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 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.