State hikes may offset Bush plan

San Francisco - One day after President Bush stood before the nation and announced a plan to loosen the grip of economic stagnation, California Gov. Gray Davis began to tighten it.

It was not his intent. Nor is he alone. Instead, he is but one of many governors - indeed almost all - who are delivering State of the State addresses this month with an ominous message: the promise of huge spending cuts and the possibility of new taxes.

In the face of the massive White House proposal, which would give roughly $100 billion to Americans next year in tax cuts and services, such news might seem less daunting. Yet the depth of the budget crises in statehouses - with deficits totaling as much as $60 billion - is forcing states to pull back on the things that would normally spur growth to the point that it may offset the benefits of the Bush plan.

It is setting up an unwitting collision over fiscal policy between Washington and the states that will help determine the future of the economy and the fortunes of Main Street.

Already, the relationship between governors and Mr. Bush has been strained by the administration's demand that they pick up more of the tab for homeland security and federal programs like Medicaid and education reform. Now, to some degree, Bush finds the success of his plan in their hands.

"Anything states do to balance their budgets is not going to help the economy," says Nicholas Jenny of the Rockefeller Institute in Albany, N.Y. And if state and local authorities have to raise taxes significantly, he adds, "that can actually have a much bigger impact on how people run their finances" than Bush's tax cuts.

In many ways, this is a normal pattern for any downturn: States must by law balance their budgets, while the federal government is free to spend itself into deficit to spur an economic recovery. What's different this time, experts say, is the magnitude of the problem in statehouses from Connecticut to California.

California's deficit alone is estimated to be as much as $35 billion. Though he did not directly mention taxes, Governor Davis acknowledged in his State of the State address Wednesday that he will be sending one of "the toughest budgets ever sent to the legislature."

Other governors have gone further. Republicans in Connecticut and Kentucky, for instance, say tax increases are necessary. How much those increases may inhibit growth - and how many people are laid off as state programs are pared down - will play a crucial role in any economic recovery.

As a result, many governors had held out hope that Bush - their former colleague as governor of Texas - would offer significant financial help to struggling states. The answer in his economic package was more parsimonious. In essence, he said: Fix it yourself. While Democrats say some $30 billion should go to states, Bush has mustered $10 billion.

"It's better than nothing, but the president was a governor, so he should get it," says Steve Maviglio, a spokesman for the California governor.

Bush, however, seems to be listening more to the ideas of a former California governor. His plan contains echoes of Reaganomics: tax cuts, even at the expense of deficit spending.

By accelerating the income-tax cut and ending the dividend tax, Bush hopes Americans will spend more and invest more. The stock market fueled the surpluses of the 1990s, as investors cashed in and paid huge capital-gains taxes. Now, their disappearance is the single greatest factor in the state budget crises.

"One of the things that has to happen for states to start to turn around is an increase in the stock market," says Scott Pattison, head of the National Association of State Budget Officers in Washington.

To many, though, the Bush plan is full of dangers. For one, they say the centerpiece of the proposal - the repeal of the dividend tax - could work against states trying to dig out from deep deficits.

Thirty-seven states depend on federal data to collect roughly $4 billion in dividend taxes. Without Washington's help, states would have to drop the tax or come up with a complicated formula of their own. When confronted with a similar situation last year on bonus depreciation, one-third of the states affected decided to go along with the federal government's decision and not rewrite codes.

Moreover, the Bush plan promises little immediate relief to the states, analysts say. The hope is that those who benefit most from the tax cuts - the rich - will spend the money and boost the economy. As it is, states will certainly create a drag on the economy this year, and forecasts for next year suggest the situation may worsen.

A surer way to get federal money into the American economy, some critics argue, is to give more of it to states, which will use it to avoid tax hikes and layoffs.

"Every dollar you give to states is a dollar that will go into the economy," says Iris Lav of the Center on Budget Policy and Priorities in Washington. "It is the most direct stimulus." Instead, she adds, the states and the federal government continue to work largely at cross-purposes: "It very likely could be close to a wash."