NEW YORK--(BUSINESS WIRE)--Fitch Ratings has assigned a 'AA-' rating to the Commonwealth of Pennsylvania's general obligation (GO) bonds, second refunding series of 2016.
The bonds are expected to sell on or about December 7 through competitive bid.
The Rating Outlook is Stable.
SECURITY
The GO bonds are direct and general obligations of the commonwealth of Pennsylvania, with its full faith and credit pledged.
KEY RATING DRIVERS
Pennsylvania faces fiscal pressures in the form of a structurally unbalanced budget, brought on by a combination of rising fixed costs, modest baseline revenue growth and a particularly contentious decision-making environment. The commonwealth's 'AA-' Issuer Default Rating and GO bond ratings reflect those limiting factors, as well as Fitch Ratings' expectation that the commonwealth will utilize the significant budgetary flexibility available to most states to respond to those pressures adequately, while also making progress toward structural budgetary balance. Pennsylvania benefits from a large, diversified and expanding, albeit slowly, economic base, which is expected to provide adequate revenue capacity to match expenditure growth.
Economic Resource Base
Pennsylvania's broad-based economy is growing, but at a slower pace than the nation. Below-average demographics, including population growth that has lagged the nation's for several decades, represent a long-term drag on economic growth. Ongoing development of Pennsylvania's significant natural gas reserves could mitigate that concern, particularly if pipeline capacity increases and prices improve. Overall, the state's economy provides a solid base for future potential revenue growth to help manage ongoing expenditure pressures.
Revenue Framework: 'aa' factor assessment
Fitch expects Pennsylvania's revenues will continue to reflect the depth and breadth of the economy, but also its slower pace of growth. The commonwealth has complete legal control over its revenues.
Expenditure Framework: 'aa' factor assessment
The commonwealth maintains solid expenditure flexibility with a moderate burden of carrying costs for liabilities and the broad expense-cutting ability common to most U.S. states. Medicaid remains a key expense driver.
Long-Term Liability Burden: 'aa' factor assessment
Pennsylvania's long-term liability burden is moderate but above average for a state, driven by unfunded pensions as net tax-supported debt is low. Pension funded ratios have eroded, with contributions below actuarial levels, but Pennsylvania is nearing full funding of its contributions following a multiyear ramp-up.
Operating Performance: 'aa' factor assessment
The commonwealth retains very strong gap-closing capacity given its general budgetary flexibility. Pennsylvania is somewhat less exposed to revenue volatility from U.S. economic declines than most states but continues to rely on material nonrecurring budgetary measures during the economic recovery. Efforts toward reducing the reliance remain stymied by unresolved political differences between the governor and legislature.
RATING SENSITIVITIES
ADDRESSING FIXED-COST PRESSURES: The 'AA-' rating is sensitive to Pennsylvania's ability to address fixed-cost pressures, particularly for pensions, without materially weakening its fiscal flexibility. Fitch anticipates the commonwealth will meet its statutory obligations through structural expenditure reform or revenue increases; any shift away from funding those commitments would be a credit negative.
MOVE TOWARD SUSTAINABLE BUDGETS: Given the magnitude of Pennsylvania's structural budget gap, Fitch anticipates some continued use of nonrecurring items in upcoming budgets. Material growth in the structural gap beyond this expectation could trigger negative rating action.
CREDIT PROFILE
Revenue Framework
Pennsylvania's income tax and sales and use tax serve as the primary revenue sources, accounting for nearly three-quarters of general fund revenues.
Historical revenue growth, adjusted for the estimated effect of policy changes, has been slightly positive on a real basis over the past 10 years. Year-over-year growth was robust leading into the recession but moderated considerably after recessionary declines in fiscal years 2009 and 2010. Fitch anticipates the long-term trend for revenue growth will be moderately above inflation but trail the pace of national economic growth given Pennsylvania's slowly growing economic trajectory.
Pennsylvania has no legal limitations on its ability to raise revenues through base broadenings, rate increases, or the assessment of new taxes or fees.
Expenditure Framework
As in most states, education and health and human services spending are Pennsylvania's largest
operating expenses. Considering just spending from state funds, education spending is the largest expense as the commonwealth provides significant funding for local school districts and the public university and college system but health and human services growth is likely to outpace it in future years. Medicaid is the largest component of health and human services spending.
While pension contributions have grown considerably in recent years as the commonwealth ramped up spending in line with a statutory plan enacted in 2010, they are not a material driver of overall expenditure growth.
Spending growth in the commonwealth, absent policy actions, will likely be in line with to marginally above revenue growth driven primarily by Medicaid. The fiscal challenge of Medicaid is common to all U.S. states, and the nature of the program as well as federal government rules limits the states' options in managing the pace of spending growth.
Pennsylvania retains solid expenditure flexibility. While Medicaid costs are somewhat beyond the commonwealth's influence given federal requirements for the program, the state's carrying costs are moderate and likely to remain so given increased pension contributions under a statutory ramp-up plan with full funding anticipated by fiscal 2017. Like most states, Pennsylvania's operating budget (outside of Medicaid) goes largely towards funding of services rather than direct service delivery, allowing the commonwealth to shift costs to lower levels of government in times of fiscal stress.
Long-Term Liability Burden
Pennsylvania maintains a moderate long-term liability burden that should remain manageable. Per Fitch's October 2016 State Pension Update report, the commonwealth's total net tax-supported debt and unfunded pension liabilities of $34 billion equaled 5.3% of 2015 personal income compared with the 50-state median of 5.1%. Fitch anticipates the pension liability burden will increase gradually, particularly given recent weak investment performance.
Debt levels reflect borrowing for various capital needs including facilities, transportation, and water and sewer infrastructure. The commonwealth uses a mix of GO (legislatively or electorate approved) and appropriation-backed bonds. Approximately two-thirds of outstanding net tax-supported debt is GO. The state has used multiple entities and mechanisms to issue appropriation debt, which is used primarily for water and sewer needs and economic development projects.
Pennsylvania's pension obligations are for the State Employees' Retirement System (SERS) and the Public Schools Employees' Retirement System (PSERS). SERS includes state employees and employees of certain state-related organizations, and the liability is essentially fully borne by the commonwealth. PSERS includes public school employees, and the liability is shared between the commonwealth and local school districts. Pennsylvania makes its PSERS contributions through appropriations to school districts, which make the only direct employer contributions to the system. The commonwealth was consistently short of its actuarially calculated annual contribution for both systems for many years, but the percentage paid steadily increased in line with legislation enacted in 2010 and reached full funding this fiscal year.
Operating Performance
Pennsylvania's ability to respond to cyclical downturns relies on the superior budget flexibility common to most states, but is hampered by slow growth prospects for revenues. The commonwealth retains broad capabilities to adjust expenditures and revenues on an annual basis to deal with a cyclical economic downturn. The Fitch Analytical Sensitivity Tool (FAST v.2.0.1) indicates such a downturn would likely have a more moderate effect on the commonwealth's revenues relative to other states, somewhat limiting the extent of fiscal challenge Pennsylvania could face. Pennsylvania's economy and revenue base have proven less cyclical than the national economy. Fitch anticipates the commonwealth would maintain an adequate level of financial flexibility in a moderate downturn. Failure to stem the growth in the structural budget gap in the coming years could materially weaken Pennsylvania's financial resilience in the event of a downturn and raise negative rating concern.
During the economic recovery, Pennsylvania has restored some financial flexibility but continues to rely on substantial non-recurring budgetary measures. The commonwealth utilized fund transfers, changes in timing of state expenditures, cuts in education spending, and one-time revenue sources to achieve annual budgetary balance in the past several years. Pension contribution deferrals have been another key non-recurring budgetary measure as the commonwealth has been consistently short of the actuarially determined contributions. Positively, Pennsylvania has steadily increased its contributions since fiscal 2010. The demonstrated commitment to the Act 120 statutory ramp-up schedule indicates Pennsylvania's intent to eliminate the deferrals, but the use of substantial one-time revenues to accommodate the funding growth indicates sizable structural gaps remain several years into the economic recovery.
The commonwealth's difficulty in reaching political agreement on fiscal measures hinders its ability to fully address its structural budget challenges and limits Fitch's assessment of Pennsylvania's operating performance. In fiscal 2016, Pennsylvania's newly elected governor and state legislature were unable to reach a full-year budget agreement. In December 2015, the governor signed into law a partial budget with substantial line-item vetoes and in March 2016 he allowed a legislatively approved full-year fiscal 2016 budget to become effective without his signature.
Despite the commonwealth's long history of contentious budget negotiations, the commitment to timely debt service has never been in question, even for appropriation-backed debt. But continued discord on basic issues of revenues and expenditures hinders the commonwealth's ability to fully utilize its financial flexibility to manage through downturns and recoveries.
Current Developments
Pennsylvania's fiscal 2017 budget makes progress on, but does not fully resolve the commonwealth's sizable structural budget gap. The budget increases funding for policy areas including K-12 education while meeting Pennsylvania's statutory commitment toward full actuarial pension funding. However, it relies on a mix of recurring and non-recurring measures to achieve balance. Fitch anticipated gradual progress towards structural balance, which the current budget achieves, albeit modestly.
General fund revenue collections through October trail the budget estimate by $182 million, or 2%. Personal income tax, sales and use tax, and corporation tax collections are all short of budget. The commonwealth's Independent Fiscal Office projects a slight improvement through the rest of the year but still anticipates an overall revenue shortfall of $466 million (1.4% of general fund revenues) for fiscal 2017. Fitch anticipates the governor and legislature will take steps to address that gap later this fiscal year.
Beyond fiscal 2017, the commonwealth will continue to face obstacles and difficult decisions before it can fully align recurring revenues and expenditures. The IFO's November 2016 economic and budget outlook report forecasts sizable structural budget gaps of $1.7 billion in fiscal 2018 (5.5% of estimated general fund revenues) and $3 billion (8.2% of estimated general fund revenues) by fiscal 2022. The gaps are narrower in the early years of the forecast from the IFO's January 2016 estimate, but have widened in the out-years. The steady growth in the gap reflects both the one-time nature of some fiscal 2017 budget measures and the continued mismatch between revenue and expenditures.
Date of Relevant Rating Committee: May 20, 2016
Additional information is available at 'www.fitchratings.com'.
In addition to the sources of information identified in the applicable criteria specified below, this action was informed by information from Lumesis and InvestorTools
Applicable Criteria
U.S. Tax-Supported Rating Criteria (pub. 18 Apr 2016)
https://www.fitchratings.com/site/re/879478
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