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<i>The Week in Public Finance</i>: A Rate Hike, Unpredictable Taxpayers and Stress-Testing Budgets

A roundup of money (and other) news governments can use.

The Federal Reserve headquarters in Washington, D.C.
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A Rate Hike

The Federal Reserve announced this week that it's raising interest rates by one quarter of a percentage point, which is its second short-term increase of the year. The move was widely expected but comes amid expectations that inflation is running well below the central bank’s 2 percent target for 2017.

The Fed also released more details on how it plans to unwind its $4.5 trillion portfolio of bonds that includes Treasurys, mortgage-backed securities and state and local government debt. Each month, the Fed receives billions in principal payments from its various holdings, and much of that repayment is then reinvested in more bonds and other securities. Now, the Federal Open Market Committee -- which is part of the Federal Reserve -- said it intends to gradually reduce the Fed’s securities holdings by decreasing its reinvestment of its monthly principal payments it receives.

For government agency debt and mortgage-backed securities, the Fed will pocket the first $4 billion in payments and reinvest what’s left. The committee expects to increase that cap by $4 billion every three months until it reaches $20 billion per month.

The Takeaway: For government borrowers, a rate hike impacts short-term debt far more significantly than it does long-term debt. In fact, experience has shown that a hike in short-term rates can actually cause a downward tick in long-term rates because inflation is dampened.

When it comes to refinancing, interest rates are still at historic lows, so a rate hike shouldn’t discourage that activity.

Variable rate debt and other short-term bonds, however, might see a slight uptick in costs. In particular, this has the potential to make it more expensive for distressed governments that need to issue short-term debt to resolve cash flow issues.

In addition, the news about how the Fed plans to unwind its bond holdings down to $2.5 trillion should ease some people’s fears about the central bank flooding the market and therefore lowering overall demand for bonds. Its outlined pace is seen as gradual.


Unpredictable Taxpayers

State tax revenues are lagging. In fact, according to a new report from the Nelson A. Rockefeller Institute of Government, “many state budgets for 2017 will have some financial holes to fill."

According to the new data, total state tax revenues declined in 19 states during the last quarter of 2016. In addition, preliminary data for the first quarter of 2017 suggest that more than a dozen states had declines in total state tax collections.

The biggest culprits have been weak sales and income tax returns and an outright decline in revenue from corporate income taxes.

Many observers have wondered how much taxpayers’ behavior in anticipation of federal tax reform has had to do with the sluggishness. Some argue that taxpayers, particularly wealthy ones, may have held off selling stocks and reporting capital gains income because they believe their income tax rate will decline in the future. If that's true, the next fiscal year could see better returns for states.

But this latest Rockefeller report puts a wrinkle in that theory.

The Takeaway: Authors Lucy Dadayan an Donald J. Boyd note that tax reform also threatens to take away the state and local tax deduction from taxpayers. That means that some taxpayers may have been worried they would lose the perk after 2017.

So, the report says, that threat may have created an incentive for high-income filers to pay off all their state and local government taxes by December 2016, rather than waiting until the April 2017 deadline. That has the effect of reducing their federal taxable income in 2016 while killing the theory that state and local governments will see an income tax boost in the coming year.

The reality is, taxpayer behavior is difficult to predict and the Rockefeller report warns it will be “very difficult” for state revenue forecasters to sort this out.

“The possibility of reform is enough to change behavior,” write Dadayan and Boyd. “States will need to do their best to understand and estimate these potential impacts, and then buckle up for the ride.”


Stress-Testing Budgets

Predicting taxpayer behavior is one of the many reasons it’s difficult to anticipate how one economic change could impact a government’s budget. In fact, an informal survey conducted by the financial modeling technology company PFM Solutions found that more than half of the local government officials they spoke to found it difficult to estimate the impact of various potential scenarios on their organization’s credit rating. More than a third had difficulty in evaluating different future financial scenarios.

The reason has a lot to do with practice. Finance officials have a lot of experience with creating budgets. But any number of economic or policy changes can impact finances and those precise scenarios change every year.

“They know how to answer the question, ‘What can we afford this year?’” said Brett Matteo, President of PFM Solutions. “But do you have the means to change variables and assumptions and evaluate the impact -- preferably in real-time? Most financial officers don’t have those tools.”

The Takeaway: This form of stress testing is rare, even at the state level. Only California, Utah and Minnesota have started regularly evaluating the impact of certain economic events on their budgets.

But there is evidence that doing so could not only help a government’s financial emergency preparedness, it can also gift it a lift in the eyes of ratings agencies.

For one, Moody’s Investors Service and S&P Global Ratings last year began their own running stress tests on the largest state budgets. They have also lauded Utah’s extensive stress-testing practice in affirming that state’s top AAA credit rating.

“I think most of the rating agencies would agree that it’s better not to assume things will be better in the future -- that it’s better to be proactive,” said Matteo. “They don’t like it when you’re surprised.”

To read this regularly, subscribe to "The Week in Public Finance" newsletter for free.

Liz Farmer is a former GOVERNING fiscal policy writer.
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