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How Two Recent U.S. Supreme Court Rulings Could Help Some Muni Issuers

Key Points
  • The U.S. Supreme Court recently gave states the ability to expand tax collections for online sales. Another Supreme Court ruling imposes restrictions on union dues.

     

  • Both decisions have the potential to modestly improve credit quality for state and local governments over time.

     

  • Muni issuers that are reliant on sales taxes or have high labor costs stand to benefit the most from the two rulings.

Two recent U.S. Supreme Court rulings have the potential to boost the credit quality of some municipal issuers. However, the impact will likely take time to develop and will vary by issuer. Individually, the rulings could increase revenues and lower labor-related costs for some state and local governments. Issuers that benefit from the two rulings will likely have greater flexibility to meet their debt service in the future, which is beneficial for bondholders.

Increased sales tax revenue could help some states

Prior to a Supreme Court ruling on June 21st, states could only collect sales taxes on online purchases made by their residents if the online seller had a physical presence in that state. A physical presence commonly referred to inventory, employees or something like a storefront within the state. Given how widespread distribution networks are, approximately 80% of all online sales were already being taxed, according to estimates by the U.S. Government Accountability Office (GAO). The GAO estimates that if all online transactions were subject to sales taxes the result would be an additional $8 billion to $13 billion of revenue for states. To combat this potential loss of revenue, some states passed laws requiring buyers to self-report online purchases they didn’t pay sales taxes on. In practice this was rarely done and difficult to enforce. States now have a clearer path to pass legislation requiring certain online sellers—not buyers—to collect and remit sales taxes.

States with a heavy reliance on sales taxes are poised to benefit the most

Sales taxes account for approximately one-fourth of total general municipal revenues, according to the Tax Policy Center. Forty-five states and the District of Columbia charge a sales tax and of those, 38 charge a sales tax at the local level—meaning the sales tax is charged by the city, county or local government. The state and local governments that stand to gain the most, in our view, will be those with a combination of:

  • High dependence on sales taxes as a percentage of overall revenues
  • High sales tax rates
  • Previous inability to tax online purchases 

The chart below shows the states with the highest reliance on sales taxes as a percentage of their overall revenues.

Sales taxes as a percentage of total state and local government tax revenues

Source: Tax Policy Center, as of December 15, 2017. Data is for fiscal year 2015. Note: “sales taxes” are a combination of “general sales” and “selective sales.”

Moody’s estimates that states most reliant on sales taxes will see the greatest average revenue gains. For example, Moody’s estimates that California, which already had many large retailers that satisfied the “physical presence” requirement and a low reliance on sales taxes, will see only a modest gain of 0.5% to 1.0% of total tax revenues. Texas, which is more reliant on sales taxes, will see a gain of 2.0% to 2.5%, according to Moody’s estimates.

Don’t expect ratings upgrades any time soon due to the sales tax ruling

Although the boost in sales tax revenues “will have a beneficial effect on long-term states credit quality,” S&P believes that the immediate credit impact “may be muted.” It also anticipates that local governments that levy sales taxes will benefit, but that the ruling won’t have a direct impact on credit quality in the near term.

(The analysis below is not intended to comment on the efficacy of unions—only the potential impact that a recent Supreme Court ruling related to unions could have on municipal bond issuers.)

The Supreme Court’s ruling on unions could lower labor costs for municipalities

On June 27th the U.S. Supreme Court ruled that requiring public employees who did not want to pay agency dues to a union violated their First Amendment rights. The ruling could result in lower revenues for unions, and therefore reduce their political clout and negotiating abilities. The Economic Policy Institute found that “unions raise wages of unionized workers by roughly 20%” and “unionized workers receive better pension plans.” Since unions regularly negotiate for higher wages and higher benefits for those they represent, if their negotiating abilities are reduced it could result in lower labor costs for municipal governments. Higher expenses allow issuers less financial flexibility to make debt service payments.  

A bit of background on unions

Federal law allows employees to join a union. Generally employees pay union dues, and in turn the union bargains with the employer on their behalf for wages, retirement benefits, work hours and other issues. This is known as a collective bargaining agreement. Employees are generally not required to join the union, but all unit workers are covered by the collective bargaining agreement. Generally, an employee who chooses not to become a union member cannot negotiate directly with his or her employer.

State and local government employees in 22 states, including California, New York, and Illinois, were required to pay some portion of union dues—an agency fee—as a condition of their employment, even if they chose not to join the union. States without this requirement are known as “right-to-work” states. The Supreme Court found that agency fees violated an employee’s right to free speech because it effectively required them to contribute money to a group they may not agree with.

Twenty-eight states already have laws restricting union dues

Source: National Conference of State Legislatures, data obtained on July 20, 2018.

The ruling could reduce employment costs in non-right-to-work states

In non-right-to-work states approximately 50% of public workers are members of a union, compared with about 18% in right-to-work states. Restricting union fee collections could cause union membership to decline, especially in states with already high union membership. For example, when Wisconsin passed legislation in 2011 that limited union dues collections, allowed contracts to be renegotiated and limited collective bargain agreements, union membership levels declined, as did median compensation for teachers. The Illinois Economic Policy Institute estimates that as a result of the Supreme Court’s ruling, public union membership in California, New York, and Illinois could decline by 189,000, 136,000 and 49,000, respectively.

The chart below ranks the annual mean wage for elementary school teachers by state. We chose elementary teachers because (A) educators as a whole tend to be the largest group of public employees in a state and (B) instead of focusing on all educators, focusing on elementary teachers helps remove some of the distortion in the data that could be caused by other higher-paying teacher occupations—like college professors. The chart is intended to illustrate which states have high labor costs; however, the differences can be explained by other factors such as higher costs of living in the Northeast and West Coast. The red bars are states that are considered right-to-work states and have restrictions on requirements for union dues.

Labor costs tend to be the highest in the Northeast and West Coast

Source: Bureau of Labor Statistics, annual mean wage for “Elementary Teachers, Except Special Education,” as of May 2017.

Note: Red bars are considered “right-to-work” states.

What to do now

The two recent Supreme Court rulings have the potential to modestly improve credit conditions for some state and local governments, but we think the impact will likely be limited and slow to develop. Overall, we have a positive view of the credit conditions for most state and local governments despite some pockets of stress. We suggest investors focus on higher-rated (AAA or AA) munis during the second half of the year, if they are investing in individual bonds. For help selecting investments that may be right for your situation, consider working with one of Schwab’s fixed income specialists.

What You Can Do Next

  • Make sure your portfolio is diversified and aligned with your risk tolerance and investment timeframe. Want to talk about your portfolio? Call a Schwab Fixed Income Specialist at 877-566-7982, visit a branch or find a consultant.
  • Explore Schwab’s views on additional fixed income topics in Bond Insights.
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Important Disclosures:

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market or economic conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.

Tax-exempt bonds are not necessarily suitable for all investors. Information related to a security's tax-exempt status (federal and in-state) is obtained from third parties, and Schwab does not guarantee its accuracy. Tax-exempt income may be subject to the alternative minimum tax. Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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