Illinois Considers Further Income Tax Increases as Temporary Tax Nears Expiration

Download FISCAL FACT No. 411: Illinois Considers Further Income Tax Increases as Temporary Tax Nears Expiration

Illinois significantly raised taxes in 2011 in an attempt to address its $8.5 billion backlog of unpaid bills and other financial difficulties. The state raised its flat 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. from 3 percent to 5 percent and increased 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. from 7.3 percent to 9.5 percent.[1] The 2011 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. increases have generated between $7 billion and $8 billion in added revenue each year.[2]

In 2015, the tax increases are scheduled to partially sunset, with the individual income tax dropping from 5 percent to 3.75 percent and the corporate income tax dropping from 9.5 percent to 7.75 percent (see Table 1). In 2025, the individual income tax is scheduled to drop further to 3.25 percent and the corporate income tax to 7.3 percent.

Table 1: Illinois Tax Rates
	Pre-2011	2011 to 2014	2015 to 2024	2025 and after
Individual Income Tax Rate	3.0%	5.0%	3.75%	3.25%
Corporate Income Tax Rate	7.3%	9.5%	7.75%	7.3%
Source: 35 ILCS 5/201(b); 35 ILCS 5/201.5; 35 ILCS 5/201(d).

Despite the added revenue from the 2011 tax increases, the state’s backlog of unpaid bills grew to $9 billion by 2013 before dropping at the end of the year to $7.6 billion.[3] Additionally, interest payments have more than doubled and the state’s credit and economic outlook remains weak.[4] The corporate tax increase has led to several instances of high-profile businesses preparing to move operations out-of-state before the state stepped in to mitigate the increased tax burden with a targeted incentive package.[5] The state has fallen considerably on our State Business Tax Climate Index as a result of the tax increases (see Table 2).

Table 2: Illinois and the State Business Tax Climate Index, 2011 to 2014
	2011	2012	2013	2014
Overall Rank	17	28	30	31
Corporate Income Tax Rank	26	45	47	47
Individual Income Tax Rank	10	11	11	11
Sales Tax Rank	34	33	34	33
Unemployment Insurance Tax Rank	41	43	43	43
Property Tax Rank	32	44	44	44
Source: Tax Foundation State Business Tax Climate Index

With the 2011 tax increases scheduled to sunset in part, and with the state budget still not structurally balanced, some policymakers may consider doubling down on bad tax policy. One proposal that has emerged in recent months is to consider a graduated, or progressive, income tax that would impose many additional rates on individual income. For example, (HJRCA0033) would amend the state constitution to allow a progressive income tax. [6] The plan includes seven tax bracketsA tax bracket is the range of incomes taxed at given rates, which typically differ depending on filing status. In a progressive individual or corporate income tax system, rates rise as income increases. There are seven federal individual income tax brackets; the federal corporate income tax system is flat. and a top rate of 9 percent, raising taxes on all income over $18,000.[7] Because the Illinois constitution currently requires individual income tax rates to be imposed uniformly on all income and all people, this proposed change would require 60 percent approval by legislators and a vote of the people to amend the constitution.[8]

Excessive taxes on income are generally less desirable than taxes on consumption because they discourage wealth creation. In a comprehensive summary of international econometric tax studies, Arnold et. al. (2011) found that personal income taxes are among the most destructive to growth, being outdone only by corporate income taxes.[9] The authors found that consumption and property taxes are the least harmful. The economic literature on progressive income taxes is especially unkind.[10] For example, the Arnold study found that reductions in top marginal income tax rates would be beneficial to long-term growth. Examining the period 1969-1986, Mullen & Williams (1994) found that higher marginal tax rates reduce gross state product growth. This finding even adjusts for the overall tax burden of the state, lending credence to the principle of broad bases and low rates.[11] Prescott (2004) finds that high tax burdens over the last several decades in Europe have led workers on average to work fewer hours than Americans, whereas in the 1970s, the opposite was the case. He finds additional evidence that the flattening of the Spanish income tax system in 1998 increased the labor supply by 12 percent.[12] This suggests that progressive income tax policy today can hinder the long-run earning potential of a worker for the rest of their life. Finally, it should be kept in mind that many Illinois small businesses pay tax under the individual income tax code.

Looking exclusively at changes to income tax rates, had HJRCA0033 and the proposed rates been in place on July 1, 2013, the snapshot date for our 2014 State Business Tax Climate Index, Illinois would have ranked 44th best for business tax climate, rather than 31st (see Table 3). If corporate rates were made higher and more progressive as well, a change we do not consider here, Illinois’ Index score would worsen further.

Table 3: Effect of higher tax rates on Illinois State Business Tax Climate Index rankings
	2014	2014 if HJRCA0033 and higher rates were law
Overall Rank	31	44
Corporate Income Tax Rank	47	47
Individual Income Tax Rank	11	33
Sales Tax Rank	33	33
Unemployment Insurance Tax Rank	43	43
Property Tax Rank	44	44
Source: Tax Foundation analysis.

The state-local tax burden borne by Illinois taxpayers rises year after year, and the state’s efforts to offer large tax incentives to politically important businesses is an implicit acknowledgement that the state’s tax code is uncompetitive and needs to be reformed. With credit ratings agencies suggesting that Illinois faces a risk of slipping back into 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. , Illinois policymakers should address structural spending issues to repair the state’s finances.[13] Extending what was meant to be a temporary tax increase, or significantly increasing the state’s income tax still further, would sidestep these fundamental issues while worsening the state’s already shaky economic footing.

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