Balanced Budgets, Uneven Pressures

With the US fiscal year 2027 (FY27) state budget season now largely complete, several important trends have emerged. Most states and local governments adopted their budgets without major delays or political impasses, an encouraging sign for two important credit considerations: governance and financial management.

Nationwide, we have seen strong income tax collections, particularly collections tied to capital gains. This is particularly pronounced in regions with outsized exposure to the financial and tech sectors. Strong financial markets have supported corporate profits, business tax collections and individual income taxes, particularly revenue tied to capital gains. Initial public offering activity, notably in California, has bolstered income tax collections. Many entities predict that this trend will continue. We will be watching carefully to see whether actual collections meet expectations and, if not, what mid-year steps issuers take to make the budget.

California Capital Gains Realizations (1995-2025)

Source: National Association of State Budget Officers. Analysis by Franklin Templeton Fixed Income Research. As of April 2026. There is no assurance that any estimate, forecast or projection will be realized. 

Outside of investment-related income taxes, most issuers are projecting flat growth across other revenue sources. As inflation has cooled down from its recent highs of the past few years, so has the rapid sales tax revenue growth we saw following the COVID-19 pandemic. There are also ongoing uncertainties over federal funding.

Expenditures, however, continue to grow. Much of this is driven by higher input costs, including inflation-driven increases in capital project expenses. With generally flat revenues and increased spending, many municipalities are having to close budget gaps. Municipalities have many tools they can use to address budget gaps, including spending cuts, revenue increases and tapping reserves. Given that budget gaps have generally remained manageable for most issuers, we’ve seen governments apply a mix of tools rather than relying on just reserves or revenue increases. Rainy day funds are still robust across most state and local governments, and we expect reserves to remain strong even when tapped to close these gaps.

Rainy Day Fund Balances 2008-2027 (Estimate)

Source: National Association of State Budget Officers. Analysis by Franklin Templeton Fixed Income Research. As of April 2026. There is no assurance that any estimate, forecast or projection will be realized. 

Public School Districts Feel the Demographic Squeeze

First, consider traditional public school districts. For most school districts, state aid is the primary revenue source which is paid on a per-pupil basis. As a result, both state fiscal health and enrollment trends matter. If a district’s enrollment declines, state aid will likely decline outside of increases in state funding. We recently published a piece, “Research matters: The impact changing demographics has on the municipal bond market,”  examining how lower birthrates are contributing to declining public school enrollment. As a result, without the states increasing per-pupil aid, revenues can decline. And schools, like other municipalities, are contending with higher costs creating more budget pressure. So, margins are narrowing, reserves are being tapped and we’ve seen downgrades accelerate. Despite these pressures, most public school districts remain highly rated, supported by strong state oversight and bond enhancement programs in many states.

New York City: Strong Governance, Ongoing Challenges

Second, we’d like to highlight New York City’s recently adopted FY27 budget. Following the election of a new mayor, the budget has drawn significant attention from investors and the public as they look for insight into the administration’s policy priorities. We have long believed New York City's budget process includes sufficient checks and balances to limit any mayor's ability to unilaterally implement changes that could significantly impact the city's credit profile. In our view, the FY27 budget reinforces that assessment.

Like many municipalities that rely on income taxes, New York City benefited from better-than-expected income tax revenues. The mayor’s initial budget proposal called for large tax increases (income taxes or property taxes) but neither plan was supported by the state or local legislators, and neither was ultimately adopted. The mayor did get state approval for a US$500 million pied-à-terre tax on second homes worth more than US$5 million, well below the broader tax increases originally proposed. He was also able to get additional state aid (likely one-time in nature) but not in an amount to enable all his spending priorities. To close the remainder of the budget gap, the city Comptroller reports that the budget contains about US$6.1 billion in total one-time budget items. These types of programs include not just the state aid increases, but a re-amortization of its pensions. While these close the current year budget gap, they tend to be one-time in nature and do not address the city’s structural budget imbalance, meaning the city still has large outyear budget gaps that will require additional solutions in future years. Positive actual-to-budget results will be important to maintain ratings. However, the city’s large and diverse economy, broad tax base, wealth levels and strong financial governance leave us with no concern regarding its ability to service debt.

New York City illustrates how strong economic fundamentals can provide budget flexibility, but also how recurring expenditure pressures ultimately require recurring solutions.

Why Issuer Selection Matters More than Ever

The FY27 budget season demonstrated that while municipalities faced many of the same macroeconomic forces, credit outcomes remained highly issuer-specific. Revenue composition, demographics, reserve levels, governance and management decisions can lead issuers facing similar pressures down very different paths. At Franklin Templeton Fixed Income, our Municipal Bond research team uses disciplined, bottom-up credit analysis to distinguish temporary budget pressures from more structural credit challenges, helping identify both risks and opportunities as market conditions evolve.