The near-term fiscal challenges facing states and municipalities present a distinct risk, Fitch Ratings says.

In the five years after the Great Recession, most states and municipalities have seen pronounced drops in revenue followed by a slow growth trend that, in conjunction with budget austerity, has improved financial stability. Many states expect to see lower tax revenue growth in the future than they did in 2013, the impact of federal healthcare reform on state budgets is uncertain, and a few states are pressured by increased funding demands from their state employee pension plans. Pressures for localities are heavier on labor costs.

Before the recession, state and local governments both benefitted from a period of sustained strong tax revenues and overall economic growth. The recession struck states more immediately, as their revenue structures depend heavily on income and sales taxes. The impact on local governments was less dramatic since they usually rely to a moderate to large extent on property taxes. The gap between property assessments and the collection of revenue therefore allowed for fairly stable revenue for an extra couple of years despite a sometimes-dramatic decline in home prices. Various protections kept property tax declines moderate even when reduced assessments were phased in. Those local governments reliant on more economically sensitive revenue or state aid were more immediately affected.

States began their recoveries sooner and implemented austerity plans while also benefitting from significant federal stimulus funds in the first years after the downturn. State revenues have been growing since 2010 and this year many saw a bump in income tax revenue motivated by acceleration of income into 2012 to avoid next year's federal tax increases. Many are using these one-time funds to further rebuild financial cushions. The labor-intensive nature of local governments means salary and benefit growth will be a pressure even as tax revenues recover.

Today, both states and localities are growing moderately. Generally, revenues are recovering along with the tepid economic recovery. Reserves for both are, in aggregate, stable or growing. The risks facing both are distinctly different.

There are a few common areas of uncertainty in state budgets for the current year, although Fitch thinks the magnitude of the related risks is manageable. Taxpayer acceleration of income into 2012 to lower exposure to federal tax increases makes forecasting for current-year revenues challenging, as it is expected to dampen collections in the 2013 tax year. In addition, regardless of their decisions on Medicaid expansion, all states face some uncertainty around the costs associated with federal healthcare reforms. Increasing pension funding demands are a significant budget challenge for a few states including Illinois, Kentucky, New Jersey, and Pennsylvania.

Most of the localities are facing labor and pension challenges. Many have not raised salaries for multiple years and are seeing continued increases in pension funding requirements. By and large, reserves remain strong despite some erosion. We expect all but a few to be able to maintain or regain the ability to produce balanced budgets.