Monday, January 17, 2011

Is Illinois the State Most Likely to Default?

At the end of December, credit default swaps for the State of Illinois had reached a five month high and were more expensive than those of California, indicating Illinois was the State most likely to default.   Actually, this was nothing new as Illinois has had the most expensive credit default swaps since early July 2010.  Bill Gross of PIMCO said he would not buy Illinois bonds.

The budget problems in Illinois are not new and have grown from root causes starting in the second term of Governor Edgar.  I have talked and written about this for over a year and been adamant fiscal year budget deficits would be close to $15 billion; I have reviewed budget proposals from different sources and made several suggestions towards a rational budget solution; and I have particularly stressed the  immense problem of pension underfunding, of which no budget solution can omit, here, here, here, and here.

During the election both candidates made statements about the budget problem, which I did not take as reliable.  One would cut government by 10% across the board and the other wanted to increase the 3% income tax to 4% with the extra 1% going to education.  Neither of these would come close to solving the budget problems.  The tax increase was not high enough and the spending cut was not practical much less sufficiently deep.  Both were good attempts to frame the question and promote public discussion but I do not know that I would have used them in a campaign where they could be mistaken as promises.  When, during the campaign, Governor Quinn's Budget Director said there would be an increase to a 5% income tax after the election, it did not surprise me.  Yet, the New Year dawned and the State had done very little with days left in the Legislative Session.  In 2010, it had passed a two tier pension system for State employees and then certain municipal employees.  While I have never been fond of a two tier pension system, I supported its creation as economically necessary.  Still, there was over $8 billion in unpaid vendor bills and disbursements, no payment to the pension funds of $3.7 billion for FY 2011 (which are among the most under funded in the nation), a looming Fiscal Year 2011 budget deficit of $15 billion, an end of a national economic stimulus to the States which was too little, an end to the Build America Bond program which put even more pressure on municipal bonds and state and municipal funding, and the prospect in Fiscal Year 2012 the State will have to start paying back interest on loans from the Federal government for unemployment insurance.  Less money would be available going forward, future interest payment were increasing for the coming fiscal year, and debt costs for Illinois on any new bond placements were going up on Illinois' deteriorating credit condition.

Consequently, even the preliminary movement towards a partial budget solution moved the credit default swap prices down a little and, while Illinois's historical use of borrowing can be troublesome if it does not come with sustainable economic growth, the more rational recognition that default is not very likely (the Bond Girl links within this link are particularly good).  The public discussion has never been well served by a shallow public understanding of the role of government spending in growing income and employment in the private sector. This had been preceded by the Governor talking about the need for bonds to pay the FY pension funding, which he never got.  No pension funding.  Then, the Legislature put forward an increase to 5.25%, with .25% to go towards an annual property tax rebate of $325 per home owner, which would have been a much larger rebate than more than 80% of homeowner's currently receive.  I t would have also increase cigarette taxes $1 per pack and raise $377 million annually going to education, although economic studies have shown that such a tax decreases overall sales taxes collected adjusted for inflation and population growth.  The corporate tax would go up to 8.4% (it may have been only 8% as there was confusion in this number in printed reports).  That proposal had replaced an old proposal for 5% individual income tax and expansion of service taxes (which I have always opposed as regressive --- I prefer looking at luxury taxes, but nobody has done a study --- although Illinois does not tax as many services as some other states).  It was immediately criticized as a huge 75% tax increase and little discussion of how to otherwise solve the budget problem.  In the end, the Legislature did not provide any borrowing for unpaid bills or pension funding, but it did approve an individual income tax rte of 5% and a corporate tax rate of 7% for the next four years only and a 2% spending increase annual cap with reversion to old tax rates if violated.  This immediately drew criticism from individuals and business owners as well as comments from the Governors of neighboring states inviting businesses to migrate despite their tax rates being similar or more.  In fact, tax rates are hard to compare with other states, because they involve income tax, sales tax, services tax, property tax, and other taxes.  Some income taxes are flat and some progressive.  Some have different taxes on the municipal level or income tax on the county as well as state level.  Governor Quinn's message in signing the bill listed savings implemented by his administration which are not significant in demonstrating competent efficiency effort and some of which may not be independently verifiable.

The deficit hawk, which was predictable, and deficit dove, however well intentioned but too general, reaction was not helpful in promoting what is needed in Illinois and what will work and what will not work in Illinois.

The bottom line is very stark and difficult.  Using information (read it all) from the Institute of Government and Public Affairs, if the deficit were to be attacked through individual and corporate income tax rate increases, the individual tax rate would have to be 7.1% and 11.3% for corporations with each !% increase from 3% and 4.8% generating $2.5 to 3 billion annually.  Borrowing by itself will increase expenses and the problem.  To attack the problem with spending cuts, all government spending by the Legislature, Judicial, and all Constitutional officers would have to be cut by 26% or more.  Such spending cuts would be disastrous with respect to employment (thousands of state jobs would be lost) and to essential government services (this includes economic safety net service unless you believe children and adults deserve to suffer and die) serving the general welfare of all citizens of the State.  The people would not accept such cuts nor should they.

This means, besides the tax increases, Illinois needs to rationally cuts spending to create efficiency (not just cuts to make cuts) and needs to borrow prudently at reasonable interest rates and yields.  The exempt and double exempt personnel positions (some of these people go back to at least the Ryan administration) need to be professionally evaluated for economic efficiency and competency.  Yet, Governor Quinn has removed only two high profile people and given preferential treatment to others, who would have been fired in the private sector, because they apparently know people.  Governor Quinn's people have demonstrated they prefer politics to properly managing state government.  Spending increase by 3.4% annually, but the spending cap in the new law is 2%.  This means at least 1.4% will have to be cut annually on top of efficiency cuts as soon as possible.  This requires professional management.

 Political management is not competent professional management.  Paying vendors will provide growth and employment, but under this budget law it will require borrowing. No one is going to be happy with what has to be done and promote an economy which provides growth.  No one is going to be happy with the factual fiscal situation and options unless government takes the necessary actions to provide the services for which government exists and the people demand for all citizens without respect to income level.

The economic issues have been confused by partisan public positioning which has not been focused on getting things done for the people.  The state is not economically bankrupt, but it has a serious solvency problem.  It can be solved.  In fact, the U.S. Bankruptcy Code allows municipalities and counties to declare bankruptcy but not states.  Political ideology has used differing economic theories to avoid dealing with the factual situation in the public arena.  Cutting by itself will alienate the people who expect government to provide services to all segments of society.  Political management will alienate people who expect government to provide services to all citizens and not just benefit an elite.  We need to work together.


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