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Question & Answer: J. Thomas Johnson

He was chosen president of the Taxpayers' Federation of Illinois a year ago this month. Prior to that, he was a state and local tax partner at accounting firms Grant Thornton and KPMG.

He served on the Illinois Gaming Board from 1990 to 1999, becoming chairman in 1993. Through the 1980s, he served in Gov. James Thompson's Cabinet as director of the Department of Local Government Affairs and then  the Department of Revenue.

He was a technical adviser on the state finances report issued recently by the Civic Committee of the Commercial Club of Chicago. This is an edited version of his conversation with Illinois Issues Executive Editor Peggy Boyer Long.  

Q. Do you think the state has a structural deficit?

It definitely does. How do we measure that? We have determined that the normal growth rate of our own source revenues is about 4 percent a year, excluding transportation funding. About 75 percent of our revenue sources have normal economic growth potential, while 25 percent of the revenue base doesn't grow at all because it tends to be consumption-based taxes, or the tax base is becoming a smaller part of the market activity in which it operates. It appears that the spending growth rate, if we continue to spend at historical levels and meet the required increase in pension fund contributions, will grow at about 7.5 percent a year over the next three years. That reflects a structural deficit.

Q. We've seen dollar estimates that range up to more than $100 billion of unfunded debt, depending on what's counted. What are you counting?

Now that's another component of the structural deficit. In my previous comments I was just addressing what we currently bring in versus what we spend. In addition, there are some programs that we are not providing required funding, even though we are incurring a liability.

The primary one is health care for retirees. Currently, we just pay the premiums as we go from year to year. 

We have not set aside assets like we do in our pension funds for future liabilities associated with the promises we've made to retirees for health care benefits after they retire. At the end of fiscal year '08 — June 30, 2008 — the state is required to report that liability, as are all state and local governments. Then we'll officially know what we owe for this program. The Civic Committee of the Commercial Club of Chicago has estimated that liability could be in the $47 billion range, which equals the under-funded pension liability of $46 billion. 

My explanation of that 4 percent to 7.5 percent structural deficit doesn't take into consideration the retiree health care benefit costs.

When all is said and done, we shouldn't be surprised that Illinois, with all of its liabilities that are not currently funded, may have the largest unfunded debt of any state in the nation.

Q. Some have used the word bankruptcy. What would it look like if we don't address this?

The tax burden that will have to be imposed on future generations will be far above the national average in order to pay these costs that we haven't been funding properly for the last 30 years. Either that, or we will have to underfund government programs, probably education. The citizens of this state will suffer, either by having too high a tax burden, or the tax burden that they are having to bear will not be buying the level of government services that will be available in other states that have met their funding requirements in these areas.

Q. Couldn't we just wait for the economy to recover?

There are two components to our revenue system that don't allow it to grow as much as it does in other states. First of all, our constitution prohibits a graduated income tax. Those states that have surpluses generally have a higher income tax burden on their citizens and do so through a graduated tax rate structure. 

Graduated tax structures produce greater growth rates because of what is commonly referred to as bracket creep. Illinois does not have that because of the flat rates, so even in a recovering economy — and we've had a pretty good economy over the last two years — our revenue system will not respond as generously as other states' revenue structures will. 

The other significant component of our revenue base is the sales tax. We have a relatively narrow-based sales tax. It doesn't tax very many services, and services have been the greatest growth area of our economy for the last 20 years. As a result of not capturing this economic growth in our tax structure, our sales tax revenues will be more anemic than will other states' because they have broader-based tax structures that include an array of consumer services.

Q. Could we cut spending enough to solve the imbalance?

First, we should put a dollar value as to this structural deficit. It's about $5 billion annually — if we have no program expansion but we meet our obligations to our pension funds and we set aside assets for health care for retirees.

Certainly, the Civic Committee doesn't think there's enough expense reduction that can be achieved to close that gap, and I tend to agree with them. The amount of cutting that would have to be done to eliminate our structural deficit would mean a significant reduction in educational funding levels, undoubtedly, because that, along with health care for those in need, makes up the bulk of current program spending.

There are a couple of areas I think where cost containment could generate in excess of $1 billion in savings. Re-evaluating the benefit structure of our public employee pension programs and the health care coverage we provide our employees and those in need under our Medicaid program provides some opportunity. We believe in the greater use of risk-based managed care, where the focus of attention, or the burden of not having healthy employees or not having healthy recipients under our Medicaid program, is borne in part by the insurer rather than totally by the taxpayers.

We think these areas should be reviewed first before we ever go to the taxpayers to ask them to address the other aspects of the structural deficit.

Q. That leaves a deficit of about $4 billion. The other side of the equation, then, is the revenue structure. How does ours stack up to other states?

We, like other states, have a relatively balanced dependency on three major taxes. I'm putting aside transportation in this entire discussion because it historically has been funded by a tax on fuel that's used on highways and vehicle and driver's registration fees. The other three major sources of revenues for state and local governments are the income tax, the sales tax and the property tax, which you would typically find in most states. There are a few states that don't impose an income tax. There are some states that don't impose a sales tax. And when you look at those states, they tend to have another unique tax to make up their revenue needs. But most states use some balance among the three major taxes.

Now, how does Illinois' measure up? 

We are less dependent than the national average on the income tax and sales tax, and we're more dependent upon our property tax to fund our state and local governments than the national average.

An interesting part of the sales tax is that, even though we're below the national average when it comes to how much is produced on a per capita basis, we have one of the highest rates. And that goes back to the issue of the narrowness of the base.

On the income tax side, we've got a relatively low rate on individuals. The corporate rate is closer to the national median when you combine the regular income and replacement income tax that's associated with the abolishment of the personal property tax. But on the individual side, middle- and higher-income individuals are taxed at relatively low effective tax rates compared to the national norm. As a result of that, our amount of per capita production from the income tax is lower in comparison to the national average.

Q. Is our tax structure stable? Well, the most stable tax of all three of them is the property tax. It's very predictable. 

The income tax on individuals and the sales tax had been very predictable as well. But what we realized right after 9/11 is that, for the first time, those two revenue sources actually decreased compared to previous years' levels. We always had a growth rate potential over the history of both taxes because of the general growth rate in the economy and the effects of inflation in the economy. So those taxes have been good, though not as good as the property tax. 

The corporate income tax is a very volatile tax because of swings in the economy. Even though, during recessionary periods, there are fewer people employed and the growth rate of wages may be less, it still has historically produced an overall growth rate in the personal income tax. But on the corporate side, when you run into companies losing money as a result of economic downturns, the amount of revenue from one year to the next can decline significantly. And in the years 2001 through 2003, we had declines in double-digit rates. 

Recovery years also tend to be volatile, in a positive way. The last three years, our corporate income tax receipts have increased at a much faster rate than personal income tax receipts. But it's a volatile tax. And if you get too dependent upon a volatile tax, then you have to have an ability to control spending in programs in a much more aggressive way than government generally can.

Q. One of your predecessors here at the Taxpayers' Federation used to joke that the only fair tax is a tax on hair oil, and that was because he was bald. One of the problems you get into when you try to design a tax structure is what criteria you use to assess fairness. Do you judge our system as it's currently structured to be fair? 

I wouldn't say it's fair. Our tax structure tends to put a higher burden, if you measure the burden by a percentage of income, on lower-income people than you will find in most other states. And the reason for that is the flat rate income tax and the high-rate, narrow-based sales tax. The 3 percent personal income tax rate is very attractive to people in the middle-income and higher-income levels because it's a very low rate in comparison to other states. That same 3 percent rate is a relatively high rate for low-income individuals in comparison. A graduated system tends to start at lower rates and go up to higher rates than Illinois' 3 percent flat rate.

And the sales tax, because it's limited to goods rather than services, tends to put a greater burden on low-income people. The percentage of personal consumption of goods for low-income people is higher than it is on services. And so the sales tax tends to be regressive because of the narrow base we have in Illinois. If you expand it to services, then it becomes slightly more progressive, certainly more progressive than the current structure, but not as progressive as other types of taxes. 

But those two things together — narrow-based sales tax on goods and a flat-rate income tax — tend to put a higher tax burden on lower-income people in our state than you would see in other states.

Q. You're saying we have a tax structure that is not responsive to the economy, is not particularly stable and tends to be unfair. Are you suggesting we should revise that structure?

I think you can make a lot of changes within the current tax structure. And one of the things I think is important is to have a tax structure that is comparable to other states as to form and burden because economic activity can flow pretty freely in this country. If you have an unbalanced tax structure in comparison to other states, then it could cause people to make investments differently. 

Q. What do you suggest?

Certainly the Civic Committee's recommendations to look at the rate structure of the income tax and some progressivity aspects, or lack thereof, of the income tax can be done within the current structure. And there needs to be a strong look at our sales tax base to see whether or not we should continue to be dependent upon taxing the sale of goods at high rates compared to all consumption at lower rates. Those two things together would affect the fairness, and it would make the tax structures more productive as to revenue growth rates.

Q. You could capture more money?

Not only more money. The growth rate in revenues is important. You need to have a revenue system that will grow at the rate of the growth of your spending. Given what government's role is — it's so much focused on health care and education — the question is do those two cost components grow at a faster rate than the general economy, and certainly health care has historically done so. That puts a lot of pressure on the revenue system, and a structural deficit develops.

Q. You imply that we might want to look at a graduated income tax. That, of course, would require a constitutional amendment.

I think it would be very challenging to get a constitutional amendment adopted. But you don't have to change the rate to get more progressivity out of an income tax. You can make an income tax more progressive through the form of exemptions or credits. For example, we now have relatively low personal exemptions — $2,000 per person — but they're available to everybody along the income scale. And there have been other proposals, such as family credits and so forth, that are a component of the school funding reform package that has been introduced in the General Assembly. And that should be evaluated. 

But I'm concerned that if we adopt a system to modify the personal income tax structure to make it more progressive that we coordinate the various tax credits and exemptions to avoid duplication of purpose. If I was doing it, I would probably look at all the credits we have in our income tax structure and see if they should be melded into one that tries to address the fairness issue.

Q. What about revisiting large exclusions, like pensions?

That's one thing that we think should be looked at as well. We think there's no policy justification for exempting all retirement income because, let's face it, sometimes the higher-income individuals have very significant retirement incomes. 

One of the phenomena that occurs is, if you contribute to a 401k or an IRA, your contributions are not taxed as you deposit them and they're not taxed when you make withdrawals. Well, who within our society contributes large amounts to 401ks and IRAs? People who tend to be at the higher income levels. So in a flat-rate tax structure those deductible contributions and the lack of taxation of withdrawals produce a lower effective tax rate than lower-income levels, and that's hard to justify.

Most other states exempt some retirement income up to a certain level. The federal government does it on the Social Security side where, if your taxable income is less than a certain amount, Social Security benefits are not taxed at all. If it's above that amount, they are. 

We should look at that.

Q. One proposal would eliminate the corporate income tax and establish a tax on business' gross receipts. How does that proposal fit into this discussion of fairness and effectiveness?

A gross receipts tax gets into this other area I talked about earlier, which is the uniqueness of tax structures. 

When a state has a tax that is not what you normally see in other states, you have to be careful that you understand the economic consequences of the tax because it could cause businesses to modify their economic activity. And a gross receipts tax is a perfect example of that.

The problem with a gross receipts tax is, one, it's a hidden tax. It's buried in the price of goods through a supply and distribution chain. And the more the activity of making something in Illinois occurs through Illinois suppliers, the heavier the tax burden. So this is a tax that is going to place a very high burden on Illinois-produced goods, even those that are exported for consumption other places. And it doesn't tax at all imported goods or services. 

Q. The explanation, though, is that exports will be sliced out.

In a gross receipts tax, exports are always exempted. But what's not understood is that only the export sale is exempt. All of the inputs along the production and distribution chain are taxed. There's a lot of buried tax in the produced cost of that good, even though you may not tax the last transaction as it's shipped outside the state. 

If you compare it to other states that don't have a gross receipts tax, or do but at a significantly lower rate, you'll say why shouldn't I buy it from somebody outside the state. It's especially onerous on small business because small business tends to have a local supply chain. All of its inputs would be taxed. Larger businesses may be buying some inputs from outside the state, and those would not be taxed so their buried tax cost would be less.

Q. There has been an argument to protect small business by stepping up the level of profits before the gross receipts tax is applied.

That's a little tricky, as well, because who is a small business buying their inputs from? Let's say farmers who may qualify because they have less than a million dollars' worth of gross receipts. But who do they buy their fertilizer from? Who do they buy their corn seed from? Who do they buy their machinery from? They tend to buy from companies that would not be eligible for the exemption. So all of the embedded tax costs on the business inputs are still in that cost structure for that small business, even though their sales would be exempt.

Q. What about the consumers?

If you look at most tax incidence studies, consumers bear the greatest percentage of any business input tax structure, whether it be a sales tax structure or a gross receipts tax structure. To a lesser extent, economic studies show labor bears some of the tax. Lower wages, less benefits, that type of thing. 

The bottom line is the seller has to be competitive. And if his costs are higher because of a tax structure, compared to production in other places, something has to give. 

Q. The argument for the gross receipts tax is that corporations aren't paying their fair share of the total take on the income tax.

What we need to understand is that more businesses are not treated as corporations for tax purposes. Income may be taxed at the individual share-holder level in their personal income tax returns. More and more businesses have chosen to be formed as Partnerships, Sub-chapter S corporations, LLCs, LLPs, and one of the benefits of the structures is that you can avoid double levels of taxation, one at the corporate level and again when the income is distributed in the form of dividends to the owners. 

In 1980, 1 percent of the personal income tax base was income from businesses. Today it's 7 percent. You have to take into account the amount of business income that is reflected in the personal income tax structure in comparison to prior periods. 

Q. Do you think Illinois is ready to broaden the sales tax base? If so, what would you include?

Let's face it, in Illinois we're generally not ready to make any significant changes in our tax structure. For whatever reason, we've had a hard time trying to explain to the public why it's necessary, why it's fair. So are we ready to expand the sales tax? 

I don't know. But I do think that we as an organization have a responsibility to try to communicate what is a fair tax structure. How do you justify, for example, that we're going to tax you at very high rates if you consume an item of goods such as clothing, but we're not going to tax you at all if you decide to spend the same dollars going to a movie or getting a haircut?

I often say to people that when we exempted food from the sales tax base, we made the sales tax more regressive. Now why do I say that? Food sold to people who were eligible to pay for that food with the use of food stamps was never taxed. And in order to afford the exemption on food, we raised the rate on everything else low-income people purchase and pay tax on in order to exempt the sale of food to middle- and high-income people.  

Q. If we were to broaden the base, are there some things you think ought to be exempted in the interest of fairness?

One would say a broad-based consumption tax shouldn't exempt anything. But I think there's always the issue of health care, whether it be doctor's visits or medicine or hospital stays. Should that be taxed? To be honest with you, it's a form of consumption. And we're looking at how to make the consumer of health care services more responsible for what they consume. And if the consumer doesn't have to pay, then there isn't as much competition in the marketplace. 

Q. Some of the tax reform proposals would swap property tax relief for a higher income tax rate. What's your thinking on that?

The property tax structure produces a lot of revenue in this state, in excess of $20 billion a year, compared to the income tax and sales tax combined. So it's a big item. And 60 percent of property tax revenues go to education. 

The problem is, though, if we talk about broad-based property tax relief, I don't think we'll ever meet the taxpayers' expectations. I'll give you an example. You often hear that the goal is to provide property tax relief to the tune of 25 percent of the educational operating rate for schools. I know what that means. It's 25 percent of about 50 percent of the tax bill, or 12.5 percent. What the person heard was that they were going to get a 25 percent property tax reduction. Normal growth rate in property taxes is 4 percent a year. So I'm expecting a 25 percent reduction. But what was really promised was only 12.5 percent. And the first year that you get the relief, the property tax bill declines 8 percent — 12 percent minus the normal growth rate of 4 percent. In the second year, half of that is gone. And in the third year it's all gone. But in order to do that, we had to create a new tax structure to produce somewhere around 2.5 billion dollars. Those taxes will continue. The relief will be gone.   

I think this would produce a tremendous amount of cynicism in the public's mind. 

I was promised something and it was not delivered. Broken promises are a problem for government. And so I think we need to be very careful. I think we need to do a better job of educating people about what is an effective tax burden. 

To be honest with you, the effective tax rate on residential property in parts of our state is lower than the national average. 

Q. It's especially bad in some areas. How do you solve that?

It's an economic development issue. Broad-based tax structure changes are not going to solve those individual high economic stress communities' problems. 

Q. What are the chances anything is going to happen soon?

It's very unpredictable. As we know, there are lots of competing interests right now with different champions. 

The governor appears to be most concerned about health care financing and expansion. The Senate president appears to be most concerned about educational funding reform. The House speaker appears to be most concerned about the structural deficit that we're facing in this state for existing programs and the long-term debts associated with those programs. And there's other interest in significant new revenues for capital funding, whether it be transportation or school construction. All of them require large demands of resources. 

How this will all work out in the long run, I don't know. 

Illinois Issues, April 2007

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