What A Graduated Income Tax Would Mean For Illinois' Financial State

Oct 15, 2020

The campaign over Gov. J.B. Pritzker’s proposal to impose a graduated income tax has focused mainly on who would pay higher taxes. But perhaps just as important is the question of how that money would be used.

The graduated income tax that Illinois Gov. J.B. Pritzker, a Democrat, wants voters to approve this November was supposed to solve one of state government’s most persistent problems: a structural deficit that forced lawmakers and budget officials to find $2 billion to $3 billion every year to keep the state budget in the black.

Of course, that was before the lethal coronavirus wreaked havoc with the national economy and strained Illinois state government’s already precarious finances. Now, seven months after Pritzker started shutting down businesses and scaring up medical supplies to contain the spread of the virus, several big questions loom that could determine whether his plan to shore up the state’s finances will succeed.

The biggest, of course, is whether voters approve the so-called Fair Tax Amendment that the billionaire governor is championing, both in his position as governor and through funding the campaign with $56 million of his wealth. 

If voters sign off on the change, a law would automatically take effect to raise income taxes on millionaires, while offering modest relief to most other taxpayers. It would add roughly $3.1 billion to the state treasury in the first full year it takes effect.

The second outstanding question is whether Congress will pass aid to state and local governments, as Pritzker and other governors have been advocating, that could help them provide services even when their revenues are dropping. 

The third is whether Pritzker and lawmakers can find other ways – through cuts, borrowing or, as Pritzker’s detractor’s fear, even other revenues – to make up any differences. 

“We’ll certainly be making some expenditure reductions across state government,” Pritzker said in an interview with NPR Illinois. He also confirmed that his administration is still exploring the idea of borrowing money from the Federal Reserve, which lawmakers gave him the authority to do this spring.

But he said passing the graduated income tax is still necessary. “Without the Fair Tax, the alternatives are not pretty. Those are not ones that I think any of us would favor,” he said. The progressive income tax, Pritzker added, would be a way to “avoid draconian cuts.”

“Does anybody think we should be making significant cuts to state police, for example, or to the public safety elements of our budget, including the National Guard?” he asked. “What about education? Do we think that education is overfunded or underfunded? What about social services, human services that in a pandemic are so vitally needed by families?”

Of course, many opponents of Pritzker’s income tax overhaul argue that program cuts are exactly what is needed before the state raises taxes.

“We’ve seen a couple of tax increases in the last decade,” said state Rep. Tom Demmer, a Republican from Dixon. “Each time they were sold as the revenue infusion that we needed to be able to right the ship. I don’t think we’ve given enough effort or spent enough time looking at the other side of the ledger.”

He noted that the governor has twice asked his agency directors to look for possible spending cuts, but that the administration has not shared those potential reductions with lawmakers.

Republican state Rep. Tom Demmer of Dixon

“There really has to be a change in the culture of Springfield that looks and makes good-faith efforts in finding every kind of cost reduction we can before coming back to taxpayers and asking them for more money,” Demmer said. “I just don’t think we’ve seen that follow-through.”

Plans Gone Awry

The onset of COVID-19 created mayhem with state budgets around the country, but perhaps nowhere so much as in Illinois. Nowhere else has bond ratings so low, or pension obligations so high, at least in total dollar amounts. Illinois also came into the crisis already owing roughly $5 billion in unpaid bills – a number that has since grown to more than $8 billion. 

With little room to maneuver financially, and the state of the economy up in the air, Illinois lawmakers passed a budget for the current fiscal year that authorized the state to borrow up to $5 billion from the Federal Reserve. That would be the second time Illinois took advantage of a special borrowing program created by the Fed in response to the coronavirus, called the Municipal Liquidity Facility. Illinois became the first state in the country to use it, when it borrowed $1.2 billion in June to cover expenses for last fiscal year, which ended in June. (The New York area’s transit agency is the only other entity to borrow from the Fed program so far.)

With the prospect that Congress may not act soon to shore up state finances, and even the possibility that voters could reject his graduated income tax plan, Pritzker has started to prepare for other options. 

In September, he told his agency directors to prepare plans to cut their spending by 5 percent for the current year, and 10 percent for the following year. The reductions would help the state deal with a potential revenue drop of $6.5 billion over those two years. 

“I can promise you that for everyone and anyone who got into public service who actually wants to serve the public, this is a nightmare scenario,” Pritzker told reporters then.

But the state would also have to use the authority to borrow from the Fed again if the graduated income tax does not pass and Washington does not send relief funds, Pritzker told Bloomberg. That borrowing would come along with cuts to state programs. Illinois has until Dec. 1 to decide whether and how much to borrow from the Fed.

The loans from the Federal Reserve, though, have to be paid back within three years. That means it wouldn’t be long before lawmakers had to find even more money to pay back the Fed’s loan, making it harder to climb out of a budget hole yet again.

Will the ‘Fair Tax’ be enough?

On its own, the graduated income tax likely won’t be enough to address Illinois structural deficits, several budget experts say.

That includes Wall Street, where all three of the major credit ratings agencies have rated Illinois’ bonds just a notch above junk bond status.

“The $3.1 billion of Fair Tax revenue that the state projects now for the first full year (fiscal 2022) would help limit growth in fixed costs as a share of the state’s budget, but it wouldn’t restore the lower pre-pandemic ratio of fixed costs to revenue,” wrote analysts for Moody’s Investors Service, one of the credit rating firms, earlier this month.

In other words, the fixed costs in Illinois’ budget – which Moody’s defines as pension contributions, debt service and retiree health benefits (OPEB) – are expected to increase at a faster rate than tax revenue coming into the state.

“Even with new revenue from the progressive tax, the fixed-cost ratio would still rise somewhat in our moderate stress scenario,” they added.

But Quentin Fulks, the chairman of the Vote Yes for Fairness campaign, which supports the progressive income tax, said he’s never tried to portray the graduated income tax as the only thing that is needed to dig Illinois out of its financial hole. It took decades for Illinois to build up its unfunded pension liabilities, he points out, and just a few years ago, the state went without a budget for two years under Gov. Bruce Rauner. So getting the state back on track will take many changes, he explained.

“There are a number of things that have to occur, but I think that the Fair Tax is one of the best solutions that we have on the table right now,” he said. 

“But, you know, $3 billion … in additional revenue every year can go back to funding things like making our pension payments on time without having to borrow or paying that interest. It will also make sure that we’re putting money into the education system, which is what is causing property taxes to go up on taxpayers,” Fulks said.

Andrew Nelms, a senior advisor for Americans for Prosperity Action, which is campaigning against the amendment, said lawmakers should agree to a more comprehensive plan for dealing with Illinois chronic deficits and towering debts before passing any tax increases. 

“As someone who represents and fights for beleaguered Illinois taxpayers, it should be the case that tax hikes would be the last resort and not the first recourse,” he said. 

Lawmakers should try further reining in pension costs, Nelms said. (Illinois legislators have substantially cut benefits for incoming state workers but have not been able to cut benefits for retirees because of protections in the Illinois Constitution.) Nelms also suggested that consolidating local units of government would save money that could be directed to schools, easing pressure on the state to pay for increased education expenses.

“If Illinoisans do reject this tax hike,” he said, “our policymakers or lawmakers or politicians should see that as Illinois taxpayers sending them a message that we don’t want more of what’s done in the past, which has traditionally been raising taxes instead of pursuing policy reforms to right the financial ship.”

Amanda Kass, the associate director of the Government Finance Research Center at the University of Illinois Chicago, says lawmakers may raise revenue through different means if the graduated income tax amendment fails. “Voters should be mindful that income taxes are probably going to change whether or not this is approved, because of the state’s fiscal condition,” she said.

The budget pressures would be exacerbated by recent changes to Illinois’ school funding formula, which calls on the state to increase its share of educational funding. The graduated income tax would cover those new expenses, but legislators would have to find a new way to pay for it if the graduated income tax fails. 

In fact, when the governor pushed for the graduated income tax in last year’s budget address, he told lawmakers they faced three choices: cutting discretionary spending by 15 percent, raising the state’s across-the-board income tax by one-fifth, or enacting the graduated income tax.

Pritzker said state government had already been “hollowed out” by Rauner just a few years ago. “Do we think it’s appropriate to make massive cuts to state government?” Pritzker asked in his interview with NPR Illinois. “We may be forced to make some cuts, there’s no doubt about that. But the alternatives are not good. That’s why I fought for a third way.”

The governor also hopes that the effects of a graduated income tax, if it passes, will help the state once the pandemic has passed.

“We all hope and believe and pray that COVID will not be with us forever,” he said. “We hope we can begin to recover a significant amount of our economic prowess and our ability to grow in the next two years. But the Fair Tax, remember, will have a permanent effect on the state.”