As recent events illustrate, state finances are procyclical: during recessions, state revenues crash, worsening the effects of economic downturns. This problem is well known, yet persistent. We argue here that, in light of predictable federalism and political economy dynamics, states will be unable to change this situation on their own. Additionally, we note that many possible federal remedies may result in worse problems, such as by creating moral hazard that would induce states to take on excessively risky policy, both fiscal and otherwise. Thus, we argue that policymakers should consider so-called “automatic” stabilizers, such as are found in the federal tax system, and we offer original empirical evidence that these stabilizers can have significant fiscal impact.

Our evidence focuses on the federal alternative minimum tax (AMT). We present an argument from microeconomic foundations suggesting that the AMT has potentially salutary—and heretofore unrecognized—effects that counteract pathologies of state budgets over the business cycle. AMT liability increases with income, and acts to eliminate federal tax subsidies for state revenue raising. Thus in flush times, when a state’s income grows so that the AMT hits more state residents, state spending becomes more expensive as the federal tax subsidy for state and local taxes is reduced. Conversely, when state fiscal health deteriorates, the federal tax subsidy grows as fewer state residents fall under the AMT, boosting taxpayer support for state spending. This stabilizing mechanism has the potential to overcome problems state politicians face committing to saving during boom times and spending during bust times.

We present empirical evidence suggesting that the AMT does indeed provide some degree of fiscal stabilization in accordance with microeconomic theory. We also provide policy suggestions regarding how the AMT could be modified to leverage this stabilization effect.

Calls to “reform” the AMT predate the recent economic downturn. AMT reform has appeared in many congressional stimulus proposals, but significant cutbacks are unlikely as federal deficits are projected to grow for the foreseeable future. Our argument here implies that any AMT reform effort should consider whether the AMT’s stabilizer function could be replaced by any other viable mechanism.

 

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