By Mark Miller

CHICAGO (Reuters) - Illinois is the national poster child for state budget messes. My home state faces a $7.4 billion general fund deficit and a $12 billion revenue shortfall. One proposed idea for plugging at least part of the horrific shortfall: tax retirement income. But our new governor, Republican Bruce Rauner, has rejected the idea.

Illinois exempts all retirement income from state taxes - Social Security, private and public pensions, and annuities. We’re leaving $2 billion on the table annually, according to the state’s estimates. And we’re hardly alone: 36 states that have an income tax allow some exemption for private or public pension benefits, and 32 exempt all Social Security benefits from tax, according to the Institute on Taxation and Economic Policy (ITEP). States currently considering wider income tax exemptions for seniors include Rhode Island and Maryland.

With the April 15 tax day just around the corner, it’s a timely moment to ask: What are these politicians thinking?

Income tax exemptions date back to a time when elderly poverty rates were much higher than they are today (federal taxation of Social Security began in the 1980s). As recently as 1970, almost 25 percent of Americans older than 65 lived in poverty, according to the Census Bureau; now it’s around 9 percent. Today, it still makes sense to tread lightly on vulnerable lower-income seniors, many of whom live hand to mouth trying to meet basic expenses. And the number of vulnerable seniors is on the rise (http://reut.rs/1olYGn7).

MORE SENIORS

But much of the benefit of state retirement income exemptions goes to affluent elderly households. The cost of these exemptions is high, and it’s going to get higher as our population ages. In Illinois, the number of senior citizens is projected to grow from 1.7 million in 2010 to 2.7 million by 2030. That points to a demographic shift that will mean a shrinking pool of workers will be funding tax breaks for a growing group of retirees.

So there’s a real need for states to target these tax breaks to seniors who really need them. Yet one of the plans floated in Rhode Island would exempt all state, local and federal retirement income, including Social Security benefits - from the state’s personal income tax. The Social Security proposal is an especially good example of a poorly targeted break.

Currently, Rhode Island uses the federal formula for taxing Social Security, which already protects low-income seniors from taxes. Under the federal formula, beneficiaries with income lower than $25,000 ($32,000 for couples) are exempt from any tax (income here is defined as adjusted gross plus half of your Social Security benefit). Up to 50 percent of benefits are taxed for beneficiaries with income from $25,000 to $34,000 ($32,000 to $44,000 for married couples). For seniors with incomes above those levels, up to 85 percent of benefits are taxed.

If Rhode Island decides to exempt all Social Security income from taxation, more than half of the benefit will flow to the wealthiest 20 percent of taxpayers, according to an ITEP analysis.

“The poorest seniors in Rhode Island wouldn’t get a dime from this change, because they already don’t pay state taxes on Social Security,” says Meg Wiehe, ITEP’s state tax policy director.

WORKING LONGER

Another tax fairness issue is inequitable treatment of older workers and retirees. The percentage of older workers staying in the labor force beyond traditional retirement age is rising - and many of them are sticking around just to make ends meet. Those workers are bearing the full state income tax burden, effectively subsidizing more affluent retired counterparts.

Some tax-cut advocates might argue that breaks for seniors will help retain or attract residents to their states. But numerous studies show that few seniors move around the country for any reason at all. Just 50 percent of Americans age 50 to 64 say they hope to retire in a different location, according to a recent survey by Bankrate.com, and the rate drops to 20 percent for people over 65.

For those who do move, taxes are a consideration - but not the only one.

“A lot of factors go into the decision,” says Rocky Mengle, senior state analyst at Wolters Kluwer, Tax & Accounting US. “Climate, proximity to family and friends are all very important, along with the overall cost of living. But I’d certainly throw taxes into the mix as a consideration.”

Smart tax policy makers and politicians should take all these factors into consideration - especially in states that are facing crushing deficits and debt burdens. Targeted exemptions for vulnerable seniors make sense, but the breaks should be affluence-tested.

“The scales would vary state to state,” says Wiehe. “But a test that makes sure taxation isn’t a blanket giveaway with most of it going to the most affluent households.”

Indeed. In the golden years, not all the gold needs to go to the rich.

(Editing by Ted Botha)