Balancing act: states rework revenue plans

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 that previously cut income tax rates will likely see impacts on their budgets
• Declining fuel tax revenues have left states exploring ways to supplement income
• Illinois’ credit quality is expected to be stable over the near to medium term

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.

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.

High yield municipals: land-secured sector update

• Most districts are residential in nature, so credit quality has some correlation to the health of the housing market. Housing demand continues to exceed supply in most areas. Homeowners with low mortgage rates are reluctant to sell, propelling buyers into new housing communities. Both factors continue to support credit quality in the sector
• Defaults have been low over the past several years. Bloomberg identifies only six land-secured credits (classified as community development districts, Mello-Roos bonds, metropolitan districts and special assessment bonds) that have experienced monetary defaults between 2020 and 2023. These six credits have bond issuances that total approximately $160 million and account for just 2% of the par amount of municipal bonds that Bloomberg has classified as experiencing monetary defaults during this period.
• Land-secured bonds remain a strong source of supply in the high yield market. Supply has historically been concentrated in states with strong population trends and legislation that accommodates land-secured issuance, such as California, Colorado and Florida. We expect to see continued steady supply in these states, as well as increased issuance in states such as Texas and Utah, in the coming years as this financing tool becomes more commonly accepted in other fast-growing areas. Issuance picked up in the sector beginning in 2019 and peaked in 2021, in line with historically low interest rates.