Lagging revenues and pension pressures continue to dog state governments
Two reports this week diverged on near-term views about states’ credit quality and budget prospects while raising the same longer-term concerns.
Tax revenue gains that lag spending growth, an uneven regional economic expansion, and challenges posed by federal tax reforms drive investment house Conning’s dimming view of state credit quality.
“Conning is maintaining its negative outlook on the states” because spending is climbing faster than tax growth and demand on expenditures, “whether through Medicaid, legacy costs, education” pose ongoing pressures, said Paul Mansour, head of municipal credit research at the firm, which manages more than $9 billion of municipal bonds held in client portfolios.
The assessment from the investment management firm’s credit research team comes in its biannual State of the States report.
S&P Global Ratings took a more upbeat near-term position with tax revenue collections higher now than at this time last year.
“Not only are revenue collections in most states higher than at this point in 2017, tax receipts are also surpassing fiscal 2018 budget estimates,” analysts wrote in the special report “For U.S. States, A More Positive Tone Emerges For Fiscal 2019 Budget Process; Can It Last?”
“A late-cycle burst of federal fiscal stimulus, in the form of tax cuts and a large spending package, should further propel an already accelerating economy,” the report added. “Although there are some outliers, S&P Global Ratings expects the state sector to conclude its fiscal 2019 budget process in a more timely and less acrimonious fashion than it has in recent years.”
Conning lowered its outlook to "declining" on U.S. state credits from stable in its fall of 2016 report. The firm’s outlook periods cover one year.
State tax revenues increased 3.8% in 2017. While that’s up from 2016, it’s not keeping pace with a 4% growth rate in expenses and 4.1% increase in gross domestic product. About 25% of the upswing in revenue is due to tax hikes and the one-time prepayment of personal and corporate income taxes due to federal tax reform changes.
“Organic state revenue growth is running behind,” Mansour said.
On the expense side, the 4% growth rate in 2017 also exceeds inflation with the consumer price index rate growing at just 2.5% last year “implying that states face difficult choices between higher taxes, spending cuts or reserve draw downs,” the report said.
Medicaid is a top source for state budgetary pain with expenses rising to 29% of total overall state spending in fiscal 2016 from 20% a decade earlier.
“Combined with the state election cycle, which includes many gubernatorial races in large states, we expect a contentious state budget enactment process this spring and summer, which is a credit concern,” the report says.
Conning assesses the general fund reserves based on a combination of GF and rainy day fund balances. They averaged about 8.2% of general fund expenses in in fiscal 2018. Conning views 10% as a healthy target.
States have wide disparities with 13 states at only 5%. That includes Illinois, New Jersey and Pennsylvania. Texas and Alaska have more than 15%.
“Are states prepared for the next recession?” Mansour asked. “In general, we don’t think they are as well prepared as they were ahead of the last recession.”
Pension pressures remain a sore spot with net unfunded liabilities edging higher in 2016 and overall funded ratios falling to 71.1% from 74.5% although some gain could be on the near term horizon due to stronger 2017 returns.
Conning says state-by-state disparities abound with some like Wisconsin at full funding levels while others like Illinois are among the weakest. Some states now required to make higher pension contributions are choosing not to fully fund their annual required contribution, most notably New Jersey.
New Jersey, Kentucky, Illinois, Connecticut, and Colorado were the weakest-funded, ranging from 30.9% to 46%.
State debt totaled $517 billion in fiscal 2016 with overall economic debt, which Conning calculates by adding in pension and other retirement obligations to debt, at $1.6 trillion. Debt medians have mostly held steady as states remain cautious about adding debt to their books. Debt service remains less than 5% of general fund expenses for most states.
“They haven’t been borrowing for operations and they haven’t been borrowing for capital if they don’t have the revenue stream,” Mansour said. “That’s a good sign that states have been acting responsibly from a credit perspective.”
Conning gives states a ranking based on a variety of economic ratios. The five top-ranked states are Utah, Colorado, Idaho, Texas and Washington. Common threads among the five range from strong economic growth, favorable business conditions and low fixed costs.
The five lowest-ranked states of Connecticut, New Mexico, Illinois, Mississippi and Kentucky “share some combination of high commodity-revenue reliance, high legacy costs, slow economic growth and a less favorable business climate,” the report says.
Another concern is the disparity in economic growth with the strongest gains concentrated in Western and Southeastern states while the Northeast lags.
Since Conning’s last report, states have begun to absorb the impact of the new federal tax law. The changes pose risks for states with high income and property taxes in the form of the $10,000 per-family cap in state and local deductions, which could pressure political leaders to cut state and local taxes.
On other non-state sectors, Conning takes a more positive view with their trends improving or at least stable thanks to “steady home price appreciation, growing consumer confidence plus higher wages and wealth levels are leading to more driving, flying and purchases - all of which increase municipal revenues.”
S&P’s favorable view of near-term budget prospects is bolstered by the relief of Medicaid spending pressures from a recent leveling off of enrollment trends. “Numerous states enter the final weeks of fiscal 2018 (for the 46 states with a June 30 fiscal year) with a tailwind and better near-term federal funding certainty,” the S&P report says.
Economic growth is projected to peak this year at 2.9% and then slow with GDP increases of 2.6% in 2019 and 2.0% in 2020.
Longer term, S&P warns over a series of risks especially for states with “still-distressed pension funding levels, which are compounded--in a few instances--by an inability to assemble a fiscal recovery throughout the economic expansion.”
About 10% of states fit that S&P description, raising concern that the sector “may see elevated rating volatility, which might continue to extend further down the rating spectrum than in the past.”
The return of market volatility poses a risk bringing with it economic concerns that could undercut state tax revenues. Equity market swings, fueled by escalating rhetoric that raises the specter of a trade war, are also ominous.
“A sustained selloff would undermine the basis for existing state revenue forecasts, most of which are built on an expectation of gradual market appreciation,” S&P said.