Conclusion: The Republican landslide in the recent election all but guarantees State & local government fiscal headwinds will continue to materialize in 2011. These headwinds will likely result in material spending cuts and tax hikes going forward, which will create a drag on the economy going forward and increased risk for State and local bond defaults.
Position: Bearish on Muni Bonds
With the incoming 112th Congress coming in overwhelmingly Republican on the margin, State & Local governments will likely see their fiscal troubles deteriorate into FY12 (which starts on July 1st, 2011 for all but four States), due to an erosion of federal budgetary support. States have only a remaining $6 billion in American Recovery and Reinvestment Act funds left to patch the FY12 budget gap of an estimated $140 billion. Incremental funding from H.R. 1586, the August 2010 Jobs Bill, buoys State spending on Medicaid only through June 2011 and adds only $10 billion to the State Fiscal Stabilization Fund.
If State & Local government revenues come in in-line with our bearish estimates, where will the much needed additional funding come from as States evaluate their budgets mid-year and as they prepare FY12 budgets? Likely not from the federal government, given the Republican Party’s platform of cutting spending and lowering taxes. Given this material erosion in funding sources, we outline below some key programs and sources of funding that may disappear in 2011 as well as some proposals that will exacerbate State and local government fiscal headwinds going forward:
Build America Bonds
The Build America Bond program has helped fund $158 billion into local public works projects since its inception, with the federal government subsidizing 35% of the interest on these taxable securities. The program is set to expire at the end of the year, unless it gets extended. Twice this year, the program has passed the House only to be shot down in the Senate (likely due to it being wrapped in with other contentious programs). If it does not make it past the lame-duck session of Congress (which began yesterday), it will likely not be extended when the 112th Congress takes session.
The program has been quite popular thus far from issuers and underwriters alike; should it fail to be extended, current estimates suggest tax-exempt muni bond issuance would increase roughly 30-35%. That’s not good for muni bond yields – especially when taken in the context of bearish underlying fundamentals of many State and municipal governments across the country.
Pledge to America is a Pledge to Cut Discretionary Spending
House Republican leaders have pledged to cut non-security discretionary spending by 21.7% in FY11. If adopted, the program would provide roughly $105 billion less for all non-security discretionary programs than Obama’s current 2011 budget. According to the Center for Budget Policies & Priorities, that translates to roughly a $32 billion haircut for State & Local government budgets, given that State & local government grants represent nearly a third of all non-security discretionary funding. If transportation programs are factored in, the haircut is a full $11.8 billion larger, for a total of $43.4 billion of lost funding in 2011. States are already projecting a $134 billion deficit in FY12; needless to say, an incremental 32% addition to the gap will require further cuts and/or tax hikes going forward, as States are mandated to have balanced budgets (w/ the exception of Vermont).
Obama’s Business Tax Break
President Obama’s proposed tax break for businesses to deduct the full cost of capital investments in the year expenses were made (rather than a full depreciation schedule) may end up costing states $20 million in tax revenues through 2013, according the Center for Budget Policies & Priorities. Further, the center suggests States may end up recouping only about 85% of the funds despite the immediate write-offs being replaced by those of later years, due to NPV calculations among other factors. All told, 24 States automatically change their definition of taxable income to conform to federal government code and another 22 update it every year to reflect any changes made on the federal level, meaning that 46 States will be directly negatively impacted by this proposal should it pass.
Getting Up To Speed
With the struggles of State & local governments making more and more news of late, we’ll continue to remain diligent in keeping you appraised on this topic. We’ve written extensively on State & local government fiscal headwinds YTD; email us if you’d like to receive copies of any/all of the following reports:
February 24: DOMESTIC PIGS – A recent release by the PEW Center on the States shows a $1 trillion gap between the $3.35 trillion in pension, health care, and other retirement benefit-related liabilities currently on States balance sheets and the $2.35 trillion in assets they have to cover them. While we are not calling for the U.S. to default on its sovereign debt, the likelihood of a State and/or local government defaults(s) may potentially lead to a downgrade in the U.S.’s credit rating.
April 20: GOVERNMENT’S MARKING TO MODEL – Property tax rates and property tax receipts continue to rise in the face of a weak domestic housing market, showing just how much the government marks their “assets” to model. We break down the convoluted municipal property value appraisal system and highlight the oncoming headwinds to local government property tax collections in the coming years.
July 21: IN A SORRY STATE INDEED - Waning federal funding, slowing tax receipts, and declining home prices will put additional strain on State and local government budgets, which have an incremental negative effect on the U.S. economy at large.
September 13: BREAKING DOWN MUNI BONDS – We firmly disagree with the relative “safety” of muni bonds, as current yields are at a disconnect with the underlying negative fundamentals that will begin to reveal themselves over the next 2-4 quarters.
October 13: CONTRACT FOR AMERICA: EVEN SLOWER GROWTH AHEAD? - Careful analysis of State & Local Government fiscal headwinds suggests that a Republican takeover of Congress may lead to decisive spending cuts, which could negatively impact U.S. economic growth in the intermediate term. Furthermore, State and Local Government’s FY11 revenue projections are very out of line with economic reality, which suggests further cuts are on the way. In this report, we analyze this divergence in great depth.