Flash Insights: From surplus to shortfall—The balance of state budgeting

Key takeaways:

• Uncertainty has been a prevailing theme in the market with changing federal policies, slowing economic growth and higher costs driving expenditure assumptions.
• Despite these challenges, states maintain strong balance sheets and possess numerous tools to address these challenges, and we have been pleased with what we’ve seen through this budget season.
• In these uncertain market conditions, the need for strong credit research cannot be overstated, and our dedicated research department has decades of experience managing across multiple economic cycles. Their unique insights are important to every stage of our municipal (muni) bond investment process, including sector and issuer selection and risk management.
   

For many individuals, summer signifies graduation and vacations. But for state houses across the country, budget season is in full swing. Most state (and local) governments have a fiscal year-end of June 30. As a result, summer is often when legislatures and governors work to adopt budgets for the upcoming fiscal year. The Franklin Templeton muni bond research team diligently monitors these budget negotiations to understand a state’s current financial conditions, figure out what priorities a state has for the upcoming fiscal year and assess the efficiency and effectiveness of government operations.

Each state’s budget and process are a bit different, reflecting unique demographic, economic, legal and political realities. But as the 2025 budget season comes to an end, we have identified several nationwide trends. We’ll review these trends below and talk about what we think they mean for state credit ratings and other levels of government that are on the receiving end of government aid and support.

The first overriding trend is uncertainty. Much of the uncertainty originates from US President Trump and his evolving policies. Federal policies can have positive or negative impacts on a state’s economy and budget, but much of the current uncertainty comes from the on-and-off-again nature of the policies due to changes in Trump’s thinking, legal battles and popular opinion. This uncertainty means that a state needs to conservatively approach its budget, ensuring the state can be nimble regardless of potential policy changes. Despite the uncertainty, states generally maintain strong balance sheets and possess numerous tools to address these challenges, and we have been pleased with what we’ve seen this budget season.

The second trend we’ve spotted is slower economic growth assumptions underlying the budgets. There are several economic inputs driving lower growth assumptions. The first is a change in inflation and inflation assumptions going forward. States (and local governments) see some of their revenues increase as inflation rises. To the extent that prices and/or wages increase, tax revenues levied on those sources also increase. On the flip side, however, when inflation growth slows or even declines, revenues can also stabilize or decline. Now that we are seeing inflation slow from the highs of a few years ago, tax revenue growth will likely also slow.

We are also seeing economic impacts due to potential and actual tariffs (which are especially pronounced in regions with high agricultural segments or trade ports). Combined with the economic impacts of federal workforce declines and termination of various office and other property leases, states are assuming slower growth ahead.

The third trend is higher costs driving expenditure assumptions. Consumers have seen costs increase for everyday items; governments have likewise felt similar pricing pressures. If a state expects revenue growth to slow, it becomes harder to afford the higher costs of programs, capital, wages, etc.

Next, let’s dive deeper into examples of what is driving these trends.

Some of the federal policies impacting state budgets include changes in federal funding and reductions in the federal workforce. Some states have lowered revenue estimates (or increased cost assumptions) to reflect changes over federal funding. Here are some examples:

• Employment reductions. For states with large numbers of federal employees, recent employment reductions related to the Department of Government Efficiency can have a financial impact. Until former federal employees get new jobs, these states are likely to collect lower personal income taxes. And if those former employees also reduce their personal spending, this could impact sales tax collections. Furthermore, if laid-off employees relocate out of the area, it could impact the housing market. This will clearly affect the DC-metro area more than elsewhere, but there are federal employees located across the country, and certain areas could be impacted more than others.
• Reduction in federal grants and spending. Numerous proposals to reduce federal grants and federal spending for states are under consideration. Examples of this include reductions in scientific and research grants to universities, changes in federal financial support for health care programs, and reductions or eliminations in transportation funding and/or social service grants. Trump has also suggested a change to the Federal Emergency Management Agency which could result in higher costs for states to fund recovery efforts after natural disasters. This could result in funding holes for existing programs, increased state spending to backfill the federal cuts, and/or cancellations of programs that could lead to layoffs and other economic impacts.

States are actively lobbying to maintain existing programs, but when it comes to budgeting, states want to be prepared if programs get cut, but not so conservative that they overestimate if funding does come in. It is a delicate balance.

Finally, we thought we’d share a few examples from actual state budgets adopted over the past few months.

California: When California Governor Gavin Newsom released the first iteration of his fiscal year 2026 budget in January, it showed revenues were ahead of budget by US$7 billion and the budget was balanced. But when the budget proposal was updated in May, the state’s assumptions had changed. The state projected a US$16 billion decline in revenue leading to a US$11.8 billion budget deficit for fiscal year 2025–2026. Newsom cited the economic impact of new federal policies as the primary driver. The state was able to close this budget gap using several of its tools, including a change in who qualifies for Medi-Cal (the state’s Medicaid program).

Texas: Texas budgets on a biennial basis, and one notable budget outcome this year was higher per-pupil spending for schools. School funding growth has been stagnant over the past several years. This budget includes higher per pupil spending, which is a modest improvement, but an improvement, nonetheless.

New York: New York state is the first to go through its budget process with a fiscal year-end of March 31. One of the current challenges for the state is how to fund the New York Metropolitan Transportation Authority (MTA), which has been struggling since the COVID–19 pandemic. Recently, the MTA and federal government have been arguing over the legality of a congestion-pricing system in Manhattan. The MTA intended to use the revenue raised from this program to repay bonds for capital purposes. With the future of the program uncertain, the MTA was left with a hole in its capital plan. New York state’s budget authorized an increase in the payroll mobility tax, which will create a revenue stream the MTA can borrow against to fund its capital plan. This is positive for the MTA, and it contributed to a rating increase for the MTA system.

Illinois: Illinois Governor JB Pritzker also cited federal funding policies as a pressure point for its budget. The state started with a US$3 billion budget deficit, which it managed to close using, among other things, tax increases on businesses, sports betting and tobacco and vape products.  

Other states across the country are also assuming lower revenue growth, higher expenses and, in many cases, the use of reserves to close budget gaps. But these headlines don’t mean that we are concerned about fundamental state credit quality. First, cycles like this one are normal, and states build reserves during the good years to help during economic challenges exactly like they are facing now. As long as reserves are used prudently and accompany other tools like spending cuts and/or revenue adjustments, reserve usage is not necessarily a credit negative. Second, conservative assumptions that are based on realistic assessments are what we want to see. Sometimes this can lead to legislators having to make hard decisions, but it also creates more financial flexibility as the state moves through its fiscal year.  

Conclusion

Over the first half of the new fiscal year, we’ll be watching how closely states perform compared to budget, how they address any further budget issues or what they do with surpluses if they arise. In these uncertain market conditions, the need for strong credit research cannot be overstated in our view, and our dedicated research department has decades of experience managing multiple economic cycles. Their informed insights are important to every stage of our muni bond investment process, including sector and issuer selection and risk management.