What's the Matter With Illinois?

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Over the last two budget cycles, every state except North Dakota has had to close a budget gap. But a handful of states stand out for the depth of their fiscal problems. For 2010, seven states had budget gaps totaling more than 25% of general fund spending, as measured by the Center on Budget and Policy Priorities. Of these, six have a clear story about how they ended up in such a mess.

Nevada is battered by weak travel to Las Vegas, while California is heavily reliant on shrinking income tax revenues. Arizona, California and Nevada were all hit particularly hard by the burst of the property bubble. Alaska's odd finances are sensitive to falling oil prices. And New York and New Jersey are feeling the effects of fewer, and smaller, Wall Street bonuses.

The most puzzling member of the "over 25% club" is Illinois. Illinois did not see a particularly large bubble (or burst) in property prices, does not have outsize exposure to finance or tourism, and has a lower-than-normal reliance on its flat income tax. So how did the state achieve a staggering budget gap equaling 47% of its fiscal 2010 budget, second only to California?

The trouble is that Illinois did not enter the recession from a position of budget balance. While California's budget shenanigans have garnered national attention, Illinois' behavior has been similarly poor but less widely noticed. The Land of Lincoln has not truly balanced its budget since 2001, and its large structural deficit has it poised for fiscal ruin in the recession. While other states can blame external economic factors, the key cause of Illinois' budget crisis is legislative malfeasance.

Illinois has taken the budget gimmicks seen in many states to an extreme. Occasionally, states postpone payments during budget crises to close budget gaps. But for the last decade, Illinois has made a standard practice of delaying vendor payments -- even in good years -- and then periodically floating general obligation bonds to clear the backlog.

The state has also used its pension system as a venue for stealth borrowing. From 1996 to 2008, the state's unfunded pension liability grew by $36 billion -- and $19 billion of that growth was due to elected officials funding pensions below the actuarially required level. (Another $6 billion was attributable to benefit increases enacted ten years ago at the height of the dot-com stock market bubble.)

Even taking its aggressive investment assumptions at face value, Illinois' public employee retirement system has assets to cover only 54% of its accrued liabilities -- one of the country's worst ratios. When the state promises future benefits to employees without setting aside the cash to pay for them, it is effectively borrowing without reflecting bond debt on its balance sheet.

Meanwhile, when the state did make required pension contributions, it often did so by floating bonds -- over $13 billion in "pension obligation notes" over the last decade. It's no surprise that in 2008, the Pew Center on the States rated Illinois' money management the third worst in the country, behind only Rhode Island and California.

Unlike tax increases and spending cuts, these gap-closing strategies make future year deficits even worse -- the state spends over $1 billion a year just to service previously-issued pension obligation bonds. Having made no real progress on its structural deficit, Illinois faces a $13 billion gap in its $32 billion 2011 general fund.

Last week, Governor Patrick Quinn proposed his FY 2011 budget, and the contents are not inspiring. Quinn's proposed budget includes delaying over $6 billion in vendor payments to the next fiscal year, and raising the state's personal and corporate income taxes by a point each. (Last year, Quinn proposed raising the personal and corporate income taxes, but was thwarted by the Democratic-controlled legislature.) These measures would combine with spending cuts to close the gap.

Illinois' low income tax, with a flat rate of 3%, serves to offset high property taxes and high sales taxes, especially in Chicago. Overall, Illinois is not a low-tax state -- in fact, it already collects more state and local taxes per capita than any Midwestern state except Minnesota. Raising income taxes would deprive the state of its one key tax environment advantages compared to its neighbors, and is the wrong answer to close the gap.

What's the consequence of foregoing the tax hike? Governor Quinn has threatened that, if his income tax increase does not pass, he will be forced to cut $1.3 billion in state aid to school districts. Legislators should take the governor up on his threat, which would represent an approximately 5% cut in total education spending, and let school districts decide whether they wish to raise property taxes to cover the gap.

Beyond education, positive fiscal reform will require getting the expense side of the state's ledger under control, especially on employee compensation and pensions. The state's required pension plan contribution has exploded to over $4.1 billion for 2011 from $1.1 billion in 2000, accounting for more than 1/8 of general fund spending and crowding out other programs. This reflects the generosity and unsustainability of public employee benefits in Illinois.

The Illinois Policy Institute, a free-market think tank based in Chicago, has promoted a creative reform on public pensions, which combines a state expenditure limit with a commitment to direct all surplus revenues into the pension fund until adequate funding is reached. New employees would be shifted to a defined contribution retirement plan that would prevent future pension funding crises.

Meanwhile, the state and localities could freeze or even cut employee wages to offset the value of generous pensions. Fewer than 2% of state employees voluntarily left their jobs in 2008, a lower figure than in any other state, which suggests that Illinois could reduce employee compensation while continuing to retain talent. (Similarly, a wage freeze at the school district level would significantly reduce the pressure from state aid cuts.)

What Illinois cannot do is go on forever with a fiscal strategy of borrowing to finance current operations. The state already has one of the worst credit ratings in America (though still better than California), which will continue to deteriorate so long as the state's structural deficit and pension underfunding problems persist. If the state fails to control spending and fix its pension problem, it is poised to follow California off a fiscal cliff.

Josh Barro is the Walter B. Wriston Fellow at the Manhattan Institute.

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