The budget season has begun. Last week, Governor George Pataki announced his proposed state budget. Mayor Michael Bloomberg is expected to put forth a spending plan for the city soon.

While politicians will undoubtedly argue over the specifics of these proposals, the bruising fights over massive spending cuts or tax hikes of years past are unlikely to emerge this time around. In general, the city and state are in fairly good fiscal shape.

Recently, at a forum sponsored by New School's Milano School, several experts offered their views of the city's fiscal state now, how we rebounded from the financial problems of 2001 and 2002, and what we should do to keep the city in good fiscal health.

From Austerity to Surplus

By Ronnie Lowenstein

The city's fiscal situation has improved remarkably. Six months ago, when the city budget for this fiscal year was adopted, the city expected that there would be a gap for the upcoming (2007) fiscal year of $4.5 billion. It was a big number, there was concerns about how we were going to manage it. But lo and behold six months later the city is not looking at a gap of $4.5 billion anymore but something closert to the tune of half a billion dollars

That's not chicken feed, but in the larger scheme of things it is relatively small, less than one percent of total city spending. There is still a significant gap of about $3 billion for the following (2008) fiscal year, which is now a year and a half off. But that is down $1 billion from the estimate that was made last spring.

So in short, the news is genuinely good. Now I'm enough of an economist to never give you good news without giving you something depressing at the same time. So, I'd like to caution you that if there has been a roughly $4 billion improvement in the last six months, about half of that is due to accounting changes. These aren't tricks or fake, but they are changes that at least in the short term have had the happy side effect of making the city's fiscal situation better.

Another caveat is, of course, that there is always risk. And it is possible that some of the problems that the federal government is having will start to affect the city in the form of lower aid flows. The Campaign for Fiscal Equity suit [on school funding] will finally be settled. This would be good news for the city and its school children, but perhaps somewhat difficult fiscal news for the city to the extent that the city will be asked to contribute. But, overall, the news is genuinely good.

Past Misuse Of Surpluses

Back in the late 1990s, New York City budgeters acted as if the good times would never end. Every year was better than the next, every year we racked up a big surplus because tax revenues were greater than we expected them to be. We used that surplus to help fill the gap for the following year. That's not a great way to budget. It only works if every year is better than the next. And over time it inured people to large out-year [or future year] gaps. If a problem goes away every year, you start saying, "what's the problem?"

There wasn't a problem until 2001. The recession, both at the U.S. level and the local level, combined with the impacts of 9/11. The fact that we had no big surplus to help remedy the following year's gap put the city in a very serious bind. Over the course of two years, the gap was estimated at well over $6 billion, and the city had to resort to a number of measures to bring the budget back into balance. It raised taxes sharply. It cut back on spending, and it also borrowed over $2 billion long term to fund short-term operation expenses, the cardinal sin in public finance.

Saved By Three Revenue Sources

We have come a long way in a few short years. Once again this year and looking at the last two years, tax revenues are going to come in stronger than the Independent Budget Office or the administration has expected. That's due to three different revenue sources.

First, the real-estate transfer taxes. We all expected the market for real estate to cool off, and it has at least anecdotally. But those property transfer taxes and mortgage recording taxes that make up the transfer taxes are continuing to go gangbusters. For the first four months of the fiscal year, we have gotten well above what we had expected for the first six months of the fiscal year. Transfer taxes don't sound particularly important, but last year they brought in $2.3 billion, which was just a little bit more than we got from the city's general corporation tax. Even though they were insignificant as recently as the late 1990s, now they are a huge mainstay of the city budget.

The personal income tax is also coming in stronger than expected. One thing that's bolstering personal income tax collections is a very strong year on Wall Street. Bonuses are on track to equal their record levels of several years ago. Wall Street profits are also doing very good things for the business tax collection, so we're seeing much greater strength there than anyone had anticipated.

We expect that together, the real estate transfer taxes, the personal income taxes and the business taxes will bring in an additional $2 billion over what had been anticipated last spring. So if we've had $4 billion improvement since last spring, a little more than half of that is right there.

Spending Restraint

Another big factor in the city's fiscal fortunes is spending restraint. Spending by city agencies has been not entirely flat, but it has grown very modestly. I'm talking about the services that the city provides: educating our kids, cleaning the streets, providing public safety. We anticipate that spending for those city services, including labor settlement, will grow at an average annual rate of 1.6 percent between 2006 and 2009. That is much less than the rate of inflation.

This is a continuation of recent trends since the city's fiscal difficulties in 2001. There is virtually no growth in existing programs, and there are no major new spending initiatives.

"Non-Discretionary" Spending

By contrast, citywide spending, which some people call non-discretionary or mandatory spending, is expected to increase more rapidly. These are big-ticket items and have all been increasing rapidly, some at double digits. They are Medicaid, pensions, health insurance, and debt service. They have all been driving city spending.

Let me start with the debt service and health insurance. We expect debt service to grow at an average annual rate of 11 percent over the next several years. This is double-digit and the numbers are huge. We are anticipating that debt service will total over $6 billion in 2009. It is being driven by a larger and larger capital program for the city and is very difficult to control, particularly with rising interest rates. Without sharp cutbacks in the capital program, there are unlikely to be changes in that forecast.

Health insurance costs are also rising very rapidly. We see them growing at an average annual rate of 6 percent a year and reaching $4 billion in 2009.

In contrast to these two very big ticket items, some of the other non-discretionary citywide spending is beginning to moderate. Medicaid was the bane of the city budgeters in recent years, and although it is still rising and still large, we are at least starting to see some moderation in that rate of growth.

There are a couple of reasons for that. The city's share of the cost of Family Health Plus [a health insurance program for low income families] was absorbed by the state last year. In addition, the state has added caps on the increase in Medicaid spending that kick in 2007. Medicaid will reach a total of $5.5 billion in 2009. It's still really big. It's still growing faster than the rate of inflation but we're expecting that growth to moderate.

The other very interesting thing about Medicaid is an accounting thing. Now normally you don't think of accounting changes as being enormously exciting, but the switch to caps by the state on the rate of growth in Medicaid is necessitating a change in how the city and the state account for Medicaid. This means that, based upon the law that was adopted, the city is going to get a $450 million Medicaid windfall this year. It is already legislated, it is going to happen. And it adds to the good news on the Medicaid front.

There is also some good news on the pension front. Pension contributions have more than doubled since 2002 following several years of really bad returns. But those problems are largely behind us... We are beginning to see some of the better returns beginning to phase in and we are expecting that pension contributions by the city will level off. In fact, if trends go the way we anticipate, they will actually begin to decline in 2008.

Even bigger, however, is an accounting change. This has not been adopted yet, but it has been accepted at the local level and is awaiting state action. The change in accounting rules would change the way we schedule our pension contributions. It is going to stretch out the number of years under which extraordinary gains and losses are accounted. These are good, common sense things to do, and they have the additional side effect of having an impact on the city budget. If they are adopted in Albany, the city will have a windfall of about $800 million this year and over $500 million next year. That is going to be followed by some modest additional costs in 2008 and 2009 and thereafter. But the net effect of those pension accounting changes is once again a big positive for the city.

The pension accounting changes together with the Medicaid accounting changes gives you roughly another $2 billion in fiscal relief. So of the $4 billion we have had of good news since last spring, about half of it is genuinely stronger tax collections than we had anticipated. Another half of it is accounting changes and to some extent it is all made possible by continued spending restraint. So rather than having a $4.7 billion gap for '07, we're looking at a gap that's more like half a billion - a gap that is very, very small by comparison to gaps in recent years. Even that could change between now and the end of the fiscal year. The gap for '08 remains considerable, but is down significantly from what we have anticipated.

Changing Our Ad Hoc Approach To Future Gaps

The way we deal with our out-year or future gaps is relatively ad hoc. Right now while the memories of 2001 are so vivid in our minds, I think everybody - the administration, the City Council, the monitors - worries about those gaps and tries to come up with ways to deal with them before they come up and bite us. But that's not always going to be the case. And, if we're fortunate over time, the memories of 2001 will recede just as they did in the late 1990s and somehow those out-year gaps will look less and less pressing. The way to handle that would be to move from a system in which we deal with them in an ad hoc basis to something more systematic.

There have been lots of differing calls for how to do this. The comptroller has called repeatedly for the establishment of a rainy day fund. Others have discussed ways of routinely doing more pay-as-you-go capitol financing. You could take some of the surpluses and invest them in new technology. Doing so would increase productivity and help damp down spending growth over time. There are lots of different things to do, but the right time to worry about how to more systematically deal with the out-year debt is when the sun is shining.

The very fact that the city's fiscal situation is better means that there are going to be new pressures and new demands on the city. There are going to be lots of calls, rightly, for important things that the city needs to fund. Similarly, there are going to be a lot of calls for tax cuts. This is a very high tax place -- the highest taxed major city in the country -- and that has a major impact on competitiveness. So it is perfectly reasonable to say we should be worrying about tax cuts. How the mayor and the council address these pressures for increased spending and reducing taxes is going to largely determine the course of the city's fiscal fortunes over the next few years.

Ronnie Lowenstein is director of the New York City Independent Budget Office

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