South Carolina’s Addiction to Bond Debt

September 30, 2015

Investigative Reports

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Sanford Pigs

Why tax cuts and spending cuts are well nigh impossible in GOP-dominated South Carolina

Eleven years ago pig squeals echoed through the marbled chambers of the State House.

Then-Gov. Mark Sanford was in a fight with the Legislature, and he was losing.

Intended to draw attention to the legislature’s pork-barrel spending, Sanford’s publicity stunt backfired (on his jacket and shoes, no less), his tax-cut proposal failed in the following session and his austere economic reforms ultimately were rejected not only by a hostile legislature but by the nation’s premiere credit-rating agency in a downgrade that stands to this day.

In a series of events not unprecedented but certainly unusual, agitated members of the General Assembly participated in discussions with credit agency Standard & Poor’s to decry the potential negative effects of Sanford’s ambitious proposal to cut income taxes, and the result was a letter from S&P analyst Eden Perry threatening a downgrade to AA+ status from AAA status, which affects the rate at which the state is able to borrow. Lower ratings mean taxpayers pay more to repay the general obligation bonds the state issues to help finance state government.

Armed with a mandate to protect the state’s credit rating, legislators bucked Sanford’s authority and rejected his proposal, but the environment that had been created along with other negative economic factors led S&P to downgrade the state from its elite AAA status in the summer of 2005, where the state has stayed ever since despite maintaining a AAA rating with two other rating services, Moody’s and Fitch.

What that has meant for South Carolina over the past decade is higher debt service and a more-limited ability to issue general obligation bonds because of revenue obligations. It also has meant that despite Republican-dominated legislatures and governors over that time, no significant income-tax cuts for South Carolinians have materialized because of credit-rating fears. Instead of real tax cuts, governors and legislators engage in more revenue-neutral tax swaps, such as the one Gov. Nikki Haley proposed in January to cut the state’s top income tax but increase the gas tax.

For those in the room during those economic discussions in 2004 and 2005, the process that played out continues to negatively affect South Carolina, its lawmakers and its citizens.

“I’m surprised we’re still where we are.”

General obligation bonds are issued by a state to raise large amounts of money and are unique among bonds in that they are backed by the full faith and credit of the taxpayers. That’s why a state’s credit rating matters so much, says S.C. Comptroller General Richard Eckstrom.

“Cutting taxes, issuing GO bonds and credit ratings are all joined at the hip,” Eckstrom says. “Rating agencies are very concerned about a state’s ability to generate revenue and its overall financial strength.

“Any time revenue declines, whether due to a tax cut or a slowdown in the economy, agencies look at whether spending is curtailed and what long-term actions are being taken to address the problem.”

In Sanford’s case, his desire to trim – OK, shear – inefficiencies he believed were rampant in state government ran him afoul of credit agencies and investors who want states to borrow, not conserve.

“It’s important to remember that rating agencies and their investors don’t want states to curtail spending on services,” Eckstrom says. “They make money when states borrow. So they want to see states engaging in a borrowing that maintains services. Gov. Sanford probably took a different view of that than the rating agencies. He wanted to reduce budgets, reduce borrowing, pay off debt and squeeze efficiencies while lowering taxes.

“The irony is that the ensuing recession did exactly that. It did what he couldn’t do. Scarcity creates efficiency. Sanford had a hard time convincing folks in the legislature dealing with budgets to be quite as committed to that as he was, but the recession did it anyway.”

Scott English was a senior advisor for Sanford from 2002-2008 and served as his chief of staff from 2008-2011. He remembers the battle with the legislature in 2004-05 vividly.

“We were fighting for a sound, responsible budget and you had members of the legislature who resented that,” says English, who resigned as Rep. Sanford’s chief of staff in August to take a position as executive director of the American Philatelic (stamp-collecting) Society.

“They wanted to spend money rather than doing the right thing and there was no general support for tax cuts. In 2004 when the budget was passed and sent to the governor, we sent 106 vetoes back to the General Assembly. We vetoed a lot of money.

“The House overrode every one of those vetoes but one in 90 minutes. There was a frenzy to override every veto. Then you had the pig situation, and off we went.”

The state – and its credit rating – went with them. English faults both lawmakers and S&P for the ensuing downgrade.

“The General Assembly played gamesmanship with credit agencies, saying ‘if they don’t bless (Sanford’s tax cut), we can’t pass it.’ Candidly, my view was that it was excuse not to pass the tax cut plan and negotiate against the governor for the pig from the year before.

“But beyond that, I think you get into a fairly dangerous area when you’re allowing a credit rating agency to influence policy. They can judge policy, but they shouldn’t weigh in in advance to influence policy, which is what happened at the behest of legislators who got involved in the process. It was a political move, and the state is still paying for it.

“I’m surprised we still are where we are.”

The Song Remains the Same

Sanford’s budget director from 2004-2007 was Kevin Kibler. He’s now a senior assistant state treasurer with an impact on current policy and thus and has an understanding of the credit-rating/bond issuance/tax-cut triangle few do.

The first piece, Kibler says, is to understand the relationship between tax cuts and credit worthiness.

“Since general-obligation bond debt is issued on the full faith and credit of the taxpayers, you pay more with a higher interest rate,” Kibler says. “Those bonds are more expensive and take longer to repay. And since they’re repaid out of revenue collected from primarily income and sales taxes, any reduction in those sources of revenue has to be weighed heavily when assessing a state’s credit worthiness.”

Sales and income taxes are the two big drivers of state revenue, accounting for approximately $6-$7 billion of the general fund in South Carolina, Kibler says. Modest tax cuts would scarcely affect those numbers, he says, or jeopardize a state’s ability to repay bond debt.

“When you look at the amount of money the state commits to servicing bond debt, it’s about $200 million or so a year,” Kibler says. “In a $6 or $7 billion dollar budget, that’s a very small percentage of the general budget that’s affected.

“In essence, when you consider the potential of lowering taxes, depending on the size of the reduction and how it’s done, you can’t argue there will be a big impact on the state’s ability to pay bond debt; it’s almost immaterial. You can actually argue that cutting taxes will grow revenue.”

Internally, Kibler says the 2005 credit downgrade wasn’t as big a deal to Sanford and his staff at the time as one might think.

“It wasn’t like the sky was falling,” Kibler says. “You take a hit, but it’s not a real material hit. We didn’t market the loss of the rating and its relationship to the General Assembly, but it wasn’t the end of the world. The whole house wasn’t falling in.

“We were looking at issues like practicing conservative philosophies for debt structure, paying down debt, addressing the state’s retirement system and its significant liabilities all while navigating high unemployment and a weak economy, things that are beyond the control of the executive office.

“No one wants to lose a AAA rating, but as far as the state’s pricing for that, the reality is it doesn’t really affect the cost for investors. We’re still a AAA with two other agencies and AA+ is still a good rating, so I’m not sure the cost is terribly significant.”

Kibler and English both admit they could not have predicted in 2005 the downgrade would have persisted for a decade and counting.

“It is surprising that 10 years later it’s still there,” Kibler says. “It’s something we’re working really hard to regain if we can.

“Based on all the data we have and the internal data from S&P, we’re extraordinarily close with only a couple of criteria keeping us out. Ratings mean nothing in and of themselves, only about what pricing you get from investors when you go out to sell the bonds. Rate reduction really hasn’t cost us all that much when you really study it. Prestige, maybe.”

Prestige and also perception among regional economic competitors such as North Carolina and Georgia who have maintained their AAA ratings through the same economic conditions South Carolina has faced over the past 10 years. That disconnect between perception and economic reality continues to frustrate English.

“You think about the substantial progress this state has made getting its finances in order since 2004 and it’s amazing,” English says. “We have paid off substantial loans from the federal government quickly, paid off some of our higher-yield bonds going back to the 1980s when our credit was lower than it is now and have a much better ability now to deal with budget shortfalls.

“By no means are we perfect, but for the love of God, there are states far worse than we are with budgeting.”

Those states may have worse financial situations, but they may not have worse political situations than the present combative climate between the executive and legislative branches, highlighted most recently by Nikki Haley’s public fight with legislators over how to pay for $200 million in incentives for Volvo.

Eckstrom says such situations as potentially irresponsible or detrimental financing plans like the balloon-payment loan Haley pushed through for Volvo and the tension between branches do not escape the attention of ratings agencies.

“Agencies look at non-financial areas as well,” Eckstrom says. “They look at how well the legislature gets along with the governor, how well the executive branch functions overall and how cooperative they are. All those factors play key roles in credit ratings.

“I think legislators say they consider input from rating agencies (when making decisions), but most don’t have a level of understanding of what those agencies are truly looking for.”

Which means any chance of real, meaningful income tax cuts without at least a concurrent tax swap will likely happen just as soon as pig(lets) fly.

Reach Ron Aiken by phone at 803-200-8809 or email him at ron@thenerve.org. Twitter: @RonAiken.