How the Credit Rating Agencies See the World of State Finance

Screenshot 2017-06-12 06.35.32Amidst all of the discussion about public-private partnerships (P3s) as a means of financing infrastructure, and concern about the future of I-69 Section 5, I came across this presentation from S&P Global Ratings in 2016 to the National Conference of State Legislatures Legislative Summit: 2016_Prunty_Presentation,

The presentation presents a fascinating window into the narrow keyhole through which the credit ratings agencies see state governments (which is of course often very different from the way that the public sees the same state governments!) and also the bigger financial picture in which P3s are being promoted in order to close the infrastructure gap.

The first part of the presentation deals primarily with the relative state of fiscal health of the states from a debt perspective. As everyone is probably aware, Indiana joins 30% of the states at the top, with a AAA rating. Neighbor Illinois is an outlier at the bottom with a BBB+ rating. Indiana also joins the majority of states with a stable outlook. A handful of states have a negative outlook, meaning things are likely to get worse.

More interesting is S&P list of key credit risks that led to where the states were at the beginning of 2016: energy-producing states losing oil revenue, current year budget pressures from revenue shortfalls or political gridlock, future year budget pressures, and large unfunded liabilities (mostly pension debt or other employment-related liabilities).

S&P goes on further to identify key themes for 2016: 1. Slower Revenue Growth, 2. Tax Incentives (for economic development), 3. Spending Restraint, 4. Aid to Higher Education, and 5. Pension Pressures Persist. #3 and #4 in particular engage the tension between short-term and long-term success. In fact, later in the presentation, the author, while seeming to champion austerity as a way of managing their debt levels acknowledges that:

For states that have made these trade offs, the impact on credit quality is favorable in the near term (3-5 years). However, looking ahead, the reduced investment in productivity enhancing areas (infrastructure and higher education), paints a dimmer picture of their long term economic growth prospects

So — austerity may help in the short run, but balancing the budget on the backs of infrastructure and higher eduction ultimately harms in the long run.

The presentation then goes on to define debt and debt sustainability, from a ratings agency perspective, and comes to the conclusion that the state and local government sector debt trends are by and large sustainable — and in particular there has been a noticeable pullback on debt issuance after the Great Recession. Most states have seen increases in economic productivity in excess of increases in debt issuance (again with a few exceptions). S&P concludes:

During the recession: states had fiscal crises, not debt crises

However, they do warn that only looking at bonded debt gives a relatively rosy picture of overall state debt — and that to get a more realistic picture, other obligations such as pension and other post-employment-related benefits need to be taken into account.

So where does infrastructure and P3 come in? 

S&P attempts to make the case that while the US has a significant infrastructure gap (structurally deficient bridges, maintenance backlog on transit, construction backlog, water and sewer deficiencies, traffic congestion, and delayed freight), that states will not be able to close this gap through debt-related financing alone, without compromising their credit ratings, especially if the operations and maintenance (O&M) costs of infrastructure are included. P3s are suggested as a potential solution, and in particular:

P3s offer states a way to fold O&M expenses into the overall cost of financing a project,

This is of course the Design-Build-Finance-Operate-Maintain model used (at this point, unsuccessfully) for I-69 Section 5. And the author does acknowledge that:

… the P3 model can be complex and in certain cases, states attempting P3 projects have encountered political opposition.

I suspect that political opposition will only increase at this point.


Analysis Shows Indiana Tax Structure One of the Most Regressive

The Institute on Taxation and Economic Policy (ITEP), a non-partisan research institute, just released the fourth edition of their landmark study “Who Pays? A Distributional Analysis of the Tax Systems in all 50 States.”  The study analyzes the tax structures of all 50 states — the  degree to which each state relies on the different types of taxes (income, property, and sales and excise taxes), the rate structures of each of these taxes, and the overall rates paid by different income groups of taxpayers.

Indiana, unfortunately, made #9 on the list that the authors call the “Terrible 10” — the 10 states with the most regressive tax structures (i.e. tax structures in which the share of family income paid in taxes goes down as income goes up).

In Indiana, the poorest taxpayers (those in the bottom 20% of the income distribution) pay 12.3% of their income on average in state and local taxes. On the other hand, the top 1% pay only 5.4% of their incomes in state and local taxes. Features that make Indiana’s taxes more regressive includes the flat income tax rate and relatively few low income tax exemptions, as well as its dependence on sales and excise taxes. Mitigating factors include the refundable Earned Income Tax Credit and the fact that groceries are exempt from sales tax.

Just as a point of comparison, it is probably not surprising that Vermont has one of the least regressive tax structures. In Vermont, the bottom 20% pay 8.7% of their income in state and local taxes, while the top 1% pay 8%. Not progressive (as the Federal tax system is) — but not nearly as regressive as many other state and local systems.

The study also provides an analysis of the regressivity of various types of taxes. In general, sales and excise taxes are highly regressive — particularly if groceries are included in the base (fortunately in Indiana they are not). Property taxes are mildly regressive. Income taxes can range from mildly regressive to progressive, depending on the way the local income taxes are structured.

Rounding out the Terrible 10 are:

  1. Washington
  2. Florida
  3. South Dakota
  4. Illinois
  5. Texas
  6. Tennessee
  7. Arizona
  8. Pennsylvania
  9. Indiana
  10. Alabama