State and Local Government Credit Headwinds Persist

Transcription

1 By Christopher Holmes State and Local Government Credit Headwinds Persist

2 Moody s Investors Service s credit outlook for state and local governments over the next year is negative on a backdrop of persistent budgetary challenges stemming from macroeconomic risks, federal budget cuts, and uncertainty pertaining to looming federal sequestration. We have maintained a negative outlook for the state government sector for five consecutive years, and for four consecutive years for the local government sector. Rising expenditures and liabilities related to employee pensions and health-care benefits will be a growing challenge for governments with materially underfunded plans, spurring some to propose cutting benefits or increase employee or local government contribution requirements. Medicaid-related costs will be on an upward trajectory for the foreseeable future, though states can now opt out of Medicaid expansion, according to the Supreme Court s ruling on health-care reform. In the midst of these challenges, state revenues have started to grow, and some states are rebuilding reserves or restoring funding to programs that they previously cut. Local governments, on the other hand, are under more pressure than their state counterparts, especially considering that they Rising expenditures and liabilities related to employee pensions and health-care benefits will be a growing challenge for governments with materially underfunded plans. typically have less flexibility in raising revenues and are running out of room to further cut services. Though a housing market recovery is emerging, property tax revenues, which account for a large portion of local government revenues, will remain depressed in most regions for the foreseeable future. Moreover, state aid to local governments will continue to stagnate as states rein in spending. Some local governments that guaranteed debt of struggling government- or private-development enterprises will face additional pressure as these organizations succumb to economic malaise. FEDERAL CUTS Eventual expenditure cuts at the federal level could have more direct consequences for Medicaid and other state programs. These cuts may also hurt state revenues through reductions in federal employment or procurement contracts, which in turn would crimp state aid to local governments. The scope and size of federal austerity measures will affect some states more than others, but overall will be a drag on the economy. The cuts that U.S. state and local governments have made themselves, including ongoing payroll reductions (see Exhibit 1), will also continue to weigh on the economy. Exhibit 1: State and Local Government Employment versus Total Non-Farm Payrolls Millions n Total Non-Farm (left) n State and Local (right) Millions Source: Bureau of Labor Statistics 2013 Government Finance Review 33

3 STATE REVENUES CONTINUE TO GROW, BUT MORE MODERATELY State tax revenues have increased for ten consecutive quarters, into calendar year 2012, but the pace of increases has slowed in recent quarters (see Exhibit 2). Tax revenues increased by 3.2 percent in the second quarter of 2012 from the same quarter of the previous year, the smallest percentage increase since On an inflation-adjusted basis, state tax revenues are still lower than pre-recession levels; in the second quarter of 2012, 24 states reported lower tax revenue collections than in the same quarter of The fate of tax revenue growth rests largely on consumer confidence and its impact on taxable retail sales in addition to the health of the labor market and the corresponding level of income tax receipts. Revenue growth to date has nevertheless been sufficient to allow states such as Michigan and Ohio to begin replenishing reserves. LOCAL GOVERNMENTS MAJOR REVENUES ARE STAGNANT Local governments are primarily funded by property taxes (roughly 30 percent) and state aid (about 35 percent), both of which have been under pressure for several years and are expected to remain so over the next two or three years. Property tax revenues typically lag changes in market real estate values because of local governments assessment practices. The most pronounced property tax declines are in regions that experienced the more severe real estate market disruption. According to Moody s Analytics, there are signs of gradually improving housing market conditions, based on the Exhibit 2: Year-Over-Year Percentage Change in Quarterly State Tax Revenues 30 n Total Tax Collections n Personal Income Tax n Sales Tax Percent 0 (10) (20) (30) Source: Rockefeller Institute of State Government 34 Government Finance Review 2013

4 pace of residential home sales, inventory levels, and building permits. 2 As of September 2012, home prices increased for eight consecutive months after declining for 20 consecutive months, according to the Case- Shiller 20-City index. At the same time, stubbornly high foreclosure activity has dampened the medium-term prospect of material home price gains, making it less likely that property tax revenues will rebound robustly anytime soon. The decline in commercial real estate market values following the recession has also suppressed local government property tax revenues. According to the Moody s/rca Commercial Property Price indexes, commercial property values have steadily increased since the trough in January 2010 but remain well below pre-recession levels. Medicaid-related costs will be on an upward trajectory for the foreseeable future, though states can now opt out of Medicaid expansion, according to the Supreme Court s ruling on health-care reform. It takes time for market value increases to be incorporated into tax assessments. The lag is at least one year for local governments that make annual market adjustments, but most will take longer, with rotating appraisals that occur in two- to four-year cycles. Thirty-five percent of Moody srated cities experienced declines in full value (estimate of total market value of property within a jurisdiction) between 2007 and 2010, and nearly 11 percent had a decline of more than 10 percent (see Exhibit 3). Given the extent of full value declines between 2007 and 2010, and additional declines that occurred in 2011 and 2012, there is a lot of ground to cover to return to pre-2007 values. STATES ARE CUTTING AID TO LOCAL GOVERNMENTS Over the last three years, most state governments have been cutting aid to local governments, and this trend is likely to persist for the foreseeable future as states contend with budget challenges of their own. In an October 2011 report, the Center on Budget and Policy Priorities indicated that 37 states cut aid to local school districts in the school year 3. Fiscal year 2013 budgets indicate that 11 states have enacted cuts to education in the coming fiscal year. According to the National Governors Association, 17 states reduced local aid as a measure to address budget gaps for fiscal year 2012 and 14 states expect to use this strategy for fiscal year Exhibit 3: 35% of Cities Experienced Tax Base Declines Between 2007 and 2010; Counties and School Districts Not Far Behind n Percentage of Rate Issuers with Declines in Full Value of 10 n Percentage of Rate Issures with Declines in Full Value of < Percent Cities Counties School Districts Percentage of Sector s Rated Issuers Experiencing Declines in Full Value Between 2007 and 2010 Source: Moody s Data - Total Rated Issuers: Cities = 2,936, Counties = 830, School Districts = 3, Government Finance Review 35

5 MORE EXPENDITURE REDUCTIONS IF ECONOMY FALTERS As the economic downturn has lingered, the tradeoffs in policy choices have become increasingly difficult. Proposed fiscal 2013 general fund expenditures remained $4.6 billion less than the $687.3 billion high set in fiscal 2008, according to the National Association of State Budget Officers. Preparing for the current fiscal year, 27 states reported having closed $64.5 billion of gaps in fiscal 2012, and 19 states projected $30.6 billion of gaps for fiscal 2013, according to NASBO s spring fiscal update. Though significantly less than the gaps faced in immediately preceding years, the total gap addressed remains large by historical standards. Most states have demonstrated willingness to make difficult fiscal decisions to align their budgets, as reflected by the fact that no states were mired in delayed budget adoption for the fiscal year that began July 1, It marked the second consecutive year that states reached timely consensus on fiscal plans. Delayed budgets can indicate political paralysis and a greater likelihood of relying on non-recurring budgetary solutions. Local governments are primarily funded by property taxes and state aid, both of which have been under pressure for several years and are expected to remain so over the next two or three years. Making large spending cuts is growing more politically difficult; some states have enacted or are considering raising taxes to help meet their funding needs. For example, in the latest legislative session, Illinois imposed a $1 per pack cigarette tax increase to help fund Medicaid, while Maryland increased its income tax rate for taxpayers with incomes greater than $100,000 (or $150,000 for couples). MEDICAID COSTS WILL CONTINUE TO STRAIN STATE BUDGETS Medicaid and pensions will remain a source of budgetary strain for state governments. The shared federal-state Medicaid entitlement program accounts for 23.6 percent of total state spending, according to NASBO, with state costs increasing from $11 billion in 1980 to $156 billion in 2010 (see Exhibit 4). Rising Medicaid costs are driven by health-care inflation and by increasing enrollment resulting from high unemployment. According to the Kaiser Family Foundation, Medicaid enrollment increased by 4.4 percent in fiscal 2011 and was expected to increase by 4.1 percent in fiscal By 2019, Kaiser estimates enrollment will have increased Exhibit 4: Actual and Projected State Medicaid Spending, Billions of Dollars Source: Congressional Budget Office; Federal Funds Information for States; National Association of State Budget Officers; Centers for Medicare and Medicaid Services 36 Government Finance Review 2013

6 by 27.4 percent compared to a baseline without reform. Per the Affordable Care Act, the federal government will pay for a significant part of the costs of this enrollment growth. Overall, the incremental costs caused by ACA s Medicaid expansion will be minimal, but the law s impact will vary among states. In their fiscal 2012 budgets, 45 states reduced hospital provider payments; 38 states implemented pharmacy cost controls; 17 states reduced, restricted, or eliminated benefits; three states reduced eligibility; 14 states implemented new or high copayments for services, and 11 states implemented cost containment related to long-term care, Kaiser reported. LOCAL GOVERNMENTS CUTTING JOBS AND TAPPING RESERVES Since labor costs are local governments largest expense, material jobs cuts have been instituted to balance their budgets. As of the third quarter of 2012, the number of people employed in local governments has declined by 3.8 percent since peaking in the third quarter of 2008, and we expect more job cuts to occur over the medium term. As budget stresses It takes time for market value increases to be incorporated into tax assessments. The lag is at least one year for local governments that make annual market adjustments, but most will take longer. mount, spending cuts have moved beyond discretionary programs and implementation of operating efficiencies, and many governments are now reducing service levels of core governmental functions such as public safety and classroom instruction. Drawing down financial reserves has been another strategy used to close budget shortfalls. Less politically controversial than cutting jobs, this strategy can have negative credit consequences as liquidity levels grow thin. Between 2007 and 2010, general fund balances declined for more than 40 percent of both Moody s-rated cities and counties, and most of these issuers balances declined by more than 10 percent. More than 25 percent of Moody s-rated school districts general fund balances declined by more than 10 percent (see Exhibit 5). Of the 2011 audits for school districts, cities, and counties, 30 percent show a declines in general fund balances from 2010, and more than half of these fell by more than 10 percent. The percent of Moody s-rated local governments with a negative fund balance is relatively small but has increased in recent years. A negative general fund balance reflects a gov- Exhibit 5: General Fund Balance Declines Between 2007 and 2010 Were Widespread n Percentage of Rate Issuers with Declines in General Fund Balance of 10 n Percentage of Rate Issures with Declines in General Fund Balance of <10 Percent Cities Counties School Districts Percentage of Sector s Rated Issuers Experiencing Declines in General Fund Balance Between 2007 and 2010 Source: Moody s Data - Total Rated Issuers: Cities = 2,703, Counties = 888, School Districts = 3, Government Finance Review 37

7 ernment with near-term liabilities that exceed available assets and typically indicates a low cash position. Fiscal year 2011 audited financial data collected thus far indicates continued growth in the number of issuers with negative general fund balances, at a pace roughly similar to prior years. to the future and undermining structural budget balance and future fiscal flexibility. Pension budgetary costs will continue to be driven upwards by both the increasing number of state government retirees and by the price of past benefit enhancements. ENTERPRISE RISK AND CONTINGENT LIABILITIES WEIGH ON SOME LOCAL GOVERNMENTS Unforeseen obligations arising out of stressed or failing government enterprises, real estate developments, and other types of projects are adding sudden and significant strains to more local governments. Typically, enterprises are self-supported by user fees and enterprise debt is paid from system related revenues; however, the local parent government often guarantees this debt or provides operating subsidies or loans that expose it to enterprise risks. When enterprises perform poorly, the government s entire financial position can be stressed. Similar to enterprise risk, more local governments are experiencing strains related to debt guarantees made on behalf of commercial developers and other legally separate entities. Several cases of credit stress due to calls on guarantees of this nature have been seen in New Jersey, Michigan, and Washington. Persistent economic weakness increases the likelihood that some of these organizations will fail and become financial burdens to associated local governments. 6 RISING PENSION PRESSURES SPUR MORE REFORMS Pension funding requirements are a growing strain on state and local government budgets. Although public pension assets grew a net 17.6 percent in 2011, following strong market performance, those gains did not offset all the losses pension plans experienced during the downturn, and subsequent returns in fiscal 2012 were in the range of only 1 percent. The median return for plans surveyed by Wilshire Associates was 1.15 percent for the fiscal year ending June 30, Some cut services. states continue to underfund the payments needed to fully amortize pension liabilities, deferring costs Local governments are under more pressure than their state counterparts, especially considering that they typically have less flexibility in raising revenues and are running out of room to further To help stem rising pension costs, some states have enacted or are considering pension reforms that provide long-term advantages, such as reducing or eliminating cost of living adjustments, implementing or increasing cost sharing with employees, raising the retirement age, or creating new plans that look more like private-sector 401(k) plans. The State of California recently adopted reforms to the California Public Employees Retirement System and California State Teachers Retirement System cost-sharing plans. The reforms require new employees to pay half of the cost of their benefits and work longer before they retire. As the proposals did not apply to existing employees, material positive budgetary effects are not likely to be felt for at least several years, unless local governments are able to follow up with additional changes through their own labor negotiations. In a more dramatic move by a standalone plan, the City of Providence, Rhode Island, cut pension benefits to current and future retirees, the first time a Rhode Island local government has altered an existing contractual agreement with retirees outside of Chapter 9 bankruptcy. The action eliminated annual cost of living adjustments, which were as high as 6 percent. A recent study by the Boston College Center for Retirement Research estimated the aggregate effect of recent COLA reductions and other reforms on the accrued liability at about $100 billion, or 11 percent of the nearly $900 billion unfunded liabilities reported by the plans included in the study. 7 We anticipate the pace of reforms will remain high, and some governments may even enact second or third rounds of reform. Even with pension reform, most local governments will have difficulty obtaining relief on rising costs related to existing retirees and employees, and will continue to face budget stress in the pensions arena. Moreover, many local governments participate in large, state-administered cost-sharing plans and are exposed to rising employer 38 Government Finance Review 2013

8 growing, and some states are rebuilding reserves or restoring funding to programs previously cut. Despite negative financial pressures on local governments, there are noteworthy positives, including their low debt burden, and though their fiscal flexibility is waning, the majority still have room to manage financial strains through spending adjustments and by raising property taxes, fees, and user charges for essential utility services. contribution mandates from these plans. Typically, there is no discretion to avoid these mandatory increases. For example, school districts participating in Pennsylvania s Public School Employees Retirement System will see employer contributions increase by 45 percent in fiscal 2013 and nearly 20 percent annually through fiscal Districts pay half the total employer contribution in Pennsylvania, the state pays the other half, and the districts do not have discretion regarding their required contributions. The practice of states making partial pension contributions on behalf of school districts and other local governments is not unusual. Given the strains on their own budgets, some states are examining these arrangements and shifting additional costs to the local level. For example, Maryland s 2013 budget shifted $136.7 million in annual teacher pension costs to the state s 23 counties and the City of Baltimore. CONTINUED CHALLENGES Moody s expects another challenging year for both state and local governments as they continue to confront repercussions of the slow economic recovery, which is reflected in our negative outlook for both sectors. Still, during this protracted period of economic and fiscal stress, many U.S. states have shown the ability to reduce spending, shift fiscal burdens onto local units, and, to a lesser extent, increase tax revenues. These powers are key to states credit standing, which remains high, despite a preponderance of downgrades over the past three years. Indeed, default risk implied by state ratings even at the weakest level (currently A2) remains low. Revenues are Local government bankruptcy and defaults remain rare. From 1970 to mid-2012, there have been only eleven defaults by Moody s rated local governments on tax-backed or general revenue-backed securities. 8 However, half these defaults have occurred in the past four years. Bankruptcy filings this year by two California cities, Stockton and San Bernardino, have raised questions among market participants about a potential erosion in local governments willingness to continue to pay debts in the face of severe financial pressure. Although some of the challenges faced by California municipalities are unique to the state, as fiscal stress escalates for local governments across the country, there is a rising risk of similar willingness failures occurring. As a result, we expect local government bankruptcies and defaults will increase in absolute number, but defaults by rated governments will remain rare relative to the approximately 10,000 credits rated by Moody s. y Notes 1. States Report Slow Tax Growth through Mid-2012, The Nelson A. Rockefeller Institute of Government, October See Moody s report, Housing Hangs On, in Précis U.S. Macro, July New School Year Brings Steep Cuts in State Funding for Schools, Center on Budget and Policy Priorities, October 7, The Fiscal Survey of the States: Spring 2012, National Governors Association. 5. Trend of On-Time State Budgets Continues as Revenues Improve, Moody s Investors Service Special Comment, July 3, See Moody s Report, Enterprise Risk Is a Growing Problem for US Local Governments, September 21, Pension Crisis Looms Despite Cuts, Wall Street Journal, September 21, This number includes: Baldwin County, Alabama; Belfield, North Dakota; Cicero, New York; Harrisburg, Pennsylvania; Jefferson County, Alabama; Orange County, New York; Polk County, Iowa; Southern California Logistics Airport Authority; Stockton, California; Vanceburg, Kentucky; and Wenatchee, Washington. CHRISTOPHER HOLMES is the public finance research director at Moody s Analytics Government Finance Review 39