A high-stakes debt ceiling standoff in Washington could have spillover effects on state spending plans that rely heavily on federal aid to fund a variety of social programs and transportation projects.
States across the country are dependent on a steady flow of cash from the federal government to supplement their own tax revenue, but that pipeline of financial assistance is at risk amid a looming deadline for Congress to avoid the nation’s first default.
Policy experts say failing to suspend or raise the debt limit could disrupt spending at the state level, particularly with regard to the recently enacted $1.2 trillion infrastructure law.
“The fact that places are in better fiscal shape than they were expecting to be in makes the direct effects a little less imminent, but it will have big effects if places are trying to think about using any of that infrastructure money” or money earmarked for social services, said Kim Rueben, who specializes in state and local government financing at the Washington-based Urban Institute.
“And so partly we're playing this game of chicken with what feels like a nuclear bomb,” Rueben said. “We really need the debt limit cap to be increased because of what it is going to broadly do for the economy — [a default] could have a negative effect on state and local governments, but it can also upset all sorts of other financial markets and banking.”
The federal government provides about $750 billion in annual aid to states, funding programs ranging from Medicaid, which covers about 75 million Americans, to food stamps, used by about 42 million households. It also includes funding for schools, roads, transportation and various housing programs for low-income families.
Many of the states that rely the most on federal funding — over 40 percent — are Republican-led states such as Alaska, Louisiana, Mississippi and Montana, largely due to low tax rates. Some Democratic-led states also get a significant chunk of federal dollars: About 36 percent of New York’s budget comes from federal aid, while California sees about 30 percent of its budget supported by Washington.
“Every state relies on federal funding for a pretty good portion of their budget,” said Rebecca Thiess, a state policy expert with Pew Charitable Trusts. “Since the Great Recession, federal funding has remained essentially a third of state budgets. So if you think about where states get their money from — it's from taxes, it's from fees, local funds, service charges — but then the federal government has this important role.”
Overall, states are on firm financial footing, according to a report last week from the National Association of State Budget Officers. Spending on health care, education and transportation is up more than 16 percent this year compared to 2020, and federal funds to states rose sharply, increasing nearly 36 percent, the report said.
Thiess and other experts cautioned that it’s difficult to predict how things would play out since the country has never defaulted on its debt, but cuts to federally funded social safety net programs on which millions of people rely to make ends meet is a major concern.
“We don't have experience of a federal default,” said Jared Walczak, vice president of state projects at the Tax Foundation. “We don't want a situation where there's uncertainty about whether the federal dollars will flow.”
Senate Republicans in recent months have signaled Democrats will need to go it alone to raise the debt limit at a time the party is already struggling to get President Joe Biden’s $1.75 trillion Build Back Better bill through Congress.
“We are focusing on getting this done in a bipartisan way,” Senate Majority Leader Chuck Schumer, D-N.Y., said this month, referencing debt limit talks with his GOP counterpart, Senate Minority Leader Mitch McConnell.
The Kentucky Republican said in October that his party would not work with Democrats to raise the debt ceiling in December, but he recently softened his tone, saying this month, “We'll figure out how to avoid default. We always do.”
Congress came close to a potential default in October before lawmakers, including a handful of Senate Republicans, raised the debt limit by $480 billion to allow the government to continue paying its bills.
Treasury Secretary Janet Yellen warned lawmakers earlier this month that the country would be unable to pay its bills soon after Dec. 15 and pressed them to quickly act to avoid a default.
“There are scenarios in which Treasury would be left with insufficient remaining resources to continue to finance the operations of the U.S. government beyond” Dec. 15, Yellen said.
While state policy experts are optimistic that Congress will find a solution in the coming weeks, they say a default would force states to re-evaluate spending plans.
"Federal default has never happened and everyone hopes and expects that it won't happen now," Walczak said. "States' programs would not grind to a halt if there was some amount of delay in getting the federal aid, but obviously they do require it to be able to fund these programs."
CORRECTION (Nov. 28, 2021, 11:05 a.m. ET): A previous version of this article misstated the name of a group that issued a report on state budgets. It is the National Association of State Budget Officers, not the National Association of State Budget Officials.