ways.

More than any other country, Germany — Nazi Germany — then set out on a serious stimulus program. The government built up the military, expanded the autobahn, put up stadiums for the 1936 Berlin Olympics and built monuments to the Nazi Party across Munich and Berlin. [...] Germany did escape the Great Depression faster than other countries. Corporate profits boomed, and unemployment sank (and not because of slave labor, which didn’t become widespread until later).

In addition to this analogy, which I recommend reading in more detail, there is an interesting graphic that helps understand the different approach the United States is taking to stimulate demand, versus its European partners.

Most industrialized countries have laws on the books that automatically increase government spending when the economy is slow. Spending on food stamps, unemployment insurance, and other benefits to poor people go up as more people qualify for assistance. And with a progressive tax rate system, a decline in income not only means lower income taxes, but a lower income tax rate. (The result taxes drop more rapidly than income.) We call these phenomena automatic stabilizers. The dark portions of the bars above show these automatic increases in government spending. The lighter colored portions show discretionary spending – which requires an act of the legislature. Great Britain and several European countries have stronger social safety nets, so their automatic spending is greater as a percentage of GDP. The United States is less. So, we are more likely to increase discretionary spending in hard economic times. The members of the European Union, as Leonhardt points out, have been willing to increase government spending, but not to the degree that we have in the U.S. There are more complicating factors – see Germany as an example – but this is an illuminating discussion.