Los Angeles is struggling to raise money and cut costs to fill a $200 million budget gap that could force thousands of layoffs and drive the city into bankruptcy. But last week, the city decided to forgo $3.4 million in revenue as it slashed taxes for Internet companies.

Officials say the tax break for the fast-growing industry is vital to Los Angeles's future, even though it puts the city in a deeper hole. They worried that without the cut, more businesses and jobs would flee the city, which has a 12.5% unemployment rate.

The decision highlights the quandary of local governments across the country as they confront dueling crises of deficits and jobs. Raising fees on businesses can help close a budget hole in the short term, but it can also scare off employers and ultimately shrink a city's tax base.

"It we didn't roll that [tax] back, there was a real chance many of them would leave," said Austin Buetner, the mayor's new economic chief. "They're high-paying businesses and the wages are spent in our city," he said. "They're spent on sales tax and buying homes and in dining establishments and in our commercial-real-estate businesses. We want to keep our offices filled with the jobs of today and tomorrow and Internet business is one of those."

Mr. Buetner said there were about 300 Internet companies in Los Angeles employing some 3,500 workers.

A report issued by the city said if Los Angeles didn't approve the tax cut it would "likely suffer an ongoing revenue loss that could exceed $3.4 million in future years." Internet companies, the report warned, would likely move outside the city, triggering a knock-on effect on retail sales, property vacancies and employment.

It is the type of recession calculus that many states and cities are beginning to make as they struggle to fill budget gaps while trying to preserve and attract local businesses.

Last month, Minnesota Gov. Tim Pawlenty-whose state is facing a $1.2 billion budget shortfall-proposed a 20% reduction in the corporate tax rate and a 20% tax cut for small business. In a statement announcing the plan, Mr. Pawlenty said the cuts will "increase private sector investment and create jobs."

In Michigan, facing unprecedented financial calamity, state Democratic Rep. Mark Meadows proposed slashing business taxes by $1.2 billion, a 44% cut. "It's our small businesses and entrepreneurs that are the true engine of growth for our economy, and we must do all we can to help our businesses create jobsand get the economy moving," Mr. Meadows said in a statement.

Analysts say giving up cash for the promise of job creation can be risky and doesn't always work. "State and local governments are going to have to place their bets on what will bring in greater revenue and keep more jobs," said Jessica Levinson, director of political reform for the nonpartisan Center for Governmental Studies in Los Angeles. "It's a balancing act that every jurisdiction will have to face.".

Few governments have any room for error. Cutting taxes can mean laying off teachers and police officers to save cash.

"This guessing game has particularly high stakes in the current economy.Most cities, counties and the states are strapped for cash and can't afford to make an ill-conceived gamble," Ms. Levinson said.

Business owners in Los Angeles have long complained about the expense and red tape that comes with doing business in the city.

Internet companies said their taxes were raised two years ago after the city's Office of Finance reassign them to a new tax category after an initial audit. Instead of being classified as multimedia businesses, they were put in the "professions and occupations" category, in effect increasing their city taxes fivefold. The tax rate was increased from $1.01 per $1,000 of gross receipts to $5.07.

Many refused to pay the increase and kept paying at their old rate. Some began to look to neighboring cities with lower tax rates.

Blythe Holden, general counsel for Shopzilla Inc., a price-comparison Web site owned by Scripps Networks Interactive Inc., said Shopzilla was looking at relocating to Santa Monica after the tax increase. The company has been in Los Angeles since 1998. Shopzilla's city tax bill would have increased from about $250,000 a year to close to a million or more under the new rate, Ms. Holden said.

Ms. Holden said Shopzilla, which has 240 employees, will stay because of the tax cut.