Recent revenue results for states have been strong and, in many cases, tax revenue has exceeded expectations, according to a report by Fitch Ratings and RBC Capital Markets.

While the increased revenue is welcomed by states, some analysts argue that this could provide temptation to reverse the tough budget cuts those states had in place. Other analysts argue that the revenue spurt shows governments have made hard decisions regarding spending cuts last year and are already reaping the benefits.

“There is the risk that extra revenues will provide the temptation to reverse some of the positive structural budgeting measures that states have taken in the downturn, particularly with the fiscal 2012 budgets, as the recent revenue over-performance came as budgets were being finalized,” Fitch analysts wrote.

Extra revenue has been realized in high-income states that saw growth in personal income tax receipts. One of the more notable states was Massachusetts, where tax revenues are up 9.4% year over year through May, with income tax revenues almost 14% above fiscal 2011 levels. Fitch said New York, New Jersey and Connecticut had revenues well above the forecast in April, and income from high earners in California lowered the budget gap for the coming year. Texas saw sales tax revenue rise 9.2% year-to-date through April.

“Overall, states are meeting or exceeding budget estimates, so there is upside for fiscal 2011 year-end results, which makes the forecasts for the coming fiscal year more conservative given the higher starting point,” Fitch wrote.

Chris Mauro, head of U.S. municipals strategy at RBC, said states are now reaping the benefits of the tough decisions made during the financial crisis and working on bringing budgets into balance, and “as a result, should be well-positioned when the economy ultimately improves.” He added that states have cut budgets by 14% since 2008 and that “state tax revenues have bottomed out and are on the increase.”

But Mauro said federal aid cuts will represent a drag on state budgets, “potentially negating some of the tax revenue growth that many states are currently realizing.”

Peter Hayes, head of the municipal bonds group at BlackRock, said state finances are improving because of significant cuts made in the past several years. This is also the fifth consecutive quarter of revenue growth for states.

Hayes added that while states have been budgeting and preparing for cuts, there is a need for caution as the increase is not nationwide. “It would be nice to say revenues are up across the board, but they are not,” he said, noting there are still pockets where revenues are down.

While many states may see improvements, local municipalities are still struggling, as much of their revenue comes from property taxes, Hayes said. While fewer cuts at the state level will help local municipalities, they could still see problems through next year.

“The budget process this year is smoother than in the past two years,” Hayes said. “The revenue increases, together with the recognition around spending cuts, are leading to state budgets being passed earlier and generally more easily this year.”

Philip Condon, chief strategist for fixed income and head of the municipal bond department at DWS Investments, the U.S. retail asset management division of Deutsche Bank, said his firm’s views differ from muni bond doomsayer Meredith Whitney. While budgets are stressed, the slight rise in revenues and the significant cuts in services and spending have paid off. Many governments are addressing pension problems and health-care benefits.

“The predicted defaults are highly overstated,” Condon said.

He added that while growth isn’t back to the 2007 range, aggressive, conservative budgeting will help municipalities. The new budgets will be in place until fiscal 2013 and after that, budget constraints may be able to loosen up.

In the report, Fitch noted that although the California governor’s budget proposal for the coming fiscal year would be a significant step toward “sounder financial footing for the state, fiscal and credit prospects remain uncertain.” In early 2011, California had a budget gap of $26.6 billion for the fiscal year ending June 30, 2012. Since then, state reductions, along with an improved economic outlook, have reduced that gap to $9.6 billion for the same period.

“The plan’s emphasis on recurring budgetary solutions, if achieved and sustained, would mark a significant shift from past budgeting practice,” analysts wrote. “However, in spite of tangible fiscal improvement, numerous fiscal challenges remain. The remaining gap is substantial, and achieving agreement on a balancing package is likely to be contentious and protracted.”

Fitch recently revised New York’s debt to positive, citing budget moves to address challenges and seek sustainable solutions.

“The enacted budget for fiscal 2012 continues the notable change from the historical tendency to rely on nonrecurring measures to address weakening in the state’s volatile revenue stream during downturns,” analysts wrote. “The focus for the credit now turns to implementation, as numerous elements of the budget may prove challenging.”

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