ECONOMIC AND BUDGET ISSUE BRIEF

Fiscal Stress Faced by Local Governments

Local governments—including counties, cities, towns, 

school districts, and special districts—play a significant 

role in people’s lives and in the nation’s economy.1

 In 

2009, the expenditures of local governments equaled 

8.7 percent of gross domestic product, and those governments employed just over 9 percent of the labor force.2

That year, local governments as a group cut their spending in real (inflation-adjusted) terms. This year and in 

upcoming years, they expect to constrain spending and 

services—primarily because of reductions in state aid and 

falling revenues. In particular, revenues from property 

taxes are poised to decline to reflect lower property values. 

To the extent that local governments address budget gaps 

by reducing spending or raising taxes, such changes will 

partially counteract the federal government’s fiscal support for the economy.

In light of those developments, this Congressional Budget Office (CBO) issue brief describes the economic conditions and budgeting practices that can lead to significant budgetary challenges—often termed fiscal stress—at 

the local level. The brief also reviews the options available 

to local governments, state governments, and the federal 

government for addressing such financial difficulty. Last, 

the brief examines two options that local governments 

very rarely use: defaulting on their debt or filing for bankruptcy. 

The Functions of Local Governments 

and the Composition of Their Budgets

Local governments vary considerably in size, purpose, 

spending, and revenue sources. Currently, there are about 

3,000 counties, 36,000 municipalities (cities, towns, 

villages, and boroughs), 37,400 special districts, and 

14,600 public school systems in the United States. 

County and city governments are generally the largest, 

both in the number of people they employ and in the 

amounts they spend. They provide services such as police 

protection, transportation, welfare payments, and job 

training, among others. Special districts are generally the 

smallest governmental entities and have a singular purpose, such as providing water or treating waste. Collectively, local governments spend more on education than 

on any other category, followed by spending on social services, housing, and transportation; administration and 

interest on their debt; utilities; public safety; and the 

environment (see Figure 1).3

The sources of local revenues vary significantly depending on the type of local government. Although counties 

and cities rely heavily on property and sales taxes, water 

and sewer districts are funded mostly by utility fees and, 

consequently, have experienced less fiscal stress than 

counties and cities during the recent economic downturn. Collectively, local governments derive nearly onethird of their revenues from state aid, about one-quarter 

from property taxes, one-tenth from sales and other taxes, 

and most of the remainder from fees and miscellaneous 

revenues; only 4 percent represents direct aid from the 

federal government (see Figure 2).

CBO A series of issue summaries from

the Congressional Budget Office

DECEMBER 2010

1. Special districts include entities such as water, electric, sewer, 

hospital, housing, and economic development districts.

2. Data on expenditures by local governments in 2009—the most 

recent year for which such information is available—are from 

Department of Commerce, Bureau of Economic Analysis, 

National Income and Product Accounts, Table 3.21, 2009. Data 

on employment are from Department of Commerce, Census 

Bureau, Annual Survey of State and Local Government Employment and Payroll, Public Employment Data, Local Governments, 

2009. Unless otherwise indicated, years referred to are calendar 

years.

3. The environment category includes parks and recreation, sewerage, solid waste management, and natural resources.
2 CONGRESSIONAL BUDGET OFFICE

ECONOMIC AND BUDGET ISSUE BRIEF

Figure 1.

Types of Spending by 

Local Governments, 2008

Source: Congressional Budget Office based on data from the 

Department of Commerce, Census Bureau.

Notes: The most recent data on local governments’ spending by 

type are for 2008.

Shares do not add to 100 percent because of rounding.

a. Includes spending on parks and recreation, sewerage, solid 

waste management, and natural resources.

b. Includes spending on water, gas, and electric utilities.

c. “Other” includes spending on diverse categories such as 

unemployment compensation, employee retirement, and the 

operation of liquor stores.

Causes of Fiscal Stress for 

Local Governments 

Fiscal stress—a gap between projected revenues and 

expenditures—can be short term, in the case of transitory 

economic shocks, or long term, in the case of structural 

budget imbalance. Such structural imbalance may arise 

from persistent economic shocks or from other factors. 

Transitory Economic Shocks

Weak economic conditions lead to fiscal stress for local 

governments by reducing their tax revenues, lessening the 

state aid they receive, increasing the demand for some services, and triggering investment losses. Primarily because 

of their reliance on property taxes—a relatively stable 

source of funds that makes up just over a quarter of revenues—local governments have experienced less fiscal 

stress during the recent economic downturn than have 

state governments. That relative stability may change, 

however. Nationally, house prices fell by 27 percent from 

the year ending in June 2006 to the year ending in June 

2010 (see Figure 3).4

 Although property tax collections 

increased 31 percent over that same period, the decline in 

house prices implies that collections will probably fall in 

the coming years as local governments gradually update 

property tax assessments to reflect lower market values. 

On average, collections of property tax revenues lag 

behind changes in house prices by three years.5

 Even 

small declines in collections could cause fiscal stress when 

the cost of providing public services is growing. 

State governments provided 30 percent of revenues for 

local governments in 2008. However, state revenues—

primarily from income and sales taxes—have plummeted 

during the weak economic conditions of the past two 

years (see Figure 4 on page 5). States have consequently 

reduced spending, in part by cutting the amounts provided to local governments. Because periods of local 

and state fiscal stress tend to occur concurrently, aid to 

local governments often falls when it is needed most. 

Following the 2001 recession, total transfers to cities 

declined by 9 percent from 2002 to 2004.6

 Although 

data on changes in local aid during the recent recession 

and slow recovery are not yet available, a recent survey 

indicates that 22 states reduced aid to local governments 

in fiscal year 2010, and 20 states have proposed additional cuts in 2011.7

 According to another survey, almost 

40 states cut spending for K–12 education in fiscal year 

2010, and 31 governors proposed to cut such funding

Education

 (38%)

Social Services, 

Housing, and

Transportation

 (18%)

Administration,

Interest, and

Other

 (16%)

Utilitiesb

 (11%)

Public Safety

 (9%)

Environmenta

 (7%)

c

4. Standard & Poor’s, S&P/Case-Shiller Home Price Indices, 

U.S. National Index, 2nd quarter, 2010.

5. Byron Lutz, “The Connection Between House Price Appreciation 

and Property Tax Revenues,” National Tax Journal, vol. 61, no. 3 

(September 2008), pp. 555–572.

6. Christopher W. Hoene and Michael A. Pagano, “Fend-forYourself Federalism: The Effect of Federal and State Deficits on 

America’s Cities,” Government Finance Review (October 2003).

7. National Governors Association and the National Association of 

State Budget Officers, The Fiscal Survey of States (Washington, 

D.C.: NASBO, June 2010).
ECONOMIC AND BUDGET ISSUE BRIEF

FISCAL STRESS FACED BY LOCAL GOVERNMENTS 3

Figure 2.

Sources of Revenues for 

Local Governments, 2008

Source: Congressional Budget Office based on data from the 

Department of Commerce, Census Bureau.

Note: The most recent data on local governments’ revenues by 

source are for 2008.

a. Examples of other sources of revenues include hospital, 

sewerage, and tuition fees.

in their budgets for 2011.8 (States have different options 

available to them when responding to fiscal stress. For a 

brief description of those options, see Box 1 on page 6.)

Economic contractions also often result in increased 

demand for a host of public services. The unemployed or 

those facing a reduced work schedule may lose access to 

health insurance, increasing demands on public hospitals 

or clinics. Crime generally increases during economic 

downturns, increasing the need for police protection.9

People who lose income often opt for less-expensive 

modes of transportation, such as public transit. As the 

number of people unemployed increases, so does the 

demand for job training programs and services provided 

by public libraries or social welfare offices. 

Local governments also may experience fiscal difficulties 

that result from investment losses; when large, such losses 

can be extremely disruptive (see Box 2 on page 7). 

Structural Budget Imbalance

Long-term imbalances in local budgets arise from a variety of sources that can be difficult to disentangle. Political 

dynamics frequently play an important role. When a 

council or other legislative body and the executive fail to 

agree on a budget—often when the two bodies are dominated by different political parties—deficits may occur. 

Arrangements with local groups such as public-employee 

unions may also be a factor. For example, according to a 

bankruptcy filing of Vallejo, California, the inability of 

the council and the mayor to control labor costs was the 

main reason for the filing.

In addition, demographic shifts, particularly occasions 

when high- or moderate-income households move out of 

a local jurisdiction, may contribute to long-term budget 

imbalance. Such shifts are often closely related to the 

relocation of businesses out of the inner cities and into 

the surrounding suburbs.10 As businesses move away, the 

jurisdiction’s tax collections drop. Over time, the need for 

public services also increases as personal incomes fall and 

unemployment increases.

Budget imbalance also may result or be exacerbated when 

a locality lacks adequate budgetary or financial controls. 

For example, questionable accounting procedures and 

loose fiscal management allowed New York City officials 

to mask growing deficits over a period of several years, 

eventually resulting in deficits so large that the financial 

markets would no longer finance them.11 Budgetary 

controls—including balanced budget requirements, debt 

limits, and tax and expenditure limits—restrict elected 

8. National Conference of State Legislatures, State Measures to Balance FY 2010 Budgets (May 2010) and State Measures to Balance 

FY 2011 Budgets (September 2010).

Aid from State

Government

(30%)

Property Taxes

(26%)

Sales and

Other Taxes

(10%)

Other Revenuesa

(22%)

Utility

Revenues

(8%)

Tax Revenues from 

Own Sources

(36%)

Fees and

Miscellaneous 

Revenues

(30%)

Aid from Federal

Government

(4%)

9. Eric D. Gould, Bruce A. Weinberg, and David B. Mustard, 

“Crime Rates and Local Labor Market Opportunities in the 

United States: 1979–1997,” Review of Economics and Statistics, 

vol. 84, no. 1 (February 2002), pp. 45–61.

10. Congressional Budget Office, New York City’s Fiscal Problem: Its 

Origins, Potential Repercussions, and Some Alternative Policy 

Responses, Background Paper (October 1975).

11. Ibid.
4 CONGRESSIONAL BUDGET OFFICE

ECONOMIC AND BUDGET ISSUE BRIEF

Figure 3.

Prices for Single-Family Homes, 

July 1988 to June 2010

(Index, July 1988–June 1989 period = 100)

Source: Congressional Budget Office based on the S&P/CaseShiller Home Price Index.

Notes: The S&P/Case-Shiller index tracks repeat sales of existing 

single-family homes financed by all types of mortgages. 

The data plotted are annual, showing the average value in 

periods running from July through June. 

The shaded vertical bars indicate periods of recession.

officials’ ability to spend more on operating expenses 

than they raise in revenues. The extent to which states 

require local governments to comply with budgetary controls varies from state to state. Financial controls, including audit practices and financial oversight bodies, help to 

ensure that resources are allocated to the purposes for 

which they were intended. Such controls also improve the 

transparency and accuracy of information that the locality provides to the public about its operations.

Borrowing by local governments may be both a response 

to and a cause of fiscal stress. If an operating deficit is 

caused by temporarily poor economic conditions, issuing 

short-term debt may help to alleviate those pressures. 

However, local governments that spend more than they 

collect in revenues for a number of years usually reach 

a limit on their ability to postpone reconciling that difference, at which point they face even more difficult 

decisions. 

Local Governments’ Responses to 

Fiscal Stress

Local governments can decrease spending and increase 

taxes and fees in response to fiscal stress, although the 

extent of those adjustments can be limited by state and 

federal requirements as well as other factors. Local governments can also shift payments and receipts or borrow 

funds to bridge a gap between spending and revenues. 

Decreasing Spending 

Local governments reduced spending in real terms by 

0.6 percent in 2008 and by 1.9 percent in 2009. 

Although comprehensive data on local spending are not 

yet available for fiscal year 2010, according to the 

National League of Cities, more than 90 percent of the 

cities that responded to its annual survey expected to cut 

expenditures in fiscal year 2010 relative to the amount 

needed to maintain services at the fiscal year 2009 level.12

Since 1970, local governments have rarely reduced their 

workforces, but they did so by 241,000 employees, or 1.7 

percent, between December 2007, when the recession 

began, and November 2010.13

Contributions to pension funds or health care funds for 

retirees are particularly vulnerable to delay during times 

of fiscal stress. State or federal laws generally do not 

require local governments to make annual contributions 

to those funds (unless the state fund covers local employees), and political pressures often lead to delays in those 

payments as a way of avoiding cuts in services or increases 

in taxes. Local governments also often postpone capital 

investments during times of fiscal stress.14 The effects of 

postponing those investments are often not immediate, 

but particularly for single-purpose entities such as water 

or sewer districts, continually doing so may ultimately

300

1990 1995 2000 2005 2010

250

150

200

100

50

12. Christopher W. Hoene, City Budget Shortfalls and Responses: Projections for 2010–2012 (Washington, D.C.: National League of 

Cities, December 2009), p. 2.

13. CBO’s calculation based on Department of Labor, Bureau of 

Labor Statistics, Current Employment Statistics, Table B-1, 

October 8, 2010. Since its peak in August 2008, employment by 

local governments has fallen by 360,000.

14. See Rebecca Hendrick, “The Role of Slack in Local Government 

Finances,” Public Budgeting and Finance, vol. 26, no. 1 (2006), 

pp. 14–46; and David R. Morgan and William J. Pammer Jr., 

“Coping with Fiscal Stress: Predicting the Use of Financial Management Practices Among U.S. Cities,” Urban Affairs Quarterly,

vol. 24, no. 1 (1988), pp. 69–86.
ECONOMIC AND BUDGET ISSUE BRIEF

FISCAL STRESS FACED BY LOCAL GOVERNMENTS 5

Figure 4.

State and Local Governments’ Tax 

Collections, July 1988 to June 2010

(Index, July 1988–June 1989 period = 100)

Source: Congressional Budget Office based on data from the 

Department of Commerce, Bureau of Economic Analysis.

Notes: The data plotted are annual, showing the average value in 

periods running from July through June. 

Values have been adjusted for inflation.

The shaded vertical bars indicate periods of recession.

result in the failure of a system or, alternatively, the need 

to make a large investment down the line when the funds 

to do so may not be readily available.

The ability of some local governments to decrease spending is sometimes limited by federal and state requirements, particularly laws that require local governments to 

pay for a portion of the costs of certain services. For 

example, more than half of the states require local governments to contribute a share of the costs of the state’s 

Medicaid program. Many states also restrict the way local 

governments deliver services—regardless of the local government’s fiscal situation. For example, many states cover 

some local employees under their pension plans and 

restrict the extent to which local governments can reduce 

their contributions to the plans when revenues fall. 

At some point, reducing spending may entail much larger 

future costs. Deferring maintenance can shorten the service lifetime of equipment or increase future repair costs. 

Missed pension contributions can lead to large budget 

shortfalls when benefits come due. Eventually, residents 

of a locality may decide to move out of the area if service 

levels are cut (or taxes increased) too much, causing the 

local government to collect less in revenues than it did 

before. 

Increasing Taxes and Fees

Local governments also can raise taxes and fees in 

response to fiscal stress. Despite the decline in property 

values over the past four years, for example, some combination of tax rate increases, lagged updates of the assessed 

values to which local property tax rates are applied, and 

expansion of the tax base through new construction has 

led to increased property tax collections over that period. 

However, such collections will probably fall in the next 

few years as the drop in property values is reflected in 

assessed values; local governments might then decide to 

increase taxes and fees to make up for the losses. Some 

states limit the extent to which local governments can 

increase tax rates or collections in a given year. Those limits most often apply to property tax rates but also extend 

to sales tax rates, assessments, and fees in some states.

Shifting the Timing of Payments

When spending exceeds revenues, local governments 

can delay scheduled payments or undertake other temporary measures that balance their budgets in one year 

by pushing costs into subsequent years. Examples of 

such measures include selling and leasing back public 

property, delaying payments to contractors, and shifting 

pay dates for employees. Local governments that repeatedly use such practices are likely to face higher prices 

from suppliers, and their payments on leased-back 

property may exceed the cost of owning those assets. 

Postponing contributions to pension or health care funds 

may also represent a short-term shift in payments.

Borrowing

Local governments can borrow to cope with fiscal stress. 

Like delaying payments, borrowing postpones rather than 

resolves the need to pay for expenses, and it may increase 

those expenses because of debt-service costs. The most 

common forms of borrowing include the use of shortterm debt to fund operating deficits and the use of longterm debt to fund capital expenses or contributions to 

pension or health care funds. Local governments also may 

borrow against future streams of revenues, such as the 

payments from settlements of tobacco cases that some are 

receiving. Short-term borrowing usually must be paid off

180

160

140

120

100

200

220

80

1990 1995 2000 2005 2010

State

Local
6 CONGRESSIONAL BUDGET OFFICE

ECONOMIC AND BUDGET ISSUE BRIEF

Box 1.

States’ Options for Addressing Fiscal Stress

States collectively have experienced more fiscal 

stress during the recent economic downturn than 

have their local counterparts, in part because of 

their greater dependence on more-volatile sources 

of revenues such as income and sales taxes. For local 

governments, collections of tax revenues grew in 

real (inflation-adjusted) terms every year for the past 

20 years, and grew 9 percent from the year ending 

June 2008 to the year ending June 2010 (see Figure 4 

on page 5).1

 In contrast, collections of tax revenues 

by state governments fell in real terms during a few 

years in the past two decades and dropped 13 percent 

from the year ending June 2008 to the year ending 

June 2010. 

When considering how to adjust their spending and 

revenues in response to fiscal stress, state governments 

can face a number of constraints. Eleven states restrict 

lawmakers’ ability to increase taxes by requiring more 

than a simple majority vote for any legislation that 

would do so beyond some statutory or constitutional 

limit.2

 Most states also have laws that require the legislature to pass and/or the governor to enact a balanced budget. States’ ability to raise revenues (like 

local governments’) is also constrained by their need 

to retain and attract residents and by political considerations. In addition, state spending is sometimes 

required by federal laws that impose mandates and by 

conditions of federal assistance—such as matching 

requirements for funding for education and Medicaid.3

States can issue short-term debt to fund operating 

deficits and long-term debt to fund capital investments and contributions to pension or health care 

funds. However, the amount of debt that can be 

issued is limited in most states by state law or the 

state constitution. 

States often turn to the federal government for assistance during periods of fiscal stress. In the past, such 

assistance has included grants, tax credits, loans, and 

guarantees on debt. From state fiscal year 2008 to 

state fiscal year 2009, federal aid as a share of total 

state spending increased from 26 percent to 30 percent.4

 The American Recovery and Reinvestment Act 

(ARRA) provided assistance to states. In particular, as 

of September 2010, the federal government had sent 

$71 billion to states in additional Medicaid grants 

and $36 billion through the State Fiscal Stabilization 

Fund, established by ARRA. Excluding the 

additional assistance provided under ARRA, federal 

payments to states for Medicaid from early 2009 to 

September 2010 were $453 billion. Also, in an effort 

to restart loan purchases by state housing finance 

authorities (HFAs) that faced high interest costs on 

their debt because of market turmoil and the failure 

of several debt insurers, the Treasury provided 

$24 billion to states in 2010. That support, which 

consisted of purchases of new debt and credit support 

to increase the liquidity of outstanding debt, significantly reduced debt-service costs for HFAs, allowing 

them to purchase new mortgages and to support 

lending to first-time and low-income home buyers. 

If a state was under great fiscal stress, it could default 

on its debt, but the last state to do so was Arkansas in 

1933. The federal government could not take control 

of a state’s fiscal operations, primarily because the 

U.S. Constitution protects the states from federal 

infringement on their sovereignty. Furthermore, 

under federal law, states cannot file for bankruptcy. 

1. Many but not all local governments have fiscal years that 

begin in July and end in June.

2. National Association of State Budget Officers, Budget Processes in the States (Washington, D.C.: NASBO, 2008).

3. For a detailed description of federal mandates, see 

Congressional Budget Office, Intergovernmental Mandates in 

Federal Legislation, Issue Brief (July 2009).

4. National Association of State Budget Officers, State Expenditure Report (Washington, D.C.: NASBO, 2009). Many states’ 

fiscal years end in June.
ECONOMIC AND BUDGET ISSUE BRIEF

FISCAL STRESS FACED BY LOCAL GOVERNMENTS 7

within a year to 18 months, depending on state law. 

Some states allow municipalities to refinance short-term 

debt with new debt, but in most cases, states limit the 

number of times that such debt may be refinanced. Prevailing interest rates in the market for municipal debt 

also limit how localities use debt to finance current 

expenditures. 

Municipalities that accumulate a large debt burden and 

that are perceived as having a significant risk of default 

tend to pay considerably higher interest rates than those 

that borrow more conservatively. Those differences in 

borrowing costs widen during economic downturns. 

Toward the end of 2008, the spread relative to the yield 

on Treasury bonds spiked to more than 5.5 percentage 

points for municipal issuers of 30-year bonds rated BBB 

but was less than 1 percentage point for issuers of AAArated bonds. Since then, rate spreads for all but the safest 

issuers have narrowed but remain elevated over historical 

levels, particularly for bonds of longer maturity. Another 

factor leading to some municipal governments’ higher 

borrowing costs has been a sharp reduction in the availability of municipal bond insurance. A countervailing 

effect on borrowing costs, however, has been the generally 

low level of interest rates.

States’ Responses to Local 

Governments’ Fiscal Stress

States may assist a local government that faces fiscal stress 

by providing more aid or by allowing the local government to collect additional tax revenues. If a local government experiences a high level of fiscal stress, the state may 

increase its oversight or even take over the fiscal operations of the locality.

Increasing State Aid or Allowing 

Additional Tax Collections 

Before decreasing spending or increasing taxes or fees, 

most local governments seek additional aid from state 

governments. State aid takes many forms, including 

increased revenue sharing, additional grants, and the provision of debt guarantees. States can help alleviate 

changes in revenues caused by local shifts in population 

by redistributing revenues from one jurisdiction to 

another. Alternatively, states can adjust taxes that cross 

jurisdictions, such as commuter or nonresident income 

taxes, to reduce the incentives for people to move to new 

areas. States also may expand the types of taxes that a 

local government can impose in times of fiscal stress—

such as allowing a locality to impose a new sales tax—or 

they may increase the maximum tax rate a locality may 

impose. For example, Massachusetts, in its fiscal year

Box 2.

Examples of Investment 

Losses That Were Disruptive 

for Local Governments

In the rare instances in which investment losses 

are extremely large, they can cause severe fiscal 

distress for local governments. The losses of 

Alabama’s Jefferson County are one example. 

Beginning in 2003, Jefferson County attempted 

to lower the cost of its debt for its sewer system 

by replacing its fixed-rate debt with variable-rate 

debt. Because interest rates fluctuate, the county 

simultaneously entered into an agreement with 

an investment bank whereby the county would 

provide fixed payments to the bank in exchange 

for variable-rate payments that the county could 

use to pay bondholders. That arrangement was 

flawed, however, because the two variable rates 

were tied to different indexes. Eventually, those 

indexes and the payments based on them 

diverged, causing the county to default in 2008. 

Another example is the Orange County Investment Pool’s losses in 1994 of $1.7 billion (which 

were about 22 percent of its assets). The losses of 

the pool, which was created to manage the revenues of about 200 local governments, occurred 

primarily because its manager invested heavily in 

assets whose value would fall if short-term interest rates rose. Beginning in early 1994, the Federal Reserve Board increased short-term rates, 

causing the value of the pool’s investments to 

drop, triggering withdrawals by local governments and calls by private banks for the collateral 

held by the pool to back loans.
8 CONGRESSIONAL BUDGET OFFICE

ECONOMIC AND BUDGET ISSUE BRIEF

2010 budget, allowed localities to impose a tax of 

0.75 percent on sales of restaurant meals.15

Providing Oversight or Assuming Control

In the event of severe fiscal stress, a state may opt to 

directly oversee a municipality using a financial control 

board or other management mechanism. At least 

15 states have passed laws establishing a method of 

detecting and managing fiscal stress at the local level. The 

laws generally set criteria for determining when a local 

government is experiencing stress, what must be done to 

resolve the problem, who has the power to implement a 

recovery plan, and when the local government no longer 

is subject to the state oversight procedures.16 Among 

those 15 states, 7 can assume fiscal management of a local 

government using a financial control board or other manager.17 States other than those 15 have sometimes established oversight authorities for ailing governments on an 

ad hoc basis, by enacting legislation to address the fiscal 

problems of a single entity. For example, when New York 

City neared default in 1975, the state of New York established three oversight bodies whose duties included overseeing the city’s accounting practices; managing its borrowing and outstanding debt; approving its budgets; 

approving contracts with employees; and, when necessary, seizing its bank accounts and directing its operations.18

Federal Responses to Local 

Governments’ Fiscal Stress

The federal government assists local governments 

through grants, loans, debt guarantees, and certain provisions of the tax code. Because local governments derive 

their authority from states, federal control of local governments would probably violate the U.S. Constitution, 

which protects the states from federal infringement on 

their sovereignty. Therefore, the federal government cannot establish an oversight program for a local government 

or force it to take action to address fiscal stress; it can only 

encourage the actions it seeks by attaching conditions to 

the aid it provides.

Federal assistance reaches local governments either 

directly, when a federal agency provides funds or other 

assistance to a local government itself, or indirectly, when 

a state passes federal assistance through to a local entity. 

Direct federal aid to local governments makes up a small 

portion of local revenues: only 4 percent in 2008. Data 

regarding the amount of federal assistance that reaches 

local governments indirectly are unavailable; Census data 

track state assistance to local governments, some of which 

includes funds that pass from the federal government to 

states and then to local governments. 

Federal aid is rarely provided to local governments specifically because they are experiencing fiscal stress, but aid 

has been provided recently for local governments in areas 

that were affected by the economic and housing downturns and by natural disasters. For example, in August 

2010, the Congress provided $10 billion for aid to the 

states, almost all of which was required to be conveyed to 

local school districts to fund jobs in education. The 

Congress also provided a total of $6 billion in 2008 

and 2009 for state and local governments to purchase, 

rehabilitate, and sell foreclosed properties through the 

Neighborhood Stabilization Program. That grant program required states to allocate funds to local areas 

experiencing the greatest percentage of foreclosures. Earlier, the federal government created the Gulf Opportunity 

Zone Tax Credit and Community Disaster Loans programs, which were targeted to localities in Gulf states 

affected by Hurricanes Katrina and Rita. Several decades 

ago, in 1975, the federal government helped New York 

City by providing up to $2.3 billion in short-term loans 

to the city. 

Local governments also benefit from the federal tax code. 

The largest amount of support has come from provisions 

that allow taxpayers to deduct local property taxes and 

either local income taxes or sales taxes (but not both) 

from their federal tax liability.19 Substantial support has 

also come from a provision that allows taxpayers to 

15. Massachusetts Department of Revenue, “Bulletin: Local Option 

Excises,” July 2009; www.mass.gov/Ador/docs/dls/publ/bull/

2009/2009_15B.pdf.

16. Anthony G. Cahill and others, “State Government Responses 

to Fiscal Distress: A Brave New World for State-Local Intergovernmental Relations,” Public Productivity and Management 

Review, vol. 17, no. 3 (Spring 1994), p. 255.

17. Charles Coe, “Preventing Local Government Fiscal Crises: Emerging Best Practices, Public Administration Review, vol. 68, no. 4 

(July/August 2008), p. 762.

18. Martin Shefter, Political Crisis, Fiscal Crisis: The Collapse and 

Revival of New York City (New York: Columbia University Press, 

1992), pp. 132–134.

19. The law allowing taxpayers to deduct local income or sales taxes 

expired at the end of 2009.
ECONOMIC AND BUDGET ISSUE BRIEF

FISCAL STRESS FACED BY LOCAL GOVERNMENTS 9

exclude from federal income tax the interest earned on 

municipal bonds. 

Local Governments’ Default or 

Bankruptcy

Local governments that experience significant fiscal stress 

may default on their debt or file for bankruptcy. Default 

occurs when a municipal government fails to make an 

interest or principal payment to bondholders or when it 

violates a term of a bond agreement. Municipal bankruptcy is a process established in federal law that allows a 

local government to restructure its debt and other obligations under the supervision of a federal court. Both 

default and bankruptcy are extremely rare.

Default

Of the 18,400 municipal bond issuers rated by Moody’s 

Investors Service from 1970 to 2009, only 54 defaulted 

during that period. The vast majority of the entities that 

defaulted were special districts that issued debt to support 

housing or health care facilities; only six were counties, 

cities, or towns.20 In most cases, investors eventually 

recovered most or all of what they were owed. But 

defaults on municipal debt have risen in the past few 

years; this year defaults have exceeded $4 billion.

Municipalities that encounter a large, sudden loss of revenues or an increase in the cost of debt service sometimes 

default. Both Jefferson County, Alabama, and Orange 

County, California, defaulted on debt when interest rates 

moved in an unexpected direction, requiring the municipalities to make large payments (see Box 2 on page 7). A 

default may also lead a municipality to file for bankruptcy, in part to protect itself from lawsuits or court 

orders related to the default.

Bankruptcy

In the past 70 years, about 600 governmental entities 

have declared bankruptcy—with about 170 of those 

occurring between 1988 and 2005.21

As specified in Chapter 9 of the Bankruptcy Code, a governmental entity must meet four main criteria before filing for bankruptcy:

B The entity must be a political subdivision, public 

agency, or instrumentality of a state (a state itself may 

not file); 

B State law must authorize its governmental entities to 

use Chapter 9; 

B The entity must be insolvent; and 

B The entity must negotiate in good faith with its creditors to restructure its debt outside of the bankruptcy, 

to the extent practical.

Laws in 26 states authorize local governments to file 

for bankruptcy under Chapter 9. Among those states, 

12 impose no restrictions on the ability of municipalities 

to file, while 14 require local entities to seek approval 

from a state authority, such as the governor, the attorney 

general, or a bond commission, before filing. In Georgia, 

state law prohibits municipalities from filing at all. The 

other 23 states have not passed laws to address Chapter 9. 

Local governments in those states would not be allowed 

to file for bankruptcy unless the state passed a law explicitly permitting them to do so.22

To establish insolvency, a judge must determine that the 

municipality cannot use its reserves, reduce expenditures, 

raise taxes, borrow, or postpone debt payments to pay its 

obligations to creditors. In a Chapter 9 case, a bankruptcy court is prohibited from interfering with the 

municipality’s property, revenues, or political or governmental powers. Consequently, the court may not require 

the municipality to sell property, raise taxes, or remove 

officials from office. However, a municipality’s unreasonable failure to exercise its taxing powers could violate its 

duty to act in good faith—disqualifying the municipality 

from bankruptcy protection.23

Benefits of Bankruptcy. One key advantage of bankruptcy 

is the “automatic stay,” which is issued by a court and 

20. Jennifer Tennant and Kenneth Emery, U.S. Municipal Bond 

Defaults and Recoveries, 1970–2009 (New York: Moody’s Investors 

Service, February 2010).

21. Andrew Ward, “GASB Issues Exposure Draft on Bankrupt 

Municipalities,” The Bond Buyer, vol. 368, no. 33140 (June 30, 

2009), p. 21.

22. Chad Farrington, “Municipal Bankruptcies Imminent? Not So 

Fast,” Columbia Management Midyear Perspectives (August 2010), 

p. 2.

23. See, for example, Sullivan County Refuse Disposal Dist. 165 B.R. 

60 (Bankr. D.N.H. 1994).
10 CONGRESSIONAL BUDGET OFFICE

ECONOMIC AND BUDGET ISSUE BRIEF

prevents creditors from taking action against the municipality and its officials without approval from the court. 

Outside of bankruptcy, a local government may incur 

legal costs and spend time addressing legal claims as they 

arise, making the task of forming and implementing a 

solution to its fiscal problems difficult. In addition, paying claims as they arise may cause a government’s problems to snowball by diverting funds from municipal services or debt service. The stay prevents such a scenario. 

Moreover, while a stay is in place, bondholders cannot 

force municipal officials to raise taxes in order to make 

debt-service payments.

Another important advantage of bankruptcy is that 

courts can implement a restructuring plan without the 

consent of every creditor. To gain the approval of the 

court, the plan must have the approval of two-thirds of 

each class of creditors whose interests would be impaired 

by the plan. Outside of bankruptcy, creditors that did not 

agree to a restructuring would maintain the rights provided to them in law and in their bond covenants. For 

example, Orange County’s restructuring agreement gave 

participants in the investment pool 77 cents on the dollar, an amount some creditors would have been unlikely 

to accept outside of bankruptcy. 

The bankruptcy process may also allow a municipal government to reduce its labor costs by facilitating the consent of employee unions to changes in labor contracts. 

For example, Vallejo, California—which filed for bankruptcy in May 2008—restructured its labor agreements 

with three out of four unions, reducing its health care 

obligations to retirees by 75 percent, from $135 million 

to $34 million.24 The city also was able to cut its personnel costs for police protection by 18 percent from the 

level specified in the contract in place before the bankruptcy, saving a total of about $6 million in fiscal years 

2009 and 2010.25

Limitations of Bankruptcy. Because a restructuring plan 

requires the consent of two-thirds of each class of creditors whose interests would be impaired by the plan, a 

municipality may emerge from bankruptcy in an only 

slightly better fiscal position than it had when it entered 

bankruptcy. If new debt is part of the plan to alleviate a 

municipal government’s cash flow problems, the government’s obligations may be stretched out over time rather 

than eliminated. Consequently, the restructuring may 

constrain government operations for years after the 

restructuring plan is approved by the court. Orange 

County, for example, is still paying debt service on a portion of the $1.2 billion of bonds it issued in 1995 and 

1996 to exit bankruptcy; the need to pay debt service 

limits the county’s ability to cut taxes, cover increased 

costs of existing services, and pay for new services. In all 

cases, some of the fiscal gains from restructuring will be 

offset by the legal costs the municipality incurs during the 

process. 

In addition, bankruptcy does not necessarily eliminate 

the political dynamics and state laws that may make 

recovery difficult. For example, in an attempt to emerge 

from bankruptcy, Orange County put an increase in its 

sales tax on the ballot, but the measure was rejected by 

the voters. State laws that, for example, limit property tax 

rates or require local governments to contribute a certain 

percentage of their employees’ pension costs each year 

also continue to limit the ability of municipalities to 

address their fiscal problems.

24. Nicholas Gelinas, “Beware the Muni-Bond Bubble; Where State 

and Local Finances Are Untenable, Investors Should Stop Throwing Good Money After Bad,” Wall Street Journal, May 22, 2010.

25. City of Vallejo, “City of Vallejo and Police Officers Association 

Reach Agreement on Labor Contract” (press release, Vallejo, 

California, January 27, 2009).

This brief was prepared by Elizabeth Cove Delisle. It 

and other CBO publications are available at the 

agency’s Web site (www.cbo.gov).

Douglas W. Elmendorf

Director