Income Tax

This past November, voters failed to ratify an amendment to the Illinois Constitution that would have permitted replacing the state’s flat rate income tax with a graduated structure. That in turn killed the “Fair Tax” legislation, which was designed to raise around $3.6 billion in new, annual revenue (during a normal economy), by imposing higher income tax rates on the wealthiest three percent in Illinois, while reducing the income taxes paid by the bottom 97 percent of the state’s earners. This failure was unfortunate because the Fair Tax would have helped address key structural flaws in the state’s tax policy that both drive its long-term General Fund deficits, and make Illinois one of the most regressive, and hence unfair, taxing states in the nation.

As things stand today, the state’s General Fund deficit is large and growing. Illinois is suffering from a long-term structural deficit in its General Fund that cannot be eliminated without re-amortizing the Pension Ramp as detailed previously, and either raising taxes, or significantly reducing spending on core services like education, public safety, and human services. The better public policy solution is to raise taxes, given that: (i) Illinois is already low spending on services when compared to the rest of the nation; (ii) Illinois has been cutting its real investment in core services for decades; (iii) underfunding core services is harming communities across the state; and (iv) flawed tax policy which resulted in poor revenue generation is the primary driver of the structural deficit in the General Fund to begin with.

There are two primary revenue sources that most states rely on to fund current services, the income tax and the sales tax. Illinois is no exception, with roughly 54 percent of its General Fund revenue in FY 2020—the last complete fiscal year before COVID-19—coming from state level income taxes (individual and corporate, collectively) and another 22 percent coming from sales taxes.

If the goal is to raise revenue to help address the structural deficit, while also making tax burden incidence fairer, the amount of any such income tax increase that low- and moderate-income families would have to pay should be offset with targeted tax relief. Please read more about CTBA’s solution to increasing the income tax in Illinois in tandem with the utilization of refundable income tax credits in the short report “Increasing the Income Tax Rate: One Method for Addressing Illinois’ Long-term Fiscal Problems”.

Part of the federal economic stimulus created under the Coronavirus Aid, Relief, and Economic Security (CARES) Act, involved increasing the tax relief businesses could claim under the existing net operating loss and excess business loss tax breaks. Among other things, the Cares Act made these tax cuts retroactive, meaning businesses can claim losses and reduce their tax liability for years in which the pandemic had no impact on their profitability.

Because the Illinois income tax code is predicated on federal law, whenever Congress increases existing tax relief already received by businesses at the federal level, that tax relief automatically applies under Illinois law, resulting in a concomitant reduction in tax revenue for the state. According to State Representative Mike Zalewski, this change in federal law could result in Illinois losing anywhere from $500 million to $1 billion in tax revenue this year, unless Illinois “decouples” from the federal change, as requested by the Pritzker Administration.  The following Issue Brief provides CTBA’s reasoning for supporting decoupling from Federal CARES Act Tax Breaks.

Do you still have questions about Illinois’ proposed amendment to the Illinois Constitution, often referred to as the “Fair Tax”? Over the past several months, the Center for Tax and Budget Accountability (“CTBA”) has been compiling some of the most frequently asked questions about the Fair Tax and has created this FAQ to help voters understand this ballot initiative.

On November 3^rd, 2020, Illinois voters will have the opportunity to ratify the proposed amendment to the Illinois Constitution that would eliminate the mandate that state income taxes be assessed using only one flat rate.

This is a crucial moment for Illinois since it has historically been, and currently remains, one of the most unfair taxing states in the nation. From a textbook standpoint, an “unfair” tax system is a regressive tax system—that is, one that imposes a greater tax burden on low- and middle-income families than on affluent families, when tax burden is measured as a percentage of income.  It is unfair because such a system fails to allocate tax burden in a manner that correlates with ability to pay, thereby worsening the substantial growth in income inequality that has occurred in the private sector over the last four decades. But building fairness into a state tax system is difficult, given that every tax—or fee for that matter—which is available to fund public services provided at the state or local level is regressive except for one: the income tax.  The income tax is the only tax that can actually be designed to comport with ability to pay and hence create some tax fairness, because it is the only tax that can be designed to assess higher tax rates on higher levels of income, and lower rates on lower levels of income.

Unfortunately, Article IX, Section 3 of the Illinois Constitution mandates that the state income tax be imposed at one flat rate across all levels of income. Hence, Illinois is constitutionally prohibited from utilizing the income tax to play the essential tax policy role of offsetting the natural regressivity of every other tax and fee imposed at either the state or local level. In fact, Illinois’ inability to build some fairness into its tax system through implementation of a graduated rate income tax has played a major role in driving the ongoing deficits in the state’s General Fund, while also hampering private sector economic growth.  The good news is a genuine opportunity for meaningful reform of the Illinois income tax now exists. That is because on June 5, 2019, Governor Pritzker signed Public Act 101-0008 (“P.A. 101-0008”) into law. If implemented, this legislation will create a new, graduated rate income tax structure, frequently referred to as the “Fair Tax” by proponents, to replace the state’s current flat rate income tax.

To learn more about how the Fair Tax not only ties income tax burden to ability to pay, but also raises new revenue in a manner that will effectively help eliminate some of the long-term structural flaws that have consistently made Illinois’ overall tax system one of the most unfair and poorly performing in the nation, please read the new CTBA Report, “Implementing the “Fair Tax” Will Help the Illinois Fiscal System Respond Better to the Modern Economy While Promoting Tax Fairness.”

The state of Illinois faces a significant structural deficit into the future. The report highlights the nature of the structural deficit and identifies two key causes: the state’s historically flawed  tax policy and the plan devised for repayment of Illinois’ pension debt. CTBA proposes both the adoption of the Fair Tax and a reamortization of the pension debt as described in the report titled: Addressing Illinois’ Pension Debt Crisis With Reamortization. Doing so would allow the State to ensure full funding for the Evidence Based Funding Formula while also improving the status of Illinois’ public employee pension system and eliminating the State’s structural deficit by 2042.

The Center for Tax and Budget Accountability (CTBA) released a report, How a Graduated Rate Income Tax Would Help Reduce After-Tax Income Inequality in Illinois, which shows that the implementation of a graduated rate income tax can reduce the regressivity of Illinois’ state and local tax system while lessening after-tax income inequality, which imposes lower tax rates on lower levels of income and higher rates on higher levels of income,

The report notes that even as average income growth for the bottom 99 percent of households in Illinois has remained relatively stagnant for almost four decades, growing by an average of just 0.25 percent per year after inflation, the cost of many basic household necessities has increased. Between 2004 and 2017, median household income grew by 6.4 percent, while the average cost of consumer goods and services grew by 29.7 percent. As a result, most low- to middle-income families have a reduced capacity to save or maintain their standard of living.

Since 1979, the nation has seen a rapid and significant increase in income inequality between low- and middle-income Americans on the one hand, and the wealthiest one percent on the other. Over that time span, the bottom 99 percent of American households saw their incomes increase by an average of just 14 percent after inflation. Meanwhile, the wealthiest one percent saw their inflation-adjusted incomes balloon by 175 percent on average—or fully 12.5 times more than the income growth realized by everyone else.

Illinois not only followed this trend, but when compared to the other 49 states, experienced one of the greatest increases in income inequality over this sequence. In fact, between 1979 and 2015, the top one percent of households in Illinois realized a 177 percent jump in inflation-adjusted income on average – which is almost 20 times greater than the nine percent average income growth experienced by the bottom 99 percent of Illinois households. And that’s before the impact of Illinois’ regressive tax system is taken into account.

Because Illinois’ tax system is “regressive,” meaning lower- and middle-income people pay a larger proportion of their earnings in state and local taxes than do higher-income people, income inequality in the state is even greater on a net, after-tax basis. 

If properly designed, however, income tax policy can help lessen after-tax income inequality. In fact, the income tax is the only tax which can be broadly used to lessen net, after-tax income inequality, because it is the only tax that can be designed to correspond to ability to pay. This is best accomplished through the implementation of a graduated rate structure that imposes lower tax rates on lower levels of income and higher rates on higher levels of income – which is precisely what Governor Pritzker has proposed doing in Illinois. And in a state like Illinois, which has to increase tax revenue to address the multi-billion dollar long-term structural deficit in its General Fund, creating a graduated rate income tax is one of the few ways the state can generate new revenue without worsening income inequality.

This report makes the case for a graduated rate state income tax in Illinois, and illustrates two possible rate structures that would accomplish each of three major objectives:

• Cut taxes for the bottom 98 percent of Illinois taxpayers;
• Limit the top marginal rate to levels that already exist in the Midwest; and
• Reduce the structural deficit by $2 billion in the first year of implementation

There are many ways to reach these objectives; the illustrations in this report are meant to show the feasibility of doing so, rather than prescribe any particular path.

In addition, the report will lay out several arguments for the urgency of passing a Constitutional amendment to allow a graduated rate state income tax in Illinois:

It is textbook capitalist policy that to be fair, a tax system should impose tax burden according to ability to pay--that is, it should impose higher tax burdens on affluent households than it does on low- and middle-income households, when tax burden is measured as a percentage of income. Illinois fails this basic standard of fairness, in large part because of its flat rate state income tax.

Illinois' unfair, flat rate income tax contributes to structural deficits. This is because a flat rate income tax cannot-by design-respond to the significant growth in income inequality that has occurred over the last three decades. This in turn has forced decision makers to underfund or cut the core public services of education, healthcare, human services, and public safety, which collectively account for over 90 percent of all General Fund spending on current services.

Illinois' unfair, flat rate income tax harms the private economy. Overtaxing low- and middle-income families, who are both good spenders and have flat to declining real incomes over time, reduces their consumer spending. The research shows that for every dollar the state cuts in General Fund spending on current services, the private sector loses an average of $1.36 in economic activity. Since most General Fund spending on core services covers the wages of the teachers, social workers, health care professionals, correctional officers, and other workers who provide public services, when Illinois' structural deficit compels the state to reduce spending, it is for the most part cutting the earnings of these workers.

Illinois' flat income tax rate is out of the mainstream. Of the 41 US states that impose an individual income tax, Illinois is one of just eight that impose the same flat rate on the income of all earners, regardless of how much they make or their ability to pay.

The two illustrations of possible rate structures in the report both use a graduated rate structure to impose higher tax burdens on higher levels of income to raise much-needed revenue. They differ in the mechanism used to deliver tax relief to the bottom 98 percent of Illinois taxpayers.

One illustration creates a $300 tax credit that would be applied to the state income tax bill of all filers with $200,000 of taxable income if filing jointly and $100,000 of taxable income if filing singly. The credit would also give tax relief on a decreasing basis to tax filers making up to $300,000 if filing jointly and $200,000 if filing singly.

The other illustration simply cuts the marginal state income tax rate for the first $100,000 of taxable income for all filers from 4.95 percent to 4.50 percent. Between $100,000 and $300,000 of taxable income, the rate would remain the current 4.95 percent.

Both scenarios give 98 percent of Illinois taxpayers-those making less than $300,000 in taxable income-a tax cut, or in the case of single filers making between $200,000 and $300,000 in the credit illustration, no tax increase.

This Report provides a detailed analysis of both Governor Bruce Rauner’s and the General Assembly’s two very different proposals for the FY2016 General Fund budget. Both budget proposals would cut services and increase the state’s deficit due to the phase down of the temporary tax increases in the state’s personal and corporate income tax rates that became effective on January 1, 2015. Collectively, those income tax rate cuts will cause Illinois’ General Fund to lose $4.6 billion in recurring revenue over the course of the full fiscal year.

While Governor Rauner’s budget proposal would cut spending by $5 billion, CTBA analysis found that $3.2 billion of his proposed spending cuts will likely not be realized in FY2016 for legal, constitutional, and related reasons, and therefore, would increase the state’s General Fund deficit to $9.2 billion. Meanwhile, the General Assembly’s proposed FY2016 budget would cut spending by $590 million, but, without the sufficient revenue needed to cover the higher level of spending it authorizes, it would increase the projected accumulated General Fund deficit to nearly $10 billion.