* State's financial future hinges on tax and spending decisions
* Democrats have firm, veto-proof control on state legislature
* Budget gap could hit $9.4 billion in 2016 without tax hikes
By Karen Pierog
CHICAGO, Nov 10 (Reuters) - Illinois Democratic lawmakers, facing the state's own version of the fiscal cliff, are expected to use their newly won veto-proof majority in the legislature to solve the state's impending financial crisis with permanently higher tax rates on personal income and corporations.
Illinois, like California, on Tuesday elected a Democratic supermajority. The outcome was thanks mainly to the handiwork of powerful state House Speaker Michael Madigan, who deftly drew new districts to favor Democrats following the 2010 U.S. Census.
Illinois, also like California, has one of the lowest debt ratings among the states.
It faces an even worse financial future unless the legislature acts quickly to make permanent the tax increases passed by Democrats in 2011, takes steps to cut spending and reforms the creaking state pension systems.
Illinois has the lowest rate of pension funding among the states and does not pay its bills on time, shifting from one year to the next a backlog of billions of dollars it owes.
Tuesday's election broke a political stalemate, turning Illinois - the fifth most populous state - into a one-party state, with Democrats firmly controlling all branches of government.
"The Democrats can install any agenda they want. They don't need any Republican votes. My recommendation to Republicans is let them go forward and see if it works," said John Tillman, chief executive of the Illinois Policy Institute, a nonpartisan public policy research group.
In the 2013 legislative sesion, Democrats will have 71 of the 118 House seats, a gain of eight seats, and 40 of the 59 Senate seats, a gain of six seats. This gives them a supermajority - three-fifths of the seats of both chambers - enabling them to pass any legislation by a veto-proof margin and making minority Republicans virtually irrelevant.
The veto override ability also diminishes the influence of Democratic Governor Pat Quinn and confirms Madigan as the most powerful politician in the state.
Predictions are that Madigan, who has been Speaker for 28 of the last 30 years, will pounce on the opportunity to make permanent temporary income tax rate increases approved in January 2011.
Illinois' flat 3 percent individual income tax rate was raised to 5 percent, with the rate scheduled to fall to 3.75 percent in 2014. The 4.8 percent corporate tax rate jumped to 7 percent and was to drop to 5.25 percent in 2014. Lawmakers also put a 2 percent cap on annual spending growth through fiscal 2015.
Dick Simpson, a political science professor at the University of Illinois-Chicago with close ties to Madigan's daughter, Attorney General Lisa Madigan, said making the higher tax rates permanent was unavoidable.
"It is imperative at some point that the income tax increase becomes permanent or else we have our own fiscal cliff to go off," he said.
Washington is grappling with a similar tax and spending crisis, often called the fiscal cliff because economists have said the country could plunge into recession around the turn of the year when previous years' tax cuts are to expire and mandatory spending cuts are to take effect.
A scathing report earlier this year by a budget crisis task force headed by former Federal Reserve Chairman Paul Volcker described Illinois as a state living beyond its means for years, repeatedly putting off tough decisions and hiding the dire state of finances from full public view.
If the tax increases are allowed to expire, the Illinois budget gap could balloon to $9.4 billion in fiscal 2016 in a state required to have a balanced budget. Lawmakers routinely skirt the requirement through budget gimmicks, the Volcker report said.
"Michael Madigan and (Senate President) John Cullerton along with Governor Quinn will have complete and unilateral control of the state's financial future," Tillman said, adding that they will also be held accountable by voters.
Madigan has said nothing in public since the election and his spokesman did not respond to a request for comment. Senate President Cullerton signaled he is not rushing to lock in the higher tax rates.
"This tax policy question and possible solutions to address a $7 billion hole left by the expiration should be decided in the next gubernatorial election (in 2014)," said Rikeesha Phelon, his spokeswoman.
The estimated $7.5 billion raised by the 2011 tax increases was quickly gobbled up by the state's annual pension payments, according to Dan Long, executive director of the Illinois Legislature's Commission on Government Forecasting and Accountability.
Prior to the tax increase, the state had sometimes relied on selling bonds to finance annual pension payments, a strategy strongly criticized by the Volcker task force. The annual pension payments required to keep the system afloat are steadily rising and interest payments on the debt are gradually gobbling more of the state's budget.
David Merriman, associate director of the University of Illinois' Institute of Government and Public Affairs, said super majority status is a mixed blessing for Democrats.
"They have no political cover to claim a bipartisan compromise was necessary to make progress. They have to take ownership of any change they enact," he said.
Democrats also will be pressured by special interests demanding spending on social programs, Merriman said. Labor unions, a key constituency of the party, also are expected to oppose pension reform. They successfully defeated a ballot measure on Tuesday that would have put a modest brake on any pension increases.
Raising taxes could be viewed positively by credit rating agencies.
"No question about it. Having revenue flexibility, particularly if you have the wealth and resources behind it, is a positive in the short term," said Richard Ciccarone, managing director and chief research officer at McDonnell Investment Management.
But he warned that a higher tax climate could have longer-term negative consequences if business growth is stunted and taxpayers flee.
The 2011 tax hikes triggered intense criticism from business executives, including from the state's largest employer, Caterpillar. Illinois responded to threats that companies would move out of state by offering tax breaks to some including financial exchange operator CME Group and retailer Sears.