WASHINGTON — Faced with the loss of stimulus aid, state and local governments are hoping the economy will rebound in time to support their budgets and defuse market concerns over credit downgrades and possible bond defaults, market participants said in their outlooks for 2011.

Government officials, who saw positive tax revenues return in the second half of 2010, are hoping the upswing will gain momentum in 2011. The revenue growth could be further supported with stock market gains and higher employment, they said.

On the other hand, funds from the American Recovery and Reinvestment Act of 2009 will be exhausted next year, leaving governments to overcome a cliff of falling revenues in fiscal 2012, which begins on July 1 for most of them. Many sources said this is the number-one concern facing state and local governments for the coming year.

Citing the budget gap concerns, Moody's Investors Service will maintain its negative outlook on the state and local government sector in 2011, said managing director Robert Kurtter. The other major rating agencies do not have outlooks for the overall state and local government sector.

Specifically, the Build America Bond program, which was not extended past Dec. 31 by the new tax law enacted earlier in the month, will likely mean that municipal debt issuance in 2011 will be lower than this year's record amount. Additionally, the loss of the higher small issuer limit for bank-qualified bonds may raise borrowing costs for small issuers, sources said.

"The trajectory is in the right direction," said Scott Pattison, executive director of the National Association of State Budget Officers. State revenues will grow by an aggregate 4% to 5% in 2011, he said.

"The big question is, how significant is the loss of the recovery act funds?" he asked. States still face budget deficits and "really tough fiscal choices," he said, adding, "There's just not going to be enough money" for some states.

State tax revenues rose 2.6% in the third quarter from the same period the previous year on an inflation-adjusted basis, according to a recent report from the Rockefeller Institute of Government. It was the third straight quarter states reported year-over-year tax growth, though some of the gains came from tax increases.

"Clearly, revenue has stabilized and is beginning to grow modestly," said Donald J. Boyd, a senior fellow at Rockefeller and co-author of the report.

Stronger consumer spending is helping state sales taxes, Boyd said. The employment market "remains pretty weak" but has stabilized, compared to last year, he said. However, "the fiscal crisis continues" as states are losing most of their stimulus funding and as budget writers struggle to find additional spending to cut, he said.

State and local finances historically lag the national recovery and this time is no different, sources agreed. As of Sept. 30, state and local spending had increased for two consecutive quarters for the first time since the second and third quarters of 2008.

But state and local growth has been anemic compared to the federal government's roaring expansion of spending.

While nationally, jobs grew in 2010, state and local governments continue to see them bleed away. State and local payrolls were cut by 198,000 between January and November, according to the Labor Department. Nagging unemployment will continue to stress government budgets, principally their income tax collections, sources said.

"The biggest risk is that revenues won't rebound quickly," said Elizabeth McNichol, a senior fellow at the Center for Budget and Policy Priorities, and a co-author of a Dec. 13 report on state budgets.

Uphill Battle
McNichol's report shows that states face an uphill battle on budget gaps in fiscal 2012.

Forty states have projected fiscal 2012 budget gaps totaling $113 billion. California and Illinois, the two lowest-rated states, face $19.2 billion and $17 billion shortfalls, respectively, for fiscal 2012.

By the time funds from the Recovery Act are fully exhausted, federal aid will have filled 30% to 40% of projected state shortfalls, according to the CBPP report. About $60 billion of ARRA funding remains for states in fiscal 2011, the report said. Only $6 billion will remain for fiscal 2012.

A jobs law enacted in August extended enhanced Medicaid funding to states through June 2011 and added $10 billion to the State Fiscal Stabilization Fund, a one-time appropriation provided by ARRA to help stabilize state and local government budgets.

Further, some states may get stung by the extension of federal income tax rate cuts. The recently passed tax act, which will continue the Bush tax cuts for all income levels for two years, could cost states $11 billion over that period due to the interaction of state and federal tax codes, McNichol said.

"We've got the cliff beginning with [fiscal] 2012," as federal aid expires, said Raymond C. Scheppach, executive director of the National Governors Association. Even with the nascent economic recovery, state revenues won't return to their 2008 levels until 2013 or 2014, he said.

Governors are not looking for additional federal aid in fiscal 2012, he said. Instead, they will be focused on pension reform and generating additional revenues, he said. States may try to get more sales tax revenues from service transactions and goods sold online.

"This 'great recession' was just a game-changer," he said. States "are moving from survival mode" to "long-run sustainability."

Twenty-nine states are welcoming new governors in 2011. There is a concern that some of the new governors will "make choices that slow down the economic recovery by cutting essential services and looking just at the spending side of the budget," McNichol said. She and other sources agreed that the November mid-term elections signaled that Americans are in no mood for tax increases.

"There's not much public support for [taxes] now," agreed Sheppach, who will leave NGA early next year to join the University of Virginia.

Pattison said the strengthening revenue picture could present a different challenge in some states. Legislators may demand governors ease off of spending cuts amid the rising revenues, even though the cuts may be vital to ensure a state's fiscal stability. New governors may face resistance from the legislatures as state economies improve, he said.

New capital projects are likely off the table for now, sources said.

"I don't see many states having the capacity to even consider anything other than token spending projects," Boyd said.

The investor community has become more cautious about credit risk and is scrutinizing issuers closely. Mary P. Talbutt-Glassberg, vice president and fixed-income portfolio manager at Davison Trust Co., said she has limited general obligation bond buying to credits rated double-A general or better. She is also scrutinizing issuers to see how much cash they have on reserve and whether they have capacity to issue more debt if needed.

Conventional thinking used to be that municipal bonds defaulted very rarely, Glassberg said. But "the last two years have burst the bubble of history," she said.

Glassberg said she also has sworn off revenue or tax anticipation notes because there is "no guarantee" those notes can be rolled over into longer-term debt.

States that have borrowed with short-term notes may have trouble refinancing that debt next year, given that interest rates are expected to rise, Sheppach said.

Even for the most troubled states, a default is not an option, Pattison said. States, which cannot declare bankruptcy under current laws, will find ways to cut spending and guarantee bondholders are repaid, he said. But that may not work on the local level, he said.

The market may see more local governments bailed out by their states, similar to Pennsylvania's aid program for Harrisburg that was approved in December, Glassberg said.

Harrisburg was approved for a state program that allows the city to implement new revenue streams to raise new money. The city did not include debt-service funding in its fiscal 2011 budget for a struggling incinerator project.

In general, states "won't be very quick" to help local borrowers "because of the precedent" set — that one bailout could provoke more, Sheppach said.

Counties and Cities
Recovery for local governments may take even longer than for states. Historically, city general funds take 18 to 24 months to recover after a national economic rebound has been confirmed, according to the National League of Cities.

Local governments face two sources of stress next year — declining revenues from property taxes and cuts in state transfer payments.

Property taxes, the largest revenue source collectively for local governments, are falling as property values are reassessed. Properties are assessed over time, so the impact on revenues will likely drag out.

"Clearly, that lag is setting in," Moody's Kurtter said. This revenue pressure on local governments is expected "to continue if not accelerate into 2011," he said.

Additionally, local governments on average get half of their local school money from states, Kurtter said.

These "two main revenue sources, which can account for 90% of what local governments get, are both going to be constrained" in 2011, he said.

Throughout the economic recession and recovery, local governments are in the unenviable position of "being at the bottom of the food chain" for revenue aid, said Tim Firestine, the chief administrative officer of Montgomery County, Md., and former vice chair of the Government Finance Officers Association's debt committee.

Montgomery County, like other counties, faces a budget gap for fiscal 2012. The gap is expected to be $300 million, Firestine said, down from a $900 million gap in fiscal 2011. But its economy has recovered going into 2011. Home foreclosures are down, property values are increasing, and the county has added 6,000 jobs this year, he said.

Still, spending cuts are imminent. "We're at a point now where it's really hard to make the cuts," Firestine said.

As for debt issuance in 2011, Firestine said the lack of BABs plus potentially higher interest rates may "reevaluate how large we size our [bond] issues."

"We're going to start pulling back on the $300 million" of debt the county typically issues a year, he said.

Debt issuance among smaller issuers may be scaled back as the higher bank-qualified limit expires. For the last two years, banks can deduct 80% of the costs of buying and carrying tax-exempt debt sold by borrowers who issue up to $30 million a year. Previously, the small issuer limit was $10 million.

In Redmond, Wash., a $15 million park acquisition deal was postponed this year and may cost more next year without the higher limit for bank-qualified bonds, said Michael Bailey, Redmond's finance director and member of the GFOA executive board.

"The higher bank-qualified limit would help create more market for bonds and would result in lower interest rates" for small issuers, he said.