Municipal Bonds: Fiscal 2025 State Outlook

_{Source: National Association of State Budget Officers, Survey of the States, 2024.}

The two primary sources of state tax revenues are income and sales taxes (Exhibit 2). Sales tax growth has remained stable (helped by inflation). Still, income tax has notably softened, particularly in states that are more reliant on capital gains and those that enacted rate cuts — some through automatic adjustments based on reserves. At the start of 2024, eight states enacted lower income tax rates.

EXHIBIT 2: STATE TAX REVENUE SOURCES FACE DIVERGING TRENDS

Sales tax growth stays strong with inflation, while income tax revenues weaken in states with capital gains reliance and new rate cuts.

_{Source: U.S. Census Bureau’s 2023 Annual Survey of State Government Tax Collections.}

In recent months, several states enacted tax cut measures:

• Kansas: The legislature approved reducing personal income tax brackets from three levels to two and exempting Social Security income from taxation. These changes and other tax cuts are expected to reduce tax revenues by over $500 million in 2025, which is just under 5% of the annual general fund budget.
• Illinois: The state will eliminate its statewide 1% grocery tax starting in 2026, which offsets tax increases on sports betting.
• Hawaii: The state passed a new budget with reductions in state income taxes, with projections to eliminate the tax for 40% of the population by 2031.

Softening revenues and the exhaustion of federal pandemic aid have tempered state spending for fiscal 2025. Pew Charitable Trusts analysis shows expected general fund spending across states is down approximately 6% for fiscal 2025, similar to the rate of decline experienced during the Global Financial Crisis.

Examples include California, which reduced one-time spending to reallocate resources to core services, and Arizona, which cut higher education spending to close projected deficits. Budget cuts preserve the reserves built up over the past few years and provide cushion against future budget shocks.

State resiliency

Even well-managed states experience financial volatility. During recessions, state budgets tend to be squeezed by declining tax revenues and rising cost for safety net programs. Unexpected events such as natural disasters, terrorist attacks, civil unrest, or pandemics can also radically change state budget forecasts. States have fiscal tools to manage these events, including raising new revenues, reducing or delaying spending, refinancing debt, borrowing, or use of reserves. These sovereign powers are a key part of why we favor state bonds.

On a relative basis, state resiliency varies (Exhibit 3). Key factors in evaluating state resiliency include:

• Reserves: Reserves increase a government’s fiscal safety margin. Reserve accumulation is especially significant for states with volatile revenue structures, such as New York, which has a heavy dependence on capital gains, and Alaska, which has a heavy dependence on oil revenues.
• Fixed Costs: Legacy costs like pensions, retiree health, and debt service reduce budgeting flexibility. Illinois, for example, expects to spend over $10 billion on pensions and nearly $2 billion on debt service in fiscal 2025, more than 22% of its $53 billion budget.
• Management: We prefer states that budget conservatively and can quickly change revenue forecasts when conditions warrant and adjust spending if necessary. In Delaware, for example, the state appropriates only 98% of expected revenues, providing a cushion for revenue shortfalls. In Ohio, if the governor believes tax receipts will be less than appropriations, they must order state agencies to reduce spending. Well-managed states also act to improve resiliency to disasters and other event risks.

EXHIBIT 3: COMPARING STATE RESILIENCY IN CHALLENGING TIMES

Varying levels of state resilience reflect differences in fiscal strength, management strategies, and budget stability — or a combination of these factors.

_{Source: Northern Trust Asset Management, our view of resiliency applies to the year starting July 1, 2024.}

Event risk and states

States depend on the federal government for fiscal assistance in recovering from major disasters. Aid flows from Federal Emergency Management Agency (FEMA) programs and one-time Congressional appropriations. The federal government responded generously to major events like the 2001 terrorist attacks, Hurricane Katrina (2005), Hurricane Sandy (2012), and recent wildfires. However, this aid is not guaranteed, and recent trends raise concerns that future disaster aid may not be as generous.

The federal deficit has reached record levels at nearly $2 trillion in fiscal 2024, constraining the government’s financial capacity. Simultaneously, the frequency of costly disasters increased dramatically, with the U.S. now experiencing 20 disasters per year that exceed $1 billion or more in damages, compared to an average of just five in the early 2000s. Additionally, the growing divisiveness in American politics may hinder the passage of future aid bills.

The rise in costs and risk of waning federal support underscores the need for resiliency among states. It also emphasizes the importance of solid governance that plans for disasters and works to harden key assets — the federal Bipartisan Infrastructure and Jobs Act of 2021 assisted by providing funds for climate resilience.

Some states have greater vulnerability to event risk than others. Exhibit 4 shows the risk of costly wildfires, hurricanes, and floods by state.

EXHIBIT 4: POTENTIAL RISE IN STATE DISASTER RISKS

The number of expensive disasters is rising, and future federal aid is not guaranteed.

_{Source: Northern Trust Asset Management, risQ, July 2024.}

Weakest states strengthen but remain near the bottom

Illinois (fourth largest), New Jersey (seventh largest), and Connecticut (nineteenth largest) are among the major municipal bond-issuing states. Their general obligation credits have recently improved, but all three, notably Illinois, remain weak compared to peers. The improvements are mainly due to a build-up in reserves, restrained debt issuance, and better pension funding, including the use of surpluses to make extra pension deposits. However, the impact of these achievements is tempered by lower reserves, high pension liabilities, and slower economic and population growth compared to state peer medians.

We have recently added to positions in these three states as their credit has improved and they built resiliency against future economic slowdowns. Bonds from these states typically offer more yield than other states, although these yield spreads have shrunk over the last two years as credit conditions have improved and each state has received rating agency upgrades.

Eye on California

Golden State issuers make up over 16% of the municipal market, by far the most of any state. California’s tax revenues are volatile, largely due to its resilience on a highly progressive income tax and the boom-and-bust nature of its large tech industry. This volatility is evident in the state’s tax revenues, which jumped from $140 billion in fiscal 2020 to $232 billion in fiscal 2022, driven by rapid growth in income taxes. California took this opportunity to build a large reserve, which was then needed as tax revenues fell to just $180 billion in fiscal 2023.

The state has used some of its reserves and implemented spending cuts in response to the revenue decline. It recently passed fiscal 2025 budget, which allocates $211 billion, down from $223 billion in fiscal 2024 and $243 billion in fiscal 2022. California now expects to end fiscal 2025 with nearly $18 billion in reserves and $14 billion in unrestricted fund balance a total of 13% of its annual budget.

We remain constructive on California’s credit due to strong reserves and liquidity, reduced debt levels, and strong management.

What this means for municipal bond investors

States as an asset class enter fiscal 2025 in strong positions due to sizable reserves and moderating fixed costs. Yet, we expect that many states will need to make modest spending cuts to continue that flexibility given slowing revenues and exhaustion of federal pandemic aid. We expect the economy to stay out of recession, but if a moderate recession occurs, state resiliency should remain strong, limiting credit downgrades and market volatility. We continue to consider state bonds to be a crucial part of core municipal portfolios.