By State Senator Dawn Clark Netsch

The Tax Picture In Illinois

Noting the inequitable shifting of tax burdens from the state to local governments, the author calls for cessation of a piecemeal approach to solving tax and revenue problems. "Thoughtful, principled and long-range considerations of tax policy" should be followed, she asserts.

Speculation about the future of Illinois' tax structure is risky; there are uncertainties and, not surprisingly, political considerations that heavily affect its future goals. We can, however, try to understand where we are now and why; that may help us to see where we are likely to go. While everyone may be familiar in a general way with what taxes we as citizens of Illinois pay to the state, it may be useful to review the components.

Major Sources of Revenue

First, what are our major sources of revenue? The state's total budget— income and outgo—is in the neighborhood of $14 billion annually. That includes, on the income side such things as the proceeds of bond sales, the state lottery and federal aid, which contributes over 1/4 (27%) of the state budget. The part of the state's fiscal picture with which we are most concerned, however, is the general funds, some $8 billion, out of which we finance elementary as well as higher education, public assistance, mental health, corrections, and all the other ordinary functions of the state.

"We have always known that Illinois suffers an imbalance in federal spending: we contribute more in tax dollars to the federal government than we receive in benefits and services. . . . For every dollar spent, we get 66 cents back."

The largest source of revenue to finance state government is the income tax, which is responsible for almost 34% of the general funds (and 24% of all appropriated funds). The individual income tax is, of course, by far the major component. In 1983, for example, it produced some $2.4 billion while the corporate income tax generated only some $416 million.

The second major source of state revenues is the sales tax which contributes 29.0% of the state's general funds (20% of all appropriated funds). In other words, nearly 2/3 of the general funds of the state come from two sources, income and sales taxes. Interestingly enough (perhaps frighteningly so), the third major source of general fund revenue in Illinois now is the public utility tax—it will contribute $635 million to the State Treasury in FY 83.

The remainder of the state's general revenue comes from a variety of sources: cigarette and liquor taxes, insurance tax, hotel tax, inheritance pickup tax, federal aid and the lottery. Another major portion of the state budget is funded by gas taxes and driver and vehicle registration fees that contribute substantial revenues which are used at the state level to construct and maintain the road system and part of which are redistributed to local governments for road related purposes.

Those, then, are the sources of our revenue at the state level. What kind of burden does this structure impose on Illinois taxpayers? Prior to the enactment of the 1983 tax package, Illinois was by most measures a fairly low tax burden state in terms of state level taxation. To illustrate, Illinois' total state tax burden in 1981 per $1,000 of personal income was $60.80. That figure was lower than the average of the Great Lakes states, lower than the average of the other nine top industrial states, and quite a bit lower than the U.S. average. Our per capita state tax rank was not quite as impressive, but even here the $641 figure was a little less than the average for comparable industrial states. There was both a plus and a minus to our tax burden position. The positive side is that Illinois peaked in 1974 in terms of its state and local tax burden and had been declining at least until enactment of the 1983 tax package. The negative side was that our state tax collections had increased in the past couple of years less than any other major industrial state or any of our regional neighbors—and that fact is, of course, not unrelated to the fiscal crisis we faced in FY 83.

One of the reasons why Illinois remained a low tax burden state is that (until the 1983 tax package) we had not had a major statewide tax increase since the enactment of the income tax in 1969. In 1983 we were unique in that respect. In 1981, 30 states imposed state tax increases, representing $2.5 billion; in 1982, 21 states increased their taxes, for another $2.9 billion annual increase. Only Illinois and Texas among the leading industrial states have not raised taxes since 1970.

As a result of this pattern, most of our state taxes, prior to the 1983 increase, were very low (and still are) compared to other states. For example, Illinois' individual income tax at 2.5% was among the lowest in the nation; 38 states had higher rates. The corporate income tax at 4% was also below national and regional averages. The state sales tax of 4% was average by national and regional standards, but we had more exemptions than most other states. Our motor fuel tax of 7 1/2 $ per gallon was exceeded by the rate in most other states. Among our state taxes, only one ranked among the highest in the nation: that was the utility tax which is levied at

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5% of gross receipts. Its rank was due not so much to the rate of tax, but to the fact that it is in effect an ad valorem tax, imposed against utility receipts which has grown dramatically because of increased rates.

Our Taxes In Context

In outline form those are the taxes upon which state government in Illinois relies and some indication of the role which the major tax sources play. Now we should attempt to place this tax structure in context—in the context of what was happening to the economy in general and that of Illinois in particular and why Illinois experienced a severe financial crisis in 1983. We should note, however, that this picture of the state tax structure is not the full story. We cannot reasonably assume state tax structure as a vacuum; we must also take into account taxes at the local government level, in part because one result of tightening belts at state level may be and usually is to shift some of the cost to local governments. That clearly was happening in Illinois. While the state tax burden is relatively low, the local burden is not. In that category, we rank highest among our regional neighbors, third behind New York and New Jersey among the industrial states and eleventh on the national level. Moreover, while the state tax rates remained unchanged from 1969 (until last year's increase) local taxes, notably the property taxes have increased substantially. A number of significant events and changes have occured in recent years which help to explain this crisis:

1) We were assaulted simultaneously by the most severe recession since the end of WWII and a sharp decline in inflation. Both take their toll on state revenues. As recently as 1979, unemployment in Illinois was 298,000, 5.5% of the workforce. At the peak of the recession in February, 1983, unemployment stood at 759,000, 13.5% of the workforce, with an average income tax liability of $478, high unemployment was costing the state over $200 million in individual income taxes alone—quite apart from the human tragedy. (Fortunately, unemployment declined to 9.9% in January, 1984.)

"• • • Because the major component of [the 1983] tax package, the income tax increase, is being allowed to expire July 1 of this year, we continue to be in a vulnerable position."

2) A second factor which has had some impact on state revenues already and will continue to have an effect in years to come is the structural shift in the pattern of state employment. This shift is one from jobs in the manufacturing sector to jobs in the wholesale-retail and service sectors. The shift has been accelerated by recurring recessions, and in Illinois it has hurt more because our state is slower to recover from a recession, and the recovery never quite returns us to where we were before. In Illinois the decline in the manufacturing sector was from 31% of total non-agricultural employment in 1970 to 22% in 1982. Even the service sector has declined in the past two years—contrary to the national trend. Wholesale and retail trade is now the number one employment sector in Illinois. The significance of this shift in employment is that both the service and the wholesale and retail sectors have lower wage and salary levels than manufacturing. That means a lower wage base against which the state income tax is assessed. This, in turn, means less revenues to the state treasury.

3) We have always known that Illinois suffers an imbalance in federal spending: we contribute more in tax dollars to the federal government than we receive in benefits and services. In 1983, that imbalance, or deficit, was estimated at $11.7 billion. For every dollar sent, we get 66$ back. Illinois does reasonably well in what it receives in entitlements and local and social programs; it is at the low end of the scale in terms of defense expenditures. Numerous studies have shown that a state like Illinois has suffered and will continue to suffer disproportionately from the national government's shift in priorities to military spending.

4) One of the most important developments of recent years that has affected our state's tax structure is the granting of major tax relief both to individuals and to corporations. If you add up all the forms of tax breaks

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available in the last fiscal year, the state revenue loss, prior to the 1983 tax package, was $470 million (growing to $819 million in FY84). The identifiable loss from the several sales tax exemptions along (the state sales tax exemption on food and drugs, and the exemption for manufacturing equipment, agricultural equipment, etc.) was over $250 million in FY83 (and a projected $400 million for FY84). In addition, the state lost revenue because of changes in federal tax laws from accelerated depreciation, the marriage penalty provision and the deduction for IRAs. We also abolished the state inheritance tax for an ultimate revenue loss of over $80-90 million annually; excluded foreign dividends from the corporate tax, a loss of $25 to $28 million in state revenues. We were probably the only state during the past decade which withstood the temptation to increase state taxes while at the same time granting massive amounts of tax relief. Obviously, that took its toll on state revenues.

It is small wonder that the state's coffers had, if not run dry, at least been seriously depleted. The result was a growing inability of the state to fund essential services. The predictable impact was a shift in financial responsibility to the local level for funding essential services. This was never more clearly evident than in the funding of public education. State assistance which provided close to 50% of elementary and secondary education funding in the mid to late 1970's dropped dramatically to under 37% in the early 1980's. This decline in state assistance further increased the burden on the local property tax to finance the schools.

Still another pressure on local governments has resulted from the abolition of the corporate personal property tax. In the first few years following abolition, the replacement revenues more than offset the loss of corporate personal property taxes. By 1982, this was no longer the case. The replacement fund depends primarily on corporate income taxes which have declined. As a result, replacement revenues have also dropped by a high of $552.9 million in 1980 to $388.3 million in 1983. In addition, the state-enacted investment tax credit, which takes effect in FY85, will eat further into the replacement fund (by an estimated $40 million the first year). The state handled the decline in state revenues with a combination of expenditure restraint and deferred spending. By FY83, however, deferred obligations had reached at least $600 million; and with stagnant revenue growth, the state was forced either to dramatically cut the budget, thereby further increasing the financial burden on local governments (or leaving essential services unmet), or to increase taxes. The Governor responded with a tax proposal which initially sought a permanent increase in individual incomes taxes from 2.5% to 4.0% and corporate taxes from 4% to 5-6% plus a 67% increase in liquor taxes. The only relief-reform provision in the package was an increase in the individual income tax exemption from $1,000 to $1,200. For the road system, the Governor proposed an increase in the motor fuel tax from 7 1/2$ to 11$ per gallon to June 30, 1984, increasing incrementally to 13d; per gallon by July 1, 1985. He also proposed raising vehicle registration fees.

"We cannot reasonably assume state tax structure as a vacuum; we must also take into account taxes at the local government level, in part because one result of tightening belts at state level may be and usually is to shift some of the cost to local governments."

While the highway and road funding proposal remained a separate issue from the Governor's tax package, passing virtually intact, the Governor's general tax package experienced serious opposition. Objection to a permanent tax hike, opposition to the size of the rate increases and dismay over the absence of tax reform, combined with a certain amount of political posturing, led to a compromise which saw a temporary retroactive 18 month income tax rate hike of 20% (2.5 to 3.0% for individuals and 4.0 to 4.8% for corporations). In addition, the state sales tax was increased by 25% from 4% to 5%. A series of tax relief measures was gilded to this package: elimination of the remaining 2% state sales tax on food and drugs, expansion of the existing machinery and equipment sales tax exemption to replacement parts; and deduction of property taxes on the individual income tax. Even with the tax relief, the new taxes were estimated to produce in excess of $900 million for FY84 and $350 million in FY85.

Result

The tax increase enabled the state to pay off its major deferred payments problem while avoiding almost $700 million in budget cuts. Indeed, it made possible a modest increase in spending. What the tax hike did not do was to provide any permanent relief for the financial burdens imposed on local governments. In addition, the lack of permanence of the income tax hike meant that the state had done little, if anything, to replace state revenue lost due to widespread tax relief enacted since 1979 and to fundamental changes in the state's economy.

The Governor's decision not to seek an extension of the income tax hike, along with the General Assembly's reluctance to support one, means that the state will lose some $790 million for its FY85 budget. It does not follow, however, that state funded services, such as education, mental health, public aid, etc. will actually be cut. With the state's improved financial condition, the prospect for continued improvement in the state's economy, and the permanent sales tax increase, the revenue gap in FY85 resulting from the phase-out of the income tax increase may be about $100 million. With many one time obligations repaid in whole or in part, the state may have from $175 to $275 million in unobligated revenues available for programs. Moreover, the Illinois Department of Revenue and Attorney General's programs for eliminating tax evasion, coupled with the possibility of a tax amnesty program, may produce additional revenues.

Despite optimistic revenue forecasts for next year, the demand far outstrips the foreseeable revenues. To cite a few illustrations, we have underfunded the pension system for the last several years; we must operate the substantial new prison capacity; the poor and unemployed have had no cost of living adjustment since 1981;

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the state's contribution to school costs has further declined; and so on.

Outlook

The 1983 tax package enabled the state to deal with a financial crisis brought on by the severe recession, decline of the Illinois manufacturing economy, and years of generous state tax relief for both corporations and individuals. But because the major component of that tax package, the income tax increase, is being allowed to expire July 1 of this year, we continue to be in a vulnerable position. We have not really caught up with all of our deferred obligations (pension contributions, for example); we have increased, not lessened our state commitments (2,500 new prison beds and a statewide probation system, for example); we have all but negated the one permanent tax increase (from 4-5% sales tax) by authorizing over $300 million in new tax relief which takes effect in FY85. Moreover, if economic recovery is not sustained, or proves to be even slower than usual in Illinois, the revenue estimates could prove too optimistic, and we would return to a hand-to-mouth fiscal existence.

Beyond this, in 1983 fiscal "fix" did little to relieve local governments of increased financial burdens brought about by reduced levels of state (and federal) aid to areas such as education, or by the decline in revenue sources such as the corporate personal property replacement funds. Nor do the Governor's plans for FY85 promise much relief in that direction.

All of this suggests at least two guidelines that state government must learn to observe:

1) We should not continue to chip away at our revenue base, as we shall do, by granting tax exemption or tax relief to every attractive program that comes along. If we want to subsidize, we should whenever possible do it directly—through appropriations so that we know the real cost and can control it. To illustrate, a state circuit breaker grant is preferable to a local homestead exemption.

2) The state must refrain from undermining local revenue sources whether through legislative action or inaction. We, at the state level, grandly enact investment tax credit (estimated loss, $40-80 million) but apply it not to state revenues but to the replacement tax fund so that local governments bear the burden. We promote or at least accept reductions in corporate income tax receipts by declining to decouple from federal accelerated depreciation, or by going along with the Governor's foreign dividend exclusion and limited unitary taxation—without acknowledging that our actions also reduce local government revenues.

Similarly, most of our tax action— both increasing taxes as we did in 1983 and reducing them through selective relief, as we have been doing some years—is taken piecemeal to respond to real or perceived crises or political pressures. We (the Governor and General Assembly) just do not make our tax decisions on the basis of thoughtful, principled and long-range consideration of tax policy: what taxes are fair, at what rates; who ought to pay and in what proportion; which level of government ought to bear primary responsibility for funding which services. It would be refreshing if we could overcome our crisis mentality and address these more important issues.

ABOUT THE AUTHOR: State Senator Dawn Clark Netsch, Democrat, 4th Legislative District, Chicago, is chairman of the Senate Revenue Committee and chairman of the Illinois Economic and Fiscal Commission. She was first elected to the Senate in 1972 and was re-elected in 1974, 1978, and 1982. A graduate of Northwestern University (B.A. with Distinction, 1948, and J.D. magna cum laude, 1952), Senator Netsch is a professor of law at Northwestern University School of Law. She is the recipient of thirteen awards and citations for outstanding service as a legislator.

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