New Jersey Budget Proposals:
A Litmus Test for the Rest of the Country?
April 26, 2010
By Howard J. Cure
Director of Municipal Research
Summary
Like many other states, New Jersey has a significant budget deficit that has been years in the making. On a percentage of revenues and income, however, its budget deficit is among the most severe in the nation. The state has failed to make structural changes in expenditures despite declining tax revenues and a tax burden driving wealthy residents out of the state. Newly elected Governor Christie has begun tackling such seemingly intractable issues as pension liabilities and health benefits. But the Republican governor needs the cooperation of the Democrat-controlled legislature to achieve meaningful structural budgetary balance. To make the state live within its means, the Governor is proposing constitutional amendments that would cap property taxes and state expenditures.
There is tremendous national interest in how New Jersey manages its affairs. Other states are waiting to see if the Governor can cap taxes and expenditures, encourage voters to defeat school district budgets if union concessions are not forthcoming, and — as a former chief federal law enforcement officer in New Jersey — challenge the endemic corruption in the state. He has limited time before the next election cycle in 2011, but we are guardedly optimistic about the possibility of meaningful reforms. Consequently, we don't exclude New Jersey state and local government issues from our clients' portfolios. While we are very selective, we find a number of essential-purpose revenue bonds that are stable from a credit perspective and present an alternative to traditional government-backed bonds until we are convinced that structural changes to state's finances have become permanent.
Current Situation
From a credit perspective, New Jersey has many positive attributes. The second wealthiest state in the nation, it enjoys a diverse economic base, though it has suffered from growing dependence on the financial services industry and exposure to pharmaceutical company mergers. The Governor has broad executive powers to reduce expenditures during strained financial times. Nonetheless, challenges to the state's finances have multiplied through several administrations. To close its budget gaps, exacerbated by declining statewide tax receipts (i.e., personal income, sales and corporate taxes), New Jersey has resorted to using nonrecurring solutions, including the following:
• Temporary tax hikes, (i.e., 2% "Millionaires Tax"),
• Suspensions of property tax deductions,
• Debt restructuring,
• Deferring the full amount of yearly pension funding,
• Use of surplus revenues and, most recently,
• Use of federal stimulus monies.
The state has freely used debt issuance for aging infrastructure, operating costs, and holes in pension funds. Given its generous employee benefits and deferred pension funding, New Jersey has one of the lowest funded pension ratios in the US and among the highest post-retirement health insurance liabilities.
Effects of New Jersey's Tax Burden
The Tax Foundation ranks New Jersey highest in state and local taxes as a percentage of income, and some 4.4% of all individual tax filers supply 55% of the state's personal income tax receipts. That burden is prompting wealthy citizens to leave. The Center on Wealth and Philanthropy at Boston College found wealthy households moving to other states — mainly Florida, Pennsylvania and New York — at a faster rate than they were being replaced. For years, New Jersey has lured New Yorkers looking for good schools and a lower tax burden. But from 1999 to 2009 New Jersey property taxes increased 70%, and the average household now pays $7,281 a year in property taxes — the highest level in the nation.
Governor's Proposed Budget
The Governor's recently released budget proposal for fiscal year 2011 (beginning July 1, 2010) estimates the deficit at $10.7 billion, more than one third of projected revenues — compared with a national average of 17%. New Jersey instituted a temporary increase in the top income-tax rate to 10.97% in FY 2010. Acknowledging the state's significant tax burden, the Governor is not recommending reinstituting the temporary tax increase, and the top rate will revert to its previous 8.97%. To eliminate the deficit, the Governor is proposing expenditure reductions of $10.1 billion. Projected revenues are almost $600 million above FY 2010 — tax receipts have finally started to grow — but otherwise there are no broadbased revenue enhancements in the budget. Some of the most significant spending reductions include the following:
| • Pensions | $3.060 billion | ||
| • Limit School Aid Increases | $1.677 billion | ||
| • Property Tax Relief Programs | $1.163 billion | ||
| • Municipal and County Aid | $339 million | ||
| • NJ Transit | $272 million | ||
| • Medicaid | $236 million | ||
| • Higher Education | $175 million | ||
| • Operating Budget | $174 million |
The largest single reduction, over $3 billion for employee pensions, seems counterintuitive given an already chronically underfunded liability, particularly in what would otherwise seem a structurally balanced budget with no gimmicks. The Governor argues, however, that savings may be realized now from pension reforms that reduce the system's underfunding. The pension reforms do not affect those already retired. Other benefit changes include public workers being required to pay at least 1.5% of their salary toward their health care. Past pension and benefit reforms were defeated since they were viewed as infringing on collective bargaining agreements, but recent publicity about the generous defined-benefit plans of public employees has allowed the legislative and executive branches to begin to address the longterm budget implications.
Constitutional Amendments
The Governor is proposing a constitutional amendment that would cap increases in property tax levies at 2½%, adjusted for growth. It would permit local entities that do not spend up to the cap to "bank" the extra levy and use it in subsequent years.
New Jersey currently has a "soft" property tax cap of 4% on revenue increases that automatically exempts enrollment increases, special education, healthcare costs, and decreases in state aid. All government entities have exemptions for public employee pension costs, and school districts may request a waiver from the State Education Commissioner or ask the voters in a referendum to exceed the cap.
Voters have routinely approved school budgets, and nearly three quarters passed last year despite the economic downturn. Approximately 200 districts have proposed exceeding the 4% property tax cap for fiscal year 2011, compared with 98 districts last year. Anticipated cuts in state aid in many districts will result in flat or reduced budgets even with the tax increases. Yet on April 20, voters rejected 58% of the FY 2011 budgets, a clear sign of antipathy toward higher taxes without more aggressive expenditure cuts.
In part, New Jersey's onerous property tax burden is inevitable: this physically small state comprises 566 individual municipalities and 591 school districts, each with its own layer of administration. As long as these fiefdoms exist, property taxes will be high.
The Governor is also proposing a constitutional amendment to cap direct state government spending, also at 2 1/2% a year. He is also seeking legislation for collective bargaining reform under which no municipality or county contract award, inclusive of benefit costs, may exceed the constitutional levy cap.
In other states, increased state aid to replace property tax revenue is sometimes promised at the time a cap is enacted. That state aid is not reliably sustained over time — particularly during economic downturns, when state aid to localities often declines. In New Jersey, the proposed state spending cap, along with collective bargaining changes, would put further pressure on localities to make meaningful structural reforms in balancing financial operations.
Outstanding Debt
According to the State of New Jersey Debt Report, of the $33.8 billion of total debt outstanding, only $2.5 billion is general obligation debt; for most of the remainder, debt payments are subject to appropriation by the legislature. The state constitution limits general obligation debt based on the operating budget for that year unless approved by a majority of the voters. The state has increasingly circumvented the need for voter approval by issuing obligations subject to appropriation. These appropriation issues are not classified as debt since they offer no legal recourse to its holders in case of nonpayment. Appropriation issues can only rely on the state's promise to pay by the legislature. The risk of non-appropriation is reduced because funding for a broad range of New Jersey's capital programs depends on market acceptance of approximately $29 billion of securities backed by general fund appropriations.
The chart "Comparing 10 year New Jersey Bonds Spread to AAA Municipals" depicts four major New Jersey debt issues: NJ general obligation bonds (Aa2 negative outlook since August 2009/AA since 2005), Port Authority of New York/New Jersey (Aa2 since March 2010/ AA- off negative watch since April 2002), New Jersey Transportation Trust Fund (Aa3 negative outlook since August 2009/AA- since 2005) and New Jersey Turnpike Authority (A3 since 2000/A+ since April 2009). Some general observations follow:
• The spreads between these four major issuers were fairly close for many years,
• By 2008, spreads widened, particularly for the New Jersey Transportation Trust Fund (a state appropriation credit), reflecting general market conditions and increased operating pressure,
• New Jersey Turnpike has seen lower spreads since July 2009 as the Authority has begun to address its revenue needs through toll increases, and
• If the credit situation improves for the State of New Jersey, the appropriation issues provides more yield than the state general obligation debt with little diminution in credit quality.
New Jersey's outstanding debt has significantly outpaced growth in population and personal income, and the state's debt ratios have suffered, both absolutely and relative to Moody's 50-state medians. The state's net tax supported debt is currently the third highest nationwide; the ratio of debt to personal income (7.3%) is fourth highest among the states, as is debt per capita.
As the Governor weighs the fixed costs of additional debt service on the strained budget against the need for significant investments in the state's infrastructure, New Jersey residents may find attractive a number of essential-purpose revenue bond issues that are not as reliant on the state for funding. They include the following:
• New Jersey Turnpike Authority: The Authority operates the New Jersey Turnpike, the state's primary commercial north/south road, and the Garden State Parkway, which serves major population centers and the Jersey shore. There is little competition from free roads, and recently implemented rate increases should improve debt service coverage.
• Port Authority of New York and New Jersey: Strong long-term prospects, with near monopolistic control over critical transportation infrastructure including the Hudson River crossings and the three major New York area airports, a trend of favorable financial results, large reserve balances, and recent toll and fare increases. It is assumed that these facilities can financially support the complex capital improvement projects currently planned, including the World Trade Center redevelopment.
• Higher Education Student Assistance Authority — State Of New Jersey Student Loan Revenue Bonds: Investors may derive comfort from the high quality of the underlying private student loan collateral, overcollateralization with excess spread expected to be over 3%, a debt service reserve fund, and a loan reserve. Another structural strength: the flow of funds traps excess spread to build parity to 120%.
• Rutgers University: Flagship state research university with growing financial resources and strengthened fund-raising profile.
• New Jersey Environmental Infrastructure Trust: The large and diverse loan pool can withstand a 45% default rate, and the credit quality of the borrowers is strong. Most borrowers provide a general obligation pledge to the repayment of their loans, and the Trust could intercept individual municipal state aid if needed to pay debt service.
• Princeton University: Exceptional balance sheet, superb student market position, and consistent operating surpluses.
• New Jersey Housing and Mortgage Finance Agency — Single Family Housing Revenue Bonds: Strong financial position with program asset to debt ratio of 1.10X. Delinquency and foreclosure rates are below state and national Federal Housing Administration rates.
Howard joined Evercore Wealth Management with over 23 years of experience in analyzing tax-exempt municipal securities. He can be contacted at cure@evercore.com.
Download: New Jersey Budget Proposals: A Litmus Test for the Rest of the Country? (PDF)
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