Out of date taxing plans could be holding back state economies, and the methods of addressing tax codes could be important to those in and accessing the municipal bond market, analysts said.
State tax schemes' inability to keep up with the modern economy is "the central question in state economic development right now," said Justin Marlowe, director of the University of Chicago's Center for Municipal Finance.
Recent data from The Pew Charitable Trusts shows that many of the states with the
Idaho, for example, had the most dramatic population increase of any state between 2009 and 2024, with nearly 2% growth every year. But its tax revenues in the fourth quarter of 2024 were down nearly 7% from the average in the same 15-year period, more than double the rate seen nationally.
The same dynamic can be seen in other growing states, including Utah, Florida, Colorado, North Dakota, Arizona, Washington, Delaware, and North Carolina. States like Texas and Nevada also had significant population gains in recent years, but their revenues were flat compared to long-term trends, according to the Pew data.
The mismatch is occurring primarily because of outdated state tax structures, said Marlowe.
Many of the states either don't have individual income taxes or have a low, flat-rate tax, relying instead on other mechanisms — mainly sales taxes — to fund their budgets.
The problem is those structures struggle to capture sufficient revenue in the current economy, which is more focused on services than goods, Marlowe said. As larger portions of states' economies are devoted to things like cloud computing and software as a service, old tax schemes aren't keeping pace with the growing populations and wealth.
The dynamic has not yet truly chipped away at states' financial footing.
A recent S&P Global report on state budgets finds they are broadly stable, coming out of the pandemic with reserves at historic highs, providing "liquidity to manage potential economic headwinds."
Though tax revenue growth has been sluggish in some states, Fitch Ratings "doesn't expect this to broadly affect credit quality," said Tammy Gamerman, director of U.S. public finance ratings.
S&P is watching the trend, and gaps could prompt "credit considerations" if they continue, but states have "generally adopted budgets where expenditures are primarily funded with recurring revenues," said Geoffrey Buswick, managing director of public finance ratings.
Moody's Ratings and KBRA were contacted by The Bond Buyer but did not provide comment.
Coming years, however, could prove more challenging.
The S&P report on state budgets estimates that federal cuts to Medicaid and the Children's Health Insurance Program could shift as much as $880 billion in obligations to states over the next 10 years.
Many of the states facing declining revenues are also likely to incur increased costs in coming years as the population continues to shift into areas where climate-related disasters are becoming most common, said Kim Olsan, senior fixed income portfolio manager at NewSquare Capital.
Allowing the current dynamic — more people and less tax revenue — to continue would be like "baking a structural deficit into your state government," said Marlowe.
"That will be very difficult to correct later on," he said.
So, state budgets experts are seriously considering reforms, he said. One solution on the table: some sort of income tax scheme.
While such a structure would be "the last resort" for politically conscious officials in growing states, Olsan said, it may be unavoidable in coming decades.
"It's a luxury to have enough other sources of revenue to not have an income tax," she said. "It would not be surprising if some of these states have to move in that direction at some point in the future."
That shift would have major repercussions for both states trying to issue debt on the muni market and investors choosing which bonds to buy.
For one thing, the affected states may simply have to issue more bonds as their populations continue to grow, said Lisa Washburn, a managing director at Municipal Market Analytics.
It will depend entirely on the demographics of the new populations — families with children will require more schools, for instance, while expanding urban areas may need to fund more transportation — but in the long term, more people will hypothetically require more infrastructure, leading to new debt, she said.
The issuance of that debt would then be affected by the new tax models being considered. Income tax structures could increase revenue in growing states, but they are inherently more volatile than other structures, Marlowe said. Their collections may be bigger in good times, but they will also respond to economic downturns. That instability is unpopular with bond investors, he said.
The most desirable debt is backed by something like property taxes, which "has a very stable, predictable collection process," Marlowe said. A general sales tax introduces a bit more volatility, while income taxes and so-called quasi-income taxes are "the poster child for a volatile tax structure."
"These types of revenue instruments are just far less predictable," he said. "That matters a lot to investors."
Still, the ultimate outcome is within states' control, Marlowe said. There are ways to capture more tax revenue while reducing volatility. Iowa recently enacted a
Marlowe also pointed to Massachusetts, which has long had an income tax structure that employs a system of credits, deductions, and exemptions to help stabilize revenue.
"People complain about it all the time, they call it 'tax-achusetts' and don't like it," he said. "But it's a revenue policy structure that bond investors like to see. "Things can be done to that effect, you just have to deliberate about it."
Changes to state tax structures could also have implications for the buy-side of the muni market, because it would alter the comparisons between tax-free and taxable investments made by fixed-income investors, according to Olsan.
Muni investors in a state like Texas, which currently has no income tax, don't have a significant incentive to invest in their own state. Because they are only getting the federal tax benefit, "the state component is irrelevant to them," she said.
But, if more states implemented income taxes — or a sort of
In that world, muni investors everywhere may behave more like those currently in "the very high tax states, like New York or California, where they have a very big incentive to buy their own state's bonds."
"It becomes a different calculation," Olsan said. "There's more of an incentive to stay in state, which would compress credit spreads and put a bit of a premium on state bonds."
The difference may not be dramatic with a 3% flat tax, for example. But, "when we start approaching 5% or more, that could change the status quo."
