Chart 1

Our View Reflects An Expectation That Local Governments Will Meet The Challenges Of A Recession

With our baseline forecast for a recession in 2023, the local government (LG) sector's track record of active budget management will be the key to credit stability. S&P Global Economics' most recent forecast ("Economic Outlook U.S. Q1 2023: Tipping Toward Recession," published Nov. 28, 2022, on RatingsDirect), includes projections for a shallow recession in the first half of 2023. Regardless of how well-prepared governments are, a prolonged period of economic weakness can have a long-term effect on economic growth, including tax base expansion, a key driver for local governments that primarily rely on property tax and other locally sourced revenues. Reserves could be drawn down somewhat in the near term to offset revenue weakness; however, we do not necessarily view this as a credit stress given that starting reserve levels are elevated.

State budget stability will be a critical focus.  State credit quality remains very strong (see "Outlook For U.S. States: Rainy Day Funds Will Support Credit In A Shallow Recession," published Jan. 5, 2023, on RatingsDirect) with healthy rainy day fund balances and most key revenue sources running at or above forecast. Softness in this trend could be a harbinger of fiscal pressure for LGs, particularly in the face of recession. Given the balanced budget requirement almost all states have, revenue weakness almost certainly means cuts to local government revenue sharing and per-pupil aid.

We expect shifts as post-pandemic effects linger beyond 2023.  Post-pandemic adjustments will continue for the foreseeable future and at least until a new normal is determined (if it ever is). This will require ongoing adjustments to address pressures that could range from health services delivery to tax base stagnation. LGs will also be challenged to respond to out-migration from metro areas and in-migration to rural and exurban areas. These changes could have tax base and operating implications for both the sending and receiving communities, but we expect LGs will be able to adjust to these shifts as needed to maintain credit quality.

Sector Top Trends In 2023

Availability of federal stimulus can help stabilize credit quality

COVID-related federal support allows LGs to start the recession from a strong position.  While there are limitations to using the State and Local Fiscal Recovery Fund money, the dollars are generally fungible enough to be used for a wide range of expenditures, making it a helpful source of flexibility during a recession. If the stimulus dollars were used to offset revenue losses, they're now part of unrestricted reserves and can be deployed as needed. However, while federal COVID stimulus might be relatively fungible it's not infinite and can't be the answer for budget imbalances for a prolonged period.

In other recessions, aid came after the economy had deteriorated, not at the front end.  Having stimulus dollars now allows LGs to confront recessionary pressures from a point of strength and provides time for contingency planning. School districts received three rounds of funding from the federal government during the pandemic and many have been able to maintain stronger reserves as a result. For schools, having funds on hand is also a stark contrast to prior recessions where districts were more likely to see cuts in state funding.

Many LGs still have unspent stimulus money.  The requirement to obligate funds by 2024 means that many issuers still have stimulus funds on hand. Issuers that don't experience fiscal stress that requires reallocating funds will still be able to use it for capital or other projects as planned, providing a boost to the local economy. LGs that have already spent it to the benefit of tax base growth will be in a better situation, but that is likely a small fraction of issuers.

Chart 2A

Chart 2B

Economic trends could have lasting implications

Property tax base trends will be important.  Although the recession is forecast to be shallow, a prolonged contraction that leads to a slowdown, or even just a cooling-off, in the housing market could affect property values (and thus property taxes). Even if a housing market slowdown takes a while to affect the tax base during an economic contraction, its effects can slow other types of revenues that local governments depend on, such as sales taxes and real estate transfer taxes. However, even with softness in the housing market, home price appreciation is still pushing affordability out of reach for many Americans. We don't expect this will affect the property tax base now, but less homeownership and more rentals could have an effect over time.

Inflation and the trajectory of long-term economic growth are still pressure points.  Most LGs have managed high inflation without significant credit deterioration to date, but even as inflation eases wage pressure may linger. Contracts settled now with high annual wage increases can have a long-term effect on structural balance, particularly if revenues start to fall during a recession. Inflation also affects other operating costs like health care where rising prices will exacerbate the challenge of maintaining structural balance. Rising costs could also contribute to scaling back infrastructure projects or result in issuing additional debt in order to complete projects, which could limit progress on addressing overall capital needs.

Some LGs will be more vulnerable to credit deterioration than others; relative strength after the pandemic will be important.  Governments that suffered more significantly from COVID economic dislocation may have used more of their federal stimulus dollars to shore up operations, limiting the amount that could be repurposed. LGs that have more reserves built up—both from federal stimulus and elsewhere—will have a better opportunity to stave off credit pressure. However, LGs must actively manage economic-related pressures to retain financial stability when stimulus funds run out, making sure to wean themselves off it or potentially find themselves facing a revenue cliff.

Chart 3

Responding to post-pandemic norms and other challenges that require constant adjustments

Return-to-office is a wild card.  The shifting sands of return-to-office make it hard to know what the downtown landscape will look like, given that many businesses are downsizing but keeping an office footprint. If there is a permanent shift away from the downtown core the problem will be broader, but because of how real estate assessments work, it will likely take several years for the impact to be felt. Considering this lag, proactive governments should be able to adjust to accommodate changes

Shifts in school enrollment haven't all shaken out.  Many schools report pupil counts remain down, particularly from pandemic relocation. Districts where enrollment drives per-pupil revenues have a greater vulnerability given that rapid loss (or gains) in enrollment can pressure operations. The challenges of finding qualified teaching staff post-pandemic places additional pressure on operations. Federal stimulus dollars on hand can assist by providing a cushion to operating reserves, but districts will also need longer-term strategies.

Chart 4

Rising fixed costs present a long-term challenge

Slower tax base growth and lower pension fund earnings in a down market can be a one-two punch.  Although 2021 pension fund earnings help offset weaker 2022 earnings, particularly since many pension funds smooth earnings over several years, prolonged lower pension fund results can have a budgetary impact. The longer these recessionary impacts last the higher the chance that they could result in credit quality deterioration. When these two credit drivers converge at a weaker point it limits capital investments that would bring growth, particularly for capital-intensive infrastructure needs related to resiliency and deferred maintenance.

Despite strong support from voters, higher borrowing costs could limit flexibility.  In November 2022, voters approved 81% of bond ballot measures for municipal issuers, demonstrating continued strong support from constituents. However, elevated interest rates are a hindrance for new sales since without advanced refundings higher interest costs incurred now will be in place for some time. In addition, higher interest rates for home buyers also limits affordability, which can have an impact on tax base growth over time. If fixed costs for homeowners remain high—particularly while the state and local tax deduction is capped—it could soften voter support for new projects and taxes.

Staying on alert for cyber attacks and severe weather events.  Maintaining cyber awareness and weather preparedness is critical for all LGs regardless of size or location. While cyber was once considered an afterthought for many LGs, the prevalence of attacks in recent years indicates the importance of a robust cyber security plan. Severe-weather preparedness is equally critical, particularly when it requires infrastructure investment or other long-term planning to address.

Chart 5

Regional variation in credit conditions is likely

We expect some areas will be affected by recessionary pressures more than others.  Regardless of geographic location, being prepared is critical. Having a plan in place in advance to address recessionary pressures can help maintain credit stability, particularly if some of the more difficult cuts (like layoffs) have been planned. Loss of revenues from sales or other taxes could also create disruption, although many LG issuers have already budgeted conservatively for 2023, particularly following high sales tax revenue growth in 2020 and 2021. Of particular concern is the rate of contraction in housing starts; the regional projection calls for a drop ranging from 17% (Pacific) to 33% (Mid Atlantic). Considering the challenges of affordability fewer housing starts now mean more price competition for existing homes in the future.

These five key data points generally correlate to tax trends and demonstrate which regions may be most vulnerable to anticipated economic pressure. While there are few significant outliers when comparing projections, confluence of weaker--or stronger--trends could affect the economic stability in some regions. Of the nine U.S. Census regions, only one, the Middle Atlantic, has four of the weakest projections, and no region has more than two of the strongest projections. As the U.S. ages, some negative trends could be exacerbated by higher dependent populations that aren't offset by growth in working-age residents. As these kinds of variations play out in local economies, some regions could see more pressure on credit quality than others.

Chart 6

Chart 7