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 “The most important thing we are accomplishing is stabilizing
the finances of the state,” Illinois Gov. J.B. Pritzker said at the March 7
press conference rolling out his proposal for a graduated, or progressive,
income tax.
But a graduated income tax structure would actually make Illinois’ moving
revenue target even harder to hit. If Illinois had adopted the governor’s
progressive tax rates in 2007, income tax volatility would have been 30 percent
higher. Larger swings in income tax revenue would make state finances less
stable, harder to predict, and increase the likelihood and size of Illinois’
already chronic budget shortfalls.
Take the 2009 recession, for example. Illinois income tax
revenues would have fallen by approximately $2.16 billion that year if
Pritzker’s proposed income tax rates were in place – a 13 percent drop. But
under the current flat income tax, revenue would have fallen by $1.55 billion –
a 10 percent drop. That’s a $613 million larger swing in revenue in just one
year. Why is a graduated income tax more volatile than a flat
tax?
With a flat tax, volatility in revenue comes from changes in net taxable income.
But with a graduated tax, unpredictability comes both from everyone’s income
changing as well as from different portions of people’s income being taxed at
different rates and the swings being wider the higher the income bracket. This
additional source of volatility results in higher tax revenue volatility when
compared to a flat tax (see appendix).
Why Pritzker’s “fair tax” would be worse for Illinois’ finances
The governor’s tax scheme would be a less stable source of revenue than the
state’s current flat tax. This is because Pritzker’s tax relies heavily on top
earners, whose incomes fluctuate more widely with the economy.
Why does volatility matter? Assume the state anticipates $3.5 billion in
additional tax revenue from all Illinoisans under a flat tax. You could
reasonably expect total income growth to fluctuate by 5.8% a year, so your $3.5
billion growth estimate could be off by $200 million. However, if we rely solely
on folks making more than $250,000 for the new revenue, then the shortfall in
tax revenue could be more than $700 million. This is because higher income
brackets see much larger swings in income growth – up to 20.8 percent – than the
lower brackets and are responsible for an even larger share of the revenue.
Losing $200 million is tough, but losing $700 million is a crisis.
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Corporate income taxes are the most unpredictable
and susceptible to change, followed by personal income tax, with
sales taxes being the most stable. Progressive income taxes are also
more volatile than flat income taxes because they rely on a smaller
tax base that includes more income from investment, or capital
gains, which fluctuates more with changes in the economy. In fact,
revenue volatility has been increasing nationwide since 2000. This
increased volatility is mostly driven by more volatility in capital
gains and an increase in the percentage of income from investments,
as opposed to wages.
This would be particularly bad for Illinois: its personal income tax
revenues are already more volatile than most other states, according
to The Pew Charitable Trusts. Increasing the state’s
reliance on corporate and progressive individual income taxes will
make future revenues less stable, harder to predict and could lead
to even larger budget shortfalls. Those budget shortfalls will
require middle class tax hikes – that’s because the middle class
makes up a larger share of taxpayers and their incomes are more
stable.
A different path forward
Pritzker’s goals – healthy state finances, a strong economy and a
tax cut for the middle class – cannot be achieved by the means he’s
proposed.
Instead, Pritzker should look to structurally reform Illinois’
spending to address the largest cost drivers of the state’s fiscal
problems: government worker health care costs and pension benefits.
The Illinois Policy Institute shows how commonsense, bipartisan
reforms can be achieved in its recently released “Budget Solutions
2020: A 5-year plan to balance Illinois’ budget, pay off debt and
cut taxes.”
Of these solutions, a spending cap – which already has bipartisan
support in the General Assembly – would do the most to shore up
state finances and prevent massive budget shortfalls exacerbated by
rapidly increased spending.
Lawmakers have two options ahead of them: They can continue to rack
up debt and pursue tax hikes that will further damage the state’s
economy, or they can break with past practices and pursue
responsible budgeting that protects both taxpayers and core
government services.
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