This January, after two years of trying, Illinois governor Pat Quinn finally got his states legislature to pass a large, across-the-board tax hike that will raise over $7 billion per year, or more than 20 percent of the states general-fund budget. The personal income tax rose from a flat 3 percent of income to 5 percent, and the corporate income tax also increased sharply. The hike was by far the largest that any state has enacted in response to the Great Recession, relative to the size of the states economy: it will fatten Illinois tax collections by 1.2 percent of state GDP annually.
Yet even this massive cash infusion wont balance Illinois budget. Having spent a decade learning that it cant borrow its way out of a fiscal hole, Illinois is about to learn that it cant tax its way out, either. Only by enacting structural spending reformsincluding fixing the pension system for its public employees, which is the nations worst-fundedcan Illinois solve its never-ending budget crisis.
Illinois hasnt really balanced its budget since the tech-boom years of the late 1990s. Faced with a growing gap between revenue and spending, state lawmakers have resorted to borrowing money to pay for current operations. This borrowing can take unusual forms; sometimes, for example, Illinois simply stops paying its bills, sending IOUs to vendors, such as hospitals that provide Medicaid services, and to local governments and authorities. (As of March, Illinois had piled up over $8 billion in such unpaid bills, and the governor and legislature were squabbling over whether to borrow even more to pay them.) All this borrowing has added up: the states bond debt and unfunded pension liabilities have skyrocketed from $20 billion in 1998 to $126 billion by this July.
Technically, Illinois shouldnt be able to amass such a heavy debt burden, since its laws, like most states, require the state budget to be balanced yearly. The problem is that Illinois balanced-budget rule is full of loopholes. The legislature, for instance, can meet the requirement simply by attesting that the budget is balanced at the time of enactment, even if it knows that budget gaps will appear later in the year. When those deficits appear, the legislature can then borrow money to close them; it doesnt have to cut spending or raise taxes, as most other states require. The balanced-budget requirement also doesnt apply to Illinois pension obligations; the state is free to treat them as carelessly as it likes.
These lax rules have allowed Illinois to increase its spending, through good times and bad, without raising taxes. In 2003, for instance, with state tax receipts still lagging from the 2001 recession, then-governor Rod Blagojevich sold legislators on a plan to float $10 billion in bonds to reinforce the states teetering pension funds. However, $2.7 billion of that money went not to the funds themselves but to substitute for the states current-year pension payment and to service the bonds own interest costs. That freed up other money, which Blagojevich used to finance an ambitious spending program, including expansions of eligibility for Medicaid and the Childrens Health Insurance Program.
Blagojevichs spending initiatives proved popular with voters, in part because his use of debt financing made them seem free. Indeed, until his impeachment and removal from office for trying to sell Barack Obamas Senate seat, he was a staunch opponent of any income- or sales-tax increase. Its hard to miss the parallel with President George W. Bushs economic policy, which combined tax-cutting with huge expansions of spending and generated massive deficits. Most states avoided this mistake during the last decade. But Illinois had the dual misfortune of its weak balanced-budget requirement and a governor more than willing to plunge the state off a cliff of indebtedness.
Unfortunately, Illinois capacity to borrow is much more limited than the federal governments, since Illinois pays roughly 3 percent more in annual interest to issue a taxable long-term bond than the U.S. Treasury does. The states debt explosion cannot last forever, and the passage of the Quinn tax package is a sign that reality is starting to register in Springfield.
However, Illinois tax-heavy approach to shrinking its budget deficit will harm its regional economic competitiveness because it must compete with lower-tax states around it. According to the Tax Foundation, Illinois residents paid 10 percent of their incomes in state and local levies in 2009, ahead of all midwestern states except Minnesota and Wisconsin. The new taxes will probably push Illinois ahead of Minnesota and further widen the gap with states like Indiana, which has already erected billboards at the state border encouraging businesses to come on IN. For years, Illinois has been losing population not just to states in the South and West but also to its Rust Belt neighbors, including Indiana; Quinns tax increase wont reverse that outmigration.
Moreover, the increase doesnt solve Illinois budget woes. Despite the new revenues, Quinns proposed 2012 budget remains significantly out of balance, running a deficit for the current years operations that Quinn wants to fill by borrowing $1.45 billion more.
An even bigger problem is that the tax increase wont fix the states woefully underfunded pension system. Each year, according to the Civic Committee of the Commercial Club of Chicago, an Illinois think tank, the state falls approximately $7 billion short of the payments that it should be making to its pension funds if its going to have the assets to pay for future pension benefits and retiree health care. At the moment, the money that Illinois has set aside covers just 38 percent of the pension obligations that it has accrued, and less than 1 percent of retiree health-care obligations. If Illinois continues to underfund its pensions, the system could run out of money within the decade. The state would then need to increase its payments into the pension funds dramaticallyor else default on benefits.
This bleak picture has some politicians in Springfield talking seriously about pension reform. The state enacted reforms in 2010 that set one of the countrys highest retirement ages, 67. But the new retirement age applies only to newly hired workers, which doesnt do much to improve the solvency of the pension funds. House Speaker Michael Madigan, a Democrat, wants a more aggressive reform that would reduce current workers future benefits. His proposal has set off a furious debate over the meaning of a provision in the state constitution that says that pension benefits shall not be diminished or impaired: most agree that the provision makes past benefits untouchable, but the future benefits of existing workers may be a different story. Because Quinn believes that reducing those benefits would be unconstitutional, the legislature may try to pass Madigans reform over the governors objection. The battle will probably be settled in court.
Rahm to the Rescue?
Chicago, the largest city in Illinois, faced a budget shortfall of over $650 million for fiscal year 2011. To close most of that gap, Mayor Richard Daley used one-time revenue gains: proceeds from selling the Chicago Skyway (a toll road in the southeast part of the city) and the rights to operate the citys parking meters for the next 75 years. But there are only so many one-shot revenue enhancements that Chicago can turn to, and they have grown unpopular, particularly since the parking lease is widely viewed as a raw deal.
To help close next years deficit, which will be at least $500 million, Rahm Emanuel, who will become Chicagos mayor in May, plans to adopt a practice pioneered by former Indianapolis mayor Stephen Goldsmith. In managed competition, city departments bid against private contractors to provide services. Emanuel notes that since Charlotte, North Carolina, adopted this practice, public departments have won 70 percent of bids, but the bidding process has encouraged those departments to find ways to do their work more efficiently. Emanuel expects to save $65 million in garbage collection alone.
Emanuel has also echoed Michael Madigan, Speaker of the Illinois House of Representatives, by saying that he wants to cut the pension benefits that current city employees can accrue in future years. This reflects a recognition that the citys out-of-control pension costs will otherwise force it to raise property taxes drasticallyespecially after Illinois passed a law last year forcing Chicago to make actuarially sound pension contributions, unlike the state, which continues to shirk its own.
These calls for reform earned Emanuel the enmity of the citys public-sector unions, none of which endorsed his bid. He managed to win nevertheless, with 54 percent of the vote in the six-candidate primary election. If Emanuel succeeds in getting a handle on Chicagos budget, he may set an example for lawmakers in Springfield.
What else can Illinois do to balance its budget? The Civic Committee has proposed a package of spending reformsmostly focused on pensions, health insurance for government employees, and Medicaidthat would save the state roughly $5 billion per year. Illinois needs to enact something along these lines if it hopes to avoid future tax increases and allow even part of the recent increase to end. But while the Civic Committees reforms go far beyond what Springfield lawmakers have been willing to do, they still wouldnt be enough for the state to balance its budget and make responsible payments for its retirees, and they would probably necessitate an extension of some of the Quinn tax increases.
Illinois path to true solvency demands much more. First, the state must bring its books into real balance, including actuarially sufficient payments for pensions and retiree health care. That will mean treating the Civic Committees program of spending cuts as a floor rather than a ceiling, especially if lawmakers hope to let any of the Quinn tax hikes sunset. It will also mean that the legislature will have to take the fight over pension cuts for current workers to the state supreme court.
But Illinois also needs reforms that will prevent it from succumbing to the fiscal illusions that let it run up such large debts in the first place. It should amend its constitution both to prohibit the use of bonds to pay for current operations and to require an independent legislative analystnot the legislature itself, as is currently the caseto certify that the budget is balanced. And it should constitutionally forbid unfunded enhancements to employee pension benefits, as Maine does. Illinois handed out $5.8 billion worth of enhancements from 1998 to 2003, one of many drivers of the states debt explosion.
Illinois senator Mark Kirk is one of the leading voices in Washington calling for a new law that would let states declare bankruptcy. Its not hard to see why such a law might appeal to him. As a January J. P. Morgan research note put it, Illinois is in a league of its own fiscally, simultaneously facing the countrys largest current-year budget gap and its biggest debt load, relative to state revenues. If any state is a candidate for bankruptcy, its Illinois. But even Illinois hasnt reached such dire straits yet. The better course of action is to start paying all its billsby figuring out what it cant afford to do and then levying sufficient taxes to pay for the rest. A simple prescription but one that works, more or less, for most states.
Josh Barro is the Walter B. Wriston Fellow at the Manhattan Institute and a regular columnist for RealClearMarkets.