While debate rages in Washington, DC over the size and extent of the economic stimulus legislation, a similar discussion is taking place in Sacramento behind closed doors: If California receives five-, ten-, or twenty-billion dollars in federal stimulus aid, how should it be used?

The Administration supports using the stimulus funds to repay or offset any borrowing needed to balance the budget.

Legislative Democrats and interest groups want to use the stimulus money to offset program cuts.

But the most economically effective and fiscally responsible use of part of the stimulus funds would be to offset one of the most egregious tax increases from last year.

The new penalty, discussed earlier this week on Fox & Hounds Daily, would raise hundreds of millions of dollars by imposing a 20 percent strict liability penalty on large businesses that underpay their taxes for any reason. It will in effect force large companies to substantially overpay taxes they do not owe to avoid the penalty.

Why is this the best use for federal stimulus funds?

First, it meets the test for stimulus outlined by the President’s top economic guru, Lawrence Summers, who has testified that economic stimulus should be “targeted, timely and temporary.” Most of the funds to be raised by the underpayment penalty are from prior tax years, which would provide a one-shot boost to California revenues in the form of defensive payments. Federal stimulus funds are also temporary, and could be used to immediately offset these payments, which are due in May. And they are targeted to large taxpayers who do business in California, who would otherwise use these tax payments for job creating investments.

Second, the ostensible reason for state assistance in the federal stimulus bill is to maintain public services without having to unnecessarily raise taxes that would depress local job creation. The underpayment penalty is a poster child for tax increases that go at the heart of job creation.

Finally, earlier notions to offset the revenue losses from repealing the new tax by increasing the authority of the tax agencies to collect delinquent taxes seem to be losing momentum.

Not all tax increases can be offset by federal stimulus funding; and not all federal stimulus funding for California can be used to offset tax increases. But repealing the underpayment penalty represents the best mix of Congressional intent and economic effectiveness.