Fitch Ratings: Says fiscal 2022 state tax cuts may complicate budgets longer-term

US states reduced taxes to a greater extent than anticipated during this past budget season, with some of the biggest changes likely to necessitate difficult budget choices in the future, Fitch Ratings says. Fitch considers a state’s ability to maintain fiscal balance when evaluating the credit implications of tax changes.

Permanent tax changes may pose fiscal challenges if they are driven primarily by one-time revenue surpluses, and states with weaker levels of financial resilience due to low reserves or rainy-day funds are more at risk. More than one-third of state governments incorporated some form of tax relief into final fiscal 2022 budgets, as exceptional revenue performance in fiscal 2021 dramatically boosted cash and statutory reserve levels.

Eighteen states enacted tax reductions of some kind this year, 12 of which cut income taxes, while six adopted a mixture of tax exemptions for federal stimulus and unemployment payments or reduced statewide property and/or service taxes. Minnesota and Wisconsin proposed tax increases in their fiscal 2022 executive budgets but ultimately reduced taxes in their final adopted budgets. Only five states raised or enacted new income or sales taxes for fiscal 2022: Florida, New York, New Jersey, Washington and Missouri, which also implemented new tax rebates.

Many adopted tax cuts were deeper than originally proposed at the start of this year’s budget season. Iowa and Missouri also accelerated the phase-in of pre-existing income tax cuts by scrapping or altering revenue triggers included in prior legislation. Iowa, Montana, Nebraska, New Hampshire and Oklahoma cut several taxes at once, and Arizona, Iowa, Idaho, Montana and Ohio reduced tax rates while also eliminating or consolidating entire tax brackets.

States cut taxes against a backdrop of robust revenue growth in fiscal 2021 that outperformed their initially low forecasts formulated early in the pandemic. Multiple rounds of federal stimulus and the lifting of public health restrictions resulted in multi-billion-dollar operating surpluses for many states, boosting available cash and allowing for substantial rainy-day fund deposits. Between January and June, most states revised their fiscal 2021 revenue forecasts upward, with some increasing by double-digit percentage point margins.

However, some states are now in a more vulnerable position should revenue growth slow and return to pre-pandemic patterns. Budget challenges, such as the rolling off of federal aid and a shift in consumer spending away from goods toward services, many of which are not taxed, are likely to curb state revenue growth over the medium term.

Arizona, Nebraska and Iowa passed deep cuts across multiple tax categories. All three states possessed healthy reserves at FYE 2020, which will serve to cushion the near-term impacts, but risk will rise in 2024 or 2025 if revenue growth stalls as the last scheduled cuts are fully implemented.

Smaller tax cuts may also prove impractical for some states such as Kansas and Oklahoma, where fiscal 2021 revenues did not significantly outperform and/or where reserves are low for the rating category. Kansas’ fiscal 2022 tax cuts were modest, but the state’s zero rainy-day fund balance remains a source of credit weakness. Even a modest tax cut could complicate Kansas’ ongoing fiscal consolidation if revenue growth returns to pre-pandemic levels. Oklahoma’s tax cuts, while moderate in their estimated near-term revenue impact, were larger than expected and could slow the state’s progress in rebuilding its pandemic-depleted reserve cushion given the state’s muted fiscal 2021 revenue rebound.