Local Governments Would Still Experience Effects Of Policy Shifts Despite Lack Of Dependence On Federal Sources

On average, U.S. states receive more than 30% of their operating revenue from the federal government, whereas U.S. local governments (LGs) receive less than 5%. However, federal government policy changes can still affect LG credit stability, particularly given that 30% of LG operating revenue comes from state sources.

LGs have historically demonstrated financial resilience by adjusting budgets to accommodate changes, and we expect that to continue. However, ambiguity regarding the magnitude and duration of federal policy (and therefore revenue or expenditure) changes adds uncertainty and can paralyze management teams' planning efforts and lead to disruption. The effects of this uncertainty could be exacerbated for LGs struggling to maintain balanced budgets given persistent elevated labor costs, slowing economic growth, and the end of federal pandemic stimulus. Prolonged economic disruption and weakness resulting from federal policies such as higher tariffs could also result in credit deterioration, particularly for issuers unprepared to weather a softer economy.

Chart 1

The impact on local governments of changes to federal spending--particularly with regard to Medicaid--depends in part on how states react. For the decade prior to the pandemic (2009 to 2019), federal grants, including for Medicaid, equated to about 24% of total state and LG expenditures. Absent Medicaid and health spending, the figure was 11%. Because Medicaid flows directly to state governments from the federal government, states would be the first to confront any changes in funding and eligibility at the federal level. While historically states have made cuts to revenue sharing for LGs, they have also served as a buffer for local governments when economic pressures have arisen.

Chart 2

What's Happening

Uncertainty is the new reality, both in terms of federal policies that have been announced and in terms of prospective changes that could affect operations. Many factors, including the severity and duration of these policy changes, could affect longer-term outcomes for credit quality. In terms of credit stability, we view LGs' ability to adjust budgets to accommodate shifting revenue or expenditures as an important mitigant against the potential impact of any federal policy shifts.

Why It Matters

Higher tariffs, immigration changes, or threats to government support, such as that from FEMA and Medicaid, can create broad-based pressure but will affect some LGs more than others. In our view, bigger-picture shifts and changes, such as slower economic growth (link to latest S&P Economic forecast in November) or the possibility of municipal bonds' losing tax exemption in the Tax Cuts and Jobs Act renegotiation, could have a more wide-ranging effect on all governments across the country. For any LG facing both national-level and local pressures, the combination could accelerate credit deterioration.

The president's order to freeze trillions of dollars in federal funding by pausing grants, loans, and other financial support in January 2025 continues to wend its way through the court system. Against this backdrop, we note the important role that federal grants play in LG operations. While this grant funding is likely a fraction of what a government receives in property or sales taxes, governments generally operate on very tight margins and so the loss of any revenue can be significant in the absence of corresponding expenditure reductions. Furthermore, given the possibility of disruptions in the flow of anticipated federal revenue, we view liquidity as an important buffer for maintaining credit stability.

Nationwide, kindergarten-to-12th-grade schools receive $119 billion, or $2,400 per pupil, from the federal government, according to the Educational Data Initiative. While this averages out to approximately 13% of total student funding, the percentage varies widely by state, from 7% (on the low end) in New York State to 23% (on the high end) in Mississippi. The three largest areas of federal spending on kindergarten-to-12th-grade education are Title I, the Child Nutrition Act, and the Individuals with Disabilities Act. Because Title I and Child Nutrition Act funds are distributed based on income levels, the amounts within a state can also vary significantly, highlighting the importance of looking at each credit individually to evaluate potential credit effects. We believe that reductions in these federal programs, should they occur, could have a bigger impact on districts with a higher proportion of students eligible for free and reduced-cost lunches.

What Comes Next

S&P Global Ratings believes there is a high degree of unpredictability about policy implementation by the U.S. presidential administration and possible responses--specifically with regard to tariffs--and the potential effect on economies, supply chains, and credit conditions around the world. As a result, our baseline economic forecasts carry significant uncertainty. As situations evolve, we will gauge the macro and credit materiality of potential and actual policy shifts and revise our guidance accordingly.

Federal policy as well as changes to and uncertainty about it are important considerations for our credit analysis for U.S. LGs. We will monitor how new policy initiatives and Tax Cuts and Jobs Act renegotiations could affect LG credit quality and how management teams adapt to changes in the operating environment.