Emerging Risks

Key emerging risks to state credit quality include:

• Shifts in federal funding priorities, including Medicaid, could strain state budgets during a period of coinciding economic softness.
• Unresolved tariff policies could result in increased consumer prices and negative sentiment, effectively muting U.S. economic growth that translates to lower state revenue growth.
• Federal workforce layoffs, coupled with efforts to curb immigration, could strain the labor supply in locations historically relying on the government sector or migrant work, resulting in higher personnel costs for employers following several years of above-normal inflation.

Structural risks to state credit quality, including elevated debt and liability profiles, rising health care and education costs, and adverse climate impacts, remain key credit considerations that we continue to monitor. While these underlying risks remain a focus of our analysis, the emerging risks could have a more immediate impact on credit stability.

Fiscal 2026 State Budgets: Overview

Initial state fiscal 2026 budget proposals recommend increasing appropriations to approximately $1.40 trillion, a 3.9% increase compared with estimated fiscal 2025 appropriations, while revenue estimates suggest a comparatively modest 0.6% increase to $1.42 trillion. On average, states expect to maintain very high rainy-day funds, which we project will equal approximately 13% of fiscal 2026 revenue estimates, a small one percentage point decrease from estimated fiscal 2025, remaining near historical highs.

Only one state, North Carolina, introduced its executive budget in March, while all others were released in February or earlier. Since then, we have made downward revisions to our U.S. economic outlook, noting an increased risk for a recession. Many states will formally revise their revenue forecast before the current fiscal year ends, and they may adjust budgets accordingly, which we believe will help maintain credit stability, given elevated federal policy uncertainty and a projected slowdown in growth. (See "Credit Conditions North America Special Update: Tariff Turmoil," published April 17, 2025, on RatingsDirect.)

As most states have built up reserves over the past few years, it would not automatically signal credit stress should they draw on those reserves. However, in its analysis, S&P Global Ratings also considers state strategies for rebuilding reserves if drawn on and the time taken to replenish. We recognize that with rainy-day funds remaining near all-time highs for most states, budget officials may turn to their coffers to help close potential budget gaps in the near term; however, we generally view this approach as a temporary measure and expect implementation of other structural solutions like expenditure cuts and revenue enhancements to help maintain budgetary balance. With increasing recession risk as a backdrop, we believe that states with ample liquidity, conservative budgeting, and active budget monitoring are best positioned to maintain credit stability. Conversely, those with weaker reserves or aggressive forecasting may face difficult budget decisions under a slow growth or recession scenario.

Tax changes could escalate and accelerate budget challenges

States with recently reduced taxes will typically have less cushion to react to potentially shrinking revenues, further exacerbating a tough budget environment. Of note, 19 states have included tax reduction proposals in their fiscal 2026 budgets, and many more have recently enacted tax reform packages, ranging from relatively modest to very significant. In addition, 39 states began 2025 with notable tax changes, including nine cutting individual income taxes and three cutting corporate taxes, according to taxfoundation.org. The changes come following years of favorable economic conditions, which we believe will weaken as slower growth, higher inflation, and potentially weaker employment trends could weigh on state budgets.

Most of the fiscal 2026 proposed tax cuts will come in the form of individual income tax reductions, with corporate income tax reductions less common and very few proposals for reduced sales taxes and grocery tax cuts. States often phase in tax reductions and frequently include trigger provisions that generally require revenues to exceed a certain growth target before triggering a tax cut. We believe these mechanisms can improve flexibility by creating an automatic mechanism to slow reductions if revenues miss forecasts.

Budget adjustments are likely required for some states to maintain structural balance

Changes will likely be more pronounced in states with aggressive revenue growth assumptions, planned significant increases in appropriations, and enacted significant tax reductions, particularly when implemented without offsetting increases in revenue. The revenue forecasts for fiscal 2026 used to prepare executive budget proposals varied significantly among states, with the most conservative revenue forecast assuming an 8% drop in fiscal 2026 (South Dakota) and more aggressive forecasts projecting over 10% revenue growth, with Nebraska, Tennessee, and Maine forecasting revenue increases of 16%, 11%, and 10%, respectively, for fiscal 2026. In some cases, state officials may have updated revenue projections since the proposals were released. Appropriation requests also varied wildly among states, ranging from a proposed 22% increase in appropriations (Texas) to an 18% decrease (Montana).

Worsening economic conditions may also affect states that have a higher reliance on corporate income tax revenues or pass-through entity tax collections, as these revenues tend to be more volatile and can often fall more rapidly in a downturn than income tax collections, which we generally view as stable.

Healthy Liquidity Should Cushion The Impact, At Least In The Short Term

Under our U.S. governments criteria, we generally assign the strongest score for our reserves and liquidity assessment for states with formal budget-based reserve targets above 8% of revenue or expenditures and a strong history of restoring reserves following depletion (before potentially adjusting for additional considerations). We expect state reserves to remain near all-time highs, with average reserve levels at approximately 17% of projected revenue for fiscal 2026.

On average, state general fund revenues decreased 8.1% between 2008-2009 during the Great Recession and fell about 6% from 2019-2020 because of the COVID-19 pandemic. Our growth forecast calls for an increasing risk of recession, and while growth could remain positive, it will be notably slower than in 2024. Despite this macro environment, we believe that projected fiscal 2026 reserves levels are sufficient to close a budget gap from a 5% revenue decline for 47 states (exceptions are California, Illinois, and Washington), and 34 could withstand a 10% revenue drop. This, coupled with great flexibility to reduce expenditures, means that most states are generally in a strong position to withstand a relatively substantial decrease in revenue in the short term, in our view.

Severity Of Evolving Risks To State Credit Quality

Federal cuts to state support: Elevated

Possible federal actions as part of the budget reconciliation process could shift as much as $880 billion of Medicaid and the Children's Health Insurance Program costs to states over the next 10 years, which we believe would be difficult for any state to absorb without material changes in spending or program eligibility. For more information, see "U.S. States Brace For Potential Medicaid Funding Gaps," published March 20, 2025. Beyond proposed cuts to Medicaid, various higher education institutions may lose significant federal support, and certain grants from the Department of Health and Human Services to states have been rescinded. States will need to manage how to fill the gaps, whether through service reductions or footing the bill.

Federal trade policy uncertainty: Moderate

With continuing tariff negotiations in place, a 90-day pause on tariffs to some countries, and various carve-outs for certain products, it remains unclear which states will be most exposed; however, the current 145% tariff imposed on imports from China raises downside risk for states reliant on trade with China. Although the economic diversity of many states can help cushion the effects of higher tariffs, a prolonged trade war would still pose significant difficulties, especially for governments heavily reliant on agricultural commodities, auto manufacturing, and other industries deeply tied to exports or global supply chains.

Federal immigration policy: Moderate

These changes could have knock-on effects on the economy and workforce, although significant uncertainty remains around the timing, magnitude, and implementation that complicates making cost or economic projections. Conversely, tighter border policies could relieve some costs for state governments that, in the past few years, faced higher social service expenditures to support new arrivals entering the U.S. For further information, see "How Proposed Immigration Policy Could Affect U.S. Public Finance Issuers' Creditworthiness," published Nov. 20, 2024.