The Depth of Illinois Debt Problem and its Potential Consequences
Dr. Kenneth A. Kriz, Director, Institute for Illinois Public Finance
Dr. Arwi S. Kriz, Research Fellow, Institute for Illinois Public Finance
Most Illinoisans know that the state is in debt, and many understand that it has a large debt. However, few understand just how large the debt is and the potential consequences for the state. At the Institute for Illinois Public Finance, we have been developing measures of states' debt burden over the last year for a research project on the effects of fiscal imbalances like debt on economic growth. While our larger research project will focus on all states and local governments, the data that we have collected should be interesting to all Illinoisans.
One of the issues with analyzing debt burdens is how to measure them properly. Many studies use what is termed "bonded debt," in other words, debt formally issued by the state and sold to the bond market. But this only captures a fraction of payments that the state will have to make to outside parties in upcoming years. A significant debt source for Illinois is debt incurred by its public pension systems, called unfunded liabilities. This debt is owed to current and past employees for retirement benefits that have already been promised but for which monies are not currently available. For example, at the end of fiscal year 2019 (FY 19), the state only had $30 billion in bonded debt. However, the state also owed $138 billion in future pension payments above the amount currently set aside in pension plans. Pension debt and other amounts owed that will not be realized until sometime in the future are called "contingent liabilities." A further wrinkle in measuring governments' debt position is that they have other assets that can be used to make future payments on both bonded debt and contingent liabilities. Therefore, we use a measure of the financial position of governments called the Unrestricted Net Position. It takes the difference between the assets a government owns and the liabilities it owes. Another advantage of using this measure is that all states calculate it according to Generally Accepted Accounting Principles, which means it is closest to an "apples to apples" comparison.
The graph below shows the distribution of state's Unrestricted Net Position as a percentage of state Gross Domestic Product, a measure of a state's economic output. Standardizing the data by dividing by something like GDP is essential because large states with greater economic capacity may carry more debt. As the graph shows, Illinois has the second-worst net position as a GDP percentage, with only New Jersey having more debt. Most states (35) have unrestricted net positions of between -6% (indicating net debt of 6% of GDP) and +2% (indicating net savings). Thus, Illinois is exceptionally abnormal in terms of its level of indebtedness. Besides New Jersey, only Kentucky and Connecticut have debt levels close to our state.
As for how the state got so far into debt, there are multiple reasons. But the states who are the outliers in the graph does present an explanation for much of the debt. All states with the worst debt positions have severely underfunded pensions. Pensions are a long-run financial time bomb. Once states get into a poorly funded position, it is very difficult to return to financial viability without fundamental reforms. The thing that differs between the states is that Illinois has seemed unwilling to address fundamental pension reform (or has tried it unsuccessfully), while the other states have enacted reforms in the past decade and are addressing their unfunded liabilities.
Whatever the reason, the state has experienced a long-term deterioration in its financial position. The graph below shows Illinois' experience compared to other groupings of states in the past two decades. The measure is the Change in Unrestricted Net Position, so in essence, this tracks the history of states leading up to their position in the earlier graph. The three lines in the graph capture the experience of Illinois (green line) compared to the average change in all states (blue) and the ten largest states by population (red). A positive value means that a state or group is running a net surplus for the year, while a negative value implies a state runs a deficit.
While there is evident variation in each of the lines over the 16 years, it is clear that except for one year at the start of the Great Recession, Illinois' financial outcome lags behind the averages. And in only one year (2006), the state ran a surplus (and only barely). This dismal record of financial prudence can be seen to directly leading to a barely tenable debt position. Contrary to popular opinion, the financial difficulties of the state did not start with a particular administration. They have been building for decades. The Illinois debt problem has become so deep as to seem unapproachable.
But what of the consequences of carrying so much debt? The state has the lowest credit rating of any state, barely above "junk" status. But the state can still borrow money, so we are not cut off from credit markets. There are at least two effects of carrying a high debt burden, one currently being realized and one potential. The current problem is that the state has to pay greater interest on its borrowing, even compared to states in similar financial positions. This effect became especially pronounced during the early part of the COVID-19 crisis. The graph below shows indices of yields on municipal bonds issued in 4 states (Illinois - blue, Connecticut - red, Kentucky - green, and New Jersey - purple). In the period leading up to the pandemic, Illinois borrowed at higher rates compared to the other states, but the "spread" between them was relatively small. But as the crisis hit, yields on Illinois bonds rose faster and to a higher level than the other states. Illinois was penalized for its financial position leading up to the crisis. While the spread has narrowed since the crisis, it is still much higher than pre-crisis periods. Our state's fiscal condition means that all state and local governments pay more to borrow.
The second effect is speculative. At some point, the major credit rating agencies may downgrade the state into junk rating territory. At that point, it is uncertain how big the effects may be in terms of higher borrowing costs or even inability to access credit markets. No state has ever been rated below investment grade. Interest rates would rise in that case, and in the extreme, the credit markets may not be willing to lend to the state. This situation would be very detrimental to the state's ability to finance its services. While we are not suggesting that this would happen, it is a possibility. Bankruptcy is not an option for the state, as it is technically a "sovereign" government, and federal bankruptcy provisions do not apply to sovereigns. Another possibility is that some type of financial control authority might be mandated by the federal government (which provides significant revenue to the state). The federal government pursued this option in the case of Puerto Rico. Having outside entities supervising governmental finances and activities would be a strong blow to state pride and the ability to attract and retain businesses. This scenario's big question is if and when credit markets will "pull the plug" on Illinois borrowing.
What is the solution to this mess? At this point, raising taxes appears to be politically infeasible. Cutting expenditures to balance the budget in a true sense does appear to be the sole option. But the level of cuts needed is drastic. The state's outside auditor has opined that the state is running a $5.7 billion structural deficit by relying on tricks such as warrants and lapse period transfers to delay payments (Mendoza, 2020). Other estimates have been in a similar range. That represents over 10% of General Funds expenditures. Cutting this much out of the state budget would require real pain and reduction in services. So once again, the state faces a question. Does it want to take the pain now or roll the dice that the financial markets will continue to support the structural fiscal imbalance? We cannot answer that but are researching the effects of these imbalances on economic growth. In future posts, we will recap our research into this question.
References
Mendoza, Susana A. 2020. Traditional Budgetary Financial Report, Illinois, Fiscal Year 2020. Springfield, IL: Illinois State Comptroller.
