When a Tax Hike Is Good News

Illinois politicians are finally showing some backbone. The economy depends on whether others do the same.

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If you live in Illinois, you got some jarring news recently: Income taxes are going up by 66 percent.

Politicians usually want to cut taxes and put more money in voters' pockets, not raise taxes and make their constituents' lives harder. So something must be dreadfully wrong to force such a draconian hardship on earnest citizens.

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Something is, in fact, wrong in Illinois, which arguably has the most dysfunctional finances of any state in the country. And it's a bad time for any tax increase, given that the economy is still weak and many families are still struggling to get by. But the ability of politicians to make a tough decision like raising taxes, no matter how unpopular, is a perverse kind of good news that suggests a bigger economic disaster may not happen.

One economic bomb that hasn't gone off—yet—is a municipal-bond crisis that could plunge state and local governments into chaos. Most Americans pay no attention to the municipal bonds that help finance roads, bridges, schools, sewage plants, hospitals, public-housing developments, and other civic projects. Ordinarily, the $2.7 trillion muni-bond market is a stable, predictable part of the financial system that produces little drama. But like many companies and consumers, state and local governments borrowed too much money prior to the recession, and made overoptimistic assumptions about the revenue flows needed to pay off that debt. Unemployment, depressed economic activity, and the plunge in property values has since decimated tax revenues, leaving many governments hamstrung with debt they can barely afford.

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If governments were to default on their debt at rates similar to consumer or even corporate borrowers, it could trigger a brand new financial panic. Municipal bonds are a major asset class, and if investors anticipating trouble started a wave of selloffs, it could quickly destabilize other parts of the financial system. That's more or less what happened in Greece and Ireland last year, forcing each country to adopt severe austerity measures almost certain to curtail growth and lower living standards. Vallejo, Calif., declared bankruptcy in 2008, and a few other U.S. cities, like Harrisburg, Pa., and Central Falls, R.I., have come close, raising fears of a domino effect.

Famed investor Warren Buffett has warned that "a municipal bond disaster is coming" and that another huge bailout by the federal government might be necessary. Except it's not clear if Washington could afford it. Wall Street analyst Meredith Whitney, one of the few to foresee the 2008 banking crisis, has said on 60 Minutes and elsewhere that local governments will default on "hundreds of billions" of dollars of debt as aid from the states and from Washington dries up. Others, including Federal Reserve Chairman Ben Bernanke, think that's an exaggeration, yet the disagreement has provided a nifty controversy for CNBC and other news outlets, making government finance another worry for consumers struggling to regain confidence.

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There's general agreement that state and local finances are in tough shape. The key variable is whether political leaders have the guts to do anything about it. Whitney seems to be banking on the ineptitude of political leaders who won't solve fiscal problems when they have the chance. But the Illinois tax hike tells a different story. Illinois faces a $15 billion budget shortfall this year, and the tax increase, which also raises corporate rates, will cover nearly $7 billion of that. The state has also cut spending on schools, prisons, healthcare, and many other services, with more cuts likely. It would have been far better, of course, if state leaders had shown spending restraint in the first place, like neighboring Indiana, which has sound finances. But they didn't, and today's taxpayers are now paying the price.

Painful as it is, that's better than putting off a solution even longer. Plus, the price is not quite as high as it might sound. Illinois's personal income tax will rise from 3 percent, which was on the low side, to 5 percent, which is still lower than rates in many other states. About 30 states impose tax rates of 5 percent or higher on middle-income earners, according to data from the Tax Foundation. In New York, the tax rate for a worker earning $50,000 is 6.85 percent. In California it's 9.55 percent. That same worker in Illinois will pay an additional $1,000 in taxes under the new rates, before deductions. That's a burden, at an inopportune time. But if Illinois were to declare bankruptcy, taxes would have to go a lot higher, with draconian cuts in services.

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The ability of state and local governments to raise taxes—no matter how odious it might be to the citizens who pay them—is a vital power that keeps states solvent and police and fire departments staffed. Analysis by ratings agency Moody's shows that municipal-bond defaults are extremely rare, largely because governments have the power to raise taxes if necessary to pay back their lenders. "Even poor states are relatively wealthy," says Moody's analyst Robert Kurtter. "They still have a tax base. They're not Lehman Brothers or Bear Stearns. These are governments that are going to exist in perpetuity." The power to tax gives investors confidence—even in a grueling recession—which in turn keeps borrowing rates low. Citizens benefit by getting basic services and infrastructure, along with parks and plazas that help improve their quality of life.

The Illinois tax hike, paradoxically, may even benefit state residents in the long run. Fitch Ratings, for instance, has indicated that the tax increase might trigger an upgrade in its rating of Illinois's debt, which along with California is currently the lowest among the states. A higher credit rating usually means lower borrowing costs, which Illinois's esteemed leaders, in theory, could pass along to taxpayers in the form of enhanced services or lower taxes in the future. (Though given the mismanagement that created Illinois's problems, voter skepticism is justified.)

Illinois still has big financial problems, and many other states face similar woes. Taxpayers are already feeling the pain, and it could intensify. Over the last two years, states have added about $40 billion in new taxes and fees, while cutting spending by about $54 billion. That's still not enough. The federal stimulus bill from 2009 sent nearly $200 billion to the states, to help cover funding shortfalls. That aid is now winding down, and the economy hasn't recovered enough yet to replace all the lost revenue. Many states still need to cut services and workers, reduce pension benefits for public employees, and impose new taxes on residents.

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The federal government, of course, faces the same challenges, only on a much larger scale. So once many Americans have absorbed increases in taxes paid to their state, they could get hit with new federal taxes that will probably be necessary to reduce Washington's huge annual deficits. If there's any consolation, it's simply this: A government funding crisis would be far, far worse.

Twitter: @rickjnewman