Authored by Mark Glennon via WirePoints.com,

Could a formal bankruptcy proceeding for the State of Illinois be the answer to it’s fiscal crisis? If you think that’s out of the question, as many do, you’re wrong. On the contrary, though Congress isn’t working on it now, the option is quite viable, though subject to obstacles and open issues. The question is certain to gain growing national attention as a number of states sink further into insolvency, so it’s time to get up to speed. I have yet to see a single Illinois politician or reporter raise the question, but plenty of others outside the state are talking about it for Illinois. More on that later.

This article summarizes the basic issues.

First, why? Why would Illinois or any other state consider bankruptcy? Just as for insolvent corporations and municipalities that reorganize, a successful state bankruptcy would provide a fresh start by putting a state on a sustainable path that frees up funding for needed services — funding that’s getting crowded out by legacy debts. It would do that in three primary ways:

• Debt that cannot be repaid gets cancelled. In the case of governments, that includes unfunded pension liabilities insofar as there’s no realistic hope of paying them. For Illinois, that means part of its $130 billion pension debt could be erased notwithstanding the state constitutional pension protection clause. Unsecured bonds and other debts could also be cut. Illinois will never have a truly balanced budget or be restored to competitiveness unless those cuts are made, as we’ve written so often before.
• Unfavorable contracts and leases can be cancelled in bankruptcy, which include employment contracts and collective bargaining agreements.
• Bankruptcy provides an orderly, rational process to sort out who gets what. Without it, a free-for-all eventually sets in for any entity that can’t meet its obligations. Creditors start suing and racing to courts to get the first judgement liens. Bankruptcy halts that tsunami of litigation and foreclosures.

There are constitutional objections to expanding bankruptcy to states. Bankruptcy for governments is a matter of Federal legislation — Chapter 9 the United States Bankruptcy Code. Today, it covers only cities, towns and other municipalities, but not states.

Expert legal opinions differ on whether Chapter 9 could simply be expanded by Congress to states, but my sense is that the weight of opinion is that Congress could, and eventually will, do so.

Congress unquestionably has the power to make bankruptcy laws — it’s expressly granted in the Constitution. Further, its power to apply bankruptcy to municipalities was upheld by courts over seventy years ago. Skeptics think putting state finances under control of a Federal bankruptcy court would upset the notion that states, unlike municipalities, are “sovereigns.”  They cite the 10th Amendment, which reserves to states powers not granted to the Federal government, and the 11th Amendment, which prohibits lawsuits in Federal courts against a state by citizens of another state. For those interested in the details, see the article linked here by Michael McConnell, a Stanford Law School professor.

A leading expert on the other side is David Skeel, a law professor at the University of Pennsylvania. He wrote outright that, “The constitutionality of bankruptcy-for-states is beyond serious dispute.” The key, as he sees it, is that bankruptcy would be entirely voluntary, which should eliminate any concerns about Federal intrusion on state sovereignty.

A professorial legal analysis, however, probably wouldn’t matter in the end. Courts often bend the rules or make new ones when major emergencies or humanitarian issues arise. Even Professor McConnell, who doesn’t like the idea of state bankruptcy, agrees with that:

If we were facing a genuine fiscal meltdown, which could be solved only through bankruptcy or some equivalent process, and if the use of that process enjoyed the support of Congress, the President, and the affected states, it is not hard to imagine the Court swallowing its theoretical objections.

Beyond the legal issues, some fear that merely authorizing the option of bankruptcy would drive up state borrowing cost because potential bond buyers would face the added risk of having debt cancelled. That’s probably true for states in or near insolvency, but wouldn’t it also instill the needed borrowing discipline never to get to that point?  Bankruptcy would only be available upon insolvency — that’s already required under the Code — which means inability to pay what’s owed. If you can’t pay you won’t pay, bankruptcy or no bankruptcy, so it might not make a difference in the long run. In any event, higher borrowing costs would only result during the period from when it was authorized to when a state filed.

Remember that most objections to bankruptcy come from the municipal bond industry, so take them with a huge grain of salt. That industry primarily just wants to protect against losses on bonds already issued. The state shouldn’t be concerned about those; only future borrowing costs should matter. Future borrowing costs are lowered, not raised, if a successful bankruptcy reduces legacy debt.

And remember that the muni bond industry is already well aware that Congress could extend bankruptcy to the states. Rest assured they know all that’s being written here, and much more. They are way ahead of the curve. To some extent, they’ve already built bankruptcy risk into what they will pay for state bonds. And their efforts to shore up their position to assure they come ahead of taxpayers and other creditor are underway, discussed in our earlier article.

Public employee unions and their supporters also don’t like bankruptcy because of the threat it poses to pension obligations. That’s perhaps rational, if you assume states will in fact eventually find some way to pay scheduled obligations. Not Illinois, in my opinion. All sides need to get on the same page about the plain math. And a bankruptcy court should not be expected to cut pensions if it’s indeed feasible to pay them in full. Unions would be wise to recognize that bankruptcy courts so far have typically favored public pensioners over unsecured bondholders. However, time is not on the pensioners’ side: The muni bond industry is hard at work doing all it can to get first liens and other mechanisms to attain priority over pensions.

Unions also worry that collective bargaining agreements could be cancelled. Well, maybe. This highlights the most important general question about how state bankruptcy would work. And the issue applies to municipal bankruptcies as well: Who controls the bankruptcy proceeding?

The key here is that, on the face of Chapter 9, the bankrupt government — basically, the incumbent politicians — have exclusive power to submit the plan of reorganization. But it’s essential, if a bankruptcy is to be successful, that the same politicians and special interests responsible for bankrupting a government not control the bankruptcy, too. Otherwise, that government is doomed forever and a day.

That problem can be overcome in a number of ways that could be written spacifically into legislation expanding Chapter 9 to states. That is, Chapter 9 would not be extended ‘as is’ to states; appropriate changes for states certainly would be made.

Puerto Rico offers a particularly interesting way to address the problem. For Puerto Rico, Congress last year passed legislation similar to bankruptcy, known as PROMESA, that included appointment of a qualified ,seven-member oversight board. That board effectively has control over most major financial issues and will have to sign off on any reorganization plan that cuts debts. Opponents of bankruptcy for states are terrified that PROMESA may have set some sort of precedent. A national television ad campaign opposed PROMESA while Congress was considering it for just that reason. We’ll be writing separately about PROMESA and whether parts of it could work for Illinois.

The problem of who controls the bankruptcy can also be overcome at the state level. Detroit handled the problem in its bankruptcy by having the state appoint an emergency manager empowered to negotiate its reorganization plan. The same concept could work for appointment of a financially competent control board similar to New York City’s during its crisis in the 1970s.

Various “bankruptcy-light” proposals have also been floated. They would have Congress use its bankruptcy power to allow states cut pension debt through a proceeding short of a full bankruptcy. One, proposed by the Manhattan Institute, was the subject of a Chicago Tribune guest article last year.

But that’s about all you’ll find from the Illinois press about bankruptcy for states. Outside, however, the discussion has proceeded for some time. In 2011 the New York Times reported that policymakers were working behind the scenes to come up with a way to let states declare bankruptcy. They did their work “on tiptoe,” according to the Times, to avoid alarming the municipal bond community. Supporters included Jeb Bush and Newt Gingrich.

Legislation never materialized but the discussion continues. Bloomberg-Business Week wrote last year under the headline, “The Case for Allowing U.S. States to Declare Bankruptcy.” Significantly, William Isaac also wrote last year that both Illinois and Chicago should already be in bankruptcy. He’s the former Chairman of the FDIC and a nationally recognized insolvency expert.

I’m not quite to the point of saying bankruptcy for Illinois is unavoidable, but it’s getting mighty close.

*  *  *

For those who dismiss the possible need for bankruptcy, I’ll let two points suffice here:

• The only legal ways to cut the state’s $130 billion unfunded pension debt, thanks to the Illinois Supreme Court’s interpretation of the Illinois Constitution, are 1) amendment of the state’s constitution, or 2) bankruptcy. However, the constitutional amendment might not work because serious objections would remain under the United States Constitution. Further, amending the state constitution then cutting pensions would would raise the question, “Why only pensions?” Shouldn’t other debts, especially unsecured bonds, be cut equally?  That would be an entirely fair objection, and the only way to fairly cut those other debts along with pensions is bankruptcy. Nobody has ever proposed a solution for Illinois that truly balances the budget and pays its debt. Pensions already consume about 25% of the state’s budget even though they remain badly underfunded, which keeps the pension debt growing rapidly.

• The reason why Illinois can’t get a budget solution in place is there’s not any real one to be had. The true budget deficit is two to three times the official one that lawmakers can’t balance. See the numbers linked here. Spending has already been slashed, and tax increases attempting to stabilize the state would be suicide — they would backfire by accelerating the flight of our tax base, ultimately lowering revenue. Illinois will continue to sink rapidly into further debt unless existing obligations, especially pension debt, get cut.

When one strips away the partisan rhetoric and posturing, the practical impact of Friday’s GOP failure to repeal Obamacare has a specific monetary impact: approximately $1 trillion.

Since the ObamaCare repeal bill would have eliminated most of the 2010 health law’s taxes, this would have lowered by a similar amount the revenue baseline for tax reform. Essentially, with the ObamaCare taxes gone, it would have been easier to pay for lowering tax rates. Now, if Republicans want to eliminate the ObamaCare taxes as part of tax reform and ensure the bill does not add to the deficit – which they need to do to assure Trump’s reform process continues under Reconciliation, avoiding the need for 60 votes in the Senate – they will have to raise almost $1 trillion in revenue.

In other words that – all else equal – is how much less tax cuts Trumps and the republicans will be able to pursue unless of course they somehow find a source of $1 trillion in tax revenue (or otherwise simply add to the budget deficit) to offset the Obamacare overhang.

Considering Paul Ryan’s statement on Friday, it appears that at least for the time being, Republicans would leave the ObamaCare taxes in place.  “That just means the ObamaCare taxes stay with ObamaCare,” he said. “We’re going to go fix the rest of the tax code.”

Ryan also pushed back on the idea that the setback on healthcare previews difficulties with other items on the legislative agenda  “I don’t think this is prologue to other future things, because members realize there are other parts of our agenda that people have even more agreement on what to achieve,” he said. “We have even more agreement on the need and the nature of tax reform, on funding the government, on rebuilding the military, on securing the border.”

While the failure to pass the healthcare bill makes tax reform harder, “it does not in any way make it impossible,” Ryan said. “We will proceed with tax reform, we will continue with tax reform.” Earlier in the week, Treasury Secretary Steven Mnuchin said that the administration has been working on tax reform for two months and plans to release a plan in the near future. House Ways and Means Committee Chairman Kevin Brady added in a statement that Republicans on his panel “are moving full speed ahead with President Trump on the first pro-growth tax reform in a generation.”

Still, quick action on legislation is unlikely; in fact while the market narrative changed on a dime last Friday, with traders now convincing themselves the delay of Obamacare means tax reform passes quicker, this is not the case. As Larry Lindsey, a former economic adviser for George W. Bush, told CNBC’s “Power Lunch” last Friday, one of the “silliest” things he’s heard from people is that the health-care proposal not passing will be good for Trump’s tax reform. “Absolutely not,” he added.

A replacement for Obamacare “was necessary for budgetary reasons, for tax reform, because it was a revenue gainer,” said Lindsey. Trump’s goals for economic growth should also be questioned now, he warned.

“They might move on to [tax reform] next, but when you have a president who can’t deliver his own caucus, then the president’s position will be weakened on all issues,” Lindsey said. “If you’re in Congress and you don’t like something, you now have an example of how you can ‘roll’ the president.”

* * *

But wait, there’s more.

While the GOP will be hard pressed to find $1 trilion in offsetting savings or revenues, their headaches could be doubled if the proposed border adjustment tax fails to pass next. As a reminder, BAT is expected to generate as much as $1.18 trillion in offsetting revenues; should BAT no be DOA, that’s another $1.2 trillion in potential government revenues that is gone.

According to James Pethokoukis of the American Enterprise Institute of Economic Policy, the fact that the Republicans failed to pass a health-care reform bill makes the odds that they will pass a border adjustment provision much smaller, and “the odds of getting a bigger stimulus plan will drop, too”, he told CNBC on Friday. Investors “won’t get to see cuts to a 15 to 20 percent tax rate” in corporate and marginal tax rates such as those Trump has proposed, Pethokoukis added. Instead, it will likely be closer to what Obama worked toward — something closer to a 30 percent tax rate, he said. It raised the specter of more discontent among Trump’s longtime supporters, considering he campaigned on that specific promise.

Echoing this sentiment, Jared Bernstein, a senior fellow from the Center on Budget and Policy Priorities, said in an interview that tax reform and the health-care proposal were “intimately connected for precise reasons. Trump once suggested achieving growth of 2 to 4 percent, but this might look more like 1 to 2 percent now because of budgetary constraints, he added. Now, the government has less money available to hit “high revenue targets,” Bernstein said.

Summarizing the above, as a result of Friday’s failure, the tax revenue “hole” Republicans have to fill now is at least $1 trillion bigger, and perhaps as large as $2.2 trillion.

* * *

But wait, there’s even more.

As the WSJ writes overnight, in theory rewriting the tax code could be easier than revamping the whole health-care industry. Republicans pride themselves on ideological unity in favor of lower tax rates. And the stakes appear lower for Americans — paperwork and money are far different than matters of life and death. “Tax reform is less visceral,” said Rep. David Schweikert (R., Ariz.) “I can pull up a calculator and say ‘it’s this or this’…it’s hard legislating to anecdotes and stories.”

But scratch deeper, and the GOP quest for a full overhaul of the tax code is fraught with squabbles, procedural hurdles and difficult trade-offs. The party’s failure on health care – after having seven years to prepare – shows how hard it is for Republicans to write complex legislation that attracts support from their moderate and conservative wings. “It’s just a reminder of how incredibly hard transformational legislation is,” said John Gimigliano, a former GOP congressional tax aide now at KPMG LLP.

As the WSJ adds, to succeed, Republicans need to bridge at least three big gaps.

• First, they need to balance competing desires to cut tax rates sharply and to slow the rise of national debt. Republican leaders in Congress say they want a revenue-neutral plan – one that brings in about as much money as today’s tax system. Faster economic growth might help, but it doesn’t fully bridge the divide. To accomplish revenue neutrality while sharply lowering rates, they will attempt to whack popular tax breaks, such as business deductions of interest on debt and individual state and local tax deductions. They will meet resistance from groups that want to protect those breaks.
• Second, they have to reconcile alternate visions of what they are setting out to accomplish and who will benefit. Mr. Trump has said his priority is middle-class tax cuts for individuals. “Not the top 1%,” said Mr. Mnuchin. House Speaker Paul Ryan (R., Wis.) and Ways and Means Chairman Kevin Brady (R., Texas) want an overhaul primarily focused on promoting economic growth, even if that means tax cuts that favor the very top of the income scale.
• The plans they all campaigned on are tilted to the top, according to independent analyses. Third, the party is at odds over the Ryan-Brady plan for border adjustment – taxing imports and exempting exports. The Trump administration has been ambivalent and sometimes critical of the idea. Senate Republicans are outright cold to it. Messrs. Ryan and Brady say it’s crucial because it provides about $1 trillion to offset corporate-tax-rate cuts and it discourages companies from shifting profits abroad.

None of those divisions inside the GOP have been resolved yet, and dozens more are lurking, including debates over tax breaks for renewable energy, credits that aid low-income households, and the treatment of carried interest income for private-equity managers.

“The notion that tax is easier than health is not borne out by the facts, ” a Senate GOP aide told the WSJ. “Having discussed health care for seven years, Republicans were 75% in agreement on the policy. On tax, none of the foundational questions have been answered.”

In short, the market is about to be significantly – perhaps “tremendously” – disappointed once again, and quite soon.