Through a circuitous route that involves musings about Nobel laureates and his old high school ("Nobel Laureates and Minnesota taxes," April 30 MinnPost), Mitch Pearlstein ultimately reaches his conclusion: Tax increases are bad.

To some extent, Pearlstein is right. In a tight economy, tax increases make it harder for businesses to meet payroll and stay afloat. However, cuts in direct government expenditures are also harmful in a tight economy. First of all, demand for public assistance increases as people lose their jobs and their health care coverage. In addition, cuts in direct government spending leads to more job losses and less economic activity, which also hurts businesses.

The bottom line is this: In response to a $6.4 billion structural budget deficit, Minnesota policymakers have two basic options: increase revenues or cut spending. Both options are bad, with the potential for further slowing economic activity. The choice for policymakers is to balance these two bad options in a way that will be least harmful to the state's economy.

At this point, policymakers should consider the advice of yet another Nobel laureate — one not mentioned in Pearlstein's article but one who actually knows something about economics.  Nobel prize-winning economist Joseph Stiglitz has considered the impact of tax increases versus spending cuts in terms of their overall impact on a state's economy.

Stiglitz notes that a $1 tax increase will lead to less than a dollar loss in consumption because a portion of each dollar of discretionary household income is saved. Thus, a $1 increase in taxes will lead to less than a $1 loss in economic stimulus. However, a $1 cut in direct government spending leads to a full dollar reduction in consumption and thereby has a more adverse impact on economic activity, at least in the short term.

Emphasis should be on stimulation
In a recession, the emphasis should be on stimulating the economy or — perhaps more accurately from a state government perspective — avoiding actions that will further de-stimulate the economy. Given the choice between revenue increases and direct government spending cuts, Stiglitz concludes that spending cuts are more detrimental to the state's economy.

This is not to say that all spending cuts must be off the table. Not all government spending is created equal, and not all of it has the same impact on economic activity; with a $6.4 billion deficit, cuts to the least productive forms of government spending must be considered. However, a dogmatic approach which focuses solely on spending cuts and excludes revenue increases most definitely is not the best way to minimize harm to the state's economy.

Gov. Tim Pawlenty and the Minnesota Legislature have reached the same conclusion. Both are addressing the deficit through a combination of spending cuts and revenue increases.  In fact, the budget bill passed by the Legislature on Friday and vetoed by the governor on Saturday contains the same amount of revenue as the governor's budget -- no more and no less.

The fundamental difference between the governor's budget proposal and the legislative proposal that he vetoed is in how they increase revenue. The legislative proposal would raise alcohol and income taxes and create a new tax on credit-card companies that impost exorbitant interest rates. The governor is relying largely on shifts.

Shifts ignore long-term structural deficit
The problem with shifts is that they do nothing to address the long-term state structural budget deficit because they produce only one-time dollars that disappear in the next biennium. In fact, the governor's proposed "tobacco appropriation bonds" (essentially the sale of a future revenue stream for the sake of a one-time cash infusion) has already been overwhelmingly rejected, even by the governor's Republican allies in the House.

Given that the governor's "tobacco appropriation bonds" appear to be off the table, the resolution to the budget debate comes down two options: tax increases or even deeper spending cuts than those already proposed by the House, governor or Senate. 

By keeping tax increases on the table, the Senate and House are actually pursuing the option that will do the least harm to the state's economy and are demonstrating a more sophisticated understanding of the state's fiscal and economic predicament than is Pearlstein. State policymakers would be well-advised to reconsider the vetoed legislative plan.

Jeff Van Wychen is a research fellow at Minnesota 2020, a St. Paul think tank; his focus is primarily on property tax and state and local budget issues.