What Happens To States And Localities If The Federal Government Hits The Debt Ceiling?

By Matthew Cameron

As the debt ceiling debate has climaxed during the past several weeks, there has been a lot of discussion about what the federal government would do if the Treasury actually were to run up against its legal borrowing limit. Would Social Security checks be sent out on Aug. 3? Would active duty military personnel get paid? Would government offices be able to stay open?

These are all important concerns, but none of them deals with what might be the most immediate and widely felt consequence of hitting the debt ceiling: the fiscal chaos it would thrust upon state and local governments. These entities provide many essential services that are dependent at least in part on federal funds and they also have their hands tied by convoluted and inflexible budget requirements, meaning they would be highly vulnerable in the case of a debt ceiling breach.

For example, the Bipartisan Policy Center simulated a situation in which the federal government, unable to continue borrowing, had to cut off funding for everything but a few “big-ticket” programs — Social Security, Medicare, Medicaid, payments to defense vendors and unemployment insurance. Although Medicaid would be protected under this scenario, it would mean that student financial aid payments would stop, grants for housing and social services would be put on hold and joint state-federal transportation projects could be disrupted. This would leave states and localities trying to fill in the gaps. Public universities would need additional money so they could disburse required tuition assistance credits to the accounts of students receiving federal loans or Pell Grants; local housing authorities would need to pick up the slack for missing federal rental vouchers; and states would have to assume the entire cost of ongoing highway construction projects (of which there are many).

There is a lot of uncertainty about what options would be open to states and localities under such unprecedented circumstances. Making things even more unpredictable is the fact that every state has different laws and procedures for dealing with short-term funding gaps. According to a 2010 report put out by the National Conference of State Legislatures, “In some states, executive branch officials have limited authority to initiate short-term borrowing for cash-flow purposes; however, in many states, even short-term loans cannot be sought without legislative approval.” Apparently, state executives in Virginia and California already are preparing to act unilaterally in case of a debt ceiling crisis, but recent controversies surrounding short-term borrowing in Illinois and New York have shown that such action is not possible in those states unless the legislature approves. Given that most state legislatures currently are out of session and that funding would need to be approved rapidly to protect against any serious disruptions, it therefore seems unlikely that many states will be able to dodge a direct hit from a debt ceiling crisis.