Labor unions and their allies in New York’s burgeoning health and social services sector are demanding new taxes on the wealthy to help close the state’s $12 billion budget gap. After all, the argument goes, it’s only fair to ask those who gained the most from the economic boom to bail the rest of us out of this bust.

But advocates of the soak-the-rich approach don’t seem to realize it’s already been tried – in fact, it’s part of the problem. A review of state fiscal trends during the past eight years shows that the current shortfall is especially severe precisely because of New York’s increasing reliance on a top-heavy personal income tax.

When Governor Pataki took office in 1995, the income tax represented just over half of the state’s total tax receipts. Five years later, after Mr. Pataki had cut the tax, its share of the total had risen to 60%. During this same period, the distribution of the tax burden shifted further up the income scale – an outgrowth of both the rising stock market and the governor’s decision to target his biggest tax reductions to low- and middle-income workers.

The 3% of New York taxpayers earning $200,000 or more generated 51% of state personal income tax receipts in 2000, according to the governor’s Division of the Budget. In other words, with a population approaching 19 million and the equivalent of the world’s eighth largest economy, the Empire State derived one-third of its total tax revenues from just 267,000 taxpayers – fewer than live in a typical congressional district.

While this is a dream scenario for progressive taxation enthusiasts, it helped give rise to the fiscal nightmare the state is now experiencing. That’s because wealthier taxpayers draw heavily on the most volatile forms of taxable income: interest and dividends, business profits, and, above all, capital gains.

New Yorkers’ capital gains income skyrocketed from $12 billion in 1994 to $62 billion in 2000 – generating at least one fourth of the total increase in state tax collections during that period.

For a time, Mr. Pataki effectively banked a portion of these stock market related gains, accumulating a budget surplus that peaked at over $3 billion.

But in the wake of the recession, the September 11 attack, and Wall Street’s slump, Mr. Pataki squandered his budgetary reserves to finance an election-year spending increase of over twice the rate of inflation.

Meanwhile, in just two years, capital gains income has fallen back near mid-1990s levels – accounting for over half the net decrease in state tax receipts since 2001.

If the state had been less reliant on revenues generated by its wealthiest residents through the personal income tax, and on capital gains in particular, spending by necessity would have increased more slowly and revenues would have decreased less sharply. As shown in the chart accompanying this article, the falloff in all other taxes collected by the state has not been nearly as severe as in New York’s income taxes since 2001.

The greatest task now facing the governor and the legislature is to close the budget gap without resorting to what the governor correctly calls “job killing” tax hikes. However, they also should be laying the groundwork of a more stable financial structure for the future.

There are two ways to accomplish this.

First, impose a state spending cap based on annual inflation and population growth, with provisions strictly mandating that surplus revenues be used to pay down debt or quickly rebated to taxpayers.

Second, phase out the state tax on capital gains. The big drop in the S&P 500 should be seen as Albany’s margin call – a signal to get out of the market.

Such a proposal would have been difficult for politicians to contemplate just a few years ago, when capital gains were generating upwards of $3.6 billion in annual taxes. But these revenues have now dwindled to the neighborhood of $800 million and are unlikely to increase soon even if the market rebounds strongly, because the sizeable losses of 2000 through 2002 will be deductible against gains for years to come.

Without taxing capital gains, the state could still reap all the ancillary benefits of future bull markets – taxes on soaring bonuses, increased consumption, and the like. Best of all, for the first time, the Empire State would become a veritable tax haven for savers and investors.

New York can’t tax its way out of its latest budget crisis. But by capping spending and minimizing taxes on investment income, the state can do more to nurture the economic resurgence it needs to grow out of this hole – and to avoid falling into new ones in the future.