Illinois Might Adopt One Of The Highest Income Taxes In The Nation

April 21, 2016

This post originally appeared as an op-ed on Forbes.
 
Tax day may be behind us, but Illinois residents could be working longer to pay their state taxes in future years under legislation unveiled by House Deputy Majority Leader Lou Lang (D)—a proposal that would see the top rate soar from 3.75 to 9.75%. Were the tax increase adopted, Illinois would fall from 23rd to 48th on the Tax Foundation’s State Business Tax Climate Index, above only New York and California.
 
Since the partial expiration of the state’s temporary tax increase under which the individual income tax briefly stood at 5.0%, many in the legislature have clamored for a tax increase, and particularly for the introduction of a graduated rate tax in the Prairie State. Intended to facilitate the payment of the state’s accumulated unpaid bills, the temporary tax increase partially sunset in 2015, with the rate dropping to 3.75%, still modestly higher than the pre-tax hike flat rate of 3.0%. However, the state still has over $7.5 billion in unpaid bills, and Gov. Bruce Rauner (R) and legislative Democrats continue to fight over adoption of a state budget, with Democrats seeking additional revenues and Rauner insisting on a range of structural reforms as a prerequisite to considering any tax changes.
 
Under pending legislation backed by top Democrats in the state, Illinois could replace its current 3.75% individual income tax with a four-rate system topping out at 9.75%. House Bill 689, sponsored by Representative Lang, would give Illinois the fourth highest top marginal income tax rate in the country, after California, Oregon, and Minnesota. Because the proposed rate schedule does not double bracket width for joint filers, the bill would also introduce a marriage penalty, meaning that married couples could pay more than they would as single filers. The proposed rates and brackets under HB 689 are as follows:
 
HB 689 Rates and Brackets

Single     Joint    
Rate   Bracket Rate   Bracket
3.50% > $0 3.50% > $0
3.75% > $100,000 3.75% > $200,000
8.75% > $500,000 8.75% > $750,000
9.75% > $1,000,000 9.75% > $1,500,000

Because the state constitution currently prohibits the imposition of a graduated-rate income tax, the legislation is contingent on voter ratification of a constitutional amendment (HJRCA 59) lifting the restriction. Previously, House Speaker Michael Madigan (D) proposed a 3% surcharge on income above $1 million. Although it is perhaps unlikely that the two pieces of legislation would be adopted in tandem, doing so would result in a top rate of 12.75%, inching the state closer to California’s top rate of 13.3%.
 
Although most individual Illinoisans would not be exposed to higher rates under HB 689, it is important to bear in mind that many small businesses are subject to the individual income tax. In fact, while most pass-through businesses (S corporations and partnerships) lack sufficient adjusted gross income (AGI) to be exposed to the new higher tax brackets, those businesses that would experience a tax increase under HB 689 account for nearly 72% of all pass-through income.

Of particular note, the companies responsible for over half of all small business income would be subject to a top marginal rate of 9.75%, which is significantly higher than Illinois corporate income tax rate of 7.75% (including two separate taxes on corporate income, one at a 5.25% rate and one at a 2.5% rate). Even businesses with income above $500,000 but not more than $1 million would pay more as pass-throughs than they would under the corporate income tax were this plan adopted. The table below gives a sense of how many Illinois small businesses would be adversely affected by the tax increase, and the percentage of total pass-through AGI they represent.

Pass-Through Businesses with AGI above $500,000 (2013)

Pass-Through Range Number % of Total AGI % of Total
$500,000 - $999,999 19,150 5.05% $4.47 billion 19.71%
$1,000,000 + 12,330 3.25% $11.79 billion $51.94%
Total Above $500,000 31,480 8.31% $16.26 billion 71.64%

Source: IRS Statistics of Income
 
This substantial impact on small businesses drives the state’s precipitous drop, should the proposal be adopted, in our State Business Tax Climate Index. The Index has five components, and at present, Illinois’ best performance is on the individual income tax component, where it ranks 10th in the nation. (The state ranks 23rd overall.) Under the proposal, the state would fall to 48th both on the individual income tax component and on the Index overall.

The proposal represents a stark departure from the current system. Not only does it entail a shift from a low, flat-rate income tax to a high, graduated-rate tax, but it also introduces a marriage penalty and fails to adopt inflation indexing of brackets, meaning that a greater percentage of state income will be exposed to higher rates over time due to inflation. All of these factors are taken into consideration in our Index, and merit careful reflection by state lawmakers, as they would result in a poorly-structured tax with one of the highest top rates in the nation.
 
Some proponents of the legislation insist that the proposal is consistent with shoring up the state’s business climate. While our Index only measures one aspect of the business climate (tax structure), the evidence is clear that uncompetitive tax systems have a deleterious effect on economic growth. Billed as a tax increase on only the richest Illinoisans, HB 689 would dramatically increase tax burdens on the state’s job creators and entrepreneurs.

 

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