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 Given the Democrats' control of the state legislature and their
opposition to many proposals for spending cuts, municipal bond fund
managers see little alternative for Republican Governor Bruce Rauner
other than eventually agreeing to hike taxes, such as raising the
state’s income tax or broadening its sales tax base.
The state has a chronic structural budget deficit, as well as the
lowest credit ratings and worst-funded pension system among the 50
states. Chicago, the third biggest U.S. city and the place where
about one in five of the state's residents live, is suffering from
similar pension issues and may have to take additional pain, the
investors said.
"What is quite simple a solution is to raise taxes," said Tom
Metzold, senior portfolio manager at Eaton Vance Management, which
has been paring down its Illinois exposure. "You're going to have a
game of chicken over who blinks first - the cutting expenditure side
or raising taxes side."
Rauner got into office in a November election after campaigning for
eliminating a temporary 2011 personal income tax hike to 5 percent
from 3 percent enacted under former Democratic Governor Pat Quinn.
That was largely rolled back in January to 3.75 percent.
 Rauner has ruled out hiking taxes unless he can get pension cuts and
other reforms, including creating areas where employees in unionized
workplaces can opt out of joining unions or paying union dues. The
Democrat-controlled House rejected this so-called right-to-work
proposal last week.
Balancing Illinois' out-of-whack budget without raising taxes for
the next fiscal year is already proving difficult. While Rauner got
spending cuts passed by lawmakers to help plug a $1.6 billion hole
in the current year, his $32 billion proposed budget for the fiscal
year beginning July 1 met resistance from Democrats.
The contentious point is $6.6 billion in proposed spending cuts, and
a key component of the budget - slashing $1.2 billion in spending
from its human services department (which includes housing and child
care services) - has already been voted down by the House.
SKIPPING AND SKIMPING
By far the biggest problem facing Illinois and Chicago are their
grossly underfunded pension funds, the result of years of skipping
and skimping on contributions and sweetening benefits for a mainly
unionized workforce.
That already dire situation got a lot worse on May 8 when the
Illinois Supreme Court threw out the state's landmark 2013 pension
reform law, saying it violated a clause in the state constitution.
The reform attempted to rein in costs by reducing and suspending
cost-of-living increases for pensioners, raising retirement ages and
limiting salaries on which pensions are based.
"The court ruling will increase the likelihood of new revenue
eventually becoming part of the budget solution," said Nuveen
analysts in a research note. "This could mean an expanded sales tax
base or income tax increase."
Illinois’ unfunded pension liabilities total $105 billion and the
funded ratio is only 42.9 percent.
The day of reckoning is approaching as Rauner and legislators have
to balance the budget for the next fiscal year. If they fail to
agree on tax increases or spending cuts to make required payments to
its pensions of $7.6 billion for 2016, the state risks further
downgrades in its credit rating.
Rauner's budget for next fiscal year relies in part on moving
current state workers into less-generous pensions - now harder after
the Supreme Court's ruling. State contributions are ratcheting
higher every year and are projected to grow to more than $10 billion
a year in 12 years.
"New revenue cannot be discussed until we address the underlying
structural issues that contributed to Illinois' fiscal crisis," said
a spokeswoman for Rauner when asked about any possible tax
increases.
A spokesman for powerful House Speaker Michael Madigan, a Democrat,
said the budget plan should be a balance between spending cuts and
revenue. Madigan scheduled a House vote this week on a proposal for
a 3 percent additional tax on income over $1 million.
Illinois Senate President John Cullerton, also a Democrat, is hoping
for a bipartisan budget solution that addresses both income and
expenses, said his spokeswoman.
APPEAL SEEN UNLIKELY
Legal experts largely dismiss the idea of an appeal of the ruling,
noting that the U.S. Supreme Court might decline to hear a case that
is so tied to Illinois state law. A spokesperson for Illinois'
attorney general did not respond to a request for comment.
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Rauner wants to amend the constitution to ensure his pension
proposal sticks – but it is a formidable challenge to get the
three-fifths majority vote required and even if successful would
take years to take effect.
“Until citizens begin paying for the services they receive at the
right price, the problems of the past 30-plus years will continue,”
said Marti Kopacz, a restructuring consultant who advised the judge
in Detroit’s historic bankruptcy.
"It doesn't take much of a tax increase and/or a combination of
some spending cuts to solve their problems, it just takes the
political will," said Guy Davidson, director of Municipal Fixed
Income at AllianceBernstein, which owns some Illinois state general
obligation bonds.
While Illinois ranks 31st among the states in terms of its state
business tax climate for 2015, according to the Tax Foundation
research group, its flat personal income tax rate is well below many
other states, particularly for higher-income earners.
The state's sales tax is 6.25 percent, though there are exemptions
for some goods. Consumers also face additional sales taxes from
local authorities - taking the total rate in Chicago, for example,
to 9.25 percent.
The recent high court ruling could breathe new life into pension
proposals that have previously been floated.
In one, Illinois would shift some costs from the Teachers Retirement
System to local school districts. But this would likely pass an
increased tax burden on in a different way and meet resistance from
some state lawmakers.
SCOOP AND TOSS
As Illinois' woes pile up, bankers are likely to pitch creative
solutions such as pushing out debt maturities or privatizing assets.
Those options each face major political or legal obstacles and
cannot alone fill the unfunded liability, investors say.
Extending debt maturities can buy time. Debt service costs account
for 5.6 percent of the state's budget, according to Nuveen. However,
the Illinois constitution prohibits “scoop and toss,” a practice
used to free up revenue by pushing principal and interest payments
into future years.
Privatisations could be a possibility, say some bankers, noting that
selling Illinois' toll roads and interstate highways is one option.
This would, though, risk a political backlash. Privatizations got a
bad name after the company that leased Chicago's parking meters
immediately tripled rates.
The state could also issue pension obligation bonds to boost funding
levels - though critics say they just add to the burden of future
taxpayers. Illinois already has $13.8 billion of outstanding pension
obligation bonds, according to S&P.
Despite all the problems, Illinois state bonds with a 5 percent
coupon trade at or above par, reflecting a sense that Illinois will
avoid a default or a haircut for investors.
"The legal framework as it exists right now is that the bonds get
paid in full, and there’s no talk yet of changing that," said
Emanuel Grillo, bankruptcy attorney and muni restructuring expert
from Baker Botts.
 There is no provision for U.S. states to file for bankruptcy under
federal law - which means there is less pressure for everyone to get
around the bargaining table.
In a corporate or municipal bankruptcy, stakeholders may fight hard
to protect their investments, but often wind up in a deal that
spreads the pain. In state finance, bondholders and pensioners can
resist haircuts until the state “has exhausted its tax base,” Grillo
said.
(Reporting by Megan Davies and Nick Brown in New York and Karen
Pierog in Chicago; Editing by Martin Howell)
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