Empire Center Special Report 02-06

EXECUTIVE SUMMARY

New York State’s 2006-07 Executive Budget would kick off a new round of personal income, business and estate tax reductions worth more than $3 billion annually when fully implemented over the next three years. But the cuts are coupled with more than $1 billion in proposed tax and fee increases that would take effect sooner.

State spending, meanwhile, would increase next year at well over twice the rate of inflation. Much of the increase is due to the steadily rising costs of health care, state employee benefits and debt service, coupled with Governor Pataki’s call for another big increase in spending on targeted school property tax breaks for homeowners.

A taxpayer’s guide

This report summarizes major proposed changes in taxes, spending and borrowing by state government, along with some of the major factors behind the numbers. It closes with a series of charts and tables providing some added perspective on the fiscal record of the Pataki administration.

Chart 1. The New York State Budget Since 1995

Chart 2. 2006-07 All-Funds Budget Breakdown

1. SPENDING

Total spending by New York’s state government is measured three ways in the annual state budget:

• All-Funds consists of spending financed by all revenue sources, including most federal aid.

• The State Funds budget excludes federally reimbursed spending but includes virtually all spending financed by the state’s own taxes, fees, fines, university tuition, bond proceeds, Lottery receipts and other revenues.

• The General Fund includes spending finances by state tax, fee and fine revenue that is not dedicated for some specific purpose.

Table 1 lists spending in each of these categories for the 2005-06 and 2006-07 fiscal years[1], as proposed in Governor Pataki’s Executive Budget. As shown, the governor’s proposed spending increases in all three categories would easily exceed the projected rate of inflation in the coming fiscal year.

Counting where it counts

While All-Funds (including federal grants) provides the broadest measure of the New York State budget, the taxing and spending priorities of New York’s elected leaders are best reflected in the part of the budget they most directly control-the part supported by state taxes, state fees and other state revenues such as Lottery proceeds and tuition, all of which are set in Albany.

For years, the General Fund was widely viewed as the best budget barometer for this purpose. However, over the past 20 years, the state has shifted more and more spending obligations to dedicated funds supported by state “special revenues,” diminishing the General Fund’s value as a true measure of what’s being done with the taxpayers’ money.

This report therefore focuses on the more inclusive State Funds budget, which includes a growing share of what used to be considered general fund tax receipts, as well as miscellaneous fees, fines and other revenue on which the state has come to increasingly rely during the Pataki era.

Chart 3. 2006-07 State Funds Budget Breakdown

A near-record increase

As shown in Chart 4, the 7.1 percent State Funds spending increase in the 2006-07 Executive Budget is the second biggest Pataki has proposed in his 12 years as governor. It’s also more than two-and-a-half times the 2.7 percent rate of inflation projected by the Budget Division for the coming fiscal year.[2] Total State Funds spending growth during Pataki’s last term will come to more than 28 percent,[3] roughly double the inflation rate, and the biggest four-year increase since the 1980s.

Chart 4. Proposed and Enacted State Funds Spending Hikes

What’s pushing up spending?

As shown in Table 2, Medicaid, STAR (the School Tax Relief program) and school aid are the biggest pieces of the proposed State Funds spending increase, accounting for 40 percent of the $5 billion hike. Heavy spending in these three areas has been a hallmark of state budgets enacted during the second half of Pataki’s tenure. STAR[4]-which has grown from zero to 5 percent of the budget in just eight years-would be further pumped up in 2006-07 by Pataki’s proposal to have the state provide an added $400 property tax rebate to homeowners in school districts that cap their spending. This proposal alone would cost $530 million, accounting for more than 10 percent of the total proposed state funds spending increase.[5]

The projected rise in Medicaid spending is due entirely to added costs the state will assume under the 2005 law capping the Medicaid expenditures of county governments and New York City at 3.5 percent this year, and taking over the entire local share of the Family Health Plus (FHP) program.[6] The rest of the Medicaid budget would actually decrease slightly if the Legislature enacts Pataki’s “cost-containment” proposals, which consist chiefly of reductions in rates paid to hospitals and nursing homes.

The most significant proposed change in benefit levels this year is a tightening of legal loopholes that make it possible for affluent elderly residents to qualify for Medicaid. As shown in Chart 5, state Medicaid spending is projected to grow by $5.7 billion (47 percent) to over $8 billion (72 percent) in the next four years, depending on whether the governor’s 2006-07 proposals are enacted.

Chart 5. Actual and Projected State-Funded Medicaid

What about “CFE”?

Ruling in the long-running Campaign for Fiscal Equity lawsuit, state Supreme Court Justice Leland Degrasse last year ordered a $14 billion funding increase for the New York City school system, including $5.6 billion a year in new operating aid. While awaiting a ruling on his appeal of Degrasse’s ruling, Pataki has proposed a school aid increase of 3.7 percent in fiscal 2006-07 (or 3.9 percent on a school-year basis). This includes $325 million from the “sound basic education” (SBE) account he established last year in response to the CFE case.

Out-year spending projections

Assuming adoption of his own proposals this year, Pataki has forecast budget gaps of $1.9 billion for 2007-08 and $3.9 billion for fiscal 2007-08, as shown in Chart 6 below. These gaps assume spending will grow by 20 percent over the next three years, including an average of 6 percent a year in the two “out” years.

The future shortfalls would be larger in the absence of roughly $2 billion in fiscal 2006 surplus funds that Pataki has dedicated in equal measures to budget gap reduction over each of the last two years of the three-year financial plan, as shown in Chart 6, below. This means any surplus funds diverted to higher spending than the governor has proposed in fiscal 2006-07 will increase the future shortfalls.

Chart 6. Projected State Budget Gaps

2. TAX CUTS AND TAX HIKES

For the first time in nearly a decade, Governor Pataki is calling for broad-based cuts in both personal and corporate income taxes as part of his Executive Budget package. The impact of the cuts would be small to begin with, totaling $211 million in fiscal 2006-07, but would grow to over $3 billion a year by fiscal 2008-09.

At the same time, however, the Governor is also seeking a series of increases in business, sales and excise taxes, and in some fees and fines. As shown in Table 3, below, the Executive Budget would raise net taxes, fines and fees by $253 million in fiscal 2007, followed by net tax and fee cuts growing to $1.72 billion in 2008-09.

The personal income tax cuts would:

Reduce the top rate from 6.85 percent to 6.75 percent. Pataki’s 1995 tax cut dropped the top rate from its previous level of 7.875 percent.[7]

“Stretch” the top tax brackets. The highest of the state’s five income tax brackets now kicks in at the relatively low level of $40,000 in taxable income for married-joint filers. The governor’s plan would raise this threshold to $60,000-meaning affected taxpayers would pay a lower rate on an additional $20,000 of income. This would save a typical middle-class couple about $190 a year.

Eliminate the “marriage penalty.” Married-joint filers are now treated less favorably than single filers in two respects: The standard deduction for joint filers is slightly less than twice as high as that for singles, and the so-called “benefit recapture” income range[8]-in which the graduated income tax becomes a flat tax-is the same for joint filers as for single filers. Effective in 2006, the governor’s plan would raise the standard deduction to fully double the level for singles. Over the next three years, it would also raise the “recapture” range and create a higher, separate range for married filers. For couples with annual incomes between $150,000 and $340,000, this change combined with the top bracket stretch and rate cut would generate savings of $984 a year. The standard deduction change will save affected couples up to $27 a year.

Create an education tax credit. The $500 per child credit for “qualified expenses” would include tuition, tutoring and educational enrichment for K-12 pupils in public or nonpublic schools in districts that have any schools failing to meet federal standards. The credit would be refundable-meaning, for example, that a couple with qualified expenses for two children and no state income tax liability to start with (which is common in New York for lower-income people) would receive a check for $1,000.

The largest elements of the proposed business tax cuts include:

• a cut in the top corporate rate, from 7.5 percent to 6.5 percent;

• substitution of full “expensing” for depreciation-allowing businesses to immediately deduct from taxes the full cost of business-related purchases;

• elimination of the Alternative Minimum Tax (AMT).

Another proposed tax cut with especially large implications for entrepreneurs and participants in family-owned businesses is Pataki’s proposed repeal of the state’s estate tax by the end of the decade.[9]

New and added taxes, fees and fines

Pataki’s budget seeks tax and fee increases that would raise over $1.3 when fully implemented, including:

• permanent elimination of the partial sales tax exemption on clothing purchases under $110[10], which would be replaced with two tax-free weeks each year on clothing purchases under $25;

• a $1 per pack increase in the cigarette tax, bringing the new total to $2.50 per pack;[11]

• extension of a temporary increase in the “fixed-dollar” minimum corporate tax filing fees, which range from $100 to $10,000 depending on payroll size;

• elimination of favorable tax treatment of subsidiary income from Real Estate Investment Trusts (REITS) and Regulated Investment Companies (RICs), which the administration regards as a loophole;

• authorization of a program that would use automated cameras to enforce $100 tickets for drivers who violate speed limits in construction zones and other “designated areas” of state highways;[12] and

• renewal of the partially reimbursable 6 percent assessment on nursing home revenues, now due to expire at the end of fiscal 2007. It would raise $230 million in fiscal 2009.

Chart 7. Total State Taxes and Share Paid by Top 1%

3. BORROWING

After nearly tripling under former governor Mario Cuomo, state-funded debt is on pace to nearly double during the three terms of Governor Pataki-including an increase of roughly 31 percent between fiscal 2002 and 2007.

Chart 8. State-Funded Debt

State Comptroller Alan Hevesi has estimated that only half of the state’s outstanding state-funded debt[13] was used to finance capital assets, such as highway and building construction. Nearly one-quarter went for “non-capital asset” uses, and slightly over 25 percent was related to bonds floated to make up for past budget shortfalls of the state and New York City.[14]

Chart 9. State-Supported Debt Service

4. STATISTICAL TRENDS: THE PATAKI RECORD

Tax reduction was the hallmark of George Pataki’s first campaign for governor 12 years ago-a theme to which he has returned in his final budget. The net annual taxpayer savings from tax cuts enacted since Pataki took office are depicted below.

Chart 10. Annual Impact of Tax Cuts Enacted Since 1994

New York’s tax burden has ranked first or second in the nation for at least 35 years, according to Tax Foundation calculations based on federal census statistics and other data.[15] When Pataki took office, New York’s tax burden ranked first, a full 30 percent above the national average. As of 2005, the state ranked second (exceeded only by Maine), about 19 percent above the average for all states.

Chart 11. State-Local Tax Burdens, 1970-2005

The bottom line

Based on this measure of state and local taxes relative to personal income, New York during the Pataki era closed more than one-third of its competitive gap with the rest of the nation. Indeed, the gap is the smallest it has been since the Tax Foundation data series began in 1970. Yet the Empire State was so far out of line to begin with that it remains an outlier in national rankings. This is largely due to a local tax burden that is far and away the heaviest of any state’s, by any measure.

The economic consequences

In the wake of Pataki’s first-term tax cuts, private employment growth in New York exceeded the national average in 1999 and 2000. But since recovering from 9/11, New York has once again fallen behind the national employment growth rate-and Pataki’s own budget predicts this trend will continue, as shown below in Chart 12.

Chart 12. New York vs. U.S. Job Growth, 1995-2009

A still-incomplete recovery

New York has gained 620,000 private sector jobs in the last 11 years. However, as of the end of 2005, the state remained 191,000 jobs below its 2000 peak. By contrast, the nation as a whole exceeded its pre-2000 private-sector level last year.

Chart 13. Pataki and Predecessors

Chart 14. Changes in State Funds Spending

As shown in Chart 14, above, public health has been the fastest growing area, by far, of the State Funds budget since Pataki took office. This partly reflects the enactment of the Health Care Reform Act and the move of HCRA expenditures to “on-budget” status in fiscal 2005-06.[16]

The second fastest-growing area: contributions to state employee pension and health benefits, constituting most of what’s known as “general state charges.” Recent pension increases reflect the impact on the state retirement investment fund of the 2000-02 Wall Street downturn and of generous pension benefit increases enacted by Pataki and the Legislature in 2000. More than half the remaining benefits cost is due to health insurance for active and retired state workers.

Change in budget shares

The overall distribution of State Funds spending has changed significantly in several respects since Pataki took office. For example, between 1994-95 and 2006-07:

• With the addition of STAR, school aid has risen to 27 percent of state-funded spending, up from 22 percent when Pataki took office.

• Health-related programs, including Medicaid and HCRA, have grown to 23 percent of the State Funds budget, up from 17 percent.

• Employee pensions and benefits have risen to 7 percent from 5 percent.

• Welfare has dropped to 1 percent of the budget from 5 percent, reflecting the huge drop in welfare recipients as a result of welfare reform.

• Transportation has dropped to 6 percent from 8 percent.

• “All other” spending”-mainly state agency operations-has dropped to 15 percent from 20 percent.

Chart 15. The State Government Workforce, 1983-2005

The large relative reduction in spending on agency operations reflects the extent to which Pataki has reduced the number of state employees, as shown in Chart 15.

Relying almost entirely on attrition and an early retirement programs, Pataki reduced the workforce by 22,000 full-time equivalent (FTE) positions, or 8 percent, during his first two years in office. Not counting the more volatile payrolls of the SUNY and CUNY university systems, state government employment at the end of 2005 was 25,400 FTEs below the level of Dec. 31, 1994, and 16,000 below the level at the end of 1983, Cuomo’s first year in office. At current average pay levels, every 10,000 workers cost the state about $600 million.

CONCLUSION

George Pataki’s 12-year tenure as governor is ending as it began-with a call for broad-based state tax cuts. Pataki has laid out a pro-growth, pro-investment tax policy agenda that could serve as a benchmark for his successor, if it is adopted by the Legislature this year. But given the tax hikes he has also proposed, it would be a stretch to call the governor’s final spending plan a “tax-cutting” budget.

Thanks to fiscal restraint earlier in his tenure, state tax reduction will be Pataki’s strongest fiscal legacy even if his lame-duck tax initiatives are rejected by the Legislature. But he leaves behind a state budget that is growing so fast that this achievement could be jeopardized within just a few years.

_______________________________________________________________________________

ENDNOTES

1. The state fiscal year begins April 1 and ends March 31.

2. In his budget address, Governor Pataki stressed that his proposed spending total was inflated by two factors that don’t reflect an expansion of existing programmatic expenses. The largest is $764 million in added expenses related to the new cap on local Medicaid expenditures and the state takeover of the locally funded portion of the Family Health Plus spending. Another $530 million in new spending is related to expanding the STAR program, which the governor classifies as a “tax cut.” However, even after adjusting for these changes, the net state funds spending increase comes to 5.3 percent – still nearly twice the inflation rate.

3. Does not include HCRA spending that was still off-budget at the beginning of Pataki’s last term.

4. Under STAR, the state pays school districts to exempt from property taxes the first $30,000 of the value of an owner occupied one-, two- or three-family home. The exemption is $50,000 for income-qualified senior citizens, and is also enhanced for homeowners in areas where house prices are above the statewide median. Although Governor Pataki counts STAR as a “tax cut,” but the program is more accurately viewed as a transfer payment and is, in fact, reported as an expenditure in the budget.

5. The rebate would be available only to homeowners living in school districts that agree to cap their annual spending increases at the lesser of 4 percent or 120 percent of inflation.

6. The state-funded share of Medicaid costs is projected to rise by $5.6 billion, or 47 percent, over the next four years. For details on the implications of the increasing shift of formerly local costs to the state level, see “From Headache to Migraine? Medicaid Cap Strengthens Need for Remedies in New York,” by Tarren Bragdon, in NYHealthMatters, HM-01, February 2006, published by the Empire Center.

7. Under a temporary tax hike approved by the Legislature over Pataki’s veto in 2003, incomes above $150,000 and $500,000, respectively, were subject to added rates of up to 7.25 percent and 7.7 percent. Those rates expired on Dec. 31, 2005.

8. New York State since 1991 has had an unusual bifurcated tax structure featuring progressive rates for taxpayers with adjusted gross incomes below $100,000, but a flat rate for all filers above $150,000. The original “benefit recapture” provision of the state income tax, which remains in effect under the new law, applies to all taxpayers with adjusted gross incomes between $100,000 and $150,000. Depending on where their income stands within this “phase-out range,” taxpayers lose a portion of the benefits of having the lower tax rates applied on a progressive basis to their income below the top bracket. For married joint filers, the “benefit” at stake totals $794 under current law.

9. New York approved a significant reduction in its estate tax in 1999, reducing the tax to a level fully credited against federal estate taxes. This effectively eliminated New York’s longstanding competitive disadvantage in the tax treatment of large estates, in particular. But in voting to phase out the federal estate tax five years ago, Congress also approved an accelerated elimination of the credit for state estate taxes. The overall tax burden on New York estates is thus effectively increasing relative to those states, such as Florida and South Carolina, which have no estate tax.

10. The sales tax exemption on clothing was first enacted in 1998 but has been repeatedly suspended “temporarily” since 2003. The exemption is scheduled to resume April 1, 2007-but under a law passed with last year’s budget, it was supposed to reappear in the spring of 2006 if the governor proposed any other tax cuts this year. In the course of repealing the exemption, Pataki’s latest budget also seeks to repeal that stipulation.

11. The revenue from the cigarette tax increase would be funneled to the HCRA budget.

12. The automated traffic enforcement proposal is supposed to ultimately raise $84 million a year-implying the state expects to issue a whopping 840,000 tickets.

13. State-Funded debt, as defined by the comptroller, is a comprehensive measure including general obligation debt, public authority bonding authorized in the state budget, and deficit financing for local governments as well as the state. This is a somewhat broader measure of state indebtedness than the “state-supported” debt reported in the Executive Budget, although all of the debt reflects borrowing authorized in budget legislation.

14. These included $2.6 billion in bonds authorized by the Legislature, overriding Pataki’s veto, to refinance bonds stemming from the New York City fiscal crisis of the 1970s. The governor and comptroller unsuccessfully sued to block the measure.

15. See data series at http://www.taxfoundation.org/taxdata/show/336.html. Among other things, the Tax Foundation says its data rankings “take the additional steps of projecting collections into the current year, counting out-of-state tax payments in the state of residence instead of the state of collection, and dividing total tax payments by total income to calculate the ‘burden’.”

16. Even excluding the HCRA spending formerly carried off-budget, the growth in budgeted public health expenditures under Pataki would still come to 243 percent-fully six times inflation.

_______________________________________________________________________________