Pay Moynihan’s Tax Lessons for the States

'Anything that grows the size of the Federal government will grow the deficit of New York.'

by E.J. McMahon |  | The Wall Street Journal

The late Democratic Sen. Daniel Patrick Moynihan of New York used to obsess over the flow of funds between the federal government and the states. He even launched an annual report, nicknamed “The Fisc,” that highlighted New York’s “balance of payments deficit” with Washington.

Year in and year out, Moynihan noted, the Empire State and its high-income Northeast neighbors sent Washington billions more in revenue than they got back in spending. Most of the region’s politicians blamed unfair funding formulas, but New York’s senior senator knew better. As he wrote in the Fisc a decade ago:

“The graduated income tax, a signal aim of the progressive movement, was meant to bring about more equality among citizens. To an extent it did that, but it also brought about a huge disparity in the uncommitted resources of the Federal against State and local governments.”

That disparity will grow larger under the budget President Obama released this week. Federal income-tax rates in the top brackets will be restored to their pre-2001 levels next year, the Bush-era cuts in capital gains and dividend taxes will be partially reversed, and itemized deductions for high-income filers (including deductions for state and local taxes) will be curtailed.

If all of this comes to pass, it will spell trouble for the New York state budget for a simple reason: New York’s finances are balanced on a narrow pinnacle of high-income households, and higher federal taxes drive top-earning New Yorkers to lower their overall tax burdens by sheltering incomes, earning less, or moving to lower-tax states.

The result is a depressed tax base for New York. And the state’s tax base is already depressed. In 2007, before the housing bubble burst, taxpayers with incomes above $200,000 generated nearly two-thirds of New York’s personal income taxes; the highest-earning 1% accounted for 43% of state income taxes, according to Gov. David Paterson’s latest budget.

New York’s dependence on personal income taxes was labeled “inherently unstable,” “volatile” and “unsustainable” in a 2009 state legislative report. Nonetheless, Mr. Paterson and his fellow Democrats in the state legislature agreed last year to impose a temporary “millionaire tax” that raised the marginal rate by nearly a third to 8.97% and kicks in at income levels as low as $200,000. The top 1% of income earners this year will pay about 41% of the state’s income taxes, even as their incomes are expected to be down by a third from their 2007 peak.

Over the next few years, Mr. Obama’s rising federal tax rates are likely to have a whipsaw effect on Albany’s finances. Mr. Paterson’s budget projects that realized capital gains by New Yorkers will surge this year in anticipation of federal tax hikes, then drop by more than 50% in 2011.

Mr. Paterson praised Mr. Obama’s budget as “a blueprint for economic and fiscal recovery.” He was particularly happy that the president has endorsed another $25 billion in temporary stimulus funding for state Medicaid spending—which will allow New York to put off overdue cuts in its bloated program.

Moynihan the politician might have been cheering the Medicaid money, too, but Moynihan the policy analyst would harbor no illusion about its longer-term consequences. As he pointed out in the Fisc’s 1999 edition: “Anything that grows the size of the Federal government will grow the deficit of New York and other such states. Hence Political Economy 101—when you are in a hole stop diggin”

Neither Mr. Obama nor Mr. Paterson is putting down his shovel. While it calls for a modest spending increase by boom-time standards (1.8%), Mr. Paterson’s budget leaves the state facing combined gaps of $30 billion over the next three years.

At the moment, New York’s fiscal crisis is less serious than California’s—which is one reason why Democrats were unwilling to make all the cuts the governor called for late last year even as the state was running out of cash. The governor’s doom-and-gloom message seemed inconsistent with headlines touting bonuses on Wall Street.

But those bonuses look like a short-run thing, pumped up by rock-bottom interest rates and federal bailouts. Stung by Mr. Obama’s criticism of their compensation practices, Goldman Sachs and J.P. Morgan are paying some bonuses in stock options, which can’t be taxed until the options are cashed in over the next few years.

Last week, Mr. Paterson’s budget office said “changes in the timing and structure of financial services sector compensation” had contributed to a $1 billion drop in projected income-tax receipts for January. Meanwhile, Mr. Obama is proposing a $9 billion a year tax on major banks, including New York’s leading institutions.

It’s not difficult to imagine how Moynihan would have reacted to presidential attacks on New York’s most important industry; an angry, wounded bear comes to mind. But Moynihan’s successor once removed, Paterson-appointed Sen. Kirsten Gillibrand, has been busy fending off criticism from a potential primary opponent, former Rep. Harold Ford Jr. He compared her to a “parakeet” for her habit of echoing the state’s senior senator, Charles Schumer. While Mr. Schumer supports the bank tax, Mrs. Gillibrand has said she is “concerned” by it. Mr. Ford, a Tennessee transplant, flatly opposes it.

In his 1999 Fisc, Moynihan proposed “Less activism in Washington in return for more revenue at home, for whatever active measures recommend themselves to the state or municipality in question.”

But in the name of fighting a recession, Washington in the Obama era has moved further away from the principle that higher levels of government should avoid doing things that can be handled capably at a lower level. New York, in particular, will soon be the poorer for it.

Read article at Manhattan Institute