Beyond Bulls & Bears

Fixed Income

Sharpen your pencils—It’s budget season

State budget offices and municipal bond analysts evaluate the economic and fiscal outlook for the next fiscal year. In this document, we examine how California, New York and Illinois have different budget situations and how they plan to balance their budgets using various tools.

For state budget offices and municipal (muni) bond analysts, January marks the beginning of budget season. This roughly six-month period kicks off with governors and budget officials releasing preliminary or proposed budgets and ends with legislatures adopting budgets prior to fiscal year end in June. This gives muni bond analysts a chance to see: 1) the state’s economic projections for the next 18 months, 2) how actual revenue and spending compares to the current-year budget, and 3) the governor’s plans on how to spend revenue, and if necessary, to close budget gaps next year. While there are several common underlying themes throughout state budgets, we have seen the impact differ from state to state. A thorough analysis is important to understand each state’s full story. But in general, strong credit profiles should help them navigate any future challenges.

Setting the stage for budget season

We know that state credit quality is very strong, and most states have ample tools to manage most budget challenges over the next fiscal year.

Reserves (“rainy day funds”) are at or near all-time highs due to a healthy post-pandemic economic recovery and higher levels of inflation, which have driven increases in sales and income taxes, the largest revenue sources for most states. In fact, many states have received rating upgrades since the pandemic.

States have been using their budget surpluses to build reserves, fund capital expenditures with cash rather than issuing bonds and pay down some long-term liabilities. Much of this excess cash was due to higher sales and income taxes, COVID-related federal aid and a strong post-pandemic economy. Nearly every state has a balanced budget requirement, but the question is how the states will balance their budgets under a slowing economic backdrop.

What the economy is telling us

As we mentioned above, high inflation has been providing increased levels of sales and income taxes. With the Federal Reserve’s (Fed) efforts to reduce inflation, we expect the growth of these tax revenues will slow with some states seeing potential outright declines as well. However, in most cases, we expect revenues to remain higher than pre-pandemic levels.

Higher inflation also causes government costs to go up as well. When revenues are seeing outpaced growth, higher inflation can offset those cost increases. We expect to see these costs continue to increase as labor contract negotiations tend to adjust to inflation with a lagged effect, but gains in state revenues may not keep up.

We expect to see smaller surpluses and, in some cases, budget gaps. States will need to increase revenues, lower costs or use reserves to balance their budgets.

Examples: While we are seeing similar trends across many of the states that have already reported financial updates or proposed budgets, the challenges can vary significantly from state to state. We’ll highlight a few examples:

California—Mind the gap

Governor Gavin Newsom released his budget proposal in early January. As expected, California projects revenue growth to slow while expenditures increase. California faces a few unique challenges as well. Due to severe weather in early 2023, the state moved its income tax filing date from April 2023 to November 2023, delaying revenue by six months. While the state was flush enough with cash to manage this, when income tax revenues came in lower than expected, the state had little time to adjust its budget to accommodate these lower receipts. If taxes were filed in April 2023, the early fiscal year (FY) 2024 budget would have been able to incorporate reduced revenue. However, by delaying the tax filing date to fall 2023, it created a hole that can’t be addressed until mid-FY24 at the earliest. California also has a tax system that relies heavily on capital gains, and when financial markets underperform, so does this revenue source. The state’s employment picture is slightly weaker than other states as the important technology sector slows, creating layoffs and fewer job openings.

All this adds up to a situation where the state has a sizable projected budget gap. If the state were to do nothing, it would outspend its tax collections. However, because of the balanced budget requirement, it can’t do that. Instead, the state will spend the next few months refining its economic and financial forecasts. Governor Newsom also announced this week that he and legislative leaders in the California State Senate and Assembly had reached an agreement to address $12 to $18 billion of the state’s budget shortfall, details of which will be finalized in April.

Because the state’s overall credit quality is so strong, it has plenty of tools at its disposal to close the gap. California state reserves are at historic highs, allowing some portion to be used in place of tax receipts. The state can also cut its outlays. Some expenditures are automatically cut based on the current law, but the state can cut more (or less) than projections. It can also utilize reserves to maintain spending on priority items. California plans to do this with certain public education spending. It can also use other budget tools, such as deferrals or delays moving spending to the next fiscal year.

Because the state’s financial position is so strong, we believe it should be able to close the current proposed budget gap successfully. We expect state leaders to approach it in a balanced way using its many tools.

New York—Sharing the wealth

Similar to California, New York’s primary revenues are also sales and income taxes, but it has several key differences. New York’s fiscal year ends March 31, rather than June 30, like most states. Because of this, New York is likely to be the first to pass a balanced budget. Its differences don’t end here. Although New York also projects revenues and its economy to slow, New York is actually projecting a budget surplus for the current fiscal year with a small gap for FY25 that will be much easier to handle. Having said this, New York faces some unique challenges itself. First, New York City’s mass transit system (“MTA”) has struggled to return to pre-pandemic ridership levels. Keeping the MTA in a good financial position will require efforts from riders, the city and the state. The state has previously provided aid to the MTA, and we expect that will continue. The state needs to find a balance in their support between what it can afford and what the MTA needs. Second, many cities and states in America, including New York City, are seeing an influx of migrants seeking asylum, forcing cities to provide services, which causes them to look for financial support from the state. New York City is no exception and has looked to New York State for help, which it expects to continue.

Illinois—Keep it up

We also want to highlight Illinois as an example of a state that is stronger from a fundamental standpoint today than it was pre-pandemic. Combined with conservative budget management, federal COVID aid and strong tax revenue growth, the state has been able to establish and grow reserves, while even paying down some liabilities. But the state of Illinois still has large fixed costs and a slower-growing economy. We are looking at its budget to see how it will navigate balancing, while still protecting the state’s credit rating. The governor’s budget proposal projects that current-year revenues are coming in close to budget, and despite increased expenditures, the state projects a fiscal surplus for FY24. As for FY25, the governor believes revenues will grow slower and expenditures will rise, but with certain tax increases, it will be able to generate a small surplus. This all assumes required funding for pensions, timely payment of bills and maintenance of reserves, which remain critical to maintaining the state’s current credit ratings.

While all muni issuers go through a budget cycle, we chose to spotlight states that have unique challenges and tools to address their budget issues. We expect that the overall strength of reserves should help each state address their unique fiscal circumstances. States also provide aid to other levels of government so following the states can help us assess sectors, such as school districts, charter schools, public higher education, health care and transportation. We’ll be keeping our pencils sharpened!



All investments involve risks, including possible loss of principal. 

Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls. Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default.


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