My thoughts on muni credit have been quite transparent. While the overall muni credit profile has demonstrated resiliency, quality cracks run deeper across certain sectors. Not to be alarmist, but evidence shows slowing revenue performance and elevated expenditure pressure within the state sector. This should come as no surprise, given that the abundance of COVID-era stimulus funds has essentially dried up and federal policy changes have shifted a greater financial burden onto states.
As I prepared my 2026 municipal market outlook, I noted states will closely pursue fiscal austerity. In my view, states are well-positioned to make the necessary budgetary adjustments as they figure out how to do more with less. I believe states are uniquely positioned to apply conservative fiscal, operational and debt management practices necessary to preserve their credit standing.
In many states, the payment of general obligation debt service is prioritized by statute or constitutional provisions. Every state except Vermont is constitutionally required to have a balanced budget and all 50 states are prevented from filing for bankruptcy under the Municipal Bankruptcy Act of 1937. Most states are bound by debt limitations, and general obligation bond authorizations require voter approval. States generally rely on effective cash management tools and the ability to drive emergency appropriations to ensure continued debt service when necessary. States also demonstrate revenue diversification and stringent spending controls.
Their relatively low debt burden and sizable, yet declining, reserves are two credit factors that allow for adaptability and flexibility. Strong quality bias is heavily supported by their substantive flexibility to adjust revenues, given high levels of financial resources (including ample liquidity and internal reserves), strong frameworks for the payment of debt service, conservative debt structures, activist pension reform, and broad economic diversification.
One of the more useful tools to gauge state-level developments is the semiannual Fiscal Survey of States produced by the National Association of State Budget Officers (NASBO). The organization's Spring 2026 edition reflects the budgetary realities of the day. The survey draws data from all 50 states, U.S. territories and the District of Columbia. The focus of the spring survey is governors' proposed budgets for fiscal 2027.
Some survey logistics — The field survey was conducted by NASBO from February through April 2026. "The survey presents aggregate and individual data on the states' general fund expenditures and revenues, annual tax and revenue changes, and balances." Generally, fiscal 2025 data represent actual figures, fiscal 2026 data are estimated, and fiscal 2027 data reflect recommended budgets.
Thirty states are on an annual budget cycle and 20 keep a biennial budget schedule.
The District of Columbia, Guam, Puerto Rico, and the Virgin Islands operate on an annual budget cycle. In forty-six states and Puerto Rico, the fiscal year begins in July and ends in June. New York's fiscal year begins on April 1; Texas' starts on September 1; Alabama, Michigan, D.C., Guam, and the Virgin Islands begin their fiscal years on October 1.
As indicated, the survey covers three areas: general fund spending; general fund revenue; and balances and rainy-day funds. The survey's eight key findings are:
- General fund spending growth is essentially flat in recommended budgets for fiscal 2027, reflecting fewer one-time expenditures from surplus funds and limited recurring spending increases.
- Estimated data show general fund spending for fiscal 2026 came in higher than originally budgeted, driven in part by supplemental appropriations and one-time investments.
- In recommended budgets for fiscal 2027, strategies such as targeted spending cuts, eliminating vacant positions, revenue increases and other measures were commonly used, signaling a constrained budget environment.
- Modest growth in general fund revenue is projected to continue in fiscal 2027 for a fifth consecutive year, following the two fastest-growing years on record in fiscal 2021 and fiscal 2022.
- General fund revenue collections for fiscal 2026 are on track to exceed original estimates in most states, particularly driven by stronger-than-expected personal income tax collections.
- Governors recommended a mix of tax increases and decreases in fiscal 2027, which collectively would have an estimated near-zero net impact on general fund revenue.
- Most states are on track to increase or maintain the size of their rainy-day funds in fiscal 2026, as measured in nominal dollars, and expect to do so again in fiscal 2027, according to recommended budgets.
- General fund ending balances are expected to resume their decline in fiscal 2026 and fiscal 2027 — after plateauing in fiscal 2025 — but are still projected to remain elevated compared to historical levels.
As we consider these findings, it is clear that budgetary conditions are more constrained, given a general tightening in revenue receipts and a careful application of surplus funds toward spending. I suspect state officials received the memo and have begun to position accordingly! To be fair, however, states have been pursuing fiscal austerity practices since before COVID.
In my view, expected revenue performance will be closely correlated to economic growth and sentiment, and I anticipate further moderation in revenue collection. Certain states may even see flat revenue activity. As the budgetary process ensues, inflation expectations will take on greater consideration. To address current revenue conditions, state spending will be adjusted downward with prioritization of expenditure needs taking on greater significance. For some, the challenge will be to identify the appropriate level of spending required to sustain suitable service delivery and fixed mandates.
In its survey, NASBO reports proposed general fund spending aggregates $1.36 trillion in fiscal 2027, a 1.4% annual decline from estimated fiscal 2026 levels. However, this figure is partly distorted by the heavy one-time changes in "one large state." Thus, using the median annual shift may provide a better view into aggregate state spending trends. Using this barometer, projected general fund spending is almost flat — with a 0.6% growth rate. Twenty-three states forecast lower or flat general fund spending in fiscal 2027, and 20 states anticipate growth under 5%. Four states forecast growth between 5% and 10%, while two states expect growth in excess of 10%.
Spending expectations from fiscal 2026 to 2027 are lower, given a decline in one-time investments of surplus funds, which tend to be relatively impactful upon aggregate general fund expenditure growth rates. I suspect the economic realities of slower growth and revenue performance will pressure available surplus funds, placing constraints on investible resources.
Actual fiscal 2026 general fund expenditures are projected to surpass initial appropriations outlined in adopted state budgets by 3.9%, partially driven by supplemental appropriations. I would argue that inflationary conditions pushed higher Medicaid and other health care expenses. Medicaid and K-12 education represent the two largest sources of state spending.
Funding increases for K-12 and longer term project-specific items also led to higher spending. Going forward, K-12 funding will likely face downward pressure, with much tied to shifting demographic patterns. The spend-down of surplus funds in fiscal 2026 further contributed to the upward spending revisions. But again, this is not likely to continue.
Much of the additional spending was enacted through midyear budget actions. The survey also shows the number of states making midyear budget cuts after initial budget passage due to a revenue shortfall for fiscal 2026 totaled 5, rising from zero in fiscal 2022, one in fiscal 2023, and two each in fiscal 2024 and 2025. Given expectations for thinning revenue performance and growing expenditure pressure, I expect the number of states making midyear budget cuts due to a revenue shortfall to rise in at least the next two fiscal years.
As mentioned, states are uniquely positioned to address unforeseen surprises in their budgets, particularly those brought about through economic shifts. As large and highly rated issuers, states have readily available access to the capital markets and their bonds generally trade actively and with strong secondary market liquidity.
Their economic diversification and deep revenue baskets provide operational and budgetary flexibility. States are quick to identify areas of expenditure cuts, particularly targeted cuts, personnel spending — such as hiring freezes— reduced employee benefits and layoffs, and the elimination of vacant positions. Certain states target pension and other post-employment benefit (OPEB) adjustments as well as Medicaid programs. Interfund transfers and draws on reserves are also effective strategies for various states.
Although about half of the states report proposed employee salary increases for fiscal 2027, the proposed 2.4% median increase is somewhat lower than the proposed 3% for fiscal 2026. Lower proposed wage advances compared to recent years can be tied to tighter budgetary constraints and modest slack in the labor market. I suspect these proposals for fiscal 2027 have not fully accounted for advancing inflationary pressure.
When considering proposed pay increases, it is important to understand salary adjustments do not follow the same formula nationwide, collective bargaining arrangements in certain states govern pay increases and not all governors include pay recommendations in their budgets.
Projected out-year budget gaps are quite common and are part of the deliberation process. Rating assignments tend to be patient and flexible regarding pronouncements of such shortfalls. However, this patience and flexibility significantly erodes when there is no clear plan to address and resolve these imbalances. Market stakeholders, including rating agencies and investors, look for specific remedial actions that typically involve revenue and/or expenditure adjustments.
The use of non-recurring revenue measures, or gimmicks, are not looked upon favorably, yet many state and local governments still employ them. Projected budget gaps are not necessarily static — they have a tendency to be moving targets— often subject to the vagaries of the revenue cycle and application of recommended fixes. NASBO's survey shows that for fiscal 2027, 13 states report projected budget gaps totaling $26.3 billion before incorporating their governors' balanced budget recommendations. For states reporting through fiscal 2028, eight are projecting budget gaps totaling $53.4 billion and three reflect projected shortfalls without specifying amounts.
State revenue projections represent a critical component of developing spending forecasts. States must be nimble enough to adjust spending as revenue trends shift, and care must be exercised so unrestricted resources are not drawn down to alarming levels. Relying on forecasts provided by state governors, general fund revenues are projected to experience modest growth in fiscal 2027 over fiscal 2026 performance. Individual estimates are prepared for sales, personal income and corporate income tax receipts. Surprisingly, most states' revenue estimates for fiscal 2026 have been revised higher.
With this in mind, revenue collections have posted modest growth each year since booking record advances in fiscals 2021 and 2022. Much of this growth is attributable to employment gains, strong consumer demand, elevated inflation, and meaningful equity market returns. "In fiscal 2023 through fiscal 2025, annual general fund revenue growth on a median basis has been between 1% and 3%. The median increase estimated for fiscal 2026 is even smaller, at 0.5%, and revenue is projected to increase on a median basis by 2.5% in fiscal 2027," per governors' proposed budgets, NASBO said. Slower revenue growth projections can be linked to weaker economic metrics, lower, but still sticky, inflation and adopted tax cuts.
As explained, the use of surplus fund drawdowns is largely responsible for annual aggregate general fund expenditures surpassing revenue totals in fiscal 2027 proposed budgets, even though spending growth flattens. According to the survey, 33 states expect positive nominal revenue growth of less than 5% in fiscal 2027, five states predict growth between 5% and 10%, two states target revenue growth exceeding 10%, and nine states are projecting year-over-year flat or declining revenue performance. In most states, fiscal 2026 revenues are meeting or surpassing forecasts. In my opinion, I expect a tighter range between projected and actual revenue performance for fiscal 2027.
Keep in mind that fluctuations in annual statewide growth rates are influenced by various factors, including tax structures and policies and individual state diversification and demographic patterns. Broader mixed tax revenue experience can be tied to stock market performance, levels of corporate profitability, economic uncertainty and impact from the One Big Beautiful Bill Act.
States receive over 80% of their general fund revenue from sales and use, personal income and corporate income taxes. The balance of state general fund revenue derives from other taxes, fees and varying types of revenue streams such as cigarette/tobacco taxes, alcoholic beverage taxes, franchise taxes, gaming taxes, lottery revenue interest income and licenses and fees for permits. While budget forecasts for fiscal 2027 show modest increases in the three primary revenue sources over fiscal 2026, secondary general fund revenue sources are projected to show a slight decline year-over-year.
According to the survey, proposed state budgets for fiscal 2027 call for a mix of tax increases and decreases. Thirty-three states recommend changes in tax policy, with governors in 14 states proposing net increases approximating $5.6 billion and 19 states advancing net decreases in taxes and fees aggregating $5.4 billion. Of course, the net impact of tax policy adjustments vary by state and territory. Recommended tax changes are expected to lower general fund revenue for fiscal 2026 by $1.93 billion.
As the largest source of aggregate general fund revenue, personal income taxes are anticipated to show the heaviest net impact in fiscal 2027 from recommended tax changes of negative $3.01 billion. Sixteen states recommend lower personal income taxes, while five states propose increases. Reductions in net sales and use taxes are also projected by recommended policy shifts in fiscal 2027 with a general fund impact of negative $200 million. Two states plan to enact net increases in sales and use taxes, while eight states are expecting to enact net decreases in fiscal 2027. Eleven states are projecting net increases in corporate income tax receipts and six anticipate net decreases.
States understand the importance of maintaining fund balances as a source of budgetary flexibility and liquidity, and they are generally determined to preserve adequate levels of rainy-day funds. During the COVID period, states were flush with federal stimulus dollars, yet pursued austerity measures. Such practices, coupled with over-budgeted revenue collections, produced sizable growth in total balances (including rainy-day funds).
While many states spent down a portion of their surplus funds for one-time purposes, the spending did not reach outsized proportions and was largely kept to standard budget practices. Ending balances are still above historical norms and while aggregate rainy-day fund balances have slipped slightly from their peak, they remain close to all-time highs and greatly outpace their highest pre-COVID amounts.
NASBO reports most states are expected to grow their rainy-day funds in fiscal 2026, with 26 states projecting increases to their rainy-day fund balances, 14 states anticipating decreases, and eight states showing no change (in nominal dollars). Fiscal 2027 governors' budgets reveal 25 states are anticipating increases to their rainy-day funds, 10 are estimating decreases and 11 show no change.
Data shows 32 states anticipate ending fiscal 2026 with rainy-day fund balances surpassing 10% of general fund spending, with nine of those states projecting a balance of over 20%. Thirteen states expect a rainy-day fund balance between 5% and 10%, while three project a balance under 5%.
As states anticipate raising reserve balances, the median rainy-day fund balance as a percentage of general fund spending dropped in fiscal 2025 for the first time since the Great Recession, declining from an all-time high of 14.9% in fiscal 2024 to 13.5% in fiscal 2025. For fiscal 2026 and 2027 the downward trend is expected to continue, as spending growth is anticipated to outpace reserve balances rather than outsized draws on rainy-day funds being the reason for lower median rainy-day fund balances as a percentage of general fund spending. I suspect such projections are predicated on a much lower likelihood of revenues exceeding forecasts.
While greater budgetary challenges can be expected over the near-term, the vast majority of states possess the financial and operational wherewithal to apply timely remedial measures that will preserve balances and maintain competitive service delivery to their populations. During this time, I anticipate very little adverse credit events that would jeopardize assigned ratings.
