Wall Street’s woes leave the state no choice but to slash spending.

David Paterson took the oath as governor of New York on March 17, 2008, succeeding the disgraced Eliot Spitzer on the same day that Bear Stearns collapsed. Paterson spent the spring and summer warning that the state faced its worst economic downturn since the Great Depression, and by early autumn, he was looking downright prophetic. As tax revenues nose-dived and New York’s budget deficit ballooned from $4 billion to over $13 billion, the new governor didn’t simply blame the problem on economic forces beyond his control. “This is the result of our increased spending over years and years,” he said during one of many fiscal-crisis news conferences. Wall Street had “bailed us out for a number of years,” he added, but “the well has run dry.”

Paterson’s tough talk implied that he would do what was necessary for New York to weather the recession and recover from it: in the short term, slash state spending to close budget gaps; for the longer term, reduce New York’s bloated public sector to a more affordable size; and, above all, avoid raising economy-killing taxes. Unfortunately, he has failed on all three counts, agreeing this past March to a 2009–10 state budget that will keep growing even as the economy shrinks. New York’s finances now precariously balance on a combination of temporary federal aid, nonrecurring “one-shot” savings and revenues, and a package of record tax and fee increases. As a result, the Empire State’s fiscal and economic outlook is worse than at any time since the fiscal crisis of the mid-1970s.

At the close of his budget negotiations with the New York State Legislature, Paterson bizarrely insisted that the new spending plan represented fiscal austerity: “If the legislature can maintain this type of discipline over the next few years, then we can actually see the light at the end of the tunnel.” But that tunnel leads to a fiscal abyss. The only way to avoid it is to halt spending growth before it’s too late.

New York State’s current budget problems were precipitated by the global financial meltdown, but they were decades in the making. Concluding that New York has the worst economic outlook of any state, an analysis by the American Legislative Exchange Council blames its combination of high taxes, excessive debt, oppressive regulatory bureaucracies, and labor policies that discriminate against nonunion employers. New York’s overall state and local tax burden lightened in the 1990s but remains among the nation’s highest. Private-sector job growth in the state has been anemic by national standards over the past 25 years, despite a series of financial-sector booms.

Further, the bursting of the real-estate bubble and the epic restructuring of Wall Street mean that New York, more than most other states, faces a fiscal reckoning. With every peak and valley in the boom-and-bust cycles of the past 25 years, Albany became ever more dependent on Wall Street. By the peak of the latest boom, the securities industry alone accounted for fully 20 percent of the state’s tax revenues—including income taxes generated by the phenomenal rise in Wall Street profits and bonuses. A surge of capital-gains and transaction taxes from a red-hot commercial and residential real-estate market added more fuel to unsustainable levels of state and local government spending.

Today’s crisis clearly isn’t just another cyclical downturn like those in 1989–92 and 2001–03. Regardless of when the broader recession ends, the financial sector that rises from the ashes of the 2008 meltdown is likely to be much leaner and more heavily regulated. That means, for one thing, that Albany will no longer be able to count on the geese that once laid its golden eggs. It also means that stopgap measures that assume another boom is just a year or two down the road will simply create bigger budget holes in the near future.

Paterson initially seemed to recognize all this, but he fumbled the opportunity that the recession gave him to push for decisive action and meaningful reform. In December 2008, the governor presented an executive budget for 2009–10 calling for a 1.1 percent spending increase, with almost nothing in the way of significant restructuring, consolidation, or downsizing of state agencies and programs. He called for 137 new or increased taxes, fees, and fines, hitting energy bills and health care as well as consumer items, to raise $4.1 billion. As a long-term plan, the executive budget was an even bigger failure, projecting spending that would rise at twice the inflation rate between 2010 and 2013—including a 36 percent increase in Medicaid and a 25 percent increase in school aid.

This was an ominous sign. In Albany, the executive budget is the floor bid in an annual negotiation with the legislature that generally goes in one direction—up. Any pressure for budget reform further diminished in February 2009, when Congress and President Barack Obama delivered a federal stimulus package promising New York nearly $25 billion over two years. A Washington bailout seemed just the way to continue paying for expenditures that the state could no longer afford on its own.

Meanwhile, public-sector unions were bankrolling a campaign to raise taxes on New York’s “wealthy,” defined as anyone earning over $250,000, and they didn’t let up even when the federal billions materialized. The unions’ proposal was embraced by many legislative Democrats, whose party had just won control of both houses of the legislature for the first time in 44 years. Paterson warned that higher income taxes would weaken the tax base by driving high-income residents away, but he never ruled out the tax hike, either—strengthening the widespread (and, as it proved, correct) impression that eventually he would cave to it.

As budget negotiations went on, tax revenues kept falling—the main reason that the $13 billion deficit that the executive budget aimed to close swelled to $17.7 billion by late March. And as the April 1 start of the 2009–10 fiscal year drew near, Paterson and Democratic leaders agreed to a budget deal that approached the worst of all conceivable outcomes.

The budget spends a total of $132 billion, an 8.5 percent increase from last year. Paterson justifies the growth by pointing out that “state operating funds” have risen less than 1 percent. However, if the definition of this category is stretched to include federal stimulus aid (which, crucially, is due to expire in 2011), then spending normally supported by state funds is actually up at least 4.2 percent—at a time when inflation is nil, economic activity is sluggish, unemployment is rising, and tax revenues keep plummeting.

What Paterson labeled an “austerity” plan also includes the legislature’s customary $170 million for pork-barrel “member item” appropriations. Spending in the budget’s three “out years”—fiscal years 2010–11 through 2012–13—is boosted further. The “$6.5 billion in spending cuts” that Paterson claimed consist mainly of avoided spending increases rather than actual reductions.

Despite the stimulus injection, the final budget also funds its spending with tax and fee increases valued at $6.1 billion—an all-time high for the Empire State and fully 50 percent more than Paterson had sought in his original record-setting proposal. This includes $4 billion from the state’s largest personal income-tax hike in nearly 50 years (the unions having won two-thirds of the soak-the-rich plan that they sought; see sidebar, below). Paterson also repealed $1.7 billion in state-funded school property-tax rebates for homeowners, while no longer even talking about the property-tax cap that he promoted, over the teacher unions’ opposition, less than a year ago.

Asked if it made sense to raise taxes in a deep recession, the governor replied, “None of this makes sense.” That’s for sure. New York State has already lost nearly 150,000 jobs since last summer, with roughly 130,000 more job losses projected through the end of the year, and higher taxes are likely to make the problem worse. That means even less tax revenue.

The budget did represent a huge victory for New York’s public-employee unions, which not only succeeded on the income-tax hike but also brushed off Paterson’s call for a pay freeze and other contract concessions. While government workers in California and Ohio were taking cuts in the form of uncompensated furloughs, more than 160,000 New York State government employees started collecting an average 3 percent pay boost within three weeks of the budget’s passage. Only in the final week of budget negotiations did Paterson finally get serious with the unions, threatening up to 8,900 layoffs by July if they didn’t start making concessions. They replied with a mocking ad campaign featuring photos of Paterson sticking his fingers in his ears. The head of the state’s Civil Service Employees Association suggested that the governor “needs a good psychiatrist, or at least he should share the drugs he’s on.”

The governor is surely clearheaded enough, however, to realize that the federal stimulus money is a budgetary bridge to nowhere, allowing New York’s state spending to stay more or less on track for another two years before derailing. Paterson forecasts that revenues will fall $2 billion short of spending in 2010–11, but the shortfall will reach $8.8 billion the following year and $13.7 billion the year after that. Higher taxes will further weaken the Empire State’s prospects for a comeback, even if the national economy recovers in line with Obama’s highly optimistic projections for the next few years.

So what now? Paterson and state lawmakers need to learn the lesson that the late senator Daniel P. Moynihan called Political Economy 101: “When you are in a hole, stop digging.” If they want renewed economic growth, their first priority should be to reverse their record tax hikes no later than 2011, when the income-tax increase is currently scheduled to expire. But this will require a much stronger effort to reduce spending across the board, and especially in three large categories: state agency operations, Medicaid, and school aid. It will also require breaking the public-sector unions’ stranglehold on New York.

Reducing the costs of state agencies is an undertaking over which the governor has a fair amount of control, as his layoff threat illustrated. (In June, he agreed to a deal that will eliminate unfilled positions and provide severance bonuses to 4,500 retirement-ready employees in exchange for the unions’ acquiescence to a modest rollback of pension benefits for future hires.) However, Paterson has yet to initiate the kind of rigorous, top-to-bottom review of agency operations and programs that is sorely needed after a prolonged period of control by one governor—George Pataki, who held office for 12 years. (Pataki’s successor, 60-week wonder Eliot Spitzer, left little discernible managerial imprint of his own.)

In contrast to New York City, where the Mayor’s Management Report is a useful (though hardly flawless) tool for measuring agencies’ performance, New York State makes little effort to hold anyone in its sprawling bureaucracy accountable for anything. A gubernatorial commitment to performance budgeting, with publicly reported measures of progress toward clearly stated goals, is a prerequisite for smart, targeted budget reductions. The governor and his top staff should also investigate outsourcing functions now reserved for public employees (see sidebar, below).

In the final analysis, however, significant money-saving reforms—reorganizing, consolidating, or eliminating agencies—require the legislature’s approval. Paterson did succeed in persuading lawmakers to close a few underpopulated prisons and juvenile detention facilities this year. But he needs to push harder for economies, even in areas of government outside his immediate control, like the sprawling state court system (which has added nearly 4,000 employees in the last dozen years) and the porcine budget of the legislature itself, which currently averages over $1 million for each of the 212 elected Assembly and Senate members (though the funds are by no means evenly distributed). Such steps can at least produce a down payment on the billions of dollars in recurring savings needed to rebalance the budget without higher taxes.

An area where savings are needed even more sorely is Medicaid. New York’s $49 billion Medicaid program is by far the most costly in the country, spending nearly 75 percent more than the national average per enrollee, though there is scant evidence that the money provides a commensurately high quality of care. Created in the mid-1960s as health insurance for the poorest state residents, Medicaid now covers more than one of every five New Yorkers—that’s 3.7 million, all told—as well as an additional half-million in Family Health Plus, a program reaching more and more middle-income households.

In fact, under both Spitzer and Paterson, expanding Medicaid enrollment has been an express goal of state policy. That was why Paterson spearheaded a budget provision that let people enter Medicaid without undergoing financial-asset tests and face-to-face interviews. As if to ensure a steady flow of new customers for publicly subsidized health care, the state has also hiked taxes and fees on employer-provided coverage by $850 million. No wonder the Medicaid rolls are now projected to grow by another 1 million people over the next four years.

To his credit, Paterson has persuaded the legislature to divert some Medicaid funding from expensive hospital inpatient care to primary- and preventive-care settings, such as doctors’ offices and outpatient clinics. This modest reform may produce bigger savings down the road, if the state can stick to it despite furious complaints from the hospital industry. For more suggested reforms, see “The Medicaid Monster.”

Finally, school aid in New York is far higher than the state can afford. New York will send $22 billion in operating aid to local K–12 school districts in 2009–10, plus $2.5 billion to make up for school property-tax breaks targeted to homeowners. New York’s education spending per pupil was already the nation’s highest two years ago, before Spitzer handed schools the first installment of what was supposed to be a record $7 billion aid hike over four years. That spending would have been difficult to finance even before the Wall Street meltdown.

With state revenues plunging, Paterson’s executive budget proposed a modest 3 percent cut in aid for school year 2009–10—a smaller hit than many school officials expected. But the February stimulus package required the state to use federal funds to restore $1.2 billion in school aid, resulting in a net aid increase of about 2 percent over the previous year—and that’s aside from another $1.7 billion in federal stimulus funds that will flow directly to school districts over the next two years. These increases are fattening a budgetary baseline that has grown far beyond the level that New York’s state and local taxpayers can afford to sustain. In the long run, spending on public schools in New York remains on a collision course with fiscal ready. But the school-financing issue points to an even broader problem. Just as teacher salaries and benefits make up three-quarters of school operating expenses, the largest share of Albany’s other aid to local governments supports the wages, salaries, and benefits of public-sector employees. These government workers are the beneficiaries of contracts that guarantee them ever-increasing pay and benefits, no matter the economic climate—unlike workers at private firms, who have responded to the recession by seeking creative ways to save jobs through wage deferrals and job-sharing. If tax revenues and state aid don’t rise—and if, as is usually the case, unions refuse to make concessions—local-government officials have three choices: they can lay off employees, cut back services, or shortchange vital capital investments.

The governor needs to frame public-sector personnel costs and rigid contracts as a comprehensive problem requiring a comprehensive solution for every level of government. In particular, the rising cost of pension and other retirement benefits can only be addressed at the state level (see sidebar, below). Also, state and local officials need more flexibility in managing their workforces and controlling labor costs—and once they have it, they need to be held accountable for results.

A sizable target for reform is the Taylor Law, which regulates public-employee unionization and collective bargaining rights. Passed in 1967, the Taylor Law effectively created a statewide public-sector labor cartel that exerts gigantic political influence on every level of government. In the 40 years after the Taylor Law’s enactment, the number of state and local government jobs increased at more than twice the rate of private-sector employment in New York, and the average pay of state and local government workers rose higher than that of private-sector workers in most regions of the state.

Outright repeal of the Taylor Law is a practical impossibility. But changing it would help redress the imbalance of power at the bargaining table between the public’s elected representatives and unions representing government workers. Reform of the law needs to focus on two areas: eliminating compulsory arbitration of contract disputes for police officers and firefighters, which has tended to drive up salaries while hindering creative approaches to improving efficiency and reducing costs; and repealing the 1982 Triborough Amendment, which has perpetuated generous pay arrangements, especially for teachers, by requiring that all provisions of a contract remain in force while a new deal is being negotiated.

If the crisis worsens, lawmakers have one more weapon at their disposal. Call it the zero option: based on the precedent set in New York City’s fiscal crisis of the 1970s, the state could enact a law declaring a fiscal emergency and freezing all government wages and salaries, including automatic “step” raises based on years on the job, until recurring expenditures are brought back in line with recurring revenues under an economically sensible tax regime. This would lead to a nasty confrontation with the unions, of course. But short of such a confrontation, labor costs will remain fixed and difficult to control.

What is missing from New York government, above all, is any realistic sense of financial limits. Two further reforms might restore it. Outside Gotham, property taxes that finance schools are easily the largest component of New York State’s heavy local tax burden. The cap that Paterson proposed last year—which would affect all districts outside the state’s four largest cities—would be a solid step in the right direction. Modeled on Proposition 21/2, which has significantly reduced local taxes in Massachusetts since its passage in 1980, the cap would incentivize local taxpayers to favor development as a way to expand local tax bases. At the same time, it would allow local voters to override limits for specific projects.

But the cap approach shouldn’t be limited to school taxes. To counteract New York’s entrenched tradition of governmental excess, the state should enact a Taxpayer Bill of Rights, which would limit the growth of government by tying increases in overall tax revenue to the rate of growth in inflation and population. State and local tax-rate increases beyond the limit would require direct voter approval—as would major debt issuances, shutting the back door through which New York’s public authorities have borrowed tens of billions of dollars without voter approval over the past 25 years.

To be sure, New York’s political sclerosis is so advanced that politicians in both parties may continue to avoid even modest reforms, despite the dire fiscal and economic circumstances (see “Madison’s Nightmare”). In that case, before the next decade is out, taxpayers will have a chance to make their voices directly heard. Once every 20 years, New Yorkers go to the polls to vote on whether to hold a new constitutional convention and alter the basic law of the state. The last time this happened, in 1997, the proposal was defeated by strange bedfellows ranging from the antitax Right to the union-dominated Left. The next vote is eight years away, in 2017. If Albany politicians haven’t made more progress by then, New Yorkers may take matters into their own hands.