What to watch in public finance 2025 — and where I was wrong in 2024

Last year was a record-breaker for the $4 trillion municipal market and a momentous one for the U.S. economy as well, what with the Federal Reserve cutting interest rates for the first time since 2022 and Republicans regaining control of the White House and both houses of Congress.

But less than a month into 2025, this year is already shaping up to be the previous one’s equal in sheer excitement. Here are four big trends in public finance that I am watching as this year progresses — and a fifth that I thought would take off last year, but never really did.

1.     Rising long-term bond yields and efforts to curb the muni tax exemption may deter borrowers. Last year saw muni bond sales hit a record $507.6 billion, with housing finance agency issues — a major solution for the nation’s shortage of affordable homes—in the spotlight as they captured about 10% of the market, almost triple their share in 2010-20. Transportation-related issuance also surged as federal funding from the $1 trillion Bipartisan Infrastructure Law of 2021 helped spur a 45% jump in state and local highway, bridge, airport, and railway construction contract awards from 2020’s level, according to the American Road & Transportation Builders Association. But last year’s sales record may not be repeated in 2025 if the issuance wave was driven less by unmet housing and transportation needs and more by a rush by borrowers to get bond deals done before the yield curve steepens even further.

Although Federal Reserve short-term interest rate cuts that began in September initially raised hopes that longer-term rates would follow suit, the difference between the overnight Federal Funds Rate and the yield on U.S. Treasury bonds maturing in 10 years is now the widest in more than two years.

The widening has pushed yields on the broadly based S&P Municipal Bond Index to their highest since June. Bond vigilantes speculate that the upsurge in municipal and corporate debt offerings in recent weeks may be based less on immediate needs and more on a rush by issuers to get deals done before long-term yield spike even further.

They cite the risk of continued inflation fueled by surprising strength in the American economy, a tight labor market, and President Donald Trump’s plans to slash immigration and, raise tariffs. Another risk is an expansion of the federal deficit if Congress fails to fully pay for an extension of the 2017 Tax Cuts and Jobs Act — including, as Trump has suggested, restoring SALT, the $10,000 limit cap on the deductibility from federal income taxes of state and local property, sales or income levies.

The bond market and consumers appear to share inflation concerns: University of Michigan monthly consumer survey data show year-ahead inflation expectations rose from 2.8% in December to 3.3% in January, the highest since May, while consumers’ long-term inflation expectation also hit 3.3%. It’s thus of little surprise that bond market data tracked by the Atlanta Fed’s EconomyNow app shows the probability of a 25 basis-point Federal Funds rate cut in the in the next three months plunged to 33.7% on Jan. 11 from 63.4% in mid-December. Add to inflation jitters the risk that Congress may limit the federal tax exemption for interest on most muni bonds, which the Treasury Department says amounts to $469.5 billion in forgone revenue in 2025-34. Such limits could raise some muni borrowers’ interest costs and diminish their appetite for debt.

2.     The party’s over for state budgets. Congress enacted an unprecedented $4.6 trillion in federal relief—enough to buy 13.7 million new electric school buses — to restart the U.S. economy after the 2020 COVID-19 recession. Included in the total was $350 billion in direct aid to state, local, and territorial governments (called State and Local Fiscal Recovery Funds, or SLFRF) to replace lost revenues and maintain essential services. The economic and budgetary infusions helped states boost post-pandemic revenues in 2022 by the most in four decades and pushed total rainy day fund balances in the following year to the highest since at least 1982, according to the National Association of State Budget Officers (NASBO).

But revenues and reserves have cooled lately and appear to be heading back to their long-term trend of far more modest average annual growth. Indeed, governors in several states, including Illinois, Maryland, New Jersey, New York, Rhode Island, and Washington, now are trying to close budget gaps in the current or coming fiscal years. Illinois Governor JB Pritzker, for example, described the fiscal outlook as “challenging” as he projected a $3 billion deficit for fiscal 2026.

These projected shortfalls stem less from a shortage of revenues, which are weakening from record-high levels driven by federal pandemic aid, and more to robust spending on salaries, fringe benefits, and Medicaid. Indeed, S&P Global estimates that state and local public-worker wages, salaries, and benefits are increasing by about 5% annually, almost double its forecast rise in consumer prices.

States may cover some of these gaps by drawing down reserves; California Gov. Gavin Newsom has even proposed tapping the state’s rainy day fund to maintain program spending even in the face of a projected $16 billion surplus for fiscal 2025-26.

Meanwhile, outlays for Medicaid, the health care program for low-income Americans funded by federal and state taxpayers, have ballooned by 189% over the past 20 years and accounted for almost 30% of total state spending in 2024, according to NASBO. State budgets may take a major hit this year if Congress attempts to cut the federal government’s share of Medicaid spending to help pay for the extension of TCJA or other tax reductions or credits. Reductions in Medicaid may also impact the revenues of nonprofit hospitals and nursing homes: The S&P Municipal Bond Health Care Index has slumped 2.3% since hitting an almost two-year high in November.

3.     Trump’s proposed tariffs may spell trouble for some state economies. The President-elect’s desire to impose steep new tariffs on imports from Canada, Mexico, and China would have a particularly large impact on Michigan and Illinois, Fitch Ratings estimated recently. In Michigan, shipments from the three countries, primarily of automotive parts and finished vehicles, make up 19% of state GDP, while Illinois, where 11.8% of GDP is threatened by the state’s large imports by refiners of Canadian crude oil. Retaliatory tariffs imposed by the three countries on purchases from the U.S. would also hurt natural-resources exporters in North Dakota, Louisiana, and Texas, according to Fitch. While Fitch considers a blanket imposition of tariffs unlikely, it warns that “enacted precisely as proposed, the broad tariffs proposed by President-elect Trump could pose a notable economic shock with tariff rates rising to levels not seen in the U.S. since the Great Depression.” To me, any risk to critical sectors of state economies represents a threat to tax and fee revenues and is something that should be watched closely by investors for signs of stress.

4.     Spiraling home insurance costs may threaten property values and tax revenues. Even before wildfires laid waste to parts of Los Angeles and Hurricanes Helene and Milton left trails of destruction in the Southeast, home insurance costs were already rising sharply—if coverage could be obtained at all—as climate change brews increasingly severe weather. Home-insurance premiums have jumped 74% since the Great Recession, according to Harvard University’s Joint Center for Housing Studies.

In fire-plagued California, several insurance companies have canceled or limited home coverage in recent years, forcing property owners to seek costly policies from the state-run insurer of last resort, the FAIR Plan. With Los Angeles wildfire losses estimated at as much as $30 billion, FAIR may need to turn to private insurers and assessments on homeowners to help it pay its share of the bill, according to Dave Jones, director of the Climate Risk Initiative at the University of California Berkeley Center for Law,  Energy & the Environment. Hurricane-prone Florida homeowners, meanwhile, have also had to seek coverage from their state’s own last resort: Citizens Property Insurance Corporation, which “is potentially one catastrophic storm or storm season away from insolvency,” Senator Sheldon Whitehouse (D-RI), told CNN.

The rising cost and diminishing availability of property insurance means some prospective homeowners will not be able to afford adequate coverage, a prerequisite for obtaining a mortgage. Despite state and local governments’ efforts to encourage homebuilding, this climate risk-driven lack of affordability may, over time, diminish demand for homes and depress property assessments and the taxes they generate. Warns Arthur Fliegelman, senior financial analyst at the Treasury’s Office of Financial Research: “Whether it be a property owner subject to declining property values, a lender with a diminished loan collateral value, or governments with declining taxing ability, the financial risk from such events will become ever more important in the coming years.

5.     My Bad: I misjudged the appeal to munis of IRA Direct Pay tax credits. As part of the $1 trillion Inflation Reduction Act of 2022, Congress authorized $36 billion of so-called direct pay tax credits for use by state, local, territorial, and tribal governments, school districts, rural electric cooperatives, and the Tennessee Valley Authority to help fund green energy projects. Under the program, governments can receive the same type of tax credits awarded to private investors under the IRA and redeem them for cash at the Treasury.

I had hoped the initiative would be a wildly popular financing complement to muni bonds, but so far, the credits have been used mostly to help pay for small-scale projects, like electric vehicle chargers in Alexandria, Virginia, and Williamsfield, Illinois. This may stem from the hurdles governments must navigate before getting their cash. Unlike previous direct pay programs, such as Build America Bonds, which provided upfront subsidies for taxable muni debt, projects funded through the IRA must be operational before any tax credits can be cashed in. Failure to follow requirements for domestic content and payment of prevailing wages may result in reduced credits, as will the use of tax-exempt debt to help raise project funds. To obtain the credits, governments must file tax returns with the Internal Revenue Service, something that few, if any, have ever had to do. President Trump’s threats to roll back parts of the IRA may further diminish the program’s allure. Sometimes good intentions founder on the shoals of regulatory obstacles!

Glasgall serves as public finance adviser to the Volcker Alliance, a nonpartisan, nonprofit organization in New York, and is a Fellow at the Penn Institute for Urban Research in Philadelphia.