While most U.S. states came out of the pandemic in relatively good economic shape, some warning signs are starting to emerge as money flowing into state coffers starts to slow.
Municipal bond issuers may see their revenue streams come under pressure from a variety of possible threats.
Inflation obscured the impact of declining revenue in many states, with numbers up in dollar terms but below the consumer price index. But the trend is accelerating, even as federal COVID-19 aid peters out amid worries that the federal government will hit its debt limit and default.
Weakening revenues should be a red flag for the states, particularly for those still planning to enact tax cuts, said Lucy Dadayan, principal research associate with the Urban-Brookings
"The revenue weakness and the declines have been much anticipated — the boom that we saw in 2021 and 2022 should have been viewed with caution because the revenue growth was fueled by temporary factors," she told The Bond Buyer.
She said high inflation artificially increased state revenues along with an unusually strong stock market and increased initial public offering activity.
Dadayan also noted that revenues rose because the pandemic artificially boosted spending on goods because business closures meant that people couldn't spend on services, which usually bring in less tax revenue.
"The enormous amount of federal aid injected into the economy, as well as the direct aid to the states and localities, helped a lot," she said. "But the bottom line is that the strong revenue growth in 2021 and 2022 was unusual and temporary — and now revenue growth is normalizing in some states and declining in other states because of the disappearing federal aid and other temporary factors, enacted
According to the institute's data, 36 of the 47 states with information reported declines in inflation-adjusted total state tax revenues in March compared to the same month last year, while 26 states reported declines in nominal terms.
A nominal number is unadjusted for inflation while a "real" number is adjusted to account for changes over time.
Total state tax revenues in March fell 9.4% in nominal terms and dropped 13.8% in real terms compared to March 2022. Nominal collections were down for the fourth straight month while inflation-adjusted revenue collections declined for the eighth month in a row.
In January through April, state tax revenue declined in 25 states compared to the same period last year.
The year-over-year median state decline was less dramatic, 2.0% in nominal terms and 6.8% in real terms.
Data show that from July through March, which for 46 states corresponds to the first nine months of their fiscal year, total state tax revenues declined by 1.5% in nominal terms and by 7.9% in real terms compared to the same period a year earlier.
Inflation-adjusted growth was mixed among the major sources of state tax revenue, with personal income taxes dropping 15.8%, corporate income taxes declining by 9.2% while sales tax revenues increased 0.6%.
Drilling down, the weakness in personal income tax revenues was more widespread when compared to sales tax revenues. But sales tax revenues have also started decreasing.
"It's alarming that the number of states reporting declines in sales tax revenues has increased in the past two months," the report said. "And these declines are in nominal terms. If we adjust numbers to inflation, the revenue picture is far more dire."
Personal income tax revenues showed double digit declines in 26 states in nominal terms in the months of March and April combined compared to the same period last year.
The declines were caused by multiple factors, the institute said, such as drops in the stock market,
The report said the weakening in state tax revenues in recent months was also in part caused by government policy decisions.
"Due to federal fiscal support and strong revenue growth over the past two years, a number of states issued rebates to taxpayers, passed tax rate cuts, expanded targeted income tax breaks, and established gas and sales tax holidays over the last two years," the report said.
It noted that several states used budget surpluses to issue rebate checks ranging from as little as $75 a taxpayer in Illinois to as high as $1,500 per taxpayer in New Jersey.
"These rebates cost states billions of dollars, but were a more targeted response to budget surpluses than permanent cuts in tax rates given growing economic uncertainty," the report said.
High inflation, higher interest rates, financial market volatility, weakening home prices and the banking crisis are all likely to lead to a continuing slowdown in economic activity, the institute said, which in turn will lead to further weakness in state tax revenue collections.
Dadayan said several states have already been revising their revenue forecasts downwards and some states are now projecting deficits and budget gaps.
"The most important thing is that states should stop enacting any tax cuts given the uncertainties in the economy," she said. "I hope no state will enact any permanent tax cuts given this gloomy picture for the state budgets."
According to the Tax Foundation, five states do not have statewide sales taxes: Alaska, Delaware, Montana, New Hampshire and Oregon.
The five states with the highest average combined state and local sales tax rates are Louisiana at 9.550%, Tennessee at 9.548%, Arkansas 9.46%, Alabama 9.25%, and Oklahoma 8.98%. The five states with the lowest average combined rates are Alaska at 1.76%, Hawaii 4.44%, Wyoming 5.36%, Wisconsin 5.43%, and Maine 5.50%.
Seven states have no personal income tax. They are Alaska, Florida, Nevada, South Dakota, Tennessee, Texas and Wyoming. Two more don't tax personal income but New Hampshire taxes interest and dividends and Washington taxes capital gains.
Eleven states have a flat personal income tax — Arizona, Colorado, Idaho, Illinois, Indiana, Kentucky, Michigan, Mississippi, North Carolina, Pennsylvania and Utah — while the rest have a system of graduated rates.
States and localities have seen federal aid provided during the pandemic dwindle.
An effort by congressional Republicans to
Congress is still working to avert a government shutdown on or around June 1, the day Treasury Secretary Janet Yellen has said the U.S. would run out of money to pay its bills.
The House and Senate are both likely to vote next week on any deal to raise the debt limit ahead of the June 1 deadline.
Other headwinds remain for state and local entities.
While the inflation picture has in some ways improved over the past year, worries still remain, according to a special economic commentary issued by Wells Fargo on Monday.
"After reaching 9.1% last June, headline CPI is back under 5% year-over-year, and unlike the environment a year ago, pipeline price pressures are clearly weakening," Wells Fargo said. "But in other ways the picture has grown more concerning. The magnitude of the core inflation slowdown has been paltry in comparison to the problem and leaves inflation still way too high for the Federal Reserve."
Wells Fargo says its baseline scenario sees "a demand-sapping recession and gradual unwinding of pandemic-era supply issues help put inflation firmly on a downward path, but are not enough to get core inflation back to the Fed's target on a sustained basis by Q2 of next year."
In its upside scenario, a recession is avoided or significantly delayed thanks to more resilient spending and hiring, generating both the ability and need for businesses to continue to raise prices at a strong rate. The Fed is slow to recognize policy is not yet sufficiently restrictive, keeping core PCE inflation at or above 3%.
And in its downside scenario market share concerns resurface and businesses begin to battle more on price. Supply constraints prove to have been more influential in inflation's rise, and in turn, their unwinding leads to a sharper reduction in inflation. Core PCE rounds to 2% by this time next year.
"As implied by the name, we see our baseline scenario, in which core inflation slows materially but remains closer to 3% than 2% in a year's time, as the most likely outcome for inflation ahead," Wells Fargo said. "However, we'd weight the balance of risks as skewed to the upside as inflation carries momentum and economic activity has continued to hang in surprisingly well."
