‘Big Beautiful’ Tax Law Puts Billions in State Revenue at Risk

President Donald Trump’s new tax and spending law will be a net revenue loser for the states, costing them $20.5 billion annually by one estimate and forcing most to consider separating from the tax components to compensate for cuts to state aid elsewhere in the law, practitioners and policy groups said.

The law Trump signed July 4 extends the cuts created under his 2017 tax overhaul and creates several new tax breaks that could flow down to state tax codes unless the states opt out, a response known as “decoupling.” The bill also imposes major changes to the cost-sharing formulas under Medicaid and the Supplemental Nutrition Assistance Program, leaving the states with a larger share of the bills.

As a result, state legislatures will have to make decisions that balance shifting revenue flows with the social safety net adjustments.

“In the short-term states will likely see some shifts in revenues due to changes in deductions, SALT cap increase, expensing rules, and exemptions,” said Lucy Dadayan, principal research associate at the Urban-Brookings Tax Policy Center. “In the long-run, states will see structural budget pressures as reductions in federal funding for safety net programs could strain state budgets.”

In many cases, legislatures will decline conforming to the federal tax cuts, including the new deduction for automobile loan interest, the higher standard deduction, and the exemptions for tipped and overtime wages, said Meg Wiehe, vice president for state fiscal policy at the Center for Budget and Policy Priorities.

“States are going to need revenue to be able to ensure their people aren’t losing health care and food assistance so it’s more important than ever for them to pay careful attention to the conformity issues and decouple wherever they can,” Wiehe said.

Forty-five states have already enacted budgets for fiscal year 2026, but some could modify their spending plans before the end of the year in response to the new federal law, Wiehe added. She named Colorado, Connecticut, Idaho, Illinois, Minnesota, New Mexico, Vermont, Virginia, and Washington as states considering special legislative sessions to adjust their budgets.

Rolling Conformity

Most states, however, will wait until 2026. Action could be swift in the 22 “rolling conformity states,” said Christian Burgos, director of state tax services with the accounting firm Berkowitz Pollack Brant.

Rolling conformity states, which automatically adapt to the latest version of the Internal Revenue Code, could see revenue impacts faster than the static conformity states, which align their laws to the federal code at a fixed date in time. California only recognizes the federal code as of Jan. 1, 2015, although lawmakers are considering a bill shifting its conformity date to Jan. 1, 2025 but keeping the state decoupled from most features of the 2017 tax law.

“I would expect a good number of states to decouple, even those that follow rolling conformity,” Burgos said. “So those states would pass legislation either limiting this bill in its entirety or rolling provisions back, including the deductions for taxes on tips and overtime, and even the interest on auto loans.”

Jared Walczak, vice president of state tax projects at the Tax Foundation, said many features of the new law are baked into state tax calculations, particularly the features that extend the 2017 tax law. States, however, will have to consider a handful of new cuts.

Four provisions benefiting individual taxpayers would cut state revenues by a total of $20.5 billion per year, or 4.2% of all state personal income tax collections, according to Walczak’s analysis of the law. The losses, however, would only occur if all states incorporate the changes into their tax codes.

More specifically, Walczak found:

• The permanent increase to the standard deduction to $31,500 for joint filers will cause a net revenue loss of $5.6 billion to the states.
• Interest on auto loans will be deductible up to $10,000 per year, costing the states $2.4 billion.
• Tip income will be exempt from taxes up to $25,000 through 2028, costing the states $1.5 billion.
• Overtime income will be exempt up to $12,500 through 2028, costing the states $11 billion.

Most states should be able to absorb the losses, but some may opt out to manage the larger challenges posed by the social safety net cuts, Walczak wrote.

Wiehe said the federal rule exempting tips is the lone revenue loser with a base of state support, noting 20 had bills on the issue this year, though none were enacted.

“This is the one new provision where I would expect some states to couple to the federal law because some lawmakers like the policy change,” she said.

Additional Impacts

States could be further impacted by other parts of the law.

A new $6,000 deduction for senior citizens could cost the states billions, though Walczak wrote “no state is currently in line to incorporate this provision.” Tax cuts benefiting businesses including increasing the Section 179 expensing cap from $1 million to $2.5 million and extending full bonus depreciation, would have a “relatively light” revenue impact on states, he found.

The higher $40,000 state and local tax deduction could affect state revenues, but the impacts remain unclear. Tax practitioners don’t have a firm understanding of how taxpayers will respond to the higher SALT cap and some may reconsider their use of pass-through entity tax workarounds that were enacted in 36 states, the tax consulting firm RSM LLP wrote.

States will also have to decide if they will allow taxpayers with large capital gains earnings to lower and defer them through the federal Opportunity Zones program, said David Wessel, a senior fellow in economic studies at the Brookings Institution.

The new law allows taxpayers to reinvest their gains into businesses, real estate, or housing in distressed areas. States must weigh whether to conform to the IRS’s treatment of capital gains for the purpose of investing in Opportunity Zones or keep taxing capital gains.