Broken System: Can Illinois’ Antiquated Means Of Generating Revenue Be Overhauled?

Dec 1, 2014

This story first appeared in the March 2014 issue.

Taxes suck.

That, it seems, is the only truism. Nobody wants to render unto Caesar. But, at least in Illinois, Caesar needs to get re-elected, and so stuff can get complicated.

Politics aside, complexity and diametrically opposed experts aren’t unusual when it comes to matters of money. Check out the most recent Nobel laureates in economics. One was Eugene Fama, a University of Chicago professor who says that financial markets take into account every morsel of data and therefore are thoroughly efficient; another was Robert Shiller, a Yale professor who argues the opposite: Markets can be swung by irrational exuberance.

Go figure.

Read enough about taxes — and there are plenty of reports and analyses issued by various groups that insist that they are not interest groups — and you’ll soon conclude that there are no got-it-nailed experts. For every Ph.D. or M.S. or B.S. or SOB who says that a tax on widgets would fix everything, there is another with equally impressive lettering who says such would be a recipe for disaster.

If we can suspend debates about spending — call that an argument for another day — taxes are, boiled down, a matter of math: The state needs something on the order of $35 billion a year to stay afloat. What’s the best way to get it? “Best,” of course, is in the beholder’s eye, but a few basics prevail. Taxes should be as low, broad-based and as stable as possible. Fair would be a big plus. These rubrics remain regardless of political persuasion.

How to do it? Close your eyes. Pretend that there are no politicians or lobbyists or constitutional restraints. Let’s develop, from scratch, a new tax system. If spending can be cut, so much the better — our dream system would not preclude all taxes being cut proportionately if programs are cut. And we can hardly invent a worse tax system than the current one.

It is tempting to compare tax policy in Illinois with health care. Given a chance to develop a system from scratch, free from tradition, political considerations and the din of special interests, no one would invent a way to collect revenue — or deliver health care — that resembles the way that it is done now. That much is obvious if only from complaints that fly from both right and left about inequities and inefficiencies built into a tax system that has proven both difficult to reform and difficult to live with.

Conservatives say taxes are too high and warn that proposals to replace the state’s flat income tax with a graduated tax would hurt the state’s business climate. Liberals say that the tax burden now is disproportionately borne by the poor and that most taxpayers would realize tax savings while the state collected more under a graduated tax.

Illinois gets low grades from the Institute on Taxation and Economic Policy, a 34-year-old Washington, D.C.-based think tank generally acknowledged as nonpartisan. In a report published last year, the institute determined that Illinois had the nation’s fourth-most-regressive tax system, thanks to reliance on use and sales taxes, property taxes and a flat income tax.

In many respects, Illinois is an outlier, alone in the institute’s analysis as the only state in the seven most-regressive states that has an income tax, a method acknowledged as having the most potential to be the least regressive way for government to extract money from the body politic. Illinois stands apart in other ways, with comparatively high property, sales and use taxes. Add it all up and, according to the institute, the poorest 20 percent of the state’s residents who take in an average of $10,100 pay 13.8 percent of their income in taxes, the second-highest state tax burden, percentage wise, for poor people in the entire nation. Meanwhile, the richest 1 percent who pull in an average of $1,489,200 a year pay 4.9 percent; the national average is 5.6 percent for the highest earners.

Given the state’s archaic tax system, it shouldn’t be surprising that Illinois suffers from a chronic revenue shortage. As of September 30, the state’s general fund was overdrawn by more than $3.6 billion, which constituted progress, considering that the fund had a negative balance exceeding $4.7 billion a year earlier, forcing vendors who do business with state government to wait months before getting paid. The state’s credit rating is the lowest in the nation, which increases borrowing costs. Future revenue prospects are, at best, uncertain thanks to the scheduled rollback in 2015 of income tax hikes instituted in 2011.

Overhauling the state’s tax system isn’t a chore likely to win votes, judging by what happened to Gov. Richard Ogilvie, the last Illinois chief executive to push for fundamental overhauls in state government, including a new constitution and the institution of an income tax in 1969. He lasted one term. Nonetheless, with tax hikes scheduled to start phasing out in January, lawmakers and the soon-to-be Gov. Bruce Rauner will have to wade deeply into state finances, with basic changes in taxation policy offering a chance for real improvement, if not re-election.

How to fix the tax system so that it works better for taxpayers and the government?

First, increase the base, then spread the burden to increase revenue stability for the state while sharing fiscal pain. Those are basic ground rules.

Even those who disagree about the merits of a graduated income tax agree on at least one thing: The tax base in Illinois is extraordinarily narrow compared with other states, largely because the state, by and large, doesn’t tax services.

Estimates vary, but as much as 60 percent of economic activity in Illinois goes untaxed as barbers cut hair, lawyers dispense advice, accountants crunch numbers, plumbers fix pipes, and so on, without the state taking a cut. The average state taxes 56 services, according to a 2011 report by the state Commission on Government Forecasting and Accountability, while Illinois taxes just 17, with all but five coming from taxes on utilities. Hawaii, which taxes 160 services, tops the nation in service taxes, with Washington and New Mexico, each taxing 158 services, close behind. Oregon is the only state that has no taxes on any services, according to the 2011 COGFA report.

Of the five nonutility service taxes in Illinois, two are levies tacked onto hotels and rental cars. A tax on coin-operated amusement devices, which brought in less than $3 million a year, and taxes on processing of photographic film and certain types of computer software, neither of which COGFA could track in terms of revenue, are the only other service taxes in Illinois, according to the state report.

“The bottom line is, we have to tax services,” says Ralph Martire, executive director of the Center for Tax and Budget Accountability, a nonprofit think tank that draws criticism from some conservatives as being too liberal.

Just how is the question.

Based on a 5 percent share for the state and an additional 1.25 percent for local governments, a tax on services could bring as much as $8.45 billion to the state, COGFA found, although the state’s share would be cut to $4 billion if business-to-business transactions were exempt, an approach favored by both Martire and Joseph Henchman, vice president for state projects for The Tax Foundation, a think tank based in Washington, D.C., that leans conservative.

Republican Rauner seems to agree with Martire and Henchman on this idea. He ran on a budget proposal that included taxing some services.

“We’re in a world right now where, if I buy a loaf of bread, it’s subject to a tax,” Henchman says. “I don’t see why lawyers and real estate agents and accountants should be exempt.”

Nor, in Henchman’s view, should a loaf of bread get a free ride.

If Illinois’ current 1 percent sales tax on groceries were raised to 6.25 percent, the same as the state sales tax, Henchman figures the overall sales tax rate could be cut by as much as 1 percentage point. Why, he reasons, shouldn’t a haute cuisine chef pay the same percentage of tax on filet mignon and lobster tail from Whole Foods that an average Joe pays on a hamburger from McDonald’s?

While food taxes are considered regressive, concerns about fairness can be addressed by giving grants to the needy, Henchman says, and given that ours is a model free from political considerations, we’ll do exactly that in our built-from-scratch system.

Retirees are next up in our sacred-cow slaughterhouse. Illinois is just one of four states that exempt retirement income from taxes. The reason lies at the ballot box, according to Henchman.

“The only reason it is exempt is because of the voting power of retirees,” Henchman says. “If it’s income, it should be subject to the income tax.”

The state comptroller has estimated that the state is missing out on as much as $1 billion a year by not taxing pensions and other retirement benefits, even as the state’s unfunded liability for public employee pensions stands at $100 billion.

Martire also sees retirement benefits as a revenue source that could help balance the tax burden across all state residents. Make the first $50,000 to $75,000 exempt, he says, and the state would still get between $600 million and $700 million from retirees. Rauner did not include a tax on retirement income in the budget blueprint he released during his campaign and has said it is not something he plans to do. However, when responding to a question in a primary debate, he left the door open to such a tax.

Between taxing services and retirees, the state would raise, under the most conservative estimates, $4.6 billion a year, plus whatever a tax on groceries brings in. Given that our exercise in designing a new tax system is a zero-sum game, where should existing taxes be reduced?

Property taxes in Illinois are more than 20 percent higher than the national average, according to the Institute on Taxation and Economic Policy, while personal income taxes are nearly 26 percent lower than the average, and sales and excise taxes are more than 10 percent lower. Property taxes now are largely devoted to supporting schools and local governments, but under our ideal scenario, the new state revenue raised by taxes on retirees and services would replace revenue generated by property taxes. A tax on services would generate $1 billion or so for local governments under COGFA’s model, which could, at least in theory, replace property tax dollars. Rauner ran on “freezing” property taxes. But he has not yet provided details on what a “freeze” would mean and how the state would compel home rule governments to make the move.

Taxes on services, retirees and groceries would raise substantially more than the $2.4 billion that supporters say would be realized if the state adopted a graduated income tax, with 9 percent being the rate for top earners who now pay the same 5 percent as everyone else. Martire and Henchman disagree when it comes to a graduated tax, with the latter’s group issuing a position paper against the idea and warning that it would be bad for business.

“I just want to avoid the situation where we put high rates on high earners just to be punitive,” Henchman explains. In the past, Rauner has voiced opposition to a graduated income tax.

Supporters, however, say it’s a matter of being fair. Taxpayers at the very top receive a greater percentage of all income than they did decades ago, when Illinois adopted a constitution mandating a flat income tax, Martire says. “If the people at the top are going to get a disproportionate share of the income growth, they should have a greater tax burden.”

Regardless of whether Illinois adopts a graduated income tax, there remains plenty of room for improvement that can be accomplished short of amending the Constitution. A tax system, Martire says, should be fair, stable, efficient and responsive to economic conditions. “Illinois is oh-for-four,” he says. “It doesn’t work.”

Bruce Rushton is a reporter for the Springfield-based Illinois Times.

Illinois Issues, December 2014