Any state’s fiscal plan must answer two basic questions:  What should the state spend? And how should the state raise the revenue necessary to support this spending? Fundamentally, spending for state services ought to be determined by comparing the benefit from the spending to the cost of raising the necessary revenue.  On the spending side, states ought to use whatever revenue-raising vehicle imposes the least burden on taxpayers. Economic principles argue for taxes that are neutral, horizontally and vertically equitable, and easy to administer.

The 2007 Budget Debate

The governor proposed two large new spending programs – a program called Illinois Covered that aimed to ensure affordable health insurance for all Illinoisans and a four-year, $10 billion increase in spending for preschool to high school education. The governor also proposed a massive infusion of money into the state’s pension systems. This would not have been new spending because it would have changed the timing of an existing obligation rather than the state’s long-term command of resources.

The governor proposed to do all three major programs without increasing sales or income taxes. Instead, he proposed three new sources of funds:  $16 billion of Pension Obligation Bonds, $10 billion from lease of the state lottery, and a new gross receipts tax (GRT) that he estimated would eventually raise $6 billion annually. Because the sale of pension obligation bonds would require repayment out of future revenues and leasing the lottery would require foregoing current (and future) lottery revenues, these proposals primarily would have changed the timing rather than the amount of state revenues.

            As of November 2007, the GRT has not been enacted, the lottery has not been leased, and there has been no new issuance of pension obligation bonds. Squabbling over health-care expansion continues, but it is clear that nothing on the scale envisioned in the governor’s original budget will be enacted in fiscal 2008.

            Health Insurance:  In 2004, the latest year for which nationally comparable data are available, Illinois spent less per capita on health care than a number of other large states and the nation as a whole. While comparisons with other states are interesting, Illinois’ relatively low spending in 2004 does not necessarily mean that it is spending too little. There may be other factors at play, such as 2004 may not be a representative year, Illinoisans may have less need for government-sponsored health care, or other levels of government may provide more health care in Illinois. Other states may spend too much or Illinois may be more efficient at delivering services than other states.

Education: In 2004 Illinois spent less per capita on K-12 education than a number of other large states and the nation as a whole. Again, this does not necessarily mean that Illinois is spending too little. Local government has greater than average responsibility for funding education in Illinois. Other states may spend too much or Illinois may be able to deliver education at lower cost than other states.

Business Taxes: Illinois business taxes are not very different from other similar states. Of course, this does not mean that the level of business taxes is appropriate, but it does suggest that, relative to its most prominent competitors, the level of business taxes in Illinois is neither a big advantage nor disadvantage.

One-Time Revenue: There are two types of one-time (or non-recurring) revenue: windfall revenue is money the state obtains on a one-time basis without giving up future claims on an asset; and liquefied assets are revenues the state obtains by converting an existing asset to current revenue or by borrowing.

Borrowing: Regardless of whether it is good state policy to invest borrowed money through pension funds, sound fiscal management dictates that borrowed money should not be used to pay operating expenses. While Governor Blagojevich’s public statements suggested that all the borrowed money would be used to pay down the state’s very significant pension debt, the precedent set in 2003 and 2004, when more than $2 billion from pension obligation bonds went to the general fund, suggests that Illinois might be cautious in pursuing this strategy.

Leasing the Lottery:  Even if leasing of the lottery generated a bid equal to or greater than the value of the stream of revenue the state would have generated from the lottery, it would create a temporary cash-flow problem under Governor Blagojevich’s plan because the leasing payment would be deposited into the pension fund. Some new revenue source would be required to offset the loss to the general fund because even without the sale of the lottery planned spending exceeds expected income.

Options for Illinois’ Fiscal Future

Change the personal income tax base to federal income tax liability:  This option would convert Illinois’ personal income tax to a surcharge on the federal income tax, and each Illinoisan’s personal income tax liability would simply be a share of their federal income tax liability.

Expand the sales tax to cover consumer services: This change would broaden the sales tax to include an important and growing segment of purchases. It was included in HB/SB 750 during the 2007 legislative session, and it was estimated that it would raise $2.2 billion even after accounting for the cost of a tax credit to reduce the burden on low- and middle-income families.

            Enact a statewide property tax on businesses: If decision makers wish to increase state revenue by levying additional taxes on business, they could adopt a uniform statewide property tax on business real estate. Such a tax could supplement or replace existing state business taxes. Currently, virtually all property taxes in Illinois are levied and administered at the local level. However, there is precedent and some experience in other states with uniform statewide property taxes. Because much of the existing administrative apparatus used to collect local property taxes could be adapted for collection of state property taxes, such a tax might have a modest administrative burden.

      The best choice?  

Of the three options we’ve considered here, changing Illinois’ personal income tax base to the federal income tax liability (Option 1) may be the most attractive, even though it would involve a radical change in Illinois tax policy. Option 1 would introduce significant progressivity into an income tax system that is now nearly proportional. The fairness of this change should be debated but if there is public support for more progressivity, Option 1 would introduce it while minimizing administrative burdens. This alternative also would change Illinois’ income tax base by taxing pension and Social Security income. This would be economically efficient because it would remove the advantage retirees have over other income earners. Perhaps most importantly, Option 1 would allow Illinois’ revenue to grow more rapidly in the future if the current trend toward disproportionate growth of high incomes continues. This change could help stabilize Illinois’ fiscal climate for many years into the future.

Conclusion

We do not believe that Illinois can attain sustained, stable fiscal balance unless it changes its fiscal system to obtain more revenue and we’ve discussed three options for doing so. Our preliminary investigation supports an option that would convert Illinois’ personal income tax to a surcharge on federal income tax liability. This change would be administratively simple, would introduce progressivity into the state tax system and would probably generate future revenue increases that would make it easier for the state to meet its future spending obligations.