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Fixed income

Balancing act: states rework revenue plans

Municipal Credit Research Team
Experienced sector specialists represent one of the industry’s largest credit research teams dedicated to municipal investing.
Muni bonds

Federal pandemic relief aid and better-than-expected revenue collections have allowed states to build up record reserves over the past few years. Some states have implemented income tax cuts as a result. But shifts in finances are forcing governments to seek solutions for recent revenue losses. And the increased prominence of electric vehicles means rethinking funding for public transportation infrastructure.

Highlights

States will likely see budget impacts from income tax cuts

Between 2021 and 2023, 26 states implemented an income tax rate (either corporate, personal or both). Of these, 13 states made multiple rate cuts. The last time in recent memory so many states cut income tax rates was between 1994 and 2001. Strong economic and revenue growth during that time also prompted more than half of the states to cut taxes.

Over the past few years, states have built up record reserves due to federal pandemic relief aid and better than expected revenue collections. Cumulative rainy day fund balances reached an all-time high of $136.8 billion in FY23 and are projected to remain at high levels in FY24. Strong liquidity, record fund balances and strong revenue growth all supported the case for tax cuts in many states.

Now that pandemic aid has been spent down and revenue growth has tapered off, states will likely see budgetary impacts from these cuts, particularly states that implemented more aggressive rate cuts. The revenue loss attributed to income tax rate cuts in FY23 was $15.5 billion, and in 2024 it is projected to reach $13.3 billion. Looking ahead, the cumulative revenue loss between 2024 and 2028 could total an estimated $111 billion, equal to about a 3.6% loss in general fund revenues, compared to projected revenue if cuts had not been enacted.

Revenue losses should be steepest in Arizona, West Virginia and North Carolina, which are each expected to lose over 10% of general fund revenues over the next five years. This magnitude of revenue loss is comparable only to tax cuts that Kansas enacted in 2012 that led to massive state cuts in school funding, two rating downgrades and exhausted budget reserves.

Unable to provide an adequate level of services, Kansas repealed most of these cuts in 2017. The Kansas legislature approved a plan to cut income tax rates in April, but the state’s Democratic governor vetoed the legislation, warning the cuts would hurt the state’s finances and impair its ability to fund key priorities.

Several other states are close behind the top three. Arkansas and Iowa are both projected to lose about 8% of revenues. Other states, like Ohio and Kentucky, opted to reduce taxes over multiple years. This could have a larger budgetary impact compared to states that enacted a onetime cut. Gradually phasing in tax cuts may enable policymakers to put off spending cuts needed to offset lost revenues, potentially creating a bigger budget problem in future years.

Assessed value has seen multiyear growth

In contrast, Michigan temporarily reduced its flat 4.25% income tax rate to 4.05% in 2023, costing the state an estimated $650 million in revenue. A 2015 law requires the state to roll back the rate in any year when revenue growth significantly outpaces inflation. The rate reverts to 4.25% for the 2024 tax year as income tax revenue growth slowed and did not trigger the automatic roll-back.

States that made the most aggressive income tax cuts may now be forced to consider cutting expenditures or hiking rates for other revenue sources, such as sales/excise taxes. In some cases, a general repeal of the income tax cuts might be needed to right-size budgets. Favorably, states have broad authority to adjust revenues and expenditures as needed.

Transportation funding shifts from miles per gallon to cents per mile driven

Gas taxes, historically the primary funding source for public transportation infrastructure, have been declining as vehicles become more fuel-efficient, or fuel-less in the case of electric vehicles (EVs). Motor fuel tax collections have declined as a percentage of transportation fund revenues to 37.6% in 2023 from 41.1% in 2016, according to the National Association of State Budget Officers. Given this decline, states are exploring ways to supplement declining fuel tax revenues by charging annual registration fees for EVs or implementing vehicle miles traveled (VMT) fees.

Oregon launched the first state pilot VMT fee program in 2015. The program continues to be voluntary, and only vehicles with a fuel economy of 20 MPG or greater are eligible to participate. Participants select a mileage reporting option and receive a bill for reported miles charging two cents per mile. To incentivize driver participation, the state provides a fuel tax credit, remote emissions testing for fuel-powered vehicles and reduced registration fees for EV drivers.

Utah and Virginia have similar voluntary programs for EV owners. In Utah, EV drivers pay a flat fee per alternative fuel vehicle or enroll in a usage program paying one cent per mile based on actual miles driven. Their VMT program benefits EV participants who drive fewer miles. For example, an EV driver in 2024 would accrue a one cent per mile usage charge until they have paid $138.50, which is an amount equal to the flat fee. Virginia’s Mileage Choice Program also provides eligible drivers with an option to pay their highway use fee on a per-mile basis instead of an annual highway use fee at the time of registration renewal.

Hawaii enacted a new road usage charge law in 2023, making Hawaii the first state to mandate road usage charges. The law provides EV drivers the option to either pay $50 or get charged 0.8 cents per mile. Mileage will be reported during annual motor vehicle inspections. The law will take effect in 2025 for EV owners and all vehicles will be required to pay a per-mile charge by 2033.

State VMT programs are expected to become more common. This year, the Biden administration announced one of the most significant climate change regulations aimed at reducing passenger car pollution. The new regulation limits gas-powered cars to no more than 30% of new auto sales by 2032. The mandate is expected to boost electric car sales. According to the Environmental Protection Agency, EVs made up only 8% of new car sales last year. This is projected to increase to 35% to 56% of sales by 2032. An increase in fuel-efficient vehicles will force more states to consider implementing some type of VMT program to address the steady decline in gas tax revenues.

Illinois' credit quality trajectory has shifted meaningfully upward

The state of Illinois has long served as the default example of a challenging credit. For years, the state’s marred reputation was well deserved, and the state’s credit rating fell to the lowest rung of investment grade. Decades of poor management failed to take seriously the state’s obligation to fund long-term obligations. An administration that refused to pass a budget impaired the state’s finances and economy. Residents were left frustrated and investors were scared off.

Leadership over the last few years has shifted the state’s credit quality trajectory upward in a meaningful way. To be sure, Illinois’ pension liabilities will always hamper the state’s fiscal flexibility, but Illinois is no longer a credit that investors should wholly avoid based on the state’s past practices.

Illinois’ credit quality is expected to be stable over the near to medium term. Revenues have consistently outperformed projections over the last three years and one-time federal pandemic relief funding has been deployed responsibly. The state has eliminated the backlog of bills it once relied on to manage cash flow and repaid all interfund borrowing. Illinois now has a Budget Stabilization Fund, expected to exceed $2.1 billion by the end of the current fiscal year (FY24). Though it is still modest at about 4.5% of expenditures, just having a reserve fund is meaningful, as Illinois had no rainy day reserve at all prior to 2022. A new state law increased the statutory target to 7.5% from 5%.

Governor Pritzker’s proposed FY25 general fund budget totals $52.7 billion, a modest 2% increase over projected Fiscal Year 2024 spending, inclusive of supplemental appropriations. Revenue projections indicate individual income taxes will

increase by 3.8% and sales taxes will be up 3.3% over the prior year. Estimated revenue growth exceeds projected expenditures by about $300 million. Of this, $170 million of the surplus would be earmarked for the Budget Stabilization Fund under the governor’s plan. The budget is expected to be adopted on time in May and to be close to the governor’s proposal.

Increased resources and attention to funding pension obligations have been key to recent credit upgrades. Supplemental pension contributions that were $700 million above the statutory amount in 2022 and 2023 were key to rating upgrades. Because pensions are not funded at an actuarially determined contribution (ADC) amount, the liability continues to grow as annual contributions fall far short of a tread water amount. But they’ve steadily been moving toward the ADC, now at about 73%. Current state statutes require the annual contribution to be sufficient to reach a 90% funded ratio by 2045.

Illinois is one of the few governments that does not set a 100% funding goal. The governor’s proposed FY25 budget would shift this goal to 100% funded by 2048, which extends the final year by three. In the near term, the impact would be slightly lower annual payments.

The plan also calls for redirecting a portion of revenues currently supporting debt service to pensions once bonded debt is retired. Illinois issued pension obligation bonds and deficit financing bonds in 2003 and 2017. Once those bonds are paid off in 2033 and 2030, respectively, the governor proposes using half of the newly available revenue for current pension payments. This would not have an impact until 2030, but a longer-term plan for pension funding and commitment to redirect resources is credit positive.

Illinois is still comfortably the fifth largest state in terms of GDP and is the sixth largest state in terms of population, with 12.7 million residents. The state economy is the 18th largest in the world, though growth is lagging. Illinois’ real GDP was up 1.3% in 2023, compared to the national rate of 2.5%. Job creation and employment lag the region and nation. Illinois is expected to be a below average performer as the economy, employment and income metrics grow at a comparatively slower pace.

Future fiscal stress is likely to come from stressed underlying governmental entities looking to the state for additional help. Over the next year, the City of Chicago, Chicago Transit Authority and the Chicago Board of Education are all likely to ask for additional funding and tax revenue. The demands to help fund Chicago’s migrant costs, transportation projects and public education will compel state leaders to balance keeping the state’s largest economy and its local credits steady with the state’s own budget stability. This may prove to be politically noisy, and these are developing situations to be closely monitored.

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Endnotes

Sources

The Bond Buyer, Oregon Department of Transportation, Utah Department of Transportation

https://www.cnn.com/2023/07/03/politics/state-tax-cuts-revenue/index.html

https://budgetblog.nasbo.org/budgetblogs/blogs/kathryn-white/2023/01/25/rainy-day-funds-reach-historic-levels

https://www.cbsnews.com/news/taxes-2023-27-states-want-to-cut-taxes-as-rainy-day-funds-reach-records/

https://apnews.com/article/tax-cuts-budget-shortfalls-states-5a28a95465296f92ba6dcf31822570a2

https://fortune.com/2024/01/03/state-tax-cut-trends/

https://publicintegrity.org/inequality-poverty-opportunity/taxes/unequal-burden/more-tax-cuts-put-states-revenue-at-risk/

https://taxfoundation.org/blog/state-tax-cuts-revenue/

https://www.taxpolicycenter.org/taxvox/three-years-state-tax-cuts

https://www.cbpp.org/research/state-budget-and-tax/states-recent-tax-cut-spree-creates-big-risks-for-families-and

https://fox4kc.com/news/kansas-gov-calls-tax-plan-too-expensive-expert-weighs-in/

https://usa.streetsblog.org/2023/07/12/what-utahs-next-gen-road-usage-charging-pilot-could-mean-for-the-rest-of-america

https://kansasreflector.com/2024/04/29/kansas-senate-fails-to-override-governors-veto-of-tax-cut-package/

This material is not intended to be a recommendation or investment advice, does not constitute a solicitation to buy, sell or hold a security or an investment strategy, and is not provided in a fiduciary capacity. The information provided does not take into account the specific objectives or circumstances of any particular investor, or suggest any specific course of action. Investment decisions should be made based on an investor’s objectives and circumstances and in consultation with his or her financial professionals.

The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Performance data shown represents past performance and does not predict or guarantee future results. Investing involves risk; principal loss is possible.

Important information on risk

Investing involves risk; principal loss is possible. All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time. Investing in municipal bonds involves risks such as interest rate risk, credit risk and market risk. The value of the portfolio will fluctuate based on the value of the underlying securities. There are special risks associated with investments in high yield bonds, hedging activities and the potential use of leverage. Portfolios that include lower rated municipal bonds, commonly referred to as “high yield” or “junk” bonds, which are considered to be speculative, the credit and investment risk is heightened for the portfolio. Bond insurance guarantees only the payment of principal and interest on the bond when due, and not the value of the bonds themselves, which will fluctuate with the bond market and the financial success of the issuer and the insurer. No representation is made as to an insurer’s ability to meet their commitments.

This information should not replace an investor’s consultation with a financial professional regarding their tax situation. Nuveen is not a tax advisor. Investors should contact a tax professional regarding the appropriateness of tax-exempt investments in their portfolio. If sold prior to maturity, municipal securities are subject to gain/losses based on the level of interest rates, market conditions and the credit quality of the issuer. Income may be subject to the alternative minimum tax (AMT) and/or state and local taxes, based on the state of residence. Income from municipal bonds held by a portfolio could be declared taxable because of unfavorable changes in tax laws, adverse interpretations by the Internal Revenue Service or state tax authorities, or noncompliant conduct of a bond issuer. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager.

Nuveen, LLC provides investment solutions through its investment specialists.

This information does not constitute investment research as defined under MiFID.

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