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Sudden changes to—or uncertainty about—the path of federal policy could cause credit instability for some U.S. local governments. More specifically, President Trump's plan to eliminate the Department of Education clouds the outlook for federal funding of public K-12 school districts.

What We're Watching

While U.S. local governments (LGs) have historically been nimble enough to adjust their budgets to accommodate changes (which we expect to continue), uncertainty about federal policy—and its impact on revenue and spending—muddies the waters for management teams' planning. Any related effects could be exacerbated for those governments struggling to maintain balanced budgets amid elevated labor costs and the end of federal pandemic stimulus.

Moreover, a sharper-than-expected economic slowdown resulting from federal policies such as higher tariffs could contribute to credit deterioration.

As the president's order to freeze trillions of dollars in federal funding wends its way through the courts, it's important to understand the important role federal grants play in LG operations. Even though this grant funding is typically a fraction of what a government pulls in via property or sales taxes, the loss of any revenue can weigh heavily (in the absence of corresponding spending cuts) because these governments generally operate on very tight margins.

On average, U.S. states receive more than 30% of their operating revenue from the federal government, compared to less than 5% for LGs. But given that 30% of LG operating revenue comes from state sources, federal government policy changes can still affect LG credit stability.

While federal policy shifts would be felt broadly across all governments, the impact to education funding for kindergarten-to-12th-grade (K-12) schools highlights the vulnerabilities of many local school districts. It's uncertain how the details of the president's executive order "to begin eliminating" the Department of Education (DOE) will unfold and what any changes would mean for federal funding of local education agencies. (A coalition including the National Education Association, the country's largest labor union, has sued to stop the dismantling of the DOE, claiming the president exceeded his constitutional authority with the order.)

What We Think And Why

Higher tariffs, tighter immigration controls, and/or threats to government funding (such as that for Medicaid) can create broad-based pressure, affecting some LGs more than others. Given possible disruptions in the flow of federal revenue, we view liquidity as an important buffer for LGs to maintain credit stability. If there are significant education-related federal aid cuts or delays, liquidity would become increasingly important—particularly for those schools or districts that depend most on federal dollars.

Across the country, K-12 schools receive, on average, $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 just 7% in New York state to 23% in Mississippi.

The largest federal spending on K-12 education goes to schools serving economically disadvantaged students, with significant spending on free/reduced price lunches and special education. Funds are distributed based on income levels, and the amounts within a state can vary widely (thus highlighting the importance of looking at each borrower on a case-by-case basis to assess credit effects).

What Could Change

The potential disruptions for local school districts go beyond the possible shuttering of the DOE and any related interruption of federal funding. While the amount of federal revenue in operating budgets is limited, school districts often depend heavily on state funding. Therefore, disruption to revenues from the state can quickly hit operations.

Should Congress pass (and the president sign) legislation that includes significant cuts to Medicaid, states might be forced to adjust school funding to balance their own budgets. This means that even if major changes to the DOE proceed without a loss of federal revenues to schools, K-12 public schools could still suffer.

As lawmakers hammer out a budget agreement, the immediacy of this pressure will become clearer. However, even if there are major cuts to Medicaid, we don't anticipate that states would automatically cut K-12 education funding.

In any event, we expect local school districts (particularly those that carry higher ratings) to plan for eventual changes to critical technical or administrative funding support provided by the DOE. S&P Global Ratings will monitor the response by schools in our K-12 portfolio that depend most on federal revenues. If, and when, we see shifts in funding or policies that affect day-to-day operations, we could take rating actions on an individual basis.

Writers: Joe Maguire and Molly Mintz