When folks observe a person or an entity engaging in self destructive behavior, there usually is a resulting conversation which attempts to explain the otherwise inexplicable behavior. What follows is our attempt to explain, without any inside knowledge, the motivation for a large state to choose a mammoth tax increase over our recommended path of frugality and sacrifice. Here goes. Here is what we think may be going on behind the scenes.
Politicians usually are not inclined to propose ridiculously high increase in tax rates without some great fear of an ever more deadly outcome that is going on behind the scenes. The Illinois politicians are proposing a personal income tax increase to go from 3% to 5% and business rates to go from 4.8% to 7%. These massive increases are on top of spectacularly high sales tax rates; cigarette taxes; fees and property taxes. By the way, the governor just ran for reelection supporting an increase of 1%. Something is going on. Here is our take on what we think is going on.
We don’t know the true gap in the accumulated pension costs for this state and the funds which can reasonably be expected to be available to meet those costs. It is reasonable to expect that any financial statement independently audited can capture a good estimate of the future costs. After all, this exercise is a mathematical calculation based on past, current and future employment levels in various wage categories with some assumptions for cost of living increases. So, for the sake of this discussion, let’s assume that the accounting rules are producing a reasonable estimate of future funding needs to meet a spectacularly generous accumulation of many pension claims.
Now, how do accountants measure the funds available to meet the anticipated cost? Well, they look at contributions coming from various sources such as municipal and state employers as well as the employees if they are required to make a financial contribution and they also make an estimate of the rate at which the funds available will grow at in the future. Their anticipated investment return. Our readings and analysis tell us the funds being contributed have apparently been woefully short of what is needed to meet the current and future costs. And on top of that, we have also read that the assumptions made about the rate at which the invested funds will grow have been unusually aggressive. This latter just means that accounting rules say you can make an assumption about a reasonable rate of return. We believe that the state of Illinois has been aggressive in setting this assumption meaning they are actually assuming a return higher that has been experienced for some time now and higher than can be justified. And we think the referee is about to blow the whistle. Not only because the financial statements are inadequately reflecting the real deficit condition in pension obligations and funding but because there could be claims made against the auditors if the state defaults. Nothing motivates an auditor to be accurate more than the fear of being held accountable for something they could have and should have known.
The auditor is supposed to be the referee; making certain that the entity, in this case the state of Illinois, is presenting its financial condition accurately according to the accounting rules. Usually an independent auditor is required to examine the state’s financial statements and render an opinion on the accuracy of the statements. These statements, with the independent opinion of the auditor saying that they are OK, are then used by the state to borrow money.
Now we conjecture there has been a meeting or two between the auditors and the politicians and the bureaucrats and we think those meetings had all the subtlety of a two by four to the head. If the auditor decides to issue a report with an unfavorable opinion stating something along the lines that the future costs are not adequately being reflected or along the lines that the investment return rate is too high or that the gap between anticipated costs and available funds is too great to maintain financial viability or any combination of these or other dire circumstance, the ability of Illinois to borrow future monies to meet maturing debt obligations could either disappear or the interest cost and terms of such future borrowing could skyrocket. We don’t know if that is what is going on.
Someone should ask.