Illinois budget's reliance on tax amendment adds uncertainty, Fitch says

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Illinois Gov. J.B. Pritzker’s $1.4 billion fiscal 2021 gamble on voters approving a progressive income tax system in November raises the stakes for local governments, schools, and the state’s budgetary progress, Fitch Ratings warns in a new commentary.

“Under the governor's budget proposal, failure of the income tax amendment would trigger fiscal actions that could exacerbate the state's structural budget challenges and pressure local governments, particularly school districts,” Fitch wrote in its first formal comment on the $42 billion general fund budget proposal unveiled by Pritzker last month.

Fitch rates Illinois two notches above a speculative grade at BBB with a stable outlook. Moody’s Investors Service and S&P Global Ratings have the state at the lowest investment grade rating with a stable outlook.

Eric Kim, Fitch’s lead Illinois rating analyst. Fitch said the governor’s budget creates fiscal uncertainty if his income tax referendum fails this year.

Pritzker is banking on voters approving a constitutional amendment that allows the state to scrap its flat income tax rate and move to a graduated structure that would raise rates on top earners to generate more than $3 billion annually. To present a cash-balanced budget based on current revenue projections, the budget reserves $1.4 billion in spending pending the outcome of the amendment as the shift to a graduated tax would take effect midway through the fiscal year.

“For local governments, and particularly school districts, the $1.4 billion of reserved items in the governor's budget proposal pose risks,” Fitch warned. That’s because the $350 million scheduled increase in school aid under the 2017 evidence-based funding formula adopted would be cut by $150 million.

About $100 million in combined income tax and sales tax revenue the state would have shared with local governments will also be set aside as will $40 million in increased state funding for school districts for certain mandated categorical items.

The reserve actions also include the deferral in payment of $400 million in employee health insurance costs and the use of more than $500 million of interfund transfers or borrowings to keep the budget cash balanced.

Both are measures that “risk exacerbating the state's structural budget challenges,” Fitch analysts Eric Kim and Karen Krop wrote. “If voters approve the constitutional amendment the governor's executive budget would avoid such non-recurring measures and appears to continue recent progress towards structural balance.”

Fitch said it will await approval of a budget before casting a credit judgment on the impact and it takes the position that it’s how the state reacts to the passage or failure of the amendment that “will be critical” to the state’s credit standing rather than the outcome of the vote.

The state’s rating reflects a pension burden that based on Fitch’s adjusted figures represents 80% of $200 billion in debt liabilities. “Fitch notes that pension contributions remain a point of structural weakness for the state, regardless of the income tax amendment vote, as the governor's proposal continues the practice laid out in current law of underfunding the systems relative to actuarial determinations,” analysts wrote.

The state’s contributions are set by a formula that in fiscal 2018 represented 71% of an actuarially based level. The state will make $8.6 billion in contributions from the general fund in fiscal 2021. Pritzker would boost the contribution by $100 million in the next budget and then $200 million annually in future years if the tax amendment passes.

“Fitch believes the supplemental annual pension contributions of $100 million-$200 million proposed by the governor if the income tax amendment passes would be helpful. But on their own, they would not materially affect Fitch's view that the state's budget remains structurally unbalanced given the sizable gap between actual contributions and the actuarially determined contribution,” Fitch said.

The Civic Federation of Chicago Friday issued an initial commentary that raises concerns over the budget’s reliance on uncertain tax revenue and the impact of the alternative plan on the state’s backlog that has been running at between $6 billion and $7 billion. That’s because the $400 million of health insurance payments that would be withheld are required under state law and union contracts.

“There are questions about whether the proposed use of potential graduated income tax proceeds is appropriate in light of the state’s severe financial pressures. There are also concerns about the long-term cost of the alternative measures proposed in the event that the constitutional amendment does not pass,” the federation wrote.

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State budgets Ratings State of Illinois Illinois J. B. Pritzker