Fitch Ratings has assigned a 'AA-' rating for the following Commonwealth
of Pennsylvania's general obligation (GO) bonds:
--$355 million first series of 2016;
--$635.55 million first refunding series of 2016.
The bonds are expected to sell on or about June 1, 2016 through
competitive bid.
In addition, Fitch has affirmed the commonwealth's 'AA-' Issuer Default
Rating (IDR), and the 'AA-' ratings on the commonwealth's outstanding GO
bonds. Fitch has also affirmed and upgraded the ratings on bonds
supported by commonwealth appropriations or otherwise capped at the
commonwealth's IDR, which are listed at the end of this release. The
ratings on these bonds are linked to the commonwealth's IDR.
The Rating Outlook is Stable.
SECURITY
The GO bonds are direct and general obligations of the commonwealth of
Pennsylvania, with its full faith and credit pledged.
KEY RATING DRIVERS
Pennsylvania faces fiscal pressures in the form of a structurally
unbalanced budget, brought on by a combination of rising fixed costs,
modest baseline revenue growth, and a particularly contentious
decision-making environment. The 'AA-' IDR reflects those limiting
factors, as well as Fitch's expectation that the commonwealth will
utilize the significant budgetary flexibility available to most states
to respond to those pressures adequately, while also making progress
toward structural budgetary balance. Pennsylvania benefits from a large,
diversified and expanding, albeit slowly, economic base which is
expected to provide adequate revenue capacity to match expenditure
growth.
Economic Resource Base
Pennsylvania's broad-based economy is growing, but at a slower pace than
the nation. While the commonwealth's non-farm payrolls grew every year
since 2009, the year-over-year (YOY) change lagged national trends for
the past five years. Manufacturing is a major employer, but services
(particularly education and health) have become much larger components
of Pennsylvania's economic profile. Below-average demographics represent
a long-term drag on economic growth with a median age of 40.5 versus the
national median of 37.4. State population growth has lagged the national
trend for several decades, indicating the potential for a smaller future
workforce. Ongoing development of Pennsylvania's significant natural gas
reserves could mitigate that concern but a weakened market tempers that
potential. Overall, the state's economy provides a solid base for future
potential revenue growth to help manage ongoing expenditure pressures.
Revenue Framework: 'aa' factor assessment
Fitch expects Pennsylvania's revenues, primarily income and sales taxes,
will continue to reflect
the depth and breadth of the economy, but also its slower pace of
growth. The commonwealth has complete legal control over its revenues.
Expenditure Framework: 'aa' factor assessment
The commonwealth maintains solid expenditure flexibility with a moderate
burden of carrying costs for liabilities and the broad expense-cutting
ability common to most U.S. states. Also, as with most states, Medicaid
remains a key expense driver but one that Fitch expects to remain
manageable.
Long-Term Liability Burden: 'aa' factor assessment
Pennsylvania's long-term liability burden is moderate but above average
for a state driven by unfunded pensions. Net tax-supported debt is low.
Pension funded ratios have eroded with contributions long below
actuarial levels, but the commonwealth is nearing full funding of its
contributions following a multiyear ramp up, which may help stabilize
ratios.
Operating Performance: 'aa' factor assessment
The commonwealth retains very strong gap-closing capacity to deal with a
cyclical downturn given its general budgetary flexibility. Pennsylvania
is somewhat less exposed to revenue volatility due to economic declines
than most states. Pennsylvania continues to utilize material
nonrecurring budgetary measures during the economic recovery, with
recent efforts towards reducing the reliance stymied by as-yet
unresolved differences between executive and legislative branch
approaches.
RATING SENSITIVITIES
ADDRESSING FIXED-COST PRESSURES: The 'AA-' rating is sensitive to
Pennsylvania's ability to continue addressing increasing fixed-cost
pressures, particularly for pensions, without materially weakening its
fiscal flexibility. Fitch anticipates the commonwealth will meet its
statutory obligations through adequate funding in lieu of more
discretionary budget items, structural expenditure reform, or revenue
increases; any shift away from those commitments would be a credit
negative.
MOVE TOWARD SUSTAINABLE BUDGETS: Given the magnitude of Pennsylvania's
structural budget gap, Fitch anticipates some continued use of
non-recurring items in upcoming budgets. Material growth in the
structural gap beyond this expectation could trigger negative rating
action.
CREDIT PROFILE
Revenue Framework
Pennsylvania's income tax and sales and use tax serve as the primary
revenue sources, accounting for nearly three-quarters of general fund
revenues.
Historical revenue growth, adjusted for the estimated effect of policy
changes, has been slightly positive on a real basis over the last 10
years. Year-over-year growth was robust leading into the recession but
moderated considerably after recessionary declines in fiscals 2009 and
2010. Fitch anticipates the long-term trend for revenue growth will be
moderately above inflation but trail the pace of national economic
growth given Pennsylvania's slowly growing economic trajectory.
Pennsylvania 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 in most states, education and health and human services spending are
Pennsylvania's largest
operating expenses. Considering just spending from state funds,
education spending is the largest expense as the commonwealth provides
significant funding for local school districts and the public university
and college system but health and human services growth is likely to
outpace it going forward. Medicaid is the largest component of health
and human services spending.
While pension contributions have grown considerably in recent years as
the commonwealth ramped up spending in line with a statutory plan
enacted in 2010, they are not a material driver of overall expenditure
growth.
Spending growth in the commonwealth, absent policy actions, will likely
be in line with marginally above revenue growth driven primarily by
Medicaid. The fiscal challenge of Medicaid is common to all U.S. states,
and the nature of the program as well as federal government rules limit
the states' options in managing the pace of spending growth.
Pennsylvania retains solid expenditure flexibility. While Medicaid costs
are somewhat beyond the commonwealth's ability to materially change
given federal requirements for the program, the state's carrying costs
are moderate and likely to remain so given increased pension
contributions under a statutory ramp-up plan with full funding
anticipated by fiscal 2017. Like most states, Pennsylvania's operating
budget (outside of Medicaid) goes largely towards funding of services
rather than direct service delivery, allowing the commonwealth to shift
costs to lower levels of government in times of fiscal stress.
Long-Term Liability Burden
Pennsylvania maintains a moderate long-term liability burden that should
remain manageable. Per Fitch's October 2015 State Pension Update report,
the commonwealth's total net tax-supported debt and unfunded pension
liabilities of $56 billion covered 9.3% of 2014 personal income compared
to the 50-state median of 5.8%. Fitch anticipates the pension liability
burden will increase gradually at least until the commonwealth reaches
full actuarial contributions, anticipated for next fiscal year based on
the current statutory schedule.
Debt levels reflect borrowing for various capital needs including
facilities, transportation, and water and sewer infrastructure. The
commonwealth uses a mix of GO (legislatively or electorate approved) and
appropriation-backed bonds. Approximately two-thirds of outstanding net
tax-supported debt is GO. The state has used multiple entities and
mechanisms to issue appropriation debt, which is used primarily for
water and sewer needs and economic development projects.
Pennsylvania's pension obligations are for the State Employees'
Retirement System (SERS) and the Public Schools Employees' Retirement
System (PSERS). SERS includes state employees and employees of certain
state-related organizations and the liability is essentially fully borne
by the commonwealth. PSERS includes public school employees and the
liability is shared between the commonwealth and local school districts.
Pennsylvania makes its PSERS contributions through appropriations to
school districts which make the only direct employer contributions to
the system. The commonwealth has been consistently short of its
actuarially calculated annual contribution for both systems for many
years, but the percentage paid has been steadily increasing in line with
legislation enacted in 2010.
Pension reform enacted in 2010 (Act 120 of 2010) made substantive
changes for new employees but did not materially affect the liability,
as current employee and retiree benefits were largely unchanged. More
importantly, it established a ramp-up of commonwealth and local school
district contributions. Under that schedule, the commonwealth will make
full contributions to both systems beginning in fiscal 2017.
Operating Performance
Pennsylvania's ability to respond to cyclical downturns relies on the
superior budget flexibility common to most states, but is hampered by
slow growth prospects for revenues. The commonwealth retains broad
capabilities to adjust expenditures and revenues on an annual basis to
deal with a cyclical economic downturn. The Fitch Analytical Sensitivity
Tool (FAST v.2.0.1) indicates such a downturn would likely have a more
moderate effect on the commonwealth's revenues relative to other states,
somewhat limiting the extent of fiscal challenge Pennsylvania could
face. Pennsylvania's economy and revenue base have proven less cyclical
than the national economy. Fitch anticipates the commonwealth would
maintain an adequate level of financial flexibility in a moderate
downturn. Failure to stem the growth in the structural budget gap in the
coming years could materially weaken Pennsylvania's financial resilience
in the event of a downturn and raise negative rating concern.
During the economic recovery, Pennsylvania has restored some financial
flexibility but continues to rely on substantial non-recurring budgetary
measures. The commonwealth utilized fund transfers, changes in timing of
state expenditures, cuts in education spending, and one-time revenue
sources to achieve annual budgetary balance in the past several years.
Pension contribution deferrals have been another key non-recurring
budgetary measure as the commonwealth has been consistently short of the
actuarially determined contributions. Positively, Pennsylvania has
steadily increased its contributions since fiscal 2010. The demonstrated
commitment to the Act 120 statutory ramp-up schedule indicates
Pennsylvania's intent to eliminate the deferrals, but the use of
substantial one-time revenues to accommodate the funding growth
indicates sizable structural gaps remain several years into the economic
recovery.
The commonwealth's difficulty in reaching political agreement on fiscal
measures hinders its ability to fully address its structural budget
challenges and limits Fitch's assessment of Pennsylvania's operating
performance. In fiscal 2016, Pennsylvania's newly elected governor and
state legislature were unable to reach a full-year budget agreement. In
December, the governor signed into law a partial budget with substantial
line-item vetoes and in March he allowed a legislatively approved
full-year budget to become effective without his signature. The
commonwealth has a long history of contentious budget negotiations, but
the commitment to timely debt service has never been in question, even
for appropriation-back debt. But continued discord on basic issues of
revenues and expenditures hinders the commonwealth's ability to fully
utilize its fiscal flexibility to manage through downturns and
recoveries.
Current Developments
Through the first nine months of fiscal 2016 (which began on July 1),
general fund revenues were tracking essentially in-line with the
estimate used in the governor's fiscal 2017 executive budget proposal
and in the enacted fiscal 2016 full-year budget. Fitch notes some
underlying risk because above-budgeted growth in more non-recurring and
volatile revenue streams such as unclaimed property, inheritance taxes,
and corporate income taxes are offsetting modest weakness in personal
income tax withholding.
The commonwealth's independent Fiscal Office (IFO) projects a modest
$150 million revenue surplus for fiscal 2016, which the administration
expects will be fully consumed by an estimated $209 million in estimated
supplemental appropriations primarily for Medicaid and corrections.
Overall the administration currently projects a nearly $200 million
negative ending budgetary general fund balance for the year. This would
be the second negative balance in three years and adds to the structural
challenge for fiscal 2017.
In January, IFO estimated a $1.9 billion structural, or current
services, general fund budget gap for fiscal 2017. Revenue performance
has improved since then, but expenditure trends have arguably weakened
for the commonwealth as demonstrated by the supplemental appropriations
the administration believes will be required this year. Regardless, the
structural budget challenge remains significant for a roughly $30
billion overall general fund budget. The governor's fiscal 2017
executive budget proposes broad-based revenue measures similar to the
ones ultimately rejected by the legislature last year. Pennsylvania's
current 'AA-' IDR incorporates an expectation of continued challenges in
reaching political consensus on final fiscal measures. But the rating
also anticipates the commonwealth will halt the growth in the
fundamental mismatch between recurring revenues and recurring
expenditures.
UPGRADE FOR CONVENTION CENTER BONDS
The upgrade to the ratings for Pennsylvania Economic Development
Financing Authority (convention center project) revenue bonds to
'A+'/Stable from 'A'/Stable reflects application of Fitch's updated
criteria for appropriation-backed debt. Essentiality of the financed
project is no longer a key driver of notching for appropriation-backed
debt.
Fitch has affirmed and upgraded the following ratings that are supported
by commonwealth appropriations and therefore linked to the
commonwealth's IDR, or otherwise capped at the IDR:
--Pennsylvania Turnpike Commission motor license fund-enhanced turnpike
subordinate special revenue bonds affirmed at 'AA-' ;
--Pennsylvania Commonwealth Financing Authority appropriation-backed
debt affirmed at 'A+'
--Pennsylvania Economic Development Financing Authority revenue bonds
(Convention Center Project) bonds upgraded to 'A+' from 'A'.
The Outlook on all of the ratings is Stable.
Additional information is available at 'www.fitchratings.com'.
In addition to the sources of information identified in the applicable
criteria specified below, this action was informed by information from
Lumesis and InvestorTools.
Applicable Criteria
U.S. Tax-Supported Rating Criteria (pub. 18 Apr 2016)
https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=879478
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Dodd-Frank Rating Information Disclosure Form
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https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1004893
Endorsement Policy
https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&detail=31
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