No Good Options as Chicago Seeks Revenue

September 17, 2019

Although the word is often applied to any difficult decision, a dilemma, properly speaking, arises when one is forced to choose exclusively from bad options. The two bad options are termed the “horns” of the dilemma. As Chicago contemplates how to close a revenue shortfall and potentially generate additional revenue for new spending priorities, however, two horns aren’t enough. Chicago’s dilemma summons the sort of multihorned creatures found in apocalyptic literature—which could almost be its own metaphor for the situation in which Chicago officials find themselves.

Facing an $838 million budget shortfall, a looming pension crisis, and an aggressive spending wish list, some Chicago policymakers and activists are expressing interest in a laundry list of new and higher taxes that could, collectively, raise as much as an additional $4.5 billion a year. Proposals include:

  • A 3.5 percent city income tax on income above $100,000
  • A financial transaction tax (the “LaSalle Street Tax,” after the street running through Chicago’s financial district)
  • The return (at a higher rate) of the reviled business head tax
  • A graduated-rate real estate transaction tax
  • Sales tax base broadening
  • Commercial lease taxes, a vacancy tax (on vacant commercial properties), and an increase in the hotel tax

Separately, a former state revenue director proposed the adoption of a modified gross receipts tax. The list shows that Chicago has no shortage of options, per se—but an extremely limited set of good ones.

New mayor Lori Lightfoot (D) has expressed opposition to several of these proposals, including the LaSalle Street Tax, which has drawn support from some city council members. Meanwhile, hoping to avoid a general property tax increase, the mayor has turned to state lawmakers in seeking expanded tax authority, most notably the authority to apply the sales tax to professional services not included in the state’s sales tax base.

Local property and, to a lesser extent, sales taxes are the workhorses of local tax collections nationwide, responsible for about 85 percent of all local tax revenue. This is borne of both practical necessity (these are the taxes most readily available to local governments) and sound policy (these taxes are relatively economically efficient). As a general rule, local jurisdictions looking for additional revenue would be advised to remain focused on these sources of revenue rather than casting about for more creative—but also often far less competitive—ones.

Chicago, however, has little leeway with either tax. Chicago’s property taxes are already among the highest in the country, and at 10.25 percent, the combined sales tax rate is tied (with two California cities) for the highest rate of any major city. Neither tax can be ratcheted up much higher. Unfortunately, the proposed alternatives are even worse.

Take the financial transaction tax, for instance. Occasionally proposed at the federal level, there’s broad recognition that such taxes distort asset prices, reduce liquidity, and can increase market volatility. Internationally, a financial transaction tax has long been mooted for the European Union, but the proposal has yet to overcome the opposition of countries justly concerned about the adverse economic ramifications. But at the local level, there’s an even more basic concern: if there’s a tax on transactions run through Chicago exchanges, those transactions simply won’t be run through Chicago exchanges. A federal tax could capture all transactions conducted within the U.S. or by U.S. persons. A Chicago tax would only cover Chicago’s trading floors, putting them at a competitive disadvantage against those located anywhere else.

A business head tax, meanwhile, is a rehash of an old bad idea, one that the city council voted in 2011 to phase out—which it succeeded in doing by 2014. Then-mayor Rahm Emanuel (D) rightly termed the tax a “job killer,” and this was when it was assessed at $48 per job per year—one-fourth of what advocates now propose. Very few cities impose head taxes, which are literally taxes on job creation; when Seattle did so last year, the city council quickly reversed itself, wiping out the tax before it went into effect.

Gross receipts taxes were once common, but most states repealed them nearly a century ago, recognizing them as nonneutral and antithetical to growth. A gross receipts tax is imposed at a low rate on the entire gross revenue of a company, not its net income. This leads to tax pyramiding, where a good or service is taxed multiple times across the production chain, and disproportionately harms low-margin firms or those struggling to turn a profit. The former revenue director raising this idea proposes structuring the tax as a so-called “margin tax,” in line with Texas and Oregon, and thus providing some limited deduction against actual costs. But in both states, the tax falls on an excessively broad definition of income.

Mayor Lightfoot’s proposed sales tax base broadening is a more attractive option, at least at first glance. Illinois, like its peers, has a narrow and eroding sales tax base that exempts a significant share of personal consumption, particularly of services. Sales tax base broadening is good policy, and a relatively efficient way to raise revenue. Moreover, since services tend to be consumed in greater proportion by higher-income individuals, sales tax base broadening makes the tax code more progressive.

However, the mayor’s proposal faces two significant obstacles. First, she proposes decoupling Chicago’s sales tax base from the state’s, with Chicago taxing services that are untaxed at the state level. Lacking a unified base is not just poor policy or the source of significant compliance costs for businesses, though it is both of those things. It could also jeopardize the city’s legal authority to collect taxes on remote sales, as the disharmonized base and multiple points of collections could impose unconstitutional undue burdens on out-of-state sellers. Second, in her public statements, the mayor has not distinguished between personal consumption of professional services (which should, ideally, be taxed) and business-to-business transactions, which should be exempt to avoid pyramiding. The sale of a good or service should be subject to the sales tax precisely once, when sold to the final consumer; anything else leads to double taxation.

And then there’s the high earners’ income tax proposal, at a possible rate of 3.5 percent. Currently, Illinois’ state income tax is competitive at a flat rate of 4.95 percent, though somewhat higher—6.45 percent—for pass-through business income. Voters will soon weigh in on granting constitutional authority for a graduated-rate income tax, however. If a constitutional amendment were ratified, the choice of rates would fall to the legislature, but Governor J.B. Pritzker (D) has proposed a top rate of 7.95 (and 9.45 percent on pass-through income). Tack on 3.5 percentage points and small business owners could face marginal rates of 12.95 percent—an incredibly steep burden.

With policymakers already concerned about the city’s business competitiveness, moreover, substantially higher commercial lease taxes could drive more companies outside city limits, and progressive real estate transfer taxes will decrease the attractiveness (and taxable value) of land in the city.

All taxes involve trade-offs. In Chicago, however, policymakers face a particularly unattractive set of options because decades of profligacy already have the city very nearly maxing out the traditional sources of local tax collections. Mayor Lightfoot inherits a precarious situation, particularly since prior generations of local officials saved money upfront by offering city employees generous pension plans that wouldn’t have to be paid for until much later.

Pensions can only be underfunded for so long. The business of running the city must continue. Consequently, difficult choices about taxes, spending, and even bankruptcy loom. But particularly as some are looking not just to cover costs but to dramatically increase the city’s budget outlays, it pays to be aware of just how unattractive the city’s remaining revenue options are.

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