U.S. States’ Fiscal Drizzle May Spill Over into Tax Policymaking

Rainy day funds are thinning just as federal policy changes and diminished federal revenue sharing are driving up states’ administrative costs, and as the U.S. contends with an elevated risk of recession. In 2026, federal revenue sharing has decreased amid economic uncertainty and reductions in federal funding. This increased fiscal pressure, jointly with a combination of economic factors, could nudge state and local tax policymakers to adopt more aggressive stances regarding indirect tax changes. More explicitly, consumption taxes, under present conditions, will certainly have extended spillover effects and, of course, probably intensify the “deadweight loss” of taxation.

The current state fiscal environment is also worth a closer look because emergency funds are only part of the picture. It’s important to differentiate between rainy day fund balances (the size of the emergency reserve in dollar amounts) and capacity (the number of days the reserve fund can cover state operations, which is determined by expenditures).

Rainy Day Funds Are Dropping

In fiscal year 2025, states’ median rainy day fund capacity decreased for the first time since the Great Recession. The good news is that median capacity reached a record-high in 2024 (a median 54.5 days), so a decline in capacity to a median of 47.8 days (about 12%) should not sound alarm bells, at least not yet. As indicated above, the current condition of states’ Rainy Day reserve funds is worsened by declining federal-state revenue sharing. In 2026, federal revenue sharing has decreased amid economic uncertainty and reductions in federal funding. Furthermore, federal revenue sharing has declined because of reduced federal funding and the termination of the State and Local Fiscal Recovery Fund (SLFRF), leading to fiscal difficulties for local governments. This overall decrease in federal funding has also caused more financial pressure on local governments.  

That said, other fiscal trends are also pressuring state and local policymakers, according to research by the Pew Charitable Trusts that analyzes new data from the National Association of State Budget Officers: “And as their rainy day capacity falls, states are also depleting their leftover budget dollars, known as ending balances, at a rapid rate. As a result, states’ overall fiscal cushions—reserves plus ending balances—are quickly eroding, leaving states with fewer resources to address widespread current and projected budget imbalances.”

My colleague, Chris Hall, the Senior Tax Officer in Vertex’s Chief Strategy Office, highlighted this dynamic earlier this year in his rundown of 2026 indirect tax trends. “Fiscal year 2026 budget drafting exercises were defined by high levels of caution, spending reductions, and uncertainty (regarding federal funding and economic conditions and trade policy),” he noted.

A Trifecta of Fiscal Pressures

That caution is likely to continue amid growing spending pressures, rising costs, and decreasing federal funding. These issues are evident in three fiscal challenges the Pew research discusses in its report:

1. Structural budget imbalances are replacing short-term shocks as the primary fiscal challenge: More states are experiencing budget gaps that stem from structural imbalances (situations in which recurring revenue is insufficient to cover recurring expenditures) rather than from short-term shocks. When a cyclical downturn arrives, states can tap emergency reserves and wait for conditions to improve. On the other hand, structural imbalances require more involved solutions, such as increasing indirect tax rates or broadening the sales tax base by taxing previously exempt goods and services (e.g., digital taxation).
2. Federal policy changes are increasing state spending obligations: New federal Medicaid and SNAP policies are projected to increase states' administrative costs along with the share of program expenses that states must cover. In response, state legislatures will face mounting pressure to identify offsetting revenue (e.g., reaching for the sales and use tax rate change lever). Indirect tax leaders should closely monitor state legislative sessions in states already reporting low reserve levels, such as New Jersey, Washington, and Illinois.
3. Elevated recession risk complicates the fiscal picture: When a recession arrives, many states will need to use emergency funds to close shortfalls caused by revenue declines as consumers curtail their spending. States that experienced substantial declines in rainy-day fund capacity in 2025, including California, Colorado, Minnesota, and North Carolina, would have less of a buffer to do so. This lack of fiscal wiggle room could replicate the temporary sales tax increases that some states enacted during and immediately following the Great Recession. Many states are now pausing tax cuts due to budget deficits and falling revenues, further exacerbated by federal funding reductions and rising expenses. This pattern is likely to persist as states face a challenging fiscal outlook in 2026. States are required to balance their budget books and generate revenue; taxes will be implemented later. The key questions are when this will happen and what form the taxes will take.

In a volatile fiscal environment defined by structural imbalances and shrinking buffers, state tax policy is unlikely to sit still; in fact, you can take that to the bank. Indirect tax groups with an agile tax compliance are better positioned to turn growing policymaking volatility into a manageable operational challenge. Stay informed and adaptable…