The latest edition of the Federal Reserve Bank of New York’s Second District Highlights, Revenue Implications of New York City’s Tax System, is available.

New York City’s tax revenues are less stable now than in the mid-1970s because the current composition of revenues makes the tax base more sensitive to shifts in the business cycle, exacerbating budgetary shortfalls during recessions, according to a study by economists Jesse Edgerton, Andrew F. Haughwout, and Rae Rosen. This increased sensitivity places considerable challenges before city officials, who are required by law to balance the budget. Therefore, these budget officials face the hard choice during an economic downturn of either cutting expenditures, which are difficult to reduce in the short run, or raising taxes.

The authors conclude that the primary cause of this instability is that the city’s tax system of the 1970s -- once dominated by property taxes -- over the years has become more dependent on personal and corporate income taxes. Revenues from the personal and corporate income taxes fall significantly and rapidly in economic downturns, while the property tax is not similarly affected. For example, between fiscal years 2000 and 2002, New York City’s real revenues from the personal income tax declined 19 percent and general corporation revenues plunged 23 percent. However, property tax revenues actually continued to grow, rising by 6 percent over the two years.

New York City generates revenues from four major taxes: property, personal income, general sales, and general corporation. The authors used three criteria to analyze the characteristics of the bases of these taxes: persistence, the extent to which trends are maintained over a period of years, rather than shift suddenly from year to year; volatility, the size of unexpected changes in the tax base; and economic sensitivity, the extent to which tax bases fluctuate in response to the business cycle, either cyclically or counter-cyclically.

The authors’ analysis of three decades of data shows that the city’s property tax base is more persistent -- has longer term and thus more predictable trends -- than the personal income tax base. In addition, the bases of New York City’s property and general sales taxes are less volatile than the personal income and general corporation tax bases, meaning that there are smaller unexpected changes in the property and sales tax bases. Last, the city’s personal income and general corporation tax bases are shown to be the most economically sensitive, meaning that they respond rapidly and strongly to changes in the economy. The general sales tax base responds less strongly. The property tax base moves independently of near-term shifts in the economy.

The expiration in 2008 of the New York State Financial Emergency Act for the City of New York could offer policymakers the opportunity to recognize the experiences of the past thirty years and to respond with policy changes if they so decide. The authors outline several such options:

• maintain the status quo, including the option to prepay debt service and certain smaller expenses to external agencies for each oncoming fiscal year;
• reduce the city’s reliance on the personal income tax and general corporation tax while increasing the effective tax rate on property;
• establish a meaningful rainy-day fund to cushion future budget gaps, which, if acted upon before 2008, would require legislative changes to the Financial Emergency Act;
• create a new external agency for capital projects to be financed with windfall tax revenues and ongoing funding, so that windfall tax revenues, in years where personal income and general corporation tax revenues are especially high, would not be embedded in the city’s operating budget and permanently raise planned expenditures.

Jesse Edgerton is an assistant economist, Andrew F. Haughwout a research officer, and Rae Rosen an assistant vice president at the Federal Reserve Bank of New York.

Revenue Implications of New York City’s Tax System »

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