The Illinois Private School Tax Credit Story Just Got Even Stranger

Now it’s not a tax shelter — it’s a gift to Washington

The Illinois legislature is giving the U.S. Treasury a gift.

After a wild ride, the Illinois House voted tonight to pass an education funding bill that includes a state tax credit for donations to private school scholarship funds. (I posted about this earlier in the day.) The version that passed the House tonight offers state tax credits of $0.75 per $1 donated to qualifying organizations that give scholarships to students from low- and middle-income families. The credit is capped at $1 million per taxpayer per year, and the aggregate amount of credits that can be allocated each year under the program is capped at $75 million. The program sunsets at the end of 2022.

Based on details that were reported before the final text went up online, I had suggested that Illinois taxpayers who are subject to the federal alternative minimum tax would be able to make money through the credit scheme. As passed by the House, however, the bill shuts down this possibility by prohibiting taxpayers from receiving credits if they claim a federal income tax deduction for their contributions to scholarship organizations.

For top-bracket taxpayers not subject to the AMT, this means that the 75-cents-on-the-dollar credit is worth considerably less. If I give $1 to a scholarship organization, I get a state tax credit worth $0.75 but I lose the ability to deduct that $0.75 from federal taxable income. (The IRS’s position is that contributions to state tax credit programs like this are deductible as charitable contributions — not as state taxes paid — but Illinois’s rule means that I can’t claim any federal deduction if I receive the credit.) If I’m in the 39.6% bracket (I’m not), then the loss of the deduction is worth 39.6% x $0.75 = $0.297. So for my $1 donation to a scholarship organization, I get a net (federal plus state) tax benefit of $0.75 — $0.297 = $0.453. The 75-cents-on-the-dollar opportunity is more like a 45-cents-on-the-dollar offer.

The puzzle is why state lawmakers want to deny Illinois taxpayers the opportunity to claim federal deductions. If the concern is that a 75-cents-on-the-dollar credit plus a federal deduction would be oversubscribed, then state lawmakers could simply make the credit less generous and still allow taxpayers to claim federal deductions. For top-bracket taxpayers not subject to the AMT, a 45-cent credit with the opportunity to claim a federal deduction would have been about as attractive as a 75-cent credit minus the federal deduction. And from the state’s perspective, the former approach is roughly 40% cheaper.

Put differently: Illinois had an easy opportunity to shift a significant portion of the credit program’s cost onto the federal government. Instead, state lawmakers have structured the credit so that the total federal taxes paid by Illinois residents will rise, and the credit program will cost the state more than it needs to. This sort of other-regarding behavior by state lawmakers is difficult to explain as a matter of politics or public choice. And given a debt crisis that has earned us the title of “America’s most messed-up state,” we might wish that state lawmakers had been a bit greedier on our behalf.