Special Briefing on State Budgets: The Big Squeeze

State Budgets Under Pressure: The Big Squeeze

The Trump Administration has swiftly ushered in a new era of “fiscal federalism.” For a discussion on the significant economic challenges consequently posed to the nation’s 50 states and 3,069 counties, Penn IUR and the Volcker Alliance convened a panel of public finance experts for a “Special Briefing on State Budgets: The Big Squeeze” on May 8, 2025.

Event Overview: Expert Panel Examines Fiscal Federalism

William Glasgall, Penn IUR Fellow and Public Finance Adviser at the Volcker Alliance, and Susan Wachter, Co-Director of Penn IUR, co-hosted the Special Briefing. The panel included:

• Emily Brock, Director, Federal Liaison Center, Government Finance Officers Association (GFOA)

• Shelby Kerns, Executive Director, National Association of State Budget Officers (NASBO)

• Vikram Rai, Former Head of Municipal Markets Strategy, Wells Fargo

• Jonathan Womer, Director, Rhode Island Department of Administration

• Teryn Zmuda, Chief Economist, National Association of Counties (NACo)

This Special Briefing was the latest in a series of 60-minute online discussions featuring distinguished guests from Penn IUR and the Volcker Alliance’s national research networks, along with other leading academics, economists, and federal, state, and local leaders. These convenings are made possible by funding from The Travelers Institute, members of the Penn IUR Advisory Board, and the Volcker Alliance.

State Governments Face Tightening Budget Conditions

Kerns set the stage for a vibrant discussion on the daunting fiscal challenges facing states and municipalities. “State budget conditions overall are tightening,” she said. “There are limited new funds, and states are making hard decisions about which priorities receive funding.” Among the resulting challenges is “the difficulty of managing expectations on all fronts,” said Kerns, “from elected officials, state agencies, the public, and other stakeholders.”

Several factors have coincided to contribute to today’s tightened budget environment. “One is that general fund expenditure growth is outpacing revenue growth in a number of states. Medical inflation is a large driver of that,” Kerns said, noting that “Medicaid makes up about 19% of state general fund spending.”

Multiple Pressures Challenge State Budgets

Beyond a mismatch of revenue and spending, Kerns highlighted the multifaceted challenges that have contributed to serious fiscal shortfalls: “Other budget pressures that states are grappling with right now include education and housing affordability. On the revenue side, we have a slowing economy, as well as the impact of tax reductions that have slowed revenue growth.” On a positive note, “while state budget conditions are tightening and much of the focus is on states’ inability to absorb federal cuts,” said Kerns, “states’ underlying fiscal positions are generally quite strong.”

Local Governments Vulnerable to Federal Budget Shifts

Turning the discussion to municipalities, Zmuda said that “as these federal shifts occur, we can expect to see varied impacts at the local level,” highlighting the heterogeneous nature of the 3,069 county governments across the United States. County-level governments are particularly vulnerable to fiscal disruption at the federal level given their high levels of community reinvestment and typically low amount of reserves. “We are dollar in, dollar out,” said Zmuda.

Historically, counties have relied on a “funding partnership” approach to finance municipal services. In the case of Medicaid, for example, “it’s a partnership between the federal, state, and local government.” Given the numerous uncertainties around the Trump Administration’s fiscal policies, localities must focus on “establishing stability as a top priority,” said Zmuda, to weather potential losses in funding or a broader economic downturn.

Municipal Bonds at Risk: Infrastructure and Tax Policy

Brock spoke on the critical importance of tax exemptions for the $4 trillion municipal bond market. “State and local governments themselves bear 75% of the cost of infrastructure in this country, and we do that by design. We like to make capital decisions locally. But we need to have the market to underpin those streets, clean water, schools, affordable housing, and so much more.”

The fiscal stability of states and municipalities relies in large part on Congress’ continued support of the municipal bond tax exemption. “It costs Congress money to provide the municipal bond,” said Brock, equivalent to “$300 billion over the course of 10 years…one of the top 10 tax expenditures of the federal government.” The tax exemption equates to roughly 200 basis points of savings, or $800 billion. In the absence of the tax-exempt municipal bond, the alternative would be “an $800 billion increase on taxes and fees to households across the United States,” said Brock.

With tax reform and budget reconciliation imminent, Brock stressed the importance of states and municipalities remaining vigilant and proactive. “It would be reckless of us to assume we’re safe unless we get ahead of the game.”

Federal Policy Volatility Challenges Strategic Planning

Sharing his perspective from Rhode Island, Womer said that “the real difficulty on the operational side for states right now is the uncertainty that’s coming out of Washington. As the [Trump Administration] proposes new executive orders, in particular cuts, and then the courts turn those around in a different way, you’re left with a lot of volatility from an operational perspective, trying to figure out how to plan and strategize going forward.”

Womer noted the advantage of states and municipalities’ “muscle memory” in managing budgets in times of economic crisis. Regardless, however, “there’s only so much preparation we can do right now with this degree of uncertainty. We’re going to have a lot of vulnerable populations put in the crosshairs,” said Womer. “We’re going to have a lot more difficulty in figuring out what budget changes need to happen at the state level to keep the programs working in our constituencies flush with programmatic needs going forward.”

Municipal Market Faces Liquidity and Policy Risks

“I’m pessimistic about the situation in the muni market,” said Rai. “I think all these machinations and the haphazard policy implementation has damaged our market.” He shared his concerns and expectations for the municipal bond market: “if munis become taxable, then that will destroy the buyer base and there will be a seismic shift in the buyer base,” Rai said, referring to a shift from retail to institutional investors.

“Now more than ever, [state and local governments] are reliant on financing their needs.” Private activity bonds, which fund higher education, hospitals, airports, and housing, have come under scrutiny in particular. “Another challenge which I believe is facing the muni market is a liquidity crisis,” said Rai. “I worry that we could see more broker-dealer exits from the muni market, which would hamper liquidity very adversely.”

Key Fiscal Challenges for States and Municipalities

Wachter summarized the five challenges that states and localities must now navigate in serving their populations amid fiscal turmoil:

1. Liquidity issues

2. Threats to the municipal bond’s tax-exempt status

3. Removal of tax-exempt status from state and local institutions

4. Withdrawal of federal programmatic support

5. A general environment of heightened uncertainty

Rai said that his primary concern is the potential for munis to lose their tax-exempt status, with liquidity issues secondary to macroeconomic challenges. “The thing I’m most worried about is reprioritizing programs that are going to be shifting around from the federal government. That’s going to be the greatest challenge,” said Womer.

“We need to fundamentally rethink our relationship with local government,” Womer continued. “On a financial basis, we have to rethink our tax base… We’re going to have to readjust all of our relationships from a financial perspective, just to remain on the right path.”

Zmuda cautioned that “the largest impacts and biggest hits” may occur in rural areas, which constitute 70% of America’s counties, as budget cuts are expected to target deferred infrastructure maintenance, Medicaid, and education in particular. “The options states have are pretty limited: to raise taxes, implement program reductions, and make budget cuts in other areas—or a mixture of all three,” concluded Kerns.

This briefing is the sixtieth in a series of sixty-minute online conversations on public finance featuring experts from the national research networks of the Volcker Alliance and Penn IUR, along with other leading academics, economists, and federal, state, and local leaders. 

Special Briefings are made possible by funding from The Travelers Institute, the Volcker Alliance, and members of the Penn IUR Advisory Board. Recordings of the entire Special Briefings series are available on the Volcker Alliance or Penn IUR websites. 

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