Be Prepared: States Confront New Revenue Challenges

The end of the pandemic brought a historic windfall of revenue gains for state tax authorities – but those days are gone. State budget stress is on the horizon, and tax shifts are certain to follow.

Quarterly receipts are reverting to the long-term trend, according to the first article in a five-part Pew series. The series explores key state fiscal challenges, ongoing policy debates, and how states must rethink budgets, reserves, and revenue sources to balance their annual accounts. For tax departments, this will likely mean more changes in sales and use tax rules and rates and more challenges in keeping pace. While the present outlook of our national economy (GDP growth) remains stable and resilient to date, nonetheless, challenges and gaps are likely to arise. Some states may have actually contributed to their own fiscal predicaments by eliminating or reducing tax rates over the past two years, thereby precipitating their budget shortfalls. Hence, some states may face fiscal imbalances or deficits shortly, which will necessitate adjustments in their state tax bases. These adjustments may include higher sales and use tax rates or an expanded tax base that covers new products and services. States may also introduce specific digital bundling taxes, which could eventually extend to the much-debated digital advertising tax.

Pew’s research delves into the fiscal environment that states currently find themselves in. Their decisions will be motivated by two goals:

1. Mitigate the risk of structural deficits: Temporary federal aid gave a much-needed boost to states’ balance sheets during the pandemic, enabling them to maintain services during a time of acute economic disruption. Many states were able to implement tax cuts on individual and corporate income, and some provided wage increases for state employees. But as temporary supports are phased out and tax revenue growth slows, states will need to revisit budget assumptions.
2. Optimizing management of reserves: Most states prudently leveraged the post-pandemic revenue surge to build record reserves. Rainy day fund balances increased by almost $100 billion from fiscal years 2019 to 2023. But more lawmakers are now eyeing those funds as resources to fill gaps in infrastructure and education budgets. At the same time, states understand that federal stimulus aid added significantly to the national debt and could be far more difficult to secure in future. They may want to increase their savings targets to reflect this risk.

Tax departments should be on the lookout for impacts on indirect tax as states navigate this new revenue landscape. Sales taxes, along with property taxes, are the largest revenue sources for local governments. And, as Vertex CTO, Michael Bernard, recently mentioned in a recent post on 2025 sales tax rate trends, property tax receipts are decreasing in many areas – a trend that’s driven by tax exemptions and reductions as well as declining property values.

As tax revenue trends return to historical norms, states may rely on a familiar strategy—increasing their share of revenue from retail sales taxes. This could include taxing remote marketplace sales, expanding delivery and service fees, and potentially introducing related excise taxes. As the January 2025 Pew article in the series asserts regarding Washington State, “There are some tough fiscal choices ahead.”