Review of the Fiscal Year 1999 Executive Budget

for the City of New York

May 19, 1998

H. Carl McCall

State Comptroller

Office of the State Deputy Comptroller for New York City

Report 1-99

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Contents

I. Executive Summary

II. Fiscal Year 1998

A. Tax Revenues

B. Board of Education

C. State Budget

D. Agency Spending

III. Fiscal Year 1999

A. Revenue Estimates

B. Expenditure Estimates

C. Tax Reduction Program

IV. Projected Budget Gaps

V. Other Concerns

A. Sports Facility Corporation

B. Transitional Finance Authority

Tables

1. Four-year Financial Plan Revenues and Expenditures

2. OSDC Evaluation of the Fiscal Year 1999 Financial Plan

3. Major Sources of the Fiscal Year 1998 Budget Surplus

4. Changes in Agency Spending Since the Budget Was Adopted

5. Major Factors Contributing to the Growth in Fiscal Year 1999 Spending

6. Proposed and Enacted Tax Reduction Program

Graphs

1. Annual City Surpluses

2. Wall Street Bonuses and Profits

3. Board of Education Expenditures.

4. Annual Change in City-fund Revenues

5. N.Y.C. Tax Revenue Growth

6. Annual Change in City-funded Expenditures

7. Projected FY 1999 City-funded Expenditures

8. City-funded Personnel Levels

9. City Pension Contributions

10. Public Assistance Expenditures

11. Growth in Medical Assistance Expenditures

I. Executive Summary

The City is likely to end FY 1998 with a surplus in excess of $2 billion, the largest surplus, both in absolute terms and as a percent of City revenues, since the budget was first balanced in FY 1981 in accordance with Generally Accepted Accounting Principles (GAAP). The FY 1998 surplus comes on the heels of last year's then-unprecedented $1.4 billion surplus. In both years, the surplus has been driven by strong Wall Street performance which exceeded expectations.

The budget surplus, combined with an improving real estate market and higher tax revenue forecasts, made it easier for the City to balance the budget in fiscal years 1998 and 1999, and to narrow the out-year budget gaps. Despite these favorable conditions, the City still projects sizeable out-year budget gaps which we will examine more closely in our report on the FY 1999 Adopted Budget.

The City has used the current fiscal improvement to reduce taxes; expand its work force, reversing a trend of the last four years; and to increase spending. The Plan shows City-funded spending declining by 3 percent in FY 1999, but our analysis indicates that spending would rise by about 6 percent for the second consecutive year. Spending patterns become distorted because of the way the surplus must be reflected in the budget.

Our estimate also includes debt service costs associated with the Transitional Finance Authority (TFA), costs that have been removed from the Plan. We believe that including both the revenues and debt costs associated with the TFA in our review of the City's Financial Plan provides a more complete picture of its finances.

Our review finds that tax revenues could exceed the City's revised estimates for fiscal years 1998 and 1999 by $450 million. However, some of these resources may be needed to restore cuts in funding ($104 million) to the covered organizations, most notably the Health and Hospitals Corporation, for wage increases negotiated by the City. In addition, the Mayor has imposed a unilateral freeze in health insurance premiums ($58 million) which is subject to ongoing discussions with the Health Insurance Plan of Greater New York.

The City should consider investing any additional surplus in ways that produce recurring benefits and ease the debt burden. For example, it could:

• fund capital projects on a "pay-as-you-go" basis;
• retire outstanding debt; or
• eliminate the one-time proceeds from the expected sale of the New York Coliseum from the Plan, and use the proceeds directly to fund transit capital projects.

Under an agreement with the Metropolitan Transportation Authority, the City would receive $200 million from the sale of the Coliseum for use in its operating budget in exchange for issuing long-term bonds for transit purposes. In our view, the City would be effectively capitalizing an operating expense, an inappropriate use of its limited bonding authority.

The City also should consider using a portion of any future surplus to create a reserve that would be drawn down only in times of fiscal stress, such as an economic downturn. The City Council has proposed creating such a "rainy day" fund. The Mayor has proposed depositing $416 million of the FY 1998 surplus in a Budget Stabilization Account. These resources will be used to narrow the FY 2000 budget gap, unless needed to maintain FY 1999 budget balance. While a step in the right direction, the Account is not a true "rainy day" fund because the surplus is being spent during a period of economic prosperity.

The City Council and the Mayor are also negotiating a package of tax reductions. The City Council Speaker has proposed eliminating the 12.5 percent personal income tax surcharge that is scheduled to expire on December 31, 1998 and changing the personal income tax rates to make the tax more progressive. The Plan currently assumes that the surcharge will be extended in its current form, generating revenues of $201 million in FY 1999. The Plan does reflect the Mayor's proposed tax reduction program which would reduce revenues by $237 million in FY 1999, primarily by accelerating the Governor's School Tax Reduction program. Both the Mayor's and the Speaker's proposals require State approval.

The Mayor has proposed using revenues from the commercial rent tax to help fund construction of new stadia for the Yankees and Mets on a "pay-as-you-go" basis, rather than issuing long-term bonds. While we applaud the Mayor for identifying resources for "pay-as-you-go" capital funding, the City should consider whether new stadia are the best use for those resources.

Table 1

Four-year Financial Plan Revenues and Expenditures

(millions)

Data Source: N.Y.C. Office of Management and Budget.

Table 2

OSDC Evaluation of the Fiscal Year 1999 Financial Plan

(millions)

Better/(Worse)

II. Fiscal Year 1998

The City projects a surplus of $2 billion for FY 1998. This would be the largest surplus both in absolute terms and as a percent of City-fund revenues since FY 1981 (see Graph 1), when the budget was first balanced in accordance with Generally Accepted Accounting Principles (GAAP). As shown in Table 3, the major source of the FY 1998 surplus, just like last year's, is much-greater-than- anticipated tax revenue collections, due to continued strength on Wall Street.

Table 3

Major Sources of the Fiscal Year 1998 Budget Surplus

(millions)

Data Source: N.Y.C. Office of Management and Budget.

In addition to higher tax revenues, other sources are expected to contribute to this year's surplus. They include $250 million from overestimating prior years' expenses; $196 million from a surplus projected by the Board of Education; $160 million from reducing the general reserve to the current level of $40 million; $122 million from lower debt service costs because interest rates and short-term borrowing were both less than anticipated; and $150 million from additional sales tax revenues because the State did not enact the City's proposal to eliminate the tax on clothing purchases that are less than $500. These resources were partly offset by higher-than-anticipated agency spending, mostly in the uniformed agencies, and the adverse impact of the State's FY 1997-98 budget. When aggregated, these factors produced $1.7 billion in unplanned resources. In addition, the City has $300 million in unneeded funds it had deposited in the 1998 Budget Stabilization Reserve at the beginning of the fiscal year, bringing the FY 1998 surplus to more than $2 billion.

Our review finds that tax revenues could exceed even the City's revised estimates by $215 million in FY 1998. While the receipt of $200 million in proceeds from the sale of the New York Coliseum may be delayed beyond FY 1998, this resource will not be needed in that year given the potential for a larger surplus.

Should the additional tax revenues materialize, we again urge the City to eliminate the one-time proceeds from the sale of the Coliseum from its operating budget and to use the proceeds directly for capital purposes. Under an agreement with the Metropolitan Transportation Authority, the City would receive the sale proceeds for use in its budget in exchange for issuing long-term bonds to fund transit capital projects. In our view, this amounts to capitalizing an operating expense and is an inappropriate use of the City's limited bonding authority.

Below is a more detailed discussion of tax revenues, the Board of Education, the State budget and agency spending.

A. Tax Revenues

Tax revenues are expected to exceed the City's initial estimates by $1,161 million.⁽²⁾ Most of the additional revenue is centered in the business and personal income taxes, and can be largely attributed to Wall Street, which significantly outperformed the City's expectations, posting its second consecutive year of record profits in calendar year 1997.

In the FY 1998 Adopted Budget, the City had forecast a reduction in securities industry profits from $11.3 billion in calendar year 1996 to $8 billion in 1997. Given the expected slowing in corporate profits growth and uncertainty about the interest rate climate in the wake of a Federal Reserve tightening in March 1997, the forecast appeared reasonable at the time of adoption. However, quiescent inflation reduced the chances that the Federal Reserve would increase interest rates, and corporate profits were stronger than anticipated, giving the market strength through the second half of the year. The Dow Jones Industrial Average surpassed the 8,000 mark in July, and recovered from a 7 percent drop in October in the wake of the Asian financial crisis. Securities profits jumped in the third quarter, and in the fourth quarter consumer confidence reached its highest level in nearly 30 years. For the entire year, the average annual increase in the Standard & Poor's 500 stock market index was 29 percent, the largest gain since 1983.

As a result, industry profits hit an all-time high of $12.2 billion in 1997 (see Graph 2), with approximately $11 billion earned by the largest firms headquartered in New York City. Once again, profits were driven largely by fees from record merger and acquisition activity. We anticipate that this exceptional performance boosted securities bonuses by as much as 25 percent, resulting in payments of about $12 billion. Combined with over $11 billion in estimated resident capital gains realizations, collections of income-sensitive taxes recorded a substantial boost.

Thus, the forecast for the personal income tax has been raised by $553 million since last June, while those of the three business taxes (general corporation, banking corporation, and unincorporated business tax) have increased $528 million. Among the other major taxes, the forecasts for the real-estate related taxes (commercial rent, real property transfer, and mortgage recording) were raised by $78 million, while the property tax was increased $65 million.

Tax revenues (after adjusting for the sales tax cut not enacted) were originally forecast to decline 1.2 percent in FY 1998. Growth in total tax revenues is now forecast to be 4.7 percent. Moreover, collections continue to surge, especially for the personal income tax. Driven by strong Wall Street bonuses, solid underlying wage gains, increased capital gains realizations, and large April 15 year-end payments, the personal income tax has grown by 17.1 percent through May. Overall, total tax revenues have grown by 5.6 percent in the first three quarters of the year. Based on this performance, we estimate that tax revenue collections will exceed even the City's current estimates by $215 million. This additional revenue will come from the business and personal income taxes.

B. Board of Education

The Board of Education projects a surplus of $196 million, the third consecutive year of budget surpluses. Annually since FY 1996, the City has agreed to return surpluses to the Board for use in the following fiscal year. This has diminished incentives for the community school districts to spend excess funding, sometimes unwisely, rather than returning the resources to the City. Last year, the Board realized a surplus of $226 million and in FY 1996, a surplus of $159 million.

The FY 1998 surplus also results from lower-than-projected enrollment growth. Enrollment grew by 7,360 students, less than half the level anticipated. Board officials attribute the lower growth to changing migration patterns, an increase in the number of students enrolled in private schools, and an improved auditing process that has eliminated nonattending students from the enrollment registers.

In total, the Board will have spent about $9.7 billion (including pension and debt service costs) in FY 1998 (see Graph 3). This exceeds last year's level by $910 million, or 10.3 percent, and is the result of additional City ($565 million), State ($285 million), and Federal funding ($60 million). The additional assistance represents the Board's largest one-year growth in funding, in percentage terms, since FY 1984.

With the additional aid, the Board closed a $121 million budget gap; funded enrollment growth-related needs; relieved some teachers from administrative responsibilities pursuant to the teachers' contract; hired additional teachers to relieve classroom overcrowding; began to restore art courses to the curriculum; and implemented instructional enhancements, such as Project Read. In addition, for the second consecutive year, the Board's central budget office is utilizing a differentiated approach for overseeing the community school districts based upon criteria that includes financial and student performance. The result is additional central office staff time for districts in need of extra help in managing their resources.

C. State Budget

The FY 1998 Adopted Budget assumed $422 million in State gap-closing assistance, including $294 million in direct assistance and $128 million in social service entitlement program savings. A major portion of the increased State aid -- $283 million -- was not forthcoming primarily because the State did not enact the City's proposals to accelerate revenue sharing funds ($148 million); increase the State reimbursement rate for preschool students with special needs ($43 million); or increase the payment for the stock transfer tax ($25 million). In addition, the value of various Medicaid cost containment actions enacted by the State was less than assumed in the Plan ($39 million).

The City did receive $139 million in gap-closing assistance from the State, half of which came from the surplus in the Federal welfare block grant. The other half largely reflected an increase in revenue-sharing funds and resources from a Medicaid rate appeal. In addition, the Board of Education received a $175 million increase in unrestricted aid.

D. Agency Spending

Agency spending rose during the year and exceeded the City's initial estimates by $116 million. As shown in Table 4 and discussed below, several factors contributed to the net increase in City spending.

During the fiscal year, the City identified new spending needs of $292 million. These needs included $138 million for unplanned spending in the uniformed agencies, that mainly resulted from higher-than-planned overtime costs, lower-than-planned attrition, and an increase in the City's share for funding emergency medical services. The City also was required to add $72 million to its operating budget to help fund the cost of closing the Fresh Kills landfill by January 1, 2002. The $72 million cost had previously been recognized in the capital budget, but the City Comptroller ruled that the City could not capitalize costs related to this liability. In addition, the City added $68 million to expand its drug elimination program, which included the accelerated hiring of 1,100 police officers.

Table 4

Changes in Agency Spending Since the Budget Was Adopted

(millions)

Data Source: O.S.D.C. analysis.

The budgetary impact of these unplanned agency costs was partly offset by the implementation of several management initiatives identified by City agencies. These initiatives are expected to generate $176 million in resources and include revenue enhancements, overtime cost-reduction initiatives, funding shifts, and reductions in the public assistance caseload. In total, the public assistance caseload will have declined by a total of 103,000 persons during FY 1998, bringing the caseload to its lowest level in 30 years.

We also note that FY 1998 spending is projected to exceed the target contained in an agreement between the City and the Municipal Assistance Corporation (MAC) by $60 million, excluding the general reserve. The City had agreed to keep discretionary spending below a certain level in exchange for $125 million in surplus MAC resources that were used to help balance the FY 1996 budget. Discussions are continuing between the City and MAC officials on ways to resolve this issue.

III. Fiscal Year 1999

The Executive Budget for FY 1999 is balanced based on the following major assumptions:

• $1.5 billion from the FY 1998 surplus.
• Resources of $595 million from successfully implementing the FY 1999 gap-closing program. The program includes savings from imposing a freeze on health insurance premiums and a further decline in the public assistance caseload.
• Implementation of the Mayor's proposed tax-reduction program that would reduce revenues by $237 million in FY 1999 and about $660 million by FY 2001.
• Extension of the 12.5 percent personal income tax surcharge that is scheduled to expire on December 31, 1998. Revenues would decline by $201 million in FY 1999 and more than $550 million annually thereafter if the surcharge is not extended in its current form.
• Tax revenue growth of $80 million, or 0.4 percent, over the FY 1998 level.
• Expenditure growth of $1.4 billion, or 6.2 percent, largely reflecting higher labor costs and new education initiatives. The size of the municipal work force would remain stable, but the City would continue to reallocate personnel resources to criminal justice agencies.

Our review finds that there is likely to be a very substantial surplus in FY 1999. Revenues could exceed the Plan estimate by $235 million and, as previously discussed, there could be $215 million in additional FY 1998 resources for use in FY 1999. In addition, the Plan includes reserves of $616 million: a $200 million general reserve and $416 million set aside in the FY 1999 Budget Stabilization Account. Our review also disclosed several issues that pose a net risk of $201 million, including a cut in funding to cover wage increases for employees of certain covered organizations ($104 million), the receipt of additional Federal assistance ($75 million), and a freeze in health insurance rates ($58 million).

A. Revenue Estimates

Total revenues, assuming implementation of the Mayor's proposed tax reduction program, would decline to $34.1 billion in FY 1999, 3.9 percent less than the level projected for FY 1998. Lower Federal and State categorical aid contributes to this revenue decline.

City-fund revenues, that portion of revenues that is either locally generated or consists of unrestricted Federal and State aid, is forecast to decline by 2.7 percent to $23.1 billion (see Graph 4). The decline is due to stagnant tax revenues and lower miscellaneous revenues. Even if the tax reduction program is not enacted as proposed, City-fund revenues would still decline, but only by 1.7 percent. The tax revenue forecast reflects the City's cautious outlook for the local economy in FY 1999.

The City forecasts that economic growth will moderate in calendar year 1998, due to a softening in the national economy and a less robust Wall Street, after the City posted its strongest performance in more than a decade in 1997. Real Gross Domestic Product (GDP) is projected to grow 2.8 percent in 1998, down from 3.8 percent in 1997. New York City employment growth is forecast to ease slightly, while growth in personal income is expected to subside from 6.3 percent in 1997 to 5.7 percent in 1998, due to slowing wage growth. The Plan projects that Wall Street profits would drop from $12.2 billion in 1997 to $8 billion in 1998, as growth in U.S. corporate profits slows. However, the City expects continued strengthening in the real estate market.

The City's scenario of slower growth in 1998 and subsequent years appears reasonable at this time, especially in the context of weak first quarter corporate profits growth and a rising trade deficit with Asia⁽³⁾. In addition, the Federal Reserve Open Market Committee is concerned that if national growth does not slow, inflation may rise. As a result, it has reportedly shifted its bias toward raising short-term interest rates. Because the City's fiscal health remains tied to Wall Street's fortunes, an interest rate increase or further reverberations from the East Asian economic crisis represent a risk to the outlook.

Given the City's current economic forecast, tax revenues are projected to reach $20.3 billion, an increase of 0.4 percent from expected FY 1998 levels.⁽⁴⁾ This small increase reflects growth in property taxes, offset by a small decline in nonproperty tax collections. This would be the first decline in nonproperty tax revenues since 1995, and follows annual average growth of approximately 8 percent for the last three years. Should the tax program be enacted as proposed, total taxes would instead decline by almost 1 percent from FY 1998 levels.

Our review finds that tax revenue collections could exceed the City's forecast by $235 million. However, the receipt of additional Federal assistance ($75 million) may not materialize. In addition, the Mayor and the City Council are negotiating competing tax reduction proposals which are essentially equivalent in value (see "Tax Reduction Program" later in this chapter).

1. Real Property Tax

Real property tax revenues are forecast to be $7.4 billion in FY 1999, an increase of $93 million or 1.3 percent from FY 1998. The increase largely reflects the expected increase in the tax levy of $212 million based on higher billable assessed values of 2.7 percent as contained in the tentative tax roll released in January. The final tax roll will be released at the end of May. Partially offsetting the increase in revenues from the higher billable assessments are increases in both the City and State tax reduction programs. The additional reduction in real property taxes for condominium and cooperative apartments will reduce revenues by $65 million in FY 1999. Additionally, the State's School Tax Reform (STAR) program is expected to lower real property tax revenues by some $43 million, a revenue loss that will be offset by an increase in State education aid.

2. Nonproperty Taxes

The nonproperty taxes, those levied on consumption, incomes and businesses, are projected to total $12.9 billion, a decline of 0.4 percent, in FY 1999. Moderating growth in personal income tax collections, along with sharp declines in the business taxes, account for the overall slowing in nonproperty tax revenues (see Graph 5).

Personal income tax collections are forecast to increase by 1.4 percent to $5 billion in FY 1999, following double-digit average growth over the last three years. The personal income tax forecast assumes the extension of the 12.5 percent surcharge scheduled to expire on December 31, 1998. The Mayor and the City Council are negotiating its extension and the Mayor's proposed tax reduction program.

The business taxes -- general corporation, banking corporation, and unincorporated business -- are together forecast to total $2.8 billion in FY 1999 (including audits), a decline of 9 percent from FY 1998 levels, with the largest decline attributable to the banking corporation tax. Besides the City's assumptions for lower Wall Street and corporate profits, factors contributing to the forecast decline include reductions in audit collections and the City's anticipation of increased credits to corporations that overpaid taxes in prior years.

Sales tax collections are projected to total $3.2 billion in FY 1999, an increase of 4.6 percent over the prior year. Expected growth in tourism may help offset some downward pressures on spending resulting from moderating wage growth. The real property transfer and mortgage recording taxes are expected to yield $555 million, an increase of 9 percent from FY 1998 levels. These taxes will benefit from increased residential and commercial activity in the local real estate market.

3. Miscellaneous Revenues

Miscellaneous revenues, net of water and sewer revenues which are offset by expenditures, are forecast by the City to be $2.6 billion, or $365 million less than the FY 1998 forecast. The decline reflects the absence of one-shot resources expected in FY 1998 from the sale of the New York Coliseum ($200 million) and other assets including the United Nations Plaza Hotel ($132 million), lower interest earnings from investments on overnight cash balances ($45 million) and lower rental income from the Port Authority of New York and New Jersey (PA) for the two City airports ($20 million). Partially offsetting these reductions are additional revenues from settlements of litigation ($50 million) and FICA overpayments ($16 million). The FY 1999 forecast is also $282 million less than forecast in January. This reduction is due primarily to the City deferring until future years $350 million expected from the settlement of its dispute with the PA related to airport rents.

4. Intergovernmental Aid

The Plan anticipates the receipt of $100 million of unrestricted intergovernmental aid. The Plan assumption of $25 million in additional State aid appears reasonable, but the receipt of $75 million in Federal aid may not materialize. The City has suggested that the Federal aid could be provided by diverting a portion of the President's proposed Economic Development Initiative for use as unrestricted urban aid and by increasing the Federal Medicaid reimbursement rate from 50 percent to 51 percent. However, these proposals require approval by both the President and Congress, which may not be forthcoming.⁽⁵⁾

5. Review Adjustments

Based upon our review, we expect tax revenue collections to exceed the City's expectations by $235 million, primarily in the business and personal income taxes. Although we agree with the City that a slowdown on Wall Street and in the rest of the local economy is possible this year, we believe that the strength generated in FY 1998 will carry over into the start of FY 1999, helping to boost business tax collections by $115 million. In addition, the City's personal income tax estimates do not appear to accurately reflect the wage growth they have forecast, and it appears that estimated and final payments have yet to catch up with the recent growth in capital gains realizations. Thus we forecast that personal income tax revenues are likely to be $145 million greater than the City expects. Finally, commercial rent tax collections are likely to be lower by $25 million, because we continue to believe that the City's recent tax reductions in this area are having a greater impact than originally projected. Even with the additional revenue we anticipate, we are forecasting tax revenue growth of only 0.5 percent in FY 1999.

B. Expenditure Estimates

Expenditures, including those reimbursed by the Federal and State governments, are projected to total $34.1 billion in FY 1999. The Plan shows that the portion of the budget funded with locally generated resources and unrestricted Federal and State aid (i.e., City funds) is projected to total $23.3 billion. This would suggest a 3 percent reduction in City-funded spending compared with the prior year's level.

However, projected spending would grow by $1.4 billion, or 6.2 percent, after adjusting for surplus transfers (see Graph 6). Under applicable accounting rules, the City cannot count the surplus as a revenue source. While it can receive the same benefit by prepaying certain expenses, this distorts expenditure patterns.

As shown in Table 5, City-funded spending would rise by more than $1 billion, or 4.4 percent, even excluding the general reserve and taking into account the potential for savings from overestimating prior years' expenses. Such a rate of growth would be nearly double the projected local inflation rate. The growth is driven by costs associated with new labor agreements and higher spending for mayoral agencies, education, and medical insurance for City employees and the indigent. These costs are partly offset by lower pension costs and savings expected from initiatives that comprise the FY 1999 gap-closing program, such as a freeze in health insurance premiums.

Table 5

Major Factors Contributing to the Growth

in Fiscal Year 1999 Spending

(millions)

Data Source: N.Y.C. Office of Management and Budget.

The FY 1999 gap-closing program has a total value of $595 million, of which $461 million would come from cost-reduction initiatives. Most of the savings would result from shifting funding responsibility to other levels of government, reducing overtime costs, freezing health insurance rates, and requiring agencies to self-fund managerial pay raises. There are also some modest program reductions, such as a cutback in funding for cultural institutions and libraries ($28 million), and the elimination of the City's subsidy to the Staten Island Rapid Transit Operating Authority ($11 million). Excluding the proposed freeze in health insurance rates, the recurring value of the gap-closing program would decline to $350 million by FY 2001. This is due largely to the City's reliance on actions that would produce one-time savings of $174 million in FY 1999, or 30 percent of the program's total value in that year.

As shown in Graph 7, nearly 60 percent of the City-fund budget is allocated to health and social services, education, and criminal justice. Debt service accounts for another 14 percent, while the remaining 28 percent is devoted to basic municipal services, such as fire fighting, environmental protection, refuse collection, and to fund administrative agencies and the offices of the City's elected officials.

Our review has identified two issues that together pose a risk of $162 million. The City has eliminated funding for the cost of labor agreements that it negotiated on behalf of its covered organizations. This initiative was first proposed in FY 1997, but was rescinded for fiscal years 1997 and 1998. In addition, the City has unilaterally decided not to fund increases in health insurance premiums for municipal employees.

1. Personnel Costs

City-funded personal service costs are projected to grow by 5.4 percent, or $641 million, to $12.5 billion. The increase stems largely from the cost of new labor agreements. The costs of new education initiatives and expanding the City's drug elimination program were offset by anticipated savings from certain cost reduction initiatives and lower pension costs.

Labor Costs

New labor agreements have now been reached with most of the municipal unions, but the agreements begin to expire in FY 2000. The Plan assumes that those employees who have not yet reached agreement with the City will accept wage increases patterned after those contained in agreements reached with District Council 37 and the United Federation of Teachers; those agreements include a two-year wage freeze at the start of the contract, then wage and fringe benefit increases totaling 13 percent over the next three years. It also assumes that wages for most employees will rise by between 4 percent and 7.75 percent during FY 1999 at a cost of about $600 million. In addition, the City has negotiated agreements with fire fighters and sanitation workers that would reward them for taking on additional responsibilities or increasing productivity, and the Mayor has announced that certain police officers will be awarded performance-based payments.

The City no longer intends to fund the cost of labor agreements it negotiates on behalf of certain covered organizations, such as the Health and Hospitals Corporation (HHC). This initiative is expected to save $104 million in FY 1999 and about $225 million annually thereafter. About 85 percent of the savings is attributable to HHC, which is experiencing financial difficulties. When this initiative was first proposed in November 1996, the City had planned to stop funding beginning in FY 1997. The City rescinded this initiative for fiscal years 1997 and 1998 in response to union opposition, but plans to implement it in FY 1999. We believe these savings are at risk because the unions continue to oppose this initiative and HHC's challenging financial situation could require an infusion of City resources.

Staffing Levels

After increasing by about 6,750 employees during FY 1998, City-funded staffing levels are projected to remain stable during FY 1999 at about 207,000 employees (see Graph 8). However, the City will continue its efforts to reallocate personnel resources among agencies. Since FY 1990, the police force and the number of teachers have grown by 13,500 employees, while 33,000 positions were eliminated in other agencies. As a result, teachers and police officers are expected to comprise 54 percent of the work force by June 1999, compared with 43 percent in June 1990.

In addition, about 38,000 public assistance recipients are working an average of about 25 hours per week in City agencies and in not-for-profit organizations as a condition of receiving welfare benefits under the Work Experience Program (WEP). More than 40 percent of the WEP participants are assigned to the Parks and Sanitation Departments, agencies that experienced large reductions in staffing levels since FY 1990. However, in response to threatened layoffs at HHC, the union representing municipal hospital workers recently sued claiming that WEP participants were displacing union employees in violation of State law, and raised other issues concerning this program. In response, the City has removed about 900 WEP participants assigned to HHC and has agreed to support early retirement legislation and help reassign laid-off hospital workers.

Fringe Benefits

City-funded fringe benefit expenses are projected to grow by $80 million in FY 1999 to nearly $2.9 billion. Costs associated with new wage agreements account for over half the increase, and most of the balance reflects a small increase in the number of retirees and a 10 percent increase in Medicare supplemental insurance premiums that the City traditionally pays on behalf of retirees.

Under agreements between the City and its unions, premiums paid to the Health Insurance Plan of Greater New York (HIP) determine the City's cost for all municipal health insurance providers. Insurance premiums have been frozen for the last three years under an agreement between the City, municipal unions and HIP, but between fiscal years 1989 and 1995 premiums grew at an average annual rate of 12 percent.

The New York State Insurance Department is no longer required to review and approve health insurance rate increases up to 10 percent. In compliance with the new law, HIP notified the Department in November 1997 that it intended to increase premiums by 5 percent effective July 1, 1998.

Although the City has not provided any legal basis to withhold payment, it has notified HIP that it is challenging the rate increase and has eliminated funding for the increase from the Plan. The City contends that HIP has not justified the rate increase, but has met with HIP officials to examine the rate increase more closely. Should the City be required to restore funding to the Plan, health insurance costs would rise by another $58 million in FY 1999.

Pension Contributions

City-funded pension contributions are expected to decline by $70 million to $1.3 billion in FY 1999, reflecting the impact of extraordinary investment earnings during fiscal years 1996 and 1997. During those years, pension fund investment earnings averaged nearly 20 percent annually, more than twice the assumed rate of return of 8.75 percent. The savings that resulted from the unexpected earnings were large enough to fund the pension costs associated with wage increases granted to municipal employees under new labor agreements.

After rising during the 1980s and peaking in FY 1988, total-fund pension costs (including Federal and State funding) have declined and remained stable at about $1.4 billion (see Graph 9). There also has been a dramatic reduction when measured as a percentage of salary and wage costs, declining from 33 percent in FY 1982 to 11 percent in FY 1999. The reasons for the decline include extraordinary investment earnings that have averaged more than 12 percent over the past decade; less generous pension benefits for new employees hired after June 30, 1973; and a 5 percent reduction in staffing levels since FY 1990.

Pension costs could be less than shown in the Plan because investment earnings have exceeded 18 percent during the last nine months, more than twice the assumed rate of return. Even without further gains during the final three months of the fiscal year, pension costs would be lower than those shown in the Plan by about $50 million in FY 1999, rising to about $250 million in FY 2002 as the gains are phased in.

While the potential for significant savings exists, there may also be offsetting liabilities. An actuarial consulting firm has been hired to conduct a biennial review of the assumptions and methodologies used to compute City pension contributions as required under the City Charter. A report expected by the end of the calender year could recommend changes in the investment earnings assumption or other assumptions that would affect pension costs.⁽⁶⁾

In addition, current labor agreements begin to expire in FY 2000 and the Plan does not provide for new wage increases or the associated pension costs. Also, the State is likely to enact legislation that will supplement the benefits of State retirees to help offset the impact of inflation. In the past, such legislation has been extended to include City employees. Three years ago, the State enacted a one-time adjustment in pension benefits that increased City pension costs by about $100 million annually. The State Comptroller has proposed a comprehensive package of pension improvements for State employees, including automatic annual cost of living adjustments for retirees that would be funded by extraordinary pension fund investment earnings.

2. Board of Education

The Plan allocates $10.2 billion to the Board of Education (including resources for pension and debt service costs), which is $491 million more than projected for FY 1998. The Board's allocation will increase once FY 1999 State aid increases are fully recognized. State and Federal education aid has increased faster than the City's budget as a whole, and, as a result, the Board's share of the City's budget will grow to more than 30 percent. This could restrict the City's flexibility to balance future budgets because State law requires the City to allocate to the Board a share of the City's total budget that is no less than the average of the prior three years.

Under the Adopted State Budget, the Board will realize an additional $158 million in unrestricted aid, which is more than adequate to close the $132 million budget gap being projected by the Board. The remaining resources may be allocated to fund proposed instructional initiatives or to help offset the impact of a gubernatorial veto of a $63 million State program that had supplemented teachers' salaries. Alternatively, the Board could reduce teachers' salaries or the City could provide additional funding.

The Governor also vetoed a legislative initiative to allocate $500 million over the next four years for capital needs, of which the Board was to receive $200 million. This initiative was considered critical because last November voters rejected a $2.4 billion school facilities bond act, and the State Legislature has not approved funding for year-round schools. Board officials believe that year-round schooling would go a long way toward relieving school overcrowding and enhancing instructional services. Increased school utilization also would enable the Board to allocate more of its capital resources for restoring the public schools to a state of good repair. However, these issues remain unresolved. Meanwhile, the Board is expected to release in March 1999 its 2000-2004 capital plan, which is expected to identify its capital needs and funding requirements.

3. Public Assistance

The Plan assumes that the Public Assistance caseload will decline by 58,000 persons between May 1998 and June 1999. Such a reduction would bring the caseload down to 718,000, 443,000 fewer than the peak in March 1995. Similarly, City-funded spending for this program is projected to decline by 14 percent to $431 million. This would be less than half the amount spent in FY 1994 (see Graph 10) and the lowest level in 16 years.

We are concerned that the Plan may not reflect the full programmatic and financial impact of implementing Federal welfare reform and other changes in the State public assistance program. For example, we estimate that an additional 52,000 adults, mostly women with children, will be required to work or be engaged in work-related activities by the end of FY 1999 to comply with Federal work requirements. The new Commissioner for Social Services intends to intensify efforts to find employment for welfare recipients in the private sector by converting existing income maintenance centers to employment centers. However, it is unlikely that the private sector can meet the demand. As a result, the City may have to expand WEP to avoid Federal sanctions. In addition, the Plan makes no assumption concerning welfare recipients who will have met the five-year life-time cap on Federal welfare benefits.

4. Services to Children

The Administration for Children's Services expects to spend nearly $2 billion in FY 1999 on child care, early childhood education, and the care of abused and neglected children, virtually the same amount as projected for FY 1998. The City estimates that these resources, combined with $100 million in the Human Resources Administration, would enable it to provide child care services to 80,000 children during FY 1999. While the State budget will provide the City with $70 million in surplus Federal welfare block grant resources, which is intended to help fund the costs of implementing Federal welfare reform, most of these resources will be needed to offset reductions in Federal and State funding.

As discussed in a separate report⁽⁷⁾, the demand for child care slots could nearly double as parents are required to make the transition from welfare to work. We currently estimate that as many of 60,000 additional children will require services by December 1998. Providing services to these children could cost between $90 million and $140 million in FY 1999 as slots are phased in during the year. Another $208 million would be needed to provide services to all 31,000 children already waiting for services. We note that the Governor vetoed a State Legislative initiative that would have provided the City with $30 million in additional child care resources.

5. Medicaid

City-funded Medicaid expenditures are projected to total $2.8 billion, only $55 million, or 2 percent, more than the prior year's level (see Graph 11). The low rate of growth reflects declining Public Assistance caseloads, a relatively low inflation rate for medical services, and an emphasis on outpatient services rather than costly inpatient and emergency room services. Unlike previous years, neither the State nor the City has proposed any new Medicaid cost containment actions. The Plan does anticipate $9 million in savings from enrolling Medicaid recipients in mandated managed care programs.

6. Debt Service

Debt service costs, after adjusting for the transfer of surplus funds, would total $3.4 billion, only 1 percent greater than the FY 1998 level. Such costs, which include those of the Transitional Finance Authority, would grow only slightly because of actual and planned City bond refundings, and lower MAC funding needs. Since the Adopted Budget, debt service costs have declined by $433 million due mainly to savings from City bond refundings ($233 million), reduced MAC funding requirements ($82 million), a reduction in seasonal financing needs from $2.4 billion to $850 million ($53 million), and lower than forecast bond issuances to finance the capital program ($46 million).

C. Tax Reduction Program

The Plan reflects the Mayor's proposals to reduce taxes by $237 million in FY 1999. While the Plan assumes the extension of the 12.5 percent personal income tax surcharge ($201 million) that is scheduled to expire on December 31, 1998, the City Council Speaker has proposed permitting it to expire.

The value of the Mayor's proposals would rise to $666 million by FY 2002. Added to the cuts enacted since FY 1995, the proposed reductions would push the FY 2002 value of the total tax program to almost $1.5 billion from $1.1 billion in FY 1999 (see Table 6). While the size of the tax program has been reduced somewhat since January, it remains a significant contributor to the out-year budget gaps.

STAR Personal Income Tax Credit Acceleration

The largest of the new tax reductions affecting FY 1999 revenues proposed by the Mayor would accelerate the personal income tax (PIT) credit established as part of the Governor's STAR program. For New York City residents, the STAR program provides both property and personal income tax relief.⁽⁸⁾ Under current law, the personal income tax credit is scheduled to be phased in and fully implemented by FY 2002. The Mayor's proposal would have the City make up the difference between the phased-in and the ultimate value of the refundable tax credit until the full credit ($125 for married couples and $62.50 for others) is in effect. If approved by the City Council and the State, City revenues would decline by $153 million in FY 1999, an amount that would be phased out by FY 2002.

PIT Credit for Resident Sub-chapter S Shareholders

Unlike the Federal government, the City levies corporate income tax on the net earnings of Sub-chapter S corporations, which are generally small, closely held companies. Shareholders are then subject to tax on their proportionate share of corporate earnings when they file their City personal income tax. The Executive Budget proposal would address the problem of double taxation by allowing resident shareholders to apply a credit to personal income tax of between 15 and 65 percent of their Sub-chapter S tax liability. This proposal, which is similar to tax relief for the City's unincorporated businesses enacted last year, is valued at $34 million in FY 1999, and $39 million by FY 2002.

Table 6

Proposed and Enacted Tax Reduction Program

(millions)

Data Source: N.Y.C. Office of Management and Budget.

PIT Dependent Care Credit

The Mayor has also proposed a refundable personal income tax credit for dependent and child care expenses. This credit is pegged to 50 percent of the State credit, which is in turn based on a sliding percentage of the Federal credit. The City estimates that 194,000 households will benefit from the credit, at a cost to the City of $27 million in FY 1999, growing to $31 million in FY 2002.

As discussed in our last Financial Plan report (Report 5-98, issued February 26, 1998), the proposed credit would improve the progressivity of the tax code, providing benefits up to $720 on top of the State and Federal credit for a low-income family with two children. However, many low-income families are unable to afford child-care arrangements that are eligible for the credit, which include formal day-care, preschool, and "on-the-books" babysitting. Instead, many families opt for "informal" care, paying relatives, neighbors, or babysitters off the books to care for their children.

A recent report by the New York City Independent Budget Office points out that the erosion of the City's household credit by inflation, combined with the Earned Income Tax Credits at the State and Federal level, has contributed to a situation in which nearly 100,000 low-income New York City taxpayers owe over $10 million in City tax, but no State or Federal tax.⁽⁹⁾ Because proportionately few low-income households could take advantage of the dependent care credit, this proposal contributes only partially to addressing this disparity. A City Earned Income Tax Credit (EITC) would help to bring the City tax code into conformity with State and Federal policy. The City Council has proposed an EITC that would benefit low-income working families.

State Authorized Clothing/Footwear Sales Tax Exemption

The State has authorized two one-week exemptions from sales tax for clothing and footwear purchases costing under $500, which will cost the City $20 million in FY 1999. The State has also authorized a permanent exemption from the sales tax on clothing items costing less than $110, valued at $135 million in FY 2000. Localities have the option of matching these State reductions, and City Council approval is expected. In addition, the Mayor has proposed a sales tax exemption for school uniforms, which would be in effect until the permanent clothing sales tax exemption is fully effective in the middle of FY 2000.

Tax Reduction Proposals Beginning in FY 2000

The Mayor has also proposed reductions in three taxes that would not affect revenues until FY 2000: a three-year extension of the cooperative and condominium property tax relief program; extension of the sales tax exemption to items of clothing and footwear costing more than $110; and an increase in the commercial rent tax base rent exemption. Together, the three proposals would reduce City tax collections by $231 million in FY 2000, rising to $352 million in FY 2002. These elements, along with the Mayor's proposal to accelerate the STAR personal income tax credit, may change in the budget adoption process as the City Council and the Mayor also consider the Council's personal income tax proposals, including one to let lapse the 12.5 percent personal income tax surcharge.

IV. Projected Budget Gaps

Despite a balanced budget for FY 1999, the Plan shows a $1.5 billion budget gap for FY 2000. The gap largely reflects costs associated with current labor agreements ($750 million) and the absence of resources used to balance the FY 1999 budget that the City does not expect to recur (i.e., a large budget surplus).

The FY 2000 gap would have been nearly $800 million larger if not for one-time resources planned for use in that year. These one-time resources include the portion of the FY 1998 surplus ($416 million) allocated to narrow the FY 2000 gap and the anticipated receipt of retroactive airport lease payments ($350 million) from the Port Authority of New York and New Jersey. FY 2000 also benefits by a $437 million rise in real property tax collections, reflecting the improvement in property values. Between fiscal years 1996 and 2000, property tax collections are expected to increase by more than $700 million, or 10 percent.

Although property tax collections are expected to rise by about 5 percent in FY 2001, the Plan shows the gap for that year growing by $600 million. The larger gap reflects growth in debt service costs. We calculate that the debt burden would reach 18.4 percent of tax and offsetting revenues by FY 2001 compared with 16.6 percent in FY 1997.⁽¹⁰⁾

The Plan shows the budget gap declining to $1.6 billion in FY 2002, reflecting continued growth in real property and other tax collections, and the full benefit of extraordinary FY 1997 pension fund investment earnings. The pension funds earned 21.8 percent in FY 1997, more than twice the assumed rate of return, and, as a result, City pension costs could be reduced by $380 million by FY 2002 when the benefits are fully phased in.

Our review has identified a number of issues that could affect the City's gap estimates for fiscal years 2000 through 2002.

The Plan assumes that the 12.5 percent personal income tax surcharge scheduled to expire on December 31, 1998 is extended. In its current form, the surcharge is expected to generate about $550 million annually during fiscal years 2000 through 2002. At the same time, the Plan assumes implementation of the Mayor's proposed tax reduction program, which would reduce revenues by $537 million in FY 2000 and $666 million by FY 2002. The Mayor has also proposed using a portion of commercial rent tax collections for "pay-as-you-go" funding to construct sports facilities, such as a new stadium for the Yankees.

In addition, the Plan makes no provision to continue beyond FY 1999 $125 million in funding for Project Read, a remedial education initiative, or to provide wage increases after the expiration of current labor contracts. Wage increases at the projected inflation rate would increase City costs by $380 million in FY 2001 and $830 million in FY 2002.

V. Other Concerns

A. Sports Facility Corporation

The Executive Budget includes a proposal to establish a New York City Sports Facilities Corporation, which would provide pay-as-you-go capital to help finance the construction of new stadia for the Yankees and the Mets, with the possibility of providing funds for other sports facilities as well. The money to fund the Corporation would come from the difference in the revenues the City would receive from only scaling down but not eliminating the commercial rent tax, as it proposed in January.

City officials believe that the construction of a new baseball stadium on Manhattan's West Side could generate more than $1 billion per year in economic activity and more than $40 million in additional tax revenues compared with the current Yankee Stadium. However, most of this economic benefit is linked to the City's view of the potential for "ancillary development" of commercial space in the area. This development is not dependent on the stadium, and would require several hundred million dollars in non-stadium infrastructure and transportation improvements. The City does not intend to finance these improvements with proceeds from the change in the commercial rent tax and has not identified another source of funding.

The City is currently unable to provide details regarding the structure of the proposed Corporation. Given that the City has competing infrastructure needs and faces constraints on expansion of its capital program, it might consider using these resources to finance a more general pay-as-you-go infrastructure program.

B. Transitional Finance Authority

The City has removed the revenue stream and debt service attributable to the New York City Transitional Finance Authority (TFA) from the projection of City revenues and expenditures in its Financial Plan. Instead, the City has provided that information in a separate submission for the TFA as a covered organization. The City maintains that this presentation properly reflects the legal structure of the TFA (i.e., it is separate from the City with respect to various legal considerations and for bond rating purposes) and, since both TFA debt service and related personal income tax revenues have been removed, the City's budget is unaffected. In our opinion, this approach does not present a full picture of the City's finances. Inclusion of the TFA in the City's budget results in a better portrayal of trends in City revenues and expenditures.

For budgetary purposes, TFA debt is simply an extension of the City's authority to issue general obligation (GO) bonds. Similar to GO debt, TFA debt is backed by City tax revenues that flow to the City as operating budget revenues only after providing for payment of TFA debt service. As a result, factors affecting TFA debt service costs (e.g., higher interest rates) directly influence the level of resources available to the City to support its operating needs. By contrast, for example, debt issued by the Municipal Water Authority is secured by water and sewer charges levied by the Water Board on the system's users. Those fees are adjusted as required to fund the debt service costs (and other needs) of the system with no impact on the City's budget.

H. Carl McCall

State Comptroller

Office of the State Deputy Comptroller for New York City

Kathleen Grimm

Assistant Deputy Comptroller

Bureau of Agency Analysis

Ken Bleiwas, Director

Mark Chernoff

Linda Goodman

John Griffith

Lawrence Kirschner

Manfred Pastrano

Adrian Techeira

Mark Waldman

Craig Weinstein

Bureau of Fiscal and Economic Analysis

James Parrott, Director

Marcia Van Wagner, Asst. Director

Michael Brisson

Diane Diamond

Michael Gibbons

Peter Hatch

Michelle Holder

Robert Horowitz

Bob Kepple

Maureen Ryan

Sandy Stevenson

Other Contributors

Yves Denize, Counsel

Lava Thimmayya, Director

Office Support

Gail Bessoir

JoAnne Corsi

Francine Cox

Terry Reed

Merlene Richardson

Ann M. Shea

Jesse Simmons

Endnotes

1. The Plan also includes a $200 million general reserve and $416 million that has been set aside in the FY 1999 Budget Stabilization Account to narrow the FY 2000 budget gap.

2. This estimate reflects certain technical adjustments. For example, it excludes sales and State School Tax Reform tax cuts that were included in the Adopted Budget but were not enacted.

3. See our Report TM-1-99, "The East Asia Economic Crisis: A Background Report on the Implications for New York City," issued April 27, 1998.

4. These estimates take into account the State School Tax Reform program and exclude the proposed tax reduction program.

5. The Adopted State Budget also would increase education aid to the City, but this aid will be needed by the Board of Education to balance its FY 1999 budget.

6. The State law which sets the actuarial assumed rate of return on pension fund investments is scheduled to expire on June 30, 2000.

7. See our Report 4-98, "Child Care Services in New York City," issued December 18, 1997.

8. STAR is budget neutral, because the loss in City tax revenues is offset by increased State aid.

9. New York City Independent Budget Office, "New York City's Tax on the Working Poor," March 1998.

10. Offsetting revenues includes water and sewer fees, payments from the Health and Hospitals Corporation, and State education building aid.