Municipal Bonds: 2021 U.S. States Outlook
States are plagued by pandemic uncertainty, but long-term resiliency remains intact.
Fiscal year 2021 budgets carry little resemblance to prior years. With most state fiscal years beginning July 1, budgets have gone through multiple last minute revisions. While most states have adopted budgets, they are likely to make additional adjustments throughout the coming year with more transparency around the coronavirus pandemic, its impact on revenues, and amount and form of additional federal stimulus made available. We think states have flexibility to adjust finances accordingly and will continue to meet debt servicing obligations. States that entered the downturn with credit strength should be resilient while those that entered with material stress may see that stress compounded.
Entering the pandemic, states held a record level 10% of revenues in reserves, at the median. Attention to building reserves following the 2008 recession has proven vital in supporting state spending since late March. Additional costs related to the coronavirus pandemic were largely supported by federal aid, while states used reserves to supplement lost revenue. Favorably, revenues were widely above budget as they moved into the pandemic. Ultimately, state revenue losses for the 2020 fiscal year ending June 30 ranged from as low as 2% to a high of 18%, annualized. Federal support in the CARES Act impacted states disproportionately, comprising anywhere from 5% of tax revenue to upwards of 70% for low population states.
State budgets vary dramatically based on the nature of revenues, impact of the shutdown, reliance on tourism, timing and nature of latest budget projection, and the number of coronavirus cases. At the close of June, most states projected 2% to 25% revenue shortfalls in 2021. We expect they will manage these shortfalls utilizing reserves, internal borrowing, federal CARES Act funding, additional federal stimulus and expense cuts. For most, this can be done without the borrowing externally. Tourism dependent states (including New York, California, Hawaii, and Nevada) are experiencing greater revenue shortfalls, as the sector will be slower to regain momentum.
As such, reliance on another round of federal stimulus is more significant. Key revenue sources for states include:
- Income taxes: Unemployment in April and May was 9% to 23% across states. While the impact of reduced income tax collection will be significant, we note that unemployment benefits are taxed as ordinary income and serve to support state budgets as well as individuals. While states reported massive declines in April tax revenue, the majority of that is attributable to the delay in 2019 tax filings. Much of this April loss will be made up in July.
- Sales taxes: After a large drop in retail sales in April, sales soared a record 18% in May with additional growth expected in June. As of June, sales remain down 8% since February. Sales tax declines are greater in tourism dependent states.
- Corporate taxes: At between 0% and 20% of budgets, corporate taxes will also see a hit as profitability falls.
State budgets are impacted by uncertainty around scale and timing of additional federal support as well as lack of transparency around the path of the pandemic. State approaches vary. New Jersey has extended the current 2020 fiscal year through September in hopes of gaining more clarity. Pennsylvania has adopted a shorter five-month fiscal year. Kentucky has implemented a single year budget as opposed to the normal two-year budget. Other states passed budgets that assume an additional degree of federal support, but include trigger cuts in the scenario no support is provided. Others have maintained existing outdated budgets, waiting for more clarity before implementing budget changes. Budget solutions include:
- Second round of stimulus: Federal support has always been a key component of recovery when entities are hit with force majeure events. Congressional agreement on a second round of municipal stimulus will be a game changer for state and local governments. We expect that next round stimulus will, at a minimum, mirror the $150 billion included in the CARES Act passed in March. Absent stimulus, many budgets will require additional expense cuts, layoffs, furloughs and salary reductions. Though another round of support may not fill all budget gaps, it would support continuation of key programs and employment, supporting more rapid economic activity. The next stimulus package may be voted on in early August.
- Use of reserves: The strength of liquidity and reserves has allowed most states to avoid otherwise dramatic budget cuts or borrowing at somewhat punitive rates during the height of market turmoil. Many will tap reserves again, and they may deplete reserves absent federal stimulus by the close of 2021. Prudent budgeting is important in order to rebuild reserves in future years.
- Expense cuts: Most states have implemented expense cuts in the current and upcoming fiscal years, though not all. Georgia has asked all states agencies to plan on a 10% expense cut, while Illinois has ratified a budget that holds spending flat from the prior year budget.
- Tax increases: While not a direct result of the pandemic, both California and Illinois will include a referendum on the November ballot to raise taxes. Illinois proposes moving from a flat to a progressive tax system and raising rates for higher earners. California aims to open up Proposition 13, allowing large commercial and industrial properties to be reassessed each year at market value, potentially adding up to $12 billion in local tax revenue. California also temporarily raised taxes on large businesses in the 2021 budget. Georgia and Massachusetts had planned to decrease the tax rates this year. One or both may be postponed.
- Borrowing: Intra-year liquidity borrowing is commonly utilized by states to smooth lumpy revenue streams against more consistent expense distribution. States’ use of these liquidity support vehicles is not viewed negatively when used to stabilize day-to-day operations. However, borrowing long-term to fill short-term budget gaps, without balancing against other measures like use of reserves or expense cuts, is a sign of unsustainable governance and can create a disproportionate financial hang-over post crisis. At this time, Illinois is the only state to commence this borrowing for a period of longer than one year, and has tapped the bond market as well as the Federal Reserve’s Municipal Liquidity Facility. New Jersey is also seeking to balance the current budget with long-term borrowing.
CONCLUSION: STATES WILL CONTINUE TO MEET DEBT SERVICE OBLIGATIONS
Until the pandemic is behind us, uncertainty remains. Continued budget adjustments will be required throughout the year. States are adequately positioned to make required adjustments and continue to meet all debt servicing obligations.
Sources: Northern Trust Asset Management, state budget and performance documents, CAFRs, Merritt Research Services, Moody’s Investors Service, Standard and Poor’s.
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