Why Illinois budget proposal raises new rating concerns
CHICAGO — Illinois Gov. J.B. Pritzker’s pension and budget proposals raised red flags among watchdogs, investors, and analysts, along with questions about the threat it may pose to the state’s investment-grade ratings.
The criticisms center on both the lack of progress on the structural budget imbalance and uncertain impact of Pritzker's proposals for the state's $133.7 billion of unfunded pension liabilities. Pritzker said his $39 billion budget proposal is a "bridge" until the hoped-for passage of a constitutional amendment in 2020 to shift to graduated income tax rates from a flat rate.
The headline on Municipal Market Analytics' initial review of the pension proposals is “Illinois taunts the rating agencies.”
Illinois has faced deeper deficits and its bill backlog has been cut in half from its high of $15.7 billion in November 2017, but it no longer has room for any missteps that could lead to a downgrade.
Moody’s Investors Service and S&P Global Ratings have the state at the lowest investment grade rating; both assign a stable outlook. Fitch Ratings has Illinois two notches above junk and assigns a negative outlook.
The MMA report warns that the risks associated with the uncertainties over the valuation of asset transfers and the arbitrage gamble on POBs are ideas that “can become gimmicks that pose credit negatives potent enough — scaled to management’s desperation to shape its spreadsheets — to smother the plan’s benefits to the state’s credit profile.”
The budget also relies on a series of one-shot revenue measures, leaving it structurally out of balance.
The state likely would already have a junk rating if some Republicans had not joined Democratic majorities in 2017 to pass a budget with an income tax hike over the veto of then Gov. Bruce Rauner, a Republican. That action ended a two-year period without an enacted budget that weakened the state's financial position.
The risk posed by Pritzker's proposed budget is clear in S&P’s stern review published Friday.
The plan “precariously balances the current budget, but punts measures to address fiscal progress to future years,” the report says.
The reliance on uncertain revenues and lingering structural imbalance is status quo for Illinois, but the pension payment reduction based on the faith that future years' budgets will address fiscal sustainability is more worrisome for the rating, said S&P’s lead Illinois analyst Carol Spain.
“If Illinois were to adopt the budget in its current form, it would have negative implications for its credit trajectory,” Spain said in an interview.
The administration is digging in. “The governor proposed a realistic plan to serve as a bridge to the future, with the ultimate goal of a fair tax system that will transform state finances, including pensions,” Pritzker spokeswoman Jordan Abudayyeh said. “No element of the comprehensive approach can be viewed in isolation and Gov. Pritzker is ready to work with the legislature to put the state back on a path towards fiscal stability.”
The budget closes a $3.2 billion deficit primarily by raising new revenue and trimming the scheduled $9.1 billion pension contribution. It’s balanced on a cash basis. S&P called the balanced label “dubious.”
Spending cuts are limited and the budget projects a 3.19% natural growth rate in base individual income taxes and 2.79% growth in base sales taxes which S&P warned could “prove optimistic” due to warnings that the economy could slow.
The budget would raise $1.1 billion of fresh revenue from a new tax on plastic bags, license fees from legalized cannabis and sports betting, closing a corporate tax loophole, taxing e-cigarettes, raising the existing cigarette tax, assessing a tax on Medicaid, changing the existing tax structure on video gambling and capping a retailers' discount. About one-third of the new revenue is one-shots, Fitch analyst Eric Kim said.
Another $175 million would be raised from a delinquent tax amnesty and while there’s no new interfund borrowing from non-general fund accounts the budget defers repayment of $320 million previously borrowed. Both are one-shots.
A projected $155 million end-of-year balance would go to pay down the now $8.3 billion backlog of the state's unpaid bills. A $1.5 billion borrowing to pay down the backlog would generate an estimated $110 million of savings for fiscal 2020.
Three of Pritzker’s five pension proposals — extending a pension buyout program now underway, issuing $2 billion of pension obligation bonds, and extending the current 50-year payment scheme established in 1995 by seven years — would have a fiscal 2020 impact. The governor also wants to transfer some assets to the system and dedicating $200 million annually from a future graduated income tax.
The proposals would trim $1.076 billion — $125 million from the buyout and $951 million from the re-amortization — off the state’s $9.1 billion scheduled payment to the five-fund system. Future reductions of $800 million annually are expected.
The POBs would be issued in the coming fiscal year possibly under a new personal income tax credit modeled after the state’s Build Illinois sales tax credit. The administration has not released the long-term impact on pension contributions through the 50-year schedule that ends in 2045 with the target of reaching a 90% funded ratio but said it hopes to in the next few weeks.
Rating agencies said the budget and pension ideas are only proposals and any action would await a review of what is ultimately adopted.
“There are definitely some red flags but we want to actually want to see what the governor and legislature come to agree on to determine credit implications,” said Kim. Resolution of Fitch's negative outlook hinges on the state's ability to address structural budget issues in the current year and fiscal 2020, and demonstrate progress toward more sustainable fiscal management.
Moody’s Investors Service would view the move to lower near-term pension contributions and extend the amortization period as a negative but is withholding judgment to see how the legislative session plays out and what is the broader context of the package that’s approved, Moody’s lead Illinois analyst Ted Hampton said.
“Policy decisions particularly on pensions could have significant implications and could change our view, but at this point nothing is a forgone conclusion,” Hampton said.
Muni market players were looking for more progress after Rauner's election defeat signaled an end to gridlock in Springfield.
“It’s disappointing. It's not a dynamic solution that people in the market were looking for because it’s not making big structural changes to balance the budget,” said Howard Cure, director of municipal bond credit research for Evercore Wealth Management, adding that he likes the idea of a shift to a graduated income tax but thinks it's risky to bank on it.
“I think the market will be a little patient with them but if they have to wait for a constitutional amendment and it doesn’t pass and the economy turns sour there is a real risk of being downgraded below investment grade,” Cure said.
“We are wasting a chance to take a bold step. We are going to keep on spending and are going to reduce the pension payment by $1 billion. We should paying the full amount of the pension contribution,” said Richard Ciccarone, the Illinois-based president of Merritt Research Services LLC.
The state’s 10-year general obligation bond trading levels — a 183 basis point spread to Municipal Market Data’s top benchmark and 168 bps on longer bonds — have held steady in recent weeks.
The administration won praise from fellow Democrats for what they called a first step toward putting the on a path to fiscal stability. While Democrats hold three-fifths supermajorities in the Senate and House, some of the tax and pension measures could face pushback.
Republicans blasted the budget as relying on more of the same poor fiscal practices like borrowing and pension “holidays” that led to the state’s deep fiscal mess under prior Democratic administrations that preceded Rauner.
Business-driven civic watchdog groups also raised concerns.
“Delaying an aggressive approach will worsen our state’s financial outlook, and continue to slow our economic and jobs growth,” said Kelly Welsh, president of the Civic Committee of the Commercial Club of Chicago, which earlier this month laid out a long-term roadmap proposal.
Civic Federation of Chicago president Laurence Msall praised Pritzker for offering a sobering but accurate assessment of the state’s fiscal strains but raised alarms over the lack of actuarial detail on the pension proposals and risk of banking on the graduated tax.
“The state’s financial condition is going to be deteriorating” in the interim, he said during a panel discussion on WTTW’s Chicago Tonight program. The federation also had offered its own long-term fiscal solvency plan.