Moving to a Progressive Income Tax Would Increase Taxes on the Majority of Illinois Employers

Download FISCAL FACT No. 423: Moving to a Progressive Income Tax Would Increase Taxes on the Majority of Illinois Employers

Key Findings

• Legislation currently being considered in Illinois would amend the state constitution to allow for a graduated-rate individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. . Plans being discussed would move Illinois from a single rate taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. to a graduated rate structure with top rates ranging from 8 percent to 11 percent.
• Sixty-one percent of employers in Illinois are pass-through entities, meaning they pay business taxes through the individual income tax. Implementing the graduated rate structure would increase taxes on many of these businesses.
• On average, 38 percent of employment at businesses with at least one employee are pass-through entities in Illinois.
• Share of pass-through employers varies based on industry, with the highest concentration occurring in the construction sector. Other highly-impacted industries are professional, scientific, and technical services; agriculture, forestry, fishing, and hunting; administrative and support and waste management services; and real estate and rental and leasing services.
• Pass-throughs tend to be smaller in size, with the majority of pass-through employers employing less than ten people. Small businesses’ performance in Illinois has lagged when compared to the rest of the country, and hiring prospects have worsened since last year.
• The Illinois economy is underperforming in comparison to other states in the region and the country as a whole. Experts express caution over using taxes as a solution to the state’s large and rising pension debt.

Introduction

Legislation currently being considered in Illinois would amend the state’s constitution to allow for a progressive individual income tax. Main rate structures being discussed would institute top rates ranging from 8 to 11 percent.

A large share of Illinois employers would be impacted by this tax legislation, since 61 percent of employers in the state are pass-through entities. This includes a large number of small businesses and firms in several of the state’s key industries. This report details how various industries and Illinois’ business tax landscape will be affected by proposed legislation.

Proposed Plans

The Illinois General Assembly is currently considering legislation that would amend the state constitution to allow for a graduated rate individual income tax,[1] which the constitution explicitly prohibits.[2]

Illinois’ current individual income tax is a single rate of 5 percent on all incomes. The rate is scheduled to decrease to 3.75 percent in 2015 if a set of temporary tax increases passed in 2011 expire as planned.[3]

The first plan under consideration is one proposed by Representative Naomi Jakobsson which would institute a top rate of 9 percent.[4] Another put forth by the Center for Tax and Budget Accountability (CTBA) would increase the top rate to as high as 11 percent.[5] The final proposal, released by House Speaker Michael Madigan, would impose a 3 percent income tax surcharge on taxpayers with incomes over $1 million. Table 1 below compares the three plans with current Illinois law.

Table 1: Illinois Individual Income Tax System under Current Law and Proposed Plans
Current Law[6]	Representative Jakobsson’s Plan Effective Date: 2015 Tax Year	CTBA Plan Effective Date: 2015 Tax Year	House Speaker Madigan’s Plan Effective Date: 2014 Tax Year
5% of federal adjusted gross income with modification (set to decrease to 3.75% in 2015 upon expiration of temporary tax increase legislation)	3% on incomes up to $18,000	0% on incomes up to $5,000	5% of federal adjusted gross income (with modification) under $1 million in 2014 (3.75% in 2015)[7]
4% on incomes $18,000 up to $36,000	5% on incomes $5,000 up to $100,000
5% on incomes $36,000 up to $58,000	7.5% on incomes $100,000 up to $150,000
6% on incomes $58,000 up to $95,000	8.5% on incomes $150,000 up to $200,000
7% on incomes $95,000 up to $196,000	9.5% on incomes $200,000 up to $300,000	8% on income above $1 million in 2014 (6.75% in 2015)
8% on incomes $196,000 up to $500,000	10% on incomes $300,000 up to $500,000
9% on incomes above $500,000	10.5% on incomes $500,000 to $1 million
11% on incomes above $1 million

Source: Commerce Clearing House; Illinois Policy Institute; Center for Tax and Budget Accountability; 98th General Assembly of the State of Illinois.

Increasing Individual Income Tax Rates Affects Employers

A pass-through entity (also referred to as a “flow-through”) is a business that does not pay business taxes via the corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. . Earnings are “passed through” to the individual owner or owners of the company, and taxes are paid through the individual income tax. Examples of pass-through entities are sole or individual proprietorships, partnerships, and S corporationAn S corporation is a business entity which elects to pass business income and losses through to its shareholders. The shareholders are then responsible for paying individual income taxes on this income. Unlike subchapter C corporations, an S corporation (S corp) is not subject to the corporate income tax (CIT). s.

These types of employers make up a significant proportion of the Illinois economy. According to data from the U.S. Census Bureau, approximately 61 percent of Illinois employers were either sole proprietorships, partnerships, or S corporations in 2011.[8] Figure 1 below provides a breakdown of the legal form of organization for employers in Illinois.[9]

All three income tax plans would increase rates on many of these pass-throughs, as many fall in the higher income brackets of a graduated income tax. These rate increases would translate into higher tax liabilities for businesses and make it more difficult for them to expand, hire more workers, or retain existing workers.

Employers Paying Individual Income Taxes are Often Small Businesses

These businesses subject to the individual income tax tend to be smaller, on average. For example, 93 percent of individual proprietorships with employees in Illinois have less than ten employees, while 63 percent of partnerships with employees have less than ten employees. The majority of S corporations with employees also have ten or fewer workers (80 percent of total).

It is important to note, however, that small businesses and pass-through entities are not one and the same. Some small businesses are classified as C corporations, and some pass-through entities (albeit a small number) employee large amounts of people. For example, 63.2 percent of employer C corporations in Illinois (what most people think of when discussing traditional “corporations”) have less than five employees.

Two measures of small business health, employment at firms with less than twenty employees and nonfarm proprietors’ income, have indicated that small businesses have “been a much weaker force for the Illinois economy.”[10] More specifically,

[w]hile a dearth of fast-growing startups has weighed on job creation nationally, in Illinois the weight is especially pronounced as entrepreneurs worry that they will end up inheriting the state’s financial problems and have to help pay for them. Small firms seeking a stable environment are looking elsewhere to set up show or expand.[11]

In a 2013 survey of Illinois small businesses with annual revenues of $10 million or less, 67 percent of owners within the state indicated that the conditions for small businesses in Illinois were worse than the rest of the nation.[12] The top reasons behind their choice were “higher taxes” and “poor government planning.”[13] In a similar survey, Illinois small business owners indicated that only 30 percent intended to hire another worker or workers in the next six months, which was a decrease of 10 percentage points from last fall’s poll.[14]

Share of Pass-Through Entities Varies by Sector

The share of pass-throughs by industry varies.[15] On average, 61 percent of employers in Illinois are pass-through entities. Table 2 below lists the share of each industry’s employers that are pass-throughs for Illinois’ private sectors.[16]

Thirty-eight percent of jobs at businesses with at least one paid employee[17] occurred at pass-throughs in Illinois in 2011, which is a sizeable share of the state’s workforce. Table 3 below lists the percentage of each sector’s employment at businesses with employees that occurred at pass-through entities.

Table 2. Share of Total Number of Illinois Employers that are Pass-Through Entities by Industry, 2011
Illinois Private Industries	Share of Total Illinois Employers that are:	Industry’s Share of Total State Private Sector GDP
	Sole Proprietorships	Partnerships	S-corporations	Total Pass-Through Entities	Pass-Through Share Rank
Construction	10%	4%	64%	78%	1	3.50%
Professional, Scientific, and Technical Services	10%	9%	58%	77%	2	9.30%
Agriculture, Forestry, Fishing, and Hunting	20%	12%	40%	73%	3	0.90%
Administrative and Support and Waste Management Services	11%	6%	52%	70%	4	3.70%
Real Estate and Rental and Leasing Services	8%	19%	43%	70%	5	14.80%
Transportation and Warehousing	6%	4%	57%	68%	6	4.00%
Accommodation and Food Services	8%	12%	48%	68%	7	3.00%
Manufacturing	5%	7%	49%	60%	8	14.30%
Arts, Entertainment, and Recreation	6%	13%	41%	60%	9	1.00%
Health Care and Social Assistance	12%	6%	41%	58%	10	7.80%
Wholesale Trade	3%	5%	46%	54%	11	7.30%
Retail Trade	7%	5%	40%	51%	12	6.90%
Finance and Insurance	12%	10%	27%	48%	13	10.80%
Educational Services	5%	5%	37%	47%	14	1.30%
Other Services, Except Government	9%	3%	32%	44%	15	2.70%
Information	2%	9%	27%	38%	16	4.40%
Mining, Quarrying, and Oil and Gas Extraction	3%	19%	16%	38%	17	0.20%
Management of Companies and Enterprises	3% (a)	5%	7%	15% (a)	18	2.30%
Utilities	1%	4%	8%	13%	19	1.90%
Total, All Private Sector Industries	9%	7%	45%	61%		100%
Columns may not sum to total due to rounding. Only includes establishments with at least one paid employee (excludes nonemployer businesses). (a) Indicates approximate value (data was excluded for confidentiality reasons, though percentage can be approximated). Source: U.S. Census Bureau County Business Patterns, Bureau of Economic Analysis Regional Economic Accounts, Tax Foundation calculations.

Table 3. Share of Total Illinois Paid Employees at Business with Employees that are Pass-Through Entities by Industry, 2011
Illinois Private Industries	Share of Total Paid Employees at Illinois Businesses with Employees that are:	Industry’s Share of Total State Private Sector GDP
	Sole Proprietorships	Partnerships	S-corporations	Total Pass-Through Entities	Pass-Through Share Rank
Construction	3%	7%	54%	65%	1	3.5%
Accommodation and Food Services	5%	18%	40%	63%	2	3.0%
Administrative and Waste Management Services	3%	12%	41%	55%	3	3.7%
Real Estate and Rental and Leasing Services	Data excluded for confidentiality purposes.	25%	30%	54% (b)	4	14.8%
Professional, Scientific, and Technical Services	5%	19%	30%	53%	5	9.3%
Agriculture, Forestry, Fishing, and Hunting	6%	14%	27%	47%	6	0.9%
Arts, Entertainment, and Recreation	4%	20%	20%	43%	7	1.0%
Mining, Quarrying, and Oil and Gas Extraction	3%	18%	19%	40%	8	0.2%
Manufacturing	1%	7%	30%	38%	9	14.3%
Wholesale Trade	1%	6%	31%	38%	10	7.3%
Retail Trade	2%	5%	26%	33%	11	6.9%
Transportation and Warehousing	2%	5%	23%	30%	12	4.0%
Health Care and Social Assistance	2%	8%	18%	28%	13	7.8%
Other Services, Except Government	2%	3%	21%	26%	14	2.7%
Information	1%	10%	13%	24%	15	4.4%
Finance and Insurance	3%	8%	10%	20%	16	10.8%
Management of Companies and Enterprises	4% (a)	5%	9%	18% (a)	17	2.3%
Educational Services	1%	2%	8%	11%	18	1.3%
Utilities	Data excluded for confidentiality purposes.	3%	1%	4% (b)	19	1.9%
Total, All Private Sector Industries	3%	9%	27%	38%		100%
Columns may not sum to total due to rounding. Only includes establishments with at least one paid employee (excludes nonemployer businesses). (a) Indicates approximate value (data was excluded for confidentiality reasons, though percentage can be approximated). (b) Indicates large portion of data excluded for confidentiality purposes and total pass-through percentage is understated. Source: U.S. Census Bureau County Business Patterns, Bureau of Economic Analysis Regional Economic Accounts, Tax Foundation calculations.

Industries Most Negatively Impacted by Tax Plans

Those sectors of the economy with a high concentration of pass-through entities would be impacted more severely by the income tax rate increase than others. Table 4 below lists the most disadvantaged industries.

Table 4: Illinois Employers with Highest Pass-Through Share

Industry	Share of Employers That Are Pass-Throughs	Share of Employees at Business with at Least One Employee That Are Pass-Throughs	Economic Position of Industry
Construction	78% (largest share)	65% (largest share)	Illinois construction sector payroll is underperforming when compared with national growth trends.[18] The industry has also shown negative employment growth in the last six years, while the state economy only saw negative employment growth during peak recessionary years.[19] Industry employment is projected to decrease in 2014.[20] Though the decrease this year is expected to be smaller than last year’s,[21] the construction industry has the worst employment growth projections out of all other industries over the next five year period.[22] Construction’s share of private real state GDP has also decreased over time.[23]
Professional, Scientific, and Technical Services	77% (2nd largest share)	53% (5th largest share)	In forecasts of the state’s long-term economic future, the high-tech services industry has been cited as source of future state growth.[24] This industry’s employment is at the highest level it has ever been, and jobs in the subsector are high-paying.[25] Real state GDP for legal services was severely impacted during the peak of the recession in Illinois and saw negative growth the next two years (the only subsector in this industry that had negative growth during these years).[26]
Agriculture, Forestry, Fishing, and Hunting	73% (3rd largest share)	47% (6th largest share)	The agriculture industry in Illinois tends to be more volatile than the U.S. industry as a whole (based on real state GDP growth). Similar to national trends, the industry’s share of total state private sector GDP has decreased in recent years.[27] However, forecasts are optimistic about the sector’s future growth prospects and predict that the state will “remain an integral component of U.S. agriculture in the longer term.”[28]
Administrative and Support and Waste Management Services	70% (4th largest share)	55% (3rd largest share)	The administrative and support services sector is expected to be “a significant source of new jobs as more expansionary businesses seek out temporary help to meet demand.”[29] The industry saw a sharper contraction in real GDP during the peak of the recession, but is now performing better in terms of growth than the U.S. average.[30]
Real Estate and Rental and Leasing Services	70% (5th largest share)	54% (4th largest share)	This is Illinois’ largest sector.[31] Both residential and commercial real estate have already seen weak growth but are finally on the path to recovery.[32] This trend has resulted in lower employment in housing construction.[33] Despite the fact that employment related to housing is no longer decreasing, its growth is lower than the U.S. average and the Midwest average.[34] The story is similar for commercial real estate, though the sector is forecasted to improve, albeit at a lower-than-average rate.[35]
Transportation and Warehousing	68% (6th largest share)	30% (12th largest)	The transportation and distribution sector, like the tech industry, was also predicted to be an industry that would propel future state growth.[36] Industry employment grew faster than average in recent years.[37] Positive employment growth is expected in the near future, but this trend is forecast to turn negative in subsequent years.[38]

Illinois Already Underperforming Regionally and Nationally

Illinois was impacted more severely by the most recent economic downturn than the rest of the country[39] and the region. It has only recovered approximately two-thirds of employment lost during the recessionA recession is a significant and sustained decline in the economy. Typically, a recession lasts longer than six months, but recovery from a recession can take a few years. . In contrast, both the Midwestern region and the country as a whole have recovered more than that (75 percent and 85 percent, respectively).[40]

Rick Mattoon, a senior research economist at the Federal Reserve Bank of Chicago, pointed out at the beginning of this year that the state “continues to underperform the nation in the current recovery” and that “[u]nemployment stays high and growth is low.”[41] He also noted the economic drain from fiscal uncertainty since businesses were unsure what the state’s tax structure would resemble in the future.[42]

In state economic forecasts prepared by Moody’s Analytics for the State of Illinois Commission on Government Forecasting & Accountability,[43] the tone was cautionary but optimistic. Though the state has seen weak growth comparatively, and there are prospects for improvement, there is also still cause for concern. For example, one report found that among other Midwestern states, Illinois was ranked in the bottom third when measured on output, income, and employment in 2013.[44] Similarly, Illinois’ unemployment rate is tied with Nevada for the second highest in the nation at 8.7 percent as of January 2014.[45] This is well above the U.S. average rate of 6.6 percent.[46]

Illinois faces severe budget woes as its unfunded pension liabilities continue to increase. According to officials at the Federal Reserve Bank of Chicago,

now that [pension] debts must be repaid, tax burdens will possibly rise above the national and regional norms. Accordingly, a potential downside is a dampening of growth and development as rising taxes, without any accompanying rise in services, diminishes the attractiveness of investment and livability in the state…[This] would likely exercise a moderating overall influence on growth and development.[47]

Conclusion

Illinois lawmakers are considering moving the state’s income tax system from a flat rate on all income to a graduated rate system with top rates ranging from 8 to 11 percent in 2015. This tax change would impact a large share of Illinois employers because many are pass-through businessA pass-through business is a sole proprietorship, partnership, or S corporation that is not subject to the corporate income tax; instead, this business reports its income on the individual income tax returns of the owners and is taxed at individual income tax rates. es which pay taxes via the individual income tax rather than the corporate income tax.

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