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The Illinois Solution: Raise Taxes

The state of Illinois continues its slide to economic decrepitude, putting the failure of liberal governance on national display for all to see. Yesterday the Illinois legislature passed measures to a bill to hike personal income taxes by 66% and the corporate income tax by 45% in a desperate bid to maintain solvency. Billions of dollars in arrears to vendors, the state faces a budget gap of $13 billion to $15 billion this year. The higher tax rates, which supposedly will expire in four years, are expected to raise $6.8 billion annually.

The good news for Illinois is that the added revenue will significantly reduce the odds of state default… at least in the near term. Based on the interest premium paid on its debt, the Prairie State has been rated as one of the sovereign entities with the highest probability of default, just behind Portugal, Ukraine and Dubai. Those fears should ease for a while.

What Illinois residents won’t see is much spending discipline. According to the Public News Service, the tax bill also limits spending growth to two percent, roughly in line with inflation. In other words, Illinois’ idea of budget discipline is to stop spending more, not to actually spend less. The bill also authorizes nearly $4 billion in new debt to fund the state’s pension payment this year, even though public employee pensions have $78 billion in liabilities as it is. It is not clear from any of the first-day news stories about the tax hike how the legislature and/or Gov. Pat Quinn hope to close the rest of the budget gap.

The threat of insolvency had thrown a pall over the state’s business climate as businesses awaited the inevitable tax hit. Now that fear has become a reality. Democrats maintain that the economy will absorb the higher personal and corporate levies in stride. According to the conservative Tax Foundation, Illinois’ state/local tax burden actually was slightly lower than the national average. But the new tax hikes will push it way up the list.

Business taxes aside, Illinois already has a reputation as an inhospitable place to do business. Last year Illinois ranked 6th worst in Chief Executive magazine’s annual ranking of the best and worst states for business. The jump in corporate income tax rates to 9.5% — which will become the fourth highest in the country (assuming Minnesota, Pennsylvania and Washington, D.C., don’t raise theirs in the meantime) — will assuredly bump the state deeper into the business-climate basement. Governors of neighboring states have already started trash talking Illinois with plans to recruit its businesses investment. In a word, the tax hike undermines any hope that strong economic growth will deliver the state from its fiscal woes.Businesses won’t be the only ones heading for greener pastures. According to the Illinois Policy Institute, the state experienced a net outmigration to other states between 1991 and 2009 of more than 1.2 million residents. The talent drain resulted in a net loss of roughly $23.5 billion a year in income over a roughly comparable period, which would have generated an additional $2.4 billion a year in state and local revenue. For purposes of comparison, the state General Fund budget in fiscal 2011 was about $25 billion.

If Illinois residents were streaming out of the state when the personal income tax was a moderate 3%, jacking up the rate to 5% — roughly $1,000 per year more for a family for a middle-income family — will only accelerate the flight. Supposedly, the tax hike is temporary, lasting only four years. But how many people have any confidence that Illinois’ financial problems won’t continue and the rates won’t be made permanent?

Illinois’ past sins have created a situation where it has few viable options. Given the enormity of its budget gap and unfunded liabilities, it’s hard to see how the legislature can close the budget gap without higher taxes. State government has been living way beyond its means for years.

Unfortunately, the political culture of the state seems little inclined to make serious spending cuts. The questions that many Illinois residents, and outside investors, will be asking are these: Will Springfield’s political class start spending again as soon as the fiscal pressure is off? Is another fiscal crisis inevitable? Will some future governor be proposing another giant tax increase before the decade is out?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.