April 11, 2013
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.
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. 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. 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.
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.”
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).
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. 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.
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.
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. 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.
 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)
 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)
 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)
 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)
 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)
March 22, 2013
Managing Economic Development in Uncertain Fiscal Times
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.
October 18, 2012
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.
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. 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. 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.
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. 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.
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).
In the Seventh District, state government employment amounts to less than one-half the level of local government. 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.
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.
 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)
 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)
 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)
February 24, 2012
Alternative financing for state and local governments: Do ‘managed competition’ and asset sales or leases make sense?
By Rick Mattoon
State and local governments are finding themselves in a fiscal bind. According to the National League of Cities’ annual fiscal survey, city governments report that their general revenues will decrease by 2.3% in 2011 and they anticipate a further decline in 2012. In particular, property taxes are falling (estimated to decline by 3.7% in 2011), with additional declines expected in 2012 and 2013. Compounding matters for local governments is the fact that their tax revenue declines are coupled with decreasing or frozen aid from state and federal governments.
State governments don’t seem a whole lot better off. The Center on Budget and Policy Priorities estimated that 29 states face budget gaps for fiscal year (FY) 2012, totaling $44 billion; and it expected this total budget gap to grow throughout the spring as revenue growth slows. This comes in the wake of the previous four years during which cumulative deficits reached $500 billion.
Given this stress on core revenues, it isn’t surprising that state and local governments may be looking to unconventional financing measures to shore up budgets. Two ideas that are frequently mentioned are “managed competition” (the idea of allowing existing government services to be competitively bid out) and asset sales or long-term leases. In the case of managed competition, discrete government services are put up for bid and often existing government units are allowed to bid against outside providers for providing a service such as collecting trash or processing permits or licenses. In the case of asset sales or leases, the idea is to immediately monetize the value of a particular asset that in many cases is not directly related to the core function of local government. In both cases, a clear objective is to improve the efficiency with which either a program or an asset is managed and to free up resources for government to focus on central operations. For example, in the case of Chicago’s lease of the Chicago Skyway, a guiding question was should the city be operating a toll road (i.e., would a city government be more efficient at operating a toll road than a private company and could resources devoted by a city government to maintaining a toll road be better spent elsewhere).
On March 14, the Civic Federation and the Federal Reserve Bank of Chicago will co-sponsor a conference called Beyond Parking Meters—The Future of Public and Private Partnerships in Illinois. (for agenda and registration-- click here). This half-day conference will examine how local and state governments should approach these types of alternative financing and what the pros and cons of these types of arrangements are. Specifically, the program will examine what types of government activities might be best suited to competitive service delivery, as well as what management and labor have learned from such programs. In examining asset sales and leases, key questions will include how to properly value public assets and structure and manage either an asset sale or lease to ensure that taxpayers are protected.
Fortunately, several previous studies are available to help guide any discussion about the privatization of either a public service or an asset by a government. In 2010, the Chicago Council on Global Affairs’ Emerging Leaders Program issued a report titled “No Free Money: Is Privatization of Infrastructure in the Public Interest?”
The key findings from the report were:
• Financial realities mean that privatization will continue;
• An effective policy would balance financial and equity consideration and define what constitutes “the public interest”; and
• Privatization is neither good nor bad but an economic tool that can be used well or badly.
In addition, the report suggests that proper oversight is critical for evaluating the long-term impact of any privatization. A concern is while the upfront savings might be significant, privatization may constrain future government actions. In the case of an asset sale, the asset can only be sold once, and after the proceeds from the sale are spent, future programs might be in jeopardy if they had previously relied on the revenue stream that the asset produced when it was owned by government. Similarly, there may be equity concerns if public access to an asset (such as a toll road) is suddenly limited by higher tolls imposed by the private firm now managing the asset.
When it comes to managed competition, the Government Finance Officers Association (GFOA) issued a best practice statement in 2006.
The statement lists key factors in considering managed competition: service level, cost, efficiency, effectiveness, quality, customer service, and ability to monitor the service providers’ work. The statement emphasizes the need to address stakeholders’ concerns and, in particular, to correctly estimate the in-house versus outsourced cost of providing the service. To do this correctly GFOA suggests governments address the following four factors:
• Determine and use a service definition that includes an analysis of service levels and performance standards to be used.
• Calculate the in-house costs that could be avoided in outsourcing the service. An important element includes estimating the direct and indirect costs related to the service. In some cases, some indirect costs may still exist even if the service is contracted out.
• Estimate the total costs of outsourcing, including the contractor’s bid price, the government’s contract administration costs, any transition costs, and any impact the contract might have on revenue.
• Finally, compare the cost savings from contracting out with the costs incurred to evaluate whether the savings will be significant.
A final source for framing privatization issues comes from the Illinois Commission on Government Forecasting and Accountability. The commission’s report titled “Government Privatization: History, Examples, and Issues” does a particularly good job at providing national and international examples of privatization and describes common measures for correctly valuing assets, such as appraising the net present value, estimating the internal rate of return, and calculating the weighted average cost of capital. These technical measures are critical to getting the valuation of the asset right.
Clearly, local and state governments will increasingly look to alternative financing structures over the next several years to help balance their service and revenue needs. Making alternative financing arrangements correctly requires appropriate accounting and asking the right questions at the beginning of the process. If you would like to find out more, please join us on March 14.
May 28, 2010
Charting Illinois’s Fiscal Future—Conference Preview (Rick Mattoon)
On June 17 and 18, the Federal Reserve Bank of Chicago and the Institute of Government and Public Affairs at the University of Illinois will co-host a program examining Illinois’s current and future fiscal prospects. (To register and view complete agenda click here ) The conference comes at a time when the national recession has left states and local governments with significant budget stress and falling revenues. The Center on Budget and Policy Priorities estimates that states face deficits of –$180 billion in FY2011 and –$120 billion in FY2012. For Illinois the problem is acute, given that the state had a structural deficit prior to entering the recession. Simply put, as Illinois’ expenditures outpaced its revenues, the state responded by building up a backlog of unpaid bills and otherwise issuing debt to balance the books.
How bad are things in Illinois? Current estimates suggest that Illinois’s budget gap for the upcoming fiscal year ranges from $11 billion to $14 billion and that its total indebtedness is approaching $120 billion if pension and other potential retiree liabilities are included. A recent Pew Center for the States study listed Illinois among the 10 worst states in terms of fiscal condition. The same organization also cited Illinois in a separate study for its underfunded pension liability, which it pegged at over $54 billion in 2007.
The conference will focus on strategies for improving the fiscal performance of Illinois in both the short run and the long run. For example, Allan Proctor, who serves as a consultant to governments and has worked as both the Deputy Budget Director for New York City and the Executive Director of the New York State Financial Control Board, will discuss strategies New York used to improve fiscal discipline and budgetary transparency in the wake of its financial crisis in the 1970s.
What systems and governance structures can be helpful in improving budget decision making? The Institute for Government and Public Affairs has been working on a multi-year project in Illinois to produce a consolidated state budget that provides a clearer picture of state obligations and available resources. This tool will help with future budget projections and allow for better budget planning.
On the important topic of pension liabilities, the conference will feature three experts—Lance Weiss (Gabriel, Roeder, Smith) Fred Giertz (University of Illinois) and Jim Spiotto (Chapman and Cutler). They will discuss how Illinois developed such a massive underfunding of its pensions and assess recent pension reform legislation and how much more needs to be done. In addition, this session will analyze the state’s responsibility for meeting unfunded pension obligations and whether any new mechanisms might help municipalities restructure pension debt.
Laurence Msall of the Civic Federation will give his perspective on how Illinois might best restore fiscal stability. The Civic Federation has launched a special initiative (The Institute for Illinois Fiscal Sustainability) that has suggested many short- and long-term strategies for cutting spending and restructuring revenues. Matt Murray from the University of Tennessee will give a multi-state perspective on which tax and expenditure strategies make the most sense in meeting the budget needs of the state while minimizing economic disruption.
The conference will also look at measures other states have used to either limit budget growth or improve fiscal decision making. These include the Priorities of Government program in the state of Washington and the local tax limitation measure, Proposition 13, in California.
The conference will conclude with a session on the implications of fiscal insolvency for the economic climate of the state and, in particular, for businesses looking to make significant investments in Illinois.
Illinois is at a fiscal crossroads. We hope you will be able to join us in investigating how we can improve fiscal performance in the state.
May 12, 2010
State-local Debt and Unfunded Employee Benefits
A combination of events surrounding the recent recession have left many state and local governments with gaping budgetary holes. A recent report by the Center for Budget and Policy Priorities estimates that states face a combined budget deficit of $375 billion for fiscal years 2010 and 2011.
Rather than raise taxes and cut spending cuts sufficiently, some governments, including Illinois , continue to add to their debt obligations to pay for current operations and debt service.
Widening deficits and mounting debt raise concerns that state and local governments will become seriously strained in meeting debt obligations and servicing their debt. If so, disruptive cuts to public services or punitive spikes in tax rates will likely take place at some future crisis point. Such sudden and possibly ill-considered corrective measures are not likely to help the cause of economic growth and development. Even before a crisis develops, a large debt overhang means uncertainty in the minds of would-be investors and in-migrants to the region as to how the obligations will eventually be paid down and, more specifically, uncertainty regarding which taxpayers will be impacted.
To be sure, not all debt accumulation diminishes a government’s capacity to repay its obligations or to finance public services. State–local government debt issuance often finances long-lived assets such as roads, school buildings, airports, and convention centers that are expected to pay for themselves, either directly through revenue streams such as highway tolls or other user fees, or indirectly by increasing economic growth and productivity of the local economy. However, to achieve such ends, judicious choices among alternative investments must be made; debt-financing of current consumption must be avoided.
The U.S. Census Bureau systematically gathers information on the outstanding debt of all state and local governments. The table below reports the Census data for the latest year available, 2007. All state and local governments reported debt outstanding of $2.4 trillion for fiscal years ending in 2007.
In the table above, long-term debt overwhelms short-term debt outstanding. In theory, long-term debt may be preferred since the borrower has more time flexibility in meeting the ultimate re-payment of principal. However, the long-term option of repaying principal on public debt may make it less visible to the electorate who must monitoring borrowing and spending by elected officials.
In examining overall debt of state and local governments in Seventh District states—both short- and long-term combined, debt levels are generally seen to vary by size. To standardize, we divide debt outstanding by each state’s gross state product (GSP; see last column). GSP measures the total production value of goods and services from all sectors within a state for the year. It is equivalent to gross domestic product (GDP) for the national economy. By standardizing debt by the size of the state’s economy, we may reflect the state’s ability to repay debt by taxing productive activity.
By this measure, all Seventh District states save Iowa would seem to be straining their debt-issuance capability compared with the national average. However, the measure is imperfect in several ways. For one, debt that is issued in fast-growing states may be financing infrastructure that will be needed for tomorrow’s (larger) population. It follows that tomorrow’s economy will be larger in these states too and provide greater potential for repaying today’s outstanding debt. However, Midwestern states have not been growing rapidly at all, so it seems unlikely they will grow their way out of debt.
The Census measure of debt outstanding also excludes an important category of debt that is thought to be potentially pernicious. In addition to the explicit debt illustrated above, which is issued through government bonds, state and local governments often accumulate non-bonded liabilities for pension and retiree health care. In the case of pensions, both governments and employees typically contribute to dedicated funds which are calculated to meet retiree payouts. But state and local governments can choose to defer the funding of their full obligations to meet future pension and retiree health benefits (OPEBs) of today’s public employees and retirees. And unlike borrowing to finance long-lived infrastructure, such obligations reflect public services consumed today or in the past that will be paid out in the future. Accordingly, unless the state or local economy grows robustly of its own accord, such debts may grow sufficiently large to cause fiscal strains and stresses in future years.
Even before the recent recession, some governments had accumulated significant unfunded pension and retiree health care debt obligations (OPEBs). These are estimated in a recent a study by the Pew Foundation . The Pew report takes a conservative approach in producing these estimates. Excluded are the unfunded obligations for public employee pensions and OBEPs of local governments. Such local government plans can be very sizable, and the state versus local split varies by state.
As shown below, the Pew study reports that state governments had compiled an estimated $731 billion in such debt as of 2008. Measured as a claim on the U.S. GDP for 2008, state government debt represented just over 5 percent of GSP (last column, author’s estimates). Among District states, both Illinois and Michigan debt of this variety exceeded national averages by wide margins.
The ability of state and local governments to redeem debt obligations is difficult to evaluate, even in the best of circumstances. Much as with private debt issuance, such evaluation requires careful scrutiny as to the purposes to which debt proceeds are used; the question being whether these purposes will pay dividends in the future or not. While inherently valuable, pension and other obligations for today’s or yesterday’s public employee services often have no such future dividends. Accordingly, state and local governments should exercise caution in deferring funding of these obligations. So, too, in their role as watchdogs of the ongoing decision making of elected officials, citizens and the electorate should carefully consider the full price of expanding public services, including pensions and OPEBs.
Not all product or wealth of a state can be readily reached by the tax or revenue system in place. For this reason, other measures of capacity may account for the “reachable” tax base under existing tax and revenue statutes and arrangements. (Return to text)
 In contrast, government-funded educational services may enhance the productivity and income streams of future workers who remain in the state, some part of which may be taxed to redeem pension obligations incurred in the past. (Return to text)
March 19, 2009
State Government Fiscal Performance in the Seventh Federal Reserve District: How bad is it? How bad will it be?
By Rick Mattoon
Throughout the nation, state governments have been crying uncle as revenues have hit a tailspin and expenses for Medicaid and public welfare have accelerated. Estimates of the cumulative deficit facing state governments exceed $100 billion, and the National Association of State Budget Officers is calling this the worst fiscal situation facing the states since World War II. Not surprisingly, states in the Midwest are feeling stress. Here I provide an update on current fiscal issues in Seventh District states (Illinois, Indiana, Iowa, Michigan, and Wisconsin), and I describe the impact on the region of the federal stimulus package (American Recovery and Reinvestment Plan).
Illinois's new governor, Pat Quinn, presented his budget on March 18. In response to current estimates of the state budget deficit ranging from $9 billion to $11 billion, the proposal includes a series of tax changes. Foremost is an increase in the state income tax rate for both individuals and businesses. The personal income tax rate would increase from a flat 3% to a flat 4.5% and would include an increase in the standard deduction from $2,000 to $6,000. The corporate tax rate would increase from 4.8% to 7.2%. The changes would raise about $3.1 billion in revenues. The governor also proposed increases in fees for several licenses, along with a cigarette tax increase.
On the spending side, education expenditures would receive a modest increase. Transportation funding would see a substantial gain through the multiyear, $26 billion “Illinois Jobs Now” program. Much of the funding would come from increases in driver’s license and auto registration fees.
The depth of the state’s problems has been highlighted by several recent reports. The comptroller’s report estimates the current backlog of unpaid bills at $4.5 billion. A March 2 report by the Civic Committee of The Commercial Club of Chicago found that total liabilities (including those for state workers’ pensions and health care) now exceed $116 billion, or $10,000 per resident. The report noted that these liabilities are a chronic problem for the state—that is, they form a structural deficit, which was caused by prior budget actions. This structural deficit is now being exacerbated by the recession.
The state’s economy has had one of the sharper reversals of fortune with the December unemployment rate rising to 9.2%, second worst in the Seventh District. In response, Governor Mitch Daniels has proposed a two-year budget of $28.3 billion, which includes an 8% cut for all state agencies, a 4% reduction in higher education spending, and no increase in K–12 education. The state also has the luxury of a $1.3 billion budget reserve, although the governor’s proposal does not draw on any of these funds.
On February 20, the state’s Democratic-controlled House of Representatives passed a one-year $14.5 billion plan. The plan received no Republican support and is likely to be revised in the state’s Republican-controlled Senate. A major sticking point is that the House’s plan requires spending $200 million of the state budget reserve as well as using $540 million in stimulus money for Medicaid. The bill also allows for some creative accounting by allowing schools to pay for utility bills out of capital funds. There is also a debate about which capital projects to support, with the Democrats favoring several higher education projects and the Republicans favoring prison expansion.
A final side issue has been a proposal to abandon the biennial budget in favor of a one-year budget. Proponents suggest that this would be more prudent in times of fiscal uncertainty. The governor opposes this, believing that more fiscal discipline is required in adopting a biennial budget.
In the face of faltering revenues, Iowa legislators have been trimming Governor Chet Culver’s proposed $6.2 billion budget for fiscal year 2009–10. So far $133 million in cuts have been approved by the legislature. In addition it has been proposed that $100 million from the state’s reserve funds be spent in the next budget. The governor has also cut $30 million from the current budget to close a smaller current budget gap. The legislature is also investigating revenue-raising options including eliminating corporate tax breaks that are not designed to create jobs. There is also a proposal to create a middle-class tax relief program, which would be funded by ending federal deductibility in state income taxes.
On the positive side, a member of the state’s Revenue Estimating Conference suggested that the revised revenue projections for the state appear to be holding steady. The conference makes its next formal projection on March 20.
Finally, Iowa anticipates receiving $1.9 billion in stimulus funds from the federal government.
Michigan—with the highest unemployment rate in the nation (11.6%)—continues to struggle. The state has faced a budget deficit every year since 2001. This year will be no exception. The estimated deficit for the next budget (beginning on October 1) is $1.4 billion. Governor Jennifer Granholm’s proposed budget will cut $670 million and calls for 1,500 state employee layoffs. The state is also planning on using $464 million in federal stimulus funds to help with Medicaid payments. The state’s budget director has been frank in stating that Michigan has two deficits—a structural deficit that has been ongoing since 2001 and a cyclical deficit that is compounding problems. Michigan intends to spend $313 million of the federal stimulus money during the current fiscal year.
Governor Jim Doyle unveiled his plan to close an estimated $5.9 billion budget gap for the next biennium. On the revenue side, the governor proposed $1.4 billion in new taxes, including a new higher income tax bracket for families earning more than $300,000, an 85 cent increase in the cigarette tax, a new tax on multistate companies, a tax on oil companies’ windfall profits, and a sales tax on Internet downloads. Most of the tax package was signed into law on February 18. The budget also assumes $2 billion in federal stimulus money.
On the spending side, $2.2 billion is expected to come from reductions to state agency budgets and $245 million from “budget efficiencies.” No layoffs are included in the budget. The proposed budget would have Wisconsin spending in 2011 what it spends in 2009.
What will be the impact of the federal stimulus money?
Seventh District states would be facing even tougher times if it had not been for the passage of the federal stimulus package. With money flowing into transportation, education, and Medicaid, the states have been able to avoid raising revenues through taxes (and other means) and cutting expenditures. On the broadest level, the following two charts illustrate the estimated multiyear impacts of the federal stimulus package’s major proposals on Seventh District states.
Relative to other federal aid efforts in past recessions, this package is notable for bolstering education spending. Previous programs tended to target Medicaid, unemployment insurance, and infrastructure. This package adds education to those other areas.
There are also estimates available for stimulus funds that have already been allotted as of March 12.
Despite federal stimulus money, state governments in the Seventh District are under significant stress. In some cases, sharp downturns in the local economy are partially to blame (e.g., Michigan and Indiana), but structural imbalances in state fiscal systems are in many cases compounding cyclical declines in the economy. The issues concerning restructuring state revenues in the face of current economic conditions will be the topic of a special program at the Chicago Fed on May 12. Click the link for more information on the conference Assessing the State and Local Sector: Where Will the Money Come From?—sponsored by the Federal Reserve Bank of Chicago, National Association of State Budget Officers, and National Tax Association.
December 22, 2008
The Economic View from the State Budget Trenches
By Rick Mattoon
It is hardly a secret that most state governments are facing tough times. Indeed, state governments are reporting that slower economic activity is affecting revenue collections. A recent fiscal survey by the National Conference of State Legislatures found a combined $140 billion deficit over the current and next budget years. Here, I am reporting the economic news coming straight from the state budget trenches in the Seventh Federal Reserve District.
For most states, some mechanism prompts an economic forecasting commission or other body to provide a prediction on where a state’s economy is headed. This type of forecast is a key component of the state budgeting process and takes advantage of the local expertise on the state’s economic conditions, which are often masked in national or regional forecasts.
The Tax Research and Analysis Section of the Iowa Department of Revenue produces an Iowa Leading Indicators Index on a monthly basis. This index provides a useful benchmark for the state’s economic condition. The figure below shows the performance of the index relative to nonfarm employment since 1999. The index’s recent performance has shown seven straight months of decline since its peak in May 2008, and it has fallen at an annualized rate of 4.8%. However, the index score of 105.6 (1999=100) indicates that Iowa’s economy is still performing better than most states’.
Click to enlarge.
The index has eight components: yield spreads (ten-year Treasury notes vs. three-month Treasury notes), residential building permits, agricultural futures price index, diesel fuel consumption, average weekly unemployment claims, average weekly manufacturing hours worked, new orders index and an Iowa stock market index. Each component has a unique standardization weighting in the index.
On November 19, the Illinois’ Commission on Government Forecasting and Accountability issued its economic and revenue update for fiscal year (FY) 2009. The commission is a bipartisan joint legislative committee with a professional staff that provides fiscal and economic information to the Illinois General Assembly.
The commission also considers the implications of its forecast for state revenues. The commission suggests that base revenues for FY2009 will be down 1.9% ($550 million) from the previous year. See the following table:
The commission also has an estimate for the revenue shortfall for FY2009 versus the budgeted expectations. This estimate is more pessimistic with revenues coming in over $1.3 billion short of budget expectations.
Michigan’s House Fiscal Agency provides frequent updates on revenue trends and periodic updates on the state’s economy.
The November revenue forecast showed FY2008 year-to-date revenue up 8.2% for 13 major taxes and the lottery. The gains reflect changes to Michigan’s tax structure, particularly for personal income and business taxes.
In addition, the University of Michigan does a statewide economic forecast. The most recent one was released on November 21. The forecast highlights Michigan’s weak labor market conditions and anticipates that employment in the fourth quarter of 2008 expected to fall at an annual rate of –4.7%. The first half of 2009 is not likely to be much better with a predicted annual rate drop of –3.2%. Even with modest recovery in the second half of 2009, employment is forecasted to drop at an annual rate of –2%. Not surprisingly this translates into anemic nominal personal income growth of 0.7% in 2009 and 1.2% in 2010.
The Wisconsin Department of Revenue issues a quarterly Wisconsin Economic Outlook. This document includes useful detail on employment and income trends in the state and a comprehensive forecast of the U.S. economy. The August report noted the slowdown in the state’s economy and projected that job growth in the state would turn negative this year. After job growth of 0.5% in 2007, declines of 0.5% and 0.4% in 2008 and 2009 are predicted. This anemic job growth will spill over into personal income growth, forecasted to be a weak 3.4% in 2008 and 2.6% in 2009. (The report notes that the 2008 income growth was aided by the federal stimulus action.) In contrast, personal income rose 5.3% in 2007.
The state budget director recently announced that November revenue projections for FY2009–FY2011 were off an estimated $3.5 billion from the June projections. There is now an estimated budget deficit of $5.4 billion (17% of the budget) from fiscal 2009–11 budget years. This is the largest deficit in Wisconsin’s history.
Like other states in the Seventh District, Wisconsin is just beginning to recognize the weakness of its revenue collection. The latest monthly statements for October showed revenues declining –2.5% for the month, although year-to-date revenues are still positive at 2.4%. On an individual tax basis (year to date), the personal income tax is up 5.6% (because of tax law changes), while the sales tax has declined –2.5% and the corporation tax is down –20.8%.
Indiana’s bipartisan State Budget Committee issues periodic revenue and economic forecasts for the state. The most recent forecast was issued on December 11, and it predicted the state would collect $721 million less in tax dollars in the current budget cycle compared with a forecast that had been made one year ago. The state’s budget surplus has shrunk from $1.4 billion to $600 million in response.
The more pessimistic revenue forecast is based on an economic forecast produced by IHS Global Insights. The IHS forecast suggested that the current recession would be the longest in post-World War II history and would see unemployment hitting 9% before the state’s economy improves.
Vanessa Haleco-Meyer provided valuable assistance in producing this blog.
March 3, 2008
The fiscal state of the states (and municipalities): Not so good
By Rick Mattoon
Plenty of evidence is emerging that state and local governments are headed into a major fiscal pinch. Tax revenues are decreasing across the board, as everything from corporate profits to employment declines. The big question is how well are the states positioned to weather this storm? Is there anything different in the nature of this economic slowdown that will make circumstances more difficult?
Based on some preliminary evidence, the future looks challenging. The Center on Budget and Policy Priorities released a survey of state budget conditions on February 25, 2008. The survey reported 25 states having budget deficits for fiscal year 2009. Specific estimates of the magnitude of the deficits were available for 21 states. These particular states report an aggregate gap of between $36 billion and $38 billion, representing roughly 8% to 9% of total general fund spending. Of the states in the Seventh Federal Reserve District reporting a gap, Illinois has a $1.8 billion deficit (6.6% of general fund); Iowa, $350 million (6%); and Wisconsin, $652 million (4.8%).
The center’s report notes that one of the more vexing fiscal problems is the current instability of property tax revenues related to the housing downturn and mortgage foreclosures. In the 2001 recession, states were able to push expenditures on to local governments because property tax revenues were relatively stable. In the current housing crisis, it is more likely that local governments will be asking state governments for help.
The report also finds that states are rapidly drawing down rainy day funds. These fund levels peaked at 11.5% of annual state spending in fiscal year 2006 and are estimated to decline to 6.7% of state spending by the end of this fiscal year. It is unlikely that this is sufficient to see the states through even a shallow recession.
A final national development is that at the February meeting of the National Governors Association, the governors requested that the federal government offer a fiscal stimulus package for the states aimed at financing infrastructure investments. It is unlikely that this will go anywhere. In the 2001 recession, the federal government offered a $20 billion aid package to the states. Half of the $20 billion was earmarked for a temporary increase in the share of federal support for Medicaid programs, with the remaining half set aside for general grants based on population.
A closer look at the impact of the housing downturn on state and local revenues
The fallout from the subprime loans and foreclosures has had a negative effect on state and local revenues. The United States Conference of Mayors (and the Council for the New American City) hired the consulting firm Global Insight to estimate the implications of the mortgage crisis. The firm estimates that U.S. gross domestic product (GDP) will be $166 billion lower than otherwise because of the crisis and that 524,000 fewer jobs will be created. The firm further estimates a $1.2 trillion decline in property values in 2008.
The report provides estimates of metropolitan growth rates and changes in tax revenues for selected metros and states. For example, the estimated real gross metropolitan product (GMP) growth rate for metro Chicago in 2008 will be 2.23%. This represents a 0.56% reduction, or $3.9 billion decrease, attributable to the mortgage crisis. Metro Detroit’s real GMP growth rate is estimated at 1.3%. A reduction of 0.97% is attributable to the housing slowdown representing a $3.2 billion decline in GMP.
As for changes in tax revenues, the following table provides the fiscal impact estimates for ten states.
As the table illustrates the fallout goes beyond just property tax revenues. Sales taxes decline because of the reduction in big-ticket items, such as appliances and furniture, that occur during a housing slump. Transfer taxes—the taxes on the passing of a title to property from one person (or entity) to another—fall in response to the lower volume of transactions; in recent years, transfer taxes had become increasingly important to municipalities. All in all, such trends suggest significant challenges.
What is the fiscal state of the states? Not very good. And it appears that the housing slowdown will make conditions more challenging than was found during the 2000-01 downturn.
January 25, 2008
OPEB … Oh No!
By Rick Mattoon
Beginning in the 2008 fiscal year, state and local governments with over $100 million in revenues will begin to report the accrued liability they face for funding non-pension post-employment benefits. In government parlance this is referred to as OPEB—other post-employment benefits—with the largest expense being comprised of retiree healthcare. Given that state and local governments have long provided healthcare benefits to both working and retired employees, why is the identification of this burden on the government’s books creating such consternation?
The answer to this question can be divided into three parts—government worker demographics, the size of the obligation and how government has traditionally paid for retiree healthcare, and the difficulty of restructuring employee benefits once granted.
• Government worker demographics. Following the national trend of an aging population, a large share of the workforce of many state and local governments is approaching retirement eligibility. For example, the Illinois Comptroller reports that in FY2006, 65% of public employees in the state were either in their 40s or 50s, up from 41% in 1986. As these workers retire, the pressure on healthcare expenditures is skyrocketing. A report by the Pew Center on the States reports that in California, retiree health costs will rise from $4 billion in 2006 to $10 billion in 2012 and $27 billion in 2019.
• The size of the OPEB liability and traditional method by which government has paid for OPEB costs. Prior to GASB 45, which requires governments to record their OPEB liabilities, most states simply met their retiree benefit costs on a pay as you go basis, where costs are paid out of current revenues. As such, few states actually put aside money to fund OPEB costs. While governments have saved to meet pension obligations, the Pew Center report estimates that 97% of the OPEB liability is currently unfunded. Estimates of the outstanding OPEB liability range from $370 billion (for a subset of governments that have reported their liability) to $1.5 trillion for the entire sector. The size of the unfunded balance differs considerably from state to state (see figure below).
• Difficulty in restructuring retiree healthcare. In the private sector, a clear strategy for limiting a firm’s exposure to retiree healthcare costs has been to either eliminate or restructure healthcare benefits. A survey by the Kaiser Family Foundation reports that only one-third of large companies still offer retiree health insurance and that these companies have often reduced their premium contribution, leaving the retiree to shoulder a larger share of the tab. The state and local governments that have been the most active in addressing OPEB costs have taken on changes to health benefits, but this has led to several difficult bargaining sessions with public employee unions and frequent legal challenges.
Are there strategies for meeting OPEB obligations?
On March 12, the Chicago Fed and the Civic Federation will host a half-day conference on what governments are doing to meet their OPEB obligations.
Presentations will include officials from the Ohio Public Employees Retirement System (OPERS) and Oakland County, Michigan. Both of these governments have been seen as innovative leaders in identifying and developing a strategy to fund OPEB expenses. Ohio had accumulated over $11 billion in assets by FY2006 to meet OPEB obligations and has moved to restructure benefits as well by placing a cap on lifetime benefits and increasing co-payments and deductibles. While the state has an unfunded liability of $6.5 billion, it has shown fiscal discipline in consistently reducing its outstanding liability.
Oakland County has used a series of fiscal tools over the last 20 years to meet its OPEB liability. These have included:
--in 1985, creating a tiered vesting schedule for retirement;
--beginning in 1987, adopting a policy to fund the full actuarially required contribution (ARC) for retiree healthcare liabilities;
--in 1988, creating a self-insurance pool for active and retired employees;
--in 2000, creating a VEBA trust which allowed the County to create a tax-exempt investment plan; and
--closing the retiree health care plan and creating a defined contribution plan in 2006.
The March 12 Chicago Fed/Civic Federation program will also bring in a number of Illinois governments to discuss their evolving strategies for meeting OPEB costs. This will include representatives from the city of Aurora, the Metropolitan Water Reclamation District, and the Chicago Public Schools. Illinois governments face a particularly acute problem. The Civic Committee of the Chicago Commercial Club has estimated that the state’s unfunded OPEB liability is $48 billion. Given that the state also faces an unfunded pension liability of $40 billion, developing a strategy to meet this challenge will be exceedingly important. Discussions in Illinois have already examined such strategies as issuing OPEB bonds, creating irrevocable trust funds and selling assets to allow for one-shot infusions of capital to help meet OPEB obligations.
For many states, meeting the twin responsibilities of pension and OPEB funding will be dominant public finance issues for some time to come. Given the increasing pressures of funding elementary and secondary education, Medicaid, and deferred infrastructure costs, creating a strategy for managing labor related benefits costs will be critical to the health of the state and local sector.
June 25, 2007
State-local Business Taxation
To most people, the subject of tax structure is a sleepy one. An important exception is when looming changes to the tax structure raise the prospects for who will pay for public services (and how much they will pay). In characterizing this debate, Senator Russell B. Long of Louisiana once said, “Don’t tax me, don’t tax thee, tax that fellow behind the tree!”
Public discussion also becomes animated when considering whether state and local tax structures (or changes to them) will hinder economic growth and development. That is to say, will tax hikes on business drive away jobs and income?
A recent symposium held at our Bank gathered experts together to consider emerging trends in business taxation. In recent years, there have been significant changes to business taxation in Midwest states, such as Ohio and Michigan. Ohio enacted a modest tax on business gross receipts in 2005, replacing a local tax on capital machinery and equipment. Michigan has phased out its largest business tax and is now considering how to replace the revenues that it formerly generated with its Single Business Tax.
The State of Illinois was considering a large “business” tax on business gross receipts to fund education and a subsidized health care initiative. To pay for it, Governor Rod Blagojevich advocated a large business tax on gross receipts because it would be paid by those who could afford it. Interestingly, the Lieutenant Governor Pat Quinn disagreed on the very same grounds.
Who was correct? As with many such matters, there is no certainty. But at the business taxation conference, I stated that I did not favor the Illinois gross receipts tax, at least on equity grounds. I argued that our most common principle of equity in taxation is a poor guidepost by which to design a state’s business tax structure. By equity, most people mean “ability to pay” such that taxation should progressively burden high-income households relative to low-income ones. The trouble with this approach is that businesses are not households. Businesses are organized groups of people ranging from line workers to mid-managers to active owner-entrepreneurs to silent capital-owning partners.
So who are we really taxing? We are not really sure. In particular, the taxation of business activity often results in changes to product prices that burden consumers rather than wealthy individuals. In the same vein, business taxation can sometimes result in lower wage offers to a firm’s workers. The ultimate result of such “tax shifting” may mean that a tax intended to “soak the rich” may have the opposite result. For example, it is easy to see (and universally accepted) that unduly high taxes on companies that sell gasoline in a state or city are largely shifted forward to consumers of gasoline in that state or city. Why would the companies pay inordinate taxes on the gasoline they sell in Chicago, for example? The answer is that they would not and they do not. This is in part because gasoline (energy) companies sell their products and services into many markets worldwide. Accordingly, when taxes on gasoline are pushed too high in any one locale, the price of gasoline rises until it becomes profitable for companies to sell it there. And since gasoline is presently a necessity for nearly everyone in the industrialized world, low-income households end up paying taxes on it that are a larger share of their household income as compared with the share of high-income households. The intent to achieve equity, in this instance, is foiled.
More generally, analysts have only a fuzzy and foggy notion across the breadth of business taxes as to which ones (and how much of them) are actually shifted to workers and to consumers. And so, to achieve equity, tools such as direct income redistribution or manipulation of the individual income tax are more reliable for this purpose. For this reason, I argue that it is preferable to design state and local business taxes around our notions of efficiency rather than on equity.
In looking at the efficiency of taxing businesses, it is important to recognize that business organizations do use costly government services, including police, fire protection, roadways, and legal protections. Having businesses pay for such services, then, is not only fair, it is efficient in several respects.
In paying state and local governments for their public services, businesses will be motivated to articulate their service needs to these governments, just as customers do with service providers in market situations. In turn, this will promote growth and development in states and localities. The resulting negotiation and conversation between governments and businesses will help identify those essential roads, bridges, and property protections that make businesses more productive. So too the process of haggling over the price and cost of government services to businesses will tend to keep governments cost efficient.
This give and take between business and government will only take place if a state's business taxes are structured as a user charge and not set unduly high in an effort to redistribute income.
The purposeful conversation on business taxes and business service levels will also spill over in positive ways to government service provision to households. In recognizing that “business” taxes are not really subsidizing household services, such as education and health care, households and their representatives will more carefully evaluate the costs and benefits of government services.
The structure of taxes can be a sleepy one. However, those who doze off during the debate may very well find themselves stuck with the tab.
February 26, 2007
Medicaid: In need of reform in Midwest states?
By Guest Blogger Rick Mattoon
The U.S. Medicaid program provides healthcare coverage and long-term assistance to over 41 million low-income families and 14 million elderly people and persons with disabilities, according to the Kaiser Foundation. Given the high and rising costs of medical care, it is not surprising that the Medicaid program typically represents the largest single budget item (roughly 20%) for most state governments, having surpassed K-12 education. As such, the rising expenditures of state Medicaid programs are often the biggest culprit in the imbalance in state budgets from year to year. The question is, given current trends, can states afford Medicaid in the future without structural changes in either the program or in funding?
Medicaid is now funded as a partnership between the federal government and the states. The federal government provides matching funds (FMAP) as determined by a formula with the matching rate varying from 50% to 77% on the dollar. Given this matching feature, states have long been motivated to take advantage of the federal match by expanding their programs. In response, the federal government has tightened up eligible services, leaving many states with sole funding responsibility for certain current program services. In turn, many states have enacted cost containment strategies.
These developments have slowed the growth of Medicaid expenditures of late, holding it to 2.8% in FY2006 from an annual average of roughly 7.7% from 1997 to 2005. States have also enjoyed some respite from Medicaid budgetary pressures with the shifting of many prescription drug expenses to the federal government under the new Medicare Part D program covering prescription drugs. Budgetary pressures also have been eased from the revenue side as widespread economic recovery in the U.S. has often yielded better than expected state revenue growth. However, the respite may prove to be short-lived; states are budgeting for Medicaid growth of 6% in FY2007. Unfavorable trends will continue to put pressure on Medicaid spending including a growing elderly population, rising general health costs and an increasing number of uninsured in the general population.
In addition to addressing funding pressures to sustain existing programs, many analysts believe that Medicaid programs should be refashioned. Recent studies to this effect have been issued by the Medicaid Commission’s report to the Secretary of Health and Human Services and a report from the Deloitte Center for Health Solutions. For example, the Medicaid Commission recommended changes in five critical policy areas. These are:
• Long-term care—including providing incentives for individuals to plan for their own long-term care needs and shifting long-term care toward at-home rather than institutional care.
• Benefit design—providing states with greater flexibility to custom design Medicaid coverage to meet the needs of their covered population. In addition, an incentive system should be considered to reward Medicaid recipients who make prudent purchasing, resource-utilization and life-style health related decisions.
• Eligibility—permitting states to consolidate eligibility categories and increasing federal support for new options for the uninsured to obtain private insurance rather than falling into the Medicaid program. So too, the federal matching program should be scaled to provide a larger match for adding low-income recipients (the intended population for Medicaid) and a smaller match for adding higher income populations.
• Health information technology—including broad support for expanding the use of information technology including having all Medicaid beneficiaries having an electronic record by 2012.
• Quality and care coordination—further expansion of coordinated care programs as well as measuring the effectiveness of treatment by providers.
The Deloitte study suggests that fundamental reform is needed, particularly in the area of actively managing Medicaid programs. The study suggests that policymakers should be guided by six key choices in reforming their Medicaid programs.
• Choice 1. What should be the core function of the state’s Medicaid program?
• Choice 2. Should the program services be directly managed by the state or should it be contracted out?
• Choice 3. Where should the state be on the continuum between “traditional” Medicaid benefits and coverage and free health care for all low-income residents?
• Choice 4. Will the state go beyond simple program administration and use the Medicaid program to actively control the costs and quality of healthcare throughout the state?
• Choice 5. Which cost savings and policy levers will the state use to reduce, or at a minimum contain, the costs of the state’s program?
• Choice 6. To what extent will Medicaid recipients share in the state’s burden of cost reduction?
Clearly when it comes to Medicaid, there is no shortage of potential reforms.
To help investigate these issues, on March 15, the Federal Reserve Bank of Chicago and the Civic Federation are cosponsoring a program to look at the current status and features of Medicaid and how states are dealing with this sizable program responsibility. The conference attendees will hear from Medicaid policy researchers including representatives from the Kaiser Foundation and the University of Illinois, as well as the directors of the Medicaid programs in Illinois, Iowa, and Indiana. A keynote address will be delivered by former Wisconsin Governor and U.S. Health and Human Services Secretary Tommy Thompson. To register for this program please go to http://www.civicfed.org/events/070315_RegistrationForm.pdf.
July 19, 2006
Honda and tax incentives
Honda recently decided on a site in Indiana for its new North American auto assembly plant over sites in Ohio and Illinois. Indiana offered Honda generous incentives of EDGE tax credits, training assistance, and real and personal property tax abatements totaling up to $41.5 million. In addition, the state will provide infrastructure support for water, wastewater, and road improvements of approximately $44 million. This offer was generous relative to packages that have been offered lately by northern states to woo automotive plants. Did the incentives swing the deal for Indiana? And how can states hope to recoup these upfront costs and revenue losses? More importantly, is society well served by such raw-knuckled competition among states for production facilities? The answers are not definitive, but, though often condemned, the use of fiscal incentives may not be such a bad thing.
Large offers of this nature have become commonplace. Speaking at the Chicago Fed’s recent symposium on the automotive parts industry, Sean McAlinden of the Center for Automotive Research reported that the state of Georgia offered Korean carmaker KIA a package estimated to be worth $409 million. This was noticeably larger than the recent average offers of $57 million in tax incentives for automotive assembly plants for northern states and $44.2 million (plus free or subsidized infrastructure and job training) for southern states.
On completion of such deals, company representatives often proclaim that the incentives did not determine the choice of location, but were rather a sweetener or a comforting pledge of good faith. Professional site selection analysts tend to echo these sentiments. Taking such statements at face value, why do states offer such high stakes packages?
No doubt, there are benefits at the ballot box to those elected officials who can brag about bringing jobs and income to the state. It has been argued that these benefits, especially for investment projects that loom large in the media, result in overly generous offers and poor decision-making by state officials. This is one reason that some states enact legal requirements making the terms of such deals easily available to public scrutiny.
But how can states afford to make such offers? One reason is that the public service costs of hosting businesses are usually lower than the taxes paid by them; that is, there is typically a fiscal surplus inherent in state business tax systems that allows state officials to discount the public tax and service bills on new investment. When I examined the likely costs of public services provided to businesses in a 1996 study, I found that, across all U.S. regions, direct business taxes tended to exceed the value of direct service benefits provided to business by a ratio ranging from 1.5:1 to 2:1. This excess may allow room for governments to lower business tax bills through selective incentives.
Even so, opponents of the use of selective tax abatements may argue that incentives were unnecessary and that businesses have an information advantage in bargaining with states for incentives even when they will end up choosing the same location in any event. Certainly, the proclamations of businesses that afterwards contend that incentives were not a primary consideration in their location decision bear this out. If so, states are arguably better off refraining from incentives and instead spending the business tax bounty on public services or returning personal taxes to state residents.
In the case of auto plants, it is interesting to note that even if individual states “give away the store” in luring a particular auto assembly facility, the end result may ultimately benefit the state’s economy. The reason is that the assembly plants typically attract auto parts suppliers to the area. As Chicago Fed economist Thomas Klier has shown (below), a typical assembly plant can draw a significant nearby supplier base. For recently opened assembly plants in North America, an average of 19 to 20 direct suppliers have typically opened up within 60 miles of the plant. More generally, assembly plants tend to pull in many more supplier plants within several hundred miles, and supplier plant employment generally exceeds assembly plant employment by around 3.5:1.
It is true that in the case of the Honda assembly plant in Greensburg, IN, many of the supplier plants will be outside Indiana’s border and tax reach. However, if all or many adjacent states are successful in attracting assembly plants, the spillover benefits of taxation and income will accrue in roughly equal measure to the states. A so-called cluster of automotive production capability may be achieved for the multi-state region.
But are the incentives necessary to achieve or preserve the region’s cluster of automotive plants? At least for highly capital-intensive industrial activities such as manufacturing, the so-called business climate of the state is paramount. Placement of an expensive investment by a company in a state must be based on a strong conviction that future government leaders will not expropriate the facility’s value through regulation, over-taxation, or non-cooperation in future land use and public infrastructure needs. The situation is not unlike making investments in a foreign country. When the capital investment is fixed and not easily moved, confidence in local government is a key factor in assessing investment risk.
In this regard, Honda’s decision to locate in Indiana rather than Ohio is understandable. While proximity to its large suppliers in Ohio and vicinity was a compelling reason for considering Indiana, the desirability of diversification among government entities may have also been a factor. As for the incentive package, there is surely more to a favorable state business climate than a flashy offer of tax incentives. But at the same time, the offer of a fiscal incentive package may be a strong signal to the business that its presence will be valued. In addition, a sizable and highly visible tax incentive package may represent an implicit acknowledgment by the state that the investment is wanted, making it more difficult for future political leaders to renege on the state’s cooperative relationship with the company.
Of course, implicit tax incentive contracts of this sort work both ways. Companies that receive generous tax incentive packages, but later do not deliver on promised jobs and investments, are easy targets for retribution by state officials. In many instances today, “clawback” provisions are included upfront that eliminate favorable tax treatment if companies do not deliver.
Even so, the “gold standard” by which public policies must be judged is whether the state could possibly do better. Opponents of tax incentives for business argue that, because of such tax breaks, critical public services such as education remain underfunded. In particular, public education suffers, contributing to sub-par income growth and exacerbating social problems such as crime, poor electoral participation, and poor public health. If we accept this view, the economic returns to the practice of competitive business tax incentives are not optimal; the economic returns from any short-term job and income gains to the local economy are less than the foregone returns that greater education spending would bring locally and nationally.
In rebuttal, one might argue that business taxes are not the only possible source of revenue for highly valued public services such as education. An ideal of government is one in which citizens understand both the value of public services provided and the real costs of these benefits and, subsequently, make their choices known at the ballot box.
With the tendency among governments to over-tax business activity, the electorate may believe that they are getting a free ride for public services—that they are not in fact paying for these services. But they are usually mistaken. People and households end up (indirectly) paying for public services in any event. After all, business taxes are ultimately reflected in higher product prices paid by state residents or in lower wages and salaries paid to employees.
So why do many voters and even some policy analysts advocate the taxation of business activity to finance public services that primarily benefit households? Some argue that Americans like their taxes hidden and furthermore that this is a reasonable way for governments to finance high-payoff public services. But this approach has risks. If taxes and prices for public services are hidden, can the citizenry really make sensible decisions about what levels, types, and extent of services government should provide? What do you think?