An uneven revenue recovery, reduced spending flexibility, labor and pension pressures, and questionable willingness to pay, will likely result in a continued above-average rate of local government downgrades in 2013, according to Fitch Ratings.

While severe downgrades in 2013 are possible, most are expected to be in the one-to-two-notch range.

"The prolonged period of declining to flat revenue over the last several years has taken its toll on local government budgets and service levels, so the expected, modest growth will provide scant budgetary relief," said managing director Amy Laskey.

Fitch's outlook for revenue is more positive than it has been in several years, although notable risk exists. Positive momentum could stall if Fitch's assessment of the bottoming out of housing values by 2013 proves premature, if the federal government does not act to avoid the fiscal cliff, or if federal decisions on deficit reduction prove more negative for state and local budgets than expected.

Fitch expects property tax base declines to slowly reverse, with flat to increasing property tax revenue expected in 2013. Moderate single-digit annual sales tax growth is also expected. Other economically-sensitive tax revenue will likely remain more volatile than either property or sales tax revenue but Fitch expects some level of growth in most areas in 2013.

Reduced spending flexibility — exacerbated by years of cuts — increase pressure on local governments to create labor efficiencies and seek pension reform.

Evidence in a limited — but increasing — number of municipal bankruptcies of management's lack of willingness to make debt service payments a priority, much less treat them as a mandatory cost, is a great concern.

Fitch believes the federal tax increases and spending cuts scheduled to take effect in 2013 will be voided or at least temporarily deferred, avoiding a fiscal cliff.

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