* From Fitch Ratings, with all emphasis added by me…

Fitch has removed the state’s IDR [Issuer Default Rating] and related ratings from Rating Watch Negative and assigned a Negative Outlook. […]

KEY RATING DRIVERS

The affirmation of Illinois’ ratings follows the passage of a fiscal 2018 budget that incorporates a permanent increase in taxes to more closely align revenues with spending and that should significantly reduce the near-term liquidity stress that had threatened the state’s investment-grade rating. The state’s financial resilience has been materially weakened by the two-year period in which it spent far in excess of tax revenues while accumulating an extraordinary level of budgetary liabilities, adding to the strain presented by the state’s unfunded retiree benefit liabilities and rising contribution burden. These factors result in a rating well below the level that the state’s solid economic base and still substantial independent legal ability to control its budget would support. The Negative Outlook reflects the uncertainties related to successful implementation of the budget, particularly given the contentious political environment in the state. These risks include reducing the accounts payable backlog in the near term, including by coming to market with bonds that were authorized in the budget; completing the sale of a state building assumed in the budget; meeting revenue targets in a slow growth environment; and achieving near-term pension contribution savings, partly at the expense of worsening the state’s long-term liability picture.

Economic Resource Base

The state benefits from a large, diverse economy centered on the Chicago metropolitan area, which is the nation’s third largest and is a nationally important business and transportation center. Economic growth through the current expansion has lagged that of the U.S. as a whole.

Revenue Framework: ‘aa’ factor assessment

Illinois’ broad revenue base, primarily income and sales taxes, captures the diversity in its economy and has shown modest growth since the end of the recession. Fitch expects revenue performance to continue to track slow economic growth. The state has unlimited legal ability to raise revenues.

Expenditure Framework: ‘a’ factor assessment

Illinois has adequate expenditure flexibility despite elevated carrying costs for debt service and retiree benefits, with much of the broad expense-cutting ability common to most U.S. states. Contribution demands associated with retiree benefits will continue to be a pressure as these benefits are constitutionally protected. Further, a recent federal court ruling that limited the state’s ability to defer Medicaid spending poses some concern about the extent of the state’s budgetary control, although Fitch believes that the ability of the court to make such a mandate remains subject to challenge.

Long-Term Liability Burden: ‘a’ factor assessment

Liabilities are an elevated but still moderate burden on Illinois’ resource base, even when considering the large accounts payable backlog that the state has accumulated. The state has very limited flexibility with regard to pension obligations following a May 2015 Illinois Supreme Court decision that found 2013 pension reform unconstitutional.

Operating Performance: ‘bbb’ factor assessment

Illinois’ operating performance, both during the great recession and in this subsequent period of economic growth, has been very weak. The passage of a permanent tax increase that much more closely aligns revenues with current spending is a positive step, although structural action on the expenditure side was limited. The budget assumed savings from pension funding changes for which achievement of budgetary savings is uncertain even as funding progress is delayed. The state will also be challenged to rebuild its financial resilience given the likelihood that a sizeable accounts payable backlog will persist.

RATING SENSITIVITIES

MEETING BUDGET ASSUMPTIONS: An inability to meet the assumptions incorporated in the fiscal 2018 budget that results in failure to reduce budgetary liabilities and materially improve the state’s stressed liquidity environment would lead to a downgrade. Specific risks to successful implementation include pension contributions above the level assumed in the budget, a failure to take significant steps to reduce the accounts payable backlog including by issuing bonds, a return to political gridlock specifically related to school funding, and a significantly slower growth revenue environment.

ONGOING BUDGETARY BALANCE: Stabilization of the rating is sensitive to the state’s ability to maintain budgetary balance over multiple years, indicating more sustainable fiscal management. Upward rating momentum is unlikely until the state more comprehensively addresses its accumulated liabilities.

CREDIT PROFILE

Illinois is a large, wealthy state at the center of the Great Lakes region. It benefits from a diverse economy centered on the Chicago metropolitan area. Illinois’ economy has gradually shifted, similarly to the U.S. in general, away from manufacturing to professional business services. The remaining manufacturing sector includes more resilient non-durables, and is less concentrated in the auto sector than surrounding states, but remains vulnerable to cyclical downturn. By most measures the economy has grown slower than the nation for many years and population levels have been stagnant.

Revenue Framework

Illinois has a diversified revenue base. It relies most heavily on personal income taxes and sales tax, which combined provide approximately three-quarters of general revenue fund revenues. The balance consists of corporate income tax, lottery and gaming revenues, and a variety of other smaller taxes and transfers. The state permanently raised the personal income tax rate from 3.75% to 4.95% and the corporate income tax rate from 5.5% to7% in the fiscal 2018 budget; these are slightly below the temporary tax rates that were in effect from 2011 to 2014. Historical revenue growth, adjusted for the estimated impact of policy changes, has been slightly above inflation but has lagged national economic growth. With Illinois’ economic performance also lagging national growth, Fitch expects a continuation of this trend of flat to modest real policy adjusted revenue growth.

Illinois 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 with most states, Illinois’ spending is largely for social services and education, although its carrying costs for debt service and pension contributions are comparatively high and retiree benefits have unusually strong legal protections.

Spending growth, absent policy actions, is likely to be higher than revenue growth, driven mainly by increasing pension contributions. Illinois has chronically underfunded its pension system based on a statutory formula that permitted a slow incremental build-up to higher contributions and targeting only 90% of full actuarial funding over the long term. Pension costs are unusually large and will continue to grow under the recently enacted budget, including due to the deferral of contribution increases triggered by lower investment returns.

As with most states, other spending drivers include Medicaid and education. Federal action to revise Medicaid’s programmatic and financial structure, including a basic restructuring of federal Medicaid funding to a capped amount remains a possibility. Whether a change in Medicaid funding has consequences for Fitch’s assessment of a state’s credit quality would depend on the state’s fiscal response to those changes. Responses that create long-term structural deficits or increased liability burdens could negatively affect both the expenditure framework assessment and the IDR. Despite carrying costs that are among the highest of the states and rising, Fitch believes that Illinois retains adequate expenditure flexibility that could be used in the budget process. There is little flexibility to control spending outside of the budget process in part because the governor cannot unilaterally make many changes. Illinois funds a broad range of services for its citizens and did not significantly reduce spending either during or since the recession. The state has ongoing capacity to make spending reductions should it choose to; however, Illinois has no ability to unilaterally modify retiree benefits following the May 2015 Illinois Supreme Court decision that found 2013 pension reforms unconstitutional. Given the magnitude of annual pension contributions, this notably constrains the state’s expenditure flexibility compared to that of most other states. The enacted fiscal 2018 budget reduces near-term spending for pensions by deferring the impact on contributions of actuarial assumption changes, including from lower return assumptions, and implementing a less costly third tier hybrid defined contribution/defined benefit plan that will also shift costs to school districts and universities for new employees. The latter change has structural benefit to the state’s budget while the former defers higher contributions into future years, allowing liabilities to rise further.

Long-Term Liability Burden

Illinois’ long-term liabilities, particularly pension liabilities, are very high for a U.S. state. As of Fitch’s October 2016 State Pension Update report, the state’s combined debt and pension burden of $147.8 billion was 23% of personal income, well above the 5.1% state median and the highest of the states. Using a more conservative 6% return assumption for pensions, instead of the 7% rate assumed under the state’s accounting valuation, would raise the burden of long-term liabilities to $181.7 billion, or 27% of personal income. The state’s three largest pension systems, covering teachers, universities, and state employees, have low funded levels driven by a history of weak contribution practices. Unfunded pension liabilities, and related contribution demands, are expected to grow as the state continues to underfund the systems.

In addition to its long-term liabilities, the state has a sizeable accounts payable balance that has accumulated through multiple years of operating at a deficit. As of the end of fiscal 2017, the accounts payable balance is estimated to total $14.7 billion. If the state issues general obligation bonds to reduce this budgetary liability, as is provided for in the enacted fiscal 2018 budget, Illinois’s debt levels would be further elevated but remain within the moderate range.

Operating Performance

Illinois’ budget management during the current period of expansion has been exceptionally weak. Temporary increases in personal and corporate income tax rates in place for four years, from Jan. 1, 2011 through Dec. 31, 2014, closed or partially closed the budget gap across five fiscal years. However, with their expiration, and the failure to enact a spending plan within expected revenues, the budget gap ballooned over the course of fiscal 2016 and fiscal 2017.

The state achieved a break in its ongoing budgetary impasse with the passage of the fiscal 2018 budget through legislative override of the governor’s veto. The budget is narrowly balanced and relies on approximately $5 billion in additional revenues to be generated by the increase in personal and corporate income tax rates and other more modest adjustments. The budget limits general revenue fund spending growth but does not make significant reductions in spending after two years of spending deferrals. The largest sources of savings are expected to come in the form of lower pension contributions as noted earlier as well as shifts in spending from the general revenue fund to other state funds. An announced 5% reduction in appropriations to state agencies and a 10% reduction to universities are expected to generate only $303 million in savings, less than 1% of general revenue fund appropriations. The budget also assumes sale of a state building in Chicago for $300 million.

The greatest risk to successful implementation of the budget is likely to be the assumed pension contribution savings, in particular related to the establishment of a third tier of benefits for new employees that also shifts the normal cost of pensions to school districts and universities. The budget assumes $500 million in savings in the first year of implementation that may not immediately materialize. The budget also delays the impact of lower investment returns on employer contributions by phasing in the impact over five years, increasing the state’s liabilities in the future.

Despite the significant increase in expected tax revenues, Illinois remains poorly positioned to address a future economic downturn. Illinois’ approach to revenue shortfalls has historically been to delay payments, as it did during the great recession when it accrued an accounts payable balance that at its peak reached 20% of the operating budget. With a backlog that is now approaching 40% of the operating budget following the inaction of recent years, the state’s ability to respond to a change in the economy is even more limited. Although it is Fitch’s expectation that the state would look to address future deficits by again deferring payments, its ability to do so may be limited by the extent to which the current backlog persists or priority payment demands reduce that flexibility. While the enacted budget package begins to address the backlog with authorized bond issuance, inter-fund borrowing, and application of federal Medicaid matching funds, it does not provide funds or a means to reduce the backlog to what might be considered a more normal operating level. Fitch expects that even with these measures, the state will carry an accounts payable balance into the foreseeable future above the peaks seen in the great recession. One source of future flexibility will arise in fiscal 2020, when annual debt service of approximately $1 billion on bonds issued previously to fund annual pension payments rolls off as the bonds mature. The state has not communicated a plan for how these freed up monies will be applied.

In Fitch’s opinion, the state will continue to be challenged to reduce budgetary liabilities that accumulated during the impasse and then to prevent a similar build-up in the future. The enacted fiscal 2018 budget authorizes up to $6 billion in general obligation borrowing to reduce the backlog, although it only provides for debt service for a lower borrowing level and the borrowing plan has not yet been determined. By applying borrowed funds to Medicaid payables, the state will generate federal matching revenues that will further reduce the backlog while also addressing a federal judge’s order to increase and bring current Medicaid payments. The state is also authorized to utilize another $2.1 billion in interfund borrowing and use of other state funds to reduce the backlog. While these sources will begin to address the accumulated budgetary liabilities, the state is likely to be left with a still very high balance that will keep pressure on its liquidity.

Asymmetric Additional Risk Considerations

Illinois has demonstrated a repeated inability to address its structural challenges due to an absence of consensus and resistance among key stakeholders. The political environment in the state remains a negative rating consideration.