2/10/2017 [06-Feb-2017] For Illinois, Having A Plan Beats No Plan

RatingsDirect
ForIllinois,HavingAPlanBeatsNoPlan
06Feb2017

AbipartisanpackageofproposedbudgetlegislationrecentlyunveiledintheIllinoisStateSenatecouldmarka
breakthroughinthestate'snearlytwoyearlongbudgetimpasse.Thelegislation,whichincludesappropriationsforthe
remainderoffiscal2017andincreasedtaxrates,offersthepotentialforthesemblance,atleast,ofashifttowardfiscal
stabilization.Whetherthelegislativepackage,referredtoasthe"grandbargain"wouldrepresentthebeginningofa
genuinefiscalrecoveryremainstobeseen.Importantelementsoftheagreement,suchasprovisionsreformingthe
state'spensions,wouldlikelybesubjecttolegalchallenge.

Nevertheless,S&PGlobalRatingsbelievesthatlegislationprovidingadditionalrevenueandenhancedfundingcertainty
couldimprovethestate'sneartermfiscaloutlookrelativetoitstrajectoryotherwise.Wetakenopositionontheparticular
elementsofthegrandbargainlegislation.However,iflawmakersweretobeginassertinggoverningcontroloverstate
finances,thatcouldhelpalleviatesomeofthepressurecurrentlybearingdownonIllinois'creditquality(GOrating
BBB/Negative).

Overview

Abipartisanpackageofproposedlegislationcallingformorerevenueandpolicychangescouldmarka
breakthroughinIllinois'nearlytwoyearbudgetimpasse
Illinoisfacesagrowingstructuraldeficitandalargeaccumulationofunpaidbudgetliabilities
PopulationlosseslikelylinkedtothefiscalmorassaretothedetrimentofIllinois'economicoutlook
Evenifthepackagewereapproved,fiscalrecoveryislikelyyearsawayand
Anoprogressscenarioleavesthestate'screditqualitysubjecttointensifyingdownwardpressure.

KeyProvisionsOfSenateGrandBargain
Thepackageoflegislationcomprising13separatebillswaswrittensothatnoneofthemwillgointoeffectunlessallof
thempassandaresignedintolawbythegovernor.Membersofthestatesenateestimatethattherevenuecomponents
ofthelegislationwouldgenerate$6.5billioninrevenueannually.

Amongthekeyprovisionsofthegrandbargainlegislativepackageare:

Increasepersonalincometaxrateto4.99%from3.75%
Increasecorporatetaxrateto7%from5.25%
Businesspayrolltax
Partialexpansionofsalestaxtoincludecertainservices
Borrowingauthorityofupto$7billiontopaythestate'sbacklogofunpaidbills
Streamlinedprocessforlocalgovernmentdissolutionorconsolidation
PensioncontributionfundingparityforChicagoPublicSchools
Budgetappropriationsforremainderoffiscal2017toincludehighereducationandsocialserviceproviders
Authorizationforadditionalcasinogambling
Stategovernmentprocurementchanges
Changestostateworkers'compensationrules

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2/10/2017 [06-Feb-2017] For Illinois, Having A Plan Beats No Plan
Twoyearlocalgovernmentpropertytaxfreezeunlessvotersapproveanincrease(exemptingChicagoPublic
Schools)and
Pensionreformgivingstateemployeesoptiontoreducebenefitcostoflivingadjustmentsinexchangeforfuture
salaryincreasescountingtowardbenefitsformula.

UnmanagedSpendingHasLedToFiscalDeterioration
Inthecontextofagrowingnationaleconomy,Illinois'fiscalcrisisis,inourview,amanmadebyproductofpolicy
ultimatumsplaceduponthestate'sbudgetprocess.Asweseeit,thegovernorinterpretedhiselectionin2014asa
mandatetopursuevariousinstitutionalchangesthatthelegislaturehassteadfastlyopposed.Thefiscalimplicationsof
theimpendingstandoffoverpolicydifferencesweremagnifiedbytheexpirationonDec.31,2014,oftemporary
corporateandpersonalincometaxincreases.Althoughthestatewasabletoendfiscal2015claimingabalanced
budget,weestimatethatitreliedonover$2.0billioninnonrecurringmeasures,constitutingstructuralimbalance,inour
view.Inadditionto$1.3billioninonetimefundsweepsand$454millionininterfundborrowing,thestatereliedon$600
millioninprepaidMedicaidexpendituresfromfiscal2014andreducedspendingfromitsgeneralfundsby$400million,
someofwhichwasnonrecurring.Also,thestatecomptrollerreportedthatlapseperiodexpendituresof$3.5billion
(expendituresreportedtothecomptrollerafterthefiscalyearend)exceededthestate'savailablebalanceof$621million
infiscal2015.Conditionsworsenedduringfiscal2016asthebudgetitselfwentfrombeingasourceofnegotiating
leveragebetweenthegovernorandlegislaturetocollateraldamagewhentalksstalemated.Althoughthestatenever
enactedacompletebudgetforfiscal2016,weestimatethatitoperatedwithageneralfunddeficitofapproximately$4
billion,or11%ofexpenditures.Lapseperiodexpenditures($3.8billion)reportedtothecomptrollerexceededthe
availablebalance($246million)byanevenwidermargininfiscal2016,contributingtothestate's$7.6billioninunpaid
billsasofJuly2016.

Despitethelackofabudget,significantamountsofstatespendinghavecontinuedtoflow,authorizedbypartialstopgap
budgetlegislation,consentdecreesorcourtorders,andcontinuingappropriations.Crucially,debtserviceisamongthe
state'scontinuingappropriations,afeaturethathastodatehelpedpreservethestate'sstatusasaninvestmentgrade
credit.Otherconsequencesofthestate'sunmanagedspendingarelessfavorable,however.Inourview,ithas
simultaneouslyreducedthesenseofurgencyamonglawmakersforfindingasolutionandfacilitatedtheaccumulationof
thenowroughly$11billioninunpaidbills.Thesenateplanwouldauthorizethestatetoissueupto$7billioninbondsto
paydownthebillbacklog.Thisprovisionallowsthestatetoeffectivelyfinanceoperatingexpenseswithdebt,whichis
notabestpracticefromacreditperspective.ButinIllinois'case,it'slikelythestatecouldrealizefiscalsavingsby
issuingbondstopaydownthebacklog.That'sbecausemuchoftheunpaidbillsbalanceaccruesinterestatelevated
ratesof9%to12%peryear.

Chart1

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2/10/2017 [06-Feb-2017] For Illinois, Having A Plan Beats No Plan

Unlikethespendingthathascontinueddespitetheabsenceofabudget,appropriationsforIllinois'highereducation
institutionsandvarioussocialserviceagenciesandthosethatrelyonthemarenotsimilarlyinsulatedfromthe
impasse.Forcertainvulnerablepopulations,includingthosewithmentalhealthneedsorchronicillnessesforinstance,
Illinoishasalreadyenteredservicelevelinsolvency.Fundinguncertaintyforthestate'shighereducationsystemandits
monetaryawardprogramforfinanciallyneedystudentsappearstohaveweakenedenrollmentsatseveralofthestate's
regionaluniversities.WebelieveIllinois'distressedfiscalconditionanddysfunctionalbudgetpoliticsnowthreatento
erodethestate'slongtermeconomicgrowthprospects.

OutmigrationAsResidentsVoteWithTheirFeet
Illinoishassufferedpopulationdeclinesinrecentyears.Whereasthestatesawpopulationgrowth,albeitatdeclining
rates,from(atleast)1991through2013,itbeganlosingpopulationin2014.Ominously,thedownwardpopulationtrend
acceleratedfrom2014through2016,exacerbatedbyoutmigrationtootherstates.AccordingtorecentCensusBureau
data,Illinoissaw0.89%ofitspopulationmigratetootherstatesin2016(yearoveryearthroughJuly),alarger
proportionateoutflowthanallbutoneotherstate(NewYork).Rankedaccordingtooverallpopulationchangefrom2014
through2016,Illinois'0.5%declinewasalsosecondtolast(WestVirginiawas50th).Previously,wehavenotedthat
givenlowratesofproductivitygainsacrosstheU.S.economy,thereisacorrelationbetweenstateswithflatordeclining
populationsandrelativelyslowereconomicgrowth.Inourview,Illinois'ongoingfiscalcrisislikelyunderminesits
attractivenesstobusinessesandresidents.Fromaglobalperspective,wehaveviewedtheabilityintheU.S.of
residentstomigrateeasilyfromstatetostateasprovidinganimplicitcheckongrossmismanagement.Therecent
outmigrationpatternseenintheCensusBureaudatasuggeststhisphenomenonmayhavebeguntoassertitselfin
Illinoistothedetrimentofthestate'seconomicoutlook.

Chart2

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2/10/2017 [06-Feb-2017] For Illinois, Having A Plan Beats No Plan

TheNeedForProgressOnAFiscalPlanIsUrgentForStateCreditQuality
Illinoisretainsseveralkeyadvantages.Notwithstandingtherecentoutmigrationissue,thestateboastsadiverse
economydominatedbytheChicagometroarea.NotonlyisChicagothefinancialservicesandinsurancesectorcenter
fortheMidwest,italsoleadstheregioninthetransportation,distribution,healthcare,andeducationsectors.Percapita
incomesexceedthenationat104%(2015)andthestate'sincometaxrateisrelativelylowat3.75%,implyingthereis
capacitytosupporthighertaxes.Comparedwithotherlargepopulationstates,Illinois'taxrevenuebasealsoexhibits
relativelybetterstabilitythrougheconomiccycles.Inour2016stressscenarioanalysisofstatebudgets,weestimated
thatarecessionofmoderateseveritywouldresultina5.5%revenueshortfallrelativetothegovernor'sfiscal2017
revenueforecast.ApplyingthesamesetofhypotheticalstressconditionstoCalifornia,NewJersey,andConnecticut,we
estimatedrevenueshortfallsof12.3%,9.3%,and7.9%,respectively.

Chart3

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2/10/2017 [06-Feb-2017] For Illinois, Having A Plan Beats No Plan

AnybenefitstheseinnateadvantagesaffordIllinoisarelostinthestormofitsfiscalcrisis,however.Thebudgetsituation
hasalsoprecludedlawmakersfromtakingstepstostemthegrowthofits$138.4billionnetpensionliability(GASB68)
and$34billionunfundedliabilityforotherpostemploymentbenefits(OPEB).At35.6%,thestate'spensionfundedratio
ranksamongtheworstinthenation.Theseliabilitiescombinedwiththestate'sseverefiscalimbalanceanddepleted
budgetaryreservesleaveitillpreparedtoaccommodateaweakeningofeconomicconditions.

It'snotourforecast,buthistorysuggeststhatwiththecurrentexpansionapproachingitseighthanniversary,thepotential
foradownturnwithinthenexttwoyearsisreasonablyplausible.Thestate'sthreemainrevenuesources(personal
income,corporate,andsalestaxes)arerunning4.5%belowforecastthroughthefirstsixmonthsoffiscalyear2017,
accordingtotheCommissiononGovernmentForecastingandAccountability.TheCGFA'schiefeconomisthas
furthermoredrawnparallelsbetweenthestate'srevenuepatternsthisyearandthoseofpriorrecessionaryperiods.This
istosaynothingoftherisksposedtothestatebythepotentialforreducedfederalaid.Inparticular,wehavenotedthat
statescouldfacedifficultpolicychoiceswithmajorfiscalimplicationsifMedicaidfundingwasblockgrantedorif,aspart
ofeffortstorepealtheAffordableCareAct,enhancedfederalsubsidiesrelatedtoMedicaidexpansionwererescinded.

Thefateofthesenatebudgetlegislationplanisunclear.Politicalpressureisratchetingup,withthestate'sattorney
generalseekingcourtauthoritytoblockstategovernmentpayabsentabudget.Inaddition,thelaborunionrepresenting
stategovernmentworkershasalsothreatenedtostrikeoveracontractdisputewiththegovernor.Butwiththe
emergenceofthegrandbargainlegislationproposal,afailurebylawmakerstoreachabudgetaccordinthecoming
weekscouldrepresentasignificantmissedopportunityforIllinois.Conversely,passageofthelegislationcouldmarkthe
firststepinthedirectionoffiscalrepairaprocessthatwebelievecouldrequireyearsofsustainedbudgetarydiscipline.
TheFiscalFuturesProjectattheUniversityofIllinoishasestimatedthatitwouldrequireadecadeofuninterrupted
economicgrowth,highertaxes,and2%annualreductionsindiscretionaryspendingtobringaboutfiscalalignment(see
"Firstyoustopdigging:ProjectionsofIllinois'fiscalimbalanceandpathstoremedyit,"Nov.30,2016).Therefore,while
thepotentialforanimprovedcreditratingcurrentlyremainsbeyondouroutlookhorizon,continuedinactionsubjects
Illinoistointensifyingpressurerelatedtoitsunresolvedfiscalimbalancethatcouldpushitsratinglower.

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2/10/2017 [06-Feb-2017] For Illinois, Having A Plan Beats No Plan
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