Although State Debt Levels Were Steady In 2023, Waning Federal Stimulus And Lower Borrowing Costs Could Increase Borrowing In Coming Years

U.S. state debt levels remained relatively flat in fiscal 2023 compared with 2022, declining a modest 1.3%. S&P Global Ratings attributes this year-over-year decline to a combination of factors, including elevated borrowing costs and inflation-induced cost pressures, record-high liquidity levels due to large budget surpluses, and substantial COVID-19 relief stimulus that could be used for one-time purposes, making pay-as-you-go (paygo) funding of capital expenditures a more attractive alternative to debt financing.

The rate-cutting cycle in the U.S. began with a 50-basis-point cut at the Sept. 18, 2024, Federal Open Market Committee meeting. S&P Global Economics believes that the Fed will continue easing monetary policy in the coming year through a regular series of interest-rate cuts. Our baseline outlook envisions a steady, spaced-out series of rate cuts that will help the Fed engineer a soft landing--where demand stays close to potential while the last bit of excess inflation evaporates. We believe the federal funds rate will fall to 3.00%-3.25% by the end of 2025 from the current 4.75%-5.00%, with another 50 basis points (bps) of cuts by the end of 2024 and 100 bps of cuts anticipated in 2025. For more information see "Economic Outlook U.S. Q4 2024: Growth And Rates Start Shifting To Neutral," published Sept. 24, 2024, on RatingsDirect.

Before the September cut, the Fed's 5.25%-5.50% target range challenged states to achieve significant savings through financings; however, lower rates in light of recent Fed actions and those anticipated continue to make the issuance environment more favorable. Given that the higher rate environment has reduced traditional refunding opportunities, some states have opted for optional extraordinary redemptions and tenders to redeploy cash and realize savings. New sale issuances have accelerated in 2024 because states have needed to balance the objective of funding critical state programs with long-term debt while striving to maintain rainy-day funds and other liquidity, thereby providing stability to state finances if an economic slowdown were to occur.

Inflation has begun to moderate in part due to the Fed's actions although it continues to adversely affect costs. Project costs have often increased well above the overall rate of inflation, with some states reporting they have revised project estimates upward by more than 30%. States have not made significant adjustments to their capital plans in general and, where possible, have leveraged American Rescue Plan Act (ARPA) and Infrastructure Investment and Jobs Act (IIJA) funds that will continue to flow into the economy over the next several years. ARPA dollars must be obligated by December 2024 and spent by the end of December 2026. The IIJA, which authorized $1.2 trillion for transportation and infrastructure spending, requires that $550 billion be spent before 2026. For example, Tennessee and Georgia have both funded their respective capital budgets with cash on hand, reducing their debt issuance expectations for fiscal years 2024 and 2025.

Since 2019, State Debt Burdens Have Generally Declined As A Share Of Real GSP And Personal Income

When evaluating a state's debt burden, S&P Global Ratings generally begins with a review of historical data. The trend of historical results and our understanding of the reasons for those trends inform our view of whether the debt burden will go up or down. We also consider a state's economic environment, our expectations for its economic growth, and that growth's likely impact on the debt burden in the future. Table 1 shows that, since 2019, the median state's debt burden has modestly decreased by most measures, including debt to personal income, debt as a percent of expenditures, and debt to real gross state product (GSP). On average, net direct debt per capita has increased modestly over the same period. This metric could increase over time if capital plans are not appropriately scaled as some states' population growth slows or declines. The five states with the most debt outstanding--are California, New York, New Jersey, Massachusetts, and Illinois--hold approximately 49% of state net direct debt outstanding (and account for about 26% of the U.S. population).

Table 1

S&P Global Economics' most recent forecast projects that U.S. GDP growth will slow to 1.8% in 2025 from 2.7% in 2024. States have a historically high level of liquidity that can be used to fund capital projects on a paygo basis, which will likely mitigate the negative impact that slowing economic growth would otherwise have on debt metrics. Therefore, we generally expect ratios will remain stable in the near-to-medium term. Many states, particularly those with larger debt burdens, employ robust debt management strategies and adhere to affordability requirements, all of which support our forward-looking view of stability when looking at median state debt burdens. We view a state's debt capacity and ability to pay debt service as correlated to its economic output, as taxes and fees generated by economic activity are the primary source to pay debt service. If generally favorable tax revenue trends reverse and the growth of state debt burdens begins to outpace growth of the revenue streams servicing them, it could suggest fiscal stress and a decreasing capacity to service debt. This is something we continually monitor throughout economic cycles.

State Current Costs For Debt, Pension, And OPEBs Tend To Correlate With The Size Of A State's Economy

States with high fixed costs, including debt, pension, and other postemployment benefit (OPEB) payments, typically have less flexibility to make necessary budget adjustments during periods of financial stress. We also expect that states with more rapid economic growth that have greater capital needs can generally support higher debt and liability levels.

Some states have increased debt burdens because they provide higher support for programs and projects that generally receive a greater proportion of funding from local governments. For example, Hawaii directly runs the public school, university, and community college systems. And Connecticut, in our view, generally provides a higher level of support to local needs resulting in a lower debt profile at the city and county level. Many states also have either constitutional or statutory requirements, or court-mandated minimums, to provide adequate educational funding, which can also lead to higher debt burdens because it can be difficult for many states to reduce funding for these programs from a legal standpoint.

Charts 1 and 2 show fiscal 2023 combined debt, pension, and OPEB current costs relative to state population and general fund revenues. On a per capita basis, South Dakota, Nebraska, Iowa, Florida, and Wyoming have the lowest current costs, with all states below $120 per capita. Six states--New Mexico, Massachusetts, Illinois, New Jersey, Hawaii, and Connecticut--had carrying costs in excess of $1,000 per capita in 2023. The median carrying cost per capita among states was $365, meaning that 25 states were below this threshold, and 25 were above it (chart 1).

Chart 1

As a percentage of general fund revenues, four states had current costs representing 2% of revenues or lower (South Dakota, Nebraska, Iowa, and Wyoming), while six states had current costs that exceeded 10% of revenues (Massachusetts, Maryland, Illinois, Hawaii, New Jersey, and Connecticut) (chart 2). The median current cost as a percentage of revenues was 4.4%, meaning that 25 states were above and 25 were below this level.

Chart 2

Combined proportionate state net pension and OPEB liabilities declined 8.8% in fiscal 2023 relative to fiscal 2022 levels. The decline in net pension liabilities and the associated improvement in pension funded ratios are largely due to positive investment returns estimated at 12% for fiscal 2023. S&P Global Ratings expects asset performance will spur notable improvement in U.S. public pension funded ratios for the fiscal year ended June 30, 2024 (July 1, 2023-June 30, 2024), with an expected 16%-17% return, adding to the positive returns for fiscal 2023. Given the typical one-year delay from pension measurement to reporting, we expect to see the positive credit impact play out over the next two years. For more information, see our report, "Pension Brief: U.S. Public Pension Funded Ratios Continue Improvement In 2024," published July 25, 2024.

Median net OPEB liabilities also declined to 0.4% of GSP in fiscal2023, from 0.5% in fiscal 2022 but increased to 0.7% as a share of personal income from 0.6% in fiscal 2022. Net OPEB liabilities per capita declined 22.7% to $248 from $321. Since most U.S. OPEB plans fund retiree medical benefits on a paygo basis, they are exposed to higher liability and cost volatility than they would be if they were prefunded. States might improve OPEB funding by adding assets, reducing liabilities, or both. Since states differ in their legal flexibility to manage liabilities, options for some to contain rising costs could be limited. Some face legal restrictions in their ability to prefund an OPEB trust, forcing claims volatility and cost escalation to directly affect these states' budgets.

Chart 3

Many States Still Fall Short Of The Minimum Funding Progress, Though Some Show Improvement

Despite efforts to improve funding discipline, many states are falling short of making meaningful progress on their aggregate pension and OPEB liabilities. Many are funding their retirement liabilities on an actuarial basis; however, if the underlying actuarial assumptions are not consistently met or if contribution methods are weak, actuarially determined contributions (ADCs) could fail to make meaningful funding progress. Our minimum funding progress (MFP) metric is an amount that we consider meaningful progress for a given year. Actual contributions exceeded MFP for 20 states in fiscal 2023, compared with 27 states in fiscal 2022. In fiscal 2023, notable excess contributions were made in Indiana, which directed $2.5 billion of reserve balances to reduce its pre-1996 teachers plan pension liability. Tennessee has made additional proactive contributions through its budget, totaling $500 million in 2023 and $550 million in 2024, to pay its net pension liability and OPEB liabilities, in excess of the ADC level and significantly above our MFP calculation. OPEB plan funding generally stands in contrast to funding for state pension plans. Most states continue to fund OPEB liabilities on a paygo basis in which annual funding is equal to the benefits distributed; assets are not set aside to accrue returns and help offset future costs.

Chart 4

Since mid-2021, wage growth has caught up with benefits because inflation and associated effects, as well as tight labor market conditions, have spurred state and local employers to increase wages to attract and retain workers. From 2019 to 2023, average annual wages per state government employee increased 21.5%, to $76,359 from $62,830. To offset the resulting rising pension costs due to higher wages, states and local governments have instituted less expensive pension plan tiers for new hires, with increasing employee contributions serving as one reform method that lessens the burden on employers. We believe that because of attraction and retention pressures, demand for wage growth will outpace the limited, or spent, ability of plans to add cheaper new benefit tiers, which could lead to rising budgetary stress from pension costs.

So far, the closing gap between wage and benefits growth does not appear to have affected state and local government hiring. The U.S. Bureau of Labor Statistics reported that state and local governments added an estimated 23,000 jobs in August 2024, marking the 31st consecutive month that state and local government employment was stable or increased. So far, reductions in future retirement benefits for new state and local government hires have not impeded employment growth in the sector, but we continue to monitor how states consider the effects of recent wage increases on the future growth of postretirement benefit costs.

Chart 5

Robust liquidity positions, strong revenue performance, federal stimulus, and strong management controls allowed states to improve pension and OPEB funding and fund capital projects in fiscal 2023 without having to increase debt levels in aggregate. We expect economic growth to slow in 2025; however, many states citing the pursuit of growth have cut taxes and could face pressures should financial forecasts not hold, or if there is a pullback in consumer spending. Although upcoming elections could cause shifts in governmental budget and policy priorities, S&P Global Ratings believes that record-high liquidity will cushion state credit stability as current costs for debt and liabilities remain manageable. Strong asset performance in fiscal 2024 and thus far in fiscal 2025, along with an ongoing focus on funding discipline, will continue to support funding progress in the near term.

Table 2

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Related Research

• Economic Outlook U.S. Q4 2024: Growth And Rates Start Shifting To Neutral, Sept. 24, 2024
• Pension Brief: U.S. Public Pension Funded Ratios Continue Improvement In 2024, July 25, 2024