Summary

The new presidential administration and Congress have indicated that they intend to bring about a dramatic federal retreat in funding for health care, food assistance, education, and other services that will push more of the responsibility for providing these essential services to the states. Meeting these new obligations would be a challenging task for states during normal times, but these are far from normal times.

As explained in this brief, a range of actions under consideration at the federal level would depress state tax collections and leave states with inadequate revenue to meet their current responsibilities, much less the new ones being envisioned for them by President Trump and the current Congress. In particular, state tax revenues are under threat from the economic fallout created by the budding trade war, aggressive immigration actions and rhetoric, and federal employee layoffs and canceled contracts. Moreover, cuts to IRS tax enforcement and proposals to narrow the federal tax base with new income tax carveouts threaten to directly reduce state tax collections independent of any change in the broader economy. In light of these significant risks to state tax revenues, states should prepare to pause or roll back their recent tax cuts and begin planning for tax increases to help them weather the approaching fiscal storm.

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Introduction

Crafting responsible state tax policy requires looking to the future and being prepared for the economic and budgetary risks that lie ahead. This is especially crucial for states right now, as the risks they face are unusually high.

President Trump and the U.S. Congress are setting the stage for a dramatic federal retreat in funding for public services, with many of those reductions likely to take the form of cuts to intergovernmental grants that states and localities use to fund education, food assistance, and the Medicaid health care program that insures 70 million Americans.^[1] On top of that, states and their localities could face significantly higher borrowing costs if a Congressional plan to begin taxing municipal bond interest is enacted into law.^[2] The combined effect of this shift in policy would be hundreds of billions of dollars, or more, in additional expense to states and localities over the next decade. This would put states in the position of having to either make up the lost funding from other sources or pare back or terminate benefits.

Compounding the significant risks to state budgets is the fact that several actions that are either underway, or being planned, by the Trump administration and the current Congress would significantly cut into the revenue raised by states’ own tax policies. Some of those actions would depress state tax revenues by shrinking state economies and tax bases, while others would directly reduce state tax collections independent of any change in the nation’s economic trajectory. Those actions include:

• Steep tariffs and erratic trade policy creating higher costs, slower growth, and more uncertainty for U.S. consumers and businesses
• Aggressive immigration enforcement and anti-immigrant rhetoric leading to declines in both employment and tax compliance among the immigrant population
• Reductions in income and purchasing power created by large scale federal layoffs and cancellation of government contracts with businesses and nonprofits
• Cuts to IRS enforcement that would allow for increased tax evasion
• Narrowing the federal income tax base with new carveouts for categories of income such as tips, overtime, and Social Security, plus whittling away at the definition of capital gains income

These revenue-reducing actions would come on top of significant state tax cuts enacted in recent years that are already straining many state budgets.^[3] And they would come at a time when states are increasingly facing structural budget deficits that make it difficult to fund essential services during good times and leave them ill-prepared to deal with new budgetary challenges.^[4] Each of the risks to state tax revenue mentioned above is discussed below.

Economic Risks of Trade War

The Trump administration briefly increased tariffs on importers of foreign goods to levels not seen in over a century before backtracking and temporarily pausing many of the levies for 90 days.^[5] As of this writing, 10 percent tariffs remain in effect for most countries, with higher rates on many goods imported from Canada and Mexico, plus a staggering 125 percent rate on Chinese goods. Well-designed, targeted tariffs can play an important role in promoting fair trade and domestic economic growth, but the Trump administration’s approach has been unpredictable, divorced from economic reality, and done without regard for either the trade policies of other countries or the consequences for the U.S. market.^[6] The potential costs to the U.S. economy—and, by extension, the state and local tax bases that rely on it—are significant.

The Federal Reserve recently predicted that the U.S. is headed for a future of higher inflation and slower economic growth—a combination known as stagflation—largely because of the administration’s trade policies.^[7] This prediction is increasingly becoming the consensus view among economic experts, and many forecasters think that the possibility that the U.S. could slip into an economic recession is on the rise.^[8]

For its part, the Trump administration is doing little to rebut these predictions. President Trump has declined to rule out the possibility that his policies will spark a recession and, in fact, has predicted that a “period of transition” lay ahead.^[9] Commerce Secretary Howard Lutnick has said that realizing Trump’s trade policy vision would be “worth it,” even if doing so pushed the U.S. economy into a recession.^[10]

An economic recession would be extremely damaging to state and local finances. State tax revenues declined by 4.5 percent during the 2001 recession and by 11 percent because of the 2007-2009 recession.^[11] Declines of that magnitude today would cost state governments between $64 billion and $158 billion in lost tax revenues annually, with local governments confronting additional losses on top of those amounts.^[12]

Even if a full-blown recession does not materialize, economic growth is virtually certain to slow in the months ahead, with negative consequences for state and local tax revenue. Personal and corporate income tax revenues, for example, are at risk if companies scale back their hiring and expansion plans, which some businesses are doing because of U.S. tariffs and retaliatory measures from other nations, and others are doing simply because the unusually high level of economic uncertainty of this moment makes it difficult to plan for the future.^[13] The recent tumult in the stock market created by the Trump administration’s policies also has the potential to hold down state and local income tax revenue derived from taxing capital gains—especially in states with larger populations of affluent taxpayers.

Superficially, the Trump administration’s tariffs could boost state and local sales tax revenues by raising prices for American consumers. Sales taxes are collected as a percentage of the price of goods and services, so higher prices will lead to more sales tax being paid on each item purchased. But tariffs do not increase the amount of disposable income that consumers have available to spend, so for many people higher prices brought on by tariffs will primarily result in them buying less with the limited dollars they have available. Moreover, an inflationary boost in sales tax revenues will be only an illusory benefit to state budgets, as inflation raises the costs facing states in much the same way that it raises the costs facing families.

Sales taxes collected from spending on discretionary items is particularly at risk in the months ahead as consumers face sticker shock from tariff-induced price hikes for motor vehicles, electronics, appliances, clothing, and other items. One likely result of higher prices on these items is that consumers will choose to delay or forgo some purchases, such as by holding onto their old car longer than they otherwise would have.^[14]

Consumer preferences could also shift to favor services over goods, as services will be less affected by the tariffs. Such a shift would reduce sales tax collections in most states as services are often exempt from sales tax.

Declines in discretionary purchases could be especially steep if consumers are growing more pessimistic of the nation’s economic outlook, as recent declines in consumer sentiment suggest. While it is normal to see some shifting in consumer sentiment following the swearing in of a new president, it is particularly concerning that these declines are occurring among people across the political spectrum.^[15] Past experience suggests that widespread declines in consumer confidence are an indicator of an approaching drop in household spending. Such a drop would directly depress sales tax revenue collections and would have broader ripple effects throughout the economy that could negatively impact other revenue sources as well.^[16] Already, there is some early evidence that consumers are opting for a more cautious approach to their own finances, as the personal savings rate rose during the first two months of 2025.^[17]

Economists are largely unconvinced by arguments from administration officials, such as Treasury Secretary Scott Bessent, that the troubling economic developments of the last few weeks are short-term effects akin to a “detox period.”^[18] The Chairman of former President George W. Bush’s Council of Economic Advisers, for instance, has said that the current administration’s policies seem to be setting the stage for “short-term pain to get more long-term pain.”^[19] And because states must balance their budgets every year, even short-term pain can create daunting fiscal challenges.

Regardless of the ultimate outcome of the growing trade war, it is indisputable that the Trump administration’s policy choices have created a moment of intense economic uncertainty for states that are clouding their budget outlooks. As Maryland Comptroller Brooke Lierman memorably explained, “no accurate economic model exists to predict President Trump’s behavior.”^[20]

Deportations and Other Anti-Immigrant Policy Actions

A key feature of the Trump administration’s policy agenda is the deportation of millions of immigrants. While the pace of deportations has so far not reached the level needed to realize that outcome, that could change if the administration secures additional resources from Congress or reroutes existing resources—military or otherwise—to the cause of mass deportations.^[21] Both deportations and the general environment of fear that surrounds them come at a significant revenue cost to federal, state, and local governments.

Recent ITEP research finds that undocumented immigrants paid $96.7 billion in taxes in 2022, with more than a third of that amount ($37.3 billion) going to states and localities.^[22]

Deporting immigrants on a large scale would cause most of those revenues to vanish from public coffers. Both income and sales tax revenues would be reduced as these individuals would no longer be in the U.S. earning taxable incomes and making taxable purchases. We predict a $7.9 billion reduction in annual revenue for every 1 million undocumented people who exit the country, with $2.5 billion of that coming out of state and local budgets. But these figures almost certainly understate the true revenue cost to states of deportations, for three reasons.

First, they do not factor in losses to business output from significant workforce declines. Sectors such as construction and agriculture would be particularly hard hit by large scale deportations, likely leading to lower amounts of taxable business activity and higher costs for food and housing.^[23] It appears that the fear of deportation is already affecting these industries, as media reports indicate that undocumented workers are increasingly avoiding workplaces that they view as especially likely targets for immigration enforcement action.^[24] In Florida, labor shortages brought about by immigration enforcement efforts have become severe enough that lawmakers are considering loosening child labor laws to allow businesses to fill low-wage job openings.^[25]

Second, it is becoming increasingly apparent that the administration’s deportation efforts will extend beyond the undocumented community and will include many documented immigrants as well.^[26] Because documented immigrants possess the legal authorization to work, they generally earn higher incomes and exhibit higher tax compliance rates than the undocumented population. Efforts to deport or otherwise intimidate documented immigrants would therefore come at an even steeper cost to state budgets than actions targeting the undocumented population.

Third and finally, a significant ramp up in deportations and a generally hostile environment toward immigrants more broadly will cause many immigrant families to take steps to retreat from public view even if they do not exit the country. This would include, for example, efforts to find less formal, off-the-books employment at jobs that are less likely to withhold income tax from paychecks. The fact that the Department of Homeland Security is on the verge of gaining access, for the first time, to highly confidential taxpayer information housed at the IRS is sure to exacerbate these outcomes.^[27] Our analysis suggests that every 10-percentage point drop in the income tax compliance rate of undocumented immigrants would lower total state and local tax collections by $900 million per year.^[28]

Federal Employee Layoffs and Contract Cancellations

The Trump administration is engaged in an aggressive and legally dubious campaign to fire hundreds of thousands of federal employees and cancel contracts with U.S. businesses and nonprofits. These actions will hurt the economies and tax bases of every state as the people who are paid, either directly or indirectly, by the federal government will report lower taxable incomes and business profits and have less money to spend on sales taxable items.

While federal employees are an important part of the workforces of every state, the economic and budgetary effects of federal layoffs will be more acute in some places than others.^[29] The places with the highest proportion of their workforces employed by the federal government are the District of Columbia (13.2 percent), Maryland (7.3 percent), Virginia (5.6 percent), New Mexico (4.8 percent), Hawaii (4.6 percent), and Alaska (4.5 percent).^[30] In some states with particularly large numbers of federal employees, state agencies are reportedly concerned that they lack the capacity to handle the flood of applications for unemployment assistance coming their way.^[31] More layoffs occurred in March than at almost any other time in the last 35 years, with the only exception being the early days of the COVID-19 pandemic.^[32]

Because of the layoffs announced so far, the D.C. Chief Financial Officer is forecasting that the District is entering a mild recession and will lose more than $1 billion in tax revenue over the next three years.^[33] Similarly, the board responsible for estimating tax revenue collections in Maryland recently cut its revenue projections by $280 million over two years—primarily due to reductions in federal employment.^[34] Virginia lawmakers, meanwhile, have discussed boosting the state’s reserve fund to deal with the budgetary fallout of federal layoffs, though ultimately opted against doing so.^[35]

State and local tax revenue will also be reduced because of the growing tide of cancelled federal contracts, grants, and leases. While many of the earliest cuts to federal contracts touted by the Department of Government Efficiency (DOGE) were less dramatic than advertised, the effects are mounting.^[36] These cancellations will constrict state and local tax revenues as people whose positions were funded by these contracts lose their jobs and contribute fewer income and sales tax dollars to state and local budgets.

A wide range of industries are being impacted by these cancellations. Communities receiving significant federal grants for scientific research are being particularly hard hit, with the prospect of lab closures appearing imminent in some places.^[37] Health services are also being scaled back after the recent announcement that the Department of Health and Human Services has cancelled $12 billion in federal grants to states.^[38] Janitorial contract jobs have been eliminated or scaled back in some places, causing federal employees to spend part of their workdays cleaning federal facilities rather than performing their core job responsibilities.^[39] Some homebuilders are concerned that their contracts with the federal government are at risk.^[40] And attempts by the federal government to cancel building leases are expected to reduce commercial property values and property taxes in some communities.^[41]

To give some sense of scale, Maryland officials estimate that federal contracts are equal to roughly 10 percent of the state’s private sector economy.^[42] While not all communities are as exposed as Maryland, the effects of these cancellations will be widely felt across the country.

Cuts to IRS Capacity to Enforce the Tax Law

The Internal Revenue Service (IRS) has been subject to increasingly deep cuts both to its funding and workforce, and more cuts appear to be on the horizon. The IRS’s core responsibility is to uphold the integrity of the tax code by ensuring compliance with tax law—both through taxpayer assistance and enforcement actions. It is widely understood that reductions in IRS enforcement lead to significant losses of federal tax revenue as tax evasion goes undetected and more people become emboldened to shirk their tax responsibilities.^[43] Less noticed, however, is the fact that states and localities also lose significant tax revenue when the IRS lacks the resources it needs to uphold the integrity of the tax code.

State taxes on personal income, corporate income, and large estates are heavily based on federal rules and their smooth operation depends in no small part on IRS enforcement of those rules. Typically, the amount of income or estate value appearing on a taxpayer’s federal tax return is a key factor in determining the amount that will appear on that taxpayer’s state (and sometimes local) tax return. When the IRS suspects that the amounts reported on federal returns were understated and federal taxes were underpaid, it opens an audit and state tax auditors typically piggyback on that effort to recover unpaid state taxes as well. If the IRS is no longer up to the task of ensuring that taxpayers are filling out their tax returns accurately and honestly, states will face a significant erosion of their tax bases.

Between 2010 and 2021, the IRS budget was cut by a fifth and the number of revenue agents dropped by 35 percent.^[44] In 2022, however, it appeared that the agency’s outlook was finally improving, as the Inflation Reduction Act was signed into law with the promise of $80 billion in new funding for the IRS to modernize its systems and ensure effective enforcement of the tax law among high-income people and large corporations. Despite early signs that the funding was yielding higher tax revenue collections, the new Congress that was sworn into office in 2023 set its sights on stripping away as much of this funding as possible.^[45] In March 2024, Congress eliminated $20 billion of IRS funding and followed that up with another $20 billion cut in December 2024.^[46]

Upon taking office in January, President Trump compounded the effects of those funding cuts with drastic reductions to the IRS workforce. In total, some 11,400 IRS employees have been fired or have taken a “voluntary buyout” so far this year.^[47] Another 20,000 employees, or nearly a quarter of the agency’s workforce—are reportedly at risk of termination in the near future.^[48] And there has also been talk of cutting the agency’s workforce by as much as half—which would amount to a loss of roughly 50,000 employees in total.^[49]

The revenue implications of these funding and staffing cuts will depend on how they are distributed across the agency’s various functions. Cutting back on IRS call centers, for instance, will make the taxpayer experience significantly worse but will not necessarily lead to large reductions in government revenue. Cutting the enforcement of tax laws as they apply to high-income people and multinational corporations, on the other hand, will cut deeply into both state and federal tax revenues. The Government Accountability Office estimates that every hour spent auditing the tax returns of very high-income people yields $13,000 in tax revenue.^[50]

The impact of IRS enforcement reductions on state revenues will depend on the extent of the reductions. Very large budget cuts would be disastrous for public revenues not just because of the revenue lost from cancellation of planned audits, but because if the IRS develops a reputation for being incapable of enforcing the tax law, unscrupulous filers will engage in far more aggressive forms of tax evasion. According to media reports, IRS officials have already noticed an increase in online comments by individuals saying they intend to pursue more aggressive tax avoidance and evasion strategies now that the likelihood of being subjected to an IRS audit seems to be dropping.^[51]

With this dynamic in mind, one recent estimate suggests that a 50 percent cut to the IRS workforce could reduce federal tax revenue by as much as $2.4 trillion over 10 years.^[52] Under that scenario, states would lose hundreds of billions of dollars of their own tax revenue as well.

New Income Tax Carveouts

President Trump campaigned on a platform that included removing various forms of income—especially tips, overtime, and Social Security—from the federal income tax base. He has also suggested creating a new deduction for personal car loan interest paid on American-made vehicles, to offset some of the price increases triggered by his tariffs on foreign-made auto parts.^[53] Congressional leadership is reportedly attempting to include at least some of those proposals in the major tax bill they expect to advance this year.^[54]

On top of that, proposals to whittle away at the definition of capital gains income are also receiving some attention.^[55] That whittling could take the form of a legally dubious, unilateral executive action to adjust the way capital gains are calculated.^[56] Or it could come in the form of a new capital gains tax shelter designed to spur wealthy families to take part in steering public dollars into private K-12 schools.^[57]

State-level income tax definitions are generally based on federal rules, so narrowing the federal tax base with new carveouts runs the risk of weakening state tax bases as well. Exactly how that would unfold depends on the details of how the federal policy change is crafted. Narrowing the federal definition of Adjusted Gross Income (AGI) would be particularly damaging to states as AGI is the starting point used in most state income tax laws.^[58] Weakening the definition of taxable income, on the other hand, would also reduce state revenues but would do so in a smaller number of states.

Even putting aside the automatic, mechanical effects of changing federal income definitions, it is also likely that a decision by the federal government to remove certain kinds of income from the tax base would inspire copycat proposals in the states. The leader of the Kansas Senate, for instance, has argued that the state should follow the federal government’s lead if tips are exempted from the federal income tax.^[59] In total, lawmakers in roughly half the states with income taxes have introduced bills this year to exempt tips or overtime from tax, inspired by President Trump’s campaign promises on these topics.^[60]

Conclusion

The policy developments unfolding at the federal level are very likely to put state budgets under increasing strain in the months and years ahead. Some of that strain is likely to take the form of cuts in intergovernmental grants to states and localities. But states’ own tax revenues are at risk as well due to the economic fallout created by the budding trade war, aggressive immigration actions and rhetoric, and federal employee layoffs and contract cancellations. Moreover, planned cuts to IRS tax enforcement and proposals to narrow the federal tax base with new income tax carveouts threaten to depress state tax revenues irrespective of any change in the nation’s economic trajectory. All these actions are likely to result in fewer resources for schools, health care, and infrastructure funding in communities across the country. In light of these significant risks to state tax revenues, state lawmakers should prepare to pause or roll back their recent tax cuts and begin planning for tax increases to help them weather the fiscal storm that is coming their way.

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Endnotes

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