For the first time in four decades, New York faces the possibility of a wrenching long-term change in how its economy works. In the 1960s, it was the loss of manufacturing jobs and corporate headquarters that transformed Gotham. Today, of course, it’s the end of Wall Street as most of the city’s residents have always known it.

New York still has a bright future without depending on the billions of dollars annually that risk-taking investment banks have been funneling into its coffers since the early 1980s. But this future is assured only if city and state leaders understand that their job is to rethink city fiscal and investment priorities.

By doing so, they can create the foundation for a recovery and future economic growth driven by entrepreneurs, not investment bankers.

At the Whim of Wall Street

For two and half decades, New York has become dangerously dependent on a thin slice of its residents and job-creators for more and more of its taxes. Those taxpayers, in turn, were dependent on their own profits and bonuses in an industry dependent on high risk, huge amounts of cheap debt and a credulous world happy to entrust its money with whatever complicated finance products well-paid investment bankers could conjure up for their high fees.

Consider: Two years ago, Wall Street generated 12 percent of the city’s direct tax revenues and 20 percent of the state’s. And when you consider that Wall Street indirectly drove up taxes based on property values and the like, the industry’s indirect share of tax revenues was much higher.

New York’s reliance on Wall Street had only grown progressively worse in recent years. In 2006, the top 1 percent of taxpayers paid nearly 48 percent of the city’s personal income taxes even after adjusting for a temporarily higher tax rate, up from 34 percent two decades ago, according to economist Michael Jacobs at the city’s Independent Budget Office.

Such growing dependence on a volatile industry was risky for the city even when Wall Street was doing well, as it increasingly did for 25 years starting in 1982 (with a couple of cyclical downturns in between). When financial-industry taxpayers have a bad year, the city’s tax revenues plummet.

But this dependence on one industry for so much of the city’s revenue and economic activity could be catastrophic today, when the city’s wealthiest taxpayers are worried that Wall Street -– and thus their own ability to generate new income and pay ever-higher taxes -– has changed forever.

Elected officials need to understand that the answer to our problems now is not to hike taxes on the wealthy and wait for Wall Street to come roaring back. Wall Street may not come roaring back, and wealthy taxpayers may feel differently about tax hikes now than they did a decade ago, when they felt more secure about their own futures.

As one measure of this possibility, just look at financial-industry pay, which neatly tracked the industry’s fortunes over the past century. As New York University Professor Thomas Philippon and University of Virginia Professor Ariell Reshef have found, financial-industry wages broke away from the rest of the economy starting in the '80s and continued their stratospheric increase relative to the rest of the economy through 2006. Toward the end of the period, financial-industry wages actually reached pre-Depression peaks relative to the rest of the economy. This jump explains New York’s huge and unprecedented increase in tax collections.

If history is any guide, though, financial-sector wages could return to a much lower “normal” level indefinitely, as they did during and after the Depression. And New York (city and state) will have to get used to sharply lower wages in its key industry, and thus sharply lower tax collections.

The Dilemmas ...

That leaves New York with two problems.

First, unprecedented tax revenues from Wall Street masked the fact that the city’s spending has grown at an unsustainable rate. While spending rose just 9 percent during Giuliani’s terms, it’s risen three times as fast under the Bloomberg administration, the highest rate since John Lindsay left office in the midst of our last structural fiscal crisis. In fact, city spending today is 22 percent higher than it was back then, when adjusted for population and inflation.

This increase is largely because pension and benefit costs for city and state workers have risen inexorably, along with spending on Medicaid and education (without commensurate results in outcomes).

Second, because of this high spending, the city has not invested in the subway and other infrastructure that it needs to compete with the rest of the country and the world in the 21st century.

… The Solutions

So New York must do two things to give itself a robust future after Wall Street.

First, the city and state must reform out-of-control labor costs that have driven the growth in their budgets. City and state officials must impress upon labor the need to increase retirement ages and to require higher worker contributions for health and pension benefits, including at authorities like the Metropolitan Transportation Authority.

If the city and state don’t do this, simple math shows that vital spending on things like police, sanitation and library service will be crowded out as these benefit costs continue to rise.

Consider: two years from now, New York City alone with spend $7 billion on pensions -– up from $1 billion annually in the late 1990s.

It’s only by doing this tough political work that New York will have a chance to cut local and state taxes, even by a modest amount, to attract a new generation of non-financial-industry entrepreneurs to the city. Unfortunately, the way our tax structure is set up now, only the Wall Street wealthy can afford to live and work here –- which is of no help to New York now that that industry has vaporized itself.

The second task for New York –- and one just as important -– is for the city and state to make it clear that they won’t skimp on vital investments in mass transit just because times are tough. Right now, the savviest private-sector companies around the world are making it clear that they won’t cut research and development investments to the bone just because revenues are down. Instead, they’re setting the stage to do well when the economy starts to recover.

New York must make the same pledge with its own physical assets so that it doesn’t fall further behind the rest of the world. This work, again, isn’t rocket science; it largely requires better prioritizing of existing spending. For example, with half of California's population, we spend $11 billion a year more than California spends on Medicaid -- and we don't get better results. Cut costs there, and it's easy to carve out more of an existing state tax to give permanently to the transportation authority, rather than levying a new job-killing payroll tax, as Gov. David Paterson has proposed.

New York’s future is simple: Less punitive taxes on individual job-creators, and much better transit infrastructure to entice those job creators here with better quality of life. These changes, along with the astoundingly low crime rates that Mayor Michael Bloomberg has continued to bring down, will create the public-sector foundation where an entrepreneurial private sector will grow and flourish.

Nicole Gelinas is a contributing editor to City Journal.