What's Behind Our Sector View

The sector's good revenue trends and ability to manage revenue and expenditure fluctuations.   Despite some weakening in the economic picture, revenue collections remain on track for local governments because of stability in property taxes and state-shared revenues as well as strong sales tax collections. Higher investment earnings have also supported revenues, a helpful trend since many local governments are hesitant to raise property taxes, given elevated inflation and economic uncertainty. Although some revenue drivers--such as commercial real estate shifts or a slowdown in consumer spending--reflect changing post-pandemic trends, to date they haven't had a significant negative impact on overall revenues. In fact, for many governments, sales taxes have rebounded to fiscal 2019 collection levels, further supporting revenue stability.

Support from federal stimulus.   With a receipt and spending time frame spanning multiple years (2020-2026), local governments continue to enjoy the support provided by federal money distributed during the pandemic. The financial cushion from stimulus dollars has allowed local governments to address localized economic, staffing, or other pressures and still contribute to an overall rise in reserves. This once-in-a-lifetime extraordinary revenue influx places local governments in a good position to address shifting budget needs, both current and potentially long term.

Economic weakening at the national level that has local impacts.   Local governments' credit stability continues despite ongoing economic pressures like high borrowing costs and slowing GDP growth (see "Economic Outlook U.S. Q1 2024: Cooling Off But Not Breaking," published Nov. 27, 2023, on RatingsDirect). However, an elevated cost of capital combined with higher prices for goods and services can squeeze operations and push up carrying costs over a longer time horizon. Local governments might also find it difficult to offset negative revenue trends arising from the expected slowdown in consumer spending, which has a direct impact on sales taxes; S&P Global Ratings' current consumer spending forecast calls for 1.8% and 1.6% growth in 2024 and 2025, respectively, down from an estimated 2.2% in 2023.

Sector Top Trends

Macroeconomic factors will test local governments in 2024

Higher-for-longer interest rates crowd out other spending needs and create long-term budgetary pressures.   An extended period of higher cost of capital--and no tax-exempt advanced refundings to employ when rates fall--is creating a period of elevated carrying charges that governments need to accommodate in their budgets. Median debt service carrying charges in 2023 for cities, counties, and school districts are 9.1%, 6.5%, and 8.9%, respectively (these figures do not include pension contributions). Higher fixed costs limit budget availability for other needs, and if sustained over a longer period can affect the ability to fund costly infrastructure, or to undertake new endeavors like the transition to electric vehicles. If higher interest rates are accompanied by slower tax base growth or a period of lower pension fund earnings, that one-two punch could start to strain credit quality if not actively managed. For governments with limited options to keep operations in balance, it could also result in the use of reserves.

In a difficult hiring environment, lower wages can't be used to offset other costs.   Prolonged high inflation has brought elevated operating and supply costs; flexible pandemic stimulus has helped to offset some of these rising costs, but it won't last forever. Lower jobless rates are usually good for local governments and S&P Global Ratings' projections include only a slight rise in the unemployment rate, to 4.3% in 2024 from a projected 3.7% in 2023. However, wages are already on the rise, which can make low unemployment a double-edged sword that results in hard-to-fill job vacancies being even harder to fill without pushing employment costs up further. Post-pandemic employment and wage growth have been climbing at different rates and widening the gap (chart 1). If higher costs are included in multiyear contracts, the likelihood of operating pressure increases, particularly if revenues don't keep pace with rising expenditures.

Chart 1

Federal stimulus spending will be in full swing during 2024

Stimulus will provide stability over the short term.   The influx of federal stimulus during the pandemic provided a variety of support for local governments, from revenue replacement to infrastructure spending. It also had a notable effect on reserves for both local governments and school districts, supporting consistent increases in the average general fund balance to over 50% for cities and counties and nearly 25% for school districts (see chart 2). Even considering economic headwinds such as higher interest rates, we expect a cushion of reserves will help local governments maintain credit stability. Federal stimulus also supports state credit strength, and could help stave off credit deterioration, particularly because some states have begun to see softness in key revenue streams like income taxes; weaker financial performance at the state level often leads to lower state-shared or per-pupil revenues for local governments.

Chart 2

As stimulus wanes, don't expect a cliff.   As federal stimulus funds approach obligation and spending deadlines in the next two years, governments that have come to rely on the extra liquidity and additional revenues will have to adjust their budgets or risk credit quality deterioration. As of June 2023 (the latest figures available), approximately 44% of State and Local Fiscal Recovery Fund dollars had been spent with another 17% obligated but not yet spent, leaving 39% left to obligate and spend. Larger governments have been using stimulus money for a wider variety of expenditures, unlike smaller ones that have primarily used it for revenue replacement (charts 3 and 4). Local governments that added permanent programming and staff or implemented sizable wage increases with stimulus will likely face the biggest difficulty in adjusting to the end of the money. Even governments that used stimulus funding only for one-time expenditures could experience a drop in reserves as they absorb inflation-driven cost growth. We expect most local governments will adjust their budgets to accommodate the loss of one-time revenues, avoiding structural imbalance and weaker credit quality. (For more information, see "U.S. Local Governments And School Districts Still Benefit From Stimulus As The Clock Ticks Down," Dec. 4, 2023.)

Chart 3

Chart 4

Economic and post-pandemic shifts in commercial and residential real estate persist

Tax base implications could be notable.   Shifts in commercial real estate and the evolution of downtowns across the U.S. are a headwind for many municipalities nationwide (chart 5). Most local governments have at least some reliance on property taxes to support operations, and tax base shifts for issuers with large and faltering commercial centers are possible. Although commercial tax rates are generally higher, residential real estate still makes up the bulk of the tax base, approximately 60% in most cities. However, in addition to being a critical source of revenues, the commercial component is also essential to location desirability. The loss of sales tax revenues from the $2,000-$5,000 spent per person, per year, from commuters could be felt more keenly, especially as S&P Global Ratings projects consumer spending will slow in the next two years. Many U.S. cities are exploring new uses for shuttered commercial buildings, from housing to universities, but playing catch up to stabilize the tax base could create a shortfall as the conversion occurs. We expect that management teams will be proactive in managing tax base changes to avoid deterioration, particularly if they could translate to revenue loss. (For more information, see "Could Empty Offices Lead To Empty Coffers For U.S. Cities?" June 22, 2023.)

Chart 5

Housing sector imbalances create long-term problems.   With a year-over-year change of 3.9% in September, the S&P CoreLogic Case-Shiller national home price index shows a return to growth in 2023 following steady declines in the second half of 2022. S&P Global Ratings estimates residential properties are overvalued in 85% of metropolitan statistical areas (down from 90% in 2022), adding to affordability issues created by high mortgage rates. New home construction--an S&P Global Ratings projection of 1.3 million units in 2024, down from 1.4 million in 2023--does not meet market demand, much less address a backlog estimated at 6.5 million units. Without closing the gap between supply and demand, home prices will remain high, and any shifts in property taxes toward residential payers due to changes in commercial real estate valuation would only exacerbate affordability.

School districts face broader concerns post-pandemic

Some school districts are facing an uphill battle juggling learning loss and the ESSER spending deadline.   Unlike the December 2026 spending deadline for state and local governments, ESSER must be used by Sept. 30, 2024, giving school districts only a few more quarters to spend their stimulus dollars. As of August 2023, nationally school districts had spent 45% of their ESSER money, leaving a sizable amount to be spent during 2024.

For most school districts, the overall impact to credit quality from ESSER money will be driven largely by their financial position before the pandemic, but financial pressures from needs post-ESSER, such as learning loss, will also play an important role. Estimates indicate that immediately following the pandemic, the average student was lagging by approximately one-half of a year in math and one-third of a year in reading. Each year lost takes approximately two full years of tutors, double math, summer school, and a longer school year to make up, which could result in expenditure pressures for some issuers.

Learning delays are 10 times greater in some states than in others, creating a disparity in needs and operating costs in the future. However, cutting extra learning now to balance the budget will translate to lower expected income levels for students as well as lower GDP growth. Falling enrollment nationwide only exacerbates the situation for school districts that are funded using an enrollment-based formula: projections by the U.S. Department of Education indicate 68% of states will have fewer students between 2021 and 2031, with an average decrease of 5.1% (see map).

Some trends require active management to maintain long-term credit quality

Planning for demographic shifts could support future credit stability.   As the cost of living continues to rise and new housing doesn't keep pace with demand, housing affordability and homelessness are increasing problems for many municipalities. An influx of migrants is exacerbating this in some regions and adding to social services costs. In addition, global aging trends could put pressure on issuers over the medium-to-long-term horizon. However, unlike severe weather or cyber attacks, some issues affect certain local governments more than others. Many cities have been addressing ongoing issues like migration and housing affordability for some time, but even with time and money, they can still be difficult to get under control. State and local governments are shouldering the rapidly growing cost of housing migrants as their numbers increase (see chart 6) and it's likely to create a sizable expenditure burden; in November 2023, the immigration court backlog reached 3 million pending cases, an increase of 1 million from 2022. If the issue is significant enough for long enough, such a shift in costs and social service requirements could affect credit quality.

Chart 6

Weather, climate, and technology dependence change bring fresh challenges.   With weather events intensifying in severity and frequency, wildfires and other extreme weather events are a growing issue for local governments across the country (chart 7). Cyber attacks are also an unpredictable occurrence, and in a recent survey, 81% of school districts--a major target for cyber criminals--said their biggest concern regarding potential attacks was insufficient funding to address cyber security. Even considering slightly more predictable risks associated with hydrological variability, these problems all have the same thing in common: a need for comprehensive, proactive management to maintain the strength and stability of the local economy. Weather and climate issues also have the propensity to affect cost of living for residents, from tax rates to homeowner's insurance. The availability and cost of homeowner's insurance is shaping changes in states like California and Florida where fewer commercial insurers are writing policies. While major storms rarely have an immediate negative impact on credit quality, when these long-tail problems build up over time, they can create economic and operational stress if not addressed effectively. (See "North American Wildfire Risks Could Spark Rating Pressure For Governments And Power Utilities, Absent Planning And Preparation," Nov. 29, 2023.)

Chart 7

Pension funding remains an important part of assessing long-term fiscal stability.   Market returns in 2023 are likely to show some recovery from 2022's losses but are unlikely to soon rebound to the highs seen in 2021. The impact of large swings in market returns on funding levels in big cities (see chart 8) emphasizes the importance of pension funding discipline that increases long-term plan funding rather than just holding current levels. For issuers with inflexible benefits and inadequate funding, deferring payments through methods such as extending amortization schedules is sometimes used to provide budgetary relief. However, these kinds of tactics can lead to intergenerational inequity where benefits are supported by a generation that probably won't receive such benefits themselves. Although we don't view weaker pension funding discipline as a common issue for local governments, using this approach to balance the budget is likelier to result in a negative effect on general credit quality. (See "Pension Funded Ratios Fall For Most U.S. Big Cities On Weakened Investment Returns," Oct. 19, 2023.)

Chart 8

Ratings Performance

Underscoring the stability of the sector, as of Jan. 1, 2024, 98% of local government ratings had a stable outlook, with only 1% each with a positive or negative outlook. Although the same stable/positive/negative distribution was consistent during 2023, it was a notable change from rating outlooks in 2021 and 2022. In January 2021, 4% of the outlooks on local government ratings were negative and none were positive. By January 2022, 3% of outlooks were still negative and 2% were revised to positive.

Chart 9