Illinois campaign puts a graduated income tax on the table

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CHICAGO -- Replacing Illinois' flat income tax rate with graduated rates would not be a cure-all for the state’s battered fiscal condition, market participants said.

Though such a change could raise more revenue, it would also expose a state with a poor track record of budget management to more volatility, experts said.

After languishing for years, debate over implementing a graduated income tax system has become a campaign issue in the governor's race.

The Democratic candidate, J.B. Pritzker, wants to see a constitutional amendment on the 2020 ballot allowing the state to join the ranks of 33 others with an income tax that use graduated rates. Illinois is among eight states to impose a flat tax, which is required by the state constitution.

Incumbent Bruce Rauner and fellow Republican lawmakers are staunch critics of such a move.

From a credit perspective, such a change could help but it comes with some dangers.

“The state will get more revenue but it’s no free lunch because it comes with increased volatility,” said S&P Global Markets lead Illinois analyst Gabriel Petek. Because the additional revenue would come from high-income individuals who get more of their income from capital investment and capital gains, the state would experience more market volatility and wider and greater swings in response to economic cycles and financial market fluctuations.

“While revenue is part of the discussion, it’s not going to be Illinois’ salvation alone. It’s going to require a balanced approach given the magnitude of the liabilities,” and that includes action on spending, Petek added.

In addition to red ink that remains even after a July hike in income tax rates that Rauner opposed, the state has a roughly $7 billion bill backlog and $129 billion of unfunded pension liabilities.

Democratic lawmakers have moved to get behind their candidate with a non-binding resolution endorsing what they have labeled a “progressive” or “fair” tax. It’s one of only a few ideas Pritzker, a businessman and heir to a family fortune, has offered to solve the state’s fiscal mess.

“It would take us about two years in total to get it all done and said,” Pritzker said at an April news conference. In the meantime, he would seek an “artificial” graduated tax by raising the overall rate while increasing various tax credits and exemptions that benefit lower income and the middle class.

Pritzker has remained silent on how much he’d like to generate, saying the ultimate rates adopted would be negotiated with lawmakers.

“You really would have to make clear to the voters, who ultimately will decide about the amendment, what those rates will be and so that would result from this negotiation,” he said.

Rauner and his fellow Republicans say the proposal is nothing more than an excuse to dig deeper in taxpayer pockets and warn it would give Democrats free rein to keep raising taxes.

“The Democrats’ progressive income tax is a calculated killer: it kills jobs and businesses and, ultimately, it will kill the middle class,” Rauner said in a recent statement.

The fiscal 2019 budget package pushed through last July by Democrats with the help of a handful of Republicans raised the personal rate to 4.95% from 3.75% and the corporate rate to 7% from 5.25%. The hikes are expected to generate more than $4.5 billion in new revenue annually. Passage of a budget and the new revenue staved off the state's bond ratings being cut to junk.

Illinois’ fiscal wounds run so deep that Gurtin Municipal Bond Management remains negative on the state and believes that “drastic changes” are needed, but just how much a graduated tax would help is unclear.

“Pinning a credit opinion on projected revenue performance in future years after the enactment of a progressive tax, with all of the other variables at play, not the least of which is a lack of reliable governance, make the view very cloudy,” said John Humphrey, head of credit research at Gurtin. “I think the best case for Illinois is that they meander through the next decade.”

Lawmakers, public policy organizations, business groups, and social services providers drew their lines in the sand in sometimes contentious debate during a hearing last week on House Speaker Michael Madigan’s resolution supporting the constitutional amendment. “A fair tax for Illinois is about putting more money in the pockets of middle-class families,” Madigan said in a statement.

Republicans filed their own resolution opposing it.

The House Committee on Revenue and Finance received 1,650 witness slips from stakeholders laying out positions in support and 2,032 against. The committee approved the non-binding resolution that endorses a graduated tax that lowers taxes on lower and middle-income residents while raising it wealthier taxpayers.

House Minority Leader Jim Durkin, R-Western Springs, called on Democrats to release the rates they want. “What is Pritzker hiding?” he said. House Majority Leader Barbara Flynn Currie, D- Chicago, countered that there are not rates being eyed, just the permission to shift to a graduated rate.

“This is all about raising taxes,” which will drive people out, warned Rep. David McSweeney, R-Barrington Hills.

While legislative backers of a graduated tax have remained silent on the range of rates they support and the targeted revenue goal, the Center for Tax and Budget Accountability in an April 30 report offered up two scenarios. Both would net $2 billion in additional revenue and trim the burden on lower and middle income earners.

“Illinois’ current tax system is unfair, because it fails to tax people according to their ability to pay,” says the report, presented at the committee hearing.

The first scenario relies on rates that range from the current 4.95% on taxable income under $300,000 to a high of 9.85% on income of more than $1 million. An income tax credit of up to $300 would apply on taxable income up to $200,000. A second scenario relies solely on rates to generate the $2 billion with tax rates set at between 4.50% and 9.85% on income over $1 million.

“Top marginal income tax rates would be no higher than rates that already exist in the Midwest. As a result, the state tax system would become fairer, more sustainable, and better for the Illinois economy,” the report says.

“If enacted, CTBA’s recommendations would wreak further havoc on household budgets and the state economy,” countered a report from the Illinois Policy Institute. It was presented to the committee by author Orphe Divounguy, an economist.

The IPI analysis says that removing the constitutional language would open the gates to future tax hikes beyond the $2 billion pitched in the CTBA report. “That won’t come close to paying for the state’s backlog of bills, ballooning pension costs or politicians’ desire for more spending,” reads the report.

Illinois needs spending reforms to hold rates in check, according to the IPI. State spending grew by 49% from 1996 to 2016 while gross domestic product grew by 35%, the report said, citing U.S. Census Bureau data. “Illinois should reject a progressive tax and lawmakers should learn to spend within their means,” the report said.

The institute says higher taxes on top earners will hurt economic activity by putting a dent in economic investment, which has a greater impact on growth.

“The tradeoff between investment and consumption is why CTBA’s $2 billion tax hike would harm the state’s economy,” the report says.

From a credit perspective, Petek said if the shift is eventually adopted the state needs to build market volatility into its budgeting and revenue projection process as other states like California and Minnesota recognize. While California has improved its fiscal status in recent years, the volatility of its revenue streams has held its rating at AA-minus, Petek said.

“Illinois doesn’t have the most stellar track record of managing” through flush economic times “in a way that improves its fiscal condition” by taking steps like building reserves or paying down debt, Petek added.

The state would also benefit from “enhanced budget management policies” on reserves, forecasting, and spending.

“Otherwise, you are at the mercy of the political situation,” Petek said.

A recurring theme among supporters throughout the hearing centered on comparisons to Minnesota, which raised its top rate in 2013 to 9.85%. The state erased red ink over the next few years, structurally balanced its books, and has billion-dollar surpluses to spare.

Minnesota and Illinois share some political similarities as during times of divided leadership Minnesota has struggled to pass a budget, resulting in a government shutdowns and the use of one-shots to wipe out red ink. The tax hike passed when incumbent Gov. Mark Dayton, a Democrat-Farmer-Labor Party member, enjoyed legislative majorities. Republicans now control the legislature.

On budgeting, the two differ. Minnesota ties spending to two formal annual revenue forecasts that account for market volatility and has formal reserve policies on surplus revenue. Illinois does not.

Currently, a similar mix of revenues make up each state’s general fund, so if Illinois shifts to a graduated tax income taxes will represent a greater percentage and it will come from high earners with incomes at the mercy of the economy, underscoring market volatility concerns, said S&P analyst Cora Bruemmer, who covers Minnesota.

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