David Paterson took the oath as governor of New York on March 17, 2008, succeeding the disgraced Eliot Spitzer on the same day that Bear Stearns collapsed. Paterson spent the spring and summer warning that the state faced its worst economic downturn since the Great Depression, and by early autumn, he was looking downright prophetic. As tax revenues nose-dived and New York’s budget deficit ballooned from $4 billion to over $13 billion, the new governor didn’t simply blame the problem on economic forces beyond his control. “This is the result of our increased spending over years and years,” he said during one of many fiscal-crisis news conferences. Wall Street had “bailed us out for a number of years,” he added, but “the well has run dry.”

Paterson’s tough talk implied that he would do what was necessary for New York to weather the recession and recover from it: in the short term, slash state spending to close budget gaps; for the longer term, reduce New York’s bloated public sector to a more affordable size; and, above all, avoid raising economy-killing taxes. Unfortunately, he has failed on all three counts, agreeing this past March to a 2009–10 state budget that will keep growing even as the economy shrinks. New York’s finances now precariously balance on a combination of temporary federal aid, nonrecurring “one-shot” savings and revenues, and a package of record tax and fee increases. As a result, the Empire State’s fiscal and economic outlook is worse than at any time since the fiscal crisis of the mid-1970s.

Business Loves NY - Not!

At the close of his budget negotiations with the New York State Legislature, Paterson bizarrely insisted that the new spending plan represented fiscal austerity: “If the legislature can maintain this type of discipline over the next few years, then we can actually see the light at the end of the tunnel.” But that tunnel leads to a fiscal abyss. The only way to avoid it is to halt spending growth before it’s too late.

New York State’s current budget problems were precipitated by the global financial meltdown, but they were decades in the making. Concluding that New York has the worst economic outlook of any state, an analysis by the American Legislative Exchange Council blames its combination of high taxes, excessive debt, oppressive regulatory bureaucracies, and labor policies that discriminate against nonunion employers. New York’s overall state and local tax burden lightened in the 1990s but remains among the nation’s highest. Private-sector job growth in the state has been anemic by national standards over the past 25 years, despite a series of financial-sector booms.

Further, the bursting of the real-estate bubble and the epic restructuring of Wall Street mean that New York, more than most other states, faces a fiscal reckoning. With every peak and valley in the boom-and-bust cycles of the past 25 years, Albany became ever more dependent on Wall Street. By the peak of the latest boom, the securities industry alone accounted for fully 20 percent of the state’s tax revenues—including income taxes generated by the phenomenal rise in Wall Street profits and bonuses. A surge of capital-gains and transaction taxes from a red-hot commercial and residential real-estate market added more fuel to unsustainable levels of state and local government spending.

Today’s crisis clearly isn’t just another cyclical downturn like those in 1989–92 and 2001–03. Regardless of when the broader recession ends, the financial sector that rises from the ashes of the 2008 meltdown is likely to be much leaner and more heavily regulated. That means, for one thing, that Albany will no longer be able to count on the geese that once laid its golden eggs. It also means that stopgap measures that assume another boom is just a year or two down the road will simply create bigger budget holes in the near future.

Atlas Mugged.

Paterson initially seemed to recognize all this, but he fumbled the opportunity that the recession gave him to push for decisive action and meaningful reform. In December 2008, the governor presented an executive budget for 2009–10 calling for a 1.1 percent spending increase, with almost nothing in the way of significant restructuring, consolidation, or downsizing of state agencies and programs. He called for 137 new or increased taxes, fees, and fines, hitting energy bills and health care as well as consumer items, to raise $4.1 billion. As a long-term plan, the executive budget was an even bigger failure, projecting spending that would rise at twice the inflation rate between 2010 and 2013—including a 36 percent increase in Medicaid and a 25 percent increase in school aid.

This was an ominous sign. In Albany, the executive budget is the floor bid in an annual negotiation with the legislature that generally goes in one direction—up. Any pressure for budget reform further diminished in February 2009, when Congress and President Barack Obama delivered a federal stimulus package promising New York nearly $25 billion over two years. A Washington bailout seemed just the way to continue paying for expenditures that the state could no longer afford on its own.

Meanwhile, public-sector unions were bankrolling a campaign to raise taxes on New York’s “wealthy,” defined as anyone earning over $250,000, and they didn’t let up even when the federal billions materialized. The unions’ proposal was embraced by many legislative Democrats, whose party had just won control of both houses of the legislature for the first time in 44 years. Paterson warned that higher income taxes would weaken the tax base by driving high-income residents away, but he never ruled out the tax hike, either—strengthening the widespread (and, as it proved, correct) impression that eventually he would cave to it.

As budget negotiations went on, tax revenues kept falling—the main reason that the $13 billion deficit that the executive budget aimed to close swelled to $17.7 billion by late March. And as the April 1 start of the 2009–10 fiscal year drew near, Paterson and Democratic leaders agreed to a budget deal that approached the worst of all conceivable outcomes.

The budget spends a total of $132 billion, an 8.5 percent increase from last year. Paterson justifies the growth by pointing out that “state operating funds” have risen less than 1 percent. However, if the definition of this category is stretched to include federal stimulus aid (which, crucially, is due to expire in 2011), then spending normally supported by state funds is actually up at least 4.2 percent—at a time when inflation is nil, economic activity is sluggish, unemployment is rising, and tax revenues keep plummeting.

What Paterson labeled an “austerity” plan also includes the legislature’s customary $170 million for pork-barrel “member item” appropriations. Spending in the budget’s three “out years”—fiscal years 2010–11 through 2012–13—is boosted further. The “$6.5 billion in spending cuts” that Paterson claimed consist mainly of avoided spending increases rather than actual reductions.

Despite the stimulus injection, the final budget also funds its spending with tax and fee increases valued at $6.1 billion—an all-time high for the Empire State and fully 50 percent more than Paterson had sought in his original record-setting proposal. This includes $4 billion from the state’s largest personal income-tax hike in nearly 50 years (the unions having won two-thirds of the soak-the-rich plan that they sought; see sidebar, below). Paterson also repealed $1.7 billion in state-funded school property-tax rebates for homeowners, while no longer even talking about the property-tax cap that he promoted, over the teacher unions’ opposition, less than a year ago.

Asked if it made sense to raise taxes in a deep recession, the governor replied, “None of this makes sense.” That’s for sure. New York State has already lost nearly 150,000 jobs since last summer, with roughly 130,000 more job losses projected through the end of the year, and higher taxes are likely to make the problem worse. That means even less tax revenue.

The budget did represent a huge victory for New York’s public-employee unions, which not only succeeded on the income-tax hike but also brushed off Paterson’s call for a pay freeze and other contract concessions. While government workers in California and Ohio were taking cuts in the form of uncompensated furloughs, more than 160,000 New York State government employees started collecting an average 3 percent pay boost within three weeks of the budget’s passage. Only in the final week of budget negotiations did Paterson finally get serious with the unions, threatening up to 8,900 layoffs by July if they didn’t start making concessions. They replied with a mocking ad campaign featuring photos of Paterson sticking his fingers in his ears. The head of the state’s Civil Service Employees Association suggested that the governor “needs a good psychiatrist, or at least he should share the drugs he’s on.”

The governor is surely clearheaded enough, however, to realize that the federal stimulus money is a budgetary bridge to nowhere, allowing New York’s state spending to stay more or less on track for another two years before derailing. Paterson forecasts that revenues will fall $2 billion short of spending in 2010–11, but the shortfall will reach $8.8 billion the following year and $13.7 billion the year after that. Higher taxes will further weaken the Empire State’s prospects for a comeback, even if the national economy recovers in line with Obama’s highly optimistic projections for the next few years.

So what now? Paterson and state lawmakers need to learn the lesson that the late senator Daniel P. Moynihan called Political Economy 101: “When you are in a hole, stop digging.” If they want renewed economic growth, their first priority should be to reverse their record tax hikes no later than 2011, when the income-tax increase is currently scheduled to expire. But this will require a much stronger effort to reduce spending across the board, and especially in three large categories: state agency operations, Medicaid, and school aid. It will also require breaking the public-sector unions’ stranglehold on New York.

Reducing the costs of state agencies is an undertaking over which the governor has a fair amount of control, as his layoff threat illustrated. (In June, he agreed to a deal that will eliminate unfilled positions and provide severance bonuses to 4,500 retirement-ready employees in exchange for the unions’ acquiescence to a modest rollback of pension benefits for future hires.) However, Paterson has yet to initiate the kind of rigorous, top-to-bottom review of agency operations and programs that is sorely needed after a prolonged period of control by one governor—George Pataki, who held office for 12 years. (Pataki’s successor, 60-week wonder Eliot Spitzer, left little discernible managerial imprint of his own.)

In contrast to New York City, where the Mayor’s Management Report is a useful (though hardly flawless) tool for measuring agencies’ performance, New York State makes little effort to hold anyone in its sprawling bureaucracy accountable for anything. A gubernatorial commitment to performance budgeting, with publicly reported measures of progress toward clearly stated goals, is a prerequisite for smart, targeted budget reductions. The governor and his top staff should also investigate outsourcing functions now reserved for public employees (see sidebar, below).

In the final analysis, however, significant money-saving reforms—reorganizing, consolidating, or eliminating agencies—require the legislature’s approval. Paterson did succeed in persuading lawmakers to close a few underpopulated prisons and juvenile detention facilities this year. But he needs to push harder for economies, even in areas of government outside his immediate control, like the sprawling state court system (which has added nearly 4,000 employees in the last dozen years) and the porcine budget of the legislature itself, which currently averages over $1 million for each of the 212 elected Assembly and Senate members (though the funds are by no means evenly distributed). Such steps can at least produce a down payment on the billions of dollars in recurring savings needed to rebalance the budget without higher taxes.

An area where savings are needed even more sorely is Medicaid. New York’s $49 billion Medicaid program is by far the most costly in the country, spending nearly 75 percent more than the national average per enrollee, though there is scant evidence that the money provides a commensurately high quality of care. Created in the mid-1960s as health insurance for the poorest state residents, Medicaid now covers more than one of every five New Yorkers—that’s 3.7 million, all told—as well as an additional half-million in Family Health Plus, a program reaching more and more middle-income households.

In fact, under both Spitzer and Paterson, expanding Medicaid enrollment has been an express goal of state policy. That was why Paterson spearheaded a budget provision that let people enter Medicaid without undergoing financial-asset tests and face-to-face interviews. As if to ensure a steady flow of new customers for publicly subsidized health care, the state has also hiked taxes and fees on employer-provided coverage by $850 million. No wonder the Medicaid rolls are now projected to grow by another 1 million people over the next four years.

To his credit, Paterson has persuaded the legislature to divert some Medicaid funding from expensive hospital inpatient care to primary- and preventive-care settings, such as doctors’ offices and outpatient clinics. This modest reform may produce bigger savings down the road, if the state can stick to it despite furious complaints from the hospital industry. For more suggested reforms, see “The Medicaid Monster.”

Finally, school aid in New York is far higher than the state can afford. New York will send $22 billion in operating aid to local K–12 school districts in 2009–10, plus $2.5 billion to make up for school property-tax breaks targeted to homeowners. New York’s education spending per pupil was already the nation’s highest two years ago, before Spitzer handed schools the first installment of what was supposed to be a record $7 billion aid hike over four years. That spending would have been difficult to finance even before the Wall Street meltdown.

With state revenues plunging, Paterson’s executive budget proposed a modest 3 percent cut in aid for school year 2009–10—a smaller hit than many school officials expected. But the February stimulus package required the state to use federal funds to restore $1.2 billion in school aid, resulting in a net aid increase of about 2 percent over the previous year—and that’s aside from another $1.7 billion in federal stimulus funds that will flow directly to school districts over the next two years. These increases are fattening a budgetary baseline that has grown far beyond the level that New York’s state and local taxpayers can afford to sustain. In the long run, spending on public schools in New York remains on a collision course with fiscal reality.

But the school-financing issue points to an even broader problem. Just as teacher salaries and benefits make up three-quarters of school operating expenses, the largest share of Albany’s other aid to local governments supports the wages, salaries, and benefits of public-sector employees. These government workers are the beneficiaries of contracts that guarantee them ever-increasing pay and benefits, no matter the economic climate—unlike workers at private firms, who have responded to the recession by seeking creative ways to save jobs through wage deferrals and job-sharing. If tax revenues and state aid don’t rise—and if, as is usually the case, unions refuse to make concessions—local-government officials have three choices: they can lay off employees, cut back services, or shortchange vital capital investments.

The governor needs to frame public-sector personnel costs and rigid contracts as a comprehensive problem requiring a comprehensive solution for every level of government. In particular, the rising cost of pension and other retirement benefits can only be addressed at the state level (see sidebar, below). Also, state and local officials need more flexibility in managing their workforces and controlling labor costs—and once they have it, they need to be held accountable for results.

A sizable target for reform is the Taylor Law, which regulates public-employee unionization and collective bargaining rights. Passed in 1967, the Taylor Law effectively created a statewide public-sector labor cartel that exerts gigantic political influence on every level of government. In the 40 years after the Taylor Law’s enactment, the number of state and local government jobs increased at more than twice the rate of private-sector employment in New York, and the average pay of state and local government workers rose higher than that of private-sector workers in most regions of the state.

Outright repeal of the Taylor Law is a practical impossibility. But changing it would help redress the imbalance of power at the bargaining table between the public’s elected representatives and unions representing government workers. Reform of the law needs to focus on two areas: eliminating compulsory arbitration of contract disputes for police officers and firefighters, which has tended to drive up salaries while hindering creative approaches to improving efficiency and reducing costs; and repealing the 1982 Triborough Amendment, which has perpetuated generous pay arrangements, especially for teachers, by requiring that all provisions of a contract remain in force while a new deal is being negotiated.

If the crisis worsens, lawmakers have one more weapon at their disposal. Call it the zero option: based on the precedent set in New York City’s fiscal crisis of the 1970s, the state could enact a law declaring a fiscal emergency and freezing all government wages and salaries, including automatic “step” raises based on years on the job, until recurring expenditures are brought back in line with recurring revenues under an economically sensible tax regime. This would lead to a nasty confrontation with the unions, of course. But short of such a confrontation, labor costs will remain fixed and difficult to control.

What is missing from New York government, above all, is any realistic sense of financial limits. Two further reforms might restore it. Outside Gotham, property taxes that finance schools are easily the largest component of New York State’s heavy local tax burden. The cap that Paterson proposed last year—which would affect all districts outside the state’s four largest cities—would be a solid step in the right direction. Modeled on Proposition 21/2, which has significantly reduced local taxes in Massachusetts since its passage in 1980, the cap would incentivize local taxpayers to favor development as a way to expand local tax bases. At the same time, it would allow local voters to override limits for specific projects.

But the cap approach shouldn’t be limited to school taxes. To counteract New York’s entrenched tradition of governmental excess, the state should enact a Taxpayer Bill of Rights, which would limit the growth of government by tying increases in overall tax revenue to the rate of growth in inflation and population. State and local tax-rate increases beyond the limit would require direct voter approval—as would major debt issuances, shutting the back door through which New York’s public authorities have borrowed tens of billions of dollars without voter approval over the past 25 years.

To be sure, New York’s political sclerosis is so advanced that politicians in both parties may continue to avoid even modest reforms, despite the dire fiscal and economic circumstances (see “Madison’s Nightmare”). In that case, before the next decade is out, taxpayers will have a chance to make their voices directly heard. Once every 20 years, New Yorkers go to the polls to vote on whether to hold a new constitutional convention and alter the basic law of the state. The last time this happened, in 1997, the proposal was defeated by strange bedfellows ranging from the antitax Right to the union-dominated Left. The next vote is eight years away, in 2017. If Albany politicians haven’t made more progress by then, New Yorkers may take matters into their own hands.

Defusing the Pension Bomb

New York’s public-pension system has become the epicenter of an influence-peddling scandal that has attracted the attention of the Securities and Exchange Commission and the state’s attorney general. But the millions in shady “placement fees” pocketed by a few politically connected middlemen are small change compared with the mushrooming cost of lavish pension benefits for state and local government retirees. Keeping these retirees in clover will demand billions more from New York’s sorely stressed taxpayers over the next few years. And the real scandal is that politicians are so reluctant to do anything about it.

In New York, as in almost every state, public employees are entitled to defined-benefit (DB) pensions—a guaranteed post-retirement income, based on peak salaries and career longevity. By private-sector standards, benefit levels are extraordinary. New York state and local government employees, as well as employees of public authorities, can retire earlier, with larger pensions, than the vast majority of the people who pay their salaries. A New York teacher with 30 years on the job, for example, can stop working at 55 and start collecting an annual pension of roughly $55,000—entering retirement with the equivalent of a $1.2 million golden parachute, according to calculations by City Journal contributing editor Nicole Gelinas.

Taxpayers must shoulder the risks of covering these already-promised benefits. The pensions are paid out of gigantic pooled retirement funds, to which government employers contribute varying amounts, depending on actuarial assumptions and market fluctuations. During the Wall Street boom of the 1990s, pension-fund assets grew enough to reduce employer contributions to all-time lows as a percentage of salaries. The downturn of 2001–03 had the opposite effect, rapidly driving pension contributions up. Since 2000, the combined annual pension costs for all governments in New York, including New York City, have risen from slightly under $1 billion to nearly $10 billion—reflecting both market conditions and benefit increases effective at the beginning of that period.

New York City’s annual pension contributions alone, up more than $3 billion over the last five years, are projected to rise by another $1 billion over the next three. Annual pension bills for the state and its local subdivisions, which now total about $3 billion, could double or triple by 2015. Rising pension costs also pose a considerable financial threat to the already-troubled Metropolitan Transportation Authority.

And these official numbers actually understate the problem because New York’s pension funds, like their counterparts throughout the country, calculate employer contributions based on government accounting standards that lowball their long-term liabilities. According to these skewed standards, the pension funds for New York State and New York City are technically at or near “fully funded” status. But Gotham’s actuary calculated in 2006 that New York City’s plans alone would be $45 billion in the hole if they employed the more sensible liability calculations that private-sector DB plans use.

Under the state’s constitution, pension benefits can’t be “diminished or impaired” for any current member of a public-retirement system in New York. So it will be difficult to stem the tide of mounting pension costs in the short term. The debate over pension reform is really about the appropriate mix of compensation for the next generation of government workers—and the impact they will have on state and local finances in the long term.

Far-fetched as it may seem, given the New York State Legislature’s shameless pandering to unions in recent years, there is precedent for pension reform. During the fiscal crisis of the 1970s, the legislature managed temporarily to scale back pension benefits for new public employees. However, the unions spent most of the next 25 years successfully clawing back much of what they had lost—and then some.

Porcine Pensions.

Governor David Paterson’s “Tier V” retirement plan, part of a June 5 deal with state employee unions, merely reset pension benefits to the levels of the early 1990s by raising the retirement age to 62; restoring a ten-year pension vesting period; and requiring employees to contribute to the pension fund throughout their careers. The governor also vetoed an extension of the existing “Tier II” retirement plan for police and firefighters, who can retire at half pay after 20 years, regardless of age. In its place, he proposed a plan that would set a minimum age of 50 for half-pay retirement after 25 years, which could produce significant savings for all New York municipalities, especially New York City.

Real pension reform, however, would go much further—by essentially throwing out the outmoded DB model for future employees. New York should follow the lead of a handful of other states, including Michigan, that have shifted non-uniformed government workers to defined-contribution (DC) accounts, like the 401(k) plans that have come to dominate the private sector. Paterson has estimated that his proposal would save the state and local governments outside New York City a total of $32 billion over the next 30 years. By comparison, a DC plan like Michigan’s, with the annual employer contribution capped at 7 percent of payroll, might save at least $10 billion more. But the greatest benefit of a DC system is that taxpayers would no longer bear all the financial risks associated with providing guaranteed pension benefits. For the first time, public-pension costs would become both predictable and easily understandable, and the real costs of proposed benefit increases would be completely transparent. With normal turnover, between one-quarter and one-third of state and city employees would be in the new system within a decade.

Of course, if pension reform were subject to regular contract negotiations, public-employee unions would never accept a shift to a DC plan from the guaranteed, ultra-secure DB plan. But this is a rare case in which elected officials can alter a fringe benefit without the unions’ consent—because the state’s Taylor Law, which governs public-sector labor issues, specifically prohibits collective bargaining on pensions. Retirement benefits could be changed legislatively, ensuring that future generations of New Yorkers aren’t stuck with the same pension problem.

Unfortunately, as the legislature’s 2009 regular session wound toward its June adjournment, leading politicians continued to seek union permission to make any changes. New York City mayor Michael Bloomberg has repeatedly called for the state to revert to a system in which pension benefits are collectively bargained, and Paterson made a series of costly concessions to the unions in exchange for their agreement not to oppose his modest restructuring of pension benefits. It’s time for the governor, the mayor, and other elected officials to reassert their managerial prerogatives—to understand that government unions will never voluntarily relinquish the gold-standard pensions that taxpayers can no longer afford.

An Outsourcing Opportunity

Could New York’s state government realize significant savings by encouraging private-sector firms to challenge entrenched public-sector monopolies? According to a 2003 report coauthored by the Manhattan Institute and the Reason Foundation, New York was spending over $3 billion a year in state funds on highway maintenance, bus transit, mental health facilities, motor vehicles record-keeping, human-resources management, prisons, and welfare and Medicaid administration. “In just these areas, efficiency gains at the low end of the 5 to 50 percent range (gains typically attributed to competitive sourcing) could translate into annual savings totaling hundreds of millions of dollars,” the report noted. “The savings potential is even larger when viewed in the context of the more than $100 billion in total annual operating expenses by New York’s state and local governments.”

Competitive contracting wouldn’t establish an automatic preference for private-sector providers. Instead, it would allow government managers to determine which provider—in-house public employees or private firms—could offer the best combination of price and value when given the opportunity to compete for service contracts.

How to identify the best opportunities? Stephen Goldsmith, former mayor of Indianapolis and one of the most accomplished practitioners of competitive sourcing in American municipal government, memorably described his approach as the Yellow Pages test. “If the phone book lists three companies that provide a certain service, the [government] should not be in that business, at least not exclusively,” he said. “The best candidates for [outsourcing] are those for which a bustling competitive market already exists.”

In practice, of course, it’s not that simple. Once opportunities for competition have been identified, there must be rules for conducting competitions and for managing and measuring results. Based on reforms successfully implemented by the federal government and the Commonwealth of Virginia, the 2003 report suggested that the governor establish a new oversight council, including representatives of the state legislature and the comptroller’s office, which would make competitive contracting the standard way of doing business for every level of government in the state. The council would conduct an annual inventory of all services and activities provided by New York State agencies and public authorities, as well as common activities of local governments. Then it would develop accounting models for determining the fully allocated and unit costs of these activities, since productive competition among suppliers depends on accurate and rigorous cost comparisons. Finally, it would identify areas for competitive outsourcing and manage the resulting competitions between in-house workers and private firms.

Another essential step would be to amend the state’s Taylor Law, which regulates public-sector labor relations, to ensure that the ultimate decisions on subcontracting and potential reassignment of work currently done by public employees would rest with elected officials—who are, after all, the ones responsible for managing costs and delivering services—instead of being negotiated at the bargaining table.

New York State has been moving in exactly the wrong direction on competitive contracting. Under a deal between former governor Eliot Spitzer and state employee unions, the state’s Department of Transportation has recently added hundreds of engineers to its ranks to replace private consultants on highway projects. And the unions are pushing Governor David Paterson to reduce or eliminate remaining private-sector contracts for other services. But with enormous—and growing—budget deficits, there has never been a better time to pursue the idea.

Tax High, People Fly

In the middle of its worst economic downturn since the 1930s, New York State has just enacted its biggest personal income-tax hike since 1961. Through last year, New York’s top tax rate was 6.85 percent. Now, individual filers with taxable incomes over $200,000, heads of households earning $250,000, and married couples with incomes over $300,000 will pay a 7.85 percent rate. And a new top rate of 8.97 percent—the state’s highest in 24 years—will kick in at taxable incomes of $500,000 for all filers. In New York City, which also imposes its own resident income tax of 3.65 percent, the combined top rate will thus reach 12.62 percent—by far the highest state and local income tax in the nation.

But the increase is even larger than it appears on the surface. That’s because the new state budget expands a uniquely pernicious provision of New York’s income-tax law. Under a standard graduated income tax, such as the federal income tax, a household in the highest tax bracket pays the top rate on just the portion of its income in that top bracket and then lower rates on portions of income falling into the lower brackets. But in New York, under a change first enacted in 1991, every household with an adjusted gross income above $150,000 has been paying the top rate of 6.85 percent on its entire income. That flat-rate treatment will apply to the new, higher rates as well—so, for example, a couple with income of $550,000 will pay 8.97 percent of every taxable dollar they earn, not just 8.97 percent of income within the new top bracket.

The flat-tax quirk is expected to generate $800 million of the $4 billion that Governor David Paterson expects from the income-tax increase. Of course, the total could fall well short of that target because of the shrinking number of high-income households and the massive capital losses that they’ve incurred. Meantime, another $140 million is supposed to come from a less-noticed budget provision that will eliminate itemized deductions, which were previously capped at 50 percent, for all households earning over $1 million.

Described by Paterson as a “temporary surcharge,” New York’s higher income-tax rates are scheduled to expire at the end of 2011. But the governor projects a massive $13 billion budget hole if the taxes aren’t renewed or made permanent. Expect a fierce campaign for renewal from the same coalition of public-sector labor unions and left-of-center advocacy groups that successfully lobbied for the tax increase in the first place (though their preference was an even larger, permanent hike). The unions’ motive was obvious: even in the teeth of an economic and fiscal crisis, they didn’t want to concede any of their rising pay and perks. So the coalition spent months, and millions of dollars, bombarding Paterson and lawmakers with a sophisticated media and PR campaign built on the assertion that New York’s wealthy weren’t paying a “fair share” of income taxes.

In fact, just the opposite was true. As of 2008, the effective tax rate for high-income New Yorkers was typically more than double the rate for middle-class families. Hundreds of thousands of low-income working New Yorkers owed no tax but collected earned income credits from the state. Prior to the downturn, the wealthiest 1 percent of New York taxpayers were generating 41 percent of all income-tax revenue—up from 26 percent in 1994. Indeed, New York’s excessive dependence on taxes from high-income households is a major reason why it sits in a deeper fiscal hole than does any state except California, which is similarly dependent on its wealthiest residents.

New York: Out of Step With Its Neighbors.

New York State and City enacted smaller temporary income-tax increases from 2003 to 2005, but the negative economic impacts, including below-average private-sector employment gains, were overwhelmed by the pro-growth effects of President Bush’s 2003 capital-gains and dividends tax cuts. This time, all the economic and fiscal trends are running in the opposite direction. By contrast with 2003, the economy isn’t poised for an explosive comeback, and the current occupant of the White House plans to repeal Bush’s tax cuts, slamming the same people who will now be paying more to the state. Taxpayers can be expected to respond to the combined federal and state tax hikes by shifting and sheltering income as much as possible. Pennsylvania’s statewide top tax rate of 3.07 percent is barely one-third of New York’s new top rate; Connecticut’s 5 percent flat rate is less than half the new combined rate in New York City; and for the most footloose New Yorkers, a well-worn path heading due south leads to the ultimate tax shelter: Florida, which has no income tax at all. Billionaire Rochester-area businessman Tom Golisano has reacted publicly to New York’s latest soak-the-rich tax hike by announcing that he will move to the Sunshine State, saving himself the equivalent of $13,800 a day, or over $5 million annually. Radio host Rush Limbaugh, who moved his primary residence to Florida a decade ago, said that he would sever his remaining business ties in New York rather than subject himself to the state’s higher taxes and annual audits.

This year’s “temporary” tax hike represents a fateful reversal of the policies followed under the three governors who ran New York for 30 years prior to the election of Eliot Spitzer in 2006. Thanks to Nelson Rockefeller, the state’s income-tax rate peaked at an astonishing 15.37 percent during the mid-1970s. Over the next 20 years, two Democratic governors, Hugh Carey and Mario Cuomo, cut the rate nearly in half, with finishing touches in the mid-1990s from Republican George Pataki. This trend reflected a bipartisan consensus that Rockefeller’s steeply progressive tax rates had been a disaster for the state’s economic competitiveness.

“Capital goes where it’s welcome and stays where it’s well treated,” the late Walter Wriston observed. Unfortunately, it may take another era of capital flight to drive that lesson home in Albany—again.


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