The majority of states are experiencing several threats to their revenue streams because of the uncertainty created by federal tax reform. With continued tax base reductions, including an increase in the state and local tax (SALT) deduction cap, states are now grappling with the impact on revenue and fiscal autonomy. As many states have recently ended their legislative sessions, with budgets established for the upcoming fiscal year, federal changes in policies and funding may require special sessions. The states will also be affected by federal tax cuts to current services. States will be forced to make difficult decisions to comply with their balanced budget requirements—unlike the federal government that is not required to balance fiscal budgets.
Meanwhile, after five rotations through the Internal Revenue Service (IRS) commissioner/acting commissioner role, Billy Long has been confirmed for the position. Many high-level departures are seriously impacting operations. With the size of audit teams shrinking, open audits are being forced to close without further action. Fewer audits will commence, and appeals will take much longer to close, as a result of staffing shortages.
States are very concerned about the impacts of federal cuts to personnel and technology budgets on state tax agency operations. States are specifically concerned about federal change notices (Revenue Agent Reports) and the impact on state revenues, if federal changes are not being processed. The impact from partnership audit programs is a concern as well. Delays in processing programs that address errors in federal tax filings could cause additional problems for the states because they wouldn’t receive the data necessary to identify needed internal corrections. Federal budget cuts to the IRS will force delays or discontinuation of projects designed to modernize technology, which will also impact customer service.
The Trump administration’s efforts to remake the federal government are causing concern among state executives about their authority and ability to adequately fund their states’ priorities. Federal efforts to mandate state policies or withhold funding, if states don’t comply, raise state sovereignty concerns.
Examples include:
- Organizing efforts to dismantle New York’s congestion pricing program.
- Eliminating the Department of Education (DOE), which impacts state programs dependent on federal DOE funding (tutoring, school meals, etc.).
- Eliminating or changing the model for supporting state disaster recovery efforts through the Federal Emergency Management Agency and other federal assistance.
The federal government has attempted (often not without inviting litigation) to mandate certain policy positions within states and to restrict or withhold federal funding if states do not comply with the administration’s goals.
Examples include:
- Requiring state and local law enforcement agencies to cooperate with Immigration and Customs Enforcement immigration and deportation programs.
- Withholding funding for states that allow students to participate in athletic programs that align with their gender identity.
- Reducing or eliminating grant funding for higher education/research.
Federal and State Taxing Powers
The U.S. Constitution assigns certain responsibilities to the federal government and reserves the balance to the states. States’ power to tax is universally recognized. See, e.g., New York ex rel. Cohn v. Graves, 300 U.S. 308, 313 (1937):
Enjoyment of the privileges of residence in the state and the attendant right to invoke the protection of its laws are inseparable from responsibility for sharing the costs of government. . . A tax measured by the net income of residents is an equitable method of distributing the burdens of government among those who are privileged to enjoy its benefits.
Federal preemption or efforts to restrict state taxing powers may violate principles of federalism. State and local governments’ autonomy in raising revenue may be impacted. Infringement of state and local governments’ taxing authority may upset the balance of power as well as checks and balances inherent in our system of government. State and local governments may be impeded from adjusting their economies to address issues of state and local control.
How Are States Reacting?
Red State Macro Trends
Republicans are becoming increasingly serious about significant cuts (if not outright elimination) of income taxes or, recently, property taxes. Typically, recognizing that they cannot eliminate one full leg of the taxation stool without replacement revenue, there is experimentation with greater reliance on transaction taxes—both increasing the rate and expanding the base. Despite recent high-profile efforts in states like Nebraska and West Virginia, no state has thus far succeeded in implementing a tax swap, but this lack of political success has not dampened enthusiasm for the overall policy project. The number of introductions of these types of bills has continued to increase year after year.
While not a tax swap per se, key changes to Louisiana’s sales tax base, effective January 1, 2025, do somewhat replace the reduction in income tax rates and exemptions. For example, the expansion of sales and use tax to digital goods and services, such as streaming, digital books, apps, games, and software-as-a-service (SaaS), and a 5% state sales tax on telecommunications and certain media services are attempts to replace lost income tax revenues.
Blue State Macro Trends
The Democrats’ approach to tax policy is currently bifurcated. In general, Democrats want to raise new money to fund social programs, but they also want to use the tax code to bring disfavored industries (such as big tech) to heel. This thinking has manifested novel taxes like the digital advertising tax and the yet-to-be-enacted data sales tax. Democrats are not wedded to either of these ideas specifically; they are more than willing to experiment to find language that survives judicial challenge and that also brings in new revenues. Privately, some Democratic leaders realize they’ve raised most traditional tax rates as high as they can without further spurring out-migration, so they are looking for new tax types to meet revenue needs.
So far, states are watching and waiting, with little legislative action to date. States are very worried about the impact of the tariffs or pared-back federal spending on their budget picture. This may all change, as the One, Big, Beautiful Bill (OBBB) Act has been enacted.
Observations
- At least 12 states have sued the Trump administration over the tariff policies.
- Six governors in the Northeast are seeking to establish new economic ties with Canada in response to the federal import duties.
- Hawaii set aside $200 million in its budget to offset possible losses to federal spending.
2025 Legislative Trends
Digital Taxation
Both sides of the aisle have an interest in taxing big tech, and they are searching for new fiscal tools to do so. To date, most of these efforts have either died on the vine or been tied up in court, but lawmakers have shown no interest in giving up. Nine states introduced 36 bills to establish Maryland-style digital advertising tax programs. Effective October 1, 2025, Washington State will begin imposing retail sales tax on a broader array of services, including digital advertising. Six states introduced 15 bills that would levy new taxes on the sale of user data.
Taxation of Services
Sales tax base expansion legislation has been a political hobby horse for Republican legislators as a means of raising new revenue to pay for an income tax (or increasing property tax) elimination proposal. This year, some Democratic lawmakers joined in on the action, with Maryland making a proposal for sales tax on services a central component of its budget plan. In 13 states, a total of 34 bills were introduced that would have expanded the sales tax base to include new services. These predominantly either expanded the base to services generally, services more specifically, or lobby services exclusively.
Income Tax Expansion
Some states have gone the other way and are considering worldwide combined reporting and taxation of foreign income without apportionment relief to increase revenue.
Conclusion
As states navigate the complexities of federal tax reforms, they are employing a range of strategies to protect their revenue streams and uphold their fiscal autonomy. The evolving landscape underscores the need for states to remain vigilant and adaptable in the face of federal policy changes.
We are monitoring federal tax policy changes and are available to assist you with analyzing the impact on your business. Please contact our Ryan tax professionals for assistance.
TECHNICAL INFORMATION CONTACTS:
Argi O’Leary
Principal
Ryan
212.871.3901
argi.oleary@ryan.com
Ryan Maness
Director
Ryan
716.837.1033
ryan.maness@ryan.com
The material presented in this communication is intended to provide general information only and should solely be seen as broad guidance and not directed to the particular facts or circumstances of any individual who may read this publication. No liability is accepted for acts or omissions taken in reliance upon the content of this piece. Before taking (or not taking) any action, readers should seek professional advice specific to their situation from Ryan, LLC or other tax professionals. For additional information about this topic, please contact us at info@ryan.com.
- Sujet
- Argi O’Leary