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What's Behind Our Sector View

In 2025, states must be prepared to navigate uncertain waters.   A change in administration in Washington, D.C. typically ushers in policy and administrative changes, and the political rhetoric from president-elect Trump leads us to believe that this transition will be more disruptive than average. Policy items such as tariffs, tax cuts, immigration reform, and curtailed federal spending, and the possibility of smaller government could all affect the credit fundamentals of states. We'll monitor ongoing actions and policy specifics as they develop.

Against this backdrop of uncertainty, states are in a position of relative credit strength.   In fall 2024, S&P Global Ratings published on all rated states following the implementation of its new "Methodology For Rating U.S. Governments." We made no state rating changes through the new criteria rollout. Of the 49 rated states, we rate 41 of them 'AA-' or higher; the most common rating is 'AAA', on 16 states. For more information about our methodology rollout, see "States' Median Reports: Our New Methodology Highlights Rating Consistency," published Nov. 20, 2024, on RatingsDirect.

Supporting these high investment-grade ratings is a national economy that, for the third straight year, will record gross domestic product increasing between 2.5% and 2.9%, with 2024's growth rate of 2.7%. We consider this growth above sustainable forecast rates and expect it will slow to a more sustainable 2.0% for both 2025 and 2026.

The strong economy is a key attribute supporting state ratings, but resilient credit fundamentals abound. We expect states' longstanding credit strengths will support rating/credit stability. States adopt balanced budgets and take actions during the year to correct when revenues are off or expenses are above expectations. They typically establish rainy day funds and use them conservatively. Debt is a tool to deliver capital projects and not a liquidity crutch. We expect all these credit norms will recur in 2025? Nevertheless, states will need all the fiscal tools at their disposal to effectively manage new credit pressures in 2025.

For most states, however, the fiscal 2026 budget cycle will be tougher than 2025's.   States must incorporate recent years' inflationary increases and wage adjustments into the budget just as federal stimulus dollars are exhausted and changes in state-level tax policy kick in, reducing available resources for many. Therefore, early estimates for fiscal 2026 budgets show tighter fiscal margins or the formation of structural gaps. Some states are looking to close gaps of up to 10% of the budget. We recognize that they could use reserves; however, in our view, using a one-time source to close the budget today could make out-year gaps harder to close. To resolve these structural imbalances, states might use a multiprong approach that could include drawing from reserves, expenditure cuts, and revenue enhancements.

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Only midway through the fiscal 2025 budget year, most states are seeing revenues and expenditures close to forecast, and thus, the majority of them won't face the dual challenge of closing out a fiscal year with a deficit and adopting a balanced budget for the next.

Available reserve balances remain at nominal highs for most states.   If a state has had the wherewithal in good times to set money aside for more difficult budgets, drawing on those reserves might not necessarily be a move toward financial instability. We look to understand the rationale behind such draws: Is the use of funds meant to bridge a short span to then retain balance or is the draw just moving the budgetary pressure to out-years?

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Sector Top Trends

Recent changes to tax policy and Tax Cuts and Jobs Act (TCJA) decisions add uncertainty.   Since 2021, more than half the states have reduced personal income tax rates and many others have adjusted aspects of a statewide sales tax. These cuts were a logical way to give taxpayers a break, as revenues were coming in above estimates. As the economy slows, we'll be monitoring to see how the new rates meet revenue estimates. In addition, the TCJA personal income tax provisions are set to expire at the end of 2025. Congress and the administration will debate whether to make these provisions permanent or let them expire, among other possibilities. States responded to the adoption of these tax policies through tax actions of their own, and thus, the decisions in Congress will have implications for state governments as well. We do not expect any clarity on the decision until late in 2025.

Revenue offsets for TCJA are on the table.   Should the administration want to extend the personal income provisions in the TCJA, the Office of Management and Budget estimates that doing so would remove $4.6 trillion from federal collections over the next decade. If the extension is made through the federal budget reconciliation process, then Congress would need to demonstrate how this would not worsen the deficit after 10 years and would look for offsets. Cost offsets at the federal level could have cost impacts at the state level and, therefore, we'll monitor Congressional debate. Many states benefit from the ability to issue tax-exempt debt; should that portion of the federal tax code again be considered as an offset (as was discussed and then not included in the original TCJA debate), there could be longer-term costs. Furthermore, the largest flow of funds from the federal level to the states occurs in the Medicaid program. Thus, any benefit, formula, or reimbursement rate changes to Medicaid, made as an offset to the cost to extend the TCJA, or otherwise, could have state-level credit quality effects as well.

Coming off a period of period of high inflation, states face uncertainty in their longer-term Medicaid outlook.   This is due to higher-cost prescription drugs and economic factors, such as inflationary pressures associated with medical care and workforce supply. Despite dropping Medicaid rolls, many states are forecasting Medicaid cost growth will continue. On average, states estimate budgeted Medicaid costs swelled by 17% in fiscal 2024, and the Kaiser Family Foundation estimates that the state share of Medicaid spending could rise as much as 7.0% for fiscal 2025. Some states made midyear adjustments to close Medicaid funding gaps in fiscal 2024; others have revisited cost estimates for fiscal 2025 to address potential increases caused by higher-than-expected enrollment, higher provider reimbursements, or continuation of Medicaid coverage for certain groups or services that was implemented during the pandemic.

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Federal-level changes could alter Medicaid funding and place a high burden on states.   As it did in past downturns, the federal government helped close an otherwise substantial Medicaid funding gap during the pandemic, including nearly $120 billion in emergency funding during a period of higher health costs and enrollment, providing stability and expenditure flexibility for many state budgets. However, our sector view incorporates uncertainty surrounding the level of federal cooperation and Medicaid funding partnership in future years that could make states more vulnerable to higher medical costs or reduce budgetary flexibility during economic downturns. A weaker federal response to future Medicaid program needs--because of reduced fiscal capacity, structural program and funding changes, or a change in policy --could strain states' economic and fiscal conditions. If this occurred, states might implement eligibility restrictions, benefit restrictions, or cut payments to providers to close Medicaid funding gaps, although these actions could be partly counterbalanced by other costs associated with a higher uninsured population.

The timing and extent of federal immigration policy changes remain unclear but warrant attention.   These changes could have knock-on effects on the economy and workforce, although significant uncertainty remains around the timing, magnitude, and implementation that complicates making cost or economic projections. Conversely, tighter border policies could relieve some costs for state governments that, in the past few years, faced higher social service expenditures to support new arrivals entering the U.S. For further information, see "How Proposed Immigration Policy Could Affect U.S. Public Finance Issuers' Creditworthiness," published Nov. 20, 2024.

Insurance costs are rising.   Another potential expense-side pressure on fiscal 2026 budgets is insurance costs. As states negotiate health care insurance, we're learning that the fiscal 2026 increases are some of the largest in recent years. In addition, as cyber attacks remain a common technological threat, the cost to insure against this risk is rising and coverage is reportedly costing more for less protection. As the nation experiences more severe and more frequent catastrophic storm events, the cost of homeowners' insurance is rising as well. States can support property owners with insurers of last resort and other programs to bolster the insurers themselves, but these costs are also rising. (See "Rising Insurance Costs And Mounting Affordability Challenges Could Weigh On Some U.S. Governments' Creditworthiness," published Oct. 31, 2024.)

States have headroom when it comes to fixed-cost liabilities.   On average, state debt metrics remain low to moderate compared with most economic and state budgetary measures and will likely remain so as states took advantage of federal funding and pursued pay-as-you-go (paygo) funding for capital needs that have traditionally been debt funded. The trend in the sector has been toward better pension funding discipline; if a state had pension funding pressures before the pandemic, it likely still does, but in most cases, the trajectory of cost increases is now more muted. Many states do have debt capacity if their fiscal 2026 budgets are squeezed, and therefore, if they opt to shift from paygo to debt, they have the flexibility to do so. (See "U.S. States' Fiscal 2023 Liabilities: Stable Debt, With Pension And OPEB Funding Trending Favorably," published Oct. 23, 2024.)

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Ratings Performance

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For the third year in a row, most outlook revisions and rating actions were favorable. At the start of 2025, seven state general obligation ratings have positive outlooks and one has a negative outlook. The seven states currently carrying positive rating outlooks are Arizona, Arkansas, Kansas, Oklahoma, Pennsylvania, Washington, and Wyoming, while the one with a negative outlook is Mississippi. We upgraded four states in 2024 (see chart 6), following upgrades on seven in the prior two years

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