Category Archives: State-local governrnent

The Fiscal Performance of Seventh District States in the 2000s

In a recent Chicago Fed Letter, Thom Walstrum examined the fiscal performance of Illinois’s state and local governments beginning in the late 1980s. His analysis showed that since at least the late 1980s, Illinois’s governments (as a whole) have consistently run a budget deficit. His analysis also revealed that the degree of overspending (or alternatively, undertaxing) by Illinois was greater than that of the average U.S. state and that growing pension liabilities have contributed significantly to Illinois’s budget deficit.

In this blog post, we expand the analysis to the other states in the Seventh Federal Reserve District.[1] Specifically, we document the expenditure and revenue patterns of District states since the early 2000s and compare them to those of the typical U.S. state.[2] We also examine the effect of the Great Recession on the fiscal performance of District states because it plays an outsized role in the overall fiscal performance of certain states over the period we examine.

As in the Fed Letter, we combine the expenditure and revenue data for state and local governments because states differ in which activities they fund at the state or local level. Also, as in the Fed Letter, to account for differences in the sizes of states’ economies, we report expenditure figures as percentages of gross state product (GSP) and revenues.[3]

Our analysis yields a number of interesting results. First, we find that the size of state and local governments (in terms of spending as a percentage of GSP) varies quite a bit among District states. Second, we find that the fiscal performance of state and local governments (in terms of spending as a percentage of revenues) also varies quite a bit. And finally, we find that though the Great Recession had a large negative impact on the fiscal performances of all District states, Illinois and Wisconsin were especially affected, primarily because the value of their pension systems’ assets declined sharply.

We first look at the size of state and local governments in District states in terms of spending as a percentage of GSP. Figure 1 shows total government expenditures as a percentage of GSP for the average U.S. state and for Seventh District states during fiscal years (FY) 2002–13. Indiana is consistently the lowest spender during this span, and it is well below the U.S. average. Iowa and Illinois are also below the national average for most of this period, though they catch up to it by FY2012. In contrast, Wisconsin’s spending is roughly the same as the typical U.S. state. Michigan tracked the national average closely until FY2007, but has been consistently above average since then. Figure 1 also shows a ramp-up in spending across all states in FY2010–11. This is the largely the result of states spending federal funds received through the American Recovery and Reinvestment Act.

fiscalperformance_figure1

Table 1 summarizes figure 1 by taking the average of the percentages over FY2002–13. It also shows a breakdown of average spending by category. We now discuss the unique features of each state’s spending (as a percentage of GSP).

  • Illinois’s total spending was below the U.S. average largely because of lower expenditures on education services and social services (and income maintenance). That said, Illinois spent more than the typical U.S. state on its insurance trust and pension liability increases, both of which are compensation for government workers, including those providing education and social services.
  • Indiana’s total spending was below the U.S. average because of lower spending on most categories, though it spent a particularly low amount on pension liability increases compared with other states.
  • Iowa’s total spending was below the national average (in spite of above-average spending on education and social services) because of below-average spending on its insurance trust and pension liability growth.
  • Michigan’s spending was above the U.S. average largely because of higher spending on education services and its insurance trust.
  • Wisconsin’s spending was quite close to the U.S. average; compared with the typical state, Wisconsin spent more on education services and its insurance trust, but less on pension liability growth.

fiscalperformance_table1

Next we look at each District state’s fiscal performance, which we define as total expenditures as a percentage of total revenues. We interpret lower percentages as better performance. It is important to note here that fiscal performance is independent of the overall size of a state’s governments, because all that matters is that the governments have enough revenues to cover their expenses. While small governments generally do not require the level of revenues that large governments do, small governments could still perform worse than their large counterparts if their revenues are not high enough. Figure 2 shows the time trends for expenditures as a percentage of revenues for each District state and the typical U.S. state. Two features of the figure stick out: First, with the exception of Illinois, District states are quite close to the U.S. average in terms of spending as a percentage of revenues. Second, while most states’ governments were hurt by the Great Recession (FY2008–09), Illinois’s and Wisconsin’s were hit particularly hard, while Indiana’s was not hit that bad.

fiscalperformance_figure2

The first row of table 2 summarizes figure 2 by taking the average of the percentages over FY2002–13. Illinois and Wisconsin spent more out of their revenues than the typical U.S. state during this period, while Indiana, Iowa, and Michigan spent less. Because FY2009 was such an anomaly on account of the Great Recession, we also calculate the averages excluding it (second row). This changes the story quite a bit for Wisconsin governments, which then perform better than the U.S. average. (With this adjustment, Michigan governments perform slightly worse than the U.S. average.)

Table 2 also shows the percentage of total revenues that each spending category represents (calculated excluding FY2009). Examining expenditures in terms of revenue, as opposed to GSP, tells a different story for several states.

  • Illinois’s total expenditures percentage is well above the U.S. average. Spending out of revenues on education is above that of the typical U.S. state, though it remains below that of the other District states. Illinois also spends more than the national average on public safety, environment and housing, interest on general government debt, its insurance trust, and pension liability growth.
  • Indiana’s total expenditures percentage is below the U.S. average. It spends less than the national average on transportation, utilities, its insurance trust, and pension liability growth.
  • Iowa’s total expenditures percentage is not only below the U.S. average but also the lowest among District states. Notably, its spending on public safety, utilities, its insurance trust, and pension liability growth is lower relative to the national average.
  • Michigan’s total expenditures percentage is slightly above the U.S. average. Its education spending is the highest among District states and markedly higher than that of the typical U.S. state. But its spending on transportation, utilities, and pension liability growth is lower than the national average.
  • Wisconsin’s total expenditures percentage is below the U.S. average. While its expenditures for education, public safety, and its insurance trust are above average, its expenditures for pension liability growth are below average.

fiscalperformance_table2

Table 2 shows that Illinois and Wisconsin were hit hardest by the Great Recession. After excluding FY2009, Illinois’s spending as a percentage of revenue decreases 6 percentage points and Wisconsin’s decreases 11 percentage points. These decreases are much larger than those for other District states and the typical U.S. state, which range from 1 to 4 percentage points. What is behind the substantial differences in fiscal performances in FY2009? We found that the source was not changes in expenditures, but changes in revenues. Table 3 shows revenues as a percentage of GSP for the typical U.S. state and states in the Seventh District. The first row is the average value during FY2002–13 excluding FY2009, the second row is the value for only FY2009, and the third row is the difference between the two. All states had lower-than-normal revenues in FY2009, but Illinois and Wisconsin fared particularly poorly. To understand why, we calculated the difference between FY2009 values and the average values of the other fiscal years for all revenue categories. General revenues were actually higher in FY2009 for the typical U.S. state and all District states. The source of the revenue declines was states’ insurance trusts. Most states saw the value of the assets in their insurance trusts fall during the Great Recession, and such declines are treated as negative revenues in the U.S. Census’s accounting framework. The insurance trust funds for Illinois and Wisconsin fared particularly badly in FY2009, which is why their expenditures-to-revenues ratios were so high over the period FY2002–13 (see the first row of table 2). That one bad year made a huge difference in Wisconsin’s overall fiscal performance over the period FY2002–13.

fiscalperformance_table3

Our exploration of the size and performance of District state governments reveals a surprising number of differences among them. There are states with relatively small governments that perform poorly (Illinois) and well (Indiana) and states with relatively large governments that perform poorly (Wisconsin) and well (Michigan). Some states were hit much harder than others during the Great Recession (compare Wisconsin and Indiana), and Wisconsin’s terrible performance in FY2009 shifted the state from being a good fiscal performer to being a bad one over our study period (FY2002–13). The most important reason for the differences in fiscal performance across states is differences in pension system management. Illinois would be closer in performance to the national average if its pension spending matched the national average, and Wisconsin would be better than average if its pension system’s assets hadn’t lost so much value during the Great Recession.

[1] The Seventh Federal Reserve District (which is served by the Chicago Fed) comprises all of Iowa and most of Illinois, Indiana, Michigan, and Wisconsin. In this blog post, we analyze the entirety of each state that falls within the District.

[2] Unlike for the analysis of just Illinois, we are limited to the period after 1999 because we do not have pension system data for other states before 2000.

[3] For more details on the methodology, see the Fed Letter. Note that data on pension liabilities for the Seventh District states, excluding those for Illinois, come from the Board of Governors of the Federal Reserve System.

Measuring Tax Capacity for Municipalities in Cook County

Illinois’s fiscal situation will likely require tax and revenue increases. How might we assess a municipality’s tax capacity, or ability to “absorb” a larger tax bill? In our previous blog, we reviewed various methods of assessing tax capacity. Now, we use the municipal-gap method to estimate tax capacities for Cook County municipalities.

The municipal gap is the difference between revenue capacity and expected expenditures. We estimate revenue capacity by multiplying the total equalized assessed property values (EAVs) in each municipality by a standard tax rate-the rate required to bring the total property tax revenues of Cook County municipalities in line with their total expenditures on non-school municipal services. Our measure of (own-source) revenue capacity excludes intergovernmental transfers. We predict expected expenditures based on estimates of each municipality’s socioeconomic and physical characteristics. Finally, we subtract expected expenditures from revenue capacity to get the municipal gap. A positive gap implies that a municipality has a larger tax capacity, and a negative gap implies a smaller tax capacity.

In practice, this analysis need not be restricted to municipalities located within one county. However, differences across counties in property assessment practices, as well as the quality and composition of services provided, may distort differences in the municipal gap. Restricting the sample to Cook County municipalities should limit differences due to these extraneous characteristics. To this end, we also exclude municipalities with smaller populations (those with populations below the 25th percentile for Cook County). Consequently, results from our analysis can be generalized to a subset of Cook County municipalities and expenditures, namely general government, which largely consists of public safety expenditures.

Data Sources and Calculations

Non-school municipal expenditures and EAVs were obtained from the Illinois Comptroller’s Fiscal Year 2014 Annual Financial Report.1 In the report, expenditures are categorized according to their reported functions (e.g., public safety) and governmental fund (e.g., general fund). We calculated non-school expenditures by combining all reported expenses across functions and funds. Revenue capacity was calculated by multiplying each municipality’s EAVs by a standard tax rate, which is the aggregate Cook County expenditures divided by aggregate EAVs; the resulting rate is 12.8%. Both expenditures and revenue capacity are normalized across municipalities by expressing them in dollars per capita.

Estimates of socioeconomic and physical characteristics were obtained from the Census Bureau 2014 American Community Survey 5-year estimates.2 We separated characteristics into two groups: environmental and control variables. Environmental variables are assumed to be more exogenous to the choices of local officials and are used to predict expected expenditures. They include the unemployment rate, poverty rate, population density, and population (logged). In contrast, control variables are assumed to be less exogenous, and either failing to control for these factors or using them to predict expenditures may bias our predictions of expected expenditures. Control variables include the percentage of the population ages 25 and older with a bachelor’s degree or higher, income per capita, the percentage of housing units that are owner-occupied, the median age of the population, and whether the municipality owns or operates a public utility company (this last measure comes from the Comptroller’s report).

Brief Data Summary

Table 1 provides descriptive statistics on expenditures, revenue capacity, and the environmental and control variables. On average, a municipality spends $2,545 per capita on non-school services. Cook County municipalities allocate, on average, 33% of non-school expenditures to public safety, and only 2% to social services. The large gap between average revenue capacity ($4,199 per capita) and average expenditures underscores the fact that we exclude a large portion of all expenditures municipalities face, such as those appropriated to overlapping governments. The sizes of standard deviations reflect substantial heterogeneity in the compositions of expenditures across municipalities, in particular for debt and capital outlay. The minimum value for the other expenditures/expenses category in part reflects reimbursements.

table1_descriptivestatistics

Calculating Municipal Gaps

We use regression analysis to derive expected expenditures. First, we estimate the effects of environmental variables on the dependent variable, actual municipal expenditures, while holding constant the control variables. Second, we predict expected expenditures using a municipality’s actual values of the environmental variables and the estimated effects.

Table 2 provides results from estimating the effects of environmental and control variables on non-school municipal expenditures. Altogether, we could find no evidence that the environmental variables affect municipal expenditures, controlling for additional factors. In addition, the adjusted R-squared value suggests that we explain roughly 40% of the variation in expenditures (around its mean). Table 3 provides an example of calculating expected expenditures for the City of Chicago (values were rounded to 2 decimal places). Multiplying a municipality’s actual values for the environmental variables by each variable’s corresponding effect results in that variable’s contribution to expected expenditures; summing all the contributions leads to expected expenditures. The final step in the analysis is subtracting expected expenditures from revenue capacity, resulting in the municipal gap.

table2_regression

table3_examplecalc

Results and Conclusion

Table 4 displays the results for municipalities with the largest and smallest gaps. Glencoe Village is assigned the largest positive gap, with an additional $15,846 in revenue per capita available after appropriating funds for expected expenditures. In contrast, Park Forest Village would require an additional $1,802 in revenue per capita to fund its remaining expected expenditures. How do the results of the municipal gap analysis using expected expenditures compare to those using actual expenditures? Table 5 provides findings for the latter scenario. Results for all municipalities included in our study may be obtained here.

table4_expected

table5_actualgaps

Mapping the municipal gaps illustrates the geographic discrepancies in tax capacity. Figure 1 displays the municipal gaps calculated using expected expenditures. For comparison, figure 2 displays the municipal gaps calculated using actual expenditures. Results are largely consistent between the two; one primary difference is that tax capacity is larger for several southern Cook County municipalities in the analysis with actual expenditures. Perhaps one unsurprising result is that, in general, northern Cook County municipalities have greater tax capacity than more central and southern Cook County municipalities. However, there are “pockets” of municipalities with smaller tax capacity located within regions that have greater tax capacity, and vice versa.

Figure 1: Gap with Expected Expenditures

weighted-municipal-gap

Figure 2: Gap with Actual Expenditures

actual-municipal-gap

In sum, identifying the ability for municipalities to absorb larger tax bills is becoming increasingly crucial to estimating local governments’ capacity to generate additional own-source revenues. Several methods exist that rely on comparisons between each government’s revenue and expenditures under hypothetical conditions. Here, we utilized the municipal-gap method to identify tax capacities for a subset of Cook County municipalities. Among the limitations of our analysis is the fact that we exclude important information on both the revenue and expenditure sides. Our analysis relies on non-school expenditures and property values to derive expected expenditures and revenue capacity. Local officials with more complete information on expenditures (e.g., for overlapping governments and schools) and revenues from additional sources (e.g., intergovernmental transfers) may benefit from estimating tax capacity using the municipal-gap approach, or one of the other methods we talked about in our previous blog.

  1. FY2014 Annual Financial Report data procured from the financial database website.
  2. U.S. Census Bureau; 2014 American Community Survey 5-Year Estimates, http://factfinder.census.gov.

Poor fiscal performance a problem for both state and local governments in Illinois

For a recent Chicago Fed Letter article, I looked back at the fiscal performance of Illinois’s state and local governments and found that, taken together, Illinois governments had been consistently spending more than they had brought in since at least the late 1980s. I also found that while the typical U.S. state often spent more than its revenues over this period, the extent of Illinois’s overspending (or under-taxing) was significantly greater. Finally, I found that the biggest difference in spending between Illinois and the typical state was that Illinois governments spent more on pensions.[1]

As I discussed in the article, in order to compare Illinois’s fiscal performance with other states’, I had to combine the data for state and local governments together. This was necessary because each state divides responsibilities for its activities differently between state and local governments (for example, some states fund K–12 schools primarily through state revenues, while others fund them primarily through local revenues).

That said, one question that naturally arises from my analysis is this: Was it Illinois’s state government, its local governments, or both that engaged in overspending (or under-taxing)? While it is not feasible to use the U.S. Census Bureau data I used for the Chicago Fed Letter to compare the performance of Illinois’s state or local governments with those of other states and their localities, it is possible to compare the performance of Illinois’s state government with that of its local governments.

There is one important caveat to the comparison that follows. During fiscal years (FY) 1988–2013, an average of 25.2% of local government revenues in Illinois came from the State of Illinois. This means that local governments in Illinois depend quite heavily on revenues from the state government to balance their books, and that some amount of overspending (or under-taxing) at the local level could be the result of unpredictable declines in revenues from the state government. However, at least for FY1988–2013, this does not appear to be the case, because the percentage of local revenues coming from the state was relatively stable (the standard deviation was 1.9 percentage points). Any overspending at the local level, then, was largely the result of locally made decisions.

Figure 1 plots expenditures as a share of revenues for the State of Illinois and for the sum of local governments in Illinois since FY1988.[2] Over these years, local governments (summed together) have never spent less than they brought in. Perhaps surprisingly, the State of Illinois often performed better than local governments, though it did much worse in the years following the 2001 and 2008 recessions. The state spent less than it brought in in seven out of the 26 years the data cover—which is not a good performance, but better than the performance of local governments.

blog-1-expliaprev

Because the Census Bureau data lump all 6,963 local governments in Illinois[3] together, it is impossible to know from the data which of these governments are responsible for the overall overspending (or under-taxing). Poor fiscal performance could be concentrated in a few large governments or be widespread. While it is well beyond the scope of this blog post to gather data on the overall fiscal performance of thousands of local governments, I am able to look at the performance of local governments’ pension systems, which is insightful because as I noted earlier, pension spending was one of the biggest contributors to overspending (or under-taxing) by Illinois governments.

Perhaps the best summary measure of the condition of a pension system is its unfunded liability. This is the difference between the discounted present value of all the future payouts the pension has promised to make and the value of the pension’s assets. The unfunded liability, then, is the amount that taxpayers will have to contribute to the pension system in order for it to be able to cover all of its promised future payouts.

Table 1 shows a breakdown by locale of the total unfunded pension liability facing Illinois state and local governments at the end of FY2014.[4] Of the $158.2 billion total, $104.6 billion (66%) was the responsibility of the state government and the remaining $53.6 billion (34%) was the responsibility of local governments. Beyond the state versus local government comparison, things get complicated because some pension systems cover overlapping geographies. The City of Chicago has six separate pension funds covering its workers, and there are three for Cook County employees (Cook County holds almost the entirety of Chicago and a number of its suburbs[5]). On top of that, most municipalities have their own police and firefighters pensions, and there is a single pension system for all other non-Chicago municipality workers called the Illinois Municipal Retirement Fund.

Even though the system of local government pensions in Illinois is somewhat complicated, it is clear from table 1 that the City of Chicago is disproportionally responsible for the accumulation of local unfunded pension liabilities. A little over one-fifth of Illinois’s population is in Chicago, but Chicago is responsible for more than half of local government unfunded pension liabilities in Illinois. Chicago residents owe $10,492 per person to their city’s pension systems, on top of the $8,130 per person they owe to the state pension systems.

blog-3-table-1

To make the comparison of the unfunded liabilities of Illinois’s local governments clearer, I show in table 2 the total per capita state and local unfunded liability by place of residence. There is one wrinkle acknowledged within the table, however, which is that Chicago residents are responsible for the pensions of all Illinois teachers, while Illinois residents outside of Chicago are not responsible for the pensions of Chicago teachers. Thus, perhaps a fairer comparison is to count the unfunded liability of the Chicago teachers’ pension fund as a state-level liability. While this change reduces the unfunded pension liability faced by Chicago residents by 13%, they still would owe a total of $17,506 per person to various Illinois pension systems. Those living outside Chicago would face a smaller, but still quite large, liability per person ($11,954 in suburban Cook County and $10,553 outside Cook County).

blog-4-table-2

While suburban and downstate police and fire pension systems make up a relatively small part of the total unfunded pension liability of Illinois’s state and local governments (5.6%), pension systems for some municipalities may be in much worse shape than others, so that these liabilities can still matter quite a bit. Table 3 shows the unfunded liabilities for police and firefighters pensions for the 25 most populous cities in Illinois. Chicago is in the worst shape, but residents of Moline, Rock Island, Evanston, and Peoria all owe more than $2,000 per resident to their police and firefighters pension systems. Some cities are in much better shape. For example, residents of Urbana owe fewer than $500 per resident to their systems.

blog-5-table-3

This blog post shows that overspending (or under-taxing) has long been a problem for both the State of Illinois and the local governments in Illinois, with the accumulation of unfunded pension liabilities playing an important role at both levels of government. And while the City of Chicago has built up a larger unfunded pension liability than that of suburban Chicago and downstate Illinois, every region of Illinois bears some blame for overspending (or, once again, under-taxing).

[1] See the Chicago Fed Letter for a detailed explanation of how I calculate pension spending.

[2]See Chicago Fed Letter for details about how these figures are calculated. Expenditures include the change in pension liabilities.

[3] 2012 Census of Governments (https://www.census.gov/govs/cog/).

[4] All unfunded liability data come from the 2015 Biennial Report of the Illinois Department of Insurance Public Pension Division, http://insurance.illinois.gov/Reports/Pension/pension_biennial_report_2015.pdf.

[5] Technically, a portion of O’Hare Airport—and therefore Chicago—is in DuPage County.

What is Illinois’s Tax Capacity?

A recent study ranked Illinois 47th among U.S. states and Puerto Rico for its fiscal health.1 Particularly concerning was the report’s finding that the combination of total debt, unfunded pension liabilities, and underfunded other post-employment benefits amounts to 61% of total state personal income. In contrast, the same figure for other Seventh District states ranges from a high of 38% in Michigan to a low of 16% in Indiana. Given the magnitude of Illinois’s debt, any plan aimed at improving the state’s fiscal solvency will likely require both expenditure cuts and tax and revenue increases.

So what is the taxable capacity of Illinois? Two broad issues arise. First is the issue of fairness: Would further taxation violate society’s notions of imposing undue burdens on those who can least afford it? Second is the issue of impairing economic activity: Would further taxation discourage economic activity or otherwise drive out taxable wealth to an unacceptable degree?

In this blog post, we describe several methods for identifying a community’s tax capacity. In general, researchers have attempted to measure and compare capacities for specific places by calculating hypotheticals that rely on norms or averages across all places. For example, how much revenue might we expect to raise in a community if we imposed average tax rates there? And how much should a community be spending on public services, given its population characteristics and its need for services? And importantly, how do the two estimates differ? Are there obvious gaps between resources and needs?

Gordon, Auxier, and Iselin (2016)2 used such a representative revenue and expenditure approach to estimate this hypothetical gap in funds a state has available for government operations. The study documents that there is enormous variation in the amount of revenue states collect and what they spend on public goods and services. To drill down to tax capacity, the study measures what each state would collect in revenues and spend on government services if it followed national averages, adjusted for state-specific economic and demographic factors. Table 1, section (1) shows the actual gap, or the difference between actual revenues and expenditures, in FY2012, assuming that states rely only on revenues that they raise themselves through taxes and fees. The gaps are sizable, but adding in federal transfers largely erases the gaps. Turning to the hypotheticals as they relate to tax capacity, Table 1, section (2) compares representative revenues, or revenues that a state would raise if it had an average tax structure, to representative expenditures, or expenditures if the state had an average spending per capita. In contrast to the actual gap, the representative gap remains even after the addition of federal transfers in all of the Seventh District states other than Iowa. In this hypothetical case, if Seventh District states (other than Iowa) adopted a nationally representative tax structure, they would not have sufficient resources even after federal transfers to provide a representative level of public expenditures.

table1

Haughwout et al. (2003)3 developed a more refined analysis, termed the “revenue-hill” method, that estimates the deterioration in tax capacity that takes place as higher tax rates discourage taxable activity. The revenue hill builds a hypothetical schedule of tax rates and revenues that demonstrates how fully a city is utilizing its tax base. The goal is to build a “Laffer Curve” that allows policymakers to estimate the economic effects of the next tax dollar (e.g., effect on employment). The closer the measure is to the top of the hill, the closer the city is to exhausting its tax capacity. Once a city is over the top of the hill, increases in tax rates will become so unproductive that revenues actually decline. These measures can be constructed for each tax base a city might use. Therefore, while a city may have reached capacity for one tax base (e.g., sales tax), it may still have capacity in another (e.g., property tax). Haughwout et al. (2003) examined four cities—New York, Philadelphia, Houston, and Minneapolis—and found that only Minneapolis was “comfortably” below its revenue hill, and thus had additional tax capacity. In the case of Minneapolis, additional taxes could provide net benefits to property owners. New York and Houston were at the top of their revenue hills, implying that additional taxes would have a negative impact on employment.

Finally, Bo Zhao and Jennifer Weiner of the Boston Fed suggested the “municipal-gap” method for measuring tax capacities across municipalities in Connecticut, by recognizing that taxable capacity can only be measured in the context of a government’s particular needs and resource costs in providing adequate services.4  For example, limited tax capacity can exist when a community faces higher costs or fewer resources for providing public services (or both). In both cases, it can be driven by economic, topographic, and demographic factors specific to the community (e.g., a relatively high rate of poverty or significant risk of extreme weather).

First, one identifies revenue capacity. Revenue capacity is defined as the ability of municipalities to raise revenue from all of the sources they are authorized to tax, even if they choose not to tax a particular base. Capacity is calculated using the “representative tax system” approach, where all communities use a standard uniform tax rate against the tax base. The rate is determined by ensuring that the statewide rate raises enough revenue to cover existing expenditures. Second, one identifies expected expenditures–the average level of spending based on the municipality’s underlying socioeconomic and physical characteristics. This number is is calculated using regression analysis to predict a municipality’s expenditures based on actual values of the underlying characteristics. One purpose of deriving expected expenditures is to remove the variation in expenditures due to the choices of local officials who may favor particular government programs.

The study focused on the costs of providing largely non-educational local services, primarily public safety. It found that large fiscal disparities in Connecticut were primarily driven by their differences in revenue raising capacity. The uneven distribution of the property tax base coupled with the relative dependence on property tax revenues in the state meant that resource-rich municipalities had, on average, per capita revenue capacity eight times that of resource-poor towns. The cost of providing municipal services was less dispersed, with the highest-cost municipalities spending 1.3 times that of the lowest-cost towns. Importantly, the study also found that non-school revenue grants from the state had limited effect in reducing fiscal disparities.

What can tax capacity studies tell us about Illinois’s fiscal problems?

Illinois has a particularly difficult choice when it comes to future tax adjustments. First, the debt overhang at the state level is so large that any future tax increases will necessarily be directed to paying down debt rather than purchasing new services. Incremental tax increases will pay for services already consumed and, as such, it is difficult to see how future taxes will provide governments with resources to support programs that enhance growth. Second, capacity studies, such as Gordon et al. (2016), suggest that Illinois has already reached its capacity limits. While it would be a stretch to adapt this to the revenue-hill concept of actual declines in revenues in response to tax hikes, it does imply that Illinois has little room to increase taxes without reducing economic activity in ways that would be damaging. The depth of the problem increases when recognizing that many Illinois municipalities also face revenue gaps that would make the compound effects of a state tax increase coupled with a local increase that much worse. As these studies show, there tends to be considerable variation in both the level of expenditures and available revenues across any state when it comes to financing government services. The question then becomes what is the geography of tax capacity in Illinois?

In a second blog, we will apply local revenue capacity and service cost to Illinois municipalities. Stay tuned to see what fiscal disparities might exist for municipalities in Cook County.

  1. Norcross, E., & Gonzalez, O. (2016). Ranking the States By Fiscal Condition.
  2. Gordon, T., Auxier, R., & Iselin, J. (2016). Assessing Fiscal Capacities of States.
  3. Haughwout, A., Inman, R., Craig, S., & Luce, T. (2003). Local Revenue Hills: Evidence from Four U.S. Cities.
  4. Zhao, B., & Weiner, J. (2015). Measuring Municipal Fiscal Disparities in Connecticut.

Detroit and Chicago: Real Property Value Comparisons

Both Chicago and Detroit have become poster children for city government financial stress in recent years. Chicago’s city and school district alike have been running structural deficits, meaning that the government has been covering its normal operating expenditures by issuing or over-extending debt and running down its assets. Both Chicago’s municipal government and school district face large shortfalls in required contributions for the future pensions of current and retired employees. Both have raised local property taxes as partial steps toward balancing their budgets. In the case of Detroit, the city has only just emerged from Chapter 9 bankruptcy while its school district teeters on insolvency under state-mandated “emergency manager” operation.

Are these places comparable in terms of their outlooks and situation? The value of real property in each place offers one fascinating indicator of the resources available to their local governments, as well as a look into how private homeowners and commercial property owners perceive the general prospects of Detroit and Chicago.

Why examine real property values? In some sense, real estate and improvements are long-lived assets that are largely fixed in place. In the market for these properties, buyers and sellers must assess and incorporate the government fiscal liabilities and service benefits – present and future – attached to these properties in the prices at which they buy and sell. High (and rising) property values may indicate that home owners and commercial property owners expect that the prospects for value in these locations are good and that they will continue to improve. And from the local government’s perspective, high values indicate that there may be room for further imposition of local taxes to fund government services, if need be.

Nuts and bolts

The estimation of the value of real property—land and improvements– in a locality is far from an exact science. The actual sales prices of property can be thought of as one reflection of an individual parcel’s value. However, as we saw during the financial crisis last decade, sales transaction prices can be very volatile, and sometimes speculative. More practically, parcels of property do not turn over frequently, so that transactions prices of all property parcels are not observed in any one year. In practice, then, local public officials often rely on various estimation methods in assessing the value of property for taxation purposes, most of which involve using a sample of information from similar properties that were sold during a year. From the recorded sales price and a property’s particular features such as size, location, age, and configuration, the property assessment office infers the value of each property and, ultimately, the total value of property against which taxes are levied.1 These taxable values are often termed assessed values or sometimes equalized assessed values and often represent some fixed percentage of market or true value.2

In the charts, we draw on such data from the local and state governments of Detroit, Chicago, and Illinois to estimate the market or true value of real property in both Detroit and in Chicago.3 For Detroit, figures on total assessed property value are published in the city’s Comprehensive Annual Financial Report (CAFR). By law, assessed value must amount to one-half of true value in Michigan. And so, to arrive at our estimates of full value, we simply double the assessed value. We believe that this yields a far upper bound on the value of residential property in Detroit because there is much evidence that, following the steep plunge in Detroit’s property market over the last decade, assessments were not reduced to accord with actual market value in a timely fashion.4

Drawing on prices of homes that recorded sales, the following chart shows that average home prices began to fall in 2004, while assessed value did not begin to fall until 2009.Detroit_Assessed_HomePricesFor Chicago, a prominent local government “watchdog” and research foundation has long been using state and city data on recorded property sales by class of property to estimate full market values.5 The accuracy of these data is believed to be reasonable, though far from exact.6

What do we see?

Due to lags in data availability, the estimates below are representative through calendar year 2014. The charts display total property value across all types, as well as the largest category in both Chicago and Detroit, that being residential property.

As shown here, Chicago real property value rose dramatically during the early part of last decade before dropping off just as dramatically. Detroit’s property values remained flat. However, Detroit’s apparent stability belies the fact that assessed values of residential properties have not been allowed to fall off in tandem with actual market transactions price there. As measured by volume of sales, the market for residential real estate in the city of Detroit became almost nonexistent during this period.7 Few homes were sold using conventional financing; almost all of them sold for cash. By some estimates, prices of homes sold fell by many multiples during this time, though they have since been heading back up in parts of the city.

Even using generous measures, and with rising home prices in some neighborhoods, residential property value overall in Detroit have continued to drift lower in recent years. In contrast, following the steep decline, Chicago property values have begun to recover for both residential and commercial (not shown) property.

Most telling, at over $80,000 per resident, the value of overall taxable real property in Chicago remained markedly higher than that of Detroit as of 2014. By even our generous measure, Detroit’s property values were only about $25,000 per resident.Detroit_Chicago_PropValuesDiscussion

It would appear that, as measured by real estate values, Chicago’s economy and prospects remain much stronger than Detroit’s. And from a local government perspective, Chicago’s taxable resources with which to pay down liabilities and fund public services appear to be much larger. Of course, there are myriad political and institutional factors at play that render such a simple assessment of wealth inadequate to characterize the fiscal capacity of these cities. In both places, for example, property wealth is concentrated in a subset of places such as near the downtown areas and along the waterfronts. Accordingly, it may be difficult to tap available property wealth selectively because existing statute largely requires that tax rates be applied uniformly. And voters and their representatives may be reluctant to allow tax hikes at all. Similarly, there may be different levels of sensitivity to taxation in these two places and among different constituencies. For example, the imposition of new and higher taxation may cause economic activity and investment to decline more sharply in one place as opposed to another.

More broadly, we might ask whether property wealth is a good indicator of potential resources that local governments may draw on to fund services. A look at more U.S. cities may be helpful. The next chart undertakes the same exercise for the most populous cities. Here we see that Chicago continues to look fairly robust by this measure, though less so than the cities of San Diego, Los Angeles, Austin, and New York City.MajorCities_ProvValues

  1. Assessed value of property for taxation purposes is often a fixed percentage of market value across all property parcels, or else it is a fixed percentage across all parcels of a certain type or class such as residential, commercial or industrial. In turn, estimates of full value of all property can be made by taking sample average ratios of “assessed value/sales price” and applying these ratios to all parcels’ assessed values.
  2. Equalized assessed values refers to the practice of further adjusting the totalities of assessed value of property across jurisdictions so that each locale’s assessed valuation represents the same or “equalized” value in relation to (percent)  sales price or true value.
  3. The city of Detroit also taxes tangible personal property of commercial enterprises such as computing equipment and furniture; Chicago does not.
  4. Using sales price and assessed values for a sample of 8,650 residential parcels in 2010, Hodge et al find an average assessment to sales price ratio of 11.47, which suggests an average over assessment or property values many times over. See Timothy R. Hodge, Daniel P. McMillen, Gary Sands, and Mark Skidmore, 2016, “Assessment Inequity in a Declining Housing Market: The Case of Detroit,” Real Estate Economics.
  5. See https://www.civicfed.org/sites/default/files/Estimated%20Full%20Value%20of%20Real%20Property%20in%20Cook%20County%202005_2014.pdf
  6. Discrepancies arise because only sample values of real estate transactions are available in any one year. In addition, full value projections derive from the median value of property in each class. However, the median property value may not represent the entire distribution of property values.
  7. See http://www.urban.org/sites/default/files/alfresco/publication-pdfs/2000739-Detroit-Housing-Tracker-Q1-2016.pdf

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.

IGPA_graph1

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.

igpa_graph2

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.

Differences in State Safety Net Spending

By Jacob Berman, Associate Economist

The social safety net in the United States consists of dozens of anti-poverty programs on the local, state, and federal level that provide benefits to low-income households. Although anti-poverty programs are generally funded by the federal government, most are administered by states. State governments have broad discretion over the generosity of programs, so the level of benefits for any given household varies widely across regions. For example, the cut off for a single-parent household with three children to be eligible for Medicaid ranges from an annual income of $50,868 in Washington D.C. to $2,652 in Alabama. Similarly, the maximum weekly benefit for unemployment insurance ranges from $674 in Massachusetts to $235 in Mississippi.

One technique for comparing safety nets across states is to use eligibility rules to determine the benefits a hypothetical low-income household is likely to receive. However, as the number of states and programs under consideration grows, this calculation becomes more difficult because eligibility rules can be extremely complicated. For example, a full description of eligibility for the Temporary Assistance for Needy Families (TANF) program, sometimes referred to as welfare, requires a 250 page document that needs to be updated every year. Instead, I compare safety net programs using data on expenditures from the national accounts, and household income data from the Census Bureau’s American Community Survey (ACS). I find that real benefits for low-income households in the most generous area, Vermont, are about two-and-a-half times greater than in the least generous area, Georgia.

Safety-net programs come in many different forms. Some programs (such as TANF) provide cash benefits which allow households to consume anything they choose, while others (such as Medicaid) provide in-kind benefits which only permit households to consume specific goods or services. Short-term programs (such as unemployment insurance) provide temporary aid, while others (such as disability insurance) are designed to provide more long-term support. Safety nets are meant to guarantee a minimum level of consumption and insure households against the risk of a large drop in market income.

My method for measuring the generosity of safety net programs is to add up the total amount spent on benefit transfers targeted at low-income households, and to divide it by the number of persons living in households below a given market income threshold. This approach has several strengths. First, my approach is comprehensive. The national accounts are the only data that include programs that are unique to all states and localities. Also, these data are derived from state outlays so they reflect households that actually collect benefits. Because take-up rates vary widely, some households do not receive benefits even though they are eligible. Second, my approach uses survey data for market income, which are accurate relative to survey data on transfers. Data on labor and capital income come from the ACS, which is the largest survey conducted by the federal government with over 3 million observations per year. Although using survey data on transfers would provide a clearer picture of which households receive benefits, the data are less reliable since the sample is much smaller and more likely to be affected by underreporting.

Since I am interested in the variance across states, I focus only on programs in which states have some discretion over benefits. These programs are as follows:

  • Medicaid
  • Children’s Health Insurance Program (CHIP)
  • Earned income credits
  • Unemployment insurance
  • Supplemental Security Income (SSI)
  • Temporary Assistance for Needy Families (TANF)
  • Supplemental Nutrition Assistance Program (SNAP)
  • Special Supplemental Nutrition Program for Women, Infants, and Children (WIC)
  • Worker’s compensation
  • Temporary disability insurance

Social Security and Medicare, the two largest transfer programs, are not included since benefit eligibility is uniform across states and not targeted to low-income households. I define low-income households as any household in the bottom quartile of the national market income distribution. Using the 2012 ACS data, that cutoff is about $14,000. (Modest changes in the low income threshold do not affect the results.)

Following Census’ methodology, I drop persons living in group quarters since the concept of a household is not well-defined in this instance. In this exercise I am primarily interested in nonelderly adults and children, so I omit elderly, childless households from the sample. The real value of a transfer payment depends on the quantity of goods and services a household can purchase within their state. Since the price level varies across regions, the outlay data and the low-income threshold are adjusted using regional price parity multipliers for each state. This correction tends to make the safety net more generous in states dominated by rural communities, such as South Dakota, and less generous in states dominated by urban centers, such as New York.

Table 1 shows the average real transfer for a low-income person in the five most generous and least generous states. Vermont ranks as the most generous state with the average low-income person receiving about $26,000 in benefits. This is due largely to the fact that, using my measure, Vermont has the most generous Medicaid program and Medicaid accounts for about half of all of the programs I consider. Vermont also has its own refundable earned income credit and SSI program. Conversely, Georgia is at the bottom of the ranking since it has some of the most restrictive laws for Medicaid and TANF.

Table 2 highlights the results for states in the Seventh District. Iowa ranks as the most generous state and Michigan as the least generous. Overall, though, the differences between states in the region are small. Medicaid accounts for much of the difference, but income support programs also play a role. All states in the region offer a refundable earned income credit ranging from 34% of the federal credit in Wisconsin to 6% in Michigan. In Iowa, unemployment insurance replaces a high percentage of previous earnings, federal SSI recipients receive additional state funding, and SNAP benefits are not subject to household asset limits.

Figure 1 plots the relationship between the percentages of persons in a state defined to be “low-income” with the natural log of the average benefit. Average benefits are shown on a logarithmic scale since the marginal utility of benefits is assumed to decline as benefits increase. The blue line is the fit of an ordinary least squares (OLS) regression. The two variables are negatively correlated and statistically different from zero. That is, states with a large percentage of households earning low market income are also states that give the least generous benefits. Since the average poor person in high poverty states will tend to have less income than the average poor person in lower poverty states, we might expect a positive correlation since most programs tend to increase benefits as market income declines. Another reason we might expect a positive correlation is if more generous benefits strongly disincentivize work. Instead, these factors appear to be outweighed by the treatment of social insurance as a normal good; richer states are more willing to pay for the benefits that safety nets provide.

It is important to remember that there are many other types of state and local government policies that influence the welfare of low-income households. Tax policies also vary widely across states and can have powerful redistributive effects, particularly consumption taxes, which are regressive. Additionally, direct government purchases, such as the provision of education or transportation services, are not included in this exercise. Outside of the budget process, regulations influence the prices households pay for goods and services. For example, restrictive zoning laws tend to increase housing costs. Transfer payments are only part of the story. Developing a more complete accounting of the redistributive effects of state and local policies would be a valuable area for further research.

Will Efforts to Fix Illinois Budget Hamper Economic Growth?

Bill Testa and Thom Walstrum

A famous quote by a notable economist, Herbert Stein, is that “If something cannot go on forever, it will stop.”

An independent “State Budget Crisis Task Force” recently concluded unambiguously that “The existing trajectory of (Illinois) state spending and taxation cannot be sustained.” This follows a growing recognition by many observers and analysts that state government (and many local governments) in Illinois have been running chronic deficits, financing public services each year for many years through added debt. Although the state’s primary funds (the General Funds) were often reported to operate in balance, total state liabilities typically exceeded revenues collected.[1]

As a consequence, Illinois state government finds itself today with hefty unfunded debt obligations—namely unfunded pension liabilities and unpaid bills for current services—amounting to over $100 billion. These debt obligations represent payment claims for government services that have already been delivered.[2] While the state government paid the wages and salaries of its teachers, professors, and state workers at the time that their services were provided, part of the employee compensation for these services was deferred to the future through the promise of retirement income. But, the state government did not put aside sufficient financial assets to pay the promised retirement income and other deferred benefits. Looking forward, no one expects the state’s likely economic growth path to lift tax revenue streams much above recent (tepid) norms.

And so, given anticipated expenditures for new and expanded programs, such as federally mandated health care expansion, expenditures for public services are likely to continue to outstrip available revenues. Agencies that rate the quality of debt for would-be investors have declared the state’s bonded debt to be of the lowest quality among all states. Thus, the state’s debt position can be expected to deteriorate further without significant intervention by the state government. Indeed, elected officials will need to act very soon to restore confidence.

To do so, the state is left with a only a couple options—cuts in spending (including cuts in promised pension payouts) and hikes in taxes and fees.[3] Curbs on the growth of spending are clearly in the cards. Even if the state devotes increasing revenues to paying down its accumulated debt—which it is now doing—it will likely also require sharp declines in public service provision. Already, for example, state aid to public education has flattened out over the past three years. Similarly, the state has trimmed its promised pension benefits for new state employees.[4]

The other possible course of action is for the state to increase tax revenues, so as to chip away at (and eventually eliminate) the debt accumulated for past public services, while covering normal and expected revenue demands of the years ahead. If we compare the overall average tax burden of Illinois with that of its neighboring states over the past 15 years, we find that Illinois actually kept its tax burdens lower than its neighbors’ from FY 1995 through 2010 by deferring its commitments for employee compensation. However, now that debts must be repaid, tax burdens will possibly rise above national and regional norms. Accordingly, a potential downside is a dampening of growth and development as rising taxes, without any accompanying rise in services, diminishes the attractiveness of investment and livability in the state.

How High Are Illinois’s Taxes?

There are many ways to measure and compare tax burdens and many individual taxes that can be compared. But in the aggregate, tax burden can generally be thought of tax revenues collected from households and businesses as a share of the productive commercial activities of the state. Such an aggregate tax rate represents the share of a state’s annual production that is charged by government to pay for public services provided to households and to businesses.

In the following analyses, we construct such an aggregate or average “tax rate” (ATR) for a state in any given year.

State’s tax rate (ATR) = state & local tax collections/state output

Tax revenues are those collected by all state and local governments in a state, rather than by state government alone. The measurement of an aggregate tax rate must include both state and local governments because the split of revenues collected between state and local differs from state to state. In each state, public service responsibilities are assigned differently to state government versus the state’s local governments—school districts, municipal governments, county governments, and special districts such as libraries and park districts. For example, particular public safety responsibilities may be alternatively assigned to the state highway patrol, county sheriff’s department, or a city police force. Given such differences, an “apples to apples” comparison can only be made by combining all revenues within a state into one measure of “state and local government taxes collected.”[5]

In the denominator of our measure of ATR, a state’s annual productive output is effectively measured by annual dollars of gross state product (GSP, the local counterpart of GDP), which represents total annual output from all industry sectors located within state boundaries. So, the tax rate (ATR) is the share of productive output (GSP) that is claimed by state and local government to pay for public services.

Looking at the Illinois aggregate tax rate from 1995 through 2010, we find that Illinois consistently maintained a lower tax rate that the national average (see chart).[6]

In the next chart, we compare Illinois’s ATR to both the U.S. average (green line) and its neighboring states’ ATRs during the same period (blue bars). As well as being lower than the national average, the Illinois tax burden was also lower than those of its neighboring states, with the exception of Missouri and Indiana.

It is generally thought that Illinois was able to maintain a low tax rate because it paid for current services through borrowing rather than through concurrent taxation. As documented by the Fiscal Futures Project, the state’s main borrowing vehicle was to underfund its mounting obligations for employee retirement. In particular, state government in Illinois maintains primary responsibility not only for its own employees’ retirement benefits, but also for those of the bulk of the statewide university system and the local school systems.[7] As of FY 2012, the unfunded pension obligations were estimated at $95 billion for the state’s five pension systems, which amounts to approximately $8,000 per capita. One estimated comparison among states for 2010 reported Illinois to have the lowest funded proportion of pension obligations, with only 45% of reserves available to meet promised payouts.

How Will Paying Off the Debt Affect Illinois’s Competitive Tax Position

Would raising taxes to meet Illinois’s public service needs (and pay off its debt) dampen economic growth? To answer this question, we look at estimates of expected gaps between Illinois’s revenues and ordinary spending. We recognize that Illinois will need not only to pay off pension-related debt, but also to meet other revenue demands for public services and other past-due bills. The state has been running in deficit, and will continue to do so to some degree, irrespective of the pension problem.

These estimates of future spending streams (and possible revenue needs) are from the Fiscal Futures Project (FFP). The FFP has consolidated the many State of Illinois Funds from which expenditures are financed. In addition, the FFP has examined past trends to predict future spending, and it has also incorporated expected new revenue demands related to, e.g., the Affordable Health Care Act. In our analysis, we take their projected average gap between spending demands and expected revenues for the years between 2011 and 2023. In particular, the gap reported in the final column in the table illustrates the hypothetical case in which Illinois cures its accumulated deficit through revenues alone. Under this scenario, the state incurs its ongoing service expenses as expected and pays down its accumulated unfunded pension liabilities on a 30-year schedule. If so, and without any new revenue enhancements, the state would run at a $12 billion per year annual deficit of expenses over revenue. This estimate is arrived at by assuming that Illinois’s recent hike in its personal income tax is allowed to expire, as it does under the current statute. The average gap is estimated to amount to 1.9 percent of GDP as measured for FY 2010.

Source: University of Illinois Institute of Government and Public Affairs Fiscal Futures Model.

To illustrate the effect on Illinois’s ATR of this further 1.9 percentage point claim on the state’s economy, we add this to the ATR that was actually in effect (on average) from FY 1995 through FY 2010. As seen by the red addition to the tax rate for Illinois in the following chart, the payment gap could potentially hike Illinois’s ATR by 22% percent and leave the state with a higher tax rate than its neighboring states and the nation.

Conclusion

It is clear from this exercise that, had public services been funded on a “pay as you go” manner, the state’s average tax rate would have been significantly higher than those of its neighbors and the nation for decades. Since public services would not have changed by using this method of payment, but taxes would have been higher, Illinois’s economic growth would likely have been lower. Going forward, at least part of Illinois’s accumulated debt will be paid for through revenue enhancements, which will push the state’s ATR above its long-run average, likely raising it relative to those of neighboring states

How much will this impede Illinois’s economic growth? Public taxes and services are not typically the most decisive factor in state growth and development. Indeed, many studies that have estimated the responsiveness of local growth to state-local tax differences find, on average, only a small to modest responsiveness of growth to state-local tax burdens. However, a tax rate hike of this size, which is conservatively estimated, would likely exercise a moderating overall influence on growth and development.[8] And for some types of business activity, especially those that could easily escape the burden of taxation by moving across a nearby border, the impacts may be greater.

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[1] Per the State Comptroller, “there are over 602 active funds, four funds comprise what is commonly referred to as the General Funds. These four include the General Revenue Fund, the General Revenue – Common School Special Account Fund, the Education Assistance Fund, and the Common School Fund.” By one estimate, these General Funds comprise approximately 41 percent of the state’s consolidated funds.(Return to text)

[2] The Illinois Commission on Government Forecasting and Accountability reports unfunded obligations for state pension funds of $94.6 billion for fiscal year (FY) 2012. Unpaid bills are estimated to be at $7.8 billion at the end of FY 2013, possibly growing to $21.7 billion by FY 2018. (Return to text)

[3] The third option is to default on debt, including failing to fully meet pension obligations. This might also reduce the state’s ability to borrow. (Return to text)

[4] As of January 1, 2011, newly hired employees covered by state plans have had their age for full retirement benefit raised, cost of living adjustment trimmed, and maximum pension amounts capped, among other changes. (Return to text)

[5] The federal government also imposes taxes and sends grants-in-aid to state and local governments. These differ from state to state, and they are excluded here. States also share tax collections with their local governments (to varying degrees), which is another reason to combine state plus local tax collections in each state for comparison purposes. (Return to text)

[6] Governments also collect user fees, such as tuition and highway tolls, to pay for services. Calculations to include them are completed separately, and do not change our results. (Return to text)

[7] An exception, the City of Chicago School System funds and maintains its own retirement program. (Return to text)

[8] These estimates of likely hikes in the ATR are conservative, given the high levels of debt that are excluded from the calculations. State government also carries very high levels of unfunded retiree health care liabilities, amounting to approximately $40 billion dollars. Unfunded pension liabilities for governments overlying the city of Chicago amount to another $23 billion, while no comprehensive estimates are available for the many underfunded local municipal pensions throughout the rest of the state. Moreover, ordinary “bonded” state and local government debt levels across Illinois rank among the highest in the country—8th among 50 states in per capita terms. (Return to text)

Managing Economic Development in Uncertain Fiscal Times

Rick Mattoon

Illinois continues to face a bleak fiscal outlook. Despite the sharp increases in Illinois’s personal and corporate income tax rates, the state still faces $10 billion in unpaid bills and an unfunded pension liability approaching $100 billion. To get back to a sustainable fiscal path, Illinois will require significant revenue increases or spending cuts or, most likely, some combination of both.

A critical point in the discussion on restoring fiscal balance is the impact that policy changes will have on Illinois’s economic development. Despite the recent tax rate increases, Illinois still ranks 27th in the nation when measuring state tax burden as a share of personal income, according to COGFA. However, given that these rate hikes were not sufficient to solve the problem, further revenue enhancements will most likely be needed—at least on a temporary basis. Accordingly, the real question is what will be the cost of future fiscal measures on economic development. In other words, can a state reach a tipping point where uncertainty over future tax rates and spending choices chills economic growth, and if so, is Illinois on the verge of tipping over?

On April 4, 2013, the Civic Federation and the Federal Reserve Bank of Chicago will hold a program examining these issues. Bill Testa, of the Chicago Fed, and Therese McGuire, of Northwestern University’s Kellogg School of Management, will discuss what economists have to say about the relationship between fiscal policy and economic growth. Testa will provide insights on Illinois’s tax structure and the gap between revenues and projected expenditures; and he will also assess the economic competition occurring among Midwestern states, putting it into context of tax rates and incentives . McGuire will summarize the literature on the effect of state tax rates on economic growth and describe what economic development strategies might best serve states. McGuire will also discuss what the cost of fiscal uncertainty is on economic growth. With regard to the tax structure, most academic literature on state tax rates suggests that rates tend to matter only when the other costs of doing business are equal at a competing location (e.g., a neighboring state). However, it is not clear yet if this will hold true for Illinois. On the spending side, much of the literature suggests that it is the composition of state spending that most matters for growth. States that spend more on infrastructure and education tend to do better in terms of economic development. In the case of Illinois, a potential solution might have taxpayers paying more taxes and receiving fewer state services. Accordingly, in regions where economic competition is fierce, such as the Midwest, tax rate imbalances may be reaching that tipping point where future tax increases in certain states can make development in adjacent states more attractive to businesses.

Of course, such fiscal problems are not unique to Illinois. Other states and localities have also had fiscal shocks, and much can be learned from how they have restored fiscal balance and tried to promote economic growth. The recent fiscal problems of California have been particularly challenging, forcing the state to make significant budget cuts and income tax increases. Several prominent California municipalities have been forced into bankruptcy; and only recently has the state been able to report a balanced budget. However, evidence suggests that the California economy is beginning to pick up steam. Recent job gains have been running above the national average, with unemployment in the state falling by 1.24 percentage points in 2012 while key housing markets in the state are showing strength. How has California managed its fiscal situation and what has been the impact of its fiscal measures on its economic development strategy? To discuss this, Tom Tait, the mayor of Anaheim, will describe fiscal changes and economic developments at the state and local levels in California.

At the state level, Michigan is another interesting example. Arguably the state has not yet recovered from the 2001 recession and has faced more than a decade of fiscal stress. Throughout this period, Michigan has made many tax and spending adjustments, such as changing the structure of its primary business tax three times. Recently the state has started to show growth again. Mitch Bean, who is with Great Lakes Economic Consulting (and who previously served as director of the Michigan House Fiscal Agency), will discuss Michigan’s roadmap for reaching fiscal balance while encouraging economic growth.

Fiscal measures at the level of localities can have an immense impact on economic growth. What are the terms and conditions that are being attached to current deals to draw business investment, according to local developers and researchers? Are unresolved fiscal issues becoming an obstacle? A panel—comprising Ivan Baker, director of economic development for the Village of Tinley Park in Illinois; Jon DeVries, director of the Marshall Bennett Institute of Real Estate at Roosevelt University; and Stephen Friedman, president of SB Friedman Development Advisors—will provide perspectives on the local development landscape and how fiscal issues affect business location and expansion decisions.

The program concludes with a keynote address by Steve Koch, the deputy mayor of Chicago. Koch has been in this position since September 2012, and his portfolio of responsibilities includes economic development strategy. Prior to his current position, he spent most of his career in investment banking. Koch will discuss how Chicago is stabilizing its fiscal position while pursuing a new economic development strategy. He also will discuss how state fiscal problems affect local governments.

To register for this April 4 program, please visit the Civic Federation’s website.

Government Employment in the Seventh District

By Bill Testa and Norman Wang

There is ongoing discussion about the appropriate and sustainable size of government in our society. At the national level, some of the debate centers on the demographic-driven expansion and long-term sustainability of social benefit programs, such as Medicare and Social Security. Expansion in outlays for such programs has been rapid. Growth in these programs chiefly involves transfers of income across population segments—from wealthier to poorer and from younger households to older ones—rather than expansion of direct government service provision and employment.[1]

Direct employment by government in the process of program delivery is an important though not-comprehensive dimension of government’s size and importance to the economy.[2] Direct employment represents services produced and provided by government agencies, including services such as education, police and fire, and national defense and security. The chart below illustrates government employment as a share of the economy’s “payroll” employment.[3] Combined, the three sectors of government—federal, state, and local government—employ between one-sixth and one-seventh of the nation’s payroll work force.

Government employment as a share of payroll employment has not changed appreciably over time. During the post-World War II era, government employment in education grew strongly with the large baby-boom generation. Since that time, the share has been falling at a slow pace.

Source: Bureau of Labor Statistics, Haver Analytics, and Census Bureau, http://www.census.gov//govs/apes/

Comparing the nation with the Seventh District, the nation’s average share lies one to two percentage points above the Seventh District average (see chart below). In the District, all levels of government employ 15 percent of payroll workers, compared with 17 percent for the U.S. overall. The chief difference arises from the fact that federal government employment tends to be greater outside the Seventh District. In particular, federal government employment is heavily concentrated in the nation’s capital and surrounding areas in Virginia and Maryland.

Interestingly, the federal government is by far the junior partner in government employment, accounting for only 2.2 percent of payroll employment in the U.S. and 1.4 percent in the Seventh District.[4] In comparison, local governments employ over 10 percent of workers in the Seventh District, which is very similar to local government employment across the nation.

Source: Bureau of Labor Statistics, Haver Analytics, and Census Bureau, http://www.census.gov//govs/apes/

Who are the local government employees? The U.S. Census Bureau tabulates employment by the general sector in which workers are serving. The following tables report local government employment for the five states of the Seventh District. For local government, it is clear that school district employment of teachers and non-instructional personnel accounts for the largest share. For 2011, employment of local public school systems in the District accounted for 56 percent of full time equivalent employment (776,000) of overall local government employment. By general category, public safety (police and fire) personnel comprised 9.5 percent of local jobs, followed by health and hospitals (6.2 percent), and higher education (4.1 percent, i.e. community colleges).

Note: Final column does not add to 100 due to exclusion of minor categories.

Source: U.S. Census Bureau, http://www.census.gov//govs/apes/

In the Seventh District, state government employment amounts to less than one-half the level of local government.[5] Of these, higher education comprises over one-half of state government employment. Unlike local school outlays, state government pays for ever smaller shares of higher education costs. Rather, funding is derived from tuition and fees, grants to university researchers, federal government R&D, and other sources.

Other prominent state government functions include prisons and corrections, with 9.3 percent of District state government jobs (up over 9 percent since 1992). Not surprisingly, at 10.5 percent of state employment, health care has been another growth area in state government. Medicaid expansion accounts for much of the growth of state spending. The federal government picks up at least 50 percent of the cost of Medicaid provision, but the share varies directly according to individual state per capita income measures and other provisions.

Note: Final column does not add to 100 due to exclusion of minor categories.

Source: U.S. Census Bureau, http://www.census.gov//govs/apes/

State and local government employment has grown moderately over the past decade. As seen in the chart below, every District state except Michigan expanded employment at a moderate pace over the decade overall, though state and local government employment has been falling over the past two to three years. Locally, the depth of the 2008–09 recession has hit government budgets hard, which has resulted in work force reductions (and service cutbacks) in cities, counties, and school districts. It is somewhat unusual that these retractions in state–local government services and employment have come about during the recovery phase of the business cycle—a time when the government sector has historically tended to support economic recovery rather than weaken it.

Government employment levels were sustained during 2008 and 2009 as the federal government stepped in with increased grant funding for state-local government services, principally through the Anti Recessionary Economic Recovery Act (ARRA). However, as these monies have run out, the devastating effects of the recession on state–local revenues has been revealed through declining levels of personnel.

As seen below, Michigan’s government employment began to fall earlier in the decade as the state’s auto-related economy weakened..

Over the past two years, state and local governments have shed over 70,000 jobs, nearly erasing the gains of the previous years of the decade. Most recently, as the national and regional economies have begun to recover, state and local government fiscal conditions are also strengthening in many locales. Accordingly, over the past few months, the pace of government job declines is beginning to attenuate.

Source: Bureau of Labor Statistics, Haver Analytics, and Census Bureau, http://www.census.gov//govs/apes/

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[1] Since the 1960s, the expansion of so-called “transfer programs” (which transfer income across household sectors) has been the fastest growing general category of government spending. In particular, prominent programs include OASDI (Social Security) and Medicare, and Medicaid—the joint federal-state government health care program that is targeted at lower income households. (Return to text)

[2] Direct employment also excludes purchases made by government agencies in the process of service provision. Among the more important of these, for example, federal government defense agencies contract extensively for military equipment with private sector companies and vendors. Federal government “consumption and investment expenditures” comprise between seven and eight percent of GDP.(Return to text)

[3] Payroll employment excludes self-employed persons, who account for about one in nine workers.(Return to text)

[4] This excludes military personnel in uniform which amounts to approximately 1.4 million personnel, versus 2.8 civilian payroll workers on federal payrolls. (Return to text)

[5] The split between state and local employment is roughly similar throughout the United States except in a few states, such as Hawaii, for example, where the state has assumed responsibility for elementary and secondary education.(Return to text)