State Of Illinois Budget Gap – Staggering, Yet Fixable by Ty Schoback, Columbia Threadneedle Investments

  • Illinois’ structural budget deficit is fixable, but will likely require tax increases in addition to spending cuts.
  • The Illinois Supreme Court’s rejection of 2013 pension reform will make resolving the State’s pension burden more challenging, but not impossible. The State continues to make its full annual required contribution (ARC) and remains on track to be 90% funded by 2045.
  • If the state is unable to pass a balanced fiscal year (FY) 2016 budget by May 31, a public rating downgrade to BBB+ is probable. A downgrade would likely have a contagion effect on other State-of-Illinois-related credits, as seen recently with Chicago-area credits when Moody’s lowered the city’s rating below investment grade.

Illinois’s structural budget problem goes beyond its underfunded pensions. The state has more of a revenue problem than a spending problem, as seen in the chart below. The temporary 2011 personal and corporate income tax increases allowed revenues to catch up with and track spending. Revenues plummeted once temporary increases expired in 2015. The expiration of the temporary 2011 tax increases is responsible for 10% of the 14.2% fiscal year 2016 budget gap.

Exhibit 1: Illinois revenue and spending trends

Illinois Budget Gap

Source: State of Illinois Comprehensive Annual Financial Reports (CAFR)

The budget and pension woes of the State of Illinois are a culmination of a decade of poor fiscal decisions. While there is no silver bullet or quick fix, the state possess the economic resources and budget tools necessary to stabilize its fiscal position over the short term and even improve them over the medium-to-longer term. However, whether or not the state is successful will depend largely on the political willingness of their respective leaders to make and implement difficult decisions.

Budget

The consequences of poor fiscal decisions made over the past decade are a rising burden of fixed spending obligations. With the expiration of the 2011 income tax increases, rising fixed costs — such as pensions, other post-employment benefits (OPEB) and debt service — now consume nearly one third of the state general fund budget.

Exhibit 2: Pension, OPEB and debt services as a percent of Illinois budget

Illinois Budget Gap

Source: State of Illinois Comprehensive Annual Financial Reports (CAFR)

Without any increase in tax revenues, this means the state would need to cut 14.2% of its total budget from only 70% of state spending. Put another way, with nearly 30% of state spending untouchable, the state’s budget deficit is more accurately reflected as a 20% budget deficit, as $9 billion of the state’s $32 billion fiscal year 2016 spending is unable to be reduced. A 20% budget deficit is a staggering number and would devastate education, infrastructure, public safety and social services funding if closed entirely with cost reductions. Cost reductions will play a role in resolving the fiscal year 2016 budget deficit, but it is likely that tax increases will be necessary to structurally close the deficit and put the State of Illinois back on a path toward long-term fiscal recovery. A modest increase in Illinois’ relatively low (compared to national averages) 3.75% personal income tax rate is unlikely to result in a detrimental population exodus.

Pensions

Illinois’s underfunded pensions make achieving a structurally balanced budget more difficult, as the burden increasingly crowds out other state spending priorities, such as education, infrastructure and social services. While the State of Illinois Supreme Court’s rejection of Illinois 2013 pension reform is a setback in the effort to lower the pension burden on the state’s budget, the state is not in dire need of pension reform. Because the state is currently required by law to be 90% funded by 2045, it is making its full ARC and the funded status has begun to stabilize and is poised to begin increasing in the coming years.

Exhibit 3: State of Illinois pension funded ratio

Illinois Budget Gap

Source: State of Illinois Comprehensive Annual Financial Reports (CAFR)

Pension reform that can pass constitutional muster and lower the annual cost burden of pension payments would be welcome assistance for the state’s budget and make for easier budget decisions for the governor and legislature, but it is not an absolute necessity for Illinois to stabilize its budget. We are more focused on the state better aligning the revenue side of its ledger with the spending side in a structural and sustainable fashion in its fiscal year 2016 budget than securing pension reform.

In closing

The State of Illinois has no shortage of challenges, including a 14% projected budget deficit for fiscal year 2016, a growing backlog of bills payable and an underfunded pension system. Despite these woes, the state has the budgetary tools, capacity and economy to resolve these challenges. However, it looks increasingly likely the state may be unable to make sufficient budgetary progress in time to avoid public downgrade to BBB+ by the rating agencies. That said, and looking beyond a short-term horizon, the state has the potential to cure its fiscal malaise and improve its credit standing should its leaders muster the political will to make the necessary budget decisions.

Important disclosure

The views expressed in this material are the views of Ty Schoback through the period ended May 28, 2015, and are subject to change without notice at any time based upon market and other factors. All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such. This information may contain certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those discussed. There is no guarantee that investment objectives will be achieved or that any particular investment will be profitable. Past performance does not guarantee future results.

This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon and risk tolerance.