A Junk Bond Rating for Illinois Is on the Ballot

Illinois doesn’t get as much attention as some other Midwestern states around Election Day. It’s no secret why: Unlike Iowa, Michigan, Minnesota, Ohio and Wisconsin, it’s not even remotely close to being a toss-up for the presidency.

What it lacks in White House intrigue, however, it more than makes up for in its own drama.

Illinois has long held the unenviable distinction of being the lowest-rated U.S. state. Its retirement systems are so underfunded, and have been for such a long time, that the phrase “Illinois pensions” is practically used as shorthand among Republicans in Washington as a reason the federal government shouldn’t send a huge aid package to state and local governments to help them get through the pandemic. 

One of the lesser-known reasons for Illinois’s struggles is its own constitution. As it stands, any state personal income tax must be a single-rate structure — that is to say, flat. That’s relatively rare across America: Of the 41 states that tax wage and salary income, just nine had a single-rate structure as of 2019, according to the Tax Foundation. At 4.95%, Illinois’s current rate keeps it competitive with Indiana and Michigan, which also have a flat-tax structure, and makes it more favorable for top earners than Iowa, Minnesota or Wisconsin. But, of course, that comes at the expense of getting less revenue from its wealthiest residents than states like Connecticut and New Jersey, which also have underfunded pensions but are still seen as better off than Illinois.

Illinois has the lowest investment-grade ratings (BBB-/Baa3) and negative outlooks from the three biggest bond-rating firms. One more downgrade and the state’s debt would become the first in at least the last half-century to be rated junk.

Governor J.B. Pritzker, unsurprisingly, wants to avoid that outcome. He’s been championing a “Fair Tax for Illinois” since his gubernatorial race in 2018, a constitutional amendment that would allow for a graduated income tax as long as voters approve the ballot measure next week. This is how the constitution’s language would change:

(a) A tax on or measured by income shall be at a non-graduated rate. At any one time there may be no more than one such tax imposed by the State for State purposes on individuals and one such tax so imposed on corporations. The General Assembly shall provide by law for the rate or rates of any tax on or measured by income imposed by the State. In any such tax imposed upon corporations the highest rate shall not exceed the highest rate imposed on individuals by more than a ratio of 8 to 5.

In anticipation of voters ratifying this amendment, the Illinois General Assembly passed, and Pritzker signed, a measure more than a year ago that lays out the new tax brackets that would take effect at the start of 2021. For individuals who make $100,000 or less, the income tax would be slightly lower than the current 4.95%. The marginal rate would jump to 7.75% for income above $250,000, 7.85% for income above $350,000, and for those making more than $750,000, Illinois would impose a 7.95% rate on all taxable income rather than just the amount that exceeds that threshold. It would bring in about $1.2 billion for the fiscal year that began July 1 and $3.1 billion for a full 12 months, according to state estimates.

Considering Illinois is facing a $4.1 billion budget shortfall in fiscal 2021, it’s not hyperbole to suggest that the passage of this amendment is a make-or-break moment for the state’s finances. Illinois’s credit rating is on the ballot this year: A failure to win over voters on the “Fair Tax” will most likely push the state into junk territory.

But don’t just take my word for it. Citigroup Inc. municipal-bond strategists led by Vikram Rai wrote in a report this month that “a downgrade is almost guaranteed” for Illinois if the tax measure isn’t approved. A rating cut would increase the state’s borrowing costs by 50 basis points, they wrote, to roughly 4% for 10-year bonds from 3.5% now. Yet, by their logic, even passing the amendment isn’t necessarily an all-clear. Rather, voters throughout the country will also have a say in whether Illinois can maintain its investment grade:

If the progressive tax ballot measure passes but Republicans retain control of the White House and Senate, the outlook for downgrade is nebulous, essentially a toss-up. Finally, if the progressive ballot measure passes and Democrats take over the White House and the Senate, Illinois may be able to avoid a downgrade after all since more generous fiscal aid can be expected from the Federal government, which will go a long way towards reversing the deterioration in the state’s credit.

Put plainly, Illinois could use a “blue wave” to help get a handle on its budget, which was already in precarious shape before the Covid-19 pandemic. Remember that Senate Majority Leader Mitch McConnell, a Kentucky Republican, said in April that he “would certainly be in favor of allowing states to use the bankruptcy route,” rather than what he saw as a move to “bail out state pensions.” Illinois isn’t in such a dire position yet, but it doesn’t take much imagination to see how draconian cuts at the state level could harm its cities and counties. On Monday, Chicago Chief Financial Officer Jennie Huang Bennett said she’s “not sure” the city will “get through the budget season without a downgrade.” Moody’s Investors Service has considered the city junk since 2015.

There’s a risk, of course, that higher taxes on top earners could accelerate outmigration from the state. Ken Griffin, the billionaire founder and chief executive officer of Chicago-based Citadel, has donated $20 million to the “Coalition to Stop the Proposed Tax Hike Amendment.” Griffin is the richest person in the state, and the coalition also includes Sam Zell, the second wealthiest. Pritzker, himself a billionaire and one of the state’s 10 wealthiest residents, has donated more than $50 million to the “Vote Yes for Fairness” committee.

For all the millions sloshing around over a policy question, there’s been relatively little in the way of robust polling on the topic. One survey released in March, just before the Covid-19 pandemic roiled the economy, showed that 65% of Illinois voters supported the amendment. That’s a larger share than Joe Biden, the Democratic presidential nominee, is expected to receive, according to FiveThirtyEight. But even that margin doesn’t make it a certainty. The Illinois constitution’s threshold is approval from “either three-fifths of those voting on the question or a majority of those voting in the election.” If you assume that the amendment’s opponents are more motivated voters, and enough of those who would say “yes” leave the response blank, it’s possible to come up with scenarios in which the graduated income tax falls short.

I’m not sure if more people would vote on the amendment if they were told Illinois’s credit rating would be cut to junk if it fails. But that’s precisely what’s on the line. In non-bond market terms, that would mean more of the budget is eaten up by debt payments, which would further erode the state’s pension funding and public services. In a “periodic review” of Illinois’s credit rating published on Oct. 23, Moody’s noted that “the state's pension liabilities are worsening while its financial capacity is suffering from reduced revenue,” adding that “while the rating reflects the dramatic economic downturn caused by the current coronavirus epidemic, the situation for some states remains fluid.” It’s not hard to read between the lines.

No politician wants to raise taxes if it can be avoided. But Pritzker and lawmakers are out of moves and need the ability to pull in more revenue in the coming years to make ends meet. Whether that happens is in the voters’ hands now. 

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.

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