Overview

New Jersey (A-/Negative GO rating) projects revenue will drop in combined fiscal years 2020 and 2021 by $10 billion compared to the governor's February executive budget proposal for fiscal 2021. We believe this drop is significant and will worsen the state's existing structural deficit, when considering actuarial shortfalls in pension contributions. Before the current pandemic, the state had started to make gradual progress in reducing its structural budget gap between ongoing revenue and ongoing expenditures.

In actual year-to-year terms, revised fiscal 2020 operating revenue would decline $1.6 billion, or 4.1% in the 12-month period ending June 30, 2020, compared to actual fiscal 2019 revenue (see table). Twelve-month 2021 revenue ending June 30, 2021, would decline $2.8 billion, or 7.6% from the 12-month period ending June 30, 2020, revised revenue forecast. The legislature's independent Office of Legislative Services forecasts slightly higher tax revenue, at $383 million above the state's projection in fiscal 2020 and $104 million higher for the extended three-month June to September period.

The state's operating tax revenue in April came in 59.7% below April 2019, led by a 71.1% decline in net income tax, a 59.6% decline in net corporation tax, and a 13.9% decline in net sales tax.

A large part of the April income tax decline is likely attributable to the deferral of income tax as a result of the extension of the income tax filing deadline from April to July, as can be seen in better income tax results for May. One-month May 2020 total major tax revenue came in 13.5% below the same May 2019 period, but with only a 2.8% one-month decline in net income tax compared to May 2019. However, one-month May 2020 net sales tax was down 20.1% compared to the same prior year period.

On a cumulative fiscal year to date basis through May, with only one month remaining in the twelve month period ending June 30, major operating tax revenue was down 8.5%, or $2.5 billion, over the same period in 2019, and net income tax was down 13.6%. The governor's earlier February 2020 executive budget proposal for fiscal 2021 projected 3.8% growth in major operating taxes for fiscal 2020, while the state now projects a 3.9% decline.

The revenue declines pose a problem due to low levels of liquidity. The state has already fully drawn down an external bank revolving credit facility for $1.5 billion. The state ended fiscal 2019 with a modest $1.3 billion budgetary reserve, or 3.3% of appropriations.

The extension of the income tax filing deadline might have caused additional liquidity problems, since in New Jersey cash flow borrowing cannot cross fiscal years. However, the state has extended the end of its 2020 fiscal year to Sept. 30 from June 30, to allow a renegotiated cash flow facility to extend past the former fiscal year end. The governor also has strong powers to withhold spending as needed to end a fiscal year in balance by cutting spending, if revenues come in less than budgeted, and used this power to allow sufficient liquidity this summer.

De-appropriations in fiscal 2020

So far in fiscal 2020, the governor has proposed de-appropriating $1.3 billion of spending, or 3.4% of originally budgeted fiscal 2020 appropriations. The state projects these spending cuts, along with various spending freezes and other measures, would turn what would have been a $1.2 billion projected negative reserve position at June 30 into a small $344 million positive reserve, although still a minimal 0.9% of appropriations (see table).

The governor has not proposed reducing pension contributions to date. Other small changes include not backfilling revenue shortfalls in lottery revenue dedicated to pension contributions, and no longer including in fiscal 2020 a proposed year early increased pension contribution as a result of the most recent pension mortality experience study calculated for fiscal 2021.

The $1.3 billion of fiscal 2020 de-appropriations cover a long list of individual items and include:

• $295 million of appropriations previously held back in February
• $397 million surplus Medicaid balances
• $135 million Homestead Benefit Program (property tax credits)
• $103 million senior public college operating aid
• $68 million opioid funding

Extended three-month fiscal year appropriations

The state has not yet formally budgeted for the extra three-month extension of the fiscal year to September from July. The governor has proposed extended appropriations of $7.58 billion, now part of the state's extended 15-month fiscal 2020 year (see table).

However, this level of spending is artificially low due to $2.19 billion of proposed one-month deferral of certain appropriations normally occurring from September into October, the first month of the new fiscal year. This would represent a large 7.2% of annualized three-month appropriations, without further federal assistance. We believe this could create a significant need to access the external debt markets for liquidity purposes in October when the money is spent in addition to ongoing October expenditures, and after the current revolving credit cash flow facility has expired. While these deferrals would improve fiscal end Sept. 30, 2020's budgetary balance, liquidity would decline significantly the following month.

The additional liquidity need in October could potentially be financed with long term bonding. A GO bond authorization of up to $5 billion that could be used for deficit financing is moving through the legislature. Additional deficit financing might be obtained from the Federal Reserve municipal liquidity facility (MLF). The exact size of borrowing to cover the deferrals, and potential revenue declines later in fiscal 2021, will be dependent on the shape of the final fiscal 2021 budget, not expected to be enacted until the end of September. The state also has the ability to issue long term bonds backed only by annual appropriations without a popular vote.

The proposed $5 billion GO bond authorization could be subject to legal challenge—the constitution only allows GO bond authorizations without a popular referendum in case of an "emergency."

New Jersey has used private revolving loan agreements for cash flow purposes in recent years. The state originally entered into a $2 billion in aggregate revolving cash flow facility for fiscal 2020 with Bank of America, N.A. and BofA Securities. This has been renegotiated to extend to Sept. 25, 2020, with a reduced $1.5 billion par amount, which has been fully drawn. State cash liquidity at fiscal end 2020 would be enhanced with the $2.2 billion of payment deferrals to October from September, but at that time the state would likely need to either draw on a MLF facility or arrange other external financing.

The governor's proposal for the extended three-month period would leave the state with what we would view as minimal budgetary reserves totaling $494 million at its new Sept. 30, 2020, extended fiscal year end—far less than the $2.19 billion one-month deferral of spending to October from September.

The proposed one-month deferral of spending to October from September:

• $951 million quarterly pension payment
• $468 million school aid payment
• $355 million Community Affairs/Treasury payments
• $250 million special education payments
• $114 million NJ Transit subsidy
• $29 million transitional aid to community affairs
• $23 million nonpublic education security aid payment

The state will also receive $2.393 billion additional federal aid under the Coronavirus Aid, Recovery, and Economic Security Act for additional COVID-19 related expenditures. This money does not provide state budget relief as it can only be spent for additional coronavirus related expenditures and must be completely spent by Dec. 31, 2020. However, as these funds can be held in the state general fund, they can be co-mingled with other investments and will have the effect of improving cash liquidity, at least until December.

While a one-month deferral in quarterly pension contributions should not significantly affect overall pension funding in the long term, the impact on state cash flow when the pension payment is made in October will significantly increase liquidity needs.

As it is, the scheduled quarterly pension contribution in October would only contribute toward paying 80% of the pensions' actuarial annually determined contribution (ADC) using a pre-pandemic actuarial valuation. In fiscal 2020, the state likely will fund slightly less than its budgeted 70% ADC contribution for the 12 months ending June 30, 2020, as the governor has proposed no longer including an early $278 million pension contribution from an updated actuarial experience study calculated for determining fiscal 2021 contributions, and by not backfilling shortfalls in dedicated lottery contributions to the pension fund.

As of May 2020, one-month lottery revenues were 5.1% below the same year earlier period, and cumulative year to date lottery revenue was $122.8 million, or 12.6% below the prior year period. New Jersey's combined pension funds were only 39.7% funded on a GASB basis in fiscal 2019. This funded ratio likely will worsen to the extent pension investment returns are less than the state's 7.3% assumed rate of return for statutory funding purposes in fiscal 2021. As of April 30, 2020, pension fund annualized returns were negative 2.47% through the fiscal year to date. (For more information on New Jersey's pension funds and credit quality, please see our most recent full analysis published April 29, 2020.)

Will the state raise its pension contribution to 80% of ADC?

A key credit question is whether the state will actually raise its pension contribution to 80% of ADC in fiscal 2021, as previously indicated, or will instead reduce pension contributions, as the state has done in previous recessions, sometimes in the middle of the fiscal year. We calculated, when the fiscal 2020 budget was adopted in 2019, that the state's structural deficit as a result of underfunding its pension funds was about 4.2% of expenditures. The structural deficit between ongoing revenues and ongoing expenditures is now likely to grow substantially, as on top of annual pension underfunding on an actuarial basis, the state will add large one-time spending deferrals and potential deficit financing for operations. The pressure to revert to lowering annual pension contributions will be intense, while deficit bonding to essentially make an increased 80% of ADC pension contribution (last year scheduled to rise to $3.81 billion in fiscal 2021 from the general fund, or 11.2% of revised general fund revenue, plus $1.09 billion from the lottery) is only substituting one liability for another.

Even at 80% of ADC, state funding would still be well short of what is needed to keep its pension fund healthy. Using our methodology, we calculate that the state's static funding ratio in fiscal 2019 (when the state contributed 60% of ADC) was only 75.3% for its main public employees' pension plan and 57.8% for its teachers' plan, while the state's 39.7% combined pension funded ratio for all its pension funds on a GASB basis in fiscal 2019 was the second worst in the nation, after Illinois.

Economic Outlook

New Jersey has had the second largest number of COVID-19 cases (only New York has had more), despite having a much smaller population. The governor has imposed social distancing restrictions that are being lifted slowly, with many businesses still affected.

IHS Markit forecasts New Jersey real gross state product to contract a steep 8.0% in calendar 2020, before expanding 6.1% in 2021, compared to a 7.6% drop for the nation in 2020 followed by 5.1% growth. The federal Bureau of Labor Statistics reports New Jersey's preliminary April unemployment rate was 15.3%. As a result, New Jersey's revised revenue forecast for steep drops in revenue is reasonable, although subject to unpredictable swings as the course of the pandemic works its way through the state.

Conclusion

Assuming the legislature adopts the governor's appropriation proposal for the extend three month period ending Sept. 30, 2020, the state projects it would end fiscal 2020 with a budgetary balance of $494 million--a very small positive balance of 1.6% of annualized appropriations, multiplying the three month appropriations by four. However, this does not count the one-month deferred appropriations of $2.19 billion, or about 7% of annualized appropriations, even though it will affect cash flow in October. Whether the state will need to seek external cash flow financing of $2 billion or more in or before October will depend on legislative action in adopting a fiscal 2021 budget for the remaining nine month of fiscal 2021. Key credit factors will be the level of structural deficit in the final fiscal 2021 adopted budget, and how quickly New Jersey's economy can recover, enabling the state to increase pension contributions without deficit financing. Before this recession New Jersey was gradually increasing its pension contributions and appeared set to begin reducing its pension liabilities. However, the risk is that New Jersey could emerge from the recession with combined debt, pension, and OPEB liabilities so large as to make paying down these liabilities increasingly difficult even during periods of moderate economic growth.