For the U.S. states, S&P Global Ratings' baseline economic forecast of slower growth in 2019 holds the potential for renewed fiscal strain. Although now long in duration, the economic expansion that began in mid-2009 has been shallow. One consequence of this was the persistence of narrow fiscal margins for many states and, relatedly, an uncharacteristically high downgrade-to-upgrade ratio lasting through 2017. This changed in 2018 when, along with stronger economic growth, state fiscal health and credit quality stabilized. However, the higher GDP growth rate in 2018—while beneficial—was driven in part by an infusion of late-cycle federal fiscal stimulus (tax cuts and deficit spending). As the effect of this stimulus fades, and in light of the Federal Reserve's ongoing tightening, we expect the pace of economic growth to decelerate in 2019. A protracted federal government shutdown would only accentuate the drag on growth emanating from Washington (see "A U.S. Federal Government Shutdown Won't Immediately Threaten State Credit Quality, But It Sets An Ominous Tone For 2019," published Dec 21, 2018).

Furthermore, the Tax Cut and Jobs Act of 2017 may have caused some taxpayers to move income into (calendar) 2017. While this contributed to windfall tax collections in 2018, states can expect growth rates to decline in 2019 as revenues revert to trend.

Risks And Opportunities

Financial Management In Fiscal 2019 Looms Large For Fiscal 2020

According to our forecast, the peak of the economic cycle occurred in 2018. Therefore, the states' financial management now—when revenues are still relatively strong—will determine much about their fiscal resilience when conditions soften. In our view, a growing list of risks with the potential to cause acute financial stress indicate that uncertainty is on the rise. Among the emerging hazards are more frequent natural disaster event risks, the increasing correlation of state fiscal health to financial market performance, and the rising threat of a full-blown trade war with its disproportionate effects on states with agriculture- and manufacturing-based economies. Consequently, we believe states have entered a new era in which fiscal resilience increasingly must encompass a capacity to withstand both the effects of traditional economic fluctuations and stress originating from a broader range of emerging risks.

Furthermore, even in the absence of an all-out trade war, higher tariffs on raw materials imports combined with rising interest rates may inflate the cost of doing deferred maintenance and new infrastructure projects. Ironically, greater investment in infrastructure could be among the supply-side policy responses that could help reverse the economy's eroding capacity for growth. Notably, the same demographic headwinds—primarily the aging population—that pressure state pension systems and Medicaid budgets are also integral to our outlook for slower economic growth rates ahead.

On the upside, several developments in 2018 present opportunities for the states to hold the line in 2019 against some of the structural pressures mentioned above. First is the U.S. Supreme Court's June 2018 Wayfair decision, which allows states to levy sales and use tax on most online transactions. The ruling is favorable for state finances because it could result in a permanently higher revenue base. However, most estimates suggest the increase will be relatively small, ranging from $8 billion to $13 billion (Government Accountability Office) to as much as $15 billion to $23 billion (National Conference of State Legislatures). Assuming the high end of the estimated range, the additional revenue equals just 2.7% of total state general fund revenues in fiscal 2018.

Following the 2018 midterm elections, states also benefit from reduced political uncertainty (at least through 2020) related to federal grant funding for their Medicaid programs. Earlier proposals to transform Medicaid into a block grant program or otherwise curtail federal funding for the program had major fiscal implications for the states. Although we expect similar ideas will periodically resurface—especially in the context of a deteriorating federal fiscal outlook—they are unlikely to pass Congress given its current political makeup.

Finally, although managing the peak of an economic cycle presents its own challenges and is at the heart of the state sector outlook for 2019, it is also an upside opportunity for states. Tax revenue grew at a faster clip in fiscal 2018 than any year since 2013 (when federal tax law changes induced an influx of one-time tax payments). This provided the states with a window of opportunity with which to build their budget reserves prior the start of the next downturn.

Credit Trends Stabilized In 2018

Given that the states' revenues and expenditures are economically sensitive, their near-term fiscal performance typically correlates with economic trends. Of the five main rating factors identified in our criteria for rating state government debt, budgetary performance is among the most fluid. While a state's economic base and liability profile (along with its governmental framework and financial management policies) are also major considerations in our criteria, material changes in these factors tend to unfold over longer periods than commensurate changes in budgetary performance. As the economy began to accelerate in late 2017 and early 2018, for example, fiscal pressure on the states eased, facilitating timelier budget adoption and better overall budgetary performance than in 2016 and 2017.

Chart 1

Current Rating And Outlook Distribution

Collectively, the states enter 2019 on generally strong footing from a credit standpoint. Fully half of the states hold either the highest (AAA) or second highest (AA+) ratings possible and 41 states are 'AA' or higher (see chart 2).

Chart 2

Trends in rating outlooks also illustrate the degree to which a stronger economic backdrop in 2018 bolstered state finances. Whereas there were nine states with negative outlooks at the beginning of 2018, currently—and for the first time since 2007-2008—there are none. Stronger economic and revenue conditions throughout the first half of 2018 helped states on the margin of a lower rating category shrink their fiscal gaps, build reserves, and avoid delays in budget implementation. It also helped that oil prices recovered, leading to higher capital investment by oil producing firms, which lifted employment and relieved fiscal pressure in several of the oil producing states. The more recent reversal of oil prices, however, could portend another round of budget pressure for these states.

Chart 3

Compared with 10 years ago, the spectrum of ratings in the state sector has widened and now reaches further down the rating scale than before. While in the immediate aftermath of the Great Recession there was just one state (California) with a rating below 'AA-', there are now five (Connecticut (A), Illinois (BBB-), Kentucky (A), Pennsylvania (A+), and New Jersey (A-)). Although the current outlook distribution points to credit stability through the near term, several of the states' credit ratings are now unusually low for the traditionally state sector. In our view, this reflects that the states have begun to bifurcate along fundamental lines.

Fundamental Weaknesses Continue To Weigh On The Credit Quality Of Several States

Through fiscal 2017, more than nine years into an equity bull market, the pension systems in three states (Illinois, Kentucky, and New Jersey) remained in distress, with funding ratios at or below 40%. Under current law, these states would need to commit to large increases in their annual pension contributions over a sustained period in order to bring their pension funding ratios closer to the median (70%). Complicating the prospects of such an initiative is that their budgetary conditions have shown limited improvement despite the now long-lived period of economic growth. Moreover, their general funds are already highly leveraged, with fixed costs consuming 24% to 31% of expenditures. Materially larger pension contributions would threaten to crowd out certain essential services in these states, likely rendering it politically untenable fiscal policy. Doing so may also contradict the U.S. Supreme Court's interpretation of the states' constitutional obligation to provide critical services, notwithstanding other contractual commitments they may have made. The daunting actuarial math endemic to mature pension systems with weak funded ratios that is on display in these states is also cautionary for the roughly 14 other states with pension funding ratios of 65% or less (see "U.S. State Pensions Struggle For Gains Amid Market Shifts And Demographic Headwinds," published Oct. 30, 2018.)

Preparing For A Rainy Day

According to S&P Global Ratings' economic forecast, real U.S. GDP growth will slow to 2.3% in 2019 and 1.8% in 2020, from 2.9% in 2018 (see table 1). The forecast also includes a revised probability of recession, now estimated at 15% to 20% within the next 12 months, up from the 10% to 15% range previously estimated. The recent uptick in equity market volatility and escalating trade tensions have caused the odds of a recession to edge somewhat higher in our forecast. We continue to believe stronger gains in labor productivity is the key to sustainably faster economic growth. While the federal tax cuts might have provided an incentive for the business investment that would make this possible, there is also some risk they primarily serve to ignite inflationary pressures (although there are not yet signs of overheating). Layered onto an economy experiencing decelerating growth, this raises the risk of a policy mistake, such as the Federal Reserve tightening monetary policy too quickly and causing the economy to tip into a downturn.

Table 1

Because fiscal years 2018 and 2019 both span calendar year 2018, they encompass what our forecast expects will be the peak year of economic growth during the current cycle. In the abstract, states operating pro-cyclical fiscal policy—building capacity during the expansion to cushion the subsequent downturn—would thus build their reserves in fiscal 2019. With this in mind, we evaluated the direction of the states' combined budget reserves (projected ending balances plus rainy day funds) as a percentage of their general fund expenditures. Reflecting stronger conditions, the median state budget reserve increased to 7.9% of expenditures in their fiscal 2019 budgets, from 7.3% in 2018. However, the gains are uneven as only 13 states' budget reserves—as a percentage of expenditures—are materially larger in fiscal 2019 than in 2018, while reserve percentages in 15 states actually declined. For the 22 remaining states with budgeted reserve percentages in fiscal 2019 that were within 50 basis points in either direction of their balances in 2018, we considered them unchanged (see map). There are also 11 states that in fiscal 2019—the tenth year of the expansion—have reserves equal to less than 5% of expenditures.

Table 2

Are Self-Imposed Fiscal Constraints A New Trend?

The history of U.S. state fiscal policy includes examples of states adopting budgetary constraints intended, at least in part, to preserve access to capital markets. For instance, the balanced budget requirements to which virtually all the states now adhere began as a response to two waves of state debt crises that occurred in the mid to late 1800s. More recently, numerous states have updated and formalized their policies for making deposits to-and-withdrawals-from their rainy day funds. In 2018, lawmakers in Connecticut, apparently seeking to assure markets that the state would avoid severe budget distress, took the unprecedented step of adding certain budget restrictions to its bond documents. Connecticut's restrictions preclude the legislature from appropriating 100% of anticipated revenues in its budget and mandate annual deposits of income tax above a "volatility cap" to the rainy day fund, unless overridden by a 60% legislative vote. In our view, these rules promote structural balance and facilitate the accumulation of a reserve, both of which are manageable in the context of an expanding economy. However, when faced with projected budget deficits in a weaker economic climate, the covenants may deprive the state of needed fiscal flexibility. In effect, the state may have relinquished a portion of its sovereignty over its fiscal affairs, which—in the U.S. municipal market—we view as a uniquely strong credit feature for the states. This may warrant a cautionary approach for other states considering the adoption of such provisions.

On balance, we expect that most states can accommodate the incremental additional pressures related to slower economic growth anticipated under our baseline economic forecast at their current rating levels. Materially weaker than forecasted economic performance, however, would reveal that even after more than nine years of economic growth, several states remain susceptible to significant fiscal stress.

Medicaid Expenditure Growth Slows But Continues To Outpace Revenues

For more than 20 years (at least), outlays for Medicaid have increased faster than state revenues or other expenditures, and thus consume an ever-increasing share of state budgets. In fiscal 2018, Medicaid expenditures represented 20% of general fund expenditures, up from 14.6% in 1997, according to the National Association of State Budget Officers' (NASBO) 2018 State Expenditure Report. However, while total Medicaid expenditures will likely continue to outpace the inflation and the broader economy, they have slowed. In its recent 2017 actuarial report, the Centers for Medicare and Medicaid Services' (CMS) Office of the Actuary projected that total (federal and state) Medicaid expenditures will increase by 5.7% per year through 2026. This remains above projected inflation and nominal GDP growth, but down significantly from 2013, just prior to implementation of the Affordable Care Act (ACA) when the CMS projected that total Medicaid expenditures would increase by 7.7% per year through 2022 (its 10-year forecast window at the time). According to research from the Kaiser Family Foundation, spending growth has slowed because of lower enrollment trends due to a strengthening economy and from savings related to states pursuing managed care and other cost containment strategies.

Currently, the share of total Medicaid costs funded by the states is approximately 38%, down from 43% prior to implementation of the ACA. Under the ACA, states have the option to expand coverage to childless adults with incomes of 138% or less of the federal poverty level. The 36 states that to-date have adopted Medicaid expansion are eligible for a higher federal matching rate for covering their expansion populations. Initially, the federal match rate for the expansion population was 100% but is ratcheting down until it levels off at 90% in 2020. In 2018, the match rate was 94% and declines to 93% in 2019, translating to a structural increase in the portion of Medicaid costs covered by the states' resources. Nevertheless, whereas the CMS projected in 2013 that the states' share of Medicaid expenditures would increase by 6.5% per year through 2022, it now forecasts a 6.0% growth rate. Although the revised estimates for slower Medicaid expenditure growth are favorable for state finances, the program will likely continue to consume a growing share of state expenditures.

Chart 4

State Liabilities And Revenue Structures Are Increasingly Prone To Volatility

State finances are increasingly sensitive to the performance of financial markets, which directly affect both state revenue performance and—through their impact on pension assets in particular—state expenditures. The equity market selloff in December raises the possibility of weaker revenue trends and pension asset performance, even in the absence of harm to the broader economy.

Revenue side volatility

On the revenue side, a decades-long evolution of the U.S. economy in favor of services and away from manufacturing and tangible goods has gone unmatched by changes in state tax codes. Most states established their sales and use tax regimes during the early to middle part of the previous century, when agriculture, manufacturing, and trade in tangible goods still dominated the economy. As services came to represent a larger and growing share of overall GDP, there has been a corresponding erosion of the states' sales tax bases (see chart 5). Either unintended or through the adoption of progressive income tax structures, personal income tax revenues have filled the gap created by a receding sales tax base. In just the past 21 years, the personal income tax has increased to 46% of total state tax revenues (2018) from 37% in 1997, according to data collected by NASBO.

Chart 5

The growing dependence on personal income tax revenues increases the states' tendency to experience revenue volatility because it typically includes investment income gains and losses. Since 1997, the annual growth rate of personal income tax revenues nationally has had a standard deviation of 7.9%, almost twice the standard deviation of total revenues (4.8%), and more than four times that of U.S. GDP (nominal, 1.98%). Due to the nature of the current expansion, led by strong corporate earnings and stock market appreciation, conditions have been favorable for growth of the personal income tax. However, in the event the economy slows more than expected, or if equity markets selloff even without triggering a broader downturn, states could be in line for a bout of downside revenue volatility.

Chart 6

By allowing the personal income tax to comprise a greater share of their revenue portfolios, the states have implicitly accepted greater volatility in exchange for the stronger average growth rate it offers. Traditionally, state tax revenues overall have grown roughly in proportion with the broader economy. However, throughout the current expansion, they have lagged GDP growth, which itself has increased more slowly than before (see chart 7). The exception to this has been the personal income tax, for the reasons cited above and because of the higher tax rates implemented by several states in recent years. Since 2011, personal income tax revenues have increased at an average rate of 6.4% per year versus 3.5% for the sales and use tax. Income taxes have outperformed over the longer term as well. From 1997 through 2018, state income tax revenues have increased at an average annual rate of 5.1%, well above sales and use tax revenues (3.4%) and total general fund tax revenues (3.9%). Therefore, were it not for the uplift provided by the stronger performing personal income tax, the post-recession growth of total tax revenues would have lagged GDP growth by a wider margin.

Chart 7

Focusing on state tax revenue aggregates, however, risks drawing the wrong conclusion. In fact, a significant portion of the personal income tax revenue increase appears to have come from one state: California. In 1997, when California's population equaled 11.9% of the U.S. population, the state's personal income tax revenues equaled 16% of total personal income taxes collected by all the states. By 2018, California's personal income tax revenue had increased to 24% of personal income taxes collected nationally despite representing a similar share (12.1%) of the U.S. population as in 1997 (see chart 8). Furthermore, removing California's personal income tax from the total shows that in the other states, revenues from the personal income tax have grown at a less impressive 4.6% annually. However, they still exhibit an elevated 7.5% standard deviation (since 1997). Therefore, as a matter of fiscal policy, this suggests the states' increasing reliance on the personal income tax may do more to increase revenue volatility than it does to raise their revenue growth rates.

Chart 8

Nevertheless, despite California's disproportionate effect on the totals, there is a trend—albeit, more gradual—toward greater reliance on the personal income tax in the other states as well. After removing California from the totals, the other states' collective reliance on the personal income tax increased to 41% in 2018 from 36% in 1997. More relevant for the credit quality of any particular state is whether the personal income tax is associated with stronger overall revenue growth trends. In a review of recent revenue trends from fiscal 2016 through 2018, we found a weak (and statistically insignificant) relationship between states with higher personal income tax reliance and faster revenue growth rates.

Chart 9

Liability side volatility

States are also increasingly susceptible to volatility originating from their liabilities, primarily reflecting the ongoing maturation of their pension plans, which mirrors the broader aging of the U.S. population. As state pension plans transition into the distribution phase of their lifecycles, their large asset bases render them susceptible to greater losses in a market correction. Simply put, mature pension plans with large asset pools have more to lose in the event of a market selloff. In addition, given their maturing status, benefits payments now exceed the contributions received by employees and employers in a majority of state pension plans. In these cases, a positive investment return is necessary just to offset the drain on assets caused by the negative net cash flows. For fully funded plans, the negative cash flows have a neutral effect on their funded status (because the payouts, while eroding the asset bases, also shrink the pension liabilities). Negative cash flows also impede plans from recovering after a down year.

The two graphs below illustrate pension plans with the same starting positions, same contribution rates, and same normal cost (new incoming liability). The only difference between the two graphs is that the second one assumes higher benefit payments, resulting in net negative cash flows. This would occur in a plan that is more mature.

Chart 10A

Chart 10B

In order to reliably fund benefits, mature pension plans also must maintain relatively higher levels of liquidity than younger plans. This can hinder the efforts of plan managers to achieve the plans' investment return assumptions. Furthermore, even as state plans have been lowering discount rate assumptions, many are often only adjusting the embedded inflation assumption while continuing to project higher real returns. The latter assumption exposes the state plans to greater volatility risk. In short, the demographic trends coupled with volatile asset returns among the state plans could lead to higher future pension costs for the states.

A Cautious Outlook For 2019

Although we expect credit quality will remain stable for most states in 2019, slowing economic growth will likely result in the emergence of renewed fiscal pressure. To date, policymakers and, perhaps, investors, may not have sufficiently reckoned with the credit implications to the states if the nation's underlying capacity for macroeconomic growth is around 2.0%. In our view, there is some risk to state sector credit quality if, in the face of surging revenues this year, lawmakers enact budgets for fiscal 2020 that include large new ongoing spending commitments. On the other hand, a continued adherence to fiscal restraint may face political resistance considering that state funding for various social services and higher education aid have not yet recovered from recession driven reductions. As we see it, therefore, the direction of budget policy for fiscal 2020 will determine much about a state's resilience to the effects of decelerating growth as well as the inevitable next recession.