The short term problem is the recession. State and local tax revenues are down by 10%. They have cut spending 7% and they have received some help from the federal government but the stimulus runs out this year. Jobs have been lost and programs that serve the most vulnerable have been cut. Some states may have to default on their debt. That would make it more difficult for state and local governments to obtain credit. In any case, government spending is around 15% of GDP. Further cuts in state and local spending will stall the recovery.
Longer term, state and local governments have assumed pension and healthcare obligations that are unfunded. It will be difficult for them to provide current services and fund their future obligations without increasing taxes. This will provide an opportunity for politicians to use the crisis for political gain. Some are paying for tax cuts by refusing to pay into pension plans. Our current political climate of anti-government and anti-tax sentiment will fuel demagoguery on the right and weaken the resolve of democrats in the center.