* New contract expected to cost $74 million a year
* Budget approved last month did not provide for pay rise
* Options: close schools, cut pension costs or raise taxes
* Ratings cuts will also raise cost of borrowing
By Karen Pierog
CHICAGO, Sept 19 (Reuters) - Chicago public school teachers returned to their classrooms on Wednesday but thorny questions remained over how Mayor Rahm Emanuel and the cash-strapped school system will pay for the tentative contract that ended a strike of more than a week.
The three-year contract, which has an option for a fourth year and which awaits a ratification vote by the 29,000-member Chicago Teachers Union, calls for an average 17.6 percent pay raise over four years and some benefit improvements.
Average teacher pay is now about $76,000 a year, according to the district, which pegged the annual cost of the new contract at $74 million a year, or $295 million over four years.
The $5.16 billion fiscal 2013 budget approved by Chicago Board of Education last month closed a $665 million deficit by draining reserves and levying property taxes at a maximum rate, while also slashing administrative and operational spending.
But that budget included no teacher salary raises with the understanding the budget would be amended once a contract was in place, according to a spokeswoman for the district. The increase agreed in the tentative contract with teachers called for a 3 percent increase in year one.
"There is really no room in the existing budget for that level of increase," said Laurence Msall, president of the Civic Federation, a Chicago-based government finance watchdog group.
Msall said the nation's third largest school system, which was already projecting a $1 billion budget deficit for fiscal 2014, will have to cut personnel, including teachers, and close low-enrollment schools to meet the contract's financial demands.
"You'll have a smaller district hopefully operating more efficiently," he said.
While there have been reports in the local media of plans to shutter dozens of schools, Mayor Emanuel is not talking specifics on school closures. He has also declined to answer questions about how he will pay for the agreement.
"When the school system looks at it, they'll look at what the academic standards are, they'll look at the enrollment, and they'll make some choices that are difficult to do," he told reporters on Wednesday.
The mayor also pointed to "major changes" coming for the district's central office, adding "there is no item we won't look at." He has already cited millions of dollars in savings from administration of the district.
As for boosting its revenue, the Chicago Public Schools would need voter approval to exceed a capped property tax levy, Msall said.
The state of Illinois is struggling with its own fiscal problems that have led to cuts in education funding, Msall said, adding that it was unlikely that the state would send more money to Chicago schools.
The state Legislature could act to ease the district's pension contributions, which will jump to $534 million in fiscal 2014 from just $196 million in the current fiscal year due to the expiration of a three-year, state-approved pension funding holiday. The Democrat-controlled General Assembly has so far failed to pass reforms for state or local pension funds despite pressure from Emanuel and Governor Pat Quinn.
Chicago teachers are required to contribute 9 percent of their salary toward their pensions, but the school system picks up most of that (7 percent), at a cost of ab out $127 million in the current budget, according to a recent report by the Civic Federation.
Chicago teacher pensions were about 60 percent funded in fiscal 2011, the report said, a level that is well-below the 80 percent level considered to be healthy. T he retirement fund, which had about $10 billion in net assets at the end of fiscal 2011, paid out just over $1 billion in benefits that year.
John Tillman, chief executive officer of the Illinois Policy Institute, a think tank that says it promotes free markets, said the school system could increase the ranks of charter schools, which are largely staffed by non-union teachers.
He also predicted Illinois' flat income tax rate will be targeted by public labor unions, which could seek a constitutional amendment to change it to a progressive tax to wring more money out of higher-earning residents that could be used to fund education and other government services.
Aside from the contract, the school system faces increased borrowing costs after it was hit with negative credit rating actions this summer, affecting about $5.6 billion of its outstanding debt.
Moody's Investors Service dropped its rating to A1 with a negative outlook from Aa3, and Standard & Poor's Ratings Services downgraded the school system to A-plus with a stable outlook from AA-minus. Fitch Ratings revised the outlook on its A-plus rating to negative from stable. The district's draining of reserves for its new budget, escalating pension costs and contentious relations with its labor unions were cited as reasons for the rating actions.
The agencies on Wednesday had no immediate comment on the tentative contract.
"We're going to be analyzing the full contract and will determine how the finances will be affected," said David Jacobson, a Moody's spokesman. (Reporting By Karen Pierog, additional reporting by Peter Bohan; Editing by Claudia Parsons)