by Charles N. Wheeler III
For the typical Illinois legislator, long-range planning usually means thinking about the next election. Struggling this spring to fashion a new budget, though, lawmakers found themselves worrying about the one after that, too.
The reason for the altered perspective? A dawning realization that serious belt-tightening would be needed now to avoid either a fiscal meltdown or a vote to raise taxes three budget years hence.
At the heart of the dilemma is the income tax increase approved earlier this year. Under its terms, the rates jumped to 5 percent from 3 percent for individuals and to 7 percent from 4.8 percent for corporations as of January 1. The higher rates, along with a suspended tax break for businesses and estate tax changes, are expected to bring in an additional $7.3 billion in the fiscal year starting July 1.
But the new rates are only temporary, a political selling point, the plan’s Demo-cratic authors hope. On January 1, 2015, midway through Fiscal Year 2015, the law calls for the individual rate to drop to 3.75 percent and the corporate rate to 5.25 percent, cutting revenues by more than $3 billion for the second half of FY 2015 and roughly double that in FY 2016.
Will the rates actually be allowed to go down? At this point, only one thing seems clear: The deeper the cuts in current spending plans, the more likely the challenge can be met.
History is not a reliable guide. Consider the fate of the state’s two earlier temporary income tax hikes. An 18-month increase was allowed to expire in the mid-1980s, while another temporary rate increase was made permanent in the early 1990s. But the first case does offer an interesting insight on the revenue loss issue.
Early in 1983, then-Gov. Jim Thompson proposed a permanent income tax increase to preserve funding for education and other key state services as a national recession battered state revenues. House Republicans, however, insisted the increase be temporary, and after lengthy negotiations, the final agreement increased the personal rate to 3 percent from 2.5 percent and the corporate rate to 4.8 percent from 4 percent, with the higher rates to sunset on June 30, 1984. Significantly, the final package also included a permanent 1-cent increase in the state sales tax, to 5 percent from 4 percent, effective January 1, 1984, to help offset the coming loss of income tax receipts, the so-called cliff factor. The plan worked; helped by a recovering economy, state revenues actually grew the year after the higher income tax rates expired.
Will the state experience a similar recovery in the coming years? Will natural economic growth provide enough dollars so that the tax hike can be shaved back without crippling education, health care, human services and other valued programs? The prognosis is imprecise; the further into the future one looks into the revenue estimating crystal ball, the murkier the picture.
Of course, four years from now, lawmakers and whoever is governor could decide to make the higher rates permanent, as some, including your author, would argue they should have done in the first place. The option seems sure to be a major issue in the 2014 elections, when voters will choose a governor, two-thirds of the Senate and the entire House. Remember, the fate of the temporary 1989 increase was a major issue in 1990, and voters chose Republican Jim Edgar, who said he’d make it permanent, over Democrat Neil Hartigan, who pledged to let it expire.
Or, drawing from the 1983 experience, the state’s future leaders could find a way to replace some of the lost income tax revenues so funding for important programs doesn’t fall off the proverbial cliff. A recent report from the legislature’s fiscal agency suggests one intriguing possibility: expanding the base of the state sales tax to include certain services.
In its study, the Commission on Government Forecasting and Accountability noted that as much as $8.5 billion could be generated if the current sales tax base included a broad base of services. If business-to-business transactions were excluded, about $4 billion could be raised.
Revenue production aside, including certain services in the sales tax base would reflect more accurately modern economic activity. Illinois, like many other states, enacted a sales tax to replace the state property tax, its main revenue source for 115 years, after property values plummeted during the Great Depression. Back then, most economic activity involved the exchange of tangible items, the base of the tax.
But the economy has changed dramatically. The commission report noted that service-related industries accounted for not quite a third of the state’s economy in 1977, but almost half by 2009. Moreover, Illinois currently taxes only a handful of services, mostly related to public utilities, so there’s room to expand. The Federation of Tax Administrators lists 168 different service categories that are taxed in the United States. Illinois taxes just 17, while the average state taxes 56; Hawaii covers 160, New Mexico and Washington, 158 apiece.
Taxing services is not a new idea, of course. Almost 30 years ago, Thompson sought such an expansion, to no avail. Currently, as part of a plan to modernize the state’s revenue structure, the Center for Tax and Budget Accountability, a Chicago-based think tank, has recommended taxing more than 40 personal, automotive, entertainment and other consumer services to produce more than $2 billion in new revenue.
In his ill-fated push for a service tax on consumer-related activity, Thompson liked to point out that if one buys a new pair of shoes, the price includes the cost of the wages paid the craftsman who made them, all subject to the sales tax. So, the governor would ask, why shouldn’t the sales tax also cover the labor of the cobbler who repairs them, and not just the cost of a new heel?
Applying that rationale through a tax on consumer services would better reflect economic activity in the state and, more importantly, increase the chances that the higher income tax rates can be rolled back without serious damage to vital programs.
Charles N. Wheeler III is director of the Public Affairs Reporting program at the University of Illinois Springfield.
Illinois Issues, June 2011