The other shoe will drop in the upcoming round of congressional budget cuts that are expected to reinforce these dramatic executive branch barrages. More immediately, though, public finance officers must also gauge how federal trade policy, a U.S.-China trade war and the other new tariffs elsewhere will affect their own states’ economies and thereby their own fragile tax revenues.
Putting aside debates over the wisdom and merits of federal spending cutbacks, freezes and policy changes, the challenge ahead for state and local government budget staff and top administrators is how to manage through this regime change from the standpoints of fiscal and personnel planning. Hopefully the directional and quantitative analysis that follows will be illuminating as well for elected policymakers and operating department heads who need to understand the rationale for unpleasant fiscal management recommendations and actions.
Looking ahead into their various upcoming fiscal years beginning in or after July, the first order of business for budgeters will be to identify which federally assisted programs are likely to be cut or eliminated and to pair those dollars off with the staffing and expense budgets they fund. In some cases, that may require creation of special revenue funds or contingent appropriation categories in the budget that can be cut or eliminated if federal funding is curtailed. This includes not only the direct expenses for personnel, supplies and contractual services but also the customary federal indirect cost reimbursements that many states and localities have grown accustomed to receiving from Washington to help defray the overhead expenses of operating federally assisted activities. For some, that’s been a hidden profit center.
Team DOGE has already focused its chainsaws on indirect costs as a prime target for cutting purported waste and abuse, so it’s quite likely that grant recipients will end up bearing those expenses themselves even if a given grant program survives. There’s an old financiers’ saying that “overhead always finds a home.” So the accountants who prepare federal grant recipients’ claims for indirect cost reimbursements need to quickly inform top management of previously reimbursed administrative costs that are now likely to bounce back into their own general fund’s central services budgets. Lately, this number has been typically at least 15 percent of grant-funded direct expenses.
Employees who are working in programs and activities funded by federal money should be told — if they have not already learned — that their continued employment is probably unlikely if federal money ends. Nobody has a “federal grant program continuation reserve” on their books. Where union contracts or civil service rules provide for tenured bumping of employees in layoff situations, early notice might best be given to those most likely to be exposed to this risk. None of this will help morale, but at this point such news will hardly be unexpected by most public employees and their union representatives.
Those are just the obvious first-order spending cuts. State budget officers are already working up their projections for various layoff scenarios not only from executive orders emanating from the Oval Office but also from highly likely congressional budget cuts for the next federal fiscal year that begins in October.
Shrinking Revenues
That’s not the end of next year’s budget problems. For starters, DOGE-driven layoffs will likely raise unemployment rates fractionally where Uncle Sam has offices. That alone will hit several state budgets directly in their own unemployment reserve funds and their income and sales tax revenues, particularly in D.C.-adjacent Maryland and Virginia but also in unexpected locations like Alaska, Hawaii and New Mexico where federal employment makes up an outsized portion of the workforces.
It gets worse: For states and cities reliant on income taxes, watch out for the probable losses to the federal tax base from cheaters emboldened by staffing cutbacks and shifting priorities at the IRS. Some analysts estimate the evaporation of federal revenue to approach 10 percent, although that may overstate the problem a bit. However that shakes out, it will cascade down to state income tax collectors because the same 1040 forms are used as the foundations for state and local filings. Depending on each state’s income tax rate structure (flat vs. progressive), their loss of revenue from counterproductive IRS staffing cuts could actually be worse than the impact of tariffs. Something like 3 to 5 percent shortfalls in average state income tax revenues is the likely ballpark for this category of collateral damages.
Next is the likely decline in interest income to be gleaned from cash portfolios next year. As states and municipalities spend down their federal dollars and interest rates begin to taper lower, which the futures market now expects, investment income will likely slide below 2024 levels. If a slump or recession ensues, this problem worsens. Look for a 15 to 25 percent reduction in this revenue line item next year for most operating budgets, except where treasurers have already locked in 2026 rates.
Tourism and hospitality tax revenues will also slip a bit at both the state and local level as Canadians and other foreign travelers hostile toward this country’s leadership shun U.S. destinations and Americans on a budget cut back on vacation spending to afford products whose prices are expected to jump due to tariffs. Some of those indirect effects have already been felt in Sunbelt states and along the Canadian border.
Trade War Math
Wall Street is obsessed with tariffs because of their impact on specific companies’ growth prospects and resulting stock prices. We all have read and seen the relentless reporting of the White House’s capricious and convoluted tariff regime, as well as the initial responses of Canada, China, the EU and other countries imposing retaliatory tariffs, threatening to do so or seeking to negotiate a mutual tariff de-escalation. This news will not end in coming weeks; constant media attention feeds the beast.
It’s a safe bet that there will be some early victories for the White House to declare as a result of its heavy-handed on-again, off-again approach to trade negotiations. Those easy wins will provide bragging rights and likely reinforce officials’ conviction that they’re on the right track everywhere else. But don’t kid yourself into thinking that this will now just be a three-month trade war with all nations surrendering so soon after suffering insults and economic pain. This is more than just an air pocket in our flight through a new Gilded Age.
Because most household budgets are constrained — after all, nobody gets a bonus to offset tariffs — they will buy smaller and fewer items. On a national and global level this results in demand destruction, which leads to production cuts and, inevitably, layoffs somewhere. It’s fantasy to expect all that to happen only overseas, especially once other countries counter with new or increased tariffs from their side and their populace shuns American products on principle. (Looking at you, Kentucky distillers and Nebraska beef packers.)
So what’s the impact on state and local tax revenues? The short answer is “bad but not deadly — we hope.” A recession by year-end is now clearly possible but not inevitable. For perspective, just remember that the U.S. is 77 percent a services economy. White House tariffs won’t affect most services that Americans provide to each other. So to put all tariffs into a macro perspective, note that exports and imports represent, respectively, roughly 11 and 14 percent of America’s total production and consumption, with China providing about 15 percent of our imports. And when it comes to goods, it’s almost certain that there will be idiosyncratic and negotiated presidential exemptions.
The fiscal/budgetary impact on sales tax revenue is therefore a fraction of the higher tariff rates, which are likely to ultimately end up lower for many countries than first declared on April 2. So even an aggressive uptick of some 15 percent in average tariff rates on all sides everywhere worldwide — taking account of exceptions, concessions, carveouts, rollbacks and whatever other Oval Office deals might be in the offing — could shrink total U.S. consumption and production each by 2 or maybe 3 percent, and less if companies cut their profit margins or if currencies adjust in our favor. But make that 4 percent if Xi Jinping and Trump both dig in their heels.
Such global tariff impacts are enough to cause a corresponding bump in the CPI inflation index closer to the 4 percent range, and they could escalate our national unemployment rate to 5 percent when the stats include federal layoffs and lower production by U.S. exporters. Despite rising unemployment, the Federal Reserve cannot let the inflation genie back out of the bottle and may be slow to cut short rates by much, at least until it can assess the data as events unfold. If Congress moves forward with mega-trillion tax cut-driven deficits, the market’s bond vigilantes may push longer rates higher despite this month’s flight to safety. Fortunately, last year’s GDP growth rate of 2.8 percent provides a momentum cushion before the entire U.S. economy actually shrinks.
Tariffs’ Fiscal Fallout
For state budgets, the likely result of tariffs and trade wars is fewer unit purchases on their sales tax ledgers and less production on their income tax ledgers. Without going into the nuances of states’ sales tax bases relative to total national consumption, and taking offsetting factors into account, it’s “close enough for government work” to estimate for now that the tariff impact on sales tax revenue for most states comes out to around 2 to 4 percent barring a Cold War-style Sino-American tariff standoff. Income tax revenue shortfalls solely from tariffs should be similar in size — again not counting the IRS problem. Those are order-of-magnitude estimates and obviously subject to changes up or down as global events unfold.
Will Uncle Sam come to the rescue? Don’t even think aboutCOVID-19 era-like countercyclical federal aid to states and localities; far more likely would be autographed checks to households. The best shot at dodging these macroeconomic problems would be a congressional deficit budget and tax bill that awards households a new “Trump tariff dividend” by sending everybody a cash payment ostensibly to compensate for higher prices at Walmart, Costco and Amazon, and to dodge a recession. Of course that would farcically just be taking money from one pocket to put it back in the other, but that’s how Congress could keep most states’ sales tax revenues in the black if lawmakers conclude that the White House has shot itself in the foot.
The fiscal takeaway is that all of this shrinkage is unlikely to become a double-digit revenue disaster for the states, even those with highly progressive income taxes such as California and New York, where a weak stock market magnifies revenue headaches. For other states, a low- to mid-single-digit average shortfall in their recurring revenues seems more likely for those with both income and sales taxes — perhaps something in the range of 2 to 6 percent for most, including the indirect revenue losses noted previously. These impairments could deepen by another percentage point or two if an impasse with China is not resolved by Labor Day. States without income taxes and with limited global export business will come out better.
Tariff impacts will not be overnight. These economic shocks may take several months to reach their full potential, so the revenue reductions will likely taper into budgets between July and December.
Local-Level Pain
These state-level revenue shortfalls will ripple downstream to their political subdivisions. Although property tax revenues should hold up going into 2026 (except for taxes from central office districts still challenged by remote work), major cities were already facing budget cuts this coming year. Some are heading for major layoffs even if the global trade friction could be magically resolved by June. Municipalities and schools that depend on an allocated share of state income and sales taxes should brace themselves for commensurate low-single-digit revenue reductions from those sources in the next fiscal year and make their own contingency plans in case trade wars worsen and federal income tax evasion proliferates.
There will eventually be state and local department heads, union leaders and grant-funded constituencies imploring elected officials to swiftly dip into reserves and rainy day funds to “tide us over” until revenues resume upward. For now, the rainy day cookie jars should remain off limits, because this slowdown could worsen into a deeper, full-fledged slump when reserves are really needed. Save the cookie jar for days of desperation when the state’s entire economy is shrinking with no end in sight, even if keeping the lid on the jar requires immediate staff freezes or cuts.
Structuring upcoming budgets for zero nominal growth at most, with modest “real” revenue losses, would be a far more prudent place to start. Revenue stagnation combined with higher CPI-driven cost-of-living payroll and pension cost increases are a devil’s mix. When it comes to budgeting into 2026, hope is not a strategy. Reserves can only be spent once. Upside revenue surprises can then be deployed through supplemental appropriations if the White House later relents.
Although clearly painful, a slowdown, a bit of mini-stagflation or even a “Trump Slump” will not be the end of the world fiscally for well-run states and local governments in the coming budget year, but it’s definitely not a rosy scenario either. For most jurisdictions, fiscal 2026 will be a year of obligatory frugality and selective shrinkage — with potentially deeper shortfalls that a chronic China trade stalemate would trigger. Budgetarily the pain next year will not be merely a scratch, but more like an errant kitchen knife cut deep enough to require a quick trip to the urgent care clinic. Budgeteers, prepare to apply first aid and treat the body politic for a mild case of physiologic shock.
Governing's opinion columns reflect the views of their authors and not necessarily those of Governing's editors or management. Nothing herein should be construed as investment advice.
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