States face broadening credit challenges, and while local governments have shown resilience, school districts are more at risk, S&P Global Ratings said in two sector reports released last week.
The rating agency's sector views for both state and local governments are stable. But S&P pointed to growing pressure on K-12 school districts from federal, state and local factors, which threatens to weaken credit quality, it said.
"The strong revenue environment local governments enjoyed in recent years ended in 2025," S&P said, noting that local governments facing growing structural imbalances will not be able to expand their way out of the situation.
"Although reserves remain high, struggling local governments may spend them down quickly," the report said.
"There are pressures that locals will be feeling, and the states can compound those pressures; sometimes they do, sometimes they don't," S&P Managing Director Jane Ridley said. "We have seen, though, that governments are ready, willing, able to make adjustments in order to stay balanced… And there are still a lot of places with high reserves coming out of the pandemic."
S&P Managing Director Geoffrey Buswick stressed that both outlooks are stable — "and a lot of that is the strength and history that we've seen of management teams taking action in a way that heads these (credit pressures) off, a prudent approach that will preserve credit quality, as well as continuing to deliver the government services," he said.
Local governments face a slowing national economy — S&P puts the chance of a recession within the next year at 30% — and shifting migration and immigration trends. The latter mean employee shortages in construction, hospitality and agriculture, which will push up issuers' capital and possibly operating costs, S&P said.
Already, many big cities have resorted to one-time budget fixes as they're confronted by slowing revenue growth and escalating costs.
"Local governments could see lower state-shared revenues or higher costs to cover programs currently funded in whole or in part by the state, including education. For some, the resulting pressure could be significant," S&P said in its report. "We expect reserves will fall on average as local governments adjust."
The hit to credit quality will hinge on the depth and duration of credit pressures, and on how management handles disruptions, S&P said.
Counties, faced with state imbalances in Medicaid and Supplemental Nutrition Assistance Program funding after Trump administration cuts, could feel pressure to fund uncompensated care and support public hospitals, according to the rating agency.
"There are county hospitals in some places that are the main care center," Ridley said. "If there is an adjustment on the Medicaid side in terms of the payments or something else, then you can have a situation where, if it's a county hospital and they're having difficulty making ends meet, sometimes counties will go in and support those operations."
Another factor is the growing trend of
"That is part of the concern, and we have seen in the past when the state might cut back its state shared revenue, then say, 'Oh, well, you can have more flexibility in your property tax rates,'" Ridley said. "If there's a lot of talk of property tax reform, we think that could create a pressure. So it's certainly something that we are watching for."
The rating agency will also be watching pressures on fiscal federalism; economic and demographic changes, such as weaker GDP growth and slowing population momentum; how state credit health shapes the local fiscal landscape, as some states balance budgets through cuts to locals; the shrinking federal role in disaster recovery; AI and digital infrastructure; and wild cards, like the limited appetite for higher taxes and stress on local governments from public hospitals and utilities with weakened operations.
For states, S&P noted that overall state debt payments are lessening, with total general fund debt service to revenue dropping to 1.8% in 2024 from 2.3% in 2020.
"We believe that most states will be able to balance slowing revenue growth against the rising expenditure needs, while maintaining ample reserve balances," S&P said, pointing to the fact that states have some time to adjust to federal policy changes on tariffs, tax structure, immigration, federal spending and natural disaster recovery support.
The rating agency said it expects "necessary adjustments" will be made by statehouses, notwithstanding the difficult choices necessary in some cases to assure structural balance.
Buswick acknowledged there may be a greater inclination among state leaders to cut funding to local governments now than in the past. States have strong revenue and expenditure controls, he said, and they have three ways to handle a structural imbalance: create new revenues, draw on reserves or adjust expenditures, including those going to different parts of government.
"At a time when there's great uncertainty, like now, creating new revenues can sometimes be hard. Governments could be hesitant to use these reserves because they're not sure how long any type of economic challenge may occur," he said. "They may have an easier time cutting what they provide downstream than they do creating new revenues or drawing from reserves."
States, which have built their rainy day funds and seen general fund surpluses in recent years, are in a relatively strong credit position, S&P said. Only four states — Illinois, Kentucky, New Jersey and Pennsylvania — are rated in the single-A category by S&P, and none are below A.
"Few expect to draw on reserves at this point in fiscal 2026, but we'll watch to see if more draw from these healthy balances in the fiscal 2027 budget cycle," S&P noted.
There are five sector trends the rating agency is eyeing among states. Tax cuts and state efforts to conform with the One Big Beautiful Bill Act's changes to the internal revenue code "create potential volatility," S&P said, especially as corporate income taxes decline, in many cases meaningfully.
Buswick pointed to a change that allowed corporations to write off capital investments immediately, in one year, rather than in 20% increments over a five-year period. That pushed many states' corporate income tax revenue lower than the forecasts for this fiscal year, he said.
Federal government policy changes are also shifting more costs onto states. Debt capacity and recent pension discipline provide near-term flexibility, but not all states face the same fiscal pressures from retirement benefits. And absent proactive capital planning and discipline around pension and other post-employment benefits governance, states could see recent progress eroded.
However, S&P predicted ongoing support
Compounding states' problems are the demographic challenges of an aging and slower-growing nation, with productivity gains unable to overcome labor shortages. As the Trump administration ratchets up its immigration crackdown, there will be fewer people available to backfill jobs.
And energy states' growth trajectory is changing, S&P said, as states with larger mineral-producing segments see slower GDP growth. S&P expects an energy sector slowdown, with lower commodity prices than in recent years; "some of these states will likely lag peers in 2026," it said.
The rating agency will be watching for management actions and event risks. Regarding the latter, S&P said sudden cost and revenue adjustments may be necessary amid geopolitical changes, cyberattacks and extreme weather events.
"We are seeing cyber risk as a mega trend in just about every sector," Buswick said. He pointed to the
"We've seen it in the past year, very prominently in the states," he said. "And so we're monitoring to see if this risk of service delivery and revenue collections and reporting measures (impact) continues."
