Urban Wire Federal Debt Drama and What It Means for State and Local Governments
Kim S. Rueben
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Financial markets have been on a pretty turbulent roller-coaster following the last minute bargain Congress struck to forestall a debt crisis, S&P’s downgrade of US Treasuries, and economic uncertainty in Europe. Most discussion has focused on national issues but it’s important to ask what this all means for state and local governments. State and local budgets are still pretty tight, with revenues well below 2008 levels (adjusted for inflation). But the current federal drama doesn’t seem to be compounding subnational government woes.

Most state and local officials knew that they were unlikely to get more federal aid after the stimulus funds dried up, but the actual deal struck by Congress is better than many states expected.  The agreement cuts federal discretionary spending a lot but largely protects entitlements, including Medicaid (and Social Security and Medicare). New limits take the form of spending caps on discretionary spending using the Congressional Budget Office’s “current law baseline,” which adjusts for inflation. Baselines are often political creations but they sometimes matter a lot—Standard and Poor’s really blew it by assuming the wrong one—and that’s clearly the case for the cuts in discretionary spending.

The money that state and local governments get from the feds is part of “other domestic discretionary programs.” Working off of an inflation-adjusted baseline means these cuts start from a higher level and thus aren’t as bad as they could be. (In the short term—i.e., fiscal 2012—the caps on discretionary spending will slice about $2 billion from non-security programs). The debt agreement may not really solve the federal debt problem but, thanks to the magic of baselines, it doesn’t do much short-term damage to state and local programs.

As Stateline pointed out, the caps actually allow for $24 billion more in spending than the budget resolution the U.S. House of Representatives approved earlier this year. That bill, which died in the Senate, proposed cutting some state grant programs by as much as 20%.

State and local governments aren’t off the hook yet.  No one yet knows how Congress will allocate these cuts across domestic programs.  The  Super Committee has broad flexibility to cut both discretionary and entitlement programs—and even raise taxes. But the chances of the panel reaching consensus are very small. If Congress can’t agree on $1.2 trillion in automatic spending cuts by the end of this year, the debt limit deal requires automatic spending reductions starting in 2012. But these exempt most of the mandatory spending that makes up the social safety net, including Medicaid, CHIP (children’s health program), TANF (welfare) and SNAP (food stamps).  A few programs that affect state and local governments, such as education funding, early childhood assistance and affordable housing  aren’t protected. But in the short term at least, the debt agreement is unlikely to  do much new damage to state and local budgets.

So what about the Treasury downgrade?  Despite getting the math wrong, S&P stood by its downgrade and even said that other issuance downgrades would follow. It has already cut its rating on some other government bonds, but those are largely housing development funds and bonds pre-funded by treasuries. S&P seems to think that any investment backed by treasuries is more at risk. Meanwhile, the other ratings agencies have largely left things alone.

The markets seem to disagree with S&P’s assessment.  In the wild ride of the past couple of weeks, Treasury yields have fallen to half century lows, and thanks to this rush to safety, many  muni yields have followed them down.  Remember that many tax-exempts are still rated AAA. Thus, the rates that state and local governments must pay on new bonds are at all-time or multi-decade lows, saving issuers money. It might be odd that a subnational government can have a higher bond rating than its parent government.  But when ratings are cut to reprimand Congress and the risk of default is still perceived to be close to zero, well, normal bond pricing rules might not apply.

So what will affect state and local governments’ bottom lines?  The stock market tumble and economic conditions. While the current uncertainty might be good for muni-issuances, it has pushed down the return on state and local investments and will possibly cut their income tax revenues too.  Specifically, public pension fund assets have lost value in the market fall, and state revenues look less rosy as capital gains turn to losses. And that will hurt states’ financial ratings.  Indeed, despite recent efforts by New Jersey to cut spending, Fitch just dropped the state’s rating from AA to AA- because of outstanding levels of debt and benefit obligations.

Federal action can definitely affect how well or poorly subnational governments fare, but the current drama doesn’t seem to have had much of a direct effect—other than that caused by sending the economy and financial markets into a dizzying tailspin.

Research Areas Economic mobility and inequality
Tags Fiscal policy Tracking the economy
Policy Centers Urban-Brookings Tax Policy Center