Illinois’ Most Expensive Tax Exemptions

February 13, 2015

The State of Illinois reduces its operating resources by more than 25% annually to provide individuals and businesses tax benefits through exemptions also known as tax expenditures.

In FY2013, the most recent year that data have been reported on tax expenditures, the exemptions in Illinois totaled $8.4 billion, which would have increased State-source General Funds revenues of $31.9 billion by 26.2%.

The two largest exemptions are the exclusion of all federally taxable retirement income from the individual income tax and taxing food and drugs at only 1.0%, (which is passed on to municipalities and counties for unincorporated areas) rather than at the full state rate of 6.25%. Together in FY2013 these two exemptions totaled $3.9 billion made up just under half of all the exemptions granted.

Unlike the federal government, which taxes certain levels of Social Security and other retirement income, Illinois exempts all retirement income from its income tax base. Out of the 41 states that impose an income tax, Illinois is one of only three that exempts all pension income and one of 27 that excludes all federally taxable Social Security income. The cost of this exemption is expected to increase over time due to a population shift in Illinois, with the number of senior citizens expected to grow from 1.7 million in 2010 to 2.7 million by 2030.

Illinois is an outlier regionally among bordering states in exempting all retirement income. Although Michigan, Indiana, Wisconsin, Iowa and Missouri all exempt Social Security income, they all also charge income taxes on other retirement income. Indiana has the lowest rate of 3.4%, which is a flat income tax rate applied to non-Social Security retirement income. Iowa charges the highest rate, which is the top rate on its graduated income tax scale of 8.68% applied to earners above $67,230.

According to data from the Internal Revenue Service, federally taxed retirement income from Social Security in Illinois totaled $8.9 billion in 2012. All other federally taxable retirement income exempted by Illinois from IRAs and pensions totaled $39.7 billion in 2012. To be clear, these totals represent benefit payments made from IRAs and pensions not savings held in accounts.

The majority of the untaxed retirement income in the State from sources other than Social Security was earned by middle to upper income households. If income from individuals with a total adjusted gross income of less than $50,000 were excluded, the total untaxed income in Illinois would still total $30.8 billion, or 77% of all federally taxable retirement income in Illinois.

Historically, the retirement tax base grows at a much higher annual rate than regular income. Retirement income in Illinois has grown at an average annual rate of 6.5%, while revenue from the individual income tax has averaged only 2.7% growth over the last 15 years.[1] Including this high growth portion of the income tax base helps to provide a more sustainable revenue source for the State.

Illinois’ second largest tax expenditure is the exemption of food and drug purchases from the State’s full sales tax rate. The exemption, enacted in 1984, reduced total sales tax revenue by $1.6 billion in FY2013. Although very few states apply their full sales tax rate to food purchases and prescription drugs, most do not exempt non-prescription drugs from the full rates as Illinois does.

The following table compares Illinois sales tax rate and treatment of food and drugs to the other states in the region.

Although the exemption is intended to reduce the cost of food and drugs to low income residents of Illinois by exempting those items from sales taxes, such relief is not targeted to only low income residents and is instead provided for all food and drug purchases. The expansive nature of this exemption is much more expensive than a focused antipoverty program. It is important to note that low income residents who qualify for federal food and nutrition assistance, such as SNAP and WIC, do not pay sales taxes on food purchased through these programs.

In a report on the food and drug exemption published in 2010, the Taxpayer’s Federation of Illinois concluded that the majority of the exemption benefited middle to upper income residents, especially after accounting for households that qualify for federal food assistance programs. The analysis showed that the highest one fifth of households by income in Illinois receive in aggregate a tax break of over $300 million, while the lowest one fifth of households save less than $50 million.

Of the total revenue loss, roughly $1.0 billion represents the amount attributable to food exemptions and $600 million is the amount for drugs. Non-prescription drugs are thought to make up about 7.5% of the total exempted drug purchases.

The Civic Federation recently recommended major changes to the exemptions for retirement income and food and non-prescription drugs as part of a comprehensive plan to stabilize the State’s finances and provide a sustainable tax base in future years. The FY2016 State Budget Roadmap called for taxing all retirement for all individuals with an adjusted gross income of more than $50,000 a year but excluding all Social Security income. The plan also called for temporarily eliminating the exemption for food and nonprescription drug through FY2019. The plan allows for the reinstatement of the food and nonprescription drug exemptions once the State’s $6.4 billion backlog of unpaid bills is paid off and after the State is able to expand the sales tax to include some services, which are currently not taxed in Illinois.

The Civic Federation’s full FY2016 State Budget Roadmap report and description of the entire comprehensive plan for the State of Illinois is available here.