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The Big Picture

With most U.S. states in the final innings of their 2024 fiscal year, fiscal 2025 budgets look more like double-headers with the playbook remaining relatively unchanged from a year ago. Budgetary priorities among states remain focused on staple issues, including enhancing grade K-12 education funding--with a bent toward expanded choice--reassessing Medicaid outlooks, and further extending tax relief.

Decidedly different this year is the evolving economic backdrop behind states' revenue projections. Although most states had anticipated a step-down in economic growth when crafting their fiscal 2024 budgets, the economy notably punched above expectations. An ever-resilient consumer kept the foretold recession at bay, but a protracted period of restrictive Fed policy, coupled with uncomfortably stubborn inflation, might finally be sufficient to weigh on consumer eagerness, or worse, capacity, to keep up the pace. The upside economic surprise, however, was not enough for all states to see a corresponding revenue bump because some have missed their initial revenue expectations.

As economic tailwinds fade, an emerging risk for fiscal 2025 budgets is that revenue could prove more sensitive to broader macroeconomic trends with limited boost to momentum. Should revenue miss its mark, states will have to exercise fiscal prudence to recalibrate and maneuver budgets toward structural alignment. This is especially true for states that enacted tax cuts--in some cases significant ones--without the hindsight of the potentially distortive effects from pandemic-era aid that have now all but completely filtered out, coupled with an elevated interest-rate environment.

The upside to an otherwise cautionary prospect is that the baseline outlook remains stable, in line with our 2024 sector view for states. (See, "U.S. States 2024 Outlook: Credit Stability Endures In Unstable Times," published Jan. 4, 2024, on Ratings Direct.) Riding on the coattails of better-than-expected economic trends, credit fundamentals continue to improve as fiscal 2025 (for most states) begins. With the soft-landing scenario emerging, the budgetary operating environment, even if a touch bumpy, should remain manageable, with reserves near or above record levels and long-term liabilities under control for most.

Economic Backdrop

Although S&P Global Ratings now anticipates the first federal funds rate cut to come in December rather than July, the shift to the tail-end of the year does not alter the broader economic outlook for the balance of the year. (See, "Persistent Above-Target Inflation Will Delay The Start Of Rate Cuts In The U.S.," published May 1, 2024.) The baseline forecast expects an annual growth rate near our March forecast estimate, with real GDP growth at 2.5% for 2024. On a four-quarter-change basis, the fourth quarter will run 130 basis points below 2023's fourth quarter and settle at about 1.8%. Even with recent inflation readings on the upside, we continue to anticipate the trend toward further disinflation taking shape in 2025 and approach the Fed's 2% target rate closer to the end of the year.

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According to S&P Global Market Intelligence, the median state's real gross state product is forecast to be about equal to the national GDP level, with 2.4% annual growth in 2024, decelerating to 1.6% in 2025. Florida and Texas are the only states to rank among the top-five fastest-growing in both 2024 and 2025. The Lone Star State is forecast to expand nearly 3.7% in 2024, followed by 2.8% in 2025, while the Sunshine State is forecast to grow 3.3% and 2.3% in 2024 and 2025, respectively. Among the slowest-growing states, Arkansas, Connecticut, and Mississippi are the only ones to rank in the bottom-10 in both years.

Median state employment is forecast to rise by 1.3% for the year, followed by a modest 0.26% in 2025. Florida and Texas lead the pack in 2025, though Arizona, Idaho, South Carolina, and Utah also rank among the top-10 fastest-growing states in 2024 and 2025. Of note, while employment growth remains positive for all states in 2024, it turns negative for six states in 2025. Again, Connecticut and Mississippi rank among the bottom-10 slowest-growing states, along with Illinois, in 2024 and 2025.

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Revenue Trends: The Variance Across Budgets

Sales taxes have generally held steady, propping up state revenue during a period of softening individual and corporate income taxes in 2023, some of which was expected given the number of tax cuts across states. Revenue performance to date has been mixed for fiscal 2024, with a majority of states performing above or in line with forecast in the current year. However, a small group are coming in below forecast and some are facing sizable revenue gaps. The Urban Institute's latest update on revenue performance (through March) notes that 21 states reported a year-over-year decline in tax collections on a nominal basis.

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Navigating Revenue Mismatches

In our view, unique circumstances have led to states' varied experiences in revenue performance. With the expectation of softening economic growth, we believe subdued revenue environments could become more widespread in fiscal 2025, requiring management teams to be equally thoughtful in making policy decisions with heightened vigilance on the expenditure side.

Arizona faces a revenue gap of an estimated $650 million in the current fiscal year, $676 million in fiscal 2025, and $343 million in fiscal 2026. The state phased in a series of income tax cuts in recent years, with the last in tax year 2023 due to the state meeting certain revenue thresholds. Following these tax reductions, Arizona's revenue collections have failed to keep up with forecast in fiscal 2024, primarily driven by personal income tax performance. In response to the projected deficits, the governor has proposed a variety of resolutions that largely include one-time appropriation revisions, as well as cuts, fund transfers, and delaying some spending. Lastly, the state has built up its reserves in recent years, which provides it with additional flexibility as it navigates the budgetary pressures that lawmakers are resolving this budget cycle.

California's budgetary pressures stemmed in part from a combination of both timing and significant revenue volatility. For tax year 2022, the state conformed with the IRS' income tax filing deadline delay due to the severe winter storms, which affected the timing of collections for fiscal 2023. Rather than having to adhere to the typical April deadline, filers had until November 2023 to file. However, the data from that filing was pivotal in helping determine the state's fiscal position as it began fiscal 2024, and California ultimately ended fiscal 2023 with far less than it had expected. The administration's latest estimates, reflected in the May revision, note that fiscal year 2023 and 2024 revenue is 20% lower than initially forecasted when the fiscal 2023 budget was adopted. The combined effect amounted to an $83.1 billion difference over the two fiscal years. The governor's proposed solutions to remedy the gap include the use of reserves, expenditure reductions, revenue adjustments and internal borrowing, delays, fund shifts, and deferrals.

Halfway through its current fiscal year, Massachusetts recognized that declining revenue in fiscal 2024 would only be addressed by reducing expenditures. The state had been collecting about 4% less than expected about halfway through the current fiscal year, which the administration resolved through a variety of expenditure reductions and by using some nontax revenue. However, according to the state's April collection report, Massachusetts' revenue performance has made an about-face and is now 2.7% more than the year-to-date forecast.

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Budget Pressures We Are Watching: Low--Moderate--Elevated--High

Overall: Moderate, offset by strong reserve balances, although the outlook tilts to moderation

As much control as states might have on the revenue side, their grip on spending tends to be firmer, though not without risks. General fund expenditures for K-12 public education typically makes up the largest share of state budgets, alongside public health outlays predominantly for Medicaid. With revenue anticipated to cool, there could be slightly more pressure on public education funding given mandated funding level requirements for most states, along with strong political efforts to increase funding in light of recent cost pressures. On balance, Medicaid cost pressures are elevated, reflecting the recent roll-off of enhanced federal FMAP funding and mixed experiences with the disenrollment process and, indeed, costs. As for infrastructure, we expect these expenditures will remain moderate, given the amount of federal funds flowing to states in recent years, such as from the Infrastructure Investment and Jobs Act (IIJA) that help manage project costs in the medium term, though again running against elevated project costs and competing talent. Finally, we expect pension and other postemployment benefit (OPEB) costs, specifically with states facing large unfunded liabilities, to remain a long-term budget pressure, especially as they strive to keep up the trend of strengthening funding discipline in recent years.

Public Education: High

As noted in the U.S. Census Bureau Annual Survey of School System Finances (latest report April 2024), per-pupil public school spending increased nearly 9% in fiscal 2022, representing the largest increase in over 20 years. The momentum to direct additional funds to public schools remains unabated because pressures at the local level have increased, stemming from pay bumps for teachers and administrative and auxiliary staff, as well as general maintenance. Given that property taxes tend to be among the leading sources of local funding, the recent run-up in property values and corresponding taxes across states have led to legislatures working to provide measurable levels of relief. To the extent that the states take on a greater share of education funding or commit themselves to it, without a corresponding structural re-alignment--such as a new recurring revenue stream or equivalent expenditure reduction--long-term structural balance will be challenging to achieve, most acutely in periods of economic contraction.

Infrastructure: Moderate

Owing in part to once-in-a-generation federal support for broad infrastructure projects, states have ramped up their plans to address long-standing capital needs and capitalize on new programs ostensibly aimed at enhancing energy security, addressing climate challenges, and reducing the federal deficit. Although the disbursement of funds will be ongoing, in the short term, the challenge states face involves elevated project and labor costs. (See, "Record U.S. Infrastructure Spending Is Colliding With Higher Construction Costs And Other Hurdles," May 14, 2024.) Although we've noted a decrease in input costs, states are being forced to reassess capital projects to maximize their long-term effects and dollars spent. Given the long runway for federal disbursement, cost pressures are not likely to abate in the short term. In tandem, climate hazards could further affect U.S. state costs associated with infrastructure investment, particularly as adaptation and resiliency measures take hold to limit asset damage and operational disruptions associated with an increasing frequency of severe weather events. (See, "Navigating Uncertainty: U.S. Governments And Physical Climate Risks," published April 23, 2024.)

Pension/OPEBs: Elevated

Pension funding woes might not be in the headlines--reflecting in some respects states' continued progress and improved funding discipline in recent years--but the adage that objects may be closer than they appear is a useful reminder (or warning) for states that lose sight of the looming surge of retirements over the next decade. That said, we believe a focus on pension and OPEB funding discipline will further support progress in the short term. Although seemingly running in place, funded ratios have improved despite the market volatility that weighed on system returns just two years ago. As we've noted before, prudent risk management will remain key to help balance the risks around an evolving economic backdrop layered with an aging population and escalating medical cost growth that, if mismanaged, could add longer-term budgetary pressure.

Medicaid: Elevated

A year after the start of the Medicaid unwinding, state enrollment levels have come down significantly from their peak, though the budgetary effects are now becoming clearer. For now, spending growth is expected to be a modest 2.5% in fiscal 2025 following a notable 17% in 2024, as cost estimates and enrollment stabilize. With the advanced visibility to the eventual elimination of the enhanced rate and disenrollment period for Medicaid, states were able to manage through the programmatic changes without significant budgetary pressures. Overall, we believe states are as well positioned as they can be to course-correct around any obstacles that their programs might present in the short term. (For additional information, see "U.S. State Medicaid Transition: Stable Condition Near Term, With Outyears Demanding Care," May 2, 2024.)

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