All posts by Rebecca Friedman

Can Budget Rules Help Reduce Fiscal Troubles in Illinois?

Fiscal analysts and credit rating agencies have criticized Illinois government officials for their fiscal mismanagement, especially the shifting of debt obligations incurred to pay for current services onto future generations. The growth of unfunded public employee pension obligations has been the most egregious example. Moreover, state and local governments have allowed bills for current services to grow unabated, while existing debt outstanding for capital projects has been refinanced beyond the useful life of the projects themselves.1

At first blush, remedies to such behaviors might seem to be simply a matter of mobilizing the will to balance budgets through spending reductions and tax increases. In some cases, the electorate seeks to discipline elected officials to behave responsibly. However, election discipline and public oversight often fall short. Elected officials may fail to reduce spending because they don’t want to appear to renege on campaign promises; similarly, tax hikes are seen to be too unpopular with the voting public. Accordingly, a helpful alternative is to build in budgetary procedures and practices that assist the public to oversee and discipline the fiscal actions and behaviors of their elected officials.

Given the sorry state of fiscal affairs in many Illinois governments, structural regulatory changes should be considered in order to hold officials accountable and to provide the public with clear and consistent information regarding the state’s financial condition. Regulations constraining fiscal flexibility could force policymakers to act more responsibly and limit their ability to make unrealistic financial promises and disguise questionable fiscal decisions.

In a recent paper by Richard Dye, David Merriman, and Andrew Crosby, the authors describe four fundamental principles of sound budgetary practice – advance planning, sustainability, flexibility, and transparency – all important areas of improvement for Illinois. The authors then outlined five methods by which Illinois could break its bad habits and adopt more robust budgetary practices.

First, Illinois should refine and expand multiyear budget planning. Currently, Illinois does not have a budget plan that looks far enough into the future, or that covers a wide enough scope of projections to maximize its usefulness as a gauge of fiscal stability. Some improvements have been made; for example, budgetary projections by the Commission on Government Forecasting and Accountability (COGFA) and the Governor’s Office of Management and Budget (GOMB) now cover three years. But they would be more informative and useful if they covered five years. Plans would also better measure fiscal stability if they covered a broader scope of projections. Currently, the plans only cover the general funds, leaving out hundreds of special funds comprising over half of the state’s budget.

Budget planning for a given year could also be expanded to include projected spending from current services, even if it does not affect that year’s balance sheet. This would help the state improve its advance planning by forcing officials to look farther into the future and analyze a broader scope of areas affected by current fiscal decisions. Furthermore, it might help the state address its sustainability issue, by holding today’s politicians accountable for future payments incurred by current services, rather than deferring payment of today’s labor into the future, handing the debt to their successors.

Second, the state of Illinois should require that meaningful fiscal notes accompany any legislation with a significant impact on future revenue flows or spending obligations. Fiscal notes, which are rarely used in Illinois, would include any cost estimates for legislation over a designated period of time. These would help Illinois better document time-shifting in its revenue and expenditures and identify nonrecurring revenue in budget documents. It is much easier for government officials to justify expensive programs or policies when the revenue flow is ambiguous and when one-time revenue sources, such as asset sales, are not disclosed.

Third, the authors suggest that the state should modify cash-only budget reporting to better track significant changes in liabilities and assets. Currently, Illinois relies on single-year, cash-basis accounting, which reports only receipts and payments in the current budget year. Accrual accounting, on the other hand, also covers changes in assets or liabilities that are attributable to that budget year, but not actually implemented until a future year. A cash-only budget allows the state to disguise time-shifting consequences of current fiscal actions. Moving away from this practice would make government spending more transparent by revealing deceptive fiscal actions, such as making payments with temporary revenue sources or promising to return loans in the future without continuous revenue sources to guarantee they’ll be paid.

Along those lines, the authors’ fourth suggestion is that Illinois should identify non-sustainable or one-time revenue sources in its budget reports, allowing the public to gain a better understanding of the time horizons of various revenue sources. Additionally, if the government must label one-time revenue sources, they might be compelled to put more continuous revenue sources toward a stronger “rainy day fund,” which would enable officials to be more flexible in responding to fiscal emergencies.

Finally, the authors argue the state should adopt a broad-based budget frame with meaningful spending and revenue categories consistently defined over time. Inconsistent terminology and accounting techniques make it difficult to track financial conditions and changes over time. For example, it can be challenging to tell how much of a year-to-year change in budget is real versus due to a change in accounting practices.

The state must not only clearly communicate a fiscal plan stretching farther into the future than it currently does, but must also make information more accessible to the public. Fiscal information should be readily available on a timely basis, and online information should routinely provide budget reports, with budget components consistently defined and explanations included when there are transfers between budget categories.

While these five practices would ideally lead to a much more sustainable financial position for Illinois, there are clearly roadblocks preventing Illinois’s government from adopting them, such as political frictions and the momentum of embedded spending and programs. For elected officials, it is often the case that in order to actually deliver upon the programs or actions they campaigned upon, they would need to generate even more debt, for example by borrowing from future budgets to pay off promised pensions today. And because Illinois’s politicians have been accumulating more and more debt for decades, it is unappealing for any of them to be the first to adopt more frugal behavior, perhaps by reducing benefits or scaling down public programs.

In the end, there is no painless path out of Illinois’s current debt crisis for citizens or politicians. But implementing these fiscal practices might serve as a way to ease the transition to better fiscal management, by giving politicians no other option and by providing the public with a more complete picture of where Illinois really stands.

  1. The issues surrounding Illinois’s fiscal conditions, as well as proposed solutions, were discussed at a December 2015 conference, Transparency and Accountability in State Budgeting: Challenges for Illinois and Other States, held at the Union League Club of Chicago. The conference was summarized in a recent Chicago Fed Letter.

2015 Civic Research Forum: Finding New Approaches to Analyzing Urban Data

In partnership with World Business Chicago, the Federal Reserve Bank of Chicago hosted the Civic Research Forum on March 17, 2015. The forum was attended by researchers from a wide range of organizations and agencies throughout Chicago. It offered attendees an opportunity to discuss their current research and their positive and negative experiences with collecting and using data. Rob Paral of Rob Paral and Associates addressed the gathering, discussing his research on demographic trends in Chicago. Moreover, he described his research challenges given the  lack of some key historical data series, as well as the structure of available data sets and surveys. He also encouraged the audience to brainstorm innovative ways of using the accessible data.

Paral explained that his firm helps strengthen relationships between organizations and the broader communities they serve by providing data on the city’s social and economic conditions. He also shared that his firm gathers information on residents’ activities and attitudes. In his presentation, Paral focused on the income data he uses to study demographic trends in Chicago. While socioeconomic and demographic U.S. Census data are available for the 77 Chicago community areas (see map below) dating back to 1930, the data necessary to calculate median household income only go back to 1970. The limitations of these historical data hinder the potential to analyze income developments in Chicago over time (both at the neighborhood level and across demographics).

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According to Paral, constructing income data for Chicago became even more difficult when the U.S. Census Bureau’s geographic grid, which includes the boundaries of blocks, tracts, and Public Use Microdata Areas (PUMAs) changed for the 2010 U.S. Census. The boundaries for these geographic units were redesigned in such a way that researchers could no longer aggregate PUMAs to match Chicago’s geography. Furthermore, beginning with the 2009–13 American Community Survey, it was no longer possible to select the Chicago-portions of census tracts for the few tracts that cover areas both inside and outside of the city limits, like it had been in previous versions. This change made it impossible to construct precise data for some individual community areas by combining data on the component census tracts.

Paral went on to discuss some of the questions related to income trends in Chicago that he is currently probing. He said his research focuses largely on the period between 1990 and 2010. Over this span, Illinois’s household income increased and then fell rapidly—a trend that was seen nationwide, though not to the degree it was within the state. According to Paral, the average household in Chicago earned 10% less income in 2010 than in 2000. Moreover, while nine out of every ten community areas had less income in 2010 than they did in 2000, some lost much more income than others. For instance, average household income declined by as much as 45% in some community areas, while other areas have seen an increase in income.

Looking at income trends of individual neighborhoods over time reveals interesting patterns about how wealth and poverty shift and consolidate geographically, Paral explained. In 1990, the wealthiest community areas were located in the far Northwest Side, the far Southwest Side, and the downtown and near-north areas. So, Chicago’s wealthiest neighborhoods were fairly dispersed back then. However, wealth became more geographically concentrated over time. In 2000, Chicago’s wealthiest areas were near the North Side and along the lakefront. And in 2008–12, this remained the case. In 1990, the poorest areas were largely consolidated in an area just west and south of the Loop (Chicago’s central business district). But over time, the poor moved farther away from the city center. In 2000, Chicago’s areas of greatest poverty were on the West and South Sides. And in 2008–12, this was still the case. The greatest income losses between 2000 and 2008–12 occurred on the far South Side, while the greatest income gains over that period happened in the “inner ring” areas near downtown (primarily just west and south of the Loop).

Paral said that while median income is the principal indicator he uses to analyze many trends, he also takes advantage of other measures of wealth provided by the U.S. Census Bureau—such as average and total household income—to get more robust views of wealth patterns and distribution across Chicago. Paral explained that by taking the ratio of average income to median income, he is able to assess the extent to which income distribution is skewed in an area—that is, how great the disparities are between the wealthiest and poorest residents in a given neighborhood. For example, a very high ratio of average income to median income suggests that there are some very wealthy residents pulling up the average (even if a majority of that neighborhood’s residents are poor).

As Paral shared, using innovative ways of combining available data, such as this method of studying the ratio of average to median income, has allowed him to examine potential weaknesses in current policies that are based on more-conventional income data and analysis. For example, he questioned the use of census tracts to determine how children are placed into public Selective Enrollment High Schools within Chicago. The current policy assigns each census tract to a socioeconomic tier, where 1 is the poorest and 4 is the wealthiest. The policy is designed to give children of poorer tiers a better opportunity of enrolling in a strong public school. However, some very poor children live in the same tract as very wealthy children. This means the average income is skewed up by these wealthy families, decreasing the chances the poor children have of being accepted into a strong public high school. Paral mentioned several census tracts where this pattern is especially problematic, such as those where there are large public housing buildings nearby very wealthy homes. In such tracts, the gap in median income between one (poor) subsection and another (rich) one can be over $100,000. Yet, because both poor and wealthy households are located in the same census tract, their children have an equal likelihood of entering the city’s best public schools.

The forum ended with the attendees sharing the research they are working on, the data they use, and any challenges they are facing. This portion of the program gave researchers the opportunity to learn of new data sources and approaches to analysis and to meet others in the Chicago research community. The forum sponsors hoped that innovation and collaboration among the attendees would eventually yield more-productive research in the coming years.

Illinois Fiscal Outlook – A Workshop Takeaway

Just how bleak is the long-term fiscal forecast for Illinois? And what are the possible solutions, if any, to the state’s financial troubles? These were among the challenging questions raised at the Illinois Fiscal Outlook Breakfast, held by the Federal Reserve Bank of Chicago and the Institute of Government and Public Affairs (IGPA) on February 27, 2015.

The event was attended by about 75 people from various companies, government offices, and universities across Illinois. Richard Dye, Co-Director of the Fiscal Future Project (FFP) within IGPA, was the primary speaker. He presented IGPA’s latest report, “Apocalypse Now? The Consequences of Pay-Later Budgeting in Illinois: Updated Projections from IGPA’s Fiscal Futures Model,” released in January. Dye was joined by panelists Woods Bowman, Professor Emeritus at DePaul University, Laurence Msall, President of the Civic Federation, and Senator Daniel Biss of Illinois’s 9th Legislative District.

The primary goal of the FFP study is to assess total state spending using a model that investigates the long-run fiscal troubles and consequences of potential state choices. The model allows analysis of a longer term than previous studies have examined, projecting out through 2026. The study expands on previous research that has focused on general spending by assessing the state’s All Funds Budget. Moving funds around within fiscal years or transferring assignments across years can lead to variations in General Funds measurements. These distortions are eliminated using the more-encompassing All Funds Budget evaluation.

The Fiscal Futures Model focuses on the Structural Budget Gap, calculated as the difference between Total Sustainable Revenue (which excludes new borrowing, decreased fund balances, and other one-time sources) and Total Spending. Overall, the study presents a grim outlook for Illinois’s fiscal future. Dye and his colleagues found that the state has run a cash deficit consistently since 2001, contributing to a large and growing structural deficit. They predict that this deficit will remain at about $9 billion for fiscal years 2016 to 2022, reaching $14 billion by 2024 if existing laws and spending trends continue (see figure below). Given that the state’s projected total spending is $74 billion for fiscal year 2016, drastic cuts would have to be made in order to address the deficit. Furthermore, not all spending can be cut due in part to contractual obligations and because cutting other spending would increase unfunded liabilities or decrease revenue from federal matching, which means the possible solutions are limited.

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The primary culprit in this large deficit, according to the FFP, is “pay-later budgeting,” which they define as “Illinois’s persistent practice of spending more than the inflow of taxes and other sustainable revenue can recover.” This essentially means borrowing based on IOUs or other liabilities in order to pay off the current deficit, thereby crowding out other spending. The largest contributors to these accumulated IOUs are unfunded pension liabilities, making up $106.5 billion of the $159 billion total sum. While there is a schedule to pay back some of these IOUs, others, including unfunded retiree health cost liabilities and unpaid bills, have no defined pay-back schedule. This will likely result in more crowding out of spending in the future. Adding to the state’s troubles is the fact that the temporary income tax increase implemented in 2011 expired on January 1, 2015. Spending, however, was not cut to sustainable levels in order to compensate for the reduced income tax revenue. The FFP predicts that Illinois tax revenue will drop $2 billion in fiscal year 2015, and $4 billion in fiscal year 2016, clearly exacerbating the state’s fiscal woes.

The study concludes that eliminating the $9 billion deficit will require either devastating cuts in discretionary spending, a 25% increase in state-controlled revenues, twice what would come from postponing the income tax rate cuts (see figure below), or some unpleasant combination of tax increases and cuts in spending.

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Bowman followed up by highlighting three financial problems that cast a long shadow over Illinois’s fiscal troubles. The first, as previously emphasized by Dye, is the need for sustainable long-term pension funding. The second is legacy costs, which are the obligations to pay for services the state purchased in previous years. Finally, a new Governor and the potential for conflict between a Republican Governor and Democratic state legislature raise new uncertainty regarding feasible political options. Bowman suggested the state might consider a value-added tax, essentially a broad-based consumption tax, that could be relatively elastic with respect to income and act as a sustainable partial solution over time. He concluded with a proposal of placing a surcharge on certain fees, such as fees for license plates, as another temporary revenue enhancement.

Msall highlighted the bad trend by Illinois of failing to tie temporary revenues to temporary spending limits and the long-term harm this can have on the state’s deficit. The Civic Federation designed a Roadmap to lay out parameters of the state’s problems and potential solutions. However, given Governor Rauner’s budget and the drop in income tax revenue that set in on January 1, the goals laid out in the Roadmap, including fixing the fiscal cliff for fiscal year 2015 and controlling state spending, will not be reachable.

Msall suggested several possible strategies to reduce the state’s deficit, including retroactively postponing the completion of the income tax rollback. Specifically, the Civic Federation proposes retroactively increasing the income tax rate to 4.25% and 6.0% for individuals and corporations, respectively, as of January 1, 2015. The Roadmap then advises that Illinois roll back the rates to 4.0% and 5.6% for individuals and corporations, respectively, on January 1, 2018. Msall noted that of the 41 states that collect an income tax, only three, including Illinois, do not tax pension income. The Civic Federation sees this as a lost opportunity for additional state revenue and proposes implementing a tax on non-Social Security retirement income for individuals with over $50,000 in total income. The Civic Federation’s plan also supports eliminating the sales tax exemption for food and non-prescription drugs through fiscal year 2019 in order chip away at the deficit. To reduce the impact on low-income individuals, the Roadmap proposes expanding the earned income tax credit, from 10% of the federal credit to 15% by fiscal year 2018.

The widespread problems the state is facing spill over to affect local governments, including Chicago, Msall explained. Based on the current trend, the city may soon be forced to choose between not funding contributions, thereby violating pension laws, or increasing taxes, which would adversely affect the city’s appeal as a place to live. Given the city’s recent credit rating downgrade by Moody’s from Baa1 to Baa2, the choices ahead will be difficult.

State Senator Biss outlined the historical series of irresponsible fiscal decisions and policy actions that have dragged Illinois into its current fiscal deficit. He also highlighted an absence of meaningful spending cuts in Governor Rauner’s budget that would be necessary to compensate for the reduced revenue. Biss described a common problematic habit in electoral politics of searching for large overall fixes to problems the state faces in order to give the outward appearance of progress. This often results in attempts to reform the internal structure of the government in an effort to weed out waste and fraud, which often don’t actually contribute to the financial troubles as much as politicians proclaim. What Illinois needs instead, he said, is to find ways of creating more revenue or cutting actual expenditures.

The undetermined status of Senate Bill 0001, sponsored by Biss, among others, contributes to the current uncertainty about Illinois’s fiscal future. This Bill’s purpose is to implement pension reform that will create substantial budgetary savings and help Illinois make actuarially required payments that are in line with national actuarial standards. However, because the bill is currently under review by the Illinois Supreme Court, the actions available to the state government are unclear. Biss concluded that the only way to dig Illinois out of its deficit is to implement many small to medium changes across society, not necessarily evenly distributed, but carefully prioritized to have the most widespread and effective impact.  For example, Biss said a comprehensive pension reform package is imperative to maintaining the state’s ability to fund key areas of state government. He cautioned that portions of Governor Rauner’s budget unfairly target poor, working-class families by reducing funding to programs that benefit them, including Medicaid, foster care, and community colleges. Regardless of the actions the state does decide to take, the path forward will not be pleasant, he warned. But by committing to a “shared sacrifice” strategy of distributing cuts across the board, Illinois will hopefully be able to make steady progress out of the current fiscal trap.

New Survey-Based Activity Indexes

By Rebecca Friedman

In a recent Chicago Fed Letter, Scott Brave and Thomas Walstrum discuss a business conditions survey that the Chicago Fed has been conducting in conjunction with the Beige Book since March 2013. To measure economic activity in the Seventh District, they construct a set of diffusion indexes based on survey responses (which are explained in greater detail in the article itself). Brave and Walstrum then compare their diffusion indexes with the Institute for Supply Management’s (ISM) purchasing managers’ indexes (PMIs) and the Chicago Fed’s Midwest Economy Index (MEI), and demonstrate how the anecdotal evidence collected for the Beige Book can often be helpful in understanding pivotal or special economic events.

Survey respondents come from all of the major industries in the Seventh Federal Reserve District, with manufacturing contacts composing the largest subset. Respondents are asked to rate the performance of their respective businesses on a seven-point scale in a series of questions covering the demand for their products or services over the past four to six weeks relative to the previous four to six weeks. A series of diffusion indexes are then calculated from the survey responses that are intended to capture changes in the prevailing direction of regional business conditions.

The figure below compares Brave and Walstrum’s Beige Book indexes against similar measures produced by the ISM. The ISM’s indexes are also calculated using a survey-based methodology allowing the authors to compare their survey responses for manufacturers and nonmanufacturers with the ISM’s national manufacturing and nonmanufacturing PMIs, as well as with a Midwest PMI (taken by averaging the ISM’s PMIs for Chicago, Detroit, and Milwaukee). Brave and Walstrum cite the strong correlation observed between their Beige Book diffusion indexes and the ISM’s national PMIs in the figure, suggesting that their indexes are capturing very similar business conditions. They also note that there may be some evidence that their Beige Book index leads the Midwest PMI.

The authors next examine the ability of their main Beige Book index (covering both manufacturers and nonmanufacturers) to predict non-survey-based measures of economic activity by comparing them with with the MEI—a monthly weighted average of Midwest economic indicators measured relative to a trend rate of Midwest economic growth. To compare the Beige Book index with the MEI, the authors adjust their Beige Book index to be relative to survey respondents’ trend (or average) responses. Their analysis comparing the two indexes suggests that their Beige Book index may slightly lead the MEI in capturing changes in the direction of regional economic activity. Brave and Walstrum also describe two recent instances where anecdotal information collected for the Beige Book was useful in this regard: 1) discerning whether the slowdown in economic growth in the first quarter of 2014 was likely to be a temporary setback and 2) capturing the recent pickup in activity in regional labor markets.

A more detailed description of the survey and index methodologies can be found here. The authors note that they continue to study the potential applications of their survey and diffusion indexes, with the intention to make their results publicly available in the future.