GURTIN FIXED INCOME CREDIT RESEARCH FLASH

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1 GURTIN FIXED INCOME CREDIT RESEARCH FLASH Colorado Austerity Ballot Measures Could Increase Credit Risks EXECUTIVE SUMMARY Since 1992, the voters of the State of Colorado (the State ) have placed many restrictions on the ability of local governments and the State itself to tax citizens through a sweeping reform program known as the Taxpayers Bill of Rights ( TABOR ). However, over the last decade, many local governments have found legal loopholes that have allowed them to work around these restrictions and have effectively added much needed revenues to cash strapped projects and budgets. Recently, populist sentiment against large government spending has grown, and three fiscally conservative proposals are on the November ballot (Amendments 60 & 61 and Proposition 101). If passed (either individually or together), the proposals would effectively create an even more tax and revenue restrictive environment that would place more pressure on State and local government credit quality. Amendment 60 and Proposition 101 both limit taxation capabilities of Colorado State and local governments, reducing their overall financial flexibility, which we believe could result in a decline in credit quality. Although Amendment 61 removes the State s ability to borrow and reduces the borrowing capabilities of local governments, we feel its passage would have only a minor near-term impact on credit quality. We will closely monitor these ballot measures and track the municipalities they effect to see whether there is any reduction in overall credit quality. BACKGROUND For nearly two decades, the State of Colorado has been a center of heated tax debate. At the general election on November 3, 1992, voters approved a constitutional amendment codified as Articles XI, Section 20 of the Colorado Constitution known colloquially as the Taxpayer Bill of Rights. In general, TABOR restricts the ability of State and local governments to impose taxes, increase revenues and spending, and issue debt and certain other types of obligations. Any tax increase that, if implemented, would increase government revenues at a rate faster than the combined rate of inflation and population increase requires voter approval. Also, because this stipulated rate does not account for rising productivity or any natural growth in revenues, additional income from year to year within the same population base cannot be taxed. Instead, these additional revenues must be earmarked for educational improvements or rebated to taxpayers if the local governments have adequate reserves. Since this amendment is backward looking, there is a ratchet effect during recessions where revenues cannot rise back to prerecession levels without a referendum. From its inception, TABOR has drastically reduced tax revenues in Colorado for both State and local governments. However, since some of the provisions of TABOR are unclear, many local governments have been able to enact litigation seeking judicial interpretation of the laws and, in 1

2 many cases, have been able to lessen the financial impact of TABOR. On November 1 st, 2005, voters further reduced the tax implications of TABOR with Referendum C. This State statute froze TABOR limits for a period of 5 years on health care, public education, transportation projects, and local fire and police pensions. The tax relief experienced during this period was sizable, and allowed many local governments to plug the many holes in their budgets. However, these tax breaks sunset in July of 2010, and have precipitated a need for action that proponents of the ballot measures feel they have filled with the three proposed initiatives. BALLOT MEASURES Each initiative on the November ballot contains provisions that would significantly either reduce revenue available to many levels of government or limit their ability borrow. At the time of this writing, current polling shows a clear minority in favor of these ballot measures; however we believe it would not be prudent to underestimate the level of populist anger currently present in Colorado. With this in mind, we take the potential passage of these measures very seriously. These initiatives cannot impair contracts, such as bonded debt contracts entered into before January 1, 2011, due to their IMPAIRMENT OF CONTRACT principles. In fact, Amendment 60 specifically states that property tax changes cannot limit the payment of bonded debt issued before However, some provisions may severely impact certain pledged revenues in material ways that could result in a decline in credit quality. As such, our concern is not that the ballot measures will in some way invalidate current bonds, but rather that the ballot measures could weaken the financial positions of the State of Colorado and certain local governments, impairing their ability to pay bondholders. AMENDMENT 60 Provisions Passage of Amendment 60 would make sweeping changes to Colorado s property tax laws. These changes would: Require school districts to cut their property tax rates by 50% of their 2011 rates by 2020 and require the State to make up the lost revenue; Roll back voter-approved increases to property tax rates or revenues made after 1992; Terminate any new property tax increase approved by voters after 10 years; Extend property taxes to enterprises and authorities such as utilities, parks, hospitals and universities while lowering tax rates to offset the revenue generated; and, Make it easier for citizens to petition to lower local property taxes. Revenue Impact Funding for public schools and local services would largely shift from local governments to the State s general fund as severe reductions to local property taxes would create a $1.87 billion annual funding shortfall that would have to be replaced by the State. The State currently provides 2

3 approximately 54% of local school districts funding, but with the passage of Amendment 60, this percentage would increase to approximately 70%. In addition, enterprises and authorities would have to start paying property taxes, negatively affecting their income statements. However, local governments receiving these enterprise property taxes would not be permitted to benefit from this new income source since they would be required to reduce tax rates to offset the additional revenue. Other entities that benefited from tax loopholes since 1992 would see their revenue increases rolled back to initial levels set that year. In our view, this is the most significant ballot initiative. We are very critical of the State s ability to fill the immense tax void created at the local level without a significant increase in income and/or sales taxes. At the time of this writing, no clear plans exist to make up the difference. Credit Quality Impact While Amendment 60 would greatly add to the State s burden of funding k-12 education, states in general have strong sovereign powers to generate revenue, giving them the financial flexibility to cover these additional costs. If Amendment 60 passes, we believe the State will fill the funding gap by increasing income taxes, sales taxes, or both. Therefore, should Amendment 60 pass, we will assess the State s funding plan to determine both its viability and financial impact. We expect the State to be able to manage through this, but if the plan does not seem viable or the financial impact is too great, we will exit all State of Colorado appropriation bonds without principalprotected structures. School Districts will, at least in the short term, be forced to dip into their reserves to meet the projected budget gaps, potentially reducing their credit quality. Historically, we have been bearish on Colorado School Districts and currently hold only the schools with the highest credit quality and state credit enhancements. Furthermore, we have reviewed the financial positions of each enterprise and authority whose bonds we manage and we believe they have the ability to pay property taxes without a material impact on their credit quality, based on current property tax rates. PROPOSITION 101 Provisions Proposition 101 would drastically reduce a wide range of state and local taxes and fees throughout Colorado. Passage of Proposition 101 would: Cut the State income tax rate from 4.63 percent to 4.50 percent and institute subsequent annual cuts until the rate reaches 3.50 percent; Exempt the first $10,000 in value from the vehicle sales tax and eliminate or reduce most other state and local taxes and fees on vehicles; and, Eliminate taxes for communications services, such as telephones, pagers or cable service. 3

4 Revenue Impact Once fully phased in, State and local government revenues would be reduced by $1.70 billion and $622 million annually, respectively. Any entities with significant Specific Ownership Tax revenues (vehicle registration) would also be greatly affected. Over an extended period of time, Proposition 101 would also severely reduce the State income tax rate of 4.63% to 3.50%. However, the tax reductions would by no means be consistent as the property tax would be reduced to 4.50% in 2011, then fall by 0.10% every year in which income tax revenue net growth exceeds 6%. It is important to note that this proposition would also cap income tax rates, further reducing the State s financial flexibility. Therefore, if Amendment 60 passes, Proposition 101 would further magnify its impact by limiting the State s ability to fill the funding gap of k-12 education. Granted, there is much room for litigation on this issue, but a preliminary estimate of the impact would be an overall reduction of 25% in the State income tax, which would result in an additional reduction of $1 billion per year in the State s revenues. Credit Quality Impact We believe the impact of Proposition 101 would be nearly as significant as Amendment 60, and should they pass together, the financial burden that the State would bear as a result of having to replace lost income tax revenue or reduce expenditures would be considerable. If Proposition 101 passes alone, we believe that the State s wide sovereign powers to tax or reduce revenues would give it the financial flexibility to manage through this loss of revenue. Vehicle registration fees and vehicle sales taxes are a minor part of local governments revenue structure and we do not believe the reduction of these revenues would materially affect the credit profile of a high credit quality local government. However, if both Amendment 60 and Proposition 101 pass, we believe it will be very difficult for the State to backfill lost school district revenues while facing reductions in its own primary revenue sources. While we believe the State would still have enough flexibility to fill these gaps, we have seen in the past that states are not always creative or effective enough at finding other revenue sources for us to be completely comfortable with their budgetary decisions. Therefore, we would evaluate the State s revenue and funding plans closely to determine their viability as well as the State s ability to maintain its strong credit quality. If these plans do not meet our criteria, we will exit all State of Colorado appropriation bonds without principal protected structures as well as any local government bonds that we deem vulnerable. 4

5 AMENDMENT 61 Provision Passage of Amendment 61 would force major changes to how the State and local governments within Colorado can use and issue debt. Specifically, Amendment 61 would: Prohibit the State from taking on new debt and restrict local governments ability to borrow; Set a limit of 10 percent of assessed taxable value of real property on local governments ability to issue bonds. Currently school districts can borrow up to 20 percent of the assessed value of all taxable property; Require that debts must be paid off within 10 years; and, Require that once a debt has been paid off, taxes be lowered by an amount equal to the average debt payment. Banning the use of any debt by the state, Colorado would become the only state in the nation without the authority to issue debt. This Amendment is intended to cover any and all types of public finance transactions other than pay-as-you-go obligations, and could be interpreted to include such things as equipment leases, economic development agreements and the acceptance of grants or federal funds that could be subject to repayment. 1 While the State does not currently issue general obligation bonds, the Treasurer s office issues appropriation debt and large amounts of revenue anticipation notes to meet the cash-flow needs of the State s General Fund and school districts. Many school districts across the State would rush to secure potential new debt if this proposition passes as they would face immense short-term budget shortfalls. Revenue Impact Overall, the specific revenue impact from Amendment 61 should be very modest. However, given that the bonding of capital projects is extremely important for states and local governments, how governments will finance major long-term capital projects will be in question. Credit Quality Impact We believe the near term credit impact would be minor if Amendment 61 passes. The credit impact of not being able to fund a government s capital program with bonds is unclear, but would materialize over an extended period of time. As such, if Amendment 61 passes, we will closely monitor the State and local governments for any deterioration in credit quality. 1 Peck, Shaffer & Williams LLP, Colorado 2010 Statewide Ballot Initiatives 5

6 CONCLUSION From a municipal credit standpoint, Colorado s November ballot outcome should be monitored closely. In our opinion, Amendments 60 & 61 and Proposition 101 all have the potential to cause a credit quality decline for the State and local governments alike if they pass. However, Amendment 60 and Proposition 101 pose the biggest risks to credit quality, especially if they pass together as each of their individual measures would collectively amplify the overall credit impact. Amendment 61 has long term implications, but we do not believe its effects to be as pronounced as the other two should it pass. Should any of these initiatives pass, we will closely examine the budgetary decisions made by Colorado State and local governments in the wake of elections to see how our credit ratings should change if at all. 6

7 Important Disclosures The opinions expressed in the report represent an assessment of the market environment at a specific time and are subject to change without notice. The opinions in the report are not intended to be a forecast of future events, or a guarantee of future results. The opinions in the report should not be relied upon as investment advice. Gurtin Fixed Income Management, LLC has not verified the accuracy or completeness of information or statistics provided by third party sources and therefore makes no representations or warranties as to the data and information provided by any third party referenced source and shall have no liability or responsibility arising out of or in connection with such referenced source. The report provides general information only without regard to specific investment objectives or the financial circumstances of any particular recipient. This report should not be construed as tax, financial, accounting or legal advice. Investors should seek such professional advice for their particular circumstances. This report does not constitute a recommendation or an offer to sell or a solicitation of an offer to buy any securities in any jurisdictions. Neither the U.S. Securities and Exchange Commission ( SEC ) nor any other federal or state agency or non-u.s. commission has confirmed the accuracy or determined the adequacy of this report. Market volatility can significantly affect performance. Investments are subject to market fluctuations and economic conditions, and may lose value. Investing in bonds involve certain risks, including the credit quality of individual issuers, negative market or economic developments and yield and price fluctuations due to changes in interest rates. Bonds decrease in value as interest rates rise. Gurtin Fixed Income Management, LLC is registered with the SEC as an investment adviser. Information about Gurtin Fixed Income Management, LLC is available in its Form ADV. For more information, please visit 7