Among the things the stock market’s slump over the past week puts into sharp relief is the game Governor Pataki is playing with the state’s budget. This is owing to one of the great ironies of the fiscal tug of war in New York politics. The left wants to keep the capital gains taxes in place, not only at the federal but also at the state level. In down markets, this means that the public budget is leveraged to precisely the mar ket players that the left loves to hate. So now the betting everywhere is that once the November election is over, Mr. Pataki is going to come looking for a tax increase, with the Mayor of New York right behind him.

It’s a game New York’s taxpayers are likely to lose, a point underscored in a new report from the State Division of the Budget. As recently as May, the governor and the legislative leaders insisted they

everything squared away. new report, Friday at Albany, shows the budget is beginning to fray. The state ended the first quarter of the 2002-03 fiscal year with cash flow $221 million below estimates in the Enacted Budget Financial Plan. The shortfall came in receipts, which were down $259 million. This means assumptions about revenue, which were predicated on a strong local and national economic recovery, may well be overly optimistic and actual revenues may prove insufficient to fund the budget.

Most of the shortfall, $129 million, occurred in personal income taxes. The good news, as far as there is any, is that withholding collections — the taxes extracted from Joe and Jane Taxpayer while they sleep — were “only slightly below estimates,” according to the report. The bigger gap seems to have come from payment of estimated taxes. These are paid by business owners, partners in businesses and firms, and the self-employed. Unlike withholding taxes, estimated taxes require the taxpayer to take out his checkbook and estimate what he or she expects to owe in taxes by the end of the year. These low receipts could be an indication on the part of these filers of low confidence in the economic outlook.

The governor and the legislature have left all the risk on the downside. There is little likelihood that, as has happened in past years, the budget will end up further in the black than expected. On the contrary, a bearish stock market is likely to have a significant impact on New York, which skews its tax burden disproportionately toward the wealthy, who are expected to see a sharp decline in capital gains this year. Next year is sure to see a huge push for tax increases from the public employees unions, which understand all too well the choices New York State now faces. Just yesterday, the state president of the American Federation of Labor-Congress of Industrial Organizations, Denis Hughes, was quoted by the New York Post calling for an increase in the personal income tax.

The right move in a situation like this — as President Bush suggested yesterday — is to cut taxes, deregulate, and take other supply-side steps designed to spur economic activity. Having resisted such incentives and having burned through a surplus to avoid spending cuts this year, New York will either have to cut the size of government or increase tax revenue the next time around. While the budget process is presently on hiatus, the key to bridging the budget gap will eventually have to be cutting public spending. Fiscal conservatives would do well to stay on alert, because those who count on the government for jobs aren’t counting on a bull market. And the governor has been playing their game.