Just how long Illinois Gov. J.B. Pritzker’s administration can ride the tide of a productive spring legislative session depends a lot on some risky bets, say market participants.
Lawmakers approved his budget, an expensive capital package, a sweeping gambling expansion, and a plan to reshape the state's income tax structure.
The first-term governor is banking on voter approval for a constitutional amendment in November 2020 to scrap the state's flat income tax requirement to replace it with a progressive rate structure that would raise about $3.5 billion in new annual revenue by hiking taxes on the top 3% of earners.
A narrow ending balance of just $160 million in the new fiscal 2020 budget means the state can’t afford much fluctuation in revenues or expenses or an end to the now 10-year old economic expansion.
With two ratings one downgrade away from junk and warnings from rating agencies that a buildup in a now $6.4 billion bill backlog or worsening of a $133.7 billion unfunded pension tab could trigger such a cut, the state has little room to maneuver.
“A new era of fiscal stability has arrived in Illinois,” Pritzker said last week after signing the $40.1 billion operating plan and $45 billion, six-year capital package as well as the tax rate structure that would take effect if voters approve the amendment.
The General Assembly passed most of the Democratic governor's agenda, even horse-trading for some GOP votes, by June 2. That’s two days after the scheduled end of the spring session but long before the start of fiscal 2020 on July 1.
The timing shows progress, competence, cooperation, and functionality, Deputy Governor Dan Hynes said last week, speaking at The Bond Buyer’s Midwest Municipal Conference in Chicago. “All of those things I think will give us a bit of a tailwind going into the coming year and future budgets.”
Market participants see progress this year in steadying the state’s fiscal ship and give the state points for an improved political atmosphere. At least two rating agencies have signaled the budget deal is sufficient to hold the state’s weak ratings at investment grade level, for now.
But many are also throwing cold water on state proclamations that fiscal stability is, given the lack of headway on pension funding and unpaid bills.
“I think it's good that the state has a budget...and they were able to get it done on time,” Laurence Msall, president of the Chicago Civic Federation, said in an interview at last week's conference. "On paper it is balanced” but it’s a narrow ending reserve of just $160 million and it still “has some structural problems.”
The plan doesn't deal with pension liabilities and the new revenue should voters adopt the progressive tax next year may fall short of what’s needed to stabilize the state's finances. "We have very significant concerns about the state budget going forward,” Msall said.
The federation is also worried about the ability of new gambling revenues to support new capital borrowing. Revenue streams like video gambling fell short of projections to cover borrowing on the last capital plan and that resulted in general fund draws. “The state has insufficient resources” to cover any new shortfalls, Msall warned.
THE STATE’S CASE
“This is a one-year budget,” Hynes said, and while happy to accomplish it, “we are very aware of the fact that we have a hill to climb still financially, bills that have to be paid, a structural deficit that has to be addressed and I think that all of what we've done, what we have set in motion, I think will instill confidence" in those watching the state. The new measures put Illinois on an "upward trajectory to financial stability," he said.
Hynes acknowledged how heavily the state’s pension woes weigh on investor and rating agencies assessments. He said the state listened to those worries in walking back a proposal to extend the current pension payment schedule by seven years, which would have trimmed more than $1 billion off the 2020 contribution.
The administration dropped the plan after announcing a $1.5 billion April tax windfall.
It helped close a fiscal 2019 gap and drove revenue projections for 2020 up by $850 million and the administration said it could now afford the full roughly $9 billion payment.
The Pritzker administration also dropped a proposed $2 billion pension obligation bond issue. A task force is examining pension fund consolidation and a separate one is probing potential asset sales and transfers to bolster the 40% funded ratio. The state would put $200 million annually from the new graduated tax revenue toward pensions.
"We are going to continue to pursue a comprehensive plan to address pension liabilities," Hynes said in an interview at the conference. Full payment of the 2020 contribution now “allows us to step back and do it more holistically and comprehensively and without some view that it was being done as a measure to just address this year's budget.”
Hynes’ comments suggested a future re-amortization remains on the table although he could not be pinned down. The amortization schedule that aims to reach a 90% funded ratio by 2045 and currently requires dedicating 20% of operating revenues to the pension contribution “needs to be looked at” and “is not the best approach,” Hynes said.
But the administration would package any future change as part of a larger plan in an effort to avert the same criticisms it faced this year that it was nothing more than a partial pension holiday. “We don’t want to do any one thing in isolation,” he said.
S&P
S&P called fiscal 2020 plan a “status quo” budget that preserves liquidity and the state’s fiscal position in the near term largely thanks to the $1.5 April income tax windfall. It allowed the state to help erase a fiscal 2019 gap and cancel plans to re-amortize the pension payment schedule that would have trimmed next year’s contribution by about $1.1 billion. Fiscal 2020 revenue projections were raised by $850 million.
“While we view Illinois' progress toward closing its structural general fund budget gap and timely budget as a step forward compared with its recent budget history, the state still faces significant credit challenges, such as a likely increasing debt and fixed-cost burdens, slow economic growth, and population loss,” S&P’s lead Illinois analyst Carol Spain wrote in its review last week of the session’s results.
“We believe that the state will need further action to achieve sustainable structural balance and address its pension liabilities to maintain an investment-grade rating,” Spain said. “The state's lack of reserves, elevated bill backlog, and high fixed costs leave it vulnerable in the face of an economic downturn and projected out-year gaps.” S&P lead Illinois analyst Carol Spain wrote.
The state will swap one debt for a cheaper one by issuing $1.2 billion of bonds to bring down the bill backlog, which carries interest rate penalties as high as 12%.
S&P rates the state at the lowest investment grade level of BBB-minus with a stable outlook. Moody’s Investors Service affirmed the state’s Baa3 and stable outlook last week and Fitch Ratings said it’s still reviewing the session’s results and expects soon to resolve the negative outlook assigned to the state’s BBB rating.
DETAILS
The budget — billed by Pritzker as a “bridge” to the graduated income tax — anticipates a narrow $150 million to $160 million ending balance that if realized would go to pay down overdue bills.
The administration has not outlined a backup plan if voters reject the income tax change.
The adopted budget shed some revenue sources from Pritzker’s original proposal. It no longer relies on license fees from legalized recreational use of marijuana, originally estimated at $170 million, and about $200 million in projected first-time sports betting license fees were moved to fund the capital budget.
The budget relies on a modest increase in natural income tax growth of around 4%, $500 million in budget relief through the passage of a managed care assessment fee that will leverage more federal Medicaid funds, $94 million from decoupling from federal tax law on repatriating income, and roughly $650 million of one-time revenues related to interfund borrowing, a refund transfer, and a delinquent tax payment incentive program that will generate $175 million.
Total spending is up about $1.3 billion or 3.6% from fiscal 2019. That’s due to a $640 million hike in pension contributions to $8.4 billion from the general fund and $640 million in additional public education spending.
GAMBLING AND CAPITAL
Senate Democrats offered some additional revenue projections stemming from various proposals in the gambling expansion package that project $2.7 billion in one-time revenues and recurring revenue of $470 million when all measures are fully implemented. The state Commission on Government Forecasting and Accountability is reviewing those numbers but has previously warned of gambling market oversaturation.
Chicago will receive one-third of tax revenue generated from a Chicago casino license included the legislation. The six new casino licenses could generate up to $1.8 billion in one-time fees.
The $45 billion capital program that will receive much of the new revenue relies on $10.7 billion of pay-go financing, $20.6 billion of borrowing, $3.6 billion in local funding, and $10 billion of federal funding.
In addition to gambling revenue, the capital package relies on a doubling of the state’s 19 cent motor fuel tax, and other transportation related fees and taxes, and cigarette and smoking-related tax hikes.
BUYSIDE
Market participants see some added value for Illinois paper due to the break in political acrimony that marked the four years Republican Bruce Rauner held the governor's office and feuded with the General Assembly's Democratic majorities.
Illinois spreads plummeted last month with the state’s 10-year ending the month at a 139 basis point spread to the Municipal Market Data’s top benchmark compared to 178 bps where it opened. That’s due to both the market’s view that the state’s ratings will hold steady for now and marketwide steep demand for high-yielding paper.
“The budget still relies on optimistic revenue projections, doesn’t do anything for pensions, sells $1.2B more bonds to refinance vendor payables, ultimately depends on voter approval of tax reform, and begs detailed further study to detect non-recurring savings. But Illinois has a functioning budget process again: a key takeaway that justifies recent spread tightening,” Municipal Market Analytics said in its weekly outlook.
While the state took no “concrete” action on pensions “on the surface, the fiscal outlook for Illinois is brighter today. Single party control of the executive and legislative branches supported passage of the fiscal year 2020 budget which the legislature sent to the governor for signature nearly a month before the new fiscal year begins,” municipal strategist Alan Schankel wrote in Janney Investment Strategy Group’s muni monthly.
Held up to spreads of low-rated senior living offerings pricing at 100-110 basis point spread to the AAA benchmark “the Illinois spread stands out” but “investors must consider the risks” that a failed constitutional tax amendment triggers a spread widening, and “Illinois is more vulnerable to the fiscal impact of a recession than most states,” Schankel wrote.
