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Municipal Perspective published on March 1, 2015

Chicago: The Tax Man Cometh

Summary

  • The taxpayers of the City of Chicago face some very difficult decisions in the months and years ahead.
  • Chicagoans confront an aggregate government budget deficit that exceeds their peers in other major U.S. cities.
  • To close the $3.2 billion aggregate structural deficit via taxes alone, Chicagoans would have to shoulder a 21 percent tax increase.
  • Chicago has limited ability to “scoop and toss,” or refinance its debt over a longer period of time or to further delay maintenance on its infrastructure.
  • Higher tax bills seem likely for Chicagoans.
  • However, in our view, a large tax hike in Chicago is unlikely, due to the voter aversion to taxes, the distributional impact of higher taxes on individual taxpayers and the potential need to increase the tax base, among other reasons.
  • In theory, Chicago taxpayers can finance the state’s government deficits – but not with tax increases, alone.

With the re-election of Chicago mayor Rahm Emanuel in the rear view mirror, the municipal market now awaits additional fiscal fixes for Chicago-area governments.

Each of the most consequential governments serving Chicago confronts significant challenges. The City of Chicago’s financial condition remains weak. Chicago Public Schools are rated Baa3/negative, one notch above “junk”. The State of Illinois’ 2013 pension reform is mired in litigation, and the expiration of a temporary income tax hike has expanded the State’s FY 16 budget deficit.[1] Cook County also faces a large structural deficit.

Higher tax bills seem likely for Chicagoans. In this White Paper, we estimate how large that tax hike might be. To do so, we aggregate the deficits of Chicago’s major governments and estimate the tax hike required to close the collective shortfall. We then calculate the effective tax rate that achieves aggregate structural balance and compare it to the aggregate effective tax rates in the Nation’s other four largest cities.

We conclude that Chicago residents can afford to finance some of their governments’ deficits with tax hikes. However, political realities and the sheer size of the area’s deficits will likely compel a mix of revenue enhancements and spending cuts. Note that the estimates we put forth here likely understate the aggregate deficit that Chicagoans face. Our figures are based on each government’s latest audited financial statements as opposed to the most recent budget projections.

How big is the Aggregate Deficit Confronting Chicago’s Taxpayers?

Based on the latest available financial statements, the aggregate structural deficit facing the major governments serving Chicago is roughly $5.7 billion.[2] This figure includes the deficits (and surpluses) of the City, Cook County, Chicago Public Schools (CPS), the Metropolitan Water Reclamation District (MWRD), Chicago Park District (CPD), City Colleges of Chicago, the Cook County Forest Preserve District (CCFPD), and the State of Illinois.

Chicagoans are responsible for $3.2 billion of this $5.7 billion total (see Table 1). Chicago’s tax base comprises roughly 50% of the tax base of Cook County, MWRD, and CCFPD and 21% of the State’s tax base, respectively. Therefore, only 50% and 21% of those governments’ deficits must be paid by Chicago taxpayers.[3]

How Much Must Chicagoans Pay to Close the Aggregate Deficit?

To close the $3.2 billion aggregate structural deficit via taxes alone, Chicagoans would have to shoulder a $3.2 billion tax hike. This amounts to a 21% tax increase, as Chicagoans presently pay roughly $15.1 billion in taxes. Raising an additional $3.2 billion would increase Chicagoans’ effective tax rate to 6.2% from 5.1%.

How Does Chicago Compare to Other Large Cities

Relative to its peers, the combined structural deficit of Chicago and its overlapping governments is large. As a consequence, so is the tax increase necessary to close it. As Table 3 illustrates, Chicago’s necessary 21% tax hike is more than twice the increase faced by Philadelphia, the next closest city.

Note that Chicago also lacks the fiscal flexibility of its peers. Chicago repays its debt, pension, and OPEB obligations more slowly than New York, LA, Houston, and Philadelphia, and its infrastructure needs are greater. As Table 4 illustrates, Chicago has limited ability to refinance its debt over a longer period of time (“scoop and toss”). It also has limited ability to further delay maintenance on its infrastructure.

Can Chicago Taxpayers Finance their Governments’ Deficits?

Yes, but not with tax increases, alone.

At least in theory, asking Chicagoans to pay $3.2 billion more in taxes might be possible. Recall that in 2011, Illinois voters implicitly sanctioned a temporary income tax hike that increased the State’s income tax take by 25%.[4] Also, the City Council increased water and sewer rates by a combined 90% between FY 11 and FY 15.[5] Finally, even if Chicago area governments imposed a 21% tax increase, they would still tax at an effective rate of only 6.2% - lower than New York City’s rate of 6.7% (see Table 3).[6]

However, in our view, a large tax hike in Chicago is unlikely for several reasons.

First, voter aversion to taxes appears to be on-the-rise in Illinois. The State’s new Governor was elected 52% to 46%, in part, on his promise not raise taxes. In his FY 16 budget, the Governor proposed lowering state income taxes.[7] At the local level, Mayor Emanuel recently touted that he had balanced Chicago’s budget for three consecutive years “without any increase in property, sales, or gas taxes.”[8] In addition, a substantial hike in taxes usually requires making significant adjustments to the largest tax categories. Any state or local proposals to increase income, property, or sales taxes in a broad based fashion are likely to be met with opposition from a variety of constituencies.

Second, our estimate that, collectively, Chicagoans can afford a 21% tax increase ignores the distributional impact of higher taxes on individual taxpayers. As Table 4 illustrates, affluent Chicagoans have a lower tax burden (measured as a percentage of income) than peers in other large cities. This suggests that a significant tax hike might be hard to enact because (a) lower income taxpayers are tapped out or (b) Chicago’s higher income taxpayers are less willing to pay as much for local services as their peers in other cities.

Third, raising a substantial amount of taxes on Chicago’s residents may require expanding the tax base. In Chicago’s case, this would likely entail levying a new income tax, like in New York City or Philadelphia. It might also include a commuter tax. Either would require approval from the state legislature, where support is lacking. The State Constitution prohibits home rule cities, like Chicago, from levying a tax on “income, earnings, or occupations” without authorization from the General Assembly.[9]

Fourth, increasing Chicago’s sales tax rate seems unlikely. The current sales tax rate in the City of Chicago is a high 9.25%. This includes the underlying levies for the City, Cook County, and the State.[10] Remarkably, the rate used to be higher before voter ire forced Cook County to lower its sales tax rate over several years beginning in 2009.

Only a portion of any new taxes will go to preserving or growing existing public services.

Fifth, only a portion of any new taxes will go to preserving or growing existing public services. Unlike the water and sewer rate hikes of recent years (which were designated to maintain and rebuild Chicago’s ailing water and sewer system), roughly 64% of the tax increases meant for the State, City, or CPS will go to funding higher annual costs for employee pensions and retiree healthcare costs.[11]

Sixth, the actual collective deficit facing Chicago’s residents is likely larger than the figures presented here. Our numbers are based on information in the latest available audited financial statements. Using audited statements facilitates comparisons between Chicago and other large U.S. cities. However, our numbers exclude new burdens associated with CPS’ $1.1 billion shortfall for FY 16. They also ignore the recent reduction in state income tax rates (from 5% to 3.75%) which have led, in part, to Illinois’ projected $6.7 billion budget deficit for FY 16.[12]

Budget balance can be achieved by trimming the City’s budget further, enacting pension reform, consolidating regional governments, raising taxes at the state level and passing the savings through to the City, or selling assets, among other strategies.

The taxpayers of the City of Chicago face some very difficult decisions in the months and years ahead. Chicagoans confront an aggregate government budget deficit that exceeds their peers in other major U.S. cities. We expect that Chicago area governments’ finances will stabilize, eventually. Budget balance can be achieved by trimming the City’s budget further, enacting pension reform, consolidating regional governments, raising taxes at the state level and passing the savings through to the City, or selling assets, among other strategies. But the City’s taxpayers appear unwilling to shoulder the entire cost of that deficit, alone.


[1] See Moody’s Investors Service Issuer Comment, February 24, 2015.

[2] Note that our definition of “structural balance” is calculated by subtracting total governmental fund expenditures from total governmental fund revenues in the financial statements. We then adjust this figure by excluding capital expenditures (which can be one-time in nature) and adding back any shortfall in annual pension or OPEB costs. Our definition assumes that each government makes its full annual required contribution for pensions and OPEB costs.

[3] Chicago’s tax base is roughly ½ the tax base of Cook County, the Cook County Forest Preserve District, and the Metropolitan Water Reclamation District. We, therefore, attributed to Chicago only ½ of the deficits of each of these issuers.

[4] See: Commission on Government Forecasting and Accountability, FY 14 Budget Summary, p. 19. Available at: http://cgfa.ilga.gov/Resource.aspx?id=222.

[5] See Series 2014 Second Lien Wastewater Revenue Official Statement and Series 2014 Second Lien Water Revenue Official Statement. http://emma.msrb.org/EP828500-EP641367-EP1043036.pdf and http://emma.msrb.org/EP830001-EP642610-EP1044251.pdf.

[6] For the purpose of simplicity, we have defined the available base as the sum of the fair market value of Chicago’s taxable property, retail sales within Chicago, and Chicago residents’ personal income. Chicago area governments, including the State, generate most of their tax revenue from these three sources. We used the same definition of “tax base” to calculate the other cities’ effective tax rates, as well.

[7] See: Chapter 2 – 14 of Governor’s proposed budget.

[8] See City of Chicago press release on Emanual’s 2015 budget address. Available at: http://www.cityofchicago.org/city/en/depts/mayor/press_room/press_releases/2014/oct/mayor-emanuel-presents-balanced-2015-budget-to-city-council.html.

[9] See Illinois Constitution, Article VII, Section 6, (d)(2)(e).

[10] See Chicago’s FY 2015 budget overview, p. 12.

[11] The combined annual pension and OPEB contribution shortfall for the governments included in this analysis was $2 billion or 64% of the estimated $3.2 billion deficit.

[12] See Yvette Shields, “Emanuel’s Chicago Win Doesn’t Take the Pressure Off,” The Bond Buyer, April 8, 2015.

 

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