State of Connecticut. How one of the nation s most affluent states finds itself in a financial bind

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1 REUTERS/Danish Siddiqui State of Connecticut How one of the nation s most affluent states finds itself in a financial bind August 2017 Thomson Reuters Pricing Service, Municipal Evaluations

2 State of Connecticut: How One of the Nation s Most Affluent States Finds Itself in a Financial Bind 2 Hartford, CT. State of Connecticut: How one of the nation s most affluent states finds itself in a financial bind The recent downgrade in the ratings by Moody s (Aa3 to A1), Standard & Poor s (AA to A+) and Fitch (AA- to A+) of the tax-supported debt, appropriations debt and other debt supported by state guarantees reflect Connecticut s ongoing and increasing structural budgetary deficits. The state continues to struggle from weak job growth and population outmigration. What s more, it has yet to adopt its budget for the new fiscal year (due July 1, 2017) and is currently operating under executive order.

3 State of Connecticut: How One of the Nation s Most Affluent States Finds Itself in a Financial Bind 3 What are the factors that have contributed to Connecticut s current situation? Fixed Costs: Bonds and Pension Liabilities At the close of FY 2016, Connecticut s net tax-supported general obligation debt was $24.1 billion, a 19.5% increase from FY Debt per capita totaled $6,505, well over the national median of $1,006. The state also sponsors three pension plans: State Employees Retirement System (SERS), Teachers Retirement System (TRS), and Judicial Retirement System (JRS). Although the state is obligated to make the appropriate annual payment to the plans, due to prior years of underfunding, the plans are seriously underfunded. Funding ratios for SERS, TRS and JRS are 39.2%, 59.5% and 51.9% respectively, with a combined net pension liability of $27.6 billion. The state is currently not making any payments towards reducing that liability. Correspondingly, the liability continues to grow. The state s OPEB liability for the Teachers Plan and the State Employee Plan totals $9.9 billion. The combined pension, OPEB and debt service payments comprise nearly 30% of state revenues among the highest fixed-cost ratio in the nation. Taxes Implemented in 1991, Connecticut s personal income tax replaced two existing high-rate taxes on personal income in the form of capital gains, dividends and interest. The tax was initially structured as a simple 4.5% flat rate on Connecticut adjusted gross income (AGI) above $12,000 for single filers and married individuals filing separately, $19,000 for heads of household and $24,000 for joint filers. In 2011, lawmakers approved the largest tax increase in state history. Four years later, faced with yet another multi-billion-dollar budget deficit, they passed the second-largest tax hike in state history. Connecticut currently has six tax brackets, the highest being 6.99% on all taxable income of $500,001 or more. One of the unforeseen consequences of income tax increases has been the tax flight outmigration of higher-income Connecticut residents and businesses to lower-tax states. A recent report by Asset Preservation Advisors 1 cites an Associated Press article reporting that tax revenue from Connecticut s 100 highestpaying taxpayers declined 45% from 2015 to 2016, resulting in approximately $200 million revenue loss for the state. Quarterly Change in State Tax Revenue Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q3 National Conneticut Illinois New Jersey Over the past two years, Connecticut s change in tax revenue has lagged below the national average. Source: Pew s analysis is based on the U.S. Census Bureau s Quarterly Summary of State and Local Government Tax Revenue, as adjusted by the Nelson A. Rockefeller Institute of Government. Data are adjusted for inflation using the U.S. Bureau of Economic Analysis Implicit Price Deflators for Gross Domestic Product, accessed March 20, Asset Preservation Advisors, Million Migration, June 2017.

4 State of Connecticut: How One of the Nation s Most Affluent States Finds Itself in a Financial Bind 4 Hartford, CT. The closing of a federal tax loophole may prove a windfall for Connecticut. Hedge-fund managers for years accumulated offshore gains without paying federal and state taxes. Congress overwhelmingly voted to close it as a way of raising revenue and stabilizing the financial sector during the 2008 financial crisis. The change, part of the Emergency Economic Stabilization Act of October 2008, was made in section 457A of the IRS code. The legislation gave managers a decade to pay taxes on money accumulated before the law changed. That deadline is now nine months away. Total payments from all managers could amount to $25 billion, according to a 2008 estimate from the Joint Committee on Taxation. Some tax specialists say the bill could be even higher: $100 billion or more. This will likely mean a surge of tax revenue for Connecticut, historically the center of the hedge-fund industry. The state isn t yet sure how much it will reap, said a spokesman for the governor s budget office. It is too early to determine how funds would be allocated by the State, whether it is to the state s rainy day account, increased aid to localities or any number of budget factors. Economic Weakness Dependent on the finance and insurance sectors, Connecticut s economy was hit hard during the recession and has struggled to come back as those sectors also exhibited slow and inconsistent recoveries. While Connecticut enjoys the second-highest per capita income in the nation 143% of the national average that has been trending lower. Moreover, the traditionally affluent Fairfield County now lags the state in average personal income growth, with a lackluster.68% ( ). Middlesex County, with higher education and healthcare centers, had the best average growth at 3.16%. However, overall, the state average personal income growth for the period was 1.88%. The national average was a more robust 3.6%. Hartford The city of Hartford (B2/BB) serves as an illustration of the impact of the state s financial plight on local government. As the state capital, Hartford faces unique challenges beyond the norm of other municipalities. Approximately half of the property in the city is owned by the state or non-profit institutions and thus not subject to tax a contributing factor to the city s financial difficulties. This places a greater emphasis on state aid to compensate for the lack of ratables. With uncertainty regarding levels of intergovernmental aid or other state support that could enable Hartford to stem its fiscal decline in light of the state s own fiscal challenges, city officials have contemplated filing for Chapter 9 bankruptcy protection. Compounding Hartford s fragile financial position is the recent announcement by Aetna Inc., one of the city s (and state s) major employers, of its intent to move its corporate headquarters out of Connecticut. Ironically, the CEOs of Aetna, Travelers and The Hartford recently pledged to contribute $10 million per year for five years with a focus on institutions such as the Hartford Public Library, law enforcement and recreation centers.

5 State of Connecticut: How One of the Nation s Most Affluent States Finds Itself in a Financial Bind 5 State Aid as a % of Local Revenue 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% % Waterbury New Haven Stamford Bridgeport Hartford Hartford relies on state aid more than any of the other large cities in Connecticut. (Moody s Rating figures based on the most recently available proposed or adopted budget.) S&P s recent rating downgrade to BB (from BBB-) stated the downgrade to BB reflects our opinion of very weak diminished liquidity, including uncertain access to external liquidity and very weak management conditions as multiple city officials have publicly indicated they are actively considering bankruptcy, said S&P Global Ratings credit analyst Victor Medeiros. The city of Hartford has engaged an outside law firm with expertise in financial restructuring. Officials also mentioned that the city would initiate discussions with bondholders for concessions to implement a debt restructuring if it didn t receive the necessary support in the state s 2019 biennial budget. S&P also said that Hartford may be downgraded again if the state passage of a budget is significantly delayed, or if the city were not to receive sufficient support in a timely manner that would enable it to manage liquidity and allow it to meet obligations in a timely manner. 2 Moody s lowered its rating to B2 (from Ba2) citing the downgrade reflects the increased likelihood that the city will pursue debt restructurings to address its fiscal challenges. Last week, the city hired a law firm to advise it on debt restructurings. City management has made public statements indicating they will need to have discussions with bondholders about restructuring its debt regardless of the outcome of the state s biennial budget as debt service costs escalate sharply leading to budget deficits over the next five years. 3 2 S&P Credit Report, 7/11/ Moody s Credit Report, 7/13/2017.

6 State of Connecticut: How One of the Nation s Most Affluent States Finds Itself in a Financial Bind 6 Budget Delay Connecticut s FY 2018 began on July 1, 2017, but did so without an adopted budget. Continued discussions between the legislature and the governor in shaping the state s biennial budget have been acrimonious. Governor Dannel Molloy has been quoted as saying I m governor in a state where Republicans and Democrats don t agree with one another, and no one agrees with me. The result has been the state operating under an executive order to provide for day-to-day governmental functions. The limited executive order will soon cause massive cuts across the board, including significant reductions in municipal aid, school funding, transportation projects and social services. The governor has called for the passage of a mini budget (90 days) that provides sufficient money to fund government until a new budget is finalized and adopted. Conclusion Connecticut s financial plight is indicative of the many issues that may be camouflaged by high wealth levels. The budget gap, pension issues and the need to provide aid and support to local municipalities, school districts, transportation projects and social services can have far-reaching consequences. The chart below illustrates the impact of rating downgrades on the trading value of the state and the domino effect it has on local municipalities (e.g., Hartford). The levels of uncertainty regarding tax increases, pension and OPEB liabilities, and potential bankruptcy of the state capital have had a serious impact on the cost of capital for all related entities. Connecticut State and Local GO Bond Spreads /08/ /09/ /10/ /11/ /01/ /02/ /03/ /04/ /05/ /06/2017 Hartford CT Waterbury New Haven Stamford Bridgeport Hartford s bond yield spreads are significantly higher than those of other large cities in Connecticut. (End of day TRPS bid yield spreads for 2031 maturities of State and Local CT GO issuers.)

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