Long addicted to massive Wall Street revenues, Albany faces an agonizing withdrawal.

The financial-market implosion and the coming transformation of the securities industry will expose the fundamental flaw in New York State’s woefully overextended public finance model. The state budget is today geared to run on an ever-expanding stream of high-octane revenues from a Wall Street that no longer exists—and the rest of New York’s economy isn’t nearly robust enough to make up the difference.

With an occasional bear-market interruption, the state’s financial dependence on Wall Street has grown steadily for more than a quarter-century. As New York’s once-mighty manufacturing sector shriveled, the securities industry’s share of all private wages in the state more than quadrupled, growing from 3 percent to 14 percent between 1980 and 2000. And after the 2000–02 downturn, Wall Street’s share of the state revenue base took another giant leap. By 2007, securities-industry wages and bonuses in New York had climbed to nearly 18 percent of private-sector wages in the state (compared with just 2 percent in the rest of the country). The average Wall Street salary and bonus as of last year was a staggering $379,000—more than six times the average for all private-sector jobs in the state.

Handsome wages translate into sizable taxes. Wall Street bonuses and salaries probably accounted for at least one-third of the net increase in state income tax liability between 2002 and 2007. That’s not counting the (taxable) capital gains and dividends generated by the last stock-market boom, or the (taxable) profits that investment banks, private equity firms, and hedge funds generated for other New York businesses, from black-car companies to white-shoe law firms. Last year, New York State’s 212,000 securities-industry employees generated more income taxes for Albany than did the 3 million or so households reporting incomes below $50,000.

In fact, while the securities industry accounted for less than 3 percent of New York’s employment and 9 percent of its GDP last year, Wall Street generated 20 percent of state tax revenues. Since the financial sector’s bonus babies made so much to start with, their pay hikes were fully taxed at the marginal state income tax rate of 6.85 percent. And the income tax is imposed on all wages and salaries earned in New York, including by residents of other states—effectively exporting a portion of the tax burden to New Jersey and Connecticut. The state thus has an even more immediate and direct fiscal stake in Wall Street than does New York City, where the economic impact of the crisis is potentially much broader and deeper.

And now all those numbers have gone shuddering into reverse. At best, New York State will experience a repeat of fiscal years 2000–01 through 2002–03, when income tax revenues dropped 16 percent, with the decrease concentrated entirely among upper-income households. At worst, a broader, more serious national recession will push New York into a much deeper hole.

The financial crisis will take the blame for New York’s looming budget crunch, of course. But the fundamental problem is out-of-control government spending. During Republican George Pataki’s third and final term as governor, which ended in 2006, the “state funds” portion of the budget (the part that excludes federal aid) rose 19 percent when adjusted for inflation, including billions added by the state legislature over Pataki’s vetoes. The rate of spending growth was the fastest since Democrat Mario Cuomo’s second term in the late 1980s—which, not by coincidence, provoked the state’s worst fiscal crisis since the 1970s. Yet this time around, Wall Street churned up so much new revenue that Pataki could leave behind a $3 billion cash balance. That rapidly shrinking cushion is now all that keeps New York from sinking into a deep pool of red ink.

In January 2007, Democrat Eliot Spitzer became the first New York governor since Franklin Roosevelt to take office just as the economy was peaking—giving him plenty of room to engineer a soft landing before it was too late. But after campaigning on a pledge to control spending, Spitzer only made things worse. His first budget called for an 8 percent spending hike (which, he absurdly countered, represented “spending control” because it was lower than the 11 percent increase enacted by the legislature during Pataki’s last year).

Worse still, Spitzer built his budget around a proposed $7 billion, four-year increase in the largest category of state spending: school aid. This was a striking departure from the budget-control strategies adopted by his predecessors in both parties. Because school finance (unlike Medicaid) is almost entirely shaped by state law and because legislators perennially treat education as their Number One budget priority, Pataki, Cuomo, and Democratic governor Hugh Carey all understood the necessity of holding down school aid in their executive budget proposals (and did so except when running for reelection themselves). They would then grudgingly allow the legislature to “buy” increases in school aid, sometimes in exchange for other budget concessions. Spitzer and his staff derided this process as a childish charade. But it served its purpose.

Predictably, the legislature sweetened Spitzer’s new formula before adopting it. But pouring so much new money into what was already the nation’s best-funded public school system only encouraged school districts across the state—including New York City’s—to expand programs further, hire additional staff, and fatten already generous teachers’ contracts. At the same time, putting yet more pressure on the budget, Spitzer and the legislature agreed to a four-year, $2 billion expansion of Pataki’s huge STAR program, which gave state-subsidized school-property-tax breaks to suburban and upstate homeowners (and further relieved pressure on school districts to constrain spending).

In his second budget, released last January, Spitzer proposed another spending increase, this time of 6 percent, despite clear signs of big trouble brewing in the financial sector. Negotiations with the legislature had barely begun when his dalliances with prostitutes forced him to resign—the same week, coincidentally, that Bear Stearns collapsed.