As Illinois Enters Its Economic Death Spiral, Can The Federal Government Be Far Behind?

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Interesting but sad reading from a recent Associated Press report. The article reported that the state of Illinois has now reached the desperation phase of its economic malaise:

– The state has not paid many of its bills for months due to shortfall of state government revenue and that situation is not about to change any time soon, according to the article.

– This the state legislature approved an increase of 66% in its personal state income tax rate. According to the article, the 66% increase is likely the biggest state increase in taxes in the country to cope with a budget shortfall. Provisions to raise other taxes to pay back long overdue vendor bills was not approved.

– The increase in personal income tax will only raise $6.8 billion vs. a budget gap of $15 billion.

– It also approved an increase in the state corporate income tax, up almost a whopping 50%.

– The legislation included a 2% cap on annual increases in state government spending except for next year when state spending will be allowed to increase beyond the 2% cap without penalty. If state spending exceeds the 2% cap after next year, it will invalidate the income tax increase.

– However, the article says that the 2% annual increases will probably all be absorbed by increased health care and retiree pension costs, resulting in further declines in money available for other state services such as schools.

Wow. Higher taxes and lower government service levels. Unpaid bills to private companies who did business in good faith with the government. Democrats blaming Republicans and Republicans blaming Democrats (note: the Republicans might have a little stronger case here since the Democrats have controlled the governor’s mansion and the state legislature for the past eight years, through both good and bad economic times.) What a mess.

Such a mess and it does not appear that the Illinois politicians really addressed the root causes of their problems, higher than expected government employee retiree pension and health care costs. Until the basic causes are addressed, all of the above actions just shift the pain elsewhere but the pain is still there and still likely to grow. But to fix the root causes, the Democrats, who still control all facets of the state government, would have to face down the unions that benefit from their lucrative retirement benefits, and unions are typically strong voter blocks for the Democrats.

Here is what I predict will happen in the next few years:

– Although these tax increase are supposed to be temporary, I would wager a consider sum of money that they eventually become permanent, especially if they do not address the underlying drivers of increased state costs.

This is an easy prediction from a logic perspective: if you needed to raise these tax rates to close the budget gap and you are still going to raise spending 2% a year, you will likely never get to a point where you can reduce taxes by the 66% if your year over year government spending is higher. This is consistent with the tenet that if you give a politician money to spend, he or she will spend it, they will never give it back to the wealth creators/taxpayers they took it from.

– The Governor expects to raise $6.8 additional billion from the personal income tax increase. However, if a state resident was making $50,000 a year and paying 3% or $1,500 a year in income taxes, starting today that same person making the same salary will pay an additional $1,000 a year in state income taxes or about $20 more a week. This is $20 that is not available to go to the movies, buy a toy for a child, go out for dinner, etc. so the $6.8 billion is likely to fall short if you consider the decline in sales tax revenue from depressed spending in the private consumer sector.

– The article and the state Democrats point out that up until now, Illinois had the lowest income tax among its neighboring states including Indiana, Iowa, Missouri, and Wisconsin. However, with a 66% increase in the state income tax rate, it is no longer able to make that claim, especially relative to Indiana which has an income tax rate of only 3.4%. Eventually, residents and companies will start looking at states like Indiana in order to ease the financial burden of higher personal income taxes.

– In fact, personal income taxes will not be the only driver of people and businesses out of Illinois. The Tax Foundation, which does a wonderful job on tax statistics and policy analysis, also has data which points out how vulnerable Illinois has made itself relative to neighboring states across all types of tax measures The Foundation has updated its tax index tables for each of the fifty states. If you look at its latest analyses, you will find the following ranks and indexes relative to the Illinois area:

* After the Illinois income tax increase takes effect, Indiana will be more attractive to families and businesses in the areas of personal income tax and will retain its advantage in corporate tax levels, property tax levels, and sales tax levels.

* Missouri will continue to be better than Illinois in corporate tax levels, property tax levels, sales tax levels and will now probably be comparable in personal income tax levels.

* With the rise in corporate taxes, Wisconsin will be better than Illinois in corporate tax levels, property tax levels, and sales tax levels.

* Even Iowa will be better than Illinois in property tax levels and sales tax levels.

* Even before the tax increases, Indiana and Missouri had much stronger overall tax favorable rankings, 4th and 16th out of 50 states, vs. Illinois which had an rank of 29th before the tax moves.

Thus, my prediction: within a few years, the death spiral will speed up for the state government in Illinois since not only will sales tax revenue declines offset the increased revenue from personal and corporate tax increases but the more tax attractive states around Illinois, namely Indiana, Missouri and Wisconsin, will siphon off both households and businesses to their states. And this siphoning does not take into account the six states that have no personal income tax at all, they may also poach some Illinois tax payers.

Once you head down the slippery economic slope of needing more and more personal and corporate taxes to feed an ever growing and inefficient government, the sources from which you take those taxes gets smaller and smaller which results in the need for even higher tax rates to offset the smaller tax bases, etc. All because the state government and the political class that runs it did not have the smarts or the courage to act bravely when times were good and cut back unreasonable government costs because of political reasons, namely union votes.

The same fate awaits the Federal government if drastic and courageous steps are not taken to get our Federal spending under control. The more any government taxes, the weaker the economy becomes because of weaker consumer and economic spending and investment which results in stunted economic growth which means higher tax rates on a smaller base which stunts growth even more, etc. Same economic principle, different level of government.

Several immediate and courageous steps are needed to avoid this fate:

– Step 1 – reduce the Federal budget by 10% a year for five years in order to get spending under control, eliminate wasteful spending on earmarks and other worthless political programs, get the politicians focused on a smaller but much more important set of issues, and return the wealth that the Federal government confiscates as taxes to the citizens that earned that wealth.

– Step 2 – significantly increase fraud and tax evasion enforcement efforts to close all government spending leaks and criminal activity, freeing up money for better use and return at least some of it to the taxpayers who in turn can spend that previously wasted money to grow the economy. The Obama administration admitted in 2010 that almost $100 billion is lost through fraud via the Medicare program every year.

– Step 3 – implement term limits for all politicians at all levels so that they would be able to do the right thing for the country and state, however painful, without worrying about the implications for the next election.

Until these steps are implemented, I would strongly suggest investment in Indiana and Missouri state bonds and stay away from any investment in the state of Illinois. You heard it first here, the death spiral has begun.
 

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