Revenues weakened, but states remain resilient, Fitch says

Although the mix of ultra conservative budgeting, the unexpected revenue growth and federal funding states received at the height of the pandemic are in the rear-view mirror, Fitch Ratings says most states continue to fare well.

States fiscal conditions remained resilient in fiscal 2023 despite weakening tax revenue growth or revenue declines, Fitch analysts wrote in a Tuesday opinion piece.

“While the unusually high post-pandemic revenue growth has, not surprisingly, come to an end for most states, cautious forecasting and generally prudent use of large surpluses has enabled states’ resilience to remain high,” Fitch Ratings Director of Public Finance Tammy Gamerman, said in an email.

At the height of the pandemic — in 2021 and 2022 — states accumulated large surpluses due to extraordinary tax revenue growth fueled by high inflation and federal pandemic stimulus, Gamerman and Fitch Senior Director Eric Kim wrote. That and conservative revenue forecasting cushioned the revenue contraction, Gamerman and Kim wrote.

“This will enable most states to maintain spending plans without threatening their improved financial positions,” Gamerman and Kim wrote.

Fitch economists have also adjusted their prognostication on when a national recession might hit.

“We still expect Fed tightening to push the [national] economy into a mild recession, but the timing of this has been pushed out to fourth quarter 2023 or first quarter 2024,” Fitch economists wrote in their Global Economic Outlook in June.

After reviewing reported tax collections in 37 states for the 12 months ending in June 2023, Fitch found that tax revenue was down from the prior year in 17 states, while another six states had growth of less than 1%.

Since the states’ monthly revenue reports vary greatly and use different presentations of tax revenue, Fitch analysts wrote that while the data is timely and indicative, it is not necessarily definitive.

Revenue tracked above or close to last year for most of fiscal 2023 (July 2022-June 2023 for 46 states) until the spring, when monthly state personal income tax collections fell at a median rate of more than 30% from record high collections in 2022, based on data from the Urban Institute.

“Almost every state with an income tax had a large drop in April collections, as taxpayers reflected 2022 stock market losses and lower non-wage income on their final returns,” Fitch analysts wrote. “From July 2022 through May 2023, total state tax collections were about 5% below the prior year.”

About 30 states have adopted pass-through entity taxes, intended to be revenue-neutral for states, but the mix of payments and credits can span multiple years and distort collections in a single year.

Declines were exacerbated in many states due to recently enacted income tax cuts and timing issues related to the implementation of pass-through entity taxes, state workarounds to the $10,000 federal cap on state and local tax (SALT) deductions, according to Fitch.

Delayed filing deadlines in California due to natural disasters further affected state income tax collections and worsened the drop from last year.

The federal government and the state allowed the majority of California residents affected by the massive storm system that hit the state earlier this year to postpone filing tax returns until October. It has presented forecasting challenges for California and reduced revenues in the fiscal year ended June 30, that forced some belt tightening at budget time.

California was the only state to propose mid-year spending reductions due to a revenue shortfall in fiscal 2023, according to the National Association of State Budget Officers’ spring survey.

Generally, states with greater reliance on sales tax revenue fared better in fiscal 2023, including Texas, South Dakota and Florida, Fitch analysts said.

Among states with no personal income tax, growth in tax revenues in the 12 months ending in June ranged from about 3% in Washington to 10% in Texas.

“However, these figures obscure a significant and broad slowdown in the rate of growth over the past year,” Fitch analysts wrote. “Data collected by the Urban Institute shows that year-over-year growth in state sales taxes fell to 2.7% in March-May 2023, a sharp contrast from 11.0% year-over-year growth in July-September 2022.”

Decelerating inflation and the waning effects of pandemic-era assistance programs are likely to further restrain sales tax growth going into fiscal 2024, Fitch wrote.

Most states have budgeted cautiously for the coming fiscal year, generally in line with Fitch’s expectation for a mild and brief recession beginning in late 2023 or early 2024. Prudent budgeting and careful revenue monitoring will be even more important for states next year, as many have ramped up actions to spend down surpluses accumulated over the past three years through both one-time and recurring tax cuts and new spending.

Looking to 2024, Fitch analysts said, the abnormally high revenue growth that marked the pandemic recovery appears to be in the rearview mirror. However, prices and wages should remain above pre-pandemic levels, keeping revenues in most states elevated relative to their pre-pandemic baseline, and tax revenues will generally continue to grow from the higher baseline, albeit at a more modest pace.