State budget season: varied, but underpinned by strength

Key takeaways

• As a whole, states continue to exhibit robust financial positions.
• Moderating inflation generally translates into lower income and tax sales receipts, but the impact differs from state to state.
• However, large “rainy-day” funds and a multitude of available tools have allowed most states to easily address any decreases in revenue expectations or rising expenses.

Introduction

As state budget season wraps up for 2024, we wanted to summarize what we have seen, what it means for credit fundamentals, and the focus for Franklin Templeton Fixed Income’s municipal bond research team going forward.

As a reminder, we published some of our initial thoughts on the kickoff to the budget season back in March, indicating what challenges we thought states could face while developing their fiscal year 2025 (FY25) budgets and what tools were available to close potential budget gaps.

Now, we are coming up to the end of the budget season and are seeing that, as a whole, states continue to exhibit robust financial positions. The strong post-pandemic recovery, federal COVID-19 aid, and revenues that were supported by surging inflation have helped states build solid balance sheets with high levels of reserves (or “rainy-day” funds) available for when the economy slows. In many cases, state credit fundamentals are the strongest they have been for some years, with many states rated higher today than before the pandemic.

However, as expected, we are seeing a lot of variety across the country. Inflation growth is slowing everywhere, which generally translates into lower income and tax sales receipts, but the impact differs from state to state. The ultimate effect depends on the local economy, fiscal policies (such as tax cuts or increases) and how well a state budgets. Nevertheless, ample reserves have meant that most states were able to easily address any decreases in revenue expectations or rising expenses. Let’s take a look at some examples.

Illinois

Illinois is an example of an issuer that is rated higher today than it was before the COVID-19 pandemic. Almost a decade ago, Illinois was one of the lowest-rated states, with an inability to adopt a budget for more than a year that was due (in part) to highly partisan politics. This led to significant budget deficits and increased borrowing to help bridge these gaps. But due to improved financial management and helped by the post-pandemic recovery, Illinois has turned around its financial position. It has enjoyed budget surpluses, implemented sensible financial management policies (including better pension funding), and built up its rainy-day funds. As a result, this budget cycle went smoothly. In order to balance the budget, policymakers did have to increase revenues, but these will also contribute to its reserves—a strong positive. The state still faces certain challenges, particularly around pension funding, but the smooth budget process that we have now seen is a far cry from that witnessed 10 years ago.

New York

New York State is a bit different from many of its peers, in that its fiscal year ends on March 31, which in turn means that the state is now nearly through the first quarter of its FY25. While New York missed the March 31 deadline to adopt a budget by a few weeks, there was very little impact to state operations during the impasse. New York is grappling with having to provide additional support to the Metropolitan Transportation Authority (MTA), as the latter struggles with lower ridership levels following the pandemic, the elimination of COVID-19 aid, and increasing cost pressures. At the same time, the state’s economic engine, New York City, has also been challenged by the migrant crisis and pressure on its commercial real estate. However, despite these headwinds, the FY24 budget performed better than expected and the state was able to pass a FY25 budget that is both balanced and contributes to reserves.

There are also some states that faced financial challenges which required tougher decisions to meet balanced budget requirements. In the two examples we provide here, we can see how varied financial decision making can be, even with a strong economic and fiscal backdrop.

Arizona

Arizona is a high growth state and benefits not just from a strong economic backdrop, but also from in-migration that brings more people to the state who can in turn generate more tax revenues. As a result of strong financial results in prior years, policymakers instituted a phased-in tax cut throughout fiscal year 2023. However, with personal income tax growth softening, the state has now had to project deficits for FY25 and FY26, with these deficits exacerbated by the previously passed tax cuts. Arizona has a divided government, which means that the governor and legislature come from two different parties, and this can create additional friction when trying to agree on a balanced budget. Ultimately, the state cut spending and tapped reserves and was able to pass a balanced FY25 budget.

California

Against a backdrop of generally strong performance across most states, California is an outlier, as it grapples with a large projected deficit for the current fiscal year (2024) as well as for both FY25 and FY26. Like other states, California is seeing slower revenue growth, inflation-driven cost pressures, and the phase out of COVID-19 aid. But California also has some unique challenges of its own. First and foremost, it has a progressive income tax structure¹ which tends to make revenues more volatile in both the good and bad years. Consequently, personal income taxes have underperformed expectations and contributed to the budget deficit. Additionally, employment growth is weaker in California than among many of its peers, and there are some negative impacts from the out-migration witnessed over the past few years. Furthermore, with continued inflationary pressure on spending and some challenges due to delays in income tax revenues related to natural disasters, the state has a large deficit to address. Nevertheless, California has a significant number of budget tools available to deal with the deficit, which lessened our concern when the budget numbers were first released. As expected, the state was able to adopt a budget using a variety of tools at its disposal. We saw the implementation of spending cuts, various deferrals and delays and a modest tapping of its reserves to close the gap. This varied approach can help California maintain its reserves in the event that FY25 underperforms estimates.

At the same time, budget season isn’t just about the states. Local governments—such as cities and school districts—are also finalizing their budgets. Local policymakers are seeing many of the same challenges as at the state level, particularly in terms of economic pressures and the elimination of COVID-19 aid. The picture becomes somewhat more complex for schools, since they receive a significant part of their revenues from the state. As a result, a school’s funding can increase or decrease based on the state’s fiscal challenges. Many cities are also tied to their states as they receive state aid or share in state revenues. This can vary widely, which makes it hard to sum up here, but we wanted to mention just a couple local governments to illustrate the above points.

The MTA

As mentioned above, lower ridership has challenged the MTA (which is in charge of public transportation in the New York City metropolitan area) as a large number of people started working from home during the COVID-19 pandemic and have continued to do so. At the same time, its operations are capital intensive, with significant fixed costs and expenditures that are increasing despite the reduced number of riders. Given how vitally important the MTA is in the New York City region, we have watched its budget development closely. When digging deeper, it becomes clear that the MTA isn’t solely reliant on farebox or ticket revenues; it also relies on state and city aid as well as tax revenues generated in the region. During the pandemic, it was important for us to see how the state would assist the MTA. We were consequently pleased to see additional support both last year and in New York State’s FY25 budget. A hiccup came when the New York governor recently announced the cancellation of a congestion pricing program in New York City, which was intended to benefit the MTA. As a result, the company is now faced with some challenges around the size of its capital program. However, thus far the state has increased aid to the MTA, made easier by the strength of the former’s budget.

Houston

Houston has benefited from strong sales tax growth which, along with COVID-19 aid, has helped it build reserves. However, it is challenged with high office vacancy rates, a structural budget gap, and legal settlements between the city and some of its employees. Houston’s structural imbalance means that ongoing, recurring revenues are not large enough to pay for spending. Therefore, in order to pass a balanced budget, it must either raise revenues or cut costs every year. With a structural imbalance, the key is to adopt a budget that helps to reduce or eliminate it, rather than exacerbate it. Combined with the challenges around the employee settlement, Houston had a difficult budget season. Ultimately, the city adopted a balanced budget that approves the sale of bonds to fund its firefighter settlement and taps into its reserve fund. Unfortunately, much of the budget gap was closed using one-time spending cuts, so Houston will likely face similar problems during the next budget cycle. In a case like this, it is important to remember the value of maintaining rainy-day funds and having access to a wide array of budget tools.

Next steps for portfolio managers and municipal bond analysts

Just because this year’s budget season is coming to an end doesn’t mean an analyst’s job is done. Our focus moves from inspecting budgets to examining how actual results track versus budget projections. Are revenues coming in as projected, and if not, then why? Have economic or demographic conditions changed and what does that mean for an issuer’s credit profile going forward? Are costs coming in higher than expected or have unforeseen spending items popped up? We will carefully follow how governing bodies address these challenges and what it means for reserves.

Generally speaking, while budget season has gone smoothly for most states, we are also watching closely to see how state decisions will impact other governments. A good example here is school spending, which is often the largest expenditure for states. We are therefore looking at school districts to understand how they are going to provide education services in case school aid starts to stabilize and trend down in line with slowing state revenue growth. We also want to understand how schools are dealing with changing demographics, as these can ultimately pressure class sizes and even result in school closures. And finally, what is the security that bondholders are relying on for repayment and how is this impacted by an issuer’s credit rating? The experienced municipal bond research team at Franklin Templeton Fixed Income is up for the challenge.

Conclusion

As budget season wraps up, we are reassured that state government credit fundamentals remain robust. We have witnessed a few years of exceptional, inflation-fueled revenue growth, COVID-19 aid, and a strong post-pandemic economic recovery, which have all supported state balance sheets. Consequently, as inflation moderates and the US economy slows, state governments appear to be in a good position to deal with the related challenges. Throughout this budget season, we have seen policymakers use diverse tools to address any budget gaps that resulted from rising expenses or declining revenue growth, with only modest draws on reserves. This puts states in a comfortable position to be able to deal with any unforeseen challenges that may arise. In the meantime, we continue to track actual results versus projections, and dig deep into anything that may raise our concerns.