Beyond Bulls & Bears

Fixed Income

US budget season implications for the muni market

A slowdown in US economic activity this year is likely to impact most states, which could face budget deficits, according to Jennifer Johnston, Franklin Templeton Fixed Income’s Director of Municipal Bond Research. She outlines implications for the muni market. 

Key takeaways:

  1. We knew that California would announce a budget deficit.
  2. California’s credit ratings incorporate the tax volatility it faces, so as long as the state employs a diverse approach to addressing any deficits, we don’t expect any ratings actions at this time.
  3. A slowdown in US economic activity is likely to impact most states and some could see budget deficits as costs rise at the same time.
  4. States and many muni credits go into this period of slower or negative growth with very strong balance sheets and reserve funds.

For those who watch state budgets closely, January marks the official beginning of “budget season” with California Governor Gavin Newsom’s release of his preliminary budget for fiscal year 2024 (FY24). With the sheer size of California’s budget and its highly volatile tax revenue structure, among other things, the California budget release gives us a peek into some of the challenges or opportunities that the larger US states will have as we move closer to June 2023 budget adoptions.

It was no surprise that Newsom announced a budget deficit. First, the state has been reporting monthly underperformance of revenues since the summer. Second, the state is highly dependent on capital gains and personal income tax revenue, which are weakening due to stock market weakness and wage growth slowing. And finally, the state had been seeing unprecedented revenue growth post-pandemic and we know that this would not continue indefinitely, especially given the Federal Reserve’s increases in interest rates and inflationary pressures.

The questions for muni credit experts included:

  • What is driving the volatility?
  • Will the announcement of California’s budget deficit lead to a downgrade?
  • Could this deficit announcement result in drawn out budget battles that hurt credit?
  • Can the deficit be eliminated?
  • Is this a trend that we are likely to see in other states?

Let’s take each of these questions.

  1. What is driving the volatility? The state’s general fund is highly reliant on income taxes and in particular, capital gains taxes. The state also has a number of taxes levied on higher income people who tend to have more volatile incomes. So, when investment markets perform well, the state tends to see sharp increases in tax revenue. But when investment markets perform poorly, we see declines, like in 2022. The two charts below illustrate the volatility of capital gains taxes.1
  2. Will the announcement of California’s budget deficit lead to a downgrade? At this point, our answer is no. First, this is a very early look into the governor’s projections and priorities; there are still four months until the next budget release and five months until adoption deadlines. Second, the state has very high levels of reserves and many tools in its toolbelt to close this budget gap. And three, we feel that so long as the state bases the budget on realistic assumptions and closes the deficit in an appropriate way, the rating is likely stable for now.
  3. Could this deficit announcement result in a drawn-out budget battle that hurts credit? While various members of the government will have their own estimates and priorities, we expect that the fact that the same party leads both the executive and legislative branches of government will enable a smooth path. Major priorities are likely to be similar, it is just the details that will need to be agreed upon. Second, the state enters this challenge with very robust reserves and many tools in its budget- deficit toolbelt. And third, there is ample time for the governor and legislature to look at potential solutions and get others on board.
  4. Can the deficit be eliminated? The short answer is yes, and a balanced budget is a requirement. The state has less power over technology sector layoffs and economic underpinnings, but as mentioned above, reserves are large and there are lots of tools to address the deficit. Over the next few months as the economic picture becomes a bit more clear, the governor will be socializing his ideas among legislators and other stakeholders. There are tough decisions ahead for the governor and legislature, but the tools available should make the question not “if” but “how.”
  5. Is this a trend we are likely to see in other states? Only a few states have released their preliminary budgets at this point, but we think that California will be more of an outlier this year rather than part of a trend. California’s budget is highly reliant on income taxes, and capital gains taxes in particular. This makes revenues very volatile, and we can see large shifts depending on how financial markets (i.e., capital gains) perform. This isn’t a surprise and the fact that the state’s revenue stream is so volatile (both to the positive and negative) is factored into the state’s rating. It’s one of the key reasons that we think the state should have higher reserves than others. If economic conditions weaken and remain weak, we could see other states reveal deficits, but that remains to be seen.

In summary, California definitely has its challenges, but we think it has the tools to deal with them in a way that should not impact its credit rating this year. Ongoing economic weakness could certainly make next year far more difficult.

Which state is next? New York State has the first fiscal year end (March 31) so we will soon have additional insight into their budget. New York City has released its $102.7 billion FY24 preliminary budget which projects increased revenue assumptions of $1.7 billion for FY23 and another $738 million for FY24, but year-over-year revenues are expected to decline by $3.7 billion or -3.5%, which brings a year-over-year revenue change that is flat.

Michigan, which has a September 30 fiscal year, updated FY22 revenue assumptions by +$1.5 billion due to outperformance of sales and income taxes. While FY23 revenues are expected to be lower than FY22, estimates have been revised higher.

All eyes are on Illinois, which should release its FY24 budget in a few weeks. A November mid-year update estimated that the current fiscal year could see a new positive surplus of $1.689 billion. Tax revenues are expected to grow $3.7 billion, about $1.3 billion of which would be used to make an additional transfer to the Rainy Day Fund.

We will be watching these developments closely and are optimistic most states can weather changing economic conditions. We have an extensive research team which highlights our ability to be nimble and can pivot quickly if we uncover any cause for concern.


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1. Source: Governor’s Budget Summary, State of California, 2023-2024.

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