State Finance in Times of Crisis

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As recent events illustrate, state finances are pro-cyclical: 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 creating moral hazard that would induce states to take on excessively risky policy, both fiscal and otherwise. Thus, we argue that policy makers should consider so-called “automatic” stabilizers, such as are found in the federal tax system.

We present an argument from micro-economic foundations suggesting that the federal Alternative Minimum Tax has potentially salutary -- and heretofore unrecognized -- effects that counteract pathologies of state budgets over the business cycle. Namely, as incomes grow and the AMT hits more state residents, state spending becomes more expensive in flush times 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 micro-theory. We provide policy suggestions regarding how the AMT could be modified to leverage this stabilization effect.

Calls to “reform” the Alternative Minimum Tax pre-date the recent economic downturn. AMT reform has appeared in many congressional stimulus proposals, but significant cut-backs 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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State finances, revenue, taxation, recession, pro-cyclical, federal remedies, moral hazard, risk, automatic stabilization, alternative minimum tax, AMT reform