State and local government credit headwinds persist.

• Author: Holmes, Christopher

Moody's Investors Service's credit outlook for state and local governments over the next year is negative on a backdrop of persistent budgetary challenges stemming from macroeconomic risks, federal budget cuts, and uncertainty pertaining to looming federal sequestration. We have maintained a negative outlook for the state government sector for five consecutive years, and for four consecutive years for the local government sector.

Rising expenditures and liabilities related to employee pensions and health-care benefits will be a growing challenge for governments with materially underfunded plans, spurring some to propose cutting benefits or increase employee or local government contribution requirements. Medicaid-related costs will be on an upward trajectory for the foreseeable future, though states can now opt out of Medicaid expansion, according to the Supreme Court's ruling on health-care reform.

In the midst of these challenges, state revenues have started to grow, and some states are rebuilding reserves or restoring funding to programs that they previously cut. Local governments, on the other hand, are under more pressure than their state counterparts, especially considering that they typically have less flexibility in raising revenues and are running out of room to further cut services. Though a housing market recovery is emerging, property tax revenues, which account for a large portion of local government revenues, will remain depressed in most regions for the foreseeable future. Moreover, state aid to local governments will continue to stagnate as states rein in spending. Some local governments that guaranteed debt of straggling government- or private-development enterprises will face additional pressure as these organizations succumb to economic malaise.

FEDERAL CUTS

Eventual expenditure cuts at the federal level could have more direct consequences for Medicaid and other state programs. These cuts may also hurt state revenues through reductions in federal employment or procurement contracts, which in turn would crimp state aid to local governments. The scope and size of federal austerity measures will affect some states more than others, but overall will be a drag on the economy. The cuts that U.S. state and local governments have made themselves, including ongoing payroll reductions (see Exhibit 1), will also continue to weigh on the economy.

STATE REVENUES CONTINUE TO GROW, BUT MORE MODERATELY

State tax revenues have increased for ten consecutive quarters, into calendar year 2012, but the pace of increases has slowed in recent quarters (see Exhibit 2). Tax revenues increased by 3.2 percent in the second quarter of 2012 from the same quarter of the previous year, the smallest percentage increase since 2010. On an inflation-adjusted basis, state tax revenues are still lower than pre-recession levels; in the second quarter of 2012, 24 states reported lower tax revenue collections than in the same quarter of 2008. (1) The fate of tax revenue growth rests largely on consumer confidence and its impact on taxable retail sales in addition to the health of the labor market and the corresponding level of income tax receipts. Revenue growth to date has nevertheless been sufficient to allow states such as Michigan and Ohio to begin replenishing reserves.

LOCAL GOVERNMENTS' MAJOR REVENUES ARE STAGNANT

Local governments are primarily funded by property taxes (roughly 30 percent) and state aid (about 35 percent), both of which have been under pressure for several years and are expected to remain so over the next two or three years. Property tax revenues typically lag changes in market real estate values because of local governments' assessment practices. The most pronounced property tax declines are in regions that experienced the more severe real estate market disruption.

According to Moody's Analytics, there are signs of gradually improving housing market conditions, based on the pace of residential home sales, inventory levels, and building permits. (2) As of September 2012, home prices increased for eight consecutive months after...