State Budgets in Transition as Revenue Slows and Surpluses Shrink

State Budgets in Transition as Revenue Slows and Surpluses Shrink

Forecast '26: In an unpredictable fiscal landscape, lawmakers will be adapting to federal funding cuts and finding ways to fund disaster preparedness and recovery.

Converting offices to residences is one strategy states may consider in an era of slower revenue growth, when property, sales and income tax cuts will be difficult to expand-or even sustain. (Ted Eytan/D.C. Policy Center)

After several years of buoyant budgets and robust revenue collections, states are navigating an unpredictable fiscal landscape.

As 2026 approaches, state lawmakers face a complex fiscal environment shaped by slowing revenue growth, declining federal support, stagnant employment figures and evolving economic conditions-including the potential for increased health care spending.

NCSL Forecast '26

This special report from State Legislatures News covers the topics NCSL's policy experts anticipate will occupy state lawmakers' time in 2026 legislative sessions. Read the full report here.

After the coronavirus pandemic, states were flush with cash, fueled by robust federal aid and higher-than-anticipated revenue collections, which in turn fueled a wave of tax cuts and spending initiatives.

However, state budget writers always knew those surpluses were temporary and a slowdown was inevitable. As states head into 2026 legislative sessions, most are on firm fiscal footing, with record high rainy day fund balances and other surplus funds they have carried forward.

But recent estimates show flattening revenue, and states are preparing to pull back on spending as a result. States were cautious in their fiscal year 2026 budgets, and that trend is likely to continue given the uncertainty over federal funding and overall economic conditions. Recent federal legislation, including the tax cut and domestic policy law signed by President Donald Trump in July, shifted the cost of some programs to states-some with immediate impact to state budgets and some that legislators may need to address in future fiscal years, particularly changes related to Medicaid and the Supplemental Nutrition Assistance Program.

What budget issues are states likely to address in 2026?

• Managing flattening revenue growth and passing cautious spending plans.
• Adapting to cuts in federal funding and the shifting federal landscape.
• Finding ways to fund disaster preparedness and recovery.

On the revenue side of the ledger, state tax policy priorities are shifting toward targeted tax cuts, enforcement, new technologies, sin taxes and federal conformity.

Hot Topic: Targeted Tax Decreases

Despite the headwinds, states remain committed to providing tax cuts-but the scope and scale of the reductions are narrowing. Broad-based income tax cuts, once a hallmark of post-pandemic fiscal policy, have given way to more targeted measures. In 2025, lawmakers focused on delivering benefits to specific groups, including families with children, seniors and low-income earners. This trend is expected to continue in 2026, as states seek to balance taxpayer support with fiscal sustainability. With significant tax relief already coming from the federal tax cut and policy bill, states may feel less pressure to enact their own tax reductions; in some cases, they may decide they have more maneuverability to increase certain taxes.

In an era of slower revenue growth, property, sales and income tax cuts will be difficult to expand-or even sustain. Look for states to consider financial circuit breakers and levy limits, and to promote office-to-residential conversions through tax breaks when advantageous. States may continue to look at refundable child tax credits and earned income tax credits to support poverty reduction.

Trending: Squeezing Out Revenue

With federal programming on the decline and employment rates showing signs of volatility, states are turning to more innovative approaches to generate revenue. Artificial intelligence is emerging as a tool for tax enforcement, with some states exploring its use in auditing and fraud detection. Other states are considering new corporate taxes aimed at dominant sectors of the economy, such as digital services and AI-driven enterprises. These targeted measures allow states to tap into emerging revenue streams without imposing broad new taxes on individuals. States taking on additional responsibilities in the wake of reduced federal programming may be the most inclined to pursue these strategies.

Hot Topic: Taxing the Digital Economy and AI

As artificial intelligence and digital infrastructure become more central to economic activity, states aim to ensure these sectors contribute to the tax base. Potential areas for taxation include data centers, digital goods and energy consumption related to AI operations. These efforts reflect a broader push to modernize tax codes and capture revenue from fast-evolving industries. States will attempt to optimize their choices by incentivizing business growth in these areas while identifying taxes that do not deter development. The fast movement of the AI sector-particularly its significant impact on data center expansion and energy consumption, coupled with limited permanent employment-requires states to conduct careful analysis to determine what is in their best interest.

Trending: Excise and Sin Taxes on the Rise

As states seek additional revenue, lawmakers are showing renewed interest in excise taxation, including sin taxes. In 2025, several states increased taxes on nicotine, tobacco, cannabis and sports betting. These taxes, which target a relatively small portion of the population, can generate revenue with limited political resistance. States will weigh the potential economic impacts, including effects on tourism and consumer behavior, before expanding these levies further. In addition, with the use of electric vehicles rising and gas tax revenue falling, states will continue to consider taxes and fees on EVs to fund roads.

Hot Topic: Federal Conformity

The president's domestic policy law introduced sweeping changes that will ripple down to the states. Among its provisions: a $6,000 standard deduction for seniors over 65; the elimination of taxes on overtime and tips; an expanded child tax credit; and a range of renewed and new personal and corporate tax breaks.

For states that automatically adopt changes to the federal tax code as they occur-known as rolling conformity-these changes could significantly reduce the state tax base. Legislatures in those states are expected to examine the implications closely. Meanwhile, states with static conformity don't automatically adopt federal tax law changes; those states may revisit their policies to determine whether updates are warranted. Some states may consider decoupling from the federal tax code when it makes sense economically and politically.

Finally, states are beginning to assess the fiscal impact of the president's tariffs. A pending Supreme Court decision could determine the legality of certain tariffs, with potential consequences for state spending and revenues. The legal and fiscal landscape remains uncertain, and lawmakers are watching closely as they consider how budgets will be impacted and how-or whether-to respond.

State appropriators are likely to be cautious as they prepare FY 2027 budgets in their upcoming legislative sessions. Look for little expenditure growth and for tax policy to remain a focus, with states pursuing a mix of targeted relief, strategic revenue generation and careful adaptation to federal changes.