Forget Schwarzenegger Scandal, California Tax Receipts Ease Budget Blues

Illinois, New Jersey, Michigan among many states seeing higher receipts; the implications for muni bonds

With Arnold Schwarzenegger's "love child" scandal grabbing California's, and the country's, attention, the bigger news for the state of the former governor, which got somewhat trampled, was it's brightened budget picture.

Tax collections in California and across many of America’s beleaguered states have surged this season, raising hopes of economic recovery and easing worries in some quarters about a feared muni bond crisis. But some view the recent optimism as a denial of reality.

A spate of recent announcements from state fiscal authorities has indeed been encouraging. California is bringing in an estimated $6.6 billion more than anticipated through the middle of next year, moving a good pace toward closing the Golden State’s $15 billion budget deficit. Illinois raised an additional $1.6 billion in tax dollars over the last four months, and estimates show it will bring in as much as $7 billion more in the coming fiscal year.

New Jersey forecasts an extra $914 million in revenue, which will help close a $4 billion budget gap. Michigan forecasts up to $690 million more in revenue than had been estimated in January. Tax receipts in Massachusetts surged 43% in April, hauling in an unanticipated $580 million in increased revenue.

david kellySpeaking to financial advisors at IMCA’s annual conference in Las Vegas this week, David Kelly (left), J.P. Morgan Funds chief market strategist, said: “I’d much rather lend to state and municipal governments than the federal government now.” He minimized concerns about the safety of municipal bonds, calling the risk of default “miniscule, historically.”

While Kelly favors equities over fixed-income now, he had positive things to say about munis, which recently have reached new highs for the year. Looking at the spreads between munis and Treasuries on an after-tax basis, Kelly said munis are a better deal. The J.P. Morgan strategist earlier in his career worked for the state of Michigan, and learned then the fact that “state economies are really very cyclical.” States don’t have all they need “to hang themselves” as does the U.S., E.U. and Japan, he added.

Despite the spate of positive revenue reports and approval of munis among many on Wall Street, criticism of municipal finance has not gone away. Perhaps the most persistent critic, analyst Meredith Whitney, CEO of Meredith Whitney Advisory Group, cast a dark cloud over all the sunny news with a commentary in Wednesday’s Wall Street Journal entitled “The Hidden State Financial Crisis.”

meredith whitneyWhitney (left) argues that states have racked up $1.8 trillion in pension benefit obligations for which taxpayers are on the hook. What’s more, these liabilities are not always fully accounted for in the data states make available. The states are in effect Enrons-in-waiting, with off-balance-sheet liabilities that can bring governments to insolvency. Increasing taxes combined with shrinking government services may limit the willingness of taxpayers to endure further tax hikes, or to continue their residence in failing states.

“Defaults in a variety of forms by states and municipalities are already happening and more are inevitable,” writes Whitney.

The debate over the state of the states is sure to intensify as the term of the federal stimulus, which has subsidized state governments to the tune of $480 billion during the economic crisis, ends in June.

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