NEW YORK - On Feb. 22, Illinois Governor Pat Quinn introduced his proposed fiscal 2013 budget. In Standard & Poor's Ratings Services' view, the budget's overall revenue forecast supporting fiscal 2013 spending is aligned with the state's current economic performance and outlook, and includes the significant revenue enhancement enacted in 2011.

Spending is significantly constrained under the current proposal, with much of the detail on how it will be accomplished left to legislative deliberation, which has had an uneven track record of consensus on key budget-balancing initiatives, S&P said. Pension contributions are the major area of increase in the budget and are funded at the statutorily required level but below the annual required contribution as outlined by the retirement system's actuaries.

The budget does not include specific pension reform proposals; instead, Gov. Quinn has convened a working group to develop recommendations for reform and for lowering state costs associated with funding pension liabilities. Both spending reduction and pension reform face implementation risk in Standard & Poor's opinion. If the budget is not adopted by May 31, a three-fifths super majority vote of the General Assembly is required rather than a simple majority, and this would create a significant hurdle for many of the difficult funding decisions.

While Illinois must balance its budget each year, it is not required to maintain balance during the year, and the proposed budget has not addressed the state's almost $9 billion accumulated deficit.

Standard & Poor's analysis of the deficit includes year-end payables as well as Section 25 liabilities. The projected accounts payable at fiscal year-end 2012 are $5.7 billion.

In addition to these reported general fund deficits, the state also records liabilities each year related to medical assistance and other health care expenditures. These are disclosed as Section 25 liabilities and represent spending for a given year that was deferred or not funded in a given fiscal year and by statute can be paid from future appropriations.

Based on the underappropriation for medical assistance in fiscal 2012, the Section 25 liabilities through fiscal 2012 could rise to $2.7 billion. Illinois also estimates unpaid business income tax refunds of about $500 million through Dec. 31, 2011.

The economic outlook that underlies the budget includes a forecast of continued steady but slow economic recovery, with Illinois underperforming the national economy in key areas such as income and employment growth as well as unemployment rates.

According to IHS Global Insight Inc., the baseline economic forecast for the state assumes employment growth of 1.3% and personal income tax growth of 3.4%. This compares favorably with a growth of 1.4% and 3.8%, respectively, for the U.S.

However, unemployment rates are projected to be 9.6% in fiscal 2013 compared with 8.7% for the U.S. The forecast assumes that the federal payroll tax cut and emergency unemployment insurance benefits are extended in 2012, that the tax cuts implemented while George W. Bush was president will be extended in 2013, and that automatic federal spending cuts scheduled for January 2013 will not occur.

These could be risks to revenue performance if not implemented. Other risks the state has identified include global economic performance, rising oil prices, and federal fiscal policy. Illinois' three major revenue sources--individual income tax, corporate income tax, and sales tax--account for 88% of total revenues. Under the proposed budget, projections are as follows:

--Individual income tax revenues are projected to be $15.3 billion, or 1.4% above fiscal 2012, after some adjustments based on federal tax code changes and an increase in the earned income tax credit and personal tax exemption authorized in 2011. The Department of Revenue projects a 3% wage and salary growth. The taxation rate is 5% as of Dec. 31, 2010.

--Corporate income tax is forecast at $2.6 billion, or 8.3% above fiscal 2012, after factoring in tax policy changes. The taxation rate is 7.0% as of Jan. 1, 2011.

--Illinois forecasts retail sales tax revenues to be 2.7% above fiscal 2012 estimates. There are three components to the base: motor vehicle sales (14% of the total), motor fuels tax (about 11%), and "all other" items (75%). Motor fuel sales are projected to rise by 2.5% compared with a 13% growth in fiscal 2012, motor vehicle sales are projected to increase by 5.5%, and the state forecasts all other items to increase by 2.5%, following a projection of 6.5% in fiscal 2012.

The governor's proposed fiscal 2013 budget includes all funds appropriations of $61.0 billion compared with $60.5 billion in fiscal 2012.

Total general fund spending under the proposal is $33.6 billion, or 1.6% above the estimated expenditures in fiscal 2012.

Pension contributions are projected to increase by nearly $1 billion and represent a high 15% of total spending. Other agency spending is about in line with last year's spending levels. Illinois estimates that state agency headcount has been reduced by 2,225, or 4.1% through fiscal 2012, with another 753 targeted for fiscal 2013. Medicaid will have to be reduced by $2.7 billion to keep fiscal 2013 spending in line with fiscal 2012.

A working group has been created to narrow down the specific spending reduction/reform initiatives. The members include the four general assembly caucus chairs of a Medicaid oversight committee.

Changes under consideration include utilization, eligibility, and optional services, as well as rate reductions. In fiscal 2012, significant cost reductions were considered with limited success as appropriations for Medicaid were $2 billion less than the actual total fiscal year liability. As expected, debt service remains elevated as the approximately $1 billion of debt service costs associated with pension bond issuance in fiscal years 2010 and 2011 are phased in.

The state's pension plans remain an increasing portion of the budget due to historical underfunding, benefit enhancement, and market value declines.

Unlike most other states, Illinois funds pension costs on behalf of other employers such as school districts and public universities. Its annual statutory contribution for fiscal 2013 is estimated at $5 billion.

This contribution is less than the annual required contribution determined by the actuary. Illinois attributes the $1 billion increase in annual costs to higher liabilities associated with assumption changes that were made following the experience reports for several of the plans.

Illinois updated the three-year plan in January and is required to do so annually. Standard & Poor's generally views multiyear planning as a positive financial management initiative allowing for long-term review of the state's revenue, spending, debt issuance, and pension challenges.

A limitation of the plan is that the accumulated deficit and other general fund liabilities are not included in the calculation of year-end surplus/deficit. This could limit the budget's effectiveness in outlining the overall financial position.

The state is forecasting surplus operations for fiscal years 2013 and 2014, with a deficit of $818 million forecast for fiscal 2015 (2.4% of projected revenue). Based on the proposed fiscal 2013 budget and revenue performance to date in fiscal 2012, Illinois now forecasts a smaller surplus for fiscal 2013.

This assumes continuation of the revenue enhancement measures net of adjustments made to corporate taxes in the November 2011 legislative session. Over this period, pension expands to 17.2% of expenditures by fiscal 2015 while debt service is projected at 5.5%. Spending is forecast to remain within the cap.

While the revenue measures implemented in 2011 are significant, they are temporary, extending through 2014. Implementing temporary tax measures is not unusual for a state but Standard & Poor's believes it could impede Illinois' progress toward long-term structural budget balance, especially given the increased debt burden and growing pension contributions.

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