Many such unilateral executive actions will face immediate court challenges, with questionable prospects in light of existing case law from the precedential 1998 Supreme Court decision in Clinton v. New York, which held that line-item vetoes and budget freezes are unconstitutional under the presentment clause. Those will be just the opening skirmishes in a longer battle over federal finances.
Although some current intergovernmental budget authorizations will likely get caught in the snare of this litigation, the immediate impact on most states and local governments will be symbolic and expectational — at least for now. A notable exception may be sanctuary cities and states, where targeted White House fiscal freezes could soon grab headlines. Unused COVID-era financial aid probably also faces federal clawback efforts.
No matter the outcome of those showy near-term constitutional legal tussles, the next tax and budget bill working through Congress will be far more determinative for governors, mayors and school officials fretting about big cuts in their intergovernmental grants. Until that plays out, there’s really not much to predict on that score except that hoping and angling for more money to rain down from Uncle Sam in 2025 is foolhardy: The new game on Capitol Hill for states, counties, cities and schools is now mostly limited to playing defense.
Rhetoric about right-sizing Uncle Sam will almost inevitably include some form of cost-shifting to states and localities. That quickly presents governors and legislatures with a hot-potato problem: In the case of Medicaid, the statutory result could be immediate health-care benefit cuts for 3 million Americans in nine states. For affluent blue states, the only positive on the table so far is a chance that the state and local tax (SALT) deduction cap will be raised.
Meanwhile, the show must go on outside of the Beltway. State and local budget officers must make clear-headed recommendations on whether to fill vacant positions, freeze certain precarious spending initiatives or continue business as usual. Looking ahead to future recessions, rainy-day fund policies should now be revisited in the light of presumed federal stinginess. Treasurers, debt managers and their outside financial advisers must make intelligent guesses as to the best strategies and timing for selling bonds in coming months to fund vital infrastructure no matter what comes out of Washington, D.C. Although Capitol Hill tax-cutters may try to sweep mounting federal deficits and a flood of new Treasury bonds under the rug of wishful economic growth, the municipal bond market will smell a rat, and that likely will elevate the cost of infrastructure borrowing as the year goes on.
In the investment arena, public cash managers must make important decisions, choosing whether to keep all their operating funds in ultra-short-term investments for now or to build out a maturity ladder to lock in staggered 2025-maturity interest rates that have risen by a half percentage point or more since October. Right now, the cash market is still paying a slight premium over futures for maturities later this year to compensate for giving up some liquidity over those holding periods.
With the Federal Reserve hopefully cutting overnight rates another time or two in 2025, the yield curve is likely to normalize this year with short rates the lowest. That puts a price on liquidity, with the possible exception of state investment pools like California’s Local Agency Investment Fund, which can arbitrage its longer portfolio maturities while offering higher-yielding overnight liquidity to local agencies if the Fed cuts further. The good news is that most cash managers should be able to meet their budget estimates this year — as long as they don’t promise more than today’s average portfolio yields.
It's a somewhat different picture for pension fund trustees and staff: They may find themselves frozen like deer in the headlights when it comes to what long-term portfolio structures now make sense if the president-elect’s promised tariffs cause inflation and voodoo math tax cuts deepen the federal deficit and kick bond yields even higher. Unless Washington politicians surprisingly demonstrate genuine fiscal responsibility beyond tax-cut fever, trustees would be wise to revisit their bond portfolios and consider a boost in their inflation-protected Treasury securities and variable-rate credit positions.
Dance of the Unknowns
The strategic problem for public financiers and pension funds today is how to position for and manage against both the known unknowns and the unknown unknowns.
The known unknowns right now are dominated by what exactly will come out of the new regime in Washington D.C. How and how much will Congress cost-shift and cut intergovernmental aid, and what strings will lawmakers attach to future funding? What will happen to Medicaid? Will the SALT deduction cap be raised? Will the year-end “quarterback sneak” victory for double-dipping public pensioners backfire with a mandate for compulsory Social Security enrollment for all new hires and compensatory taxation for incumbents? Will Trump’s promised tariffs ultimately result in higher prices and then a new round of payroll-cost inflation? What industries and thence states would likely come out winners if corporate America makes big investments in domestic manufacturing as a result? Will huge tax cuts result in swelling federal deficits that push both Treasury and municipal bond yields higher, to the detriment of pension funds and infrastructure funding plans? For these issues, a great deal of clarity will reveal itself by summer, at least directionally, since Congress will be keen to enact a new tax bill sooner than later and most of these issues revolve around that.
Perhaps more fiscally impactful nationwide in 2025 could be a callback of federal (and private-sector corporate) employees who now enjoy remote work full time. It’s an idea that may trickle down to state and local agencies in ways that shake up and slightly shrink the public-sector workforce — though not without union blowback. Already we’ve seen this idea tried in Philadelphia. Will public employees still working remotely all week eventually be compelled to take a pay haircut — or take a hike — as their employers borrow from the new corporate playbook for cutting payroll costs? That’s now a known unknown.
The unknown unknowns for states and localities are how Washington policymaking intersects with the goliath global economy and realpolitik. These are longer-term issues unlikely to spring up in 2025, but could surprise financiers and policymakers in later years. Will massive deregulation and investment bubbles ultimately result in yet another boom-bust market cycle that plunges the U.S. and other economies into a deep, dark recession, crushing state budgets, pension funds and labor markets? It’s a scenario that invites so much federal debt and money printing that bond vigilantes might push interest rates skyward, beyond the control of politicians and central bankers. Will artificial intelligence combined with Department of Government Efficiency (DOGE)-driven efforts to slash the federal workforce flow down to office workers nationwide, cutting public-sector payroll costs but perversely backfiring on the states with mounting unemployment bills?
These are scenarios entirely beyond the control of state and local leaders, but they do underscore the heightened importance of heftier rainy-day funds as fiscal self-insurance.
In the face of all this uncertainty, it’s only natural that most state and local leaders are treading water, awaiting the outcome of congressional and Supreme Court decision-making. That implies business as usual for cash and debt managers who are unlikely to make big moves to play interest rates in either direction, pending more clarity on the federal budget. For pension funds, don’t be surprised to see more talk about risk-offset portfolio strategies in trustee study sessions this year, as consultants will be called into action to lay out the options and the costs of various “portfolio insurance” gambits.
Outside the Beltway
So much for the big federalism picture. Let’s focus now on financial trends peculiar to states and municipalities. These include prospects for tax revenues, financial reporting, the financial impact of artificial intelligence, and incentives for home-builders, data centers, economic development and office conversions.
The good news for states with income taxes — and localities that receive a share of those revenues by formula — is that last year’s stock and speculative market gains will boost revenues in 2025. (Think Nvidia, the Magnificent 7 stocks and bitcoin.) Just last month the mutual fund industry issued a near-record level of taxable capital gains distributions that will show up in their investors’ 2024 1099 forms. That alone will produce unbudgeted higher revenues.
Given their tax structures, California and New York will be the biggest beneficiaries, with smaller windfalls elsewhere. Right now we’re also seeing wealthy investors take profits in early January from stock gains they punted into 2025 to defer capital gains taxes, and those receipts too will greatly exceed most state budget office estimates for 2025. There’s also a fair chance that a reawakened IPO market will produce much-awaited capital gains for new billionaires, with tax revenues to follow. Sales taxes may not grow much, but they should remain stable along with the full employment economy as long as overdone tariffs don’t cut into unit sales nationally.
Financial reporting issues may heat up in later months. Standard governmental financial reporting models are being challenged, as finance officers keep pushing back on whether increasingly complex annual reports are actually being read by anybody. Meanwhile, plenty of financial data will eventually become machine-readable for bond underwriters, insurers and investors, accessible through one or more public clearinghouses: Keep your eyes on the Municipal Securities Rulemaking Board’s EMMALabs “sandbox,” which seems ripe for exploitation by artificial intelligence data-gobblers seeking to profit from public information. Hopefully the professional associations can find a way to use AI systems to read, digest and digitize today’s word-processed financial reports without imposing unduly heavy costs on thousands of small-staffed local governments.
AI will keep making headlines in other ways, but odds favor a delayed reaction at the state and local level. Don’t count on big productivity gains from this technology to shave personnel costs off local budgets this year; low-tech work rules like forcing remote workers back to the office may instead steal that show. If the so-called DOGE team actually succeeds in shrinking federal government payrolls through automated systems, it’s pretty likely that such technology can eventually apply in states, cities, counties and schools. But it won’t be this year, as the private sector needs more lead time to develop, test, fine-tune and then market its applications, presumably by using Uncle Sam’s shrinking workforce as its guinea pig. My guess is that any ensuing state and local workforce reductions will evolve mostly through retirements and attrition, not layoffs.
Housing Scenarios
Although Washington politicians talk big about incentivizing the supply of housing, it’s primarily local governments that need to step up with new ways to cut red tape and promote development. Look for new land-use incentives to include tax breaks as well as deregulatory zoning and building code initiatives. The role of states, aside from pre-emption of the local zoning codes that make it so hard to build multifamily housing, might well be financial incentives including targeted subsidies to cooperating cities for infrastructure that feeds into the cost of new homes. It’s one of the few topics where the states and cities can go on the offensive in lobbying D.C. politicians for federal help — despite the possibility that it might come with sticks as well as carrots — because housing costs are a huge headache for all of their constituents.
A related pro-housing angle would be for Congress to expand the Opportunity Zone (OZ) concept to include residential developments in communities anywhere that meet federal requirements, which could include new alternative criteria where there is a housing deficiency. Center-city office conversion for residential or mixed-use facilities could also become a target for reformulated OZs, with additional support provided by the states.
So public financiers will have a lot to look forward to — or in some cases dread — as the new year unfolds in Washington, state capitols and city halls. Although we will all wait anxiously to see what emanates from the political circus and partisan budgeting theatrics in Washington, there are plenty of other financial policy and management issues at the state and local level that will keep their leadership busy this year as well. One thing for sure, change is in the wind.
Governing's opinion columns reflect the views of their authors and not necessarily those of Governing's editors or management. Nothing herein should be construed as investment advice.
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