President Barack Obama and Congressional leaders are in the middle of tough negotiations to avert the cliff before the start of the new year. Economists have warned the combination of tax hikes and across-the-board spending cuts, often referred to as sequestration, could plunge the country back into recession.
A downturn or a downgrade in the U.S. debt rating resulting from the federal budget battles would threaten the credit quality of the public sector, Moody's said.
"Rating changes could ensue for public finance credits that have direct, or in some cases indirect, linkages to the rating and credit standing of the U.S. government," it said.
"These rating changes would occur if Moody's lowers the U.S. government's rating as a result of the fiscal cliff, or a federal budget agreement is reached that fails to reduce the ratio of federal debt-to-GDP over the medium term," it added.
Sequestration would mostly impact states indirectly as federal grants to people shrink and they spend less money. Currently, Medicaid, the healthcare program for the poor that states administer with federal reimbursements, is safe from sequestration. Moody's warned that if Obama and Congress were to decide to cut it in their agreement, "the credit impact would be more severe."
"The largest component of the sequester is an approximately 9.4 percent, $30 billion across-the-board cut to discretionary defense programs," Moody's added. "If it is implemented, the economic impact will be most heavily felt in states with high concentrations of defense procurement contracting such as Maryland, New Mexico and Virginia."
Local governments only receive 5 percent of their revenues from direct federal payments, on average, meaning they too will only be affected by sequestration as lower spending hurts their revenues, Moody's said. Cities dominated by the federal government and military could be hit harder.
While Medicaid is off limits in sequestration, Medicare, the health insurance program for the elderly, would have to reduce reimbursements for services by 2 percent. That would hit non-profit hospitals.
Sequestration would also cut agencies that fund research at universities, but will likely only impact new grants, while the availability of federal financial aid may shrink, hurting higher education, Moody's said
The agency also said defense spending cuts will hurt military housing and could negatively impact revenue bonds for it.
(Reporting By Lisa Lambert; Editing by Leslie Adler)