Municipal Bonds: Fiscal 2027 State Outlook

State Revenues Keep Growing; Reserves Steady

Income and sales tax receipts, the largest revenue sources for states, continue to grow briskly. U.S. Census data shows personal income tax collections are up 9.5% and sales taxes 4% year-over-year through the second quarter of 2026, with both growing faster than inflation. Fiscal 2026 (which ended on June 30 for most states) receipts came in about 2-3% above budgets, according to the National Association of State Budget Officers (NASBO). This likely means most states will post a surplus for fiscal 2026 when they close their books, bolstering reserves. States project fiscal 2027 revenues will continue to grow, with the average forecast for personal income taxes up 3.7% and 2.6% for sales taxes. We see these projections as realistic and appropriately conservative given our sanguine economic expectations.

The continued boom in stock markets and significant new initial public offerings (IPOs) have created large capital gains that have boosted the U.S. economy. States with progressive income taxes have seen the largest boost to their tax receipts. California’s fiscal 2026 revenues grew 11% over 2025, more than double the 5% growth in Texas, which does not have an income tax. The pipeline of future IPOs, particularly for AI-related companies, appears likely to continue this trend in fiscal 2027, but beyond that, capital gains taxes are volatile and not a dependable or easily predictable revenue source. Dependence on capital gains adds risks to states that rely on them, underscoring the importance of building reserves for credit quality.

State tax regimes have been stable over the last year, with a modest $5-6 billion of aggregate tax cuts and tax hikes. 2026 legislative sessions passed slightly more tax increases than cuts, reversing the trend from previous years. Some states continue to focus on simplifying tax structures, including progress on plans to eliminate personal income taxes. These reductions have slowed, responding to cost shifts from the federal level to states, requiring additional state spending. Some states have adjusted by moving to peg their income tax reductions to meeting revenue targets. For example, North Carolina will only phase in income tax reductions if revenues exceed thresholds. We see this as a more fiscally conservative approach, supporting credit quality.

EXHIBIT 2: RESERVES HOLD ABOVE PRE-PANDEMIC HIGHS

Reserves remain steady, with NASBO-reported rainy day funds remaining well above pre-pandemic peaks levels with median levels of nearly 13% projected for FY27. We expect reserves to modestly trend down as a share of spending as states balance the impacts of federal policy changes, including cuts to Supplemental Nutritional Assistance Program (SNAP) and Medicaid, along with continued pressure to reduce disaster relief from the Federal Emergency Management Agency (FEMA). All of those changes would shift costs towards the state budgets . Reserves remain ample to provide states with a cushion in case of potential economic contractions and/or additional spending needs.

State Resilency

Macroeconomic trends or unplanned events like natural disasters can impact states’ budgets. However, states have fiscal tools to manage these events, including raising new revenues, reducing or delaying spending, refinancing debt, borrowing or using reserves. These enormous sovereign powers support resiliency and are a key part of why state bonds are a core holding across the municipal portfolios we manage.

State resiliency varies on a relative basis. Our key evaluation factors include:

• Reserves: Reserves increase a government’s fiscal safety margin. Reserve accumulation is particularly important for states with volatile revenue structures, for example New York, which depends heavily on capital gains, and Louisiana, which depends heavily on oil revenues.
• Fixed Costs: Long-term liabilities like pensions, retiree healthcare and debt service reduce budgeting flexibility. Light debt issuance and strong investment returns have eased fixed costs in recent years, yet some states still face a heavy burden. Kentucky’s annual retirement costs, for example, equal nearly two times annual debt service payments. However, the state continues to make supplemental contributions beyond the required levels, which, combined with strong investment returns, pushed funded ratios at 11 of Kentucky’s 12 pension funds to over 50% in 2025.
• Management: We continue to prefer states that budget conservatively and can quickly change revenue forecasts and adjust spending. Delaware, for example, has a statutory requirement that limits spending to 98% of estimated revenue. This is designed to promote fiscal discipline and buffer revenue shortfalls.

EXHIBIT 3: RESILIENCY COAST-TO-COAST

Federal Policy Impacts

States continue to focus on the impact of last year’s sweeping federal tax legislation on Medicaid and SNAP. Both are shared federal-state programs that states administer. Changes to FEMA are also top of mind.

Medicaid changes were delayed under the One Big Beautiful Bill Act (OBBA) but are beginning to be felt. Medicaid enrollment is already down 7% as states change eligibility to reduce costs that were shifted to them. State responses to Medicaid shifts varied widely as they developed their 2027 budgets. Some have moved to reduce costs. For example, North Carolina reduced their provider reimbursement rate to save nearly $100 million, about 0.3% of their annual budget. Other states have looked at revenue options to mitigate the impact of additional costs of maintaining coverage for their residents. Hawai’i and Washington passed new taxes on high earners with funds earmarked to support stabilizing healthcare costs. As Medicaid cuts are felt, state policymakers will be under pressure from their hospitals, which will feel the pinch of lower reimbursement rates and more charity care.

SNAP changes took effect in fiscal 2026, increasing state administrative costs due to new compliance requirements. Additional changes are set to take effect in fiscal 2027. Those include a reduction of the federal reimbursement rate for operating the safety-net program by 50% as well as new restrictions such as work requirements and semi-annual verifications. Some states opted to introduce those new rules early, and as a result, enrollment declined across the U.S. by an average of 11% through April 2026, as reported by the Center on Budget and Policy Priorities. The reduction has provided interim savings, but additional cuts are coming in fiscal 2028. States will be required to shoulder between 5-15% of the annual benefit costs, adding an average of $168 million to state budgets that fiscal year. We see these costs as manageable given the size of state budgets and expect states to reduce their costs ahead of more federal cuts.

EXHIBIT 4: ENROLLMENT FALLS AS STATES PARE BACK

FEMA: Natural disasters continue to increase in severity and frequency across the U.S., according to independent assessments. Federal government support through FEMA grants and allocation of non-financial resources have historically been crucial to supporting recovery efforts after these disasters. This aid has protected bondholders from the impact of major disasters. Reducing the role of FEMA in managing disaster recovery continues to be discussed, including by the president, although he has not yet formally proposed legal changes. The president has also increasingly denied once-routine small disaster declarations in states that are not in his political favor, a worrisome trend if applied to larger disasters. Twenty-seven27 disaster declarations were denied in 2025, up from 17 in 2024. The denial of federal aid for a major disaster would represent a shift in practice that would force state and local governments to rely more on reserves for recovery, which we would see as negative for state and local credit quality.

The November midterm elections will result in a new Congress in January 2027 that may modify the current Congress’ Medicaid and SNAP changes and be more hostile to FEMA changes. Potential shifts in federal policy will be difficult for states to predict, and they will likely need to develop their fiscal 2028 budgets based on current law rather than waiting for modifications from the new Congress.

Property Tax Reform

Property taxes were a hot topic in state legislatures this year, and the debates are continuing ahead of the election. Property tax is a pillar of local government revenues, yet the impact of changes to property tax reverberate to states because state and local governments share many costs such as public schools. The passage of Proposition 13 of 1978 in California, for example, led to an enormous shift from local property tax to state income tax that still exists today.

Property taxes are on the rise nationally, largely due to the delayed impact of the run-up in property values during the pandemic. This has raised political pressure in state capitals to cap or reduce local property tax. Florida, for example, will seek voter approval this November for a major expansion of the homestead exemption for residents, reducing revenues to local governments. It’s estimated that property tax accounts for over 40% of local government general fund%general% revenues, so a steep cut to this crucial revenue source will impact local services,  pressuring the state to backfill those services. Florida presently has no plan to raise or authorize replacement revenues. This could lead to credit pressure on both the state and its local governments if not carefully managed.

Texas and Indiana have also passed legislation to curtail property tax growth without backfilling it with new state revenues, pressuring their local governments and school districts. Some Indiana local governments have increased their own income taxes to recoup revenues. Hoosier school districts are struggling given new requirements to share property tax revenues with charter schools. Texas’ reductions to property taxes have pressured school district finances, which has already led to ratings downgrades for some districts while setting up new pressures for the next legislative session. We continue to monitor reserve levels at both the state and local levels to offset the immediate impact of the proposed policy changes.

California’s credit has performed well since the early 2010s as it built reserves, improved liquidity management and reduced liabilities like debt and unfunded pensions. The state’s economy continues to post strong growth and it remains the center of innovation: A recent report showed California had attracted three times the venture capital funding of the other 49 states combined so far this year through August. California’s major credit challenges are its volatile revenue structure, increasing natural disaster risks and rising costs of its Medicaid program, known as Medi-Cal. We see reserve accumulation as particularly important for California given the volatility and concentration in its progressive tax structure and high risk of natural disasters. The state expects to end fiscal 2026 with about $50 billion in reserves, roughly 20% of annual spending. Continuation of the run-up in technology stocks and expected IPOs would bolster the state’s revenues this year, yet federal Medicaid cuts will challenge the next governor.

New York enters fiscal 2027 from a position of financial strength, supported by elevated reserve levels, strong revenue flexibility and a proven record of fiscal management. The enacted FY27 budget preserves substantial reserves while increasing funding for key priorities including Medicaid, education and the Metropolitan Transportation Authority. Despite risks presented by the state’s reliance on economically sensitive income tax revenues and potential budgetary pressure in FYY28 and beyond from federal policy changes (particularly around Medicaid funding), projected budget gaps remain manageable relative to the state’s size. New York's substantial reserve cushion, diverse economy and long history of proactively addressing fiscal challenges make it one of the most resilient state credits in the municipal market.

Conclusion

State credit strength remains elevated as fiscal 2027 begins, with solid reserves, revenue flexibility and a strong macroeconomic outlook that should continue to grow tax revenues. Costs are expected to rise for states over the next year as the reduction in federal support moves from headline risk into actual state budgets. The reaction of states to federal budget cuts may cause future credit differentiation between the states. We continue to view state bonds as core component of municipal portfolios.

–with contributions from Makai Edwards and Michael O’Leary

Glossary

1. Capital Gains: Profits from the sale of assets like stocks or property, which can significantly impact income tax revenues in states with progressive tax systems.

2. Debt Service: Payments made to cover the interest and principal on a state’s outstanding debt.

3. FEMA: A federal agency that provides disaster relief funding to states, currently under political scrutiny.

4. Funded Ratio: An actuarial measure of a pension plan’s financial health, calculated as the ratio of assets to liabilities.

5. General Fund: The primary operating fund for a state, used to finance most government services.

6. Municipal Bonds: Municipal bonds are issued by state and local governments to pay for expenditures including highways, bridges, or schools. Income from municipal bonds is often exempt from taxes.

7. NASBO: National Association of State Budget Officers, a key source for state budget data and analysis.

8. One Big Beautiful Bill Act (OBBBA): A sweeping U.S. federal law enacted on July 4, 2025, that extends and expands key provisions of the 2017 Tax Cuts and Jobs Act (TCJA).

9. Progressive Income Tax: A tax system where the rate increases as income rises, often resulting in higher volatility in revenue during economic swings.

10. Rainy Day Fund: A reserve of money set aside by states to cover unexpected shortfalls or emergencies, such as economic downturns or natural disasters.

11. Safety Net Program: Government programs that provide support during economic hardship, including Medicaid and SNAP (Supplemental Nutrition Assistance Program, commonly referred to as "food stamps").