State governments tend to boast strong creditworthiness. They have a multitude of revenue streams, the ability to adjust budgets on the fly, and tend to have broad economies. These factors contribute to the sector’s generally high credit quality, with only seven states rated below AA. However, we expect the slowing economy to reveal imbalances that could affect credit quality and lead to diverging performance within the sector. We’re watching three factors in particular: income tax exposure, cash cushions relative to historical volatility, and the level of aggregate long-term liabilities.
1. Exposure to income tax revenues
Income tax revenues tend to be more volatile than other types of tax revenues. California and New York often are cited as especially exposed to income taxes because of their reliance on income tax (as measured by income tax’s percentage of total state revenues). However, tax rates are also part of the equation. States that have a high reliance on income tax and high top marginal tax rates, such as California, New Jersey and New York, are generally the most susceptible to the income volatility inherent in high earners’ bonuses and capital gains. For this reason, we think those states are at greater risk in a downturn.
2. Liquidity cushions
We believe cash and reserves, which typically provide a cushion throughout an economic cycle, become even more important in a downturn when revenues tend to fall short of expectations and expenditures can exceed expectations. In aggregate, states began fiscal year 2023[i] with cash cushions well above pre-Great Recession levels (see graph).