But there are also some quirky features of this new landscape that present more obscure challenges and even some economic development possibilities. For the public workforce, implementing new payroll features to comply with the 2025 tax law, particularly its overtime taxation provisions, will be the first order of the day, but that’s a bookkeeping and software sideshow in the long run. The main event is that many states’ and some municipalities’ budget reserves are shriveling.
While states and localities collectively face cost shifting for essential functions once paid for by Uncle Sam, such as cybersecurity networks, the most important task for many in 2026 will be a review and reset of their financial reserves policies. If Uncle Sam is now prone to write counter-cyclical checks to taxpayers rather than sending money to states in the next recession, and less likely to provide natural disaster recovery aid, then rainy-day funds may need to be beefed up, not depleted in futile efforts to provide end-of-life support to formerly federally funded programs that remain popular locally.
So as the various state and local operations that heretofore were supported by federal dollars are wound down or shrunk, public financial managers face two immediate challenges: They must help policymakers address advocates’ calls to use reserves to plug new funding holes. Behind the scenes, they also must replace federal grant reimbursements for overhead “indirect costs” that helped defray their internal expenses for administrative functions like HR, purchasing and accounting, as well as office space.
In the past two years, a lot of high-level professional discussion has gone into “rethinking reserves,” some of it on the premise that states and localities may have been squirrelling away too much money for contingencies. The argument presented by some is that certain risks from natural disasters and recessions could be insured commercially or handled with short-term borrowing, so maybe the rainy-day fund balances are excessive. That rethinking now needs to be rethought, in the light of the White House’s clear disdain for sending cash to states and localities — especially to those with leaders who dispute presidential priorities.
So public finance officers now need to recalibrate the amount of reserve cash they will need to hold or accumulate to use in future recessions, modeling their revenue shortfalls with data from the past five major business cycles going back to 1981. Budget shortfalls from those episodes can provide the metrics needed to rightsize their general fund balances and rainy-day reserve funds to cope with coming business cycles beyond their control.
Some may challenge whether this is really necessary in today’s high-tech economy, but that argument fails to address what may happen if artificial intelligence becomes so prevalent that massive layoffs and workforce reductions induce an economic adjustment unlike any seen before. Each rainy-day scenario analysis also needs to consider the potential downside of a major speculative financial market correction triggering a recession during a five-year time frame.
For natural disaster recovery, it’s true that commercial insurance might be able to provide the emergency funding needed for cleanup and to repair critical infrastructure if the Federal Emergency Management Agency remains unresponsive, but that raises the question of the adequacy of insurance companies’ reserves to cope with massive widespread regional disasters such as earthquakes, wildfires or Category 5 storms. Then there’s the risk of costly misconduct lawsuits that plague urban police departments. The point here is that a multifactor risk analysis is necessary.
Payroll Perplexity
There are a few other matters that public financial managers need to address on a more immediate timeline. The first is the mundane but complex task of producing payroll tax information required by the president’s widely misunderstood “no tax on overtime” policy. Starting with the 2025 W-2s due by the end of January 2026, most employers are expected to produce a record of some kind to document how much of an employee’s 2025 compensation comes from qualified overtime pay. Employees will need that number to complete their income tax returns.
The problem here is that the congressional definition of eligible overtime is tied to the formulas of the federal Fair Labor Standards Act, which excludes pay for hours worked of less than 40 in a given week and does not treat holidays, vacation and sick time as hours worked. So there will be a lot of manual calculations needed to come up with those numbers.
The financial community has been waiting anxiously for the Treasury and the IRS to produce regulations for how this is to be done, and guidance was just released. Look to the professional associations and the various payroll services firms to soon provide actionable recommendations on how to report the necessary information to employees for their 2025 income tax returns. A free Dec. 1 training event is planned by the Government Finance Officers Association.
Going forward, it’s expected that the payroll service vendors will install new data fields in their software to enable employers to keep 2026 records that comply with the One Big Beautiful Bill Act (OBBBA)’s requirements, but that still requires retraining the entire workforce to log their working hours consistent with the new rules. That may seem like a mundane task, but the costs of getting it wrong next year will be painful to employers who remain asleep at the switch.
One wild card to watch for in the Trump era might be a budget-gimmick revenue-grabbing movement in Washington to require universal Social Security participation by states and localities for their new hires. That would help wallpaper over the system’s current funding shortfall by immediately collecting new taxes from a substantial percentage of the governmental workforce at the expense of distant future liabilities. Politically, this would also force a review and reduction of those public employers’ pension benefit formulas, possibly resulting in a push for 401(a) defined contribution plans.
Eliminating a tax loophole for those systems would be a fiscal punch in the nose to organized labor and the exempt grandfathered public employers who now dodge the income redistribution features of Social Security’s tax and payout structure. Foresighted leaders should add a paragraph to new labor agreements that gives them an option to reformulate pension benefits with cost parity for affected employers if this were to occur.
A New Landscape for Opportunity Zones
Speaking of tax loopholes, there’s another aspect to OBBBA that public finance professionals and their economic development colleagues should be monitoring, given its long-term impact on business activity and resulting tax revenues. The 2025 law made “permanent” — as much as anything in tax law is ever permanent — the juicy tax breaks available to developers and qualifying businesses in opportunity zones. Zero for their investors’ capital gains tax rates is a huge incentive.
We are waiting to see federal rules and state-level designations of which census tracts will be qualified for these attractive incentives. Those are expected to become effective later in 2026, and full implementation is expected in January 2027. For investors and developers, this makes early 2026 a “dead zone” in their planning calendars as they are unlikely to initiate new projects until the ground rules are established and locations unambiguously identified. But after that, the race to attract developments will begin.
So the coming months will be a savvy time for finance and development professionals to lobby their state officials to identify and seek designation of qualifying low-income census tracts in their communities and to interact with area developers and other business leaders who can provide insights into local land-use policies that would make projects in their communities more attractive for capital investment. Public officials responsible for economic development should use this time to revisit local zoning policies and reconfirm what kinds of physical developments they want to encourage.
One of the learnings from the previous round of opportunity zone financings was that multi-unit housing projects were well suited for these tax-favored projects. That could open the door to much-needed increases in senior citizen housing and other apartment construction that are good candidates for developers to pursue, if they can capture the benefits of the new tax law. Aside from housing, don’t be surprised to also see some small modular nuclear reactor projects near rural communities eligible for these tax breaks, and other towns welcoming AI and quantum computing data centers.
For the most part, though, the Trump administration’s policies will have little direct effect on the historic functions of state and local government finance professionals. Short-term interest rates may recede a bit as the president appoints new “easy money” members to the Federal Reserve board, but the municipal bond market remains largely untouched. Maybe one to two hundred localities will find impactful ways to capitalize on opportunity zones.
Aside from the cutbacks in federal grants, the White House will otherwise have little immediate impact on the day-to-day work of most public financiers, once they get their payroll systems updated to handle the overtime kerfuffle. It’s what could happen in future recessions and disaster recoveries that should keep them up at night in coming years.
Governing's opinion columns reflect the views of their authors and not necessarily those of Governing's editors or management.
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