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End and Means: Illinois Should Examine Its Revenue Structure

Charles N. Wheeler III
WUIS/Illinois Issues

Has the time come to overhaul Illinois’ venerable (outdated?) revenue structure?

The question is more than academic, given the daunting challenge for Gov. Pat Quinn and the Illinois General Assembly to craft a balanced budget for next fiscal year with some $2 billion less in receipts due to the partial rollback of the 2011 income tax increase.

In a few weeks, Quinn is scheduled to unveil his FY 2015 spending plan, and under budgeting reforms enacted a few years ago, the governor can’t propose appropriations that would total more than expected revenues. Thus, the governor’s proposal must cut almost $2 billion in spending, according to administration projections, with education and human services the most likely targets.

Lawmakers won’t take up the governor’s proposal in earnest until after the March 18 primary elections, but they’ll face the same constraint then: They can’t authorize more spending than anticipated revenue under existing law, which includes the sharp drop in personal and corporate income tax rates next January 1, halfway through the fiscal year.

Might the legislature decide to keep the current rates to avoid slashing popular programs, as advocates are urging? Certainly a possibility, and probably not that politically risky for most lawmakers, given the relatively safe districts they enjoy. But Quinn will try to avoid that topic heading into the November 4 general election, as whichever Republican wins his party’s nomination can be expected to argue strongly for lower taxes.

But here’s the really scary part: Even if the rates are held at current levels of 5 percent for individual and 7 percent for corporate taxpayers, Illinois still would face huge future budget deficits, just not humongous ones. The latest disheartening forecast comes from the University of Illinois’ Institute for Government and Public Affairs, which a few months back released a study projecting a budget gap — the difference between total revenue and total spending — of $7 billion by 2025, even with the higher income tax rates kept in place. If the rates drop as scheduled, the projected deficit would be $14 billion, the academic researchers calculated.

“Illinois has a chronic, structural fiscal problem, and there is no single solution,” the study concluded. “Increases in economic growth alone are insufficient. Increases in taxes alone are insufficient. Cuts in spending alone are insufficient. Aggressive pension changes alone are insufficient. Illinois must make aggressive changes in multiple areas or will face fiscal imbalances for many years to come.”

So, to rephrase the opening question: Should state policymakers consider reshaping the state’s tax system? Consider the two main revenue sources for state programs, the income tax and the sales tax:

  • Income tax. Enacted almost 45 years ago, the state income tax was seen as a way to shore up state finances and provide more money to local public school districts. Its two main negotiators — Republican Gov. Richard B. Ogilvie and Democratic Chicago Mayor Richard J. Daley — settled on flat rates of 2.5 percent for individuals and 4 percent for corporations, dictated in part by worries about passing muster under the 1870 Constitution. Its drafters embodied their agreement into the 1970 Constitution, with its provisions for a flat rate tax and for an 8-to-5 ratio cap between corporate and individual rates.

But the distribution of earned income and personal wealth has changed markedly since 1969, and the divide between the super wealthy and most everyone else has widened. In Illinois, for example, the bottom 60 percent of income earners actually took home less money on an inflation-adjusted basis in 2010 than they did in 1979, according to an analysis of data from the U.S. Bureau of Labor Statistics by the Center for Tax and Budget Accountability.
The disparity has bolstered calls for Illinois to move to a graduated income tax, in which high-end taxpayers would be assessed a higher rate for marginal income above certain levels, as with the federal income tax. That’s the norm in most of the 43 states that impose an income tax; top rates include Iowa’s 8.98 percent on taxable income above $66,000 and Wisconsin’s 7.75 percent on taxable income above $310,000. Illinois is one of only six states, including Indiana, that have a single, flat tax rate on all income.

Opponents warn that graduated rates would mean almost everyone would pay more, a dubious claim at best, given that no brackets have been established —in fact, the Constitution would have to be amended to allow graduated rates — and lawmakers who would enact the rate structure are not likely to increase everyone’s taxes. Indeed, more than 90 percent of taxpayers would see their income tax liability go down as a percentage of their base income under one formula laid out by the Center for Tax and Budget Accountability, while raising an estimated $2.4 billion in added revenue.

Similarly, while most states exclude Social Security benefits from taxable income, Illinois is one of only five states that exempt private, military and other governmental pensions from taxation, at a cost of some $2 billion to the state. Means-testing or otherwise narrowing the exemption would bring in added dollars.

  • Sales tax. A product of the Great Depression, the sales tax was enacted in 1933 to replace the state property tax that, until the economic collapse, had been Illinois’ chief revenue source since territorial days. At the time, most consumer spending involved a customer buying something tangible — a physical object — from a merchant, who under the new tax collected an additional 2 percent of the purchase price for the state.

Eighty-some years later, though, consumers are much more likely to be paying someone to do something for them, in transactions that don’t involve the exchange of anything tangible. In fact, service-related industries now account for more than 60 percent of the Illinois economy, according to data from the U.S. Commerce Department’s Bureau of Economic Analysis, and the shift is continuing.
But that fast-growing sector is not part of the state’s tax base because the sales tax does not cover most services. One hundred sixty-eight different service categories are taxed in the United States, according to the Federation of Tax Administrators, ranging from haircuts to brain surgery. The average state taxes 56 of them, and Hawaii, New Mexico and Washington each tax more than 150. Illinois taxes just 17, mostly related to public utilities, the fewest of any of its neighboring states, in some cases by a wide margin. Iowa’s base includes 94 services, for example, and Wisconsin rings up 76.

If Illinois were to expand its sales tax base to include all services, the state could garner as much as $8.5 billion in new revenue, according to the legislature’s Commission on Government Forecasting and Accountability. Even if business-to-business dealings were excluded, along with such vital consumer needs as medical care and legal services, the state still could bring in about $2 billion more.

Will these proposals, or any other, be part of the legislative debate this spring? Probably not; the governor and lawmakers won’t want to tackle tax reform before the general election. The issue should be part of the campaign debate, though, because without such structural changes, Illinois likely faces a future of red ink.

Charles N. Wheeler III is director of the Public Affairs Reporting program at the University of Illinois at Springfield. 

Illinois Issues, February 2014

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