CRE Still Faces The Specter Of Higher Taxes After Failure Of Pritzker's Fair Tax Amendment Plan

Illinois faces a higher unfunded pension debt than any other state in the nation, and the failure of Gov. J.B. Pritzker’s Fair Tax Amendment ensures even a partial solution is off the table. The governor’s proposal, shot down by voters on Nov. 3, would have amended the state constitution to allow a graduated income tax, replacing the present flat tax.

It’s a key issue for anyone in commercial real estate. The growing size of the unfunded pension obligations, which now stand at $139B, corrodes the state’s ability to fund public education and puts pressure on local governments to kick in more for schools, according to CoStar Group Director of Market Analytics Brandon Svec.

“Ultimately, local governments will be forced to hike property or other taxes, and a lot of times that means commercial property owners will face higher costs,” he said.

High property taxes are a hot-button issue across the state, with many commercial owners already crying foul that current tax rates hamper new investment and development. But cutting pension payments is both politically toxic and unconstitutional, leaving Pritzker with an array of bad options, ranging from boosting the flat tax, painful spending cuts and layoffs, more federal borrowing or some combination of them all to solve the state’s budget shortfall.

But even those drastic steps won’t solve Illinois’ fiscal woes. At best, they would simply close the state’s budget gap, which stood at $3.9B for the current fiscal year, according to a November report from the Governor’s Office of Management and Budget. Annual total pension costs are projected to increase from $9.9B in 2020 to $11.8B in 2025. 

As of Dec. 3, the state also had a backlog of $6.9B in unpaid bills, which piled up after Illinois went two years without a budget as Pritzker’s Republican predecessor, Gov. Bruce Rauner, battled the Democratic-controlled Legislature.     

The unfunded pension and health care obligations remain additional hovering threats to the state’s business climate. Although the Chicago region possesses many qualities that experts say continue to attract business, some worry those mountains of debt and the need to eventually put the state on the path to fiscal stability could eventually choke off sources of new capital.

Finding the right path is going to be almost impossible, according to Svec.

“When I used to give presentations on the state budget situation, I’d joke that we should make sure to lock the windows on our 51st-floor office because by the end someone might want to jump out the window,” he said.

Even though Pritzker’s original proposal to amend the constitution was far-reaching, it was insufficient, Svec added. The governor estimated in 2019 a graduated income tax would generate about $3.4B in new annual revenue, but after the coronavirus crushed the economy, that estimate shrank to $1.2B.

“It was not going to do nearly enough to make a sizable dent,” Svec said.

But Illinois is one of the few states with a flat tax, which takes a 4.95% bite out of every paycheck, and Pritzker contends that’s an unfair burden on low-income residents.

“For at least the last 50 years, the burden of shoring up our state finances has fallen hardest on the 97% of Illinoisans who make $250K a year or less,” the governor said during his February budget address. “You’ve been paying a higher portion of your income when you include income taxes, property taxes and sales taxes, than those who make $1M a year or more. That’s not fair, and I’ve made it very clear that I believe it’s time for a change.”

The governor and state legislators proposed raising the tax on $1M of income to 7.99%, while incomes of $100K or less would have remained at the 4.95% rate or slightly lower.

Illinois residents were flooded this fall with automated phone calls, television ads and mailers both supporting and opposing Pritzker’s top policy goal. The governor’s fellow billionaire Ken Griffin, CEO of the hedge fund Citadel, was the top funder of the campaign against the proposed change, kicking in nearly $50M. Pritzker ponied up more than $56M of his own money to support the Fair Tax Amendment, which failed with 55% of voters opposed.  

Svec said a 2017 tax hike, which raised the flat tax from 3.75% to 4.95%, soured many voters on an additional increase.

“Obviously I’m disappointed,” Illinois Senate President Don Harmon told Bisnow in a written statement. “Illinois had a chance to take a step toward financial stability and property tax relief and didn’t take it. But the voters have spoken and we will move forward. That’s the way democracy works. I will work with the governor and my colleagues to figure out our next moves.”

Commercial real estate leaders typically opposed Pritzker, but some told Bisnow they don’t share Griffin’s hard line on higher taxes. They’re willing to pay more, as long as any such shift is paired with pension reform.

“Would I support a graduated income tax? Sure, but to not pair it with a constitutional amendment that would get us pension reform feels a little negligent,” Glenstar Managing Principal Michael Klein said. “Either the governor continues to kick the can down the road or he puts a proposal forward that ties both things together, and then he has a shot at getting it approved.”

“It’s a big problem to have these things hanging over us, and with no plan to deal with it,” he added. “Institutional investors are already staying away from Chicago because of the debt issue.”

A CoStar analysis completed just before the pandemic upended the market showed Class-A office landlords in the Central Business District paid $8.81 per SF in taxes, or roughly 25% of the average rental rate of $35.17 per SF. That was twice the national average, roughly 40% above Minneapolis, the second-most-burdened CBD studied by CoStar.

RSM Real Estate senior analyst Laura Dietzel agreed the state’s budget troubles are a concern, but she isn’t ready to hit the panic button from a business or real estate perspective. Although some cities may be experiencing an exodus to the Sun Belt, most Chicago businesses will want to stay even if Illinois’ finances remain unsettled.

“There are other considerations,” she said. “People aren’t leaving en masse, so Chicago still has a pipeline of high-quality, highly educated workers, and corporations follow that talent pool.”

That could change if taxes escalate and those highly educated people start seeking out cheaper housing, but with COVID-19 disrupting so many real estate sectors, it will take time to tease out cause and effect.

“It’s a little bit too soon to tell right now,” Dietzel said.     

Finding a way out of this morass of budget deficits, unfunded pension liabilities and high taxes won’t be easy, Svec said.

“If [Sen. Mitch] McConnell keeps control of the Senate, federal help seems unlikely, and quite frankly, looking at the ability of the state of Illinois over the next 10 years, there is no solution that I can identify only using revenue increases," he said. "We’re going to have to do something on the expense side.”  

Moody’s Investors Services already assigns Illinois its lowest investment-grade rating. According to a report it issued the day after voters ditched the graduated income tax amendment, the state would need to impose a nearly 11% across-the-board reduction to free up about $3B.

“This degree of austerity would have significant implications for delivery of core education, healthcare, corrections and other services,” Moody’s reported.  

Illinois has the ability to borrow up to $5B from the U.S. Federal Reserve under its program, which expires on Dec. 31, to aid states hit hard by the coronavirus pandemic. Pritzker said last week that level of new borrowing would add too much debt, but Illinois would borrow $2B to help fill this year’s budget deficit, according to the Chicago Tribune. Budget cuts will have to make up the rest.

“There will be cuts, and they will be painful,” Pritzker said at a Nov. 4 press conference.

Even if the state takes the medicine needed to get through the next fiscal year, unfunded pension liabilities will keep ticking up, Svec points out. It is going to take a separate constitutional amendment before the state can cut into that growing pile. But that’s not a step anyone should take lightly.

“We can’t act like that’s an easy lever to pull, because these pensions represent someone’s livelihood,” Svec said. “These aren’t just numbers. There are real people involved, people who have worked for their entire careers as public servants for the state of Illinois.”

He said limiting the impact on current retirees would perhaps make it more palatable to legislators, but even that isn’t certain.    

“You would still be picking and choosing who to take money from," Svec said. "But if you don’t do that, there is no way to tax your way out of this situation.”