The bottom line for state and local budgets: Sales and income tax revenues largely remain steady. The tariff revenue crunch for subnational governments hasn’t arrived. For the next year or so, other federal fiscal policies, along with unknowables including the impact of technology on employment, are more likely to keep public budgeters and managers preoccupied.
On the tariff front, some of the favorable news could just be a matter of timing: Nobody in the global supply chain wants to get into the Oval Office's crosshairs by raising their prices visibly. Auto sticker prices often still reflect older inventory. Petroleum prices have softened a bit this year and declined significantly since inflation peaked in 2022, helping consumers at the gas pump and restraining the recent consumer price indexes (CPI). Retail price inflation is also mitigated as suppliers and consumers find lower-priced substitutes. Households keep spending because they still have jobs. For now at least, most sellers’ pricing and political power is too weak to pass along imported goods’ tariff costs to buyers.
However, many economists expect that these are transitional behaviors — that ultimately the larger global corporations in particular will reassert their pricing power and pass the tariffs along to retailers and consumers wherever and whenever they can do so without drawing presidential invective. The questions for public financiers now are how long that will take and whether it may just be a one-time bump in prices that doesn’t ignite an ongoing new cycle of inflation.
Remarkably to many pundits, there has not been a wave of tariff retaliation from the other side of these deals. Some nations’ leaders play the long game, and some may even doubt the president’s “emergency” legal authority, which might evaporate at the steps of the Supreme Court. That materially reduces both the inflation impact and, more importantly, the labor market impact, as U.S. exports remain unabated (with a few exceptions like American wine and spirits no longer going to Canada’s liquor stores).
Because imports are only 14 percent of U.S. GDP, the overall price impact of 18 percent tariffs would not likely exceed 0.14 x 0.18, which is 2.5 percent. It will take until 2027 for those tariff costs to wind their way entirely through the economy on top of whatever inflation rate applies to everything else, and it’s now clear that product substitutions and sellers’ profit concessions will reduce that number. As a result, the multiyear impact on inflation likely will remain muted, probably pushing the overall CPI into the mid- to upper 3 percent range by 2026, which will not bring huge expectations of a replay of the stagflationary 1970s or the more recent post-COVID-19 inflation.
That’s good news on two fronts: First, it allows the Federal Reserve (Fed) to make at least a few token cuts in overnight interest rates in coming months, although not as large as the Oval Office keeps advocating. Second, the inflation expectations of workers still remain subdued, which reduces union pressure for budget-busting wage increases in the coming year. With federal workforce reductions adding some new supply of governmental professional talent at the state and local level and keeping the overall labor market in relative balance — even if on the soft side in the latest reports — for most public employers the 2026 budget outlook for compensation costs remains relatively benign.
So for the time being at least, the worst tariff outcomes have clearly been avoided. What’s important now is to understand what could change on the legal and trade fronts — and what still lies ahead no matter what happens to tariffs.
Legally, the White House stands on thin ice with its emergency tariff declaration, and several courts have already deemed it an overreach. A strong case can be made that the president’s authority doesn’t extend to widespread global application of import taxes — and certainly not to their selective use as ways to punish countries like Brazil, with which we have a trade surplus, that happen to have unfriendly political leadership. But even if the Supreme Court rules Trump’s tariffs illegal, the GOP-controlled Congress could grant new powers to the White House, so there are multiple workarounds available to the administration trade team. It’s probably fanciful thinking to expect that most of today’s announced tariffs will go away just by magic during this president’s term.
Three Time Frames
More important from a state and local fiscal standpoint is where things end up with China and for strategic industrial materials when the current trade truce with that country ends in November. A steeper tariff on the wider range of Chinese products — along with already-high tariffs on computer chips, steel and aluminum — could kick up the CPI by yet another percentage point. But those effects are unlikely to show up in retail product pricing until later in 2026. Fortunately, none of this materially affects the cost side of public-sector budgets unless and until consumer inflation feeds into higher salaries and wages. For now that seems unlikely: Police cars with imported components will cost more, but police officers’ salary increases will remain modest.
This leaves budget offices with three distinct half-year time frames to manage through. The first is what’s left of 2025, where the tariff impact on sales and income taxes is negligible. The second will be the first half of calendar 2026, when many of the newly set tariffs finally start working their way into the supply chain but producers and distributors keep eating at least half of the cost. That would likely bring a kickup in CPI inflation to a higher number but still less than 4 percent.
The real mystery is what happens by this time next year, in the second half of 2026. That would be the period of maximum pressure on the CPI. Even as various suppliers and sellers stop absorbing some of the tariffs in coming months, don’t forget that after next September the 12-month price comparisons will be calculated from the higher base level being reset this fall. We’ll then see if tariffs induce actual ongoing inflation, elevate consumers’ inflation expectations, or produce just a one-time increase in prices. Will it be a trend or a bump? The Wall Street view is increasingly that it’s the latter, but with various scattered sticker shocks still likely in 2026 as consumers start paying a higher percentage of the tariffs.
In a year, it’s conceivable that consumers will begin facing more than half of the impact of tariffs when they buy things at retail. Even so, it’s unlikely that they will buy significantly less in dollar terms, so nominal sales taxes should hold up as long as employers’ payrolls hold steady. Income taxes could suffer a bit from weaker corporate profit margins, but that could be overcome by higher capital gains taxes payable next year from this year’s bullish stock market.
Even by late 2026, there seems to be little risk that foreign trade retaliation will seriously cut into U.S. exports, so the odds of tariff-driven unemployment remain lower than what may arise by then from artificial intelligence displacing white-collar workers. If a steady but soft labor market prevails throughout 2026, the macro picture for most states and localities should be navigable except for those already entering their fiscal years with budget deficits for whatever reason. State and local leaders’ bigger budgeting problem is federal aid cutbacks, not tariffs.
Other Fiscal Issues
The inflation-rate wild card as 2027 approaches is whether the U.S. economy by then has begun a new era of longer-term disinflation driven by cost-saving AI technology. Tariffs at current levels would become a secondary issue. By replacing workers, technology’s longer-term economic force would hit the job market, potentially cutting payroll income tax revenues and boosting states’ costs of unemployment insurance. Those who glowingly point to technology and capital investment as counterforces to dampen tariff costs should be careful about what they hope for.
As for the rest of governments’ budgets, there are still some negatives to manage. Investment income from governmental cash portfolios will almost certainly decline in 2026, as the Fed is expected to cut short-term rates in coming months and a new chair is expected to favor the president’s call for easy money with even lower yields on operating cash. On the expense side, monthly health insurance premiums paid by both employers and workers (and underfunded retiree medical plans) will outpace the CPI inflation rate as new drugs coming on market get approvals and those costs get passed along to employers.
Overall, the macroeconomic outlook for state and local revenues is still relatively stable, with GDP presumed to continue growth but at slower rates. The stock market continues to anticipate a supportive economy at least through next year, barring a breakdown in the China trade talks. The massive tax cuts in the One Big Beautiful Bill Act will add very little lift to the 2026 economy from additional fiscal stimulus other than business tax incentives that are unlikely to generate measurable new employment in just one year.
There is still some downside protection on Capitol Hill: If the economy starts to sputter by next spring for whatever reason, it’s a safe bet that GOP lawmakers will rush through a pre-midterm “Trump tariff rebate” with direct payments to working-class households like those mailed in 2020. What won’t be happening next year is an intergovernmental countercyclical funding bill like those that propped up pandemic-era state and local budgets, so don’t hold your breath for downside budget protection from Uncle Sam.
As for me, I’m one of those armchair economists who now need to eat our hats for over-estimating the worst-case fiscal outcomes that looked far more likely back in April. It was always the case that other elements of the new administration’s fiscal policies would have far deeper consequences for states and localities than tariffs. I still suspect that a good chunk of tariffs’ retail price inflation is being postponed and swept under the rug, but if it takes three years to reveal itself, that amounts to a nothingburger for today’s policymakers. Time is better spent on other financial management issues falling out of Washington and on preparing the workforce for AI.
Governing’s opinion columns reflect the views of their authors and not necessarily those of Governing’s editors or management. Nothing herein should be construed as investment or tax advice. Disclosure: The author was the president and CEO of ICMA-RC over 20 years ago. That firm is now doing business as MissionSquare Retirement; he has no current affiliation or interest there.
