Tax Policy and Education Funding — Finding a Balance for Small Businesses
By Allison Flanagan, Director of Policy Analysis
Plenty of research shows that changes in tax policy, like increasing tax rates on the wealthiest individuals in the state, do not cause a negative reaction in the economy, especially when those changes ensure the public sector has the capacity to make adequate investments in services that boost the economy. To adequately invest in core public services and infrastructure, tax policy needs to be right. That means taxes should be assessed fairly and generate adequate revenue to sustain public investments in core services over time; public investments which research shows support small businesses and spur the economy.
So how does state tax policy impact small businesses, property taxes and the funding of public services like education? To break this down a little, we first have to understand that the most significant tax small businesses pay is the property tax — which is not levied by the state of Illinois but actually levied by local governments. Local property taxes account for nearly 46 percent of all taxes businesses pay in Illinois, as shown is Figure 1.
In 2018 businesses paid approximately 31.9 percent of all property taxes in Illinois.[1] This means businesses are paying just under one-third of the primary revenue used by local governments in Illinois.[2]
One reason Illinois businesses pay so much in local property taxes is simple: local governments over-rely on property taxes as a revenue source to fund services because the state fails to provide enough revenue. In fact, despite ranking relatively low–35th among all states — in overall tax burden as a percentage of income, Illinois ranks quite high — sixth nationally — in property tax reliance.[3]
Over time, as the state fails to raise enough revenue to support core services, businesses’ share of taxes paid to the state decreases, but to make up for what the state fails to provide, more businesses pay taxes levied by local governments, primarily through property taxes. In Illinois in 2018, just 36 percent of all business taxes go to the state while 52 percent go to local governments, as seen in Figure 2.[4]
Over-relying on local property taxes to fund services is not the best way to tax businesses. That is because property taxes are a cost that businesses must pay whether or not they are profitable. This approach to taxation takes sales revenue away from a business’s ability to decide how best to invest in its operations. Since 2012, Illinois has relied on businesses for property tax revenue more than the U.S. average, as seen in Figure 3.
From an individual’s standpoint, moving from over-reliance on local property taxes to more state-based revenue sources — like implementing a graduated rate income tax structure, or Fair Tax, which would increase state revenue from the top 3% of income earners — to fund public services is desirable as well. This is because Illinois is so over-reliant on property taxes in its state and local revenue mix, that property tax growth is far outstripping growth in income for the vast majority of Illinois residents, as shown in Figure 4.
Which begs an important questions: why is Illinois so over-reliant on property taxes?
Illinois over-relies on property taxes because the state fails to pay its fair share of the cost of public education. In fact, as of FY 2017, Illinois ranked 1st in the U.S. for reliance on local funding to support K-12 education, with 67.5 percent of total K-12 funding coming from local funding sources. Of that local funding sources, 88 percent is revenue from property taxes, as seen in Figure 5.
To begin rectifying the over-reliance on property taxes, following end of FY 2017, Illinois decision makers replaced one of the least-equitable K-12 public education funding formulas in the country with the Evidence-Based Funding for Student Success Act, or EBF.[5] The EBF represents the best practice in school funding because it ties the dollar amount taxpayers invest in schools to those educational practices which research shows actually enhance student achievement over time. (For more information about the EBF, please read “Underfunding the EBF”).
The EBF establishes a funding metric for state-level investments in K-12 education which sets a target of increasing year-to-year state formula funding for K-12 education by at least $300 million (the “Minimum Target Level”). Illinois satisfied the Minimum Target Level for increased year-to-year state funding of
K-12 education in each of the first three fiscal years — FY 2018, 2019, and 2020 — during which the EBF was implemented.[6] That streak stands to be broken, however, as the FY 2021 General Fund Budget does not increase K-12 funding under the EBF, but rather holds it level with FY 2020.[7]
Decision makers felt constrained to hold the FY 2021 General Fund appropriation for K-12 level with
FY 2020, because of the hit state revenue is expected to take due to the COVID-19 pandemic. Obviously, the economic consequences flowing from the pandemic will make it far more difficult for any state, not just Illinois, to even maintain, let alone increase it.[8]
The good news is that even with the unknown impact of COVID-19 on K-12 education funding, since its inception in 2017, beginning with the 2017–2018 school year, the EBF has proven that it is working to enhance investments neglected by the state’s prior foundation formula. (For more information, please read “Underfunding the EBF”). In the school year just prior to the implementation of the EBF, not only did Illinois rank in 1st in reliance on local funding for K-12 education, but ranked 50th in the portion of education funding covered by state rather than local tax revenue. On average, compared to the rest of the U.S., Illinois receives less in state funding, relying more on local funding, as seen in Figure 6.
So, to lessen the over-reliance on local property taxes used to fund education, more state-based resources are needed to continue the progress made to the EBF thus far. Allowing for a graduated rate income tax would provide the opportunity to increase revenue for the state to provide increased investment in education, and doing so in a way that is fair.
So why does all of this matter for small businesses? From a small business perspective, it would be quite beneficial for the state to enhance its investment in public education. That is because there is one, key policy initiative state government can pursue that — according to researchers Noah Berger and Peter Fisher — the evidence shows is more likely to “strengthen the overall state economy than anything else”: provide access to a high quality public education.[9] This finding was echoed by Jeffrey Thompson, who concluded that education spending has been found to raise state GDP, increase employment in metropolitan areas, and raise personal income at the state level.[10] Higher levels of educational attainment strongly correlate to lower levels of unemployment and higher wages.[11] In essence, a quality public education helps build a labor force that has the numeracy and literacy skills required for good jobs in the modern economy. This can be seen in exaggeration as a result of the COVID-19 pandemic, displayed in Figure 7.
From the small business perspective, a quality K-12 system is especially crucial, since the local labor force is the primary pool from which most small businesses tend to hire. From an individual’s viewpoint, while having a high quality K-12 education may not guarantee a bright economic future, not receiving a quality K-12 education almost certainly guarantees long-term economic struggles, from both wage and employability perspectives.[12]
In the end, the graduated rate income tax structure often referred to as the “Fair Tax” would provide additional state revenue that decision-makers, who are statutorily required to increase education funding year-over-year, which in turn can provide relief to local governments who rely on property taxes to fund education.
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[1] CTBA estimate of property tax extensions by property type using: Illinois Department of Revenue, Property Tax Statistics, Table 8: Average Tax Rates, 2014–2018 and Table 15: Comparison of Equalized Assessed Valuations by Class of Property https://www2.illinois.gov/rev/research/taxstats/PropertyTaxStatistics/SitePages/PropertyTaxYear.aspx?rptYear=2018. This is based on the property classified as commercial (25.3 percent) and industrial (6.6 percent). The remaining 3 percent of property taxes are for properties classified as farm, railroad, and mineral.
[2] IRSI Issue Brief: HJRCA 49: A Constitutional Amendment Regarding the Rules Governing Pension Benefit Increases (Chicago, IL: June 2012), 4.
[3] Federal Tax Administrators. “2019 State & Local Revenue as a percentage of personal income.” https://www.taxadmin.org/2019-state-tax-revenue; and Lincoln Institute of Land Policy, “ Significant Features of Property Tax: Illinois Highlights”, 2019, https://www.lincolninst.edu/sites/default/files/il_may_2019_final.pdf.
[4] Totals for Illinois do not add due to rounding.
[5] 105 ILCS 5, Evidence-Based Funding for Student Success Act, 2017.
[6] CTBA analysis of ISBE Evidence-Based Funding Formula Distribution Full Calculations Fiscal Years 2018, 2019, 2020
[7] CTBA analysis of Illinois Public Act 101–0637, http://www.ilga.gov/legislation/publicacts/101/PDF/101-0637.pdf
[8] CTBA analysis of ISBE Evidence-Based Funding Formula Distribution Full Calculations FY 2019.
[9] Noah Berger and Peter Fisher, A Well-Educated Workforce is Key to State Prosperity (Washington, DC: Economic Policy Institute, August 22, 2013), http://www.epi.org/publication/states-education-productivity-growth-foundations/.
[10] Jeffrey Thompson, Prioritizing Approaches to Economic Development in New England: Skills, Infrastructure, and Tax Incentives (Amherst, MA: University of Massachusetts Amherst, Political Economy Research Institute, August 18, 2010).
[11] Bureau of Labor Statistics, Current Population Survey, (Washington, D.C.: May 22, 2013) http://www.bls.gov/emp/ep_chart_001.htm.
[12] Noah Berger and Peter Fisher, A Well-Educated Workforce is Key to State Prosperity (Washington, DC: Economic Policy Institute, August 22, 2013), 1–2; Michelle T. Bensi, David C. Black, and Michael R. Dowd. “The Education/Growth Relationship: Evidence from Real State Panel Data.” Contemporary Economic Policy 22, no. 2 (April 22, 2004): 297.
