AN ANALYSIS AND CRITIQUE OF THE RECENT S&P BOND RATING DOWNGRADE OF OKLAHOMA
July 13, 2017 - 11:18am CDT
By William Freeland and Jonathan Small
Standard & Poor's (S&P) recent downgrade of Oklahoma state government debt should be considered with a healthy degree of skepticism. S&P has a dubious track record of accuracy, objectivity, and impartiality in bond ratings. Rather than raise taxes, state policymakers would be wise to seek to bolster economic competitiveness, thereby boosting the underlying economy and enhancing future, medium-term tax returns. The state would also be well served by relying less heavily on taxation of income and severance taxes on energy extraction, both of which are extremely volatile and highly fluctuating in their annual collections and which create substantial, demonstrated forecast error in revenue collections.
Standard & Poor's (S&P) recent downgrade of Oklahoma state government debt should be considered with a healthy degree of skepticism. S&P has a dubious track record of accuracy, objectivity, and impartiality in bond ratings. These ratings advise debt investors on the relative risk of failure to receive consistent, timely interest payments and, more drastically, loss of initial investment principal through debt default. S&P ranking of this risk often exhibits an agenda that can be difficult to detect, leaving their assessments with potential bias and questionable accuracy relative to the true underlying risk of the debt they rank.
Moreover, analysis of Oklahoma’s fiscal positions by other credible organizations, as well as a review of available data, suggest a much stronger fiscal position than S&P recognizes in their recent ratings action. And S&P, in maintaining a “high, investment grade” credit ranking for Oklahoma state government debt, recognizes the state has a much stronger fiscal position than many flawed media reports and opportunistic, agenda-driven commentary by some policymakers seems to suggest.
Still, the state’s economy has underperformed in recent years, particularly due to depressed energy prices depressing the state economy’s overall performance and thereby lowering associated tax returns. Rather than raise taxes, state policymakers would be wise to seek to bolster economic competitiveness, thereby boosting the underlying economy and enhancing future, medium-term tax returns. The state would also be well served by relying less heavily on taxation of income and severance taxes on energy extraction, both of which are extremely volatile and highly fluctuating in their annual collections and which create substantial, demonstrated forecast error in revenue collections.
Summary of S&P Memo Downgrading Oklahoma
In summarizing the recent S&P ratings opinion, which downgraded Oklahoma government debt, we must begin by clearly and firmly establishing what is a “buried lede” in coverage of the ratings action: Oklahoma retains a very high “investment grade” bond rating from S&P. Thus, the overwhelming, broader message of S&P to bond investors, as well as to fiscal policymakers in Oklahoma, is the strong creditworthiness of Oklahoma government debt. Oklahoma has a strong fiscal position, particularly compared to the other 50 states. Figure 1 summarizes how the ratings system works for the various agencies, including S&P.1
Nevertheless, S&P has indeed downgraded Oklahoma government debt a notch, noting a slight weakening in their assessment, while still noting the broader soundness of the state’s fiscal policy regime. According to the March 1, 2017, “ratings action” memo:2
S&P Global Ratings lowered its rating on the state of Oklahoma’s general obligation (GO) bonds and appropriation debt backed by the state’s credit enhancement reserve fund one notch to ‘AA’ from ‘AA+’. At the same time, we lowered our rating on the state’s appropriation debt to ‘AA-’ from ‘AA’. The outlook is stable. S&P Global Ratings also assigned its ‘AA-’ rating, with a stable outlook, to the Oklahoma Capitol Improvement Authority’s (OCIA) series 2017B (Capitol Repair Project) state facilities revenue bonds, issued for Oklahoma.
S&P cites recent revenue shortfalls, which they categorize as “persistently weak revenue collections.” Moreover, they essentially view Oklahoma as having a structural, persistent lower pattern of state revenue collections relative to the trajectory of state government spending—while treating that spending trend as somewhat sacrosanct and largely escaping their fiscal scrutiny. They also cite an underperforming economy, particularly noting the Oklahoma state economy’s focus on energy extraction, which has seen lower prices depress the state’s economic growth in recent years.
The partially stated and fully implied remedy is additional stable revenues to be raised by the state, in addition to enhancing the level of the state’s rainy day fund and an improvement in state economic performance generally.
A Critical Look at S&P Ratings
Government-Granted Oligopoly and Conflicts of Interest
The major rating agencies, including S&P, are essentially granted a de facto monopoly by government through financial regulation. Work by Mercatus Center scholar Lawrence J. White has covered this issue in depth, focusing on the “Nationally Recognized Statistical Ratings Organizations” regulations by the Securities and Exchange Commission (SEC).3 In short, financial institutions’ regulation and related capital-holding requirements are based on the risk of the portfolio held by those financial institutions. That risk assessment must come from an SEC-accepted ratings agency; the SEC’s decision to grant only some agencies the designation of acceptable creates a monopoly within the marketplace for bond risk assessment.
In addition to the monopoly problem, ratings agencies face a conflict-of-interest problem.4 The ratings are paid for under an “issuer pays” business model, whereby the entity issuing the debt also pays the ratings agency for the rating. Thus, agencies could be incentivized to give a desired rating to debt issuers so that the issuer doesn’t seek the desired rating from an alternative ratings agency.
These fundamental issues with ratings agencies call into question the accuracy of the debt rankings, both due to the incentives and the underlying dynamics of the current ratings market, but also conceptually by reducing both competition and the related potential innovation in ratings that might exist in a more market-driven regime of debt risk assessment.
S&P Scandal and Subsequent Federal Action against Firm
The issues of monopoly and conflict of interest are not merely conceptual. Recent experience has exposed the problems that exist in the current bond ratings regime.
S&P was forced to pay a $1.5 billion settlement, finalized in 2015, to the U.S. Justice Department and various state government entities.5 This was due to a fundamental “defrauding” of investors in the lead-up to the subprime mortgage crisis of 2008 and the subsequent “Great Recession.”
Moreover, this underlying “defrauding” of investors is widely cited as a major source of the subprime crisis, as the underlying risk of mortgage-backed derivatives was substantially underrated by the rating agencies. This lays a major cause of the subprime crisis and “Great Recession” directly at the feet of the ratings agencies—S&P in particular.6
This charge against S&P should serve as substantial context to take S&P rankings with a healthy degree of skepticism with respect to their accuracy and the potential for underlying bias.
Oklahoma Government’s Fiscal Condition
Overall Fiscal Health: Mercatus State Fiscal Condition Index
The Mercatus Center at George Mason University has analyzed the underlying fiscal condition of the 50 states. As seen in Figure 2, Mercatus ranks Oklahoma highly. Oklahoma sits at 8th overall, anchored by a strong 2nd place ranking in “trust fund solvency” and a 5th place ranking in “long-run solvency.”7 This suggests that S&P is right to give Oklahoma a strong, investment grade credit rating—but also serves to offer substantial basis to reconsider their downgrade, given the state’s strong comparative position, particularly with respect to long-run solvency, and a low total debt and liabilities burden.
Revenue Shortfall in Oklahoma—and 30 Other States
Though S&P hits Oklahoma primarily for a revenue shortfall, 30 other states face a similar circumstance: this according to data from the National Association of State Budget Officers (NASBO) and summarized by MultiState Associates.8 It is bizarre for S&P to offer pervasive judgment on Oklahoma’s revenue situation when shortfalls are part of a broader national trend in state revenue collections. This is important context to consider regarding S&P's downgrade of Oklahoma and the state’s broader fiscal picture.
Oklahoma Fiscal Policy and Revenue Volatility
Spending Trends in Oklahoma
Figure 4 shows the trend of spending in Oklahoma in recent decades.9 The chart shows that spending in Oklahoma has been stable over the most recent decades, essentially sitting at a constant level relative to personal income in the state. Though the state’s share of that spending total has dropped slightly over the past decades (though at an extremely modest level, perhaps more closely approximating a flat trend), with modestly growing federal funds granted to the state keeping overall spending constant, this should not be viewed as a sign of “budget cuts” or of declining capacity for the provision of public services in the state. A large portion of government programs are “fixed cost” expenditures, not growing in fiscal necessity as the economy grows. These fixed cost budget outlays are satisfied at a relatively constant, binary level and not linked directly to any underlying growth criteria. This suggests that in an ideal fiscal baseline, state spending should modestly shrink as a share of income as overall state income grows. Thus, these figures demonstrate a relatively healthy, static level of state spending in Oklahoma.
Volatility of Taxes in Oklahoma
One issue that does plague Oklahoma’s fiscal policy regime, including greatly exacerbating the possibility of revenue shortfalls and forecasting error, is the potential volatility created by Oklahoma’s reliance on taxation of personal income, business income, and energy extraction. The joint work of economists Arthur B. Laffer, Stephen Moore, and Jonathan Williams have shown the tremendous volatility inherent in the taxation of personal income and business income relative to consumption taxation through general sales and use taxes (aggregate state corporate income tax collections fell by nearly 75 percent, personal income tax collections by 17 percent, and sales and use tax collections by only 7 percent in 2009, at the depth of the Great Recession).10
Moreover, data from the Pew Charitable Trusts show that Oklahoma’s tax system as a whole has above-average volatility relative to the 50 states (Oklahoma ranked as the 15th most volatile state between 1996 and 2015), with severance taxes and taxation on personal income leading the state’s various tax types as the most volatile (Oklahoma severance taxes had a measured volatility index score of 37.5, personal income taxes 8.3, and sales taxes 4.6). Reducing the reliance on personal income and severance taxes on energy extraction would go a long way to achieve revenue stability in the state, reduce forecast error of state revenue collections, and thus reduce the potential for revenue shortfalls in future years.
This can and should be accomplished by broad-based and fundamental tax reform which reduces the penalty on work and encourages economic growth and ancillary state revenue growth.
Tax Policy Competitiveness in Oklahoma
Two studies from the Tax Foundation detail the evidence showing that Oklahoma should be looking to improve the state’s competitiveness with respect to tax policy, not raising taxes and thereby further harming the state’s competitiveness. According to the “State Business Tax Climate Index,” Oklahoma ranks only 31st overall among the 50 states.11 And according to the “Location Matters” study, which calculates the tax burden faced by firms in different industries and at different levels of maturity, Oklahoma averages a ranking of 19 across the seven different industries in a fierce and economically competitive environment.12
These two studies detail the hard truth that Oklahoma is lagging with respect to economic competitiveness due to the state’s system of taxation. As such, raising taxes is a questionable solution to the state’s problems. Oklahoma would be better served by pro-growth tax reform enhancing future state revenue prospects behind higher economic growth, not short-sighted tax hikes.
Economic Performance in Oklahoma
Energy Extraction and the Oklahoma Economy
A key feature in the Oklahoma economy mentioned extensively by S&P is depressed energy prices and the related impact on Oklahoma given the state’s reliance on the energy industry for the health of the broader economy and as a driver of tax revenues. It’s worth reviewing the salient details that establish the factual basis for these claims.
Figure 5a and Figure 5b plot crude oil and natural gas prices.13 The substantial decline in market prices for both commodities is clearly evident.
An October 2015 presentation by economist Mark Snead of RegionTrack Economic Forecasting and Analysis shows the importance of the energy industry to Oklahoma’s economic performance and annual tax returns.14 Figure 6, a composite of four charts and his expert conclusions, demonstrates the factual basis for showing how the depressed energy prices plotted above affect Oklahoma. As Snead notes, Oklahoma has the highest contribution from energy extraction to total state earnings of any state. Moreover, he shows how the energy industry drives the state’s economy (measured by wage and salary data) and tax returns as a result, with recent declines in prices depressing both metrics substantially.
Relatedly, in Figure 7, Snead plots the share of state earnings coming from the capital holders of the means of production. Largely due to the extent that Oklahoma’s capital stock consists of the tools of energy extraction, we see that Oklahoma’s state economy has an above average sourcing of state income from returns to capital. This further establishes that Oklahoma’s economic performance and the subsequent flow of that performance into state tax returns is highly reliant on energy prices.
Oklahoma’s Labor Force
Underlying weakness in Oklahoma’s broader economy is another major reason for shortfalls in tax revenue in recent years. Consider the underperforming labor force in Oklahoma. Coming out of the Great Recession and the associated major job losses in the state (as in the nation at large), Oklahoma has faced a slow and anemic recovery. Though the state is approaching full employment, it is still falling short of the mark, as Figure 8 from the Bureau of Labor Statistics shows.
Moreover, as Figure 9 from the Pew Charitable Trusts shows, Oklahoma’s labor force participation rates and labor force as a percent of the population demonstrate a major gap relative to a more robust concept of full employment that includes potential, able-bodied workers that have left the labor force entirely.15 This has been discussed previously by OCPA and continues to pose a major economic challenge to the state.16
Income and Production in Oklahoma
In addition to the labor force, consider the recent decline in aggregate personal income. This is illustrated in the data in Figure 10, also from the Pew Charitable Trusts.17 Though Oklahoma has had strong income growth over the last decade, income declined over the last year. Moreover, only five other states faced income declines over the last year, all of which are states with economies highly reliant on energy extraction for their overall economic health and growth potential, like Oklahoma.
Bearing in mind that income is highly correlated with state gross domestic product (GDP), the net sum of the state’s productive output, it’s worth turning to Figure 11 from the Bureau of Economic Analysis, which compares all states’ quarterly growth in GDP over the last seven quarters.18 Oklahoma has seen negative GDP growth four out of seven of those quarters and ranks only 47th overall among the 50 states in GDP growth over that period. These figures demonstrate the extent of Oklahoma’s most recent economic woes.
Looking beyond state GDP, it’s also worth analyzing the Philadelphia Federal Reserve Bank’s State Coincident Index and State Leading Index. The State Coincident Index provides a broad aggregation of numerous metrics of state economic health and normalizes all figures into an index comparable over time and between states.19 The State Leading Index, displayed in Figure 12, uses the underlying methodology of the Coincident Index to forecast the broader economic health and performance of the states for the six months ahead of the most recently available month of the Coincident Index.20 The most recent data release details data up to December 2016.
Comparing Oklahoma’s Coincident Index score to the other 49 states, Oklahoma ranks only 22nd. That rank was 16th as of December 2014, and Oklahoma’s -0.54 percent change since that date ranks it as the 45th lowest state. Going back further to December 2012, Oklahoma’s index score ranked the state at 14th, and its percent change from that date to the present was only 5.35 percent, ranking the state 46th in growth over the period. Turning to the State Leading Index, the Philadelphia Federal Reserve projects a 0.9 percent increase in the Coincident Index score in the six months preceding December 2016, ranking the state at a depressing 42nd overall.
Conclusions and Solutions to Oklahoma’s Poor Economic Performance
In conclusion, the data clearly show the impact of lower economic production, fewer people working due to the depressed labor market, and lower income growth in Oklahoma. We see the direct effect of depressed income tax returns and, to a lesser extent, an indirect effect of depressed tax returns on those taxes based on consumption such as the sales tax as poor economic performance flows into poor tax returns. Moreover, as the Oklahoma economy underperforms expectations, associated taxes driven by the economy will similarly underperform forecast expectations. Couple this underperformance in the economy with depressed severance tax revenues due to lower energy prices, and much of the state’s recent revenue shortfalls can be explained.21
Conclusions, Summary of Critiques, and Recommendations
Recent S&P ratings action downgrading Oklahoma has enhanced preexisting pressure to raise taxes in the state. But this downgrade in ratings should not be used to advance that case, because of substantive skepticism in S&P’s underlying rating and because of a misdiagnosis in the true problems plaguing the state.
S&P’s ratings have been substantially incorrect in the past and, worse still, they have been systematically biased. Additionally, the agency is likely overly concerned with the short-term interests of bondholders of state debt, and grossly underappreciating the long-run potential of economic growth and the benefits of a less volatile tax regime.
Moreover, bear in mind that S&P’s ranking of Oklahoma still recognizes the state as having an extremely strong fiscal regime worthy of a “high, investment grade” credit ranking. Analysis by other outside organizations, as well as a review of associated data, similarly shows the strong standing of Oklahoma’s fiscal policy regime, particularly with respect to long-term items such as unfunded liabilities and outstanding state bond debt relative to appropriate baselines.
Still, there is some truth in S&P concerns regarding Oklahoma’s recent revenue shortfalls, and public policy must address these concerns. Unfortunately, both S&P and key executive-branch officials in Oklahoma provide the wrong solution.
Oklahoma’s anemic economy, in part caused by low energy prices but more broadly due to issues in economic competitiveness, must be addressed to solve the problem of chronic revenue shortfalls. This means enhancing economic competitiveness in Oklahoma through pro-growth economic reform, not further stymieing the economy through higher taxes.
Oklahoma needs to diversify its economy by fostering substantive growth in industries outside the energy sector. This will bolster overall economic performance, increase earnings and the performance of labor markets, and reduce the impact of energy prices on Oklahoma’s economic well-being and on annual tax returns. The only viable pathway to substantive diversification through broad, fast-paced, dynamic economic transformation is by creating a climate that offers a more competitive economic policy regime to entrepreneurs. This unavoidable reality provides the basis for understanding the necessity of improving Oklahoma competitiveness in order to improve both the stability and robustness of state revenue collections.
Additionally, the state should seek to reduce reliance on highly volatile sources of revenue—such as personal income taxes, taxes on business income, and severance taxes on energy extraction—in order to stabilize revenue collections and reduce forecast error that helps lead to chronic mid-year revenue shortfall crises.
About the Authors
William Freeland is an independent public policy analyst, research economist, and data scientist with a decade of experience in public policy research and advocacy. He has worked as a research analyst and economist for the American Legislative Exchange Council (ALEC), as an economist at the Tax Foundation, and as a member of the research faculty at the George Mason University Law and Economics Center.
Jonathan Small is the president of the Oklahoma Council of Public Affairs. A Certified Public Accountant, he previously served as a budget analyst for the Oklahoma Office of State Finance, as a fiscal policy analyst and research analyst for the Oklahoma House of Representatives, and as director of government affairs for the Oklahoma Insurance Department. Small’s work includes co-authoring “Economics 101” with Dr. Arthur Laffer and Dr. Wayne Winegarden.
1 Trading Economics, http://www.tradingeconomics.com/country-list/rating
2 S&P Global Rating Opinion on Oklahoma State Debt, https://www.ok.gov/OSF/documents/OklahomaGeneralObligation03012017.pdf
3 Lawrence J. White, “A Brief History of Credit Rating Agencies: How Financial Regulation Entrenched This Industry’s Role in the Subprime Mortgage Debacle of 2007-2008,”The Mercatus Center, https://www.mercatus.org/publication/brief-history-credit-rating-agencies-how-financial-regulation-entrenched-industrys-role
5 Reuters, “S&P reaches $1.5 billion deal with U.S., states over crisis-era ratings,” Feb. 3, 2015, http://www.reuters.com/article/us-s-p-settlement-idUSKBN0L71C120150203
6 Lawrence J. White, “A Brief History of Credit Rating Agencies: How Financial Regulation Entrenched This Industry’s Role in the Subprime Mortgage Debacle of 2007-2008,”The Mercatus Center, https://www.mercatus.org/publication/brief-history-credit-rating-agencies-how-financial-regulation-entrenched-industrys-role
7 Eileen Norcross and Olivia Gonzalez, “Ranking the States by Fiscal Condition: 2016 Edition,” Mercatus Center, https://www.mercatus.org/system/files/Norcross-Fiscal-Rankings-2-v3_1.pdf
8 “Thirty-One States Face Revenue Shortfalls for the 2017 Fiscal Year.” MultiState Associates. https://www.multistate.us/blog/thirty-one-states-face-revenue-shortfalls-for-the-2017-fiscal-year
9 The Pew Charitable Trusts, “Fiscal 50: State Trends and Analysis,” http://www.pewtrusts.org/en/research-and-analysis/collections/2014/05/19/fiscal-50-state-trends-and-analysis
10 Arthur B. Laffer, Stephen Moore, and Jonathan Williams, “Figure 8: State Tax and Revenue Volatility,” in Rich States, Poor States: 7th Edition, American Legislative Exchange Council, https://www.alec.org/app/uploads/2015/12/RSPS_7th_Edition.pdf
11 Jared Walczak, Scott Drenkard, and Joseph Henchman, “2017 State Business Tax Climate Index,” Tax Foundation, https://taxfoundation.org/publications/state-business-tax-climate-index/
12 “Location Matters: The State Tax Costs of Doing Business,” Tax Foundation, 2015, https://taxfoundation.org/location-matters-2015/
13 André Barbé, Andrew David, and Alan Fox, “Effects of Declining Crude Petroleum and Natural Gas Prices on U.S. Sectoral Trade,” United States International Trade Commission, 2015, https://www.usitc.gov/research_and_analysis/trade_shifts_2015/specialtopic.htm
14 Mark Snead, “Presentation: Oklahoma Academy & 2015 Town Hall,” RegionTrack Economic Forecasting and Analysis
15 The Pew Charitable Trusts, “Fiscal 50: State Trends and Analysis,” http://www.pewtrusts.org/en/research-and-analysis/collections/2014/05/19/fiscal-50-state-trends-and-analysis
16 William Freeland, “How to Increase Labor Force Participation in Oklahoma,” OCPA Perspective, January 2017, http://www.ocpathink.org/article/how-to-increase-labor-force-participation-in-oklahoma
17 The Pew Charitable Trusts, “Fiscal 50: State Trends and Analysis,” http://www.pewtrusts.org/en/research-and-analysis/collections/2014/05/19/fiscal-50-state-trends-and-analysis
18 Bureau of Economic Analysis report, https://www.bea.gov/newsreleases/regional/gdp_state/2017/pdf/qgsp0217.pdf
19 Philadelphia Federal Reserve Bank, “State Coincident Index,” https://www.philadelphiafed.org/research-and-data/regional-economy/indexes/coincident/
20 Philadelphia Federal Reserve Bank, “State Leading Index,” https://www.philadelphiafed.org/research-and-data/regional-economy/indexes/leading/
21 It is also important to remember that in one year alone the oil and gas and manufacturing sectors in Oklahoma cut 21,800 jobs. When one considers the economic impact of losing jobs—especially those that typically pay more than $80,000 a year—it is not surprising that Oklahoma’s economy is hurting. According to the Oklahoma Tax Commission, from calendar year 2014 to calendar year 2015, Oklahomans lost $13 billion in Oklahoma taxable income. The static loss of that income in personal income tax dollars, which ordinarily would have been collected by the State, is $363 million. The price of oil went from more than $100 per barrel late in the fall of 2014 to around $30 per barrel in 2015. Oklahomans reduced their purchases subject to sales tax and use tax by $4.1 billion from FY 2015 to FY 2016, according to data from the state’s Comprehensive Annual Financial Report (CAFR).