Illinois Tax Reform Sideshow Long on Gimmicks, Short on Solutions
This story was published with Crain's Chicago Business.
Gov. Bruce Rauner says he wants to freeze local property taxes, but his new Illinois budget seeks to shift hundreds of millions of dollars of spending for teacher pensions off the state’s books and on to the same homeowners and businesses he says desperately need tax relief.
Inconsistencies, omissions and logic-bending myopia have long been the stuff of tax-reform talk in Illinois, and there’s no indication that will change heading into a 2018 governor’s race in which Rauner and rivals in both parties push competing visions for curing the fiscally ailing state.
Rauner, in his budget, also seeks to begin a roll back of a recent income tax hike, while most Democrats vying to unseat him embrace a structural change in the income tax to make the wealthy pay more.
If history is any guide, neither of those two very different paths is likely to lead to long-lasting improvement in the state’s fortunes.
Illinois’ tax structure is a crazy quilt of levies stuck in the economic and political realities of the Great Depression and solidified by lobbying clout and partisan inertia. Largely absent from the election year debate is talk of any comprehensive overhaul that would address income, sales and property taxes as part of an interrelated system for funding schools, pensions and other critical government services.
Instead, as it has been for decades while state and local finances spiraled downward, change is being approached as a series of one-off Band-Aids.
The school funding conundrum is a case in point.
Local property taxes here are among the highest in the nation for a simple reason: State government covers only about one-fourth of the cost of schools, just under half the national average, federal data show.
That renders schools dependent on local revenues to cover the lion’s share of their funding. Indeed, state records show nearly two thirds of the average property tax bill in Illinois goes to cover school costs, and that share would almost surely rise further if Rauner got his wish on the pension cost shift.
Upending that dynamic would require a major increase in state revenue, which currently is insufficient to cover other obligations and make a dent in the education funding disparity.
Officeholders in Illinois have long fought reform battles on the margins of the tax code while the fundamental problem – a leaky, outdated system that annually forgoes the collection of billions of dollars of receipts while treating special breaks as hallowed entitlements – is ignored under the sway of reelection politics.
“Reform is costly, politically, which is why you almost never see it,” said James Nowlan, co-author of “Fixing Illinois,” a 2014 assessment of state financial problems. “It’s either too hot to handle politically or it’s so far beyond their ability to handle it.”
Nowlan, a former Republican member of the state House, said the result is that tax changes that do get enacted are narrowly tailored. “If they do something, it’s to help specific people – seniors, veterans, nonprofit groups,” he explained. “And they just end up shifting the burden to others. It’s a jerry-built system.”
The tax system in Illinois is in many ways a three-legged stool in danger of collapsing because its main supports, the income, sales and property taxes, are riddled with costly exemptions. Taxes do not exist in a vacuum, and the flaws in each undermine the effectiveness of the others.
Most states tax income, but Illinois is one of only eight that requires blue-collar and middle-class taxpayers to pay the same rate as the affluent, currently 4.95 percent. It is also one of the few that exempts all retirement income from taxation at a cost of $2.5 billion a year in lost revenue, according to a recent estimate from the Civic Federation, a budget watchdog.
Most states charge sales taxes, but Illinois is one of the few that chooses not to apply that tax to a wide array of services. If Illinois followed the lead of neighboring Iowa, where the taxing of services is extensive, the annual revenue boost would amount to between $1.2 billion and $2.9 billion, according to projections from the legislature’s bipartisan fiscal forecaster.
And because Illinois picks up such a small share of school spending, most of the burden gets dumped on local property taxpayers.
This is hardly a recent development. State politicians, fearful of jeopardizing their own re-elections by pushing state tax hikes, have for decades been passing the tax onus on to school districts and local governments, effectively thwarting significant change.
The financial pit Illinois has dug itself over the years may be extreme, but the aversion of its political leaders and voters to taking on sweeping tax reforms is very much in the mainstream across the nation.
Indiana, which like Illinois has a narrow sales tax base that excludes most services from taxation, launched an effort to broaden it in 2015 that went nowhere. Republican state lawmakers in Michigan enacted a range of taxes on services in 2007, only to repeal them 17 hours after they took effect. And Missouri voters in 2016 approved a constitutional ban on extending the sales tax to services beyond those already being levied.
“There have been dozens and dozens and dozens of efforts to look at state tax systems on a very rigorous basis,” said John Mikesell, an economist and professor at Indiana University who specializes in tax policy and government finance. “You could fill a medium-size office with those studies. They pretty much all say the same thing and they pretty much all produce no results. (Public officials) do things only under great duress.”
Comprehensive and effective tax change requires foresight, nuance, fortitude and compromise, things that wither under the demagoguery and gamesmanship of politics. There are examples aplenty in Illinois both new and old.
In 1994, then-Republican Gov. Jim Edgar rode to re-election savaging his Democratic opponent for proposing a swap that would hike income taxes to lower property tax bills and bankroll schools. A few years later, Edgar reversed himself and pushed his own version of a swap, only to have it shot down by fellow Republicans in the legislature.
Ever since, property tax bills have relentlessly skyrocketed as the state share of school funding plummeted.
As Rauner now pushes for re-election, he boasts that funding for schools has increased under his watch. Even so, state data show the Illinois share of total school spending fell from 26 percent to 24 percent during Rauner’s first two years as governor. Data from his third year in office is not yet available.
Meanwhile, the top Democrats hoping to oust Rauner all embrace the idea of replacing Illinois’ flat rate income tax with the sort of progressive tax system in place in most surrounding states and at the federal level that levies higher rates on taxpayers with higher incomes. But doing so in Illinois would require a difficult to achieve amendment to the state constitution to implement.
Data from the U.S. Census show revenue generated by Illinois’ current flat rate income tax is higher on a per capita basis than in neighboring states with so-called graduated income taxes.
That suggests two things. Such a push by Democrats, depending on how rates might get set, runs a risk of actually lowering revenues and further harming already fragile state finances.
On the flip side, Rauner and other critics of a graduated tax claim its adoption would be tantamount to a tax hike. The revenue numbers from neighboring states with such taxes don’t bear that out.
In many ways, the duress of yesteryear very much frames Illinois tax controversies of today. Desperate for revenue during the economic depths of 1930s, Illinois enacted its first ever state income tax with rates ranging from 1 percent for those of modest income to 6 percent for the wealthy.
That graduated tax was struck down before it could be implemented by the Illinois Supreme Court, which ruled that only a flat tax would be allowed under the 1870 state Constitution then in place.
It would be another three plus decades before Illinois began levying an income tax that passed legal muster, this time with a single rate charged to all individual taxpayers. The flat rate mandate was then enshrined in a new Constitution that went into effect in 1970.
The 1930s, however, did see adoption of another pillar of state revenue:, the sales tax, with an initial rate set at 2 percent.
Back then, taxpayers spent most of their disposable income on retail purchases, but the consumer climate has changed dramatically over time with an ever larger share of spending allotted to services from hairstyling to landscaping to help from attorneys, accountants and other professionals.
Some states have adapted their sales tax policies to capture modern spending trends. Illinois has not.
The Illinois sales tax is a composite of a state rate that now sits at 6.25 percent and local sales taxes that vary by community but add up. In Chicago, the total tax on purchases comes to 10.25 percent, among the highest in the nation.
The anachronistic structure of the Illinois sales tax, however, leads to anomalies.
It puts a greater financial onus on those of low-income, who spend more of their resources on taxed retail purchases instead of untaxed services. The sales tax in Illinois generated more than $8 billion in revenue in 2017, state records show, but on a per capita basis the yield falls behind that in states like neighboring Iowa where the total sales tax rate is limited to just seven percent.
The difference? Iowa applies the tax to an array of services that Illinois does not.
After accounting for inflation, Illinois has registered almost no growth in its sales tax base since 2000, while growth in personal income outpaced sales tax revenue by 28 percent over that period, according to a 2017 analysis by economist Natalie Davila, the former director of research for the Illinois Department of Revenue.
National economic trends only underscore the factors weighing down Illinois. In 1966, goods-producing industries accounted for more than one third of gross domestic product, according to the Pew Research Center, a non-partisan D.C. based think tank. In 2016, they made up only 18 percent. That decline is mirrored by the rise of services, which now comprise more than two-thirds of the private sector pie.
When he first ran for governor in 2014, Rauner indicated a willingness to add more services to the sales tax base. He didn’t push for it once in office, however.
It’s a common phenomenon among officeholders. Last year, base-broadening sales tax legislation was taken up in 23 states, but nothing passed.
One of those states was Indiana, which has a narrow sales tax base like Illinois. The sales tax rate is a uniform 7 percent across Indiana, which unlike Illinois does not allow municipalities to levy add-ons.
Tax policies are tailored to reflect the economic makeup of each state, and that can make tax climate comparisons to other states misleading That hardly stops politicians and ideological activists from trying anyway.
Also complicating meaningful comparisons between Illinois and its neighbors are two significant differences.
Illinois residents, on average, make much more per year than counterparts in neighboring states, and that is reflected in higher per capita tax burdens. And no other state in the region has a metropolitan core as populous and economically dominant as Chicago.
For those on the political right, Indiana has become the touchstone by which to measure what they see as the tax profligacy of Illinois. Not only does Indiana have that flat state income tax, but the rates are far lower than those charged in Illinois—3.23 percent for individuals and 6 percent for corporations.
But Indiana, it turns out, is a cherry-picker’s delight when it comes to making tax comparisons. Often overlooked is that Indiana counties also levy local income taxes; Illinois does not have local income taxes.
So taxpayers in Lake County, Ind. this year pay a combined state and county income tax rate of 4.73 percent, just short of what their immediate neighbors in Chicago will pay. In Marion County, home to Indianapolis, the combined tax rate for individuals is 5.25 percent, higher than in Illinois.
What’s more, seniors in Indiana must pay taxes on some sources of retirement income. Illinois does not tax any retirement income.
J. Fred Giertz, an economics professor at the University of Illinois, said tax code comparisons between states are further complicated by the fact that side-be-side rankings don’t indicate what a state is trying to achieve: Higher-taxing states may be working toward different goals, such as providing more public services, than their lower-taxing counterparts.
The problem arises when growth in a state’s revenue base cannot keep pace with spending. In Illinois, Giertz said, the sales tax in particular is falling behind.
“Every state falls short of taxing all consumption, but in Illinois we have a lower share than most,” he said.
Some tax challenges are even more urgent. The decreasing reliability of the motor fuel tax, or the gas tax, offers another case study on the political difficulty of plugging those holes. While sales and income tax revenue continue to rise annually, if disappointingly, gas tax revenue has dropped seven percent in the past decade. All states face this problem because cars are more fuel-efficient and hybrid and electric vehicles are becoming more popular.
Oregon is experimenting with a technological solution, taxing drivers on the miles they drive. Democratic governor candidate J.B. Pritzker told the Daily Herald in January the state should consider such a plan.
The Republican Governors’ Association slammed the idea as an “unprecedented government invasion of privacy.” One of Pritzker’s rivals for the Democratic governor nomination, State Sen. Daniel Biss of Evanston, raised similar concerns over the privacy implications of installing mileage tracking devices in every vehicle.
“No politician wants to suggest any taxes – especially a new one,” said Cook County Commissioner Larry Suffredin, who last year had backed a controversial tax on sweetened beverages that fueled a public outcry and was killed soon after it went into effect.
In the absence of unpopular steps to restructure tax systems, superficial or untested tax talk take center stage. The most significant tax reform of the decade occurred in Kansas, where Tea Party-inspired Republicans slashed income taxes in the belief that doing so would spur economic development and population growth.
Neither happened, but huge budget deficits did. Kansas, though, opted for tax-cutting reform. The road ahead for Illinois and other states will almost certainly involve tax increases, by way of widening the array of transactions that can be taxed. It won’t be easy.
“Just starting from scratch is almost the only way to get over our tax structure, to modernize it and get it in a way that would work going forward,” said Carol Portman, president of the nonpartisan Taxpayers Federation of Illinois. “But it would take years and years and I don’t think I see it as politically viable in the near future.”