U.S.

Public Schools Experience More Competition For Funding

Primary Credit Analyst: Jennifer K Garza (Mann), Dallas (1) 214-871-1422; jennifer.garza@standardandpoors.com Secondary Contact: Sarah L Smaardyk, Dallas (1) 214-871-1428; sarah.smaardyk@standardandpoors.com

Table Of Contents
School Funding Systems Charter Schools Compete For State Funds Will Competition Deliver Better Results?

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U.S. Public Schools Experience More Competition For Funding

Funding for U.S. public schools has long been controversial, and debates about what constitutes adequate funding -and fair taxation to support it -- continue to be prevalent. As state governments experienced revenue shortfalls over the past several years, education has not always been spared from cuts. In 2009, public schools benefited from federal stimulus funds, which provided a temporary windfall and partially hedged the reduced level of state funding for many public schools during the recent recession. Standard & Poor's Ratings Services has observed some emerging trends in school districts across the U.S., including raising tax rates and using reserves to offset state funding reductions, along with reducing extracurricular programs, increasing class sizes, implementing furlough days, and eliminating staff. Policymakers at all levels of government generally recognize that U.S. students are falling behind their international peers, and that there are disparities between students of different income levels within the country. To address this, the federal government reauthorized the Elementary and Secondary Education Act, better known as No Child Left Behind, in 2002. A Senate committee has recently approved an amendment to the law, referred to as the Strengthening America's Schools Act, that provides new education options for many families, requires goals and progress targets, requires teacher evaluation systems, and provides low-income students access to effective teachers. Under federal law, parents can now choose to send their children to public schools outside of their districts if they feel the current school is unsafe or for academic performance reasons, which creates a new level of competition for public schools and charters. Overview In the recession's wake, many U.S. public school districts have had to deal with less state government support per pupil, even as concern about educational standards rises. We believe that school districts that can raise local revenues are better equipped to deal with any funding crunches. While alternatives to public schools might improve overall student academic performance, we believe they could present credit risks to public school districts in the long term.

Some states have also recognized the need to improve the overall quality of education because they view it as an important factor in economic development. We believe that in a rapidly changing economy, where technology and increased global competition have altered the employment landscape in the U.S., the quality of education and the skillset of the employment base will become an increasingly distinguishing factor when states compete for development projects. One way in which states have sought to improve education is through increased funding for charter school initiatives. The expansion of charter schools could improve the overall quality of education by fostering increased competition. At the same time, it could pose a credit risk to public school districts that cannot retain students, since many state funding systems are based on per-pupil formulas.

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U.S. Public Schools Experience More Competition For Funding

School Funding Systems

States generally distribute education funding for kindergarten-grade 12 using complex formulas in which student enrollment tends to be an important determinant. However, the specific factors in the funding formulas vary significantly from state to state. Some formulas are weighted to account for the number of students with disabilities, living in poverty, or for whom English is a second language. The allocation for students with different needs can vary significantly depending on the funding formula. In addition, the state's allocation to a specific school district may vary based on trends in the Consumer Price Index (CPI), sales tax, or income tax revenues. Moreover, some states design their formulas to give districts with higher poverty levels and less access to local funding additional assistance. The nuances of a state school funding formula can have a significant influence on a school district's credit quality. Many states use a statewide per pupil funding equalization formula, whereby higher property taxes in rich communities trigger a corresponding decrease in state aid, so all students statewide get the same amount of per pupil operational funding. In these states, wealthy districts cannot easily tap into their stronger tax base and all students, whether from rich or poor districts get similar per-pupil funding. However, bond issues for capital funding might still be more easily financed in more property-rich areas, due to their stronger ability to support them. However, in states that do not have a statewide school equalization formula for state aid, districts in property-rich areas have the capacity to significantly boost their state funding with locally approved tax levies. In these cases, there is a greater correlation between the local tax base's wealth and credit quality. In addition, a greater reliance on locally collected revenues can help minimize the impact of reductions in state funding. By contrast, schools with lower income levels and a more limited local tax base often lack the capacity to generate significant additional resources. This can often mean that children in low-income districts with the highest needs go to schools with the fewest resources, as is the case in many urban areas throughout the U.S. Many of these cities are desperately trying to close poorly performing schools or consolidate schools that are not fully used in an effort to reduce facilities costs and redirect those dollars to improving education. But many of these cities are seeing limited success, since the closing of any school is highly controversial among parents, civic leaders, and teachers' unions. In addition to the formula-specific factors, a state's overall spending priorities can have a significant influence on the credit quality of individual school districts and charter schools. According to U.S. Census data, the average per-pupil state funding level within the nation has risen overall, to $10,560 per pupil in 2011 from $10,259 in 2008. However, the increase is not equally spread across all states. According to a study from the Center for Budget and Policy Priorities, only 13 states (Alaska, Connecticut, Delaware, Iowa, Maryland, Massachusetts, Montana, New Hampshire, North Dakota, Rhode Island, Tennessee, West Virginia, and Wyoming) increased their per-pupil spending (after adjusting for inflation) from fiscal years 2008-2013. Each state has constitutional provisions that mandate a certain level of K-12 education spending. According to Standard & Poor's research on the 2014 state budgets, most states continue to provide less per-pupil funding than they did before the recession, primarily because of the sluggish pace of the economic recovery and continued population growth. Although states' major revenue streams are improving overall, most states are still projecting a slow recovery, which their latest budgets reflect. Although most states plan to increase public education funding in 2014, we've

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observed that even with the increase, many are still not providing per pupil funding at prerecession levels. Per-pupil funding for charter schools is typically the same or slightly lower than that of the local public schools for operating assistance, while there is often little or no public support for charter school capital funding.

Lawsuits challenge the adequacy of state funding

In some instances, the debate over the adequacy of school funding has moved from budget and policy discussions to the courtroom. The escalation has, in many cases, resulted from continued budget cuts and alleged inequities in school funding. According to our research, about one quarter of all states have pending or recently resolved lawsuits that challenge aspects of their funding systems. Although the details differ from state to state, this trend highlights the fiscal challenges public schools experience when revenue-raising alternatives are scarce and education spending must compete with other growing areas of most state budgets, such as health care.

Charter Schools Compete For State Funds

In addition to the increased competition between education spending and other areas of the state budget, we've observed a rise in the number of charter schools that are competing with public schools for a limited number of state dollars. In many states, funding for charter schools comes from transfers of per-pupil state aid from the school district where the student resides. Charters are, on average, receiving less money per pupil than the corresponding public schools in their areas. However, the average figure is controversial because some believe charter schools do not enroll as many students that require significant special education or student support services. In addition, some charters are not required to provide transportation or meals. These schools have also faced fiscal challenges as per-pupil funding contracted during the recession (for more information, see "Funding Volatility May Cause Public Charter School Credit Quality To Deteriorate Further," published June 27, 2013, on RatingsDirect). Charter schools are authorized and operating in 41 states, and Standard & Poor's rates approximately 187 of the more than 6,000 such schools throughout the U.S. There is a significant difference in rating distributions when comparing charter schools and public schools that Standard & Poor's rates. The majority of charter schools we rate are in the 'BBB' category, with 80% of the ratings in the low-investment-grade category; the remainder we rate 'BB+' or lower. In comparison, our rating distribution for public schools is significantly higher, with 98% rated in the 'A' category or stronger. In Standard & Poor's view, charter school ratings inherently have more credit risk than public schools because they can go out of business before final bond maturity. Factors that could cause a charter school to close include the risk of charter non-renewal or revocation, the need to continually attract students in order to receive per pupil funding, typically high debt loads, competitive pressures from other charter schools or public schools, sometimes limited depth of management, and potential changes in state funding formulas, all of which can affect charter school finances. Academic outcomes are important to charter schools in that they often can be a key driver of enrollment demand. The number of charter schools in the nation has increased significantly recently, creating competition for public and private schools. In 2011, 3.6% of students nationwide were enrolled in charter schools, according to the U.S. Department of Education. In selected cities, particularly inner cities, the percentage is much higher. For example, in

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Washington, D.C., 37.8% of students are enrolled in charter schools. California, Arizona, and Michigan have the highest number of students enrolled in charter schools. Proponents believe that charter schools can improve student achievement because their independence provides more flexibility: They can offer longer school days, adjust the curriculum to meet student needs, create a unique culture, and develop "next-generation" learning models. They also typically enroll more academically motivated students and demand significant parental involvement, which public schools don't, or can't, require. In addition, state laws require that charter schools be held accountable and have defined achievement goals embedded in their charters. These requirements are meant to force the schools to do better than local public schools or risk closure.

Will Competition Deliver Better Results?

Federal and state governments are trying to strike a balance between promoting charter schools and voucher programs and setting limits on their growth. While these programs draw students -- and their per-pupil funding -- away from local school districts, many believe increased competition is the key to better academic outcomes. We expect that if academic performance at charter schools rises, we will see a continued shift in enrollment from public schools to charter schools, particularly in urban areas. However, due to some recent restrictions on charter school growth, we think a rapid or widespread shift to charter schools isn't likely. Still, in areas where the shift to charter schools has been strong, such as New Orleans and Philadelphia, the redirection of state funds to follow students to the charter schools will continue to create greater fiscal challenges for public school districts. We believe there isn't yet sufficient evidence to determine whether competition from charter schools will have a significant impact on the overall credit quality of public school districts. The loss of students would undoubtedly put pressure on school districts' budgets, but it could also generate a renewed focus on the quality of education and an impetus to reinvest and consolidate aging facilities to attract students back. As is the case with many other factors affecting a school district, the credit impact of increased competition from charter schools will largely depend on management's response to the changing environment.

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