WASHINGTON (Reuters) - Even the best managed U.S. state and local budgets might not be able to weather another economic recession, Standard and Poor's Ratings Services warned on Thursday, saying another downturn would likely be worse for states than cities and counties.
In an outlook on state and local government credit quality in 2013, the rating agency said it now considers the economy as important as financial management when it assesses state and local debt.
Should the national recovery from the 2007-09 recession stall, most state and local governments would "likely muddle through the year," it said.
"If the economy were to contract, even an aggressive financial management response may be insufficient to ward off negative pressure on credit ratings for some governments."
Many states and local governments have reached firm budgetary ground in the last year, with revenue growing slowly and spending easing slightly. Still, federal budget negotiations over the so-called "fiscal cliff" threaten to send the U.S. economy back into recession and the sovereign debt situation in Europe could also cause a downturn, S&P said.
The "fiscal cliff" is made up of two parts - automatic tax increases in January and the beginning of 10 years of across-the-board spending cuts totaling $1.2 trillion. While states and local governments have been girding for reductions in grants and other direct federal monies, many cities and counties say the cuts are too small to capsize their budgets.
"For the state and local government sector, the main risk to credit quality from the fiscal cliff would be indirect and would stem from the fiscal pressures of another recession. There would also be direct effects, however, from reduced federal grants," S&P said.
State revenues will likely continue growing in 2013, but the income and sales taxes that make up the bulk of state budgets are highly sensitive to economic conditions, according to the agency. That means a contraction, especially if people lose jobs and stop spending, would cut deeply into state budgets.
Local governments, meanwhile, rely chiefly on property taxes, which have yet to recover from the housing downturn.
But cities and counties do not contend with the growing cost of Medicaid, the healthcare program for the poor that is run by states with partial reimbursements from the federal government. Medicaid recently outstripped education as the largest expense of states and can often take up a third of budgets.
All states except Vermont must balance their budgets and that requirement along with ever-expanding Medicaid costs could create an "onerous" situation in another recession, S&P said. Simply put, more people would enroll in the program just as state revenues dropped.
That situation played out in the 2007-09 recession, as state revenues hit the lowest levels seen in decades and demand for assistance from the jobless and homeless reached record highs. The federal government stepped in to take on a greater share of Medicaid costs through its economic stimulus plan - a step S&P does not expect it to take again during the current "fiscal cliff" and deficit fights.
"In our view, the political and fiscal climate in Washington D.C. makes it unlikely that extraordinary fiscal support would be made available to the states in the event of an economic downturn in 2013," S&P added.
Reporting By Lisa Lambert. Editing by Andre Grenon