The $29 trillion federal debt held by the public is becoming an increasingly local problem. Washington’s fiscal challenges have led to increased borrowing costs as well as reduced federal aid to states, cities, and other local governments—who may soon have to reconsider their budgets as they face a difficult choice: cut services, raise taxes, dip into reserves, or incur further debt.
Based on estimates done before the latest reconciliation bill (the One Big Beautiful Bill Act, which is expected to significantly deteriorate the country’s fiscal outlook), the federal debt is expected to grow from 124 percent of gross domestic product (GDP) in 2025 to 135 percent in 2035, which means that the federal government will absorb an increasingly larger share of the economy and capital markets.
As a result, investable capital will flow at increasing rates to U.S. debt, making it necessary for other borrowers—including state and local governments—to offer higher interest rates on their bonds to compete with U.S. Treasury debt.
Indeed, as federal rates have risen, it has already become more expensive for local governments to borrow. As of late July 2025, the Bloomberg 30-year tax-exempt municipal bond yield benchmark reached a peak of 4.81 percent, a sharp rise from the COVID-era lows of 1.5 percent.
Federally, net interest costs are forecasted to surpass all other spending categories, besides Social Security, by 2052. This trend of rising interest costs crowding out other spending is likely to trickle down to state and local governments.
Another channel through which the national debt may influence local budgets is federal aid. Federal grants are currently the largest single source of revenue for state and local governments, and they are decreasing. According to the Census Survey of State and Local Government Finances, in 2022 (the most recent year available), 28 percent of all state and local revenue came from the federal government—a share larger than income, property, sales, or any other tax. Some of this money came in the form of special COVID-relief grants. These grants provided American municipal and state governments with $885 billion in direct aid and were required to be spent by 2024. Before COVID, federal aid represented about 20 percent of state and local government funding and primarily funded Medicaid.
In theory, these COVID grants were intended to fund public health spending or mitigate COVID-related economic impacts. They could not be used to pay off legal judgments, settle debts, fund underfunded public employee pensions, or prop up rainy-day/reserve funds. In practice, however, much of the money went to nonemergency and recurring programs. With pandemic-era grants expiring in 2024, state and local governments are now under pressure to find alternative funding for these services.
Besides the scheduled phase-out of COVID aid, fiscal pressure in Washington has led to reductions in other types of funding for states. The latest reconciliation bill capped the federal Medicaid reimbursements, passed a larger share of Supplemental Nutrition Assistance Program (SNAP) costs to states, and drastically reduced Biden-era clean energy infrastructure grants. Funding for some transportation projects was slashed, too. More cuts are likely to come.
This comes as states have already been feeling a strain on their budgets. This year, many states are projecting shortfalls in the billions—including California, Washington, Maryland, Pennsylvania, and Illinois. Even Florida is expected to face deficits of $2.8 billion in 2026, and potentially $6.9 billion in 2027.
This fiscal tightening is not limited to states: Major cities like Los Angeles, San Diego, Houston, and Chicago are also facing substantial budget gaps.
Although many of the fiscally stressed governments have announced hiring freezes and other prudent cost containment measures, they have not been enough. Instead of “right-sizing” the scope of their activities, state and local governments—faced with both higher borrowing costs and less federal support—have unfortunately opted to dip into their record-high savings accumulated during COVID and issue more bonds, even amid today’s elevated interest rates.
As federal support dries up from many ends, and its return becomes not only politically but economically less feasible, state and local governments should resist the temptation to push costs to an indefinite future and drive down precious savings to fund permanent programs—precisely the approach that has led to the status quo—and opt instead for a serious, responsible reorganization of their finances.
