Fitch Ratings has upgraded the State of South Dakota’s Long-Term Issuer Default Rating (IDR) to ‘AAA’ from ‘AA+’. In addition, Fitch has upgraded the ratings on appropriation-backed bonds linked to the state’s IDR as follows:
–Approximately $134 million in South Dakota Health and Educational Facilities Authority (SDHEFA) vocational education program revenue bonds to ‘AA+’ from ‘AA’;
–Approximately $4.5 million in South Dakota Building Authority (SDBA) revenue bonds to ‘AA+’ from ‘AA’.
The Rating Outlook is Stable.
SDHEFA’s vocational education program revenue bonds are limited obligations of the authority, payable solely from lease rentals and amounts in the debt service reserve. Lease rentals are subject to appropriation by the state legislature and derive from two sources, program revenues collected by participating institutions and appropriations from the state’s general fund.
SDBA’s revenue bonds are special, limited obligations of the authority, the security for which derives from lease rental payments made by several departments and bureaus to the SDBA, subject to annual legislative appropriations and held in a separate trust fund by the state treasurer.
KEY RATING DRIVERS
The upgrade of South Dakota’s long-term IDR to ‘AAA’ from ‘AA+’ is based on the application of Fitch’s revised U.S. Tax-Supported Rating Criteria, released April 18, 2016. The new criteria include more focused consideration of the economy and its impact on key rating factors. The state’s high credit quality is supported by consistently conservative fiscal operations, including ample reserve balances and a history of maintaining budgetary balance. The long-term liability burden is exceptionally low for a state. Fitch has likewise upgraded SDHEFA’s vocational education program revenue bonds, which are rated one notch below the state’s IDR.
Economic Resource Base
South Dakota’s economy is diverse with important concentrations in agriculture, manufacturing, trade, finance and tourism. Although the state’s population is relatively small, population gains have accelerated in recent years. During the current economic expansion, employment gains have been steady and positive, albeit below national averages, driven in part by the state’s slow labor force growth. Personal income performance is more volatile than national trends, affected by its large farm sector, although the economy has diversified across multiple other sectors.
Revenue Framework: ‘aaa’ factor assessment
Revenues in South Dakota, which are dominated by a broad statewide sales tax, have generally exhibited less sensitivity to broader national economic cycles than those of other U.S. states. Fitch anticipates revenue growth in the future will match historical trends, with growth slightly faster than corresponding national GDP gains. The state has full control over tax rates.
Expenditure Framework: ‘aaa’ factor assessment
Education and social services are the largest expenditure responsibilities and will likely drive spending growth over time. Ample flexibility is based on an exceptionally low carrying cost burden and the solid ability to reduce spending common to most U.S. states.
Long-Term Liability Burden: ‘aaa’ factor assessment
On a combined basis, long-term liabilities in South Dakota are among the lowest of the states. Tax-supported debt, primarily bonds secured by annual appropriations, is low given the state’s historical reluctance to issue bonds. The main pension system covering state and participating local employees is fully funded, and the state carries no other post-employment benefit obligations.
Operating Performance: ‘aaa’ factor assessment
Fiscal management is conservative. Financial flexibility is healthy, guided by a requirement to start and end the fiscal year with a balanced budget. Additionally, the state maintains ample flexibility through several well-funded reserve funds.
CONTINUED ADHERENCE TO CONSERVATIVE MANAGEMENT: The rating is sensitive to South Dakota’s maintenance of its conservative approach to managing state finances and liabilities. The Stable Outlook reflects Fitch’s expectation that changes to the state’s approach are unlikely.
South Dakota’s economy is diverse. In addition to its longstanding agriculture sector strength, the state benefits from the presence of notable manufacturing, trade, finance and tourism sectors. Although the state’s population is small, growth has exceeded the U.S. average since 2010, a reversal of the trends in place through the two previous decades.
During the last recession and the recovery that followed, the labor market was less volatile in South Dakota than in the nation as a whole, with fewer jobs lost in the downturn but slower growth in the recovery. Nonetheless, employment in the state at present is 4.9% higher than the last pre-recession peak and 8.1% higher than the recessionary trough. Recent employment gains have been steady but below national averages, attributable in part due to very slow labor force growth. The unemployment rate is consistently among the lowest of the states, most recently measuring 2.5%, half the nation’s overall rate.
Personal income per capita in South Dakota, at 94.6% of the national average, ranks 25th among the states. Growth in personal income is subject to greater volatility in South Dakota than in the nation, influenced in part by trends in the state’s important agricultural economy. In 2015, aggregate personal income was flat in South Dakota, while on a per capita basis personal income declined.
A broad-based sales tax is South Dakota’s dominant tax revenue source. As of fiscal 2017, when the rate rises to 4.5%, from 4%, about two-thirds of general fund receipts will be derived from sales taxes. Additional narrower revenue sources include a contractor’s excise tax, insurance company tax, tobacco taxes, lottery receipts and earnings from various trust funds, among other levies. There are no individual or corporate income taxes.
Growth prospects for state revenues are strong. Historical revenue gains have exceeded national GDP and inflation benchmarks, and revenues have exhibited less severe cyclicality relative to the nation’s economy due in part to the absence of personal and corporate income taxes. Sector-specific taxes have periodically been exposed to narrower developments affecting those industries. Revenues from banking activity, including the bank franchise tax and unclaimed property receipts, have been affected by consolidation and other industry trends as well as national economic cyclicality.
The state has an unlimited legal ability to raise revenues.
South Dakota’s primary expenditure commitments are for education and health and human services, including Medicaid. Support for K-12 schools is the bulk of education spending, including both direct aid as well as funds for property tax relief. The state’s support for schools will rise further beginning in fiscal 2017 with planned teacher salary increases funded from the sales tax rate increase noted above. Medicaid spending has risen steadily in recent years given the state’s growing eligible population and the impact of state personal income growth over time on federal matching funds.
Consistent with most states, the pace of spending growth in South Dakota is expected to be marginally higher than revenue growth in the absence of policy actions.
South Dakota retains ample expenditure flexibility, driven by a requirement to achieve budgetary balance. The state has generally been willing to make significant cuts to spending, including for directly-provided services and for transfers to local levels of government. Carrying costs for liabilities are exceptionally low.
Long-Term Liability Burden
South Dakota’s long-term liability burden is very low, the result both of a reluctance to rely on borrowing for capital needs and strong pension contribution practices that historically supported solid funded pension ratios. As of Fitch’s 2015 state pension update, the combined burden of net tax-supported debt and unfunded pensions was 1.7% of personal income, among the lowest of the states.
Tax-supported debt consists of appropriation-backed bonds issued through two authorities, the South Dakota Building Authority (SDBA) and SDHEFA; the state is prohibited from issuing general obligation bonds in excess of $100,000. Net tax supported debt, including outstanding SDBA and SDHEFA bonds and capital leases, totaled a minimal 1.4% of personal income as of June 30, 2015. Debt liabilities have been further minimized by application of one-time funds to prepay certain obligations. The state also provides contingent support through reserve make up provisions for certain self-supported housing and economic development borrowings.
South Dakota’s retirement liabilities are among the lowest of the states. The unfunded liability for the state’s major multi-employer plan, the South Dakota Retirement System (SDRS), historically very low, was eliminated given one-time contributions in fiscal 2014 and 2015 in excess of the actuarially required levels. As of June 30, 2015, SDRS’ ratio of assets to liabilities was 100% on an actuarial basis and 104.1% under GASB 67. Using Fitch’s 7% return assumption (versus the 7.5% assumed by the system) would lower the funded ratio to a still high 94.8%. Actuarial contributions have been fully made for years. The state reports no liability for other post-employment benefits.
South Dakota maintains exceptional gap-closing capacity, driven by the presence of sizable reserves and a conservative approach to budgeting. The state was affected by revenue declines in the last recession, including sales and bank franchise taxes but quickly responded with spending cuts, including to education, fund transfers and revenue measures.
Several reserves and trust funds help support the state’s financial resilience. A budget reserve fund (BRF) receives unobligated general fund cash and holds a balance of $99 million as of May 2016, equal to 6.7% of forecast fiscal 2016 general fund revenues. The BRF is capped at 10% of prior year appropriations. Additionally, a general revenue replacement fund (GRRF) is also available to cover year-end revenue shortfalls; its balance of stands at $44 million, equal to 2.9% of general fund revenues. The state has periodically drawn on these reserves for other needs, including in fiscal 2014 and 2016 to pay down debt and provide ongoing debt service savings.
Several sizable trust funds are also present that receive constitutionally dedicated resources and support specified education and health-related spending priorities through annual transfers to the general fund.
South Dakota’s fiscal flexibility is supported by consistently conservative operating practices which have been further strengthened in recent years. The state cemented its longstanding practice of starting and ending each fiscal year with a balanced budget by passing a constitutional amendment requiring budget balance in 2012. The state has also instituted multi-year operating, capital and debt planning, and budgeting distinguishes between ongoing and one-time revenues and spending.
Recent Operating Performance
South Dakota’s recent operating performance has been steady. Year to date through April, fiscal 2016 receipts are 4.3% higher than collections in the same period last year and 0.6% above the level assumed in the adopted fiscal 2016 budget. Sales tax collections under budgeted expectations are offset by higher tobacco taxes, insurance taxes and lottery receipts.
Including legislative changes made in the 2016 session, the state forecasts that ongoing receipts in fiscal 2016 will rise 4% over actual fiscal 2015 ongoing receipts. Sales taxes are forecast to rise 3.6%. Budget revisions in fiscal 2016 included a one-time, $27 million draw from the BRF as part of a plan to prepay $42 million in higher education-related debt. Including this prepayment, expenditures are forecast to grow 6.2%.
The fiscal 2017 budget incorporated several notable policy changes, including the 0.5% increase in the sales tax noted earlier, with newly-generated revenues dedicated primarily to teacher salary increases and additional property tax relief. Fiscal 2017 ongoing receipts are forecast to rise 11.2%, incorporating the $107 million arising from the sales tax rate change, while expenditures are forecast to rise 8.6%, driven by the expanded education spending.
In addition to the sources of information identified in Fitch’s applicable criteria specified below, this action was informed by information from Lumesis and InvestorTools.
U.S. Tax-Supported Rating Criteria (pub. 18 Apr 2016)
Dodd-Frank Rating Information Disclosure Form