articles Ratings /ratings/en/research/articles/190523-when-the-cycle-turns-government-framework-is-a-significant-factor-in-states-ability-to-navigate-downturns-10981918 content
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When The Cycle Turns: Government Framework Is A Significant Factor In States’ Ability To Navigate Downturns

The government framework is one of five factors S&P Global Ratings assesses to arrive at a U.S. state's indicative credit level. A state's government framework, which includes its legal structure and political environment as defined by federal and state law, can influence its fiscal position through various economic cycles. In our rating scoring methodology, the state government framework assessment carries equal weight with other major factors including the economy, budgetary performance, and the debt and liability profile. (For more information, see "U.S State Ratings Methodology," published Oct. 17, 2016.)

In our opinion, the framework within which a state raises revenue, spends, and issues debt influences its ability to manage fiscal pressures through various economic stress scenarios. A state's financial management and budgetary performance structure, in addition to its government framework, also inform its ability to effectively manage through recessions. While there is likely some correlation between how these factors collectively lead to rating changes over time, we note that the government framework may not change as frequently as other rating factors given the complexity involved in making changes. Distinctively, a state's government framework could include constitutional, statutory or state-imposed restrictions, which may be administratively, legally, or politically arduous to change. Where our view of the government framework has changed, particularly at lower rating levels, we have often seen rating movement.

We view states with strong government frameworks as better able to curtail effects of fiscal stress by enhancing revenue and containing expenditure pressures. Conversely, they could be challenged if institutionalized government frameworks limit their ability to respond effectively. Eleven years after the start of the Great Recession in 2008, most U.S. states have weathered the consequent fiscal and economic stress relatively well and maintained credit ratings above 'A'. (As of May 23, 2019, Illinois and New Jersey were rated 'BBB+' and 'A-', respectively. See "U.S. State Ratings And Outlooks: Current List."). However, with slower projected economic growth and the risk of recession in the next 12 months at 20%-25% based on S&P Global's economic forecast in April, U.S. states have shown wider spreads in rating levels and, with some states, a generally weaker capacity to respond appropriately to another recession. As discussed in our commentary, "When The Credit Cycle Turns, U.S. States May Be Tested In Unprecedented Ways," (Sept. 17, 2018), states face long-term structural pressures and the potential for diminished countercyclical support from the federal government in the next downturn.

Most states enjoy the flexibility to set and modify tax rates as well as other factors that affect their ability to raise and collect revenues. If a state can make these changes without major constitutional, legal, political, or administrative difficulty, these discretionary powers, prudently used, can quickly and favorably influence its fiscal condition. On spending, while state governments generally have broad service responsibilities, most enjoy what we view as considerable discretion in establishing funding levels for assistance, shifting responsibilities to local government and establishing or changing disbursement dates for various programs. Absent constitutional or other legal mandates, this affords control over budgets and cash flow, which, in our view, can positively affect fiscal standing.

Government Framework In Our Criteria

Our U.S state methodology incorporates a state's fiscal policy framework, system support, and intergovernment funding within the government framework, which comprises 20% of a state's indicative credit level. A state's government framework and political restrictions (or the lack of them) on executive actions can provide flexibility to deal with changing fiscal positions, or can limit its ability to make necessary changes in practical sense and is considered in our scoring. The independent assessment of a state's balanced budget requirements, revenue structure, disbursement autonomy, voter initiatives, legal framework for debt, system support, and local government funding wrap up into an average assessment to determine the overall government framework score within the range of 1 to 4, with 1 being the strongest. Across states, government frameworks are strong, reflecting the inherent sovereignty of state governments and their general ability to effect changes to their laws through established processes. We have calculated a median government framework score of 1.47 across all states.

In the map below, we have color-coded the states, indicating our assessment of their government framework. The states are categorized as significantly weaker than the median, within 10% of the median, and significantly stronger than the median. According to the framework described, 20% of states scored significantly weaker than the median (higher than 1.6), 50% of states were within 10% of the median, and 30% of states were significantly stronger than the median (lower than 1.3).



Government Framework And State Credit Quality

Considering the weighting of government framework in the criteria, states with the highest ratings only slightly correlate with the strongest government framework. While the median score for the 15 'AAA' rated states is strong at 1.2, three states (Tennessee, Texas, and South Dakota) were just slightly weaker than the median at 1.5. However, these states are also able to navigate their relatively stricter government framework with strong financial management practices and keeping their fixed cost low relative to budgets.

We observe, however, that government framework becomes more critical as credit quality weakens. States with ratings below 'AA' category correlate more closely with weaker government frameworks. Three of the five states with the weakest government framework have ratings below the 'AA' median for states. Notably, two of the five lowest rated states (Connecticut and Illinois) also have scores significantly weaker than the median government framework. The average score of the five lowest rated states (below 'AA-') is significantly weaker than the median government framework score. When facing projected deficits, states' most expedient options consist primarily of spending down accumulated reserves, revenue diversions and increases, or expenditure cuts within the confines of its current laws. However, as fiscal pressures persist and these options dwindle, the ability to make changes that are more fundamental to its fiscal situation as well as the enabling framework to do so become more critical.

Some of these changes demonstrate the states' fundamental sovereignty over the management of their resources and contribute to the sector's strong creditworthiness. The inability to achieve these effectively during an economic contraction as needed can signal credit deterioration.


Our Analysis Of Fiscal Stress Susceptibility Reveals Additional Vulnerability For States

In "When The Credit Cycle Turns, U.S. States May Be Tested In Unprecedented Ways," published Sept. 17, 2018, S&P Global Ratings evaluated the states' level of fiscal preparedness for another downturn and found that, overall, the picture is mixed. While most states are in an adequate position to manage through a hypothetical recession that causes moderate budget stress, doing so would require making fiscal adjustments that go beyond drawing from accumulated budget reserves alone because for most states, budget reserves remain insufficient to absorb even the first-year fiscal effects of a downturn. In response to deficits that emerged in the wake of the Great Recession, for instance, states employed a mix of tax increases and expenditure cuts as they attempted to maintain balanced budgets. Therefore, the states most at risk of experiencing severe fiscal stress in a recession, according to the study, are those with a combination of a propensity for revenue volatility, insufficient budget reserves to withstand the first-year fiscal deficits associated with a moderate recession, and elevated fixed costs.

When comparing the risk of fiscal stress (low to elevated) for each state to its government framework, we observe that some of the states with the weakest government framework also show elevated risk to fiscal stress in the event of a recession. For California, Connecticut, Illinois, and Louisiana these risks are currently reflected in their rating, which are below the median across states.

For the states with low risk to fiscal stress as well as stronger government frameworks, we believe that their government frameworks provide additional flexibility (such as raising taxes and reducing budgeted expenditures), which could further prevent credit deterioration even in the face of fiscal pressures from a recession, all else being equal. All three states (Indiana, North Dakota, and Ohio) are currently rated 'AA' and above.


Changes Are Few But Could Be Significant To Rating Transitions

Changes in government framework are not frequent but there have been changes for nine states since 2016, some of which have been significant. While some changes reflect revisions of laws affecting a state's government framework, some other changes reflect a shift in our view of a state's ability to practically act within its framework when needed. As a state's fiscal position declines and credit quality becomes weaker, we have observed that weaknesses in its government framework--or ability to implement it--becomes more apparent. This could lead to a shift in our view of the government framework and, subsequently, the rating. The most significant changes have been in Illinois and Connecticut, which led to weaker government frameworks. However, New York and Ohio have also shown significant improvement in their government frameworks in the same period.

Examples Of Recent Changes In Government Framework Score

Connecticut (A/Positive, 1.9)

Connecticut's government framework changed (to 1.9 from 1.6 in 2017) correlating with its rating transition to 'A+' from 'AA-' in May 2017. The state has had an additional downgrade and outlook changes subsequently. As the state experienced a very sizable budget gap because of successive downward revenue adjustments, it faced increasingly limited remaining flexibility to respond to any further downward revenue adjustments due to the large expenditure cuts already made as well as the large portion of the budget already devoted to fixed costs.

A key feature of Connecticut's government framework is a balanced budget requirement. In developing its budget, Connecticut operates under a constitutional expenditure cap that limits spending growth to the greater of personal income growth or the inflation rate, unless the governor declares a state of emergency, or three-fifths of each house of the legislature votes to exceed the limit due to extraordinary circumstances. The expenditure cap excludes debt service, payments from federal grants, and matching payments, while certain pension costs are phased in under the cap in stages beginning in 2024.

Connecticut, which is not a voter-initiative state, has the autonomy to raise taxes and has adjusted its tax structure over time. However, It has relatively broad service responsibilities with about 27% of 2018 budgetary expenditures tied to education funding and other resources shared with local government units. Although it has legal flexibility to adjust funding to local governments, we believe it might be politically difficult to make large municipal aid cuts, in light of a four-month budget impasse following large proposed cuts in municipal aid by the previous governor. The state has avoided sharp midyear reductions in these areas in recent years.

Illinois (BBB-/Stable, 2.1)

Illinois' government framework has changed significantly (to 1.8 from 1.3 in 2016, 2.2 in 2017, and 2.1 in 2019) correlating with its rating transition to 'BBB-' from 'A-' in the same period. The state faced significant fiscal challenges, which were accompanied by political gridlock and significant delays in structural budget alignment and adoption. However recent changes within the political environment increase the probability that the executive and legislature will agree on revenue enhancements in future budget sessions, slightly improving our view of the state's government framework .

Article VIII, Section 2 of Illinois' constitution requires the governor to propose in February a budget for the ensuing fiscal year with recommended expenditures that do not exceed estimated available resources. Budget enactment requires approval by the General Assembly of expenditures that do not exceed expected available resources. Once enacted, there is no constitutional requirement for the state to maintain balance between its resources and expenditures throughout the year, however. The state has a history of carrying deficits into subsequent fiscal years. In our view, the state's legal ability to end--and frequent practice of ending--its fiscal years in a deficit position represents a key weaknesses in the its government framework. In 2016, we lowered the government framework score on the state based on our view of ineffective balanced budget requirements in light of the budgetary impasse that year, leaving the state without a comprehensive, balanced budget in fiscal 2016 and fiscal 2017. The government framework was further weakened due to Illinois incurring unmanaged spending in fiscal year 2017 without a fully enacted budget as well as practical limitations, in our view, in its ability to withhold funding to lower levels of government. Illinois is not a voter initiative state.

The state has autonomy to raise revenues, which it did as part of the fiscal 2018 budget. When the previous temporary tax increases lapsed, the state's accumulation of accounts payable mushroomed. From Jan. 1 through May 31 of each year, the General Assembly has authority to approve a budget with a majority vote. The threshold increases to a three-fifths majority in both houses from June 1 through Dec. 31. From a cash management perspective, Illinois has a high degree of flexibility to defer disbursements, as evidenced by its history of accounts payables.

New York (AA+/Stable, 1.1)

New York's government framework changed to 1.1 from 1.4 in 2017 after the state-enacted budget established a mechanism to assist with budget balance and mitigate federal risks. Under this provision, the budget director--dependent on certain thresholds being met if federal funding decreases--has the ability to uniformly reduce appropriations and cash disbursements, thereby increasing the state's flexibility to deal with federal uncertainties. The 2020 budget is the third consecutive year of including this mechanism. While this change was significant, it did not change the state's rating.

The New York State constitution and state finance law require the governor to submit a balanced cash budget each fiscal year. The state legislature and governor have the authority to raise taxes, and have previously implemented temporary income tax surcharges, permanent tax changes, and other measures. The state can also adjust disbursements in nearly all areas, including statutory provisions in Medicaid to limit spending to enacted levels.

The state does not have a voter-initiative process. It has wide latitude to issue debt secured by different revenue streams. State-supported debt (as defined by law) carries a limit of 4% of personal income, and debt service is capped at 5% of total government fund receipts. We don't view these as significant impediments to debt issuance flexibility under the state's rolling five-year capital plan.

New York typically enacts its debt service appropriation bill before the start of each fiscal year, which is important due to the sometimes-late operating budget enactments in previous years, appropriating all GO, appropriation, and special tax-secured debt for the coming year. The constitution prioritizes GO debt service payment. Should the legislature not make appropriation for debt service, the constitution requires the comptroller to set apart money from the general fund for this purpose.

This report does not constitute a rating action.

Primary Credit Analyst:Ladunni M Okolo, New York (1) 212-438-1208;
Secondary Contact:David G Hitchcock, New York (1) 212-438-2022;

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