Overview

A strong government framework, prudent budget management practices that support timely and considerable expenditure adjustments to help address potential revenue shortfalls, and a low debt burden support S&P Global Ratings' 'AA' issuer credit rating (ICR) on Arkansas. Weaker economic metrics compared with the national average, including lower income levels, slower long-term population growth and a comparatively high age-dependency ratio, partially offset these strengths.

Recently accelerated individual and corporate income-tax-rate cuts were approved during a special legislative session. However, even after the cuts, the state projects to end fiscal 2023 with an operating surplus.

Strong revenue growth in fiscal 2022 (a 9.2% increase in net available general revenue), and a conservative budget, produced a $1.6 billion budgetary surplus (27.8% of spending, or what the state refers to as available distributions). The governor called the legislature into a special session in August 2022 to address the surplus, resulting in multiple tax changes. The most substantial is a resolution to accelerate tax cuts passed in December 2021. The previously announced plan gradually reduced the state's top individual income tax rate to 4.9% in 2025 and included safeguards limiting reductions under certain circumstances. The new plan reduces the top individual income tax rate to 4.9%, retroactive for calendar year 2022. Additional key items approved during the special session include:

• A one-time, up to $150 individual tax credit ($300 for married taxpayers filing jointly) for taxpayers whose incomes fall below certain thresholds; and
• Accelerated a previously planned corporate income tax rate reduction to 5.3% from 5.9%--now effective for the calendar year 2023 rather than 2025.

We view the rate reductions as significant. The income-tax-rate reduction and credits are estimated to reduce general revenue by approximately $500 million in 2023 (7.6% of 2023 estimated net general revenue).

The most recent general revenue forecast, published by the Arkansas Department of Finance and Administration (DFA) in November 2022, conservatively projects a $598 million 2023 surplus (9.9% spending) based on estimated net general revenue collections of $6.62 billion (11.4% below actual 2022). However, through February, net general revenue collections of $4.54 billion exceeded the forecast by 5.6% and have increased 4.4% year over year.

The revenue forecast further projects a small 0.4% decrease in net general revenue in 2024, followed by a modest 3.6% increase in 2025. The DFA economic models used to guide the revenue forecasts assume a shallow recession in 2023, which aligns with our recent forecast (see "Economic Outlook U.S. Q1 2023: Tipping Toward Recession," published Nov. 28, 2022, on RatingsDirect).

Very strong reserve levels are likely to provide sufficient liquidity and budgetary flexibility if revenues unexpectedly decline and fall short of estimates. Strong budgetary performance in recent years resulted in significant growth among Arkansas' combined reserve funds (general revenue allotment reserve, budget stabilization trust fund (BSTF), general revenue restricted reserve funds, and catastrophic reserve fund). The combined balance increased 157% in 2021 to $1.5 billion, 91% in 2022 to $2.9 billion, and is projected to grow 23% to $3.8 billion (a very strong 63% of spending) in 2023.

Arkansas gross state product (GSP) growth is generally slower than the U.S., and on a one-, five-, and 10-year basis, it has trailed by 0.76 (2021), 0.29, and 0.78 percentage points. This trend temporarily reversed in 2020, with Arkansas GSP growth increasing 0.41% compared with a national contraction of 2.75%. The state's higher concentration in manufacturing (positive 3.8% compared with the U.S.) and increased consumer demand for goods versus services following the pandemic, coupled with a federally stimulated economy, might have aided the unusually strong growth in 2020. Also, other sectors, specifically leisure and hospitality, which were most negatively affected by the pandemic, are less prominent in Arkansas (leisure and hospitality –negative 0.6% compared with the U.S.). S&P Global Market Intelligence forecasts GSP growth will trail national GDP growth from 2023-2026 (3.12% compared with 5.81%). We generally anticipate state GSP will grow slower than the U.S., with periodic overperformance, as seen in 2020.

Environmental, social, and governance

Environmental, social, and governance (ESG) factors have no material influence on our credit rating analysis for Arkansas. For more information, see "ESG Credit Indicator Report Card: U.S. States And Territories," published March 31, 2022.

Fiscal 2024-20025 Biennial Budget Proposal

• The 2024-2025 executive budget recommendation requests $6.3 billion for 2024 (a $314 million, or 5.2% increase from 2023) and $6.5 billion for 2025 (a $181 million, or 2.9% increase from 2024).
• Based on the November DFA general revenue forecast, the executive spending recommendations would generate a $255 million (4.0% of the recommended budget) surplus in fiscal 2024 and a $309 million surplus (4.7%) in fiscal 2025.
• Additional spending requests are primarily for education funding, with a $200 million recommended increase in 2024 and an additional $350 million increase in 2025.

What We're Watching

• Whether revenues continue to trend above forecast in the medium-to-long term, particularly provided recent permanent tax reductions to two primary revenue sources and an expected shallow recession.
• Liquidity: How expenditure reductions are balanced using reserves through economic cycles.
• Pension performance: Poor 2022 market performance eliminated most of the progress made in 2021 and state contributions generally fall short of costs. Coupled with what we view as optimistic assumed returns, funded ratios could worsen in the near term.

Credit Fundamentals

• Strong budget framework and good financial management, including a balanced-budget requirement and controls to identify revenue shortfalls and make intra-year adjustments to restore balance.
• Maintenance of strong reserves aided by robust cash-flow monitoring, and demonstrated willingness to restrict spending when necessary.
• High revenue-raising threshold requiring a 75% legislative majority for increasing certain revenue, coupled with limitations on reducing public education expenditures.
• Adequate, albeit historically stable, economic profile, with GSP, wealth, and income indicators generally below U.S. averages.
• Low debt burden and rapid amortization coupled with the state's expectation for modest new debt over our outlook period.
• Adequate pension funding discipline.