Progressive tax uncertainty could trip Illinois’ already-stumbling economy

The elections scheduled for November 2020 are already injecting uncertainty into the economy, and the progressive income tax ballot question will make matters worse.

Illinois politicians are not historically gifted at planning ahead. Illinois is among the least prepared for a recession and, as of July 24, had a paltry Budget Stabilization Fund of $59,912.

This would cover mere seconds of state spending.

Gov. J.B. Pritzker continued the state’s tradition of poor planning when he proposed a progressive tax plan with overly optimistic revenue estimates and convinced legislators to send a progressive income tax constitutional amendment to the ballot in 2020.

One overlooked factor contributing to a year that will likely see yet another Illinois budget deficit: the spike in policy-related uncertainty that accompanies presidential elections, and the resulting slowdown in economic activity.

National elections produce spikes in policy uncertainty. This means the U.S. economy, and with it Illinois’ economy, is expected to slow down in the upcoming election year – regardless of who becomes America’s next president. Making matters even worse for Illinois is the uncertainty of what the state’s income tax policy will be, which will be determined by voters during the presidential election in November 2020.

Why economic growth stalls in elections years

When there’s uncertainty about who will be making policy decisions, what those decisions will be and how they will affect the economy, individuals and businesses who have money to spend will pause before writing a check.

Economists Scott Baker, Nicholas Bloom and Steven Davis found that to be the case: a rise in policy-related uncertainty is associated with lower economic growth. Over time, policy uncertainty has risen alongside: 1) the growth in government spending, taxes and regulation; and 2) the increased political polarization and its implications for the policy-making process and policy choices.

Because the payoffs associated with private economic decisions are increasingly affected by government policies that are subject to change – such as the progressive income tax amendment – people and businesses are cautious. They spend less and save more, resulting in lower growth and declining interest rates. The authors also found that policy uncertainty leads to an increase in stock price volatility. Increased policy uncertainty foreshadows declines in investment, output and employment.

Declining growth means less tax revenue

Declining economic growth poses major challenges for states that struggle to pay the bills. And Illinois, which hasn’t passed a balanced budget since 2001, has a tendency to spend beyond its means. Through years of bad habits , the state has driven itself to the edge of a fiscal cliff and the uncertainty caused by possible policy changes will only make things worse.

Pritzker promised his current push for a tax increase – a shift from a flat to a progressive income tax – would fix the state’s finances. However, the governor’s math fails to account for any slowdown in economic growth.

Deficits tend to increase in periods of low economic growth because economic growth is a major driver of the level of tax revenues. If the economy is growing more slowly, tax revenues will also increase at a slower pace and the likelihood of a budget deficit increases.

Pritzker’s progressive income tax rates rely on a small base of wealthy taxpayers. During a period of declining economic growth, high market volatility and falling interest rates, aggregate income earned by those individuals will grow more slowly. As a result, income tax revenues will fall short of the administration’s projections. That will only cause them to look farther down the income brackets for more revenue, meaning middle-class tax hikes are sure to follow.

This is not to mention the fact that Illinois also has a huge amount of pension debt. The state currently reports $137 billion in unfunded pension liabilities.

Lower economic growth and declining interest rates mean pension funds have to rely more on complex and risky assets in order to achieve investment return targets. The increase in policy-related uncertainty puts state and local pension funds on even shakier ground.

Solutions

Illinois has two strong options for addressing its looming fiscal crisis.

First, the state should enact rigid fiscal rules such as a spending cap. The proposed constitutional spending cap amendment would tie growth in state spending to growth in the state’s economy, providing certainty about what future budgets will look like and increasing the likelihood of revenues matching expenditures. The state should also take advantage of years in which revenues exceed expenditures by building up a solid rainy-day fund.

Second, Illinois should reform its pension system to ensure its survival. Through an amendment to the Illinois Constitution’s pension clause, Illinois could restructure the pension system, protecting already-earned benefits while slowing the accrual of future benefits.

Illinois politicians’ spendthrift ways are not sustainable, especially in the face of a stalling economy. As the news media generates excitement around presidential candidates and the coming election, the accompanying policy uncertainty will likely slow economic growth.

Illinois should take this slowdown into account. Planning now could help avoid damaging budget deficits later.