Illinois On The Fiscal Brink

Monday, June 13, 2016
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Illinois—a state that has long embraced progressive fiscal policies—has moved one step closer to the financial abyss. Last week, Moody’s Investors Service issued the jarring announcement that it was downgrading Illinois’s general obligations bonds to Baa2 from Baa1, which is just two levels above junk bond status. The next day, Standard & Poor’s followed suit by lowering its rating to BBB+, or three levels above junk bond status. In one important sense, this is really not news at all, since Illinois had thirteen bond downgrades under its previous governor, Patrick Quinn, even though it passed a temporary tax increase that collected an additional $31 billion in revenues between 2011 and 2015, 90 percent of which was funneled into pension payments for public employees.

The reason Illinois’s credit ratings have declined is that the state has been unable to live within its means. Even with its tax increases, Illinois has not had a balanced budget since 2001, though one is required under its Constitution. The latest credit downgrade stemmed from the inability of key players in the state to agree on any budget at all for the coming year. It is therefore no surprise that Moody’s observes: “The rating downgrade reflects continuing budget imbalance due to political gridlock that for more than a year has kept Illinois from addressing revenue lost due to income tax cuts that took effect in January 2015.” This remark reflects the bias of rating agencies to worry more about the condition of government balance sheets than the overall health of the state economy. Reduced expenditures are another, superior way to bring a budget into balance, which is necessary, for—as Moody’s ruefully notes—Illinois is running a structural budget gap of about 15 percent of its general fund expenditures.

The backstory is somewhat more complicated. In January 2015, when Bruce Rauner, who had amassed a tidy fortune in private equity, was elected governor, the temporary Illinois tax increase to a flat 5 percent reverted to its former rate of 3.75 percent. Many Democrats, led by the formidable Michael Madigan—Speaker of the Illinois House of Representatives for 31 of the last 33 years—wanted to reverse those tax cuts and replace the Illinois constitutionally mandated flat tax with a progressive tax in order to cut the deficit. Without any deliberation, the Illinois House passed an unbalanced budget with revenues under $33 billion and expenditures at close to $40 billion—a $7 billion deficit. Rauner did not have to exercise his veto threat because the budget was rejected by the Illinois Senate, even with its large Democratic majority. But a few days ago, Rauner did exercise his veto of a stop-gap educational measure that would appropriate $4 billion for education and human services, which he chastised as an “unfunded, empty promise.”

This clash of wills is no surprise, because Rauner’s worldview is the opposite of Madigan’s. The governor has been steadfast in his belief that raising taxes is throwing money down a sinkhole, unless and until someone introduces structural reforms to pull Illinois back from the brink, most notably in labor markets. The state is known for the extensive benefits that it lavishes on public employees, most of whom are unionized. It has generous workers’ compensation laws, high property taxes, a devastating public pension shortfall for retirees, and no right-to-work law, which all make the cost of doing business in Illinois among the highest in the nation. Madigan wants to postpone the reform discussions until the budget is passed. Rauner knows that if he allows that to happen, he will lose all leverage on his reform.

This impasse also makes the state highly vulnerable to competition from other states, including its immediate neighbors like Indiana, Michigan, and Wisconsin—not to mention states like Texas and Tennessee that have better business climates. Indeed, it is just this awareness that explains why a Democratic state like Illinois elected a Republican governor, while keeping its Democratic legislators. Voters in states like Illinois have two competing desires. On the one hand, they want to get the largest share of the state pie of goodies for their district, which means keeping in office incumbent members of the state House and Senate. Whatever people in other districts might think, Madigan’s base in the 13th ward near Midway Airport is not likely to vote him out of office any time soon. But at the same time, they would like to have a governor who is willing to rein in the excessive demands of the legislature. Hence the vote for Rauner in 2015, and giving him an uneasy mandate to reduce the size of the overall pie from which they crave the largest slice.

These conflicting forces have precipitated a pitched ideological debate. When the latest bond downgrades were announced, the blame game began, with each party denouncing the obstinate behavior of the other side for leading to the current impasse. Noted leaders like Chicago’s Mayor Rahm Emanuel, whose city bonds achieved junk status long ago, bellowed that Rauner is “auditioning to be Donald Trump’s running mate.” A low blow. The difficulties that are faced in Illinois are endemic to all governments—federal, state, and local—that operate on progressive principles in both the long and the short run.

According to the progressive playbook, politicians should disrupt the operation of competitive markets to supply hefty short-term benefits to their friends and political allies. Then, they should have the state borrow money to put off paying the tab. In Illinois, the dam broke on public employee pensions back in 1994 when the ubiquitous Madigan and then-Republican governor Jim Edgar struck a deal which back-loaded funding for state pension plans, as the Illinois Policy Institute reports. Their compromise plan called for smallish contributions in the early years for pensions that would come due only years later—that is, now. The thought was that someone else could pick up the pieces in the next period.

But it never quite works out that way. Today, the state’s unfunded pension liabilities have increased to nearly $100 billion with no relief in sight. The situation becomes only worse considering that the 1970 Illinois Constitution contains an explicit provision under which every pension obligation “shall be an enforceable contractual relationship, the benefits of which shall not be diminished or impaired,” which this past March led to striking down state legislation to modify the annuity benefits for current and future workers, without their consent.

The circumstances thus impose an intolerable legal bind on top of the state’s political woes. Normally, the enforcement of public contracts is a good thing, for it is the only way to fund long-term, capital improvements, and to give ordinary people a degree of certainty in planning for the future. That principle applies with full force to contracts entered into in private competitive markets, free of any subsidies or preferences by the state. But the political economy of public employment shows the danger of extending this principle uncritically to public contracts, where the same strong political actors are on both sides of the bargaining table simultaneously. Thus it is an open secret that state legislatures are all too willing to enter into one-sided contracts that give public employees wages and benefits far higher than those that are received by workers in the private sector. The willingness of these union forces to work ceaselessly and effectively to get these benefits is only increased by their knowledge that the benefits in question are fully vested the moment the ink is dried on the page.

The defect of this system is apparent. At no point does anyone have a chance to ask the question appropriate to all cases of self-dealing, which is whether the government has received fair value for the obligations that it incurs. That can be done whenever the state obtains goods and services from a competitive market in which, like private firms, it can play one potential vendor off against another. But it cannot do this whenever it sets up monopoly unions with which it then obligates itself to deal.

At this point, it seems clear that the current impasse in Illinois represents a deeper failing that will be well-nigh impossible to reverse in the current populist political climate. One object of sound governance is to make sure that each public expenditure brings to the citizens of the state benefits greater than the costs that they are required to bear. Putting that ideal into practice, however, is far more difficult than it first appears. Traditional constitutional efforts have concentrated on limiting the way in which the government exerts its coercive efforts on citizens, chiefly through taxation and regulation. These protections have been vastly whittled down today, but at their best they sought to preserve competitive institutions from the ravages of factional influence.

Unfortunately, these same constitutions contain few if any provisions that explicitly deal with the ever-expanding importance of the distribution of public benefits in the form of services, licenses, permits and contracts. In order to deal with this onslaught of public “givings,” it becomes necessary to invoke the inverse of the takings clause, which provides “nor shall public property be given to private parties without just compensation.” That approach was incorporated into the Supreme Court’s well-known decision in Illinois Central Railroad v. Illinois (1892), in connection with transfers of state property to public use. But that doctrine cannot be so limited in its application. It must also apply to labor contracts that provide any group monopoly rents for services that could have been rendered more cheaply and effectively in competitive markets.

The clear implication of the analysis is striking. As a matter of first principles, it is imperative that no public union should ever be allowed to negotiate adversely to the state. Once public unions are recognized, financial ruin is not inevitable for all governments at all level. But even the risk is too high to tolerate, given that the union structure offers no state-wide benefits to offset the huge long-term downside. In insisting on this point, it is important to realize that public unions are far more potent than private ones for two reasons. First, public employers are more vulnerable to political pressures than private ones who have to answer to shareholders, not voters. Second, the union strike threat is more credible against public employers, for the shut down of the firm means the end of police, prison, and other services that are difficult to outsource to India or anywhere else. It was for these reasons that the original national labor relations statute exempted public employees. It is highly unlikely the decision to allow public unions will be reversed until we see the de facto bankruptcy of state and local governments, for which Illinois may well turn out to be the first of many.