Fitch Ratings does not expect any widespread near-term rating impact for US state and local government credits due to federal deficit reduction efforts, although the efforts present much uncertainty and risk.
Until decisions are made specifying the levels and allocations of spending reductions and other actions such as federal tax changes, the fiscal impact on individual state and local governments will not be known. Fitch notes that although both state and local governments receive aid from the federal government, such funds are much more significant to state budgets. Nevertheless, local governments could bear the brunt of federal cuts to states if the states maintain budget balance by reducing aid to the locals.
The first round of cuts related to the agreement that emerged from the U.S. debt ceiling debate in August includes only $25 billion in reductions in federal fiscal 2012.
Fitch notes that the most significant risk for states is reductions in funding for Medicaid, which accounts for the bulk of federal aid to the states.
Medicaid is not affected by the first round and protected from automatic cuts. However, the bipartisan joint committee in Congress charged with identifying a second round of at least $1.2 trillion in savings to avoid the automatic cuts has the potential to affect essentially any area of federal spending, including Medicaid.
Depending on the nature of federal deficit reduction, some state and local credits will be more heavily affected than others. For example, a high income state would be hurt by a reduction in the minimum federal Medicaid match while a poorer state would not be affected at all. In contrast, an across-the-board reduction would particularly affect states most reliant on federal Medicaid funding.
On the local government level, school districts with a large low income population, counties that provide social services, or places with a large federal military, military contracting, or other federal presence are significantly more vulnerable to federal action.