Recessions and the social safety net: the alternative minimum tax as a countercyclical fiscal stabilizer.

• Author: Galle, Brian

INTRODUCTION I. MICRO-FOUNDATIONS OF THE AMT's STABILIZATION EFFECT II. WEAKNESS OF STATE STABILIZATION TOOLS A. Tax Rate Increases B. Borrowing 1. Exit pressures on local borrowing 2. Political economy of local debt 3. Legal limits on local debt C. Rainy Day Funds III. FEDERAL INTERVENTIONS A. Federalize Social Insurance B. Subsidies and Tax Exporting IV. THE ALTERNATIVE MINIMUM TAX AS AN AUTOMATIC STABILIZER A. Tax Mechanics of the AMT 1. General features of the AMT 2. State and local taxes 3. Other provisions B. AMT Liability Is Increasing in Income at the Jurisdictional Level V. EMPIRICAL EVIDENCE OF STABILIZATION EFFECT A. State Spending B. Local Spending C. Revenue Effects VI. TWEAKING STATE AND FEDERAL TAX TO IMPROVE STABILITY A. Problems Translating Federal Subsidies to State Revenues 1. Voter ignorance of AMT liability 2. Taxpayers anticipate later tax increases 3. Timing of the residual benefits of the AMT B. Some Policy Possibilities 1. Tax the middle class ... and the very rich 2. Exploit the natural salience of filing season 3. Accelerate rebates 4. Guarantee deductibility 5. Target state education efforts CONCLUSION INTRODUCTION

Economic downturns make for tough fiscal times for state and local governments. State fiscal belt-tightening has the potential to drive up unemployment and drive down consumer demand, further slowing the economy. (1) Throughout the recent recession, a steady stream of headlines warned that state budget cuts threatened to delay economic recovery. (2) The crisis underscores that any sensible strategy for managing the ups and downs of the business cycle should include some provision for ensuring that state revenues will ease the pain of recessions and slowdowns, rather than compounding it. (3)

In this Article, we argue that states are poorly situated to make such plans for themselves, and that many conventional forms of federal subsidy would risk worsening the problems that states face. However, the path to a well-designed subsidy already has been laid in a surprising place: the federal alternative minimum tax (AMT). (4) We investigate empirically the impact of the AMT, and suggest some modest alterations that would make it a more effective stabilizer for unsteady state economies.

The Article makes three key contributions to the literature, as well as some smaller ones. First, we show for the first time empirically that the AMT affects state spending and that this effect is countercyclical. Second, we add to a minute legal literature exploring stabilization policy at the state level and consider the impact state policy has on the cycles of national economic health. (5) And, third, we attempt to remedy the neglect, in the legal literature and elsewhere, of how to design a federal policy that would mitigate the negative business cycle effects of state budgeting. (6)

Turning to the substance of our argument, the standard goal of macroeconomic policy in general is to be "countercyclical," stabilizing the economy by moderating both booms and busts. (7) Extremes in either direction can lead to unwanted effects, whether they be job loss or excessive inflation. (8) During downturns, this means that government may have a role to play in stimulating the economy, such as through increased spending, tax cuts, or expansionary monetary policy. (9) Traditional microeconomic theory also offers similar prescriptions, counseling that transfers of wealth from richer periods (booms) to poorer periods (busts) increase overall social welfare. (10)

States are in a difficult bind when it comes to stabilization policy, however. Their revenues are tied to the business cycle, so that budgets get tighter just when the need for countercyclical spending increases. (11) Raising taxes to make ends meet is contrary to the usual macroeconomic recommendations and is especially difficult in a modern climate where tax increases drive away productive citizens and businesses. Whereas Congress can largely avoid this dilemma simply by borrowing, states risk driving out citizens with excessive debt, and nearly all state legislatures face legal constraints to maintain a balanced budget. Those legal constraints, moreover, are sensible responses to the incentives of legislatures in prosperous times, which would otherwise likely take on excessive debts. (12)

The result is that state finances tend to contribute to, rather than mitigate, the pain of economic downturns. (13) And in a world where states are so closely economically interdependent, these effects are felt well outside any one state's borders. (14) As recent events illustrate, state budget crises contribute to national economic woes. (15)

Accordingly, we argue that the federal government can play some role in stabilizing state budgets, leading us to the question of how best to design such an intervention. Simply shifting some countercyclical programs, such as unemployment insurance, to the federal budget would be somewhat helpful (albeit at some cost to federalism), but would lead to undesirable distortions in state policymakers' incentives. Discretionary grants to hard-hit states are unappealing, because they may be too slow and targeted more by politics than economic needs. On the other extreme, a steady-state subsidy for state revenues--say, federal revenue sharing along the lines of the Canadian model---contributes to overheating the economy during growth periods, and distorts state budgets upward. The ideal instrument, then, is one that automatically directs federal dollars to a state if and only if its economy is struggling. (16)

The federal tax system already contains a set of instruments that approximate this ideal. The tax code grants state taxpayers a deduction for the money they pay to their local government--the state and local tax (SALT) deduction--which, in effect, is a federal matching grant for eligible state levies. (17) The much-reviled AMT, as we will both model and support with original empirical evidence, acts to shut off this matching grant when state economies are thriving. In combination, these provisions and others help target federal dollars to struggling states.

In light of the present crisis, we obviously do not claim that this support mechanism functions perfectly. Realistically, no stabilization policy could entirely protect states from a recession of this magnitude, but we acknowledge several current aspects of the AMT that likely reduce its efficacy. Thus, we also suggest several policy tweaks, some at the federal level and some that could simply be adopted by states, that would make better use of the support offered by the tax code.

Overall, we find that the literature's neglect of stabilization policy has been unfortunate, because it has led to the entrenchment of several pieces of conventional wisdom we think need reconsideration. Perhaps most prominent is the canard that states should not raise taxes during downturns, repeated recently during California's 2009 budget crisis. (18) In fact, taking into account federal matching grants, raising tax rates can actually, on net, increase a state's wealth. At the same time, we show that the most effective political structure for tax increases may be to tax the middle class.

Part I of the Article offers more background on the rationale for government interventions in the business cycle. Part II explains why states cannot themselves establish effective countercyclical taxing and spending policies. Part III elaborates on why standard forms of federal subsidy also are suspect. Part IV models the potential power of the AMT to serve as a countercyclical federal subsidy and sets out some empirical support for our basic assumption that AMT liability at the jurisdictional level rises with state income. Part V presents the results of our empirical investigation into the stabilizing effects of the AMT. Part VI suggests some policies to improve the AMT's countercyclical effects. We then conclude.

1. MICRO-FOUNDATIONS OF THE AMT'S STABILIZATION EFFECT

   The primary arguments for countercyclical fiscal policy can be broadly characterized as social insurance arguments and macroeconomic stimulus arguments. Although our general idea can apply in both domains, we will focus exclusively on the social insurance aspects of countercyclical fiscal policy. (19)

   The value of social insurance, or any insurance for that matter, hinges on the notion that individuals experience diminishing marginal utility of income. That is, as an individual consumes additional units of a good, each increment of the good contributes less to the individual's utility than the previous one did. (20) An immediate consequence of this diminishing marginal utility of income is that individuals can improve their welfare by foregoing small amounts of income during good times (by paying an insurance premium) with the expectation that they will receive a relatively large transfer during bad times (when the event that was insured against occurs). (21)

   In the social insurance context, the government body taxes individuals in relatively good financial condition to provide transfers to individuals who have suffered some economic loss. (22) These transfers are often referred to as fiscal "smoothing," because they level out the peaks and valleys of lifetime earnings. (23) Social insurance programs may prove to be superior to privately provided insurance if they allow for larger pools in which to diversify the underlying risk, or if there is adverse selection due to information asymmetries about the underlying risk each person faces. (24) As a descriptive matter, social insurance is generally provided with respect to income losses resulting from involuntary unemployment (25) or more general problems leading to poverty (26) to the near exclusion of private insurance. Social insurance programs generally targeted at the chronically poor or elderly populations also exist in the health insurance market alongside private competitors...