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Trouble on the Horizon: Tax Increases Set to Expire in 2015 Raise the Sepctre of Even Greater Cuts

Flickr/ Mark Byzewski

 

“We have an impossible situation. If we solved pensions, then we would be looking at only $6 billion worth of debt with a dramatic drop of revenue taking place in 2015. That’s the best-case scenario.”Kent Redfield, emeritus political science professor at UIS

As lawmakers spend countless hours debating gun control measures and changes to the public employee pension systems, the next potential budget disaster in the state is on its way. 

In 2011, Democratic lawmakers approved an income tax increase that moved the personal tax rates from 3 percent to 5 percent and the corporate tax from 4.8 percent to 7 percent. The increase was temporary and is set to begin phasing out in 2015, when the rates will drop to 3.75 percent for individuals and 5.25 percent for corporations. When that happens, the revenue the state brings in will drop dramatically. The lack of planning for the tax rollback in budgets approved since the increase could result in a hastily approved extension of the current tax rates or painfully deep cuts to all areas of state spending. “It’s almost like Illinois is envious of really poor fiscal policy everywhere else. So why should the feds be the only ones with a fiscal cliff? Let’s create our own. And so we did, and it’s really brutal,” says Ralph Martire, executive director of the Center for Budget and Tax Accountability. 

Income tax revenues are expected to hit their peak under the increased rates in the next fiscal year. In Fiscal Year 2014, which begins July 1, the state will bring in $18.6 billion from the personal and corporate income tax. But as the tax rates start to roll back in 2015, that number will drop substantially. Between FY ’14 and FY ’16, the state will see a $4.7 billion decrease in income tax revenues, according to projections from Gov. Pat Quinn’s budget office. Projected increases in sales tax revenues are expected to soften the blow a bit, but the overall loss of revenue is projected to be $3.8 billion. 

Those who want the tax increase to go away and those who think the state cannot get by without the revenue agree on one thing: The governor and the General Assembly are doing little to prepare for the phase-out. 

Sen. Matt Murphy, a Republican from Palatine, says Democrats “promised” that the increase would be temporary. “There’s no sign that they’ve taken any steps for that to occur,” he says. “On all fronts, despite Illinois families struggling with less money at the end of the month because of the tax increase, the [budget] problems have only gotten worse.”

One legislator is already calling to make the tax increase permanent. Skokie Democratic Rep. Lou Lang proposed a plan to address the state’s $96 billion unfunded pension liability. Lang’s plan, House Bill 2375, would use the revenue from the tax increase to pay down the liability. Any additional money would be rebated to taxpayers. Lang’s plan would also ask employees to contribute more to their retirement and increase the retirement age to 67. 

“I have not committed to that lightly,” Lang says of his proposal to make the current tax rates permanent. He says that while he is the only lawmaker speaking out in a very public way about the tax increase, he thinks more of his colleagues agree that the revenue will continue to be needed. “I think many believe that it would be impossible for us to balance our books and create the kind of budget we want to create and take care of the needs of the people of the state of Illinois without the funds that the tax increase has provided to us. If we can resolve the pension problem without it, perhaps we can do it. ... But I haven’t seen the path to making that happen yet.”

He adds, “I think in the end, most legislators, even those who won’t vote for it, think that sometime in the next two years, we’re going to have to do something about extending that income tax increase.” 

Northbrook Democratic Rep. Elaine Nekritz is spearheading pension reform efforts in the House. Her proposal does not call for directing more revenue to the systems. It would instead reduce benefits for current employees and guarantee that the state makes its required annual contribution into the systems. Nekritz is hesitant to assume that the tax increase could be phased out, even if lawmakers can make changes to the pension systems that would reduce the state’s annual contribution. “If we passed this bill tomorrow, and we could wave a magic wand and enjoy the $2 billion in savings that this would provide us, we still have enormous fiscal pressures. We still have $9 billion in unpaid bills. We still have a group health insurance that’s placing significant pressure on us. Medicaid is facing significant pressures. We’re going to have to take a look at all that in 2014 and see how that all works,” she says. 

“If we still don’t have a resolution on pensions that reduces the annual payment that we need to make, you’d essentially have to shut down state government if the tax increase went away,” says Kent Redfield, emeritus professor of political science at the University of Illinois Springfield. “If there’s no pensions agreement, then nobody can make the numbers add up.”

Redfield says that even if pension changes pass and are upheld by the courts, the state could find itself in a fiscal position similar to the one it was in when the tax increase was approved in 2011. “We have an impossible situation. If we solved pensions, then we would be looking at only $6 billion worth of debt with a dramatic drop of revenue taking place in 2015. That’s the best-case scenario.”

Redfield says as the phase-out draws nearer, he expects a push to at least extend the current rates, if not make them permanent. “We could get back to the original deal, which was that we’re going to have the temporary tax increase to pay off the bills,” he says. “The additional revenue was supposed to pay off the bills ... but all that revenue is now going to pensions.”

Redfield predicts that the timing of the decision and the length of any potential extension would likely be dictated by politics. “That may be politically the most palatable way to go about it, is to extend it for three years, five years, four years whatever. You extend it another four years, and that gets you through the next gubernatorial election, which has nothing to do with public policy but everything to do with the politics of the situation.”

But Martire says that extending the current rates would not stabilize the state’s budget. “If we were starting from scratch and our spending and our revenues were equal to each other, over time we would still have a deficit, even if we never added a program or expanded a service area, because our revenues don’t grow with the modern economy in Illinois and our costs will,” he says. “The problem is, tax policy in Illinois has been flawed like this, creating this kind of structural deficit for a long time, and unless we fix tax policy to correspond to where economic growth is really occurring in a modern economy, we will never be able to balance our budget.” 

Martire says the state should extend sales taxes to some consumer services because services now make up more than half of the state’s economy. Before passing the tax increase in 2011, the Senate approved another plan that would have extended the sales tax to some services, but the idea was not included in the tax increase that ultimately passed. 

Martire says that lawmakers should also approve a constitutional amendment that would allow the state to have a graduated income tax. The state’s Constitution calls for a flat tax. Such an amendment has been introduced in the House and has more than 15 sponsors signed on. If it were passed, it would also have to be approved by voters. Martire says that a graduated income tax would target wage growth, which has taken place mostly among higher earners. “If the goal is to raise adequate and sustainable revenue for funding public services while maintaining low overall effective tax rates, then tax burden should be assessed primarily where income levels are high and expanding most generously over time,” said a report from the Center for Budget and Tax Accountability. “Since 1979, the bottom 60 percent of Illinois tax filers have seen their overall incomes decline, with the vast majority of income gains going to the top 10 percent of Illinois tax filers. A graduated individual income tax rate structure would shift tax burden from families struggling to get by to those who are gaining significant growth in real income over time — generate revenue needed to help reduce the structural deficit.”

Bond rating agencies are also less than thrilled with the state’s taxing structure when compared with the projected growth in costs. A December report from Moody’s Investor Services said: “Despite a diverse economy with above-average wealth, lackluster demographic and economic characteristics indicate that, even with continued U.S. economic improvement, the state’s existing tax structure will not provide enough revenue to address the rising cost of pension benefits and other state expenses. In addition, the state’s payment backlog remains high.”

Republicans say the key to restoring revenues is encouraging economic growth by cutting taxes, fees and regulations. House Republicans have introduced a package of more than 30 bills geared at kick-starting business growth in the state. The proposals include making the research and development tax credit permanent, making changes to the workers’ compensation system geared at bringing down the cost to businesses, reducing the fees required for incorporating a business and an immediate rollback of the income tax rates for individuals and corporations. “I think there is little question that we are in deep financial trouble in the state of Illinois. And there’s only one way in my view to legitimately work in the direction of trying to get us out of trouble. And that is ... creating jobs, letting people go to work so that they can spend money, and ... we can begin to realize revenues,” says Rep. Dwight Kay, a Glen Carbon Republican. 

“We’ve got a state that’s going backward in many respects. We have a growing number of unpaid bills, nearly $10 billion now. We have an undefined liability for pensions that’s continuing to grow. We have a continually growing state government that is crowding out the private sector,” says Ted Dabrowski, vice president of policy for the Illinois Policy Institute. “We’re going to have to flip all of our policies upside down. What we need to do is have very large economic growth.” 

The institute has created an alternative budget plan that Dabrowski says would allow the tax increase to sunset. The plan calls for an expansion of the use of managed care, administered by private sector providers in the Medicaid program, and an end to revenue sharing with local governments. The state sends more than $1 billion of income tax revenue back to local municipalities. It also includes a $750 million cut to general state aid to schools. Under the current budget, general state aid was cut by $161 million, and Quinn has proposed a $150 million cut for next fiscal year. “This is, of course, one of the tougher ones,” Dabrowski says of the education cut. “But we have to decide as a state collectively that there has to be shared sacrifice.”

Oak Park Democratic Sen. Dan Kotowski says that before they consider extending the tax increase, lawmakers have to scrutinize all areas of the budget, including special funds and money that is automatically transferred out of the General Revenue Fund before the budgeting process begins. “We can’t go back to taxpayers and ask them to continue to foot the bill until we have moved forward on these fundamental reforms.”

Quinn’s staff refuses to comment on the tax rollback. They say the governor is focusing exclusively on pension reform for now. 

Redfield says that Quinn’s reaction is not surprising because the tax sunset is such a touchy subject politically. If he weighs in, “all the headlines will read ‘governor wants to extend tax increase.’” According to a recent poll from the Paul Simon Public Policy Institute, more than 60 percent of Illinois voters oppose an extension of the current tax rates. 

“He cannot be thinking about that when the elected officials of Illinois have not even reformed their own pension system, much less all of the pension systems that are in deep need of being addressed,” Quinn spokeswoman Brooke Anderson said during a briefing on the governor’s proposed budget. She says the governor’s budget proposal was based on current revenues and current laws. 

“The goal is to solve today’s crisis today,” Anderson says. But while Quinn and lawmakers deal with today’s crisis, Illinois’ next fiasco is lurking around the corner.

Illinois Issues, April 2013

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