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Rauner Plays Down a Tax Hike, but Can the Pension Mess Be Fixed Without One?

Illinois is laboring to pay its bills without the revenue from 2011’s income tax increase.

Bruce Rauner delivers the State of the State address in Springfield   Photo: Anthony Souffle/Chicago Tribune

In his State of the State address Wednesday, Bruce Rauner made his case against raising taxes, or against raising taxes without structural reforms that include aspects of his “turnaround agenda,” or …  something.

But we can’t just raise taxes again. We know that doesn’t work. While the 2011 tax hike was in place, our credit rating was downgraded five times, we barely made a dent in our bill backlog, state support for schools was cut, our unfunded pension liabilities went up $28 billion, and our economic growth fell to almost half the national average. Raising taxes without improving our ability to compete will not help the people of Illinois, and in fact, it will make things worse.

He’s not specifically saying that raising taxes made the state’s fiscal health worse, just that we can’t “just” raise taxes again, which I suspect lots of people would broadly agree with. Rauner has agreed to allow Democrats to raise taxes if they pass  his desired reforms, though he was critical of the idea. Nonetheless, the litany of measures he mentions in the wake of the tax increase arguably implies that it was a failure.

So, is he right?

“Some of it is technically true,” says Amanda Kass, research director for the Center for Tax and Budget Accountability. “But it’s misleading.”

Take pensions. Yes, the combined unfunded liabilities of the state retirement systems increased from $83.1 billion in 2011 to $111 billion in 2015. But that increase comes with some big asterisks.

First, that $83.1 billion unfunded liability was unusually low, one of only two of the past 15 years in which the liability fell from the prior year, as two state pension analysts explained last year: “The systems experienced exceptionally strong investment returns in FY 2011, which caused the unfunded liability to drop slightly to $83.1 billion.”

Second, the unfunded liability increased because of changes intended to make the pension budgeting more accurate. “It grew during that period,” Kass says, “because the systems changed their assumptions on investment returns.”

In other words, the unfunded liability indeed grew, but it didn’t have much to do with the 2011 increase in income tax.

The unfunded liability isn’t like a mortgage, a specific debt that remains unchanged. Actuaries have to predict mortality rates and investment returns in order to make assumptions for what the liability will be decades from now. From 1996 through 2015, the total unfunded liability of the state pension systems grew by $94 billion dollars; $21 billion of that comes from changed investment assumptions. Another $14 billion comes from “other factors,” which includes adjusted mortality rates.

In 2012, for instance, changes in investment-return assumptions added $4.6 billion to the unfunded liability, and other factors added another $1.2 billion. In 2014, changes in investment-return assumptions added $11 billion to the unfunded liability. This is not necessarily a bad thing, because it’s a more conservative assumption, but it makes the top-line number even scarier.

It’s also true that the state’s contributions to the pension systems fell below what would have been actuarially required to reduce the unfunded liability. But that is by design, for better or worse. “The pension ramp is backloaded,” Kass says, “so the liability grows before it goes down.”

The “pension ramp,” as you may recall, was a law passed in 1995 that was designed to make the state reach pension-funding goals of 90 percent by 2045. Payments were low at first, but then “ramped up” in 2012.

If you follow the pension mess, you’re probably aware that the pension ramp has dramatically increased required payments into the pension systems; Dave McKinney has an excellent piece on that in Crain’s. In 2011, just before the ramp kicked in, pension costs as a percentage of total general funds were at a mere 4.8 percent; they’re scheduled to peak in 2016 at more than a quarter a quarter. Under current law they will remain around 25 percent until 2045, when the systems reach the actuarially safe level of 90 percent.

But the unfunded liability is scheduled to grow as well, as documented in this report from the state’s Commission on Government Forecasting and Accountability (see Appendix A). From now until 2020, it’s scheduled to grow from about $111 billion to $118 billion. From 2027 through 2030, the unfunded liability will remain at a peak of around $128 million. Only then will it decline to an unfunded liability of $35 billion—which sounds like a lot but nonetheless represents a 90-percent-funded system. Over that time, the unfunded ratio is actually projected to improve every year, while the percentage of the general funds those represents remains the same.

That, of course, is a high percentage of general funds, for a very long time—another worry about the drop in the state’s income tax. In 2010 and 2011, the state used general obligation bonds to meet pension payments, which will increase spending in fiscal year 2016; in 2012 and 2013, the state was able to pay its increasing obligation under the pension ramp out of the general funds. Since Pat Quinn’s income tax hikes started expiring in 2015, keeping the state’s accounts in line has become increasingly difficult, as the Civic Federation detailed a couple of weeks ago:

The projected growth in unpaid bills is not surprising in light of the decrease in income tax rates that took effect midway through FY2015 and the State’s hefty contributions to its dramatically underfunded pension funds. State officials closed the budget gap in FY2015 mainly by using budgetary gimmicks and one-time revenue sources.

It will also make it difficult to address the bill backlog. According to the most recent report of the Governor’s Office of Management and Budget, the state had made respectable progress, lowering it from a high of $9.4 billion in December of 2012 to a low of $3.5 billion in July of 2015.

There were peaks and valleys in between, but the trend was good. “We steadily began to pay it down due to the tax increase,” Kass says. “Bills are shooting up again because of the lack of revenue. The backlog has since climbed to $6.6 billion in December of 2015.

The potential savings from structural reform in the absence of the state’s brief tax hike are also put in stark relief by the lack of a budget, as it is forced into a default state of austerity. While “just” raising taxes again is an unlikely scenario, both fiscally and politically, the current state of affairs lays bare just what the state would have to do without at its old level of taxation as it waits for the benefits of lower taxes to begin.

“We’re on track to spend $2 billion more this year than we take in, with no money for higher education and $1.5 billion less for human services,” Kass says. “We’re on autopilot, and our budget exceeds our revenues.”

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