Fiscal Sustainability AND Retirement Security: A Reform Proposal for the Illinois State Universities Retirement System (SURS)

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Feb 9, 2012

I have released a paper today that proposes a new plan for the State Universities Retirement System.  Co-authored with Robert Rich, the Director of IGPA, the paper proposes a hybrid system that would be partially funded by both workers and universities. It contains several components that reflect some of the ideas that have been publicly discussed by state leaders in recent weeks.

 The proposal has four basic components: 

1) Create a new hybrid retirement system for new employees that would combine a scaled-down version of the existing SURS defined benefit plan with a new defined contribution plan that would include contributions from both employee and employer; 

2) Peg the SURS “Effective Rate of Interest” to market rates; 

3) Redistribute the SURS funding burden to include a modest increase in employee contributions and new direct contributions from universities, thereby reducing state government’s burden on state government; and

4) Align pension vesting rules with the private sector, which would decrease the years new employees hired after January 1, 2011 would need to work for their pension benefit to be vested.

The plan is intended to substantially reduce state expenditures on public pensions, while still providing a reasonable source of secure retirement income to university employees. 

Click here to read the full paper.

Social Security Funding

Filed Under (Finance, U.S. Fiscal Policy) by Don Fullerton on Dec 30, 2011

Here is an interesting article, in the Washington Post, entitled “Payroll tax cut raises worries about Social Security’s future funding“.  It points out that the recent payroll tax cuts are intended for short term stimulus, but they muck with the way that social security benefits are funded.  Instead of coming frm payroll taxes, that money now will haveto come from general revenue. 

As it points out: “For the first time in the program’s history, tens of billions of dollars from the government’s general pool of revenue are being funneled to the Social Security trust fund to make up for the revenue lost to the tax cut. Roughly $110 billion will be automatically shifted from the Treasury to the trust fund to cover this year’s cut, according to the Social Security Board of Trustees. An additional $19 billion, it is estimated, will be necessary to pay for the two-month extension.” 

As it goes on to say, “The payroll tax cut changes that. Instead being a protected program with its own stream of funding, Social Security, by taking money from general revenue, becomes more akin to other government initiatives such as Pentagon spending or clean-air regulation — programs that rely on income taxes and political jockeying for support.”

The WSJ is “Wrong”: The U.S. is NOT a Net Exporter of Petroleum

Filed Under (Environmental Policy, Finance, Other Topics, U.S. Fiscal Policy) by Don Fullerton on Dec 2, 2011

Just a couple days ago, the Wall Street Journal reported that “U.S. exports of gasoline, diesel and other oil-based fuels are soaring, putting the nation on track to be a net exporter of petroleum products in 2011 for the first time in 62 years.”  Taken literally, this fact is strictly “correct”, but it is misleading.  It is therefore very poor reporting.  The authors either don’t understand the words they use, or they are deliberately trying to mislead readers.

The reason it is misleading is because the article implies the U.S. is headed toward “energy independence”, and that implication is wrong.  It goes on to say:  “As recently as 2005, the U.S. imported nearly 900 million barrels more of petroleum products than it exported.  Since then the deficit has been steadily shrinking until finally disappearing last fall, and analysts say the country will not lose its ‘net exporter’ tag anytime soon.”  That statement and several expert quotes in the article clearly imply the U.S. is headed toward “energy independence”.   

Strictly speaking, the WSJ is correct that the U.S. exports more “petroleum products” than it imports, … but “petroleum products” do not include crude oil!!  “Petroleum products” include only refined products like gasoline, diesel fuel, or jet fuel.  The implication is only that the U.S. has a large refinery capacity!

The U.S. is a huge net importer of crude oil, and a huge net importer of all “crude oil and petroleum products” taken together, as you can see from the chart  below (provided by the U.S. Energy Information Administration).   In other words, we import boatloads of crude oil, we refine it, and then we export slightly more refined petroleum products than we import of refined petroleum products.  Big deal.

If the WSJ reporters knew what they were talking about, or if they were not trying to mislead readers, then they should have just stated that the U.S. is a huge net importer of all “crude oil and petroleum products” taken together.  They didn’t.  That is why I conclude they do not understand the point, or that they are trying to misrepresent it. Neither conclusion is good for the Wall Street Journal.

They are simply wrong when they say:  “The reversal raises the prospect of the U.S. becoming a major provider of various types of energy to the rest of the world, a status that was once virtually unthinkable.”  Just look at the figure!

 

A Look at Herman Cain’s 999 Tax Plan

Filed Under (Finance, Other Topics, U.S. Fiscal Policy) by Don Fullerton on Oct 21, 2011

The point of this blog is to inject some substance into discussion of Presidential candidates. To see the problem, consider what I wrote on my facebook page: “In an airport for an hour yesterday, we could not avoid hearing CNN talk about the upcoming presidential debate. For the entire hour, we heard only comments like: Perry needs to come out swinging; or, ‘Is Cain a viable candidate?’; or, Bachmann has really fallen in the polls; or, ‘This now boils down to a two-man race’, followed immediately by the wisdom that ‘Yes, but we don’t know yet who the two men are.’  What inanity! It is JUST a horse race! Not a single comment during the entire hour had anything whatever to do with any substantial issue of policy. Is this all we get?”

There must be more to consider, in this important decision.  So, I started by looking at Herman Cain’s 999 tax reform plan.  See more at his website, with the key bullets in the insert below. 

Bear in mind that I’m a former Deputy Assistant Secretary of the U.S. Treasury (1985-87), so I worked hard on President Reagan’s successful “Tax Reform Act of 1986” to lower the rates and broaden the base.  Since 1986, however, Congress has managed to reintroduce plenty of new deductions and tax breaks, while raising the rate.  Maybe it’s time to do something again!

Cain’s proposal has a lot of similarities to the 1986 reform, if perhaps more extreme.  It is meant to be revenue neutral, raising the same total tax.  It would eliminate virtually ALL deductions, like mortgage interest paid, and it would cut rates drastically.  It would eliminate the income tax as we know it, and introduce a national sales tax (or value added tax).   What about the accuracy of Cain’s claims below?  By reducing rates drastically, this proposal probably WOULD reduce the distorting effects of taxation by reducing the interference of taxes in the productive activities of workers and business – what economists call “deadweight loss”.  For similar reasons, it probably would provide greater incentive for work and investment, and therefore probably provide some stimulus to growth.  That’s all for the good.

However, ANY tax reform plan of ANY politician EVER, no matter what motivation, will always have two effects to watch out for.  First, any tax reform will always raise taxes on some taxpayers and reduce taxes for others.  It will have distributional effects worth analyzing.  Second, it will therefore create disruptions and reallocations.  Activities to pay additional tax may shrink – laying off workers who may remain unemployed for some time until they can re-train and find work in other activities that now face lower tax rates and hope to expand.  That is, for only one example, the Cain plan might hurt homeowners and homeownership by eliminating the mortgage interest deduction.  With such pervasive changes, however, the disruptions will be widespread and costly in themselves.

Finally, for now, note the point about distributional effects.  Nothing in any of Cain’s bullets says anything whatever about distributional effects.   I’m afraid this point is the Achilles heel of Cain’s 999 plan.  According to the non-partisan Tax Policy Center, Cain’s plan will greatly reduce taxes of those with the highest incomes and raise total taxes on those with low incomes.  It is ‘regressive’.  And you don’t even need to read the TPC analysis to know this is true.  Cain’s plan cuts the top personal rate from 35% to 9%.  There is no amount of tax-base broadening for those high income taxpayers that can get back the same tax revenue from them.  And currently those with the least income pay no Federal tax at all.   Under Cain’s plan, everybody will pay the 9% sales tax, on everything they buy.  Moreover, if those low-income individuals are working, they will probably bear some additional burden of the 9% business tax that applies to all profits AND wages paid: it applies to all sales revenue minus purchases and capital investment, not subtracting wages paid to workers.

I’d personally favor another revenue-neutral reform like the TRA of 1986, one that lowers the rates and broadens the base.  Such a reform would undoubtedly cause some disruptions and adjustments costs.  And it would help some while hurting others.  But perhaps it could be designed in a way that also tries to be distributionally neutral, not adding tax burdens on those least fortunate while cutting taxes on those already doing well.

Performance Incentives for Higher Education: You Get What You Pay For

Filed Under (Other Topics) by Nolan Miller on Oct 12, 2011

The Daily Illini ran a story today about a change to the way public universities will be funded in the future.  This year’s higher education bill, HB 1503, contains provisions instructing the Illinois Board of Higher Education to come up with performance measures that will be used, in part, as a basis for funding public colleges and universities in the state.  Let me begin by saying that, in general, holding government bodies accountable for their performance is a good idea.  The people of the state have a right to know that their money is being well spent.  I encourage the adoption of performance measures in all areas of public expenditure.

Having said that, I encourage (e.g., warn) the Illinois Board of Higher Education to keep in mind that when you pay someone to do something, they’re going to do exactly that.  So, you need to be careful what wish for.  If you increase a school’s funding when they increase their graduation rate, you should expect them to increase their graduation rate, and in many cases they’ll adopt the lowest-cost approach to doing so.  Sure, they may increase advising and keep closer tabs on students as they work their way through their educational careers.  That would be great.  But, they might also be more lenient in counting credits toward graduation, lowering their standards, or they might be more reluctant to admit students who seem unlikely to graduate on time, decreasing access.  While increasing advising effort costs money, relaxing standards and not admitting students who are unlikely to graduate (assuming there is another student waiting to take his place) are relatively costless.  We should not be surprised if, in the face of increased incentive, public universities make use of the latter two tools to increase graduation rates, because we paid them to do it.

To be sure, legislators and the IBHE are aware of these possibilities.  In fact, the bill suggests that there should be both overall performance measures (e.g., graduation rates) as well as measures that look at how well the school serves at-risk students.  However, incentives are complicated, so-much-so that social scientists have a name for what happens when they go awry.  We call it the “Law of Unintended Consequences.”  Further, there is increasing evidence that when you create explicit, monetary incentives to do a thing, you crowd out intrinsic incentives.  So, while you may have student advisors who today go the extra mile to get a student through to graduation out of a sense of altruism or duty, once you put a price on performance, this sense of duty seems to take a back seat.  People start to say “if I go the extra mile to help this student, it isn’t going to affect our overall graduation rate, which is what the state really cares about, so why bother.”  In an environment where people generally do their jobs, and do them well, because it is the right thing to do, putting a price tag on things can significantly reduce their intrinsic motivation.

The next point of concern comes from the funding structure.  It is unclear whether the incentive payments will be “new” money in addition to that already allocated to public colleges and universities, or whether it will be a reallocation of current money.  Much ado is made regarding government funding from the idea that people can do more with less.  We often hear cries to reduce “waste, fraud and abuse.”  But we need to keep in mind that public colleges and universities in Illinois have just been through a years-long belt-tightening process.  The easy cuts have already been cut.  Trying to squeeze the incentive payments within current budgetary allocations encourages “robbing Peter to pay Paul,” pulling resources away from other functions in order to meet performance goals, and the tighter the budget gets the more schools will be tempted to increase their performance scores through the cheapest way possible (i.e., lowering standards) rather than through the “right” way (i.e., increasing learning).

Finally, in setting up the pool of money available for performance bonuses, the IBHE needs to be careful not to exacerbate competition between public schools.  If the bonus pool is fixed and awarded to schools based on how well they meet performance goals, this may increase incentives to compete with other public schools.  Perhaps they will increase marketing expenditures in order to attract better students.  However, if all public schools do this, in the end you might have a lot of money going to marketing firms that would otherwise go to student services, and students more-or-less ending up in the same places they would have gone before.  Or, schools may spend money on improving student services such as the quality of the gym and/or the dorms, which make students happy but do not contribute to educational attainment.  The stronger the incentives offered by the new system, the more temptation there will be to engage in expenditures of this sort.  If competitive incentives are strong enough, forcing public schools in Illinois to compete more intensively over students may actually leave less money available for education and reduce overall attainment.  More unintended consequences.

Let me finish by saying that I’m not necessarily against performance incentives. But, incentives are complicated things, and the unintended consequences of incentive payments are often as important, if not more so, than the intended ones.  Designing incentive schemes that induce the behavior you want without encouraging the behavior you don’t want is a very difficult task.  I hope the IBHE is up to it.

What is the meaning of a budget number?

Filed Under (Environmental Policy, Retirement Policy, U.S. Fiscal Policy) by Don Fullerton on Oct 7, 2011

With all the argument in Washington about how to balance the budget, a reminder is worthwhile that none of these numbers make any sense at all!  What “should” be the meaning of the government budget?  And, does any number provided by anybody actually have that meaning?

In general, a budget deficit is supposed to mean that one’s current consumption exceeds income, which would indicate a decrease in wealth.  Indeed, that’s the problem with a deficit – drawing down our wealth (which could even turn from positive to negative!).  The U.S. Federal budget numbers fail to provide such a meaning, for several reasons.

First, the Federal budget includes ALL spending, not just consumption.  Some of that spending is actually investment, such as new spending on buildings, bridges, roads, airplanes, and any long-lived military equipment.  The budget does not show the breakdown between what we really use up this year, and what spending is really investing in the future.

Second, Social Security is “off-budget”, unless you are looking at a unified budget.  Okay, I said that in a way that is intentionally confusing!  The basic problem here is that social security is SUPPOSED to run a surplus, so that we can set aside some funds from those now working to pay them when they are retired.  If it does not run a surplus to save for the retirement of the baby boom generation, then we’ll be in big trouble when the baby boom generation retires!  The current social security surplus is too small for that.  Then, however, the big problem is that the unified budget mixes the social security budget with the rest of federal spending.  So when you see a deficit in that account, it’s really worse than it looks, because it includes the small social security SURPLUS that’s already not a big enough surplus for social security to break even!

Third, the U.S. Federal Budget is confusing about what is a “Tax Expenditure” and what is government “Spending”.  A tax expenditure is really ‘spending via tax break’, as when a taxpayer gets a special credit or deduction for doing some particular activity.  The Congress could instead have accomplished the exact same thing by an ACTUAL spending program, providing subsidy to the same set of eligible individuals for doing the exact same activity.  So it really does not make much sense to say you want to cut spending and not raise taxes, because eliminating one of those tax breaks is really the same as eliminating an equivalent spending program.

Fourth, a Federal “mandate” might require a certain kind of spending by a firm.  To take a simple example, suppose some safety regulation requires construction firms to provide a hard hat to all workers.  That’s really equivalent to a tax on that firm, equal to the amount they have to spend on hard hats, where the revenue of that “tax” is spend by government on the provision of hard hats.  But then the problem is that mandates are so pervasive.  Some ‘true’ measure of the size of government would be HUGE, if we counted the dollar cost of all mandates as a “tax”, as if it were in the government budget.

Closing the Barn Door after the Horses Escape

Filed Under (Finance, Other Topics, U.S. Fiscal Policy) by Don Fullerton on Sep 2, 2011

The New York Times today says that the Federal Housing Finance Agency is set to sue major U.S. banks such as Bank of America, JPMorgan Chase, Goldman Sachs, and Deutsche Bank, among others.  The U.S. government argues that the banks sold packaged mortgages as securities to investors while ignoring evidence that the homeowners’ incomes were inflated or falsified.  That is, the banks failed to perform the due diligence required under securities law.  When many of those homeowners were unable to pay their mortgages, the securities backed by the mortgages tanked.  Housing and financial crises ensued.

Kinda late, isn’t it?  Well, certainly it’s too late this time, to prevent the housing and financial crises of the past few years.  What is the point of the suit, then?  Does the U.S. Federal government really need the money that they can get from these banks, as damages, and will they give it back to all of us who lost money during those years?  The U.S. might sue for around a billion dollars, which is peanuts these days.  Divided by 333 million Americans, that would be about three dollars each.  Why bother?

An important conceptual point here is the difference between ex post liability (after the fact) and ex ante incentives (beforehand).   The point of this suit is not to collect a billion dollars after the fact, although arguments are made about the fairness of those liable to pay for damages.  Rather, the point is to provide the proper incentives to private companies before the next time.  To a private company, a billion dollars really is a lot of money.  If they have to worry about the loss of a billion dollars, for ignoring their legal responsibilities, then maybe next time they’ll be more careful to follow the law.

Government regulation can take alternative forms.  One alternative is to send auditors and inspectors into every bank, every day, to check what they are doing.  That would be very expensive.  A cheaper alternative is to let the banks decide for themselves if they are exercising due diligence, but with the “threat” hanging over their head that they might get sued if they don’t.

Are U.S. Taxes Too High?

Filed Under (Environmental Policy, U.S. Fiscal Policy) by Don Fullerton on Aug 19, 2011

The last-minute deal between Congress and the President managed to save the day, just before the deadline, but it’s not a very specific plan.   Any coherent long term plan for serious deficit reduction will still have to include cuts to defense and cuts to entitlement programs like Social Security and Medicare.  But the Republicans did not want to cut defense, the Democrats did not want to cut Medicare, and they can’t cut the large portion of the Federal budget that goes to interest payments on existing debt.  So instead, in the short run, they load high percentage cuts onto the small percentage of the remaining Federal budget that could be called discretionary.  Thus it seems we will experience very large cuts to items like National Parks, environmental programs, highways, training, education, and social infrastructure.

If the American people really want a government that is extremely small, especially compared to other developed economies such as those in the OECD, then the deficit problem could conceivably be solved by spending cuts alone (as long as those cuts include defense and entitlements).  Certainly some Tea Party Republicans want a Federal budget that small.  But I suspect that some other Republicans only think they want a Federal budget that small and would change their minds once they see the decimation of so many Federal programs.

In 2009, before the current round of cuts, the United States ranked third-to-last among the 23 OECD countries for the percentage of GDP collected by government.  I’m sure we would not want to match the 48% collected by some Scandinavian countries, or even the 40% collected by other European countries.  Somewhere in the middle, Canada appears with 31% of GDP collected by government.  The United States stood at only 24%, which exceeds only Mexico and Chile.  With only spending cuts and no increase in taxes, the U.S. could soon have the smallest government among all 23 nations of the OECD.  The following graph is from the Toronto Globe and Mail.

 

What might this mean for our state? Illinois is quite unusual, having just raised the State income tax to cover some of the growing annual deficit.  Other states with new Republican governors have drastically cut spending instead of raising taxes.  These actions might nudge Illinois upward, in the ranking of states by the ratio of tax collections to total state income, but it may allow Illinois to meet more of its obligations (including unfunded pension liabilities).  If Illinois did not raise any taxes, it may have had to renege on some such promises.

Republicans would tell you that smaller government and a smaller tax bite is always better for job growth.  But it’s a matter of degree, and a matter of balance.  A state with the smallest possible budget would have very little spending on infrastructure, road quality, sanitation, police protection, education, training, and other social services.  Yet many of those programs are important for businesses to be able to function properly.  The trick is to find the right balance, with spending on the minimal decent level of such programs, as necessary for businesses and employees alike.

With no increase in Federal taxes, the recent deal on cuts in spending is likely to mean cuts in all kinds of Federal discretionary spending, including grants to the states.  The U.S. Congress will then be likely to enact more unfunded state mandates, which means requiring the states to spend their own money to provide basic services that the Federal government used to provide.  State governors and legislators will be unhappy about these changes, with even more pressure on state governments.

Green Taxes Part III: Potential Revenue for Illinois?

Filed Under (Environmental Policy, U.S. Fiscal Policy) by Don Fullerton on Jul 15, 2011

In my last two blogs, I wrote about ways to meet the Illinois state revenue needs, ways that might work better than the increase in the income tax.  This blog continues the list of possible “green taxes”.  In general, a green tax applies either directly on pollution emissions or on goods whose use causes pollution.  For raising a given amount of revenue, the basic argument for green taxes can be summarized by the adage: “tax waste, not work”.   That is, a tax on pollution might have good effects on the environment, because it discourages pollution.  In contrast, an income tax discourages earning income.

In early January 2011, the State of Illinois enacted legislation to raise the personal income tax rate from 3% to 5% and to increase the corporate income rate from 4.8% to 7%.  Along with a cap on spending growth, these tax increases reduce the state’s projected budget deficit in 2011 by $3.8 billion (from $10.9 to $7.1 billion).  The governor justified the tax increases on the grounds that the State’s “fiscal house was burning” (Chicago Tribune, January 12, 2011).  In my piece with Dan Karney for a recent IGPA Forum, we don’t debate what caused the fiscal crisis in Illinois, nor argue the merits of cutting spending versus raising revenue.  Instead, we just take it as given that politicians decided to raise revenue as part of the solution to the State’s deficit.  Then we analyze the use of a few green taxes as alternative ways to raise revenue.

While many green taxes are possible, we focus on four examples that have the potential to raise large amounts of revenue: carbon pricing, gasoline taxes, trucking tolls, and garbage fees.  Indeed, as we show, a reasonable set of tax rates on these four items can generate as much revenue as the income tax increase.  We apply each hypothetical green tax directly to historical quantities of emissions (or polluting products) in order to obtain an approximate level of potential revenue generation. 

In a short series of blogs, one per week, we now discuss each of the four green taxes and their potential for revenue generation.  In past weeks we covered Carbon Pricing and Gasoline Taxes.  This week we cover Trucking Toll and Garbage Fees.

Every day hundreds of thousands of vehicles crowd Illinois’s roads and highways.   Data from the Federal Highway Administration indicates that over 50,000 trucks (six tires and over) cross into Illinois from neighboring states along the interstate highway system.  While these trucks bring needed goods to Illinois, they also congest the roads, degrade the road surfaces, and fill the air with soot.  They also become involved in vehicle accidents that cost the lives of many in Illinois.  To compensate the state, Illinois can impose a toll for long-haul trucks using Illinois’s highways.  For example, a $5 per truck toll on 50,000 trucks daily would raise almost $100 million annually.  (In comparison, the existing Illinois toll road system generates approximately $600 million annually.)  The truck toll can be implemented using existing transponder technology deployed at weigh stations along the interstate highways.  (As an aside, we note, the constitutionality of state trucking tolls is not clear, because the federal government determines the rules of interstate commerce; however, major portions of the existing interstate highway system are subject to tolls, including the heavily travelled I-95 corridor in Delaware. )

Next, residents of Illinois generate approximately 19 million tons of garbage per year (or more than one ton per person per year), and 60 percent of that waste ends up in landfills.  Currently, large municipal waste landfill operators currently pay state fees that total $2.22 per ton of solid waste dumped.  But few municipalities in Illinois charge fees designed to discourage the creation of waste by residents (Don Fullerton and Sarah M. Miller, 2010, “Waste and Recycling in Illinois,” Illinois Report 2010, pp.70-80). 

However, empirical evidence shows that taxing garbage at the residential level does reduce garbage production (Don Fullerton and Thomas C. Kinnaman, 1996, “Household Responses to Pricing Garbage by the Bag,” American Economic Review, 86, pp. 971-84).  Yet the exact garbage taxation mechanism varies by program.  For instance, a fee can be levied on garbage bags themselves or on the containers that hold the garbage bags.  Regardless, a tax rate equivalent to one penny per pound of garbage would generate almost $240 million in revenue per year, or 6.3% of the expected revenue from the income tax increase.

Finally, consider a Portfolio Approach.  Remember, at issue here is not whether to raise taxes.  We presume the State has decided to raise taxes by $3.8 billion (as done already through the income tax increase).  Here, we merely explore alternative ways to raise revenue other than through the income tax. 

Anyway, instead of implementing only one of the green taxes describe above, Illinois could choose to implement several green taxes simultaneously.   This portfolio approach would keep rates low for each individual green tax, but still generate large amounts of total revenue that can add up to a large share of the total expected revenue from the recent income tax hike.  According to the numbers in all three blogs, one simple and moderate plan would combine the following green taxes and pay for more than  half of the needed revenue:  A carbon tax of $10/ton would collect $1 billion (raising electricity prices by about 7.5%), a gas tax increase of 14 cents per gallon would collect $0.7 billion (raising gas prices by about 4.4%), a trucking toll of $5 would collect $100 million, and a garbage fee of one penny per pound would collect $240 million.  Then the recent income tax increase could be cut by more than half.

Moreover, green taxes have the added benefit that they provide incentives to reduce the polluting effects of carbon emissions, gasoline use, truck exhaust, and household garbage generation.

Green Taxes Part II: Potential Revenue for Illinois?

Filed Under (Environmental Policy, U.S. Fiscal Policy) by Don Fullerton on Jul 7, 2011

Last week, I wrote about carbon pricing as a way to meet the Illinois state revenue needs (instead of an increase in the income tax).  This week, in the “continuation”, I write about a possible increase in the gasoline tax.  First, I’ll set the stage again.

In early January 2011, the State of Illinois enacted legislation to raise the personal income tax rate from 3% to 5% and to increase the corporate income rate from 4.8% to 7%.  Along with a cap on spending growth, these tax increases reduce the state’s projected budget deficit in 2011 by $3.8 billion (from $10.9 to $7.1 billion).  The governor justified the tax increases on the grounds that the State’s “fiscal house was burning” (Chicago Tribune, January 12, 2011).  In my piece with Dan Karney for a recent IGPA Forum, we don’t debate the reasons for the underlying fiscal crisis in the State of Illinois, nor argue the merits of cutting spending versus raising revenue to balance the budget.  Instead, we just stipulate that politicians decided to raise revenue as part of the solution to the State’s deficit.  Then we analyze the use of “green taxes” as an alternate means of raising revenue that could mitigate or eliminate the need for increasing income taxes.

In general, green taxes are taxes either directly on pollution emissions or on goods whose use causes pollution.  In the revenue-raising context however, the basic argument for green taxes can be summarized by the adage: “tax waste, not work”.   That is, a tax on pollution might have good effects on the environment, because it discourages pollution.  In contrast, an income tax discourages earning income.

While many green taxes could be implemented, we focus on four specific examples that have the potential to raise large amounts of revenue: carbon pricing, gasoline taxes, trucking tolls, and garbage fees.  Indeed, as we show, a reasonable set of tax rates on these four items can generate as much revenue as the income tax increase.  We apply each hypothetical green tax directly to historical quantities of emissions (or polluting products) in order to obtain an approximate level of potential revenue generation. 

In a short series of blogs, one per week, we now discuss each of the four green taxes and their potential for revenue generation.  This week: Gasoline Taxes.

Gasoline sales in Illinois are subject to a state excise tax set in 1990 at $0.19 per gallon.  In addition, other state fees and a federal excise tax of $0.18 per gallon are applied to gasoline sales for a total tax rate in Illinois of $0.61 per gallon, according to the American Petroleum Institute.  However, economic studies find that the existing tax rates on gasoline are below the optimal rate that would account for all the costs of pollution and time wasted due to traffic jams.  For instance, the “optimal” U.S. total gasoline tax has been estimated to be about $1 per gallon, according to Ian Parry and Kenneth Small (2005), “Does Britain of the United States Have the Right Gasoline Tax” [American Economic Review, 95(4): 1276-89].  Illinois would have to raise the tax rate by 40 cents to reach that $1 total optimal rate.  The third line of table 2 shows that a $0.40 per gallon gasoline tax hike would collect approximately $2.0 billion (just over half of the $3.8 billion from the income tax increase).  Yet that tax increase would raise by 12.4 percent the $15.9 billion Illinoisans spend annually on gasoline.

Table 2 includes alternative calculations of revenue generation levels from a gasoline tax.  For example, a generic 5 cent per gallon excise tax increase would generate $250 million (see table 2 line 1). 

The existing $0.19 per gallon excise tax in Illinois is not indexed to inflation, so the real revenue to the State from the gasoline excise tax has steady fallen over time.  The second line of table 2 calculates that the state could adjust the tax rate back to its 1990 purchasing power by raising the rate 14 cents per gallon (from 19 cents to 33 cents).  That would just account for inflation since 1990.  The increase in revenue would be $700 million (which is 18.3% of the expected revenue from the income tax increase).

Illinois residents would then pay 4.4% more for gasoline, INSTEAD of paying more income tax.  The point is that the gas tax would discourage driving and air pollution, instead of discouraging workers from earning income.