Should Illinois End Its Retirement Tax Break?

Apr 1, 2015

News Analysis — Illinois continues to be pummeled with bad budget news. The General Assembly’s nonpartisan budget analysts at the Commission on Government Forecasting and Accountability say income tax receipts will be down $1.9 billion in the next fiscal year. That’s thanks to the tax cut that took effect January 1, lowering the individual income tax rate from 5 percent to 3.75 percent.

Meanwhile, Democratic lawmakers have gone into the Statehouse attic to dust off seemingly every recent failed tax hike proposal: a progressive income tax, the 3 percent “millionaire’s tax,” increased sales taxes on satellite TV and sugary drinks, and a transaction tax targeting the big Chicago futures and options exchanges. Gov. Bruce Rauner is proposing yet another pension overhaul, claiming $2.2 billion in immediate savings, as though it won’t be subject to a lengthy court challenge. “Reckless” is how the usually measured House Speaker Michael Madigan described that idea.

Brian Mackey writes the State of the State column for Illinois Issues magazine.
Credit Matt Penning / NPR Illinois

There is another option, though few politicians are willing to talk about it. It could regenerate much of the revenue lost to the January tax cut. You might call it closing a special interest loophole. The interest group, of course, will call it bloody murder. But regardless of how one spins the idea, it’s worth broaching the subject.

We need to have a talk about taxing retirement income.

Zap! That’s the sound of me being electrocuted on the third rail. Talking about a tax on retirement income will no doubt be painful, but people will do surprising things when $2.3 billion is on the line.

That’s how much extra revenue the economist Natalie Davila calculates Illinois could have collected in 2012 had the state taxed retirement income at the then-current 5 percent income tax rate. Davila is the former director of research at the Illinois Department of Revenue, and makes a thorough analysis of the topic in a recent issue of Tax Facts, the newsletter of the Taxpayers’ Federation of Illinois. She writes that Illinois is a true outlier in how it taxes retirement income, including Social Security, pensions, 401(k) plans and the like. “Such plans are funded with ‘pre-tax contributions,’ meaning the income is set aside and not taxed when earned,” Davila writes. “The federal government and most states delay taxation and tax payments to individuals from the plans (except for a portion of Social Security); Illinois never taxes the income. Only Illinois, Pennsylvania and Mississippi exempt all ‘retirement income’ from taxation.”

How did Illinois arrive at this policy? Davila points to prior research by former state Rep. Jim Nowlan, who suggests the idea was to make Illinois’ flat income tax rate a little more progressive, and blunt its effect on impoverished seniors. At the time, nearly one in four seniors lived below the poverty line. But that was in the early days of the Great Society, and elder poverty has declined significantly since then — to just over 8 percent in 2010, Davila writes. At the same time, poverty for younger age cohorts is increasing.

Davila makes one other key point, and it’s particularly salient for those of us in Generation X and younger — and even a fair share of Baby Boomers — who wonder if we’ll ever have enough savings to opt out of our 9-to-5s. She writes that the number of senior citizens who work has gone up, from 11.5 percent in 1992 to 18.5 percent in 2012 — and the figure is expected to hit 23 percent by 2022. “It is important to note that working seniors have to pay income tax on their earnings, while seniors who can live on their retirement income do not pay Illinois income tax on that income,” Davila writes.

Picture that disconnect: The wealthy retiree, tanned and tired after a morning golfing at the country club, stops at a store. She breezes past the elderly Walmart greeter, standing for hours a day on a rectangle of foam in order to make ends meet. They both expect the same level of protection from the Illinois State Police, and each counts on the public schools to educate her grandchildren. But one of them continues to pay for those services; the other says she paid her dues and is now content to let the rest of us pick up her share of the bill.

If that seems a cartoonish example, consider how much of Illinois’ tax-free retirement benefits go to people relatively high up the income scale. Citing 2012 figures from the Illinois Department of Revenue, Davila writes that of the nearly $45.5 billion value of the retirement income subtraction for Illinois residents, more than half goes to people whose adjusted gross income was greater than $75,000.

That said, there are many people on fixed retirement incomes who do not make a lot of money, and undoing the retirement tax exemption could be disproportionately burdensome for them. Davila projects that for income tax filers claiming a retirement exemption, the effective tax rate — that is, the tax rate after exemptions are figured in — would more than double for people at the lower end of the income scale, while barely budging for millionaires. “This data suggests that policy proposals to tax retirement income should contemplate a mechanism to protect those at the lower end of the income scale,” she writes.

Having to get into that level of complexity to explain a policy proposal suggests one is likely to have a political problem. And taxing retirement income might well be the most politically difficult idea many lawmakers have ever considered.

For politicians, playing with anything that adversely affects senior citizens is a most dangerous game. Senate President John Cullerton knows it. Back in 2011, in a speech to the City Club of Chicago, he pointed out how much more money Illinois would collect if it taxed retirement income. He said he would be open to taxing retirement income as part of a broader overhaul of the state’s tax structure. That was enough for the Chicago Tribune to run with a story under the headline “Cullerton suggests taxing retirement income.” It began: “Senior citizens who thought they escaped the pocketbook pain of Illinois’ major income tax increase soon could find they didn’t elude the taxman’s grasp after all.”

If you listen quietly, you can still hear the echo of spit-takes as the story was read across Illinois the next morning, from the Senate press office to Republican Party headquarters. The state GOP pounced, and Cullerton extended his remarks in a State Journal-Register op-ed: “I never had nor did I ever say I had a proposal to impose an income tax on retirement income. There is no John Cullerton retirement income tax.”

Likewise, Rauner knows the pain of not denouncing a retirement tax hard enough. Once again, the Tribune, covering a debate in advance of the 2014 primary: “Rauner, who has been successful in previous forums by sticking to a tight script, appeared caught off guard when asked about the concept of imposing the state income-tax on retirement income in Illinois.”

“I don’t have a position on that yet,” Rauner said. “What I would recommend we do is look at our entire tax code in Illinois, look at every tax and every tax base and every rate and then compare ourselves to other well-run states that we compete with.”

That was enough ammunition for a union-backed political group to run a pair of ads describing Rauner as “open to taxing our Social Security and retirement income.” Appearing at an event to outline a handful of tax proposals for Illinois, Rauner blamed then-Gov. Pat Quinn for the ads. “I have never, ever said I want to tax Social Security,” Rauner said. “That’s baloney.”

Politicians have good reason to genuflect before senior citizens: They make up a huge proportion of the electorate, particularly in the nonpresidential years in which Illinois governors are elected. According to 2014 exit polls, Rauner’s best performance was among voters aged 65 and older — he defeated Quinn by 18 percentage points among that group, compared to five percentage points overall. And Illinoisans aged 50 and older vote at a high rate — they accounted for 55 percent of the turnout in 2014, despite being just 31 percent of the population.

Even former Gov. Rod Blagojevich recognized the value of an appeal to Illinois’ elder citizens, using his amendatory veto powers to add free public train and bus rides for seniors to a bailout of the Chicago Transportation Authority. This led to one of my favorite moments on the FBI wiretaps, in which his excellency was incredulous that Illinoisans weren’t more grateful: “I [expletive] busted my ass and pissed people off and gave your grandmother a free [expletive] ride on a bus.” The free [expletive] rides for seniors were later scaled way back, subject to a means test that kept the benefit in place for those at the bottom end of the income ladder. And therein lies a potential opening on the retirement tax.

“Of course, I’m not going to turn down a free ride, and I think it’s a nice gesture,” Marion Cheney, then 87, told the Tribune in 2008. “But if it costs too much money for the CTA, they can have my dollar. I don’t want them to have to cut routes because I’m getting a free ride.”

CTA finances were so desperate back then that the agency was contemplating significant reductions. Seniors feared being cut off from a crucial connection with the outside world. It’s not all that different from the many services Rauner wants to cut in order to balance the state budget. He’s targeted home care for the elderly, public transportation subsidies and many other programs whose beneficiaries include or are primarily senior citizens.

Perhaps the governor and legislative leaders could engage some of the state’s political grandfathers in an appeal to the common good. People like Quinn (who’s collecting a $137,952 annual pension — tax free), former Gov. Jim Edgar ($176,029 annually, totaling $1,725,107 so far — tax free) and former Gov. Jim Thompson ($143,182 annually, totaling $2,458,301 so far — tax free).

It would be a call for shared sacrifice, just like the appeal Rauner made in his inaugural address, but which has not been much in evidence in his policy proposals. It would not be an easy case to make, but who better to make it than some of Illinois’ most famous pensioners, arm in arm with graying Illinois’ choice for governor?

A version of this story ran as the State of the State column in the April 2015 edition of Illinois Issues magazine.