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Municipal Podcast recorded on March 20, 2015

The Commonwealth of Pennsylvania

Podcast Transcript

Welcome to the Breckinridge podcast. This is Chris Day and with me today I have Mike Bonanno, a Credit Analyst here at Breckinridge. Mike, welcome to the podcast.

Thank you, Chris.

So today, we wanted to talk about the Commonwealth of Pennsylvania and Mike, we have seen a good number of headlines involving Pennsylvania in the past year or so; could you provide a quick recap?

Sure, Chris. So, within the last year, Pennsylvania has seen downgrades from all three major agencies: Moody's downgraded the Commonwealth from Aa2 to Aa3 stable in July 2014, and S&P and Fitch followed suit with downgrades from AA to AA- stable in September 2014. All three agencies cited the Commonwealth's pensions and ongoing budgetary imbalance as the primary reasons for the downgrades. Despite the recent flurry of negativity, it should be noted that Pennsylvania remains higher rated and has relatively more manageable debt and pension burdens when compared to other states facing similar issues such as New Jersey and Illinois. There are also inherent characteristics that give us a reason to be constructive on the Commonwealth.

So you mentioned that the two primary drivers of the Commonwealth's downgrade are its pension and budget imbalances. Did the newly elected Governor Wolf's budget address either of those topics?

So in his budget address, the Governor rightfully addressed both topics, although in varying degrees, and when it comes to Pennsylvania's pensions, the Governor's budget proposed a number of ideas such as issuing 3 billion in pension obligation bonds as well as modifying the investment strategy to reduce investment fees and enhance returns.

Okay.

While the Commonwealth could absorb this proposed borrowing without significant impact on their debt ratios, the 3 billion is really just a drop in the bucket when compared to the 50 billion unfunded liability. Similarly, while shifting investment management strategies may reduce fees and increase ROI, it is not a solution to addressing longer-term liability. Wolf also mentioned that he would dedicate a portion of the revenues from his proposed liquor store modernization and sales tax increase to the pension arc.

Okay, so where do we stand on the current status of the pension liability and the Commonwealth's efforts to address it?

Well, for perspective, Pennsylvania's unfunded liability to personal income is 8.2% when compared with Illinois and New Jersey who are at 16% and 9.7%, respectively. While the governor's proposals are a notable first step, more will be needed to be done to properly address the unfunded liability. The Commonwealth's pension obligations are a significant source of its budgetary stress and a significant driver of rating direction.

Right.

So ideally, reform would include annual budgetary relief which would help the Commonwealth address its other primary challenge, its structurally imbalanced budget. Ultimately, the compromises in the final budget on June 30th will have implications on credit quality trend and provide insight on the relationship we can expect between Wolf and the legislature going forward. Wolf has proven to be proactive in conversing across the aisle so hopefully this continues and produces a positive working relationship.

So you mention that the structural imbalance in the budget is the other key driver behind the rating. In the Governor's proposed budget, was there any progress made in terms of addressing the projected $1.6 billion budget deficit for Fiscal Year '16, or addressing the longer-term imbalance between revenues and expenditures?

Well, the Commonwealth has seen tepid revenue growth over the last two years which has contributed to its yawning budget deficits. According to the Pennsylvania Department of Revenue, fiscal year to date general fund collections are 2.3% above estimate which is a good sign, but overall revenue growth is expected to remain modest when compared to the national average. In the past, the budget has been balanced through broad expenditure cuts, notably to education spending and use of non-recurring sources of revenue. In his new budget, Governor Wolf took a contrarian approach to his predecessor by proposing enhancements to existing revenue streams. Such enhancements include raising the personal income tax from 3.07% to 3.7%, increasing the state sales tax from 6% to 6.6%, and implementing a 5% severance tax on the Commonwealth's bountiful shale gas resources, the proceeds of which will be earmarked for public education. If all of these increases were adopted as-is, it is estimated that they would generate roughly 4.7 billion which would close the budget deficit, reduce property taxes, and increase education funding.

Okay, now given the historically conservative sentiment within the Pennsylvania legislature, what can we realistically expect from the final budget?

Well, Pennsylvania's budget woes will not necessarily be resolved in one session, but we do believe that Governor Wolf has proposed a budget that holds potential for compromise and progress. Both sides have acknowledged that something must be done in order to address the Commonwealth's continued deterioration. Interestingly, and perhaps not coincidentally, a portion of Governor Wolf's proposal looks somewhat similar to Senate Bill 76 of 2013 which proposed increases in the sales tax from 6 to 7%, and raising the personal income tax from 3.07% to 4.34%.

Sure.

So the primary goal of that bill was to replace property tax revenue, dollar for dollar, with the increased sales and personal income tax collections. Governor Wolf's current proposals are more moderate and have the same focus on dollar for dollar reduction in property taxes, so given the similarities in shared goal between the Governor's and the Senate's proposals, it is reasonable to assume that the proposed tax increases are initially palatable to both sides.

Okay.

It is important to know, however, that shortly after the Governor's budget address, Jake Corman, the Senate Majority Leader, stated that the GOP won't consider tax increase proposals without pension reform. So his comments indicate that the increases in taxes will need to be accompanied by some sort of reform, although the extent of which that would be acceptable to Mr. Corman is not clear.

Okay, so it sounds like there is plenty to be discussed around the pensions and the budget. Are there any other topics that may come up during the budget negotiations?

Yeah, so privatization of the state's liquor store system has been an ongoing pivot point in previous and current budget negotiations. Governor Wolf wants to modernize and retain Commonwealth control of the liquor system, while many in the legislature support the privatization of the liquor system. The House bill in favor of full privatization recently passed a committee vote, but Governor Wolf has stated that he would veto any attempt at full privatization. This leaves compromise as the only option although it is tough to speculate the extent of the compromise at this time.

Okay, so obviously there are some headwinds out there, but as you kind of alluded to at the beginning of the podcast, we are still relatively comfortable with Pennsylvania, correct?

Absolutely. We are certainly wary of Pennsylvania's weaknesses, but feel that it is a different story from some other recently downgraded states such as Illinois and New Jersey for a number of reasons. The Commonwealth's relatively diverse and broad-based economy holds significant potential for economic growth, specifically in the development of its natural gas resources. Further, key employment areas such as education and health services have remained relatively stable. Outside of its economic base, the Governor's current tax proposals highlight the capacity for enhancing revenue collections from existing recurring sources which, if implemented, would be more than sufficient in alleviating its structural imbalance. We also see the Commonwealth's debt burden as manageable at 2.7% of personal income as compared to New Jersey and Illinois at 10% and 5.3%, respectively. So overall, when compared to other struggling states, it is our view that Pennsylvania's potential to address its obligations is reasonably strong.

Excellent, well, thank you very much for joining us today, Mike. We appreciate your time and hope that you in the field have found this informative. We look forward to having you join us next week.

 

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