Retirement tax could be next if ‘fair tax’ passes, Moody’s says

Retirement tax could be next if ‘fair tax’ passes, Moody’s says

The credit rating agency also said Illinois will soon pass the point of no return on public pension debt. It warned against schemes to stretch or delay pension payments.

Illinois Gov. J.B. Pritzker has tried to sell his signature policy proposal, the progressive income tax amendment, as a fix to the state’s chronic budget deficits and ever-rising debt burdens.

But recent reports from credit rating agency Moody’s Investors Service show why the so-called “fair tax” would fail to fix the state’s financial problems while exposing retirees and the middle class to higher taxes.

“The ‘Fair Tax’ proposal is unlikely to be the last of the state’s revenue-raising initiatives, given the scale of its need for additional fiscal capacity,” Moody’s wrote in a report released Oct. 1. “Additional revenue options Illinois could pursue include taxing retirement benefits and applying the state’s sales tax to a greater number of service transactions.”

All 32 states that have adopted a progressive tax structure tax retirement income in some form. And Illinois state Treasurer Michael Frerichs said in June, “One thing a progressive tax would do is make clear you can have graduated rates when you are taxing retirement income.”

Without structural reforms to balance the budget and reduce debt burdens, Illinois politicians will likely continue to ask taxpayers to pay more to receive less in services.

This has been the trend of the past two decades, as Illinois’ pension crisis drove a 32% drop in funding for essential services despite rising tax burdens. If voters on Nov. 3 approve the “fair tax” amendment and scrap the current flat tax protection, they’ll be granting state politicians permanent new taxing powers that make it easier to raise everyone’s taxes without fixing the cause of the state’s unending demand for more revenue.

Accounting for slower economic growth after the COVID-19 recession, the initial “fair tax” rates that would take effect if voters approved the progressive tax amendment would raise $3 billion. Illinois has a $6 billion deficit for the current budget year, a backlog of unpaid bills worth nearly $8.1 billion as of Oct. 22, and will have to make larger than expected payments next year for both operating funds borrowing and pension contributions. According to the Illinois comptroller, debt service payments on principal alone for borrowing used to paper-over holes in the current year’s budget will cost $1.23 billion next budget year, plus any interest.

Moody’s estimated in a report issued Sept. 8 that Illinois pension debt at the start of fiscal year 2019 was nearly $230 billion. Illinois had the highest pension debt-to-GDP ratio in the nation for the fourth consecutive year, with pension debt equal to 25.6% of the state’s total economic output.

Illinois' pension crisis is nation's worst

As detailed in an original report from the nonpartisan Illinois Policy Institute, economic fallout related to COVID-19 will further increase pension debt and the annual costs of the state retirement systems. The combination of lower expected government revenues and lower investment returns on pension assets will drive the state’s chronically mismanaged pension system closer to total collapse. Moody’s estimates Illinois’ pension debt for fiscal year 2020 will jump to an all-time high of $261 billion.

Illinois already spends the most in the nation on pensions as a percentage of the state’s revenues, but it also has the largest gap between what it pays and what it would take to adequately fund the systems. Moody’s calculates that Illinois would need to pay an additional 5.6% of its revenues towards the pension system, on top of the current 16.1%, just to “tread water” or prevent the debt from increasing each year.

Many states contributed more than the tread-water level in 2019, according to Moody’s. Among the top five states with the most pension debt, only Illinois and New Jersey failed to make actuarially sufficient contributions.

Illinois’ pension system requires deep structural reforms to prevent the debt from continuing to grow, driving more tax increases and service cuts. Raising more money from taxpayers to throw into the broken existing system cannot solve the problem. Only Connecticut – the last state to adopt a progressive income tax – spends more of its budget on “fixed costs.” Fixed costs represent spending on debt service and employee retirement benefits, including both pensions and retiree health care.

Connecticut’s progressive tax failed to solve that state’s budget problems but did lead to a 13% jump in tax rates for middle-class taxpayers, 35% property tax hike, 362,000 jobs lost from the labor market, increase in poverty and contributed to many seniors fleeing new taxes on their retirement.

Illinois currently spends 27.3% of all the money it collects from taxpayers on debt service and government worker retirement benefits. Moody’s projects that percentage could rise to between 36% and 39% by fiscal year 2024, depending on how quickly state revenue collections recover from the COVID-19 recession. Moody’s notes 30% fixed cost spending has been considered Illinois’ “highest sustainable level,” so it is about to fly past its breaking point.

Moody’s also warned against any plan to reduce pension contributions in the near term by stretching out or delaying pension payments through schemes known as “reamortization.” Pritzker has endorsed these types of pension gimmicks in the past, including delaying payments and swapping bond debt for pension debt, but backed off these plans after pushback from ratings agencies. Such gimmicks increase the cost of the systems in the long run while allowing politicians to dodge fixing the structural problems, leaving their successors to figure out whether there are any solutions left.

Political games and delaying action on true reform helped create Illinois’ pension crisis in the first place. Yet with the state’s budget in as bad of shape as it’s ever been, lawmakers unwilling to address structural spending reform will likely be tempted to look at a combination of these unsound gimmicks and further tax increases.

If voters approve Pritzker’s “fair tax” amendment, they’ll be granting politicians new powers to target the middle class and retirees with tax hikes. The fact that the initial rates hitting incomes over $250,000 fall far short of raising the revenue needed to close the fiscal gap, as Moody’s reports, makes it virtually certain that they will raise taxes on those making much less.

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