BY EDWARD E. LEAMER

Tax shortfalls are forcing California and many other states to make a difficult choice between higher taxes or less spending. This is a big problem for the year ahead since the economy is in a very fragile condition with tepid and tentative spending plans by business and consumers. The way that state budget crises are handled may determine the health of the economy in the following year. So which is better: less spending or more taxes?

The answer, I am sorry to report, is more taxes. The economy is able to absorb gradual changes in spending, but rapid and substantial reductions in spending cause economic downturns and rising unemployment. The recession of 2001 was caused by a rapid $100-billion reduction in business spending on equipment and software. Reductions of a comparable magnitude in spending by consumers or government this year would likely cause another dip and rising unemployment.

Of course, it is true that tax increases cause spending reductions by the affected taxpayers. But if history is a guide, these spending reductions are so gradual that they are hardly noticed. Except for those families that are living paycheck-to-paycheck, a tax increase will come from savings accounts and leave current spending largely unaffected.

Because of the sharp differences between the short-run effects of spending cuts and tax increases on total spending, now is the time to lean strongly toward tax increases. Now is also the time to put more of the tax burden on those with discretionary income whose personal spending will not be substantially affected by a tax increase.

In choosing between spending cuts that affect spending levels but not employment levels, versus those that directly affect employment levels, lean strongly toward the cuts that don’t affect employment levels. For the economy overall, the one sure way to get a sharp reduction in consumer spending is to put people out of work.

Then, in a year or two, when the economy is less fragile, we need a state budget that maintains and improves California’s competitiveness. Tax rates on businesses and wealthy taxpayers cannot be permanently out of line with other states and countries without seriously harming job prospects for all of us. Thus, tax increases this year need to be explicitly temporary.

We also need to prevent this from happening again. The exceptional revenue growth in the later half of the 1990s by itself was not the problem. The problem was buying into the hype and thinking that the Good Fairy of the New Economy would provide us with exceptional growth and low unemployment forever. Businesses were the first to become disenchanted with this fairy tale and cut back spending on information technology in 2000. State governments are scheduled to become disenchanted this year, forced to adjust to disappointing reductions in tax revenues. Consumers are still in Never-Never Land, spending future income they will never have.

Faced with the inevitable ups and downs of tax revenues, states should opt for conservative planning that limits the chance of making spending commitments that are impossible to live up to. We should tie next year’s budget plans to this year’s revenue.

Leamer is the Chauncey J. Medberry Chair in Management in The Anderson School and director of the Anderson Forecast.