Lessons from Illinois: Accounting to the rescue?

Sep 16, 2019

By Rick Mattoon, Senior Economist, Chicago Federal Reserve Bank and member of External Advisory Panel for the Government Finance Research Center at the University of Illinois in Chicago.

When it comes to public finance, Illinois provides a cautionary tale; if not a horror story.  The state has garnered national attention for

• Failing to pass a budget from July 1, 2015 to August 31, 2017
• Running a pension system that is 38% funded
• Carrying a structural budget deficit, which is currently$6.5 billion    This is just payments to vendors and does not include pension contributions.  Most of it is to healthcare providers.
• National studies routinely rank Illinois in the bottom five for fiscal condition.

I have always had an interest in Illinois’ fiscal health both personally and professionally. But though there are few surprises in store for me, it’s my guess that many state taxpayers only recently have come to realize the depth of the state’s fiscal problems and wonder how deficits of these magnitudes went seemingly unattended for years.  Work by the Fiscal Futures project at the University of Illinois Chicago (https://igpa.uillinois.edu/policy-initiatives/fiscal-futures-project) identified that the state began running a structural budget gap in 2000 and yet structural reform to the state’s fiscal problems have largely been delayed year after year.

Some of the issues cited above are caused by issues that can be obscured deep in the accounting which has been permissible in Illinois.  Illinois isn’t alone in using accounting rules that hide the true nature of its fiscal health, but it is a at the extreme in the fiscal impacts that a lack of transparent accounting may have.

The first problem is the widespread use of cash accounting in reporting fiscal condition.   This method allows the state to not recognize certain liabilities even if leaders know they will come due in future budget years.

By representing the cost of government as largely consisting of annual expenses and not future liabilities, taxpayers are encouraged to consume more government services.  Ideally, if the real price of services is correctly identified, taxpayers are confronted with a realistic choice. If current tax payments are insufficient to cover government services, they can either agree to pay higher taxes to maintain service levels or accept lower service levels that match current tax resources.

Legacy costs such as pensions and OPEB are the most alarming of the costs that have been historically ignored. When fully accounted for, the cost of government workers is not just their annual salary but also all future benefits being accrued each year.

This lack of accounting clarity makes solving a fiscal problem far more difficult.  When a deficit is reported, taxpayers may become suspicious of proposed solutions—particularly when they require new taxes.  Who wants to pay more taxes to pay for bills accrued years ago?

A further problem is that due to the duration of the fiscal imbalance, the state can’t dig itself out in one or two fiscal years.  The solution will require fiscal discipline over many years. To be successful, new governors and legislators will have to adhere to a prescribed fiscal path. Binding future elected officials to a plan they did not create is difficult at best.  Yet, to gain taxpayer confidence, a fiscal path that will be followed with certainty, will be needed as well as the implementation of measures that ensure that taxpayers know the actual cost of government services.

Certainty, however, is in rare supply for most governments. They will always fall victim to recessions that will strain government resources particularly when government receipts are increasingly pro-cyclical and government spending is counter-cyclical.  Responsible states realize that building adequate reserves are critical for smoothing government spending over a recession. For Illinois this presents two problems. Digging out of its fiscal hole leaves the state with little in the way of budget reserves to buffer an economic downturn.  Additionally, staying on a debt repayment program will be harder to do when demand for social safety net programs spike during a recession.

The final dimension of certainty has to do with potential investment in the state.  Illinois has many desirable features that make the state attractive for investment including a world-class city, skilled workforce and excellent market location.  However, on the margin, investors would like to know what sort of tax liability they may be facing in the future. The issue is perhaps best summarized by famed investor Warren Buffet who said "In the public sector, you know, it's a disaster. ... If I were relocating into some state that had a huge unfunded pension plan, I'm walking into liabilities . . . Those are big numbers, really big numbers. ... And when you see what (the state may) have to do — I say to myself, 'Why do I want to build a plant there that has to sit there for 30 or 40 years?'"

"The opinions in this piece are exclusively those of the author and not those of the Federal Reserve System or the Federal Reserve Bank of Chicago "