How The Debt Ceiling Debate Impacts Local Governments

By:

Michael Gleeson

Update as of 2/3/23: On Wednesday, February 1, Speaker McCarthy met with President Biden to try to forge a path forward. “I think that at the end of the day, we can find common ground,” McCarthy told reporters outside the West Wing. The White House in its read out struck a different tone, saying: “The President welcomes a separate discussion with congressional leaders about how to reduce the deficit and control the national debt while continuing to grow the economy.” Translation, lets move past the debt ceiling and find a way to address government spending, which will be a non-starter for the House GOP.

On January 19, 2023, U.S. Treasury Secretary Janet Yellen sent a letter to House Speaker Kevin McCarthy announcing the government hit the debt ceiling and would begin taking “extraordinary measures” to conserve cash in order to prevent a default on the nation’s debt. In her letter, Yellen indicated the Treasury could use extraordinary measures for a few months, setting a target date of early June as the time when the Treasury would exhaust its ability to pay its obligations.

Congress and the White House are not in agreement on next steps to raise or suspend the debt limit, as has been done in all past instances. Negotiations between the two appear stuck, with the House Republican Majority seeking concessions from the White House in the form of federal spending cuts to a variety of programs. The House Democratic minority and the White House have so far refused cuts and favor passing a “clean” debt ceiling increase, meaning one with no cuts in spending associated with it.

President Biden indicated a willingness to meet with House Speaker McCarthy, and will meet with McCarthy on Wednesday, February 1, but the way forward to resolving the impasse remains uncertain.

Uncertainty About How Long Congress and The White House Have to Reach an Agreement

The Treasury indicated early June is the date when the department will no longer be able to pay its obligations. This date is a moving target.

In April, the federal government will see an influx of cash with the tax filing deadline, which could extend how long the Treasury can continue to pay its obligations for a few weeks or a month. However, if the U.S. slides into recession, the cash collected by the federal government could be less than expected, causing the Treasury to run out of cash sooner.

The unpredictability of when the Treasury will exhaust its extraordinary measures means that a delay in finding a deal could inject uncertainty into financial markets, which could be consequential for cities, towns and villages.

How Could Municipalities be Impacted by a US Government Default?

Domestic discretionary spending, which includes federal grants for local governments, is often the part of the federal budget most vulnerable to cuts.

Of every dollar spent by the government, 25 cents is spent on Medicare and other healthcare programs, 21 cents is spent on Social Security, 13 cents is spent on defense, 7 cents is spent on retirees and veterans, and 7 cents is spent on debt service. Combined, these areas of spending represent nearly 75 percent of all government spending. Although this part of the federal budget is usually off limits to cuts, this time some House GOP lawmakers are seeking to place entitlement cuts on the table. Others do not.

Cuts to the remaining 25 percent could be big and could hit local governments hard. According to one municipal securities expert NLC spoke to, funding for infrastructure is one area where cities could see support from the federal government slashed, leaving cities to make up the gap in their budgets from reduced federal spending. Other areas that could be affected include education and housing.

Financial markets could also be impacted by a federal default or even just the uncertainty around not raising the debt limit. In 2011, America faced a similar impasse, where Congress and The White House disagreed about raising the debt ceiling. While the debt limit was raised in time to avoid a default, equity markets were roiled and liquidity in debt markets dried up.

If the U.S. defaults, it would raise borrowing costs for municipalities, leaving less money to go towards cities’ projects and forcing more money to be directed to cover debt service.

For smaller cities, a default could have a profound effect. It would have impacts on city operations, as municipalities vie to make their debt offerings more attractive in the marketplace.

Mayor Mark Shepherd of Clearfield City, Utah and chair of the Finance, Administration and Intergovernmental Relations Federal Advocacy Committee at NLC said that his city would be forced to strengthen its credit to attract investor dollars in a market where there is less liquidity. He said that the city would have to boost coverage ratios, save more cash, increase fees and taxes all “to make the case that Clearfield debt is still worth the risk.” If a city is saving cash that means less investment back into the community and increasing taxes would impact the lives of residents and possibly decrease spending by residents at local businesses.

A default would also mean higher interest rates for all types of debt at a time that residents and businesses are experiencing high inflation. The one-two punch of increasing interest rates and inflation would mean that mortgage rates would go up, businesses’ borrowing costs would increase, and businesses and residents would have fewer dollars to invest in local communities. The likely net effect for sales tax driven economies would be to see a decrease in receipts. But this could go further and effect property taxes, as mortgage rates would rise, impacting property prices, and remissions from businesses to local governments could decrease, as local governments raise taxes and residents have fewer dollars to spend on goods and services.

Takeaway

The US has been in a similar position before, and each time a bipartisan majority ultimately found a way forward before the debt limit was crossed. But with a slim majority in the House and partisanship still running high following the midterm elections, there appear to be fewer Members of Congress willing to compromise this time.

At this time, rating agencies, who are in the forecasting business, as well as markets, still believe that Congress and The White House will get through this moment. The question is at what cost to cities.