Tough budget decisions ahead as state tax revenue drops

U.S. states' tax revenue is sliding broadly, raising the prospect of difficult budget decisions in coming years for officials as they spend through cash amassed during the pandemic.

Total state tax revenue sank in September for the 14th straight month on an inflation-adjusted basis, falling by 5.6% from a year earlier, according to a fresh analysis from the Washington-based Urban Institute. Of those that provided information, 34 of 46 states reported year-over-year declines.

Cooling economic growth, tax cuts and weak stock-market performance are big contributors to the drop in revenue. Healthy rainy-day funds will soften the blow for some time, but states will eventually have to figure out how to raise more revenue or cut spending, said Lucy Dadayan, principal research associate at the Urban Institute. 

"They'll have to come up with new revenue sources, increase the tax rates, reverse the prior tax cuts, or cut spending on different areas," she said in an interview.

Nearly all states saw robust revenue growth on the heels of the pandemic, fueled by federal stimulus, inflation-driven increases in sales-tax proceeds, elevated spending on taxable goods rather than services and surging stocks. Now those trends are reversing, thanks in part to the Federal Reserve's interest-rate increases to tame inflation. 

"Economic challenges lie ahead due to factors like persistent inflation, financial market volatility, higher interest rates, weakening housing prices, and geopolitical crises," Dadayan wrote in a report released Nov. 7. "These could further dampen state tax revenue collections in the months ahead."

For investors in the $4 trillion municipal-bond market, the key will be to monitor how states navigate the revenue declines, said Dora Lee, director of research for Belle Haven Investments.

"What investors will be focused on is how quickly states draw the balances of their rainy-day funds down and what other tools they utilize to offset the declines," said Lee. "For example, are they raising taxes, cutting spending in addition to using reserves."

New York laid out the strains on its tax-revenue outlook last month in a midyear update to its financial plan for this fiscal year. 

Picasa/Patrick Daxenbichler - stock.ado

The state said tax proceeds are expected to drop by $9.6 billion from the previous year, an 8.5% decline. In response, the office of Governor Kathy Hochul, a Democrat, said it's considering limiting financial support for migrants.

"New York State can only shoulder this financial commitment for a limited duration without putting other areas of the state budget at risk," Blake Washington, the state director of the Division of the Budget, wrote in a memo. 

Other big states are seeing signs of a slowdown as well. In Texas, sales-tax revenue — the largest source of funding for its budget — was down 0.3% in October from a year earlier, the first time in 31 months it failed to grow. And California is poised to fall short of its budget forecasts as weakness in stocks crimps tax revenue.

"We're not at a catastrophe level now," said Emily Mandel, an economist at Moody's Analytics. "States are coming in below, but this isn't going to require massive course readjustments at this point. Chances are states might be adjusting their spending plans and just pulling back in some areas as a result of this."