What's Behind Our Sector View

As local governments grapple with higher costs following several years of high inflation, a weakening national economy will exacerbate challenges.   Bolstered by strong reserves due in part to federal stimulus during the pandemic, local governments (LGs) are well placed to weather challenges. However, slower forecast GDP growth in 2025 and fewer anticipated rate cuts from the Federal Reserve will create additional strains as LGs continue to accommodate rising operating costs from inflation and wage and salary growth. Pressures on the revenue side persist with soft turnover in the housing sector as interest rates remain restrictive, limiting tax base appreciation. Adding to these stresses, some federal policy expectations from the new Trump administration, including on immigration, could have a marked effect on local economies by reducing the workforce and school enrollment. Fewer people also mean lower sales tax collections, potentially reducing an area of solid revenue growth many LGs have enjoyed for some time.

LGs will face the paradox of maintaining operating stability as the revenue and policy environment becomes increasingly unpredictable.   The pace and magnitude of policy changes from the new Trump presidency are impossible to guess. However, as in the first Trump administration, we expect some policies will adversely affect some LGs more than others, particularly large cities and counties. This uncertainty can disrupt the focus of LGs and add risk for those whose policies put them at odds with the administration. However, in our view, governments are generally well prepared to maintain credit quality as they address these challenges, and the stable foundation of state credit quality remains supportive for LGs.

Adaptive budget management will keep the sector stable.   LGs are known for active management of fiscal challenges as well as their ability and willingness to adjust budgets to maintain operating balance. S&P Global Ratings expects more budget balancing will need to come from the expenditure side, given the impact of inflation and affordability on voter willingness to approve tax increases. In our view, in changing and uncertain times the governments most able to weather the storm without a deterioration in credit quality are those with robust planning skills and back-up plans ready to put into action when the policy or financial landscape changes. Starting from a position of financial strength will help LGs address the hurdles, but a proactive management response remains critical. Increasing turnover or shortages in financial management or accounting personnel could, on the margin, affect issuers' ability to conduct financial oversight, maintain proper internal controls, and produce timely and transparent financial reports, all of which raise governance risk and, in some cases, limits issuers' ability to maintain strong credit metrics that support our ratings on LGs.

Sector Top Trends

Higher costs, slower growth, and economic and policy uncertainty will test even the most resilient governments.   Heightened uncertainty in 2025 regarding federal policy--fiscal and otherwise--will complicate financial planning and decision-making for LGs, and will be exacerbated as the pace of economic growth slows and costs remain stubbornly high.

Economically sensitive revenues will increase at a slower pace, while uncertainty around the timing and extent of federal policy changes will make them more difficult to predict. Even property taxes--historically a source of stability through economic downturns--could stagnate in some cities if pain in the office real estate sector weighs on taxable valuations. At the same time, still-elevated costs of labor, construction, and financing will limit governments' expenditure flexibility.

Chart 1

As the federal government takes up budget negotiations next year, we're watching fiscal policy closely. A reduction in funding for programs administered by the states, in particular Medicaid, could have wide-ranging consequences for state and LG budgets and their ability to keep funding current priorities. Counties, often the medical providers of last resort for underinsured populations, might have limited ability to reduce emergency and inpatient expenditures in the event of a broader devolution of health care spending to states. Still, even a unified Republican government could be hard-pressed to make sweeping funding cuts; states on both sides of the aisle have benefitted from federal spending programs, including Biden-era CHIPS and Inflation Reduction Act funds.

S&P Global Ratings Economics forecasts a downshift in U.S. GDP growth in 2025 to 2% versus the three-year average 2.7% that has supported local economic growth and helped revenues exceed expectations (see "Economic Outlook U.S. Q1 2025: Steady Growth, Significant Policy Uncertainty," published Nov. 26, 2024, on RatingsDirect). Within our rated universe, we observe a historical relationship between GDP growth and operating results, indicating the possibility of weaker operating results as GDP falls (see chart 2). In addition, significant uncertainty about the pace and extent of federal trade, immigration, and fiscal policy change creates greater risks around the baseline, requiring LGs to be nimble and adaptable, even as other fiscal pressures mount. The uncertainty will keep governments on their toes, requiring more active management of risks and, potentially, more frequent budget updates to reflect changing conditions.

Chart 2

Strong financial performance supports cities and counties' credit stability.   Good revenue trends and the availability of federal stimulus have helped support LGs' financial operations and allowed issuers to build a reserve cushion even as expenditures have risen with inflation (chart 3). As signs of a weaker economy loom, this fiscal prudence will help support credit quality.

Chart 3

The deadline for designating American Rescue Plan Act (State and Local Fiscal Recovery Funds [SLFRF]) money was December 2024, but the spending deadline isn't until December 2026, leaving two years in which LGs must spend the stimulus funds. The majority of the $261 billion SLFRF spent to date has been for revenue replacement (chart 4). We expect that governments who used the money to offset recurring expenditures--a practice most prevalent among smaller entities--will have greater difficulty closing their budget gaps, particularly as the economy slows. Although relying on reserves to bridge the gap during a short period of budgetary mismatch isn't an immediate indicator of weaker credit quality, an active response to shortfalls is essential to maintaining credit stability.

Chart 4

In recent years, some smaller issuers have faced financial management constraints caused by skilled labor shortages, management turnover, and a dearth of auditors. To the extent these limitations affect issuers' ability to conduct financial oversight, maintain proper internal controls, and produce timely, transparent financial reports, they could affect our view of management and overall creditworthiness. Good governance practices are also essential for managing costs such as sizable unfunded pensions. Governments that haven't actively managed large obligations could be particularly vulnerable to any factors that weaken their ability to fund both legacy and current operating costs.

More frequent and costly extreme weather events will require greater intergovernmental support and test local resilience to climate risk.  The frequency and cost of disasters are increasing; in the U.S., the average annual cost of billion-dollar disasters rose to $123 billion in the past five years from $62 billion in the 2000s (CPI adjusted) (chart 5). At the same time, extreme weather events are making it increasingly difficult for property owners in certain parts of the country to find affordable (or any) insurance, which could dampen housing prices and local economic growth in the longer run.

Chart 5

State and local governments rely heavily on federal disaster relief funds to rebuild and recover from extreme weather events, and emergency public assistance to state and local agencies has nearly doubled in the last decade, excluding the pandemic (see chart 6). While we expect federal support for disaster recovery will not waver, any delays in funding the Federal Emergency Management Agency (FEMA) could interrupt rebuilding and recovery efforts from previous disasters. As usual, Congress will have to act to authorize additional funding for disaster recovery early in 2025 ahead of the next major event; however, the administration transition and multiple fiscal and policy deadlines in 2025 could complicate the legislative process.

Chart 6

As the cost associated with climate-related disasters climbs, we expect that the balance of risk sharing between federal, state, and local agencies will continue to evolve, particularly around flood risk. This year, for example, FEMA announced a new resilience standard for flood zone rebuilding projects that use public assistance funds. In the long term, for LGs exposed to climate-related disasters, evolving risk and underwriting standards will raise costs of rebuilding and will likely lead to additional debt and liabilities associated with building resilience. We believe that strong governance, including disclosure, planning, and provisioning for climate-related risks, can lower credit risks for issuers with high physical risk exposure.

Strength and makeup of local economy will make a difference in how governments respond to new obstacles.   Strength, or weakness, in the tax base and local economy remains a critical factor for credit quality. Even with the pressure on commercial real estate following the pandemic, we haven't seen major changes to tax base growth trends in recent years. However, given the work-from-home landscape shift, urban centers haven't recovered from the revenue implications of fewer daytime workers. This can, and has, led to credit deterioration for some cities, but we don't view it as an outsize risk for most.

The residential housing market helps offset any deterioration in the commercial real estate market, as LGs can shift more of the tax burden to residential. Although this provides flexibility for cities to offset weaker commercial valuations, it means higher taxes for residential property owners, an outcome that increases housing unaffordability, particularly when homeowner insurance premiums are also rising. Any mismatch between housing supply and demand doesn't have a direct effect on LGs at present, but it could weigh on the longer-term growth of the property tax base and its revenue-generating potential. Home price appreciation slowed markedly in 2023 and 2024, but after two very hot years affordability remains a hurdle, especially for first-time home buyers (see charts 7 and 8).

Chart 7

2025 will reveal which school districts relied on stimulus funds for recurring commitments.  Public school districts will face their own set of challenges in fiscal 2025, among them the end of federal stimulus, a tougher state fiscal environment, falling enrollment, and continuing efforts to expand school choice at the state level.

K-12 school districts that relied on Elementary and Secondary School Emergency Relief (ESSER) dollars to fund recurring commitments such as new hires, permanent salary increases, and backfills will be most vulnerable to the end of federal stimulus. Even in cases where ESSER-funded positions are temporary, districts that used the money for staffing will need to make difficult cuts to payroll and services to balance their budgets in 2025-2026. Where federal funds were used for permanent salary increases, the fiscal pain is likely to be even greater, exacerbated by inflation and labor scarcity. And the broader economic slowdown in 2025 means that states will be less inclined to make up the difference.

In total, nearly $190 billion was awarded under ESSER. Not all states reported on how ESSER money was spent, but based on data from states that did report, a significant share (more than 50% in 2022, according to the U.S. Department of Education) was spent on labor. Districts with a higher share of students eligible for free and reduced-price lunch received the highest funding per pupil, and are likely to face the most painful fiscal cliffs, even as student needs remain high.

Schools across the country are also grappling with demographic change, leading, in some cases, to shrinking enrollment as birthrates fall and affordability struggles drive families to migrate to lower-cost areas (see chart 9). Districts with dropping enrollment that use pupil count as the driver of revenues could face budget pressure if they don't act to bring staffing and expenditures in line with funding levels. Similarly, districts that serve sizable immigrant populations could also see their funding decrease if curbs on immigration materially affect per pupil revenue.

Chart 8

Finally, a rising number of voter-led and legislative initiatives to expand school choice programs could pressure public school enrollment and funding. In November 2024, voters in three states (Colorado, Kentucky, and Nebraska) rejected ballot initiatives that would expand or enshrine school choice and state funding for non-public education expenses. But with more than 35 states already offering some form of support for school choice, we expect legislators and advocates will keep pushing for greater public funding for private education.

Ratings Performance

The LG sector remains extremely stable. As of Jan. 1, 2025, 97% of LG ratings had a stable outlook, while 1% had positive or negative outlooks (a modest increase from 1% in 2023, when outlooks were balanced). As part of the implementation of our Methodology For Rating U.S. Governments criteria published Sept. 9, 2024, we placed 436 LG ratings on Under Criteria Observation. These reviews are currently underway and will be completed by March 2025.

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