After going two-and-a-half years without passing a budget and seeing the state’s credit rating downgraded, the Illinois legislature overrode the Governor’s veto to enact a tax hike. While the plan does include a positive, yet limited reform, its higher rates could inflict economic harm and will do little to address the massive unfunded liabilities in the state’s pension program. Illinois should serve as a warning to other states with pension systems in the same poor fiscal condition.
The new Illinois budget will increase the personal income tax from 3.75 to 4.95 percent, and the corporate income tax will grow from 5.25 to 7 percent. This gives Illinoisans the 16th highest average income tax rate in the nation. Neighboring states are already putting out welcome mats for residents and businesses from the Prairie State looking for relief. Although lawmakers projected that these changes will add $5 billion in revenue, part of this new cash flow will have to be used to cut down the $15 billion backlog in the state’s unpaid bills. And if the higher taxes compel folks to flee the state, the revenues may fall short of expectations.
Illinois’ ongoing fiscal crisis has been driven by its generous state pension programs. They now face an unfunded liability of $129.8 billion. Over the last year it has increased by $19 billion and consumes 16.7 percent of the FY 2018 budget proposal. The newly-enacted budget does include pension reform, but only for ne wly hired teachers. It would allow these new employees to choose from the current modelled pension program and a 401(k). The 401(k) would allow teachers to put away 4% to 6.2% of their salary into this fund, and the state would contribute 2% as well. This model would push the responsibility to the school districts instead of the state.
There are several factors that have driven up the costs of the promised benefits. The state allowed its employees to retire in their 50s and receive at least 75% of their pay depending on their position. In 2013, over 63 percent of beneficiaries across the states’ five pension program retired before age 60. Though reforms were enacted that increased the retirement age to 67 for new hires starting in 2011, Illinois taxpayers are still stuck with the bill for the mistakes of the past. While payouts are often higher than received by private-sector retirees, many retirees also get annual cost-of-living adjustments of 3 percent. Lawmakers’ reform options are limited due to language in the Illinois Constitution guaranteeing that pensions “...[s]hall be an enforceable contractual relationship, the benefits of which shall not be diminished or impaired.”
Illinois is not the only state facing fiscal calamity. Pew Charitable Trusts reports that, combined, states face a $1.1 trillion gap. Even that figure could understate the real burden by over $2 trillion. The Hoover Institution notes that it was calculated based on an assumption that assets will achieve a rate of return of 7 to 8 percent per year. However, in 2015, states saw average returns of only 2.87 percent. An estimate of the current unfunded liability (including the lower return) results in a shortfall of $3.85 trillion.
The gap varies across the states, but New Jersey, Kentucky, and Connecticut have the most dangerously low funding ratios, with South Carolina, Pennsylvania, and Rhode Island close behind. While six states have a ratio above 90 percent, their forecast could change suddenly. From 2014 to 2015, Oregon’s funding ratio dropped from 104 to 92 percent.
State and local lawmakers should be wary of their state’s ratio because it does affect their ability to borrow at a low interest rate and secure liquidity. States need a way to solve this growing issue without increasing taxes and promoting policies that lead to economic decline. With the problems at hand, there are steps that should be implemented, sooner rather than later to increase transparency of the real risks and to alleviate the massive funding gaps:
States should calculate their pension balances using more realistic assumptions of returns.
States should move from defined-benefit to defined-contribution plans. Taxpayers would be relieved of long-term costs and beneficiaries would have more control over their plan and portability.
The states should increase the retirement age for future employees and reduce the increase of living costs that incurred on their pension. As the Illinois Policy Institute reports, this can be done while protecting current workers close to retirement.
These are a few recommendations that would protect taxpayers and government workers and prevent pension systems from collapsing. For additional information, NTUF has laid out Five Principles for Public Pension Reform.