WASHINGTON - Two Standard & Poor's reports released yesterday give a grim warning of rough times ahead for state and local government finances: as the nationwide economic downturn and housing slump continue, revenues will also continue to fall and municipal bond issuance will increase.

One of the reports, which focused on how the weak economy is taxing state budgets, said that many states' fiscal 2009 budget proposals are already out of balance soon after being announced as revenues have dropped, which may lead to a shift to bonds for capital funding. States will also face gaps of more than $30 billion to balance 2009 budgets with reduced tax revenue expectations from weaker growth, the ratings agency said.

"I think a significant issue is the very fluid revenues, and many states have subsequently revised revenues downward," Standard & Poor's director Robin Prunty said in an interview. "For any state that has an income tax, April is a pretty pivotal month. Most states, when they were formulating their budgets ... no one was really forecasting a recession, and/or an economy that was weaker, as it's performing now. I think that's why we're seeing additional downward revisions."

Pruntysaid bonds may be issued at a "faster pace" than states might have otherwise planned as revenues falter and issuers are no longer able to rely on pay-as-you-go funds to finance projects.

She pointed to Arizona in particular, which is contemplating a sale of $744 million of lease-purchase financing to fund school capital improvements, rather than the funds from its operating budget on which it typically relies.

The most significant bond issues in the planning stages are taxable pension obligation bonds to address unfunded pension liabilities, the report said, noting Illinois' proposed $16 billion bond issue, Alaska's $5 billion bond sale, and Connecticut's proposed $2 billion issue. West Virginia and Kentucky are also contemplating such bond issues.

The report said that budget proposals are showing "substantial and broad-based reductions" in spending, with the exception of education. That could change, though, prior to the adoptions of final budgets and the revenue outlooks at that time. Spending cuts are the primary tool for balancing budgets and many states are already implementing targeted spending reductions before the budgets were introduced.

The report also said that the federal stimulus package approved by Congress in mid-February does not seem likely to boost state budgets, and in fact, could be detrimental to governmental revenues.

The accelerated depreciation allows a business to claim an immediate federal tax deduction of up to 50% of the cost of new equipment purchases, rather than following the standard accounting approach of depreciating the full cost gradually over the useful life of the equipment. This main tax cut provided by the package is expected to have a potential negative impact on state revenues because state tax law requirements are tied to the federal tax code, so states will not be receiving the lost funds.

Arizona Gov. Janet Napolitano in late-February told the Senate Finance Committee that state budgets would face major shortfalls in fiscal 2009, and that the stimulus package would cause states to lose at least $2 billion in state revenue because of that business tax cut.

Prunty agreed that the tax cut is partially a factor, but said also important is that states do not consider the rebate checks going to taxpayers to be a factor in their revenues.

The other Standard and Poor's report, which focuses more on state and local issuers, said the economic slowdown will affect issuers in three "big" ways. It will sharply lower the sales tax revenue available to governments, rapidly deplete the rainy-day reserves they have set up, and cause decreases in the revenues dependent on economic activity, such as building permits, fees, and realty transfer taxes.

The report said the slow economy has depleted reserves that governments draw upon to fill budget holes, which in turn can mean more borrowing as the "viability of internally funded capital projects decreases or disappears altogether."

The report added, "More borrowing again means higher costs for the jurisdiction, raising expenses while revenues are falling."

State and local governments also face changes in how they issue debt following the downgrades of many monoline insurers, which localities are veering away from in the wake of rating downgrades of the insurers. Many issuers are turning to a reliance on their underlying ratings or letters of credit, the report said.

"It's clear that these jurisdictions are operating in a different world than the one that existed only a year ago," the rating agency said.

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