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Outlook For U.S. States: Federal Funds Fuel Spending; Will Inflation Impede The Impact?



Through 2021, the economic recovery and once-slowing spread of COVID-19 has allowed all states to return to a more benign budgetary environment, but as we enter 2022 with two variants once again leading to worsening virus case counts, inflation at a 40-year high, and supply chain disruptions and employment shortages, uncertainties are on the rise. Even with these challenges, we expect 2022 to continue to see strong revenue collections and expenditure actions to help lead to balanced budgets. All 16 of our state rating actions in 2021 were positive in nature, with 10 reversing negative outlooks assigned early in the pandemic back to stable. Without these event driven actions, we expect 2022 to be less active in terms of changes. For more on the 2021 rating actions, please see the Appendix.

Active managerial budgetary controls coupled with the multiple rounds of federal stimulus should allow states to remain in a strong credit environment. The American Rescue Plan Act (ARPA) provided direct stimulus to the states with a variety of potential uses, whereas the Infrastructure Investment and Jobs Act (IIJA) is targeting traditional infrastructure. Most of the states are just now allocating the ARPA funds, and the IIJA monies will being to flow to projects in 2022 and over the next few years. We will be watching how these funds are spent and to what extent they affect budgetary structural balance. The more the existing funds are used for one-time revenues, the better for credit quality, but also, newly created infrastructure could come with ongoing operational and maintenance costs. We will consider how states factor these potential recurring expenditures and the revenues necessary to sustain infrastructure projects over their useful life in future budgets.

Broader, non-COVID or stimulus, credit aspects are also expected to continue to affect creditworthiness in 2022. Environmental, social and governance (ESG) attributes continue to be a hot topic in capital markets and we expect the states to continue to lead in the identification, quantification, and disclosure of such risks and opportunities. Cybersecurity risks have become more common and cyberattacks more costly in 2021, this trend, unfortunately, is likely to continue in the new year. Other technological disruptions could be coming as well. The growth in use in public finance of cryptocurrency and the changing regulatory environment could present challenges or opportunities for those states trying to address crypto demand. Additionally, this year, states with LIBOR exposure will need to ensure that they are prepared for the cessation of citing U.S. dollar denominated reference rates in 2023.

Overall, even with various risk affecting credit in the sector, states enter 2022 in a generally strong position, and with the lessons learned from the past two pandemic years and buoyant reserve levels, they are prepared to face the challenges ahead.

Chart 1


Questions That Matter

1. Why is the state sector view for 2022 stable?

Throughout the pandemic, states have adjusted revenue and expenditure expectations in a timely manner. We begin 2022 with three states on positive outlook (California, Illinois, and New Jersey) and only one, Vermont, on negative outlook.

How this will shape 2022

States enter 2022 in a good credit position.  Reserve levels for many states are at all-time highs, with an aggregate $188.6 billion expected to be available by 2022 fiscal year end. Fiscal 2021 ended with 21 states with rainy day or budget stabilization fund balances over 10% of general fund expenditures and fiscal 2022 is set to see that count grow to 27 states. However, these balances may not fully account for the breadth of unspent resources many states carried forward. We believe the combined build-up of reserves and other available resources provide an operating flexibility and liquidity cushion for states to navigate their economic recoveries and emerging budgetary risks.

Economic growth not seen in a decade will continue.  The 5.5% U.S. GDP growth expected in 2021 was the strongest seen in over three decades. Even the 3.9% S&P Global Economists forecast for 2022 will exceed any growth in the past 10 years. This should allow state revenues to come in close to or on target for fiscal 2022. (See "Economic Outlook U.S. Q1 2022: Cruising At A Lower Altitude," published Nov. 29, 2021 on RatingsDirect, for more on the economic outlook.)

Multiple recessionary driven pressures remain.  Inflationary challenges, supply chain bottlenecks, staffing shortages, and volatile markets reacting to pandemic swings will pressure state revenues and services. The buoyant reserves and expected very strong growth will allow the sector to remain stable in the face of the continuing economic uncertainties.

What we think and why

Active management and adequate liquidity remain key to creditworthiness.  Continued prudent and timely budgetary controls will hold as a hallmark of good state governments. Managing the challenges of deploying the various rounds of stimulus money falls heavily on states, but mostly to existing administrative structures, so should be manageable.

Don't expect more from the federal government.  With mid-term congressional elections and 36 governorships up for election, new stimulus and additional sweeping policy initiatives are unlikely to occur in 2022. But, spending what has already been distributed will take years. (For more on the Infrastructure Investment and Jobs Act (IIJA), please see "Construction Ahead: Roughly $1 Trillion Infrastructure Act Tackles Backlog And Future Risks," published Nov. 10, 2021.)

Fixed costs continue to demand large shares of state resources.  Even with the long positive run in the stock markets, the combined fixed costs of debt service, pensions, other post-employment benefits (OPEB) and Medicaid are still typically over a quarter of a state budget, and in some states these remain over 40% of the budget. This concentration limits flexibility and where well above average drives budget discussions over other priorities. (For more on fixed costs, please see "U.S. States Weigh Risk Reduction In Managing Pension And OPEB Liabilities,"Sept. 20, 2021, and "U.S. States' And Transit Debt Hit Emergency Brake During Pandemic As Infrastructure Needs Accelerated,"June 9, 2021.)

What could change our view to positive or negative

Vaccination successes continue.  Should vaccines provide defense against existing and new variants and more and more of the population become protected, the economic impacts from repeated identification of new strains could lessen, allowing for a stronger economic recovery.

Federal Reserve actions affect inflation.  Should inflationary pressures continue at levels detrimental to economic growth for months, the Fed could act quickly to attempt to rein in rates. If such actions were successful, then inflation could be a lesser pressure in the second half of the year.

2. What does pandemic-year three look like?

States were able to navigate the shift to remote working at the onset of the pandemic and found new and innovative ways to provide services while managing expense budgets over the past two years. This experience positions them well to steer through the challenges ahead and should help as pandemic-year three begins in March 2022.

How this will shape 2022

We're unfortunately learning more Greek letters than we may want to know.  Virus surges are expected to continue. As the Omicron and Delta variants continue to spread as we head into the new year, 2022 is looking to be more of a year three of the pandemic and not a rapid transition to an endemic life with the virus.

Supply chain disruptions abate.  Pandemic-driven travel lockdowns caused discretionary spending to slow, leading to increased savings throughout the U.S. This in turn caused a demand for goods. Throughout 2021 imports exceeded any month-over-month point in the prior three years (see chart 2); this is expected to slow as inflation mutes demand.

Chart 2



What we think and why

The end of the federal public health emergency matters fiscally.  The current 6.2% enhanced federal medical assistance percentage flowing to the states will expire along when the public health emergency expires--currently March 31, 2022. But there is a provision in the Build Back Better bill being debated in Congress to step that down through Sept. 30, 2022.

Infrastructure spending will ramp up.  Many states are just beginning to approve ARPA fund uses and the IIJA monies are expected to be spent over the next 5 years, but with a larger share of the grants targeted for action in 2022. S&P Global economists believe that infrastructure spending has a positive multiplier effect on the broader economy.

Employment challenges will continue as the Great Resignation ages.  The national unemployment rate has returned to 4.2%, a level reflecting a robust economy, and yet over 10 million positions remain open. Employment decisions made by workers seeking higher wages or more satisfying roles will continue in the new year.

What could change our view to positive or negative

Lockdowns return.  Although not expected, should a variant emerge with more severe outcomes, we could see rapid economic contraction again.

A more rapid return to pre-pandemic activity.  The counterargument to the return of lockdowns is a reduced viral spread. Should mutations continue to lead to weaker health effects or vaccination options continue to widen, the economic activity spurred by federal spending could introduce a positive credit environment.

Population movement could lead to income tax challenges.  Although the 2020 census did show a continued population shift to the south and the west, the exodus from the "rust belt" was not as severe as some had predicted. One risk we see is if high-wealth individuals move in meaningful numbers from states dependent on income taxes due to changing tax codes. This is not in our baseline forecast, but as the economy changes and government services need to be funded, we are watching this potential.

3. How will the political landscape affect credit?

The level and speed of inter-governmental funding has played a key role in credit maintenance over the past two years. This aid, along with the federal-state Medicaid relationship, will help recovery and liquidity, but uncertainties remain. With state and congressional elections looming, and the political discord in D.C., we expect the federal budget and debt ceiling discussions to remain contentious.

How this will shape 2022

With political focus on DC, states will step up and lead on important issues.  Congressional midterms typically lead to policy and programmatic gridlock in Washington. In turn, states will continue to be the incubators of governmental innovation. From resolving employment shortages, to homelessness, to retirement funding challenges, we expect state will continue to innovate.

Federal budget continues to lurch from CR to CR.  The current administration appears to be addressing national issues through large stimulus bills and the nation's operating budget is getting pushed along with no change from one continuing resolution to another. Currently, the government is funded through mid-February. This slows any federal-level innovation, as only existing programs are funded in CRs.

What we think and why

Medicaid is still a significant influence on state spending.  Through the pandemic we have seen Medicaid rolls grow by 16.8%. Although early on, as the virus spread, people were hesitant to get elective surgery, we have seen Medicaid costs slowly rise. As federal law has prohibited removing anyone from eligibility once on Medicaid during the health emergency, once the emergency ends, we expect to see states verify the roll and cull the ineligible. Until such time, costs could remain high. Also, states currently receive a 6.2% higher federal Medicaid matching reimbursement during the pandemic, which will at some point be rolled back, which would cause an immediate hit to state budgets.

What could change our view to positive or negative

Stimulus packages could lead to budgetary imbalance or increased leverage.  The Build Back Better plan looks to make changes to social infrastructure programs. Should this cause expenses for state-level programs to increase faster than complementary revenues, a budgetary structural balance could emerge. Additionally, ARPA and IIJA funds incentivize infrastructure spending.

4. What ESG issues will challenge credit quality?

ESG factors continue to contribute to state credit discussions. States generally have broad tools to address ESG risks and the financial resources and personnel expertise to implement comprehensive risk management strategies to insulate operations from the evolving nature of these issues. For example, states typically lead the response to storm events, political protests, and service delivery challenges and we expect the focus on these risks to continue to heighten in 2022. We share our ESG views on state credit quality in dedicated paragraphs of our individual state credit reports, but also through other commentaries.

How this will shape 2022

Quantification and disclosure of ESG issues remains in the spotlight.  As the credit risks and the ESG risks continue to be identified, assessed and compared, disclosure will be a hot topic in the sector. What risks affect credit is key to ratings, but how ESG is valued and information desired in the market are evolving. And, in that as states go so go the rest of the sectors, any precedent set in state-level disclosure will be meaningful broadly.

What we think and why

Environmental risks heightened by storm headlines, drought, and climate transition risk.  On average, annually in each the past five years there have been almost 17 storms with losses of over $1 billion, and the drought in 2021 at one point was affecting two-thirds of the states. These conditions are expected to continue and will bring further credit focus to the actions states are taking, and the associated costs to remediate these catastrophic events. In addition, we believe states will continue to lead on climate transition policies and implementation of renewable energy solutions to achieve net-zero greenhouse gas emissions--however, we believe state actions may not be uniform across the sector. (Please see "ESG in U.S. Public Finance Credit Ratings: 2022 Outlook And 2021 Recap," Nov. 29, 2021, for more information.)

LIBOR elimination comes into public finance focus.  The London Inter Bank Overnight Rate (LIBOR) is no longer being cited in many currencies but will continue to be a viable reference rate in U.S. dollars through June 30, 2023. Public finance issuers with LIBOR rate exposure will need to be taking governance actions in 2022 to prepare for any rate change in payment obligations.

Cyber-hygiene remains a credit discussion.  Cybersecurity lapses continue to create disruption and drain liquidity throughout public finance. States have a leading role in role-modeling and supporting strong cyber-hygiene practices. As the federal government mandated the zero-trust cybersecurity approach for its own agencies in 2021, we would expect states would begin to adopt this standard as well in 2022. Zero-trust architecture is where every user is verified prior to gaining access to the system. (For more on cybersecurity in ratings, please see "ESG Brief: Cyber Risk Management In U.S. Public Finance," June 28, 2021, and "Cyber Risk In A New Era: Are Third-Party Vendors Unwitting Cyber Trojan Horses For U.S. Public Finance?," Oct. 25, 2021.)

What could change our view to positive or negative

Rapid up-take of decentralized finance (DeFi) and cryptocurrencies could disrupt traditional markets.  We expect DeFi to continue to complement, not supplant, traditional finance in 2022. Regulators are discussing their role and as new regulations are passed, the velocity of change or volume of disruption could become clearer. Regulators will have to strike a balance between encouraging innovation and ensuring stability of both existing markets and the developing DeFi markets.

5. Will any economic sectors out-perform others and which states may benefit?

There has been variation in how different sectors of the economy performed through the pandemic and we expect this to continue in 2022. This will continue to have implications for state revenue performance. All sectors of the economy have experienced the recovery, but for some the pace of recovery to pre-pandemic levels has been more rapid than others. In 2022, we expect the economic recovery to continue, but also the pace to remain uneven and influenced by coronavirus variants.

How this will this shape 2022

Technology and service sectors will remain strong.  The work-from-home pivot those sectors made during the onset of the pandemic continues to serve them well with increased productivity and minimal virus-related disruptions. These sectors tend to have some of the higher paying jobs, and so income tax revenues are expected to remain steady, but we are watching whether inflation will affect collections.

The pre-pandemic Wayfair decision bolstered and stabilized sales tax revenue.  The shift to online shopping and delivery throughout the pandemic was captured in state sales tax revenues and this has contributed to budget stability. As online shopping and delivery companies became essential services, state sales tax revenues surprisingly held to forecast and then grew. As the world now knows how to operate in a viral-surge environment, we see sales taxes as being a more stable source of revenue than believed pre-pandemic.

What we think and why

States with energy sector concentration have rebounded from the 2020 price plunge.  The 2022 energy sector will see uneven recovery from the depth of the pandemic, but continued sector strengths hold. Oil- and mineral-producing states face ongoing risk from increasing regulations of carbon emissions and an accelerating energy transition to renewable energy. Over time, we expect these evolving credit risks to exert negative pressure on state operating environments. Coal prices and production have also staged an unexpected bounce back, although likely to be a temporary respite from declining long-term trends. (For more on energy states, please see "U.S. Oil And Gas-Dependent States Are Out Of The Woods (For Now)," April 15, 2021.)

Tourism states have nearly recovered, but variants continue to drive volatility.  The last of the major economic sectors to recover has been tourism, including convention center activity. We have returned state such as Hawaii and Nevada to stable outlooks, but the volatility in the sector will likely remain as new variants emerge, and governments act. International and business travel have not reached pre-COVID levels. The course of the pandemic will weigh on recovery but other factors such as corporate commitments to reduce carbon footprints could also slow progress.

What could change our view to positive or negative

Vaccination responses to new variants are too slow.  Should there be a need for greater near-lockdown regulations to respond to emerging new variants, the economic recovery could suffer. Our baseline scenario does not expect this.

Inflationary pressures not absorbed into economy.  With inflation set to remain above levels seen over the past decade, should this change affect sectors differently, those states where the core economic activity is negatively affected could see revenue pressures.

Vacation deprivation bookings abound.  After two-plus years of pandemic-induced staycations, should the vaccines continue to show efficacy and the travel restrictions lessen, those places with high tourism sector concentration could see a meaningful boost in activity.


State Rating Actions In 2021
Date State To From Action
March 9 Illinois BBB-/Stable BBB-/Negative Outlook change
April 13 Oklahoma AA/Stable AA/Negative Outlook change
April 30 New Mexico AA/Stable AA/Negative Outlook change
May 4 Alaska AA-/Stable AA-/Negative Outlook change
May 13 Connecticut A+/Stable A/Stable Upgrade
June 11 New York AA+/Stable AA+/Negative Outlook change
June 30 Michigan AA/Stable AA/Negative Outlook change
July 8 Illinois BBB/Stable BBB-/Stable Upgrade
Aug. 3 New Jersey BBB+/Positive BBB+/Stable Outlook change
Aug. 4 Pennsylvania A+/Stable A+/Negative Outlook change
Aug. 25 Wisconsin AA+/Stable AA/Stable Upgrade
Aug. 26 Minnesota AAA/Stable AAA/Negative Outlook change
Sept. 2 California AA-/Positive AA-/Stable Outlook change
Sept. 21 Hawaii AA+/Stable AA+/Negative Outlook change
Sept. 22 Nevada AA+/Stable AA+/Negative Outlook change
Nov. 18 Illinois BBB/Positive BBB/Stable Outlook change

Chart 3


Chart 4


This report does not constitute a rating action.

Primary Credit Analyst:Geoffrey E Buswick, Boston + 1 (617) 530 8311;
Secondary Contacts:Sussan S Corson, New York + 1 (212) 438 2014;
David G Hitchcock, New York + 1 (212) 438 2022;
Ladunni M Okolo, Dallas + 1 (212) 438 1208;
Oscar Padilla, Dallas + 1 (214) 871 1405;
Research Contributors:Andrew J Stafford, New York + 212-438-1937;
Thomas J Zemetis, New York + 1 (212) 4381172;

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