Fiscally, the “known unknowns” include the impact of the OBBBA’s election-year GDP stimulus on income and sales tax revenues as well as the uncertain ways presidential tariff policies and litigation play out in the real economy this year. Fortunately for states and municipalities, those are secondary uncertainties, ones whose potential ricochets won’t change their operations very much before the November elections. Even so, there are a half-dozen practical challenges that the public finance community is facing this year.
Let’s start with the known knowns. Top of that list is the impact of OBBBA so far, and top of mind as we head into tax season is the no-tax-on-overtime kerfuffle. Contrary to the expectations of most workers, the new federal tax code made only some of their overtime pay tax-exempt, and therein lies the hassle for employers as workers get their W-2s and sidecar overtime statements later this month, while employers also install new payroll accounting systems for 2026. Payroll managers nationwide face a communications headache in coming weeks, and many are scrambling now to explain new rules and time sheet formats to confused or disbelieving employees.
On the fiscal front, the new OBBBA tax breaks for overtime and tip income will result in an estimated $40 billion of refunds to federal taxpayers in coming months. None of that money goes directly into state and local coffers. However, there will be a small indirect OBBBA refunds kicker of a fraction of 1 percent to 2026 sales tax revenues as this refund largess recirculates locally. Partisan politicians and pundits will try to make a big deal about these remittances, but from states’ and localities’ actionable public finance and budgetary standpoint, they are just a hill of beans on a prairie landscape.
While all that is going on, there is a good chance that Congress will once again fall into dysfunction with the expiration of its latest budget resolution and trigger yet another shutdown. Political theatrics aside, there probably won’t be much impact on state and local finance from that Capitol Hill drama.
Amid these fiscal impacts, various states with income taxes will have differing levels of lost revenue from the federal definitions of taxable income under the OBBBA. Some states will follow the IRS template for taxable income with the new tip and overtime exclusions. Corporate income taxes will be reduced by accelerated-depreciation deductions, but some states do not conform to all the IRS formulas on that score. Higher allowable federal deductions for state and local taxes will benefit some local taxpayers but have zero impact on the financial practices of these governmental units themselves. The Tax Foundation has provided a road map to understand the differing levels of conformity in states’ definitions of taxable income.
On the expense side, 19 states just increased their minimum wages. Those raises will elevate payroll costs for seasonal workers and lower-skilled employees in municipal maintenance operations. “Pay equity” issues may arise among other public workers on the lower end of salary schedules who expect to be paid more than the statutory minimum. But most budgets have already baked in those expenses, so it’s a known known.
For a few hundred local governments, the single most noteworthy feature of OBBBA will be its reincarnation of “opportunity zones” (OZs), which had been set to expire. The new law makes that concept permanent and gives the states until mid-2026 to designate new zones under revised criteria, with the expectation that the huge tax loopholes it provides to developers will gain traction in 2027. There will be a lot of jostling to secure local zones through state-level politics, and after that a new land rush will begin. Already there are controversial projects targeting probable OZ locations for construction of massive data centers to serve the burgeoning AI industry.
Stability, for a While
Because midterm elections are notorious for “change” voting waves, the interests of incumbent national politicians are to keep the economy on an even keel and project confidence, stability and optimism for average or better GDP growth. Recent Federal Reserve leaders’ economic projections comport with that sanguine outlook. With that as a political backdrop, the inertia in 2026 should favor budgetary stability, labor stability and investment stability.
The primary revenues of states and local governments are comparatively more predictable this year, with income and sales taxes driven by a national economy that continues to grow steadily with friendly gentle winds in its sails from modest federal fiscal stimulus, even with the drag of tariffs. Revenues from income taxes should outrun sales taxes as business owners and investors come out ahead of workers — and have a lower marginal propensity to consume their income from capital.
Gambling taxes could be the biggest new state revenue story, but they won’t move the budget needle too much this year as only a dozen states may seek some extra income by taxing online casinos. Alert and savvy state treasurers might explore ways to milk the prospectively trillion-dollar predictions market industry, which presently escapes taxation.
Meanwhile, property values in most states will be more stable overall this year than any time since the pandemic, with less voter angst about skyrocketing local taxes, although some state politicians will keep promising property tax relief of one kind or another. The outliers are jurisdictions that are now playing catch-up in their outdated assessments. For local budget offices, this should be the most predictable year for that key revenue source in the 2020s.
On the public workforce front, while “affordability” remains a political hot potato, official inflation rates are sufficiently subdued to keep unions from expecting more than the consumer price index (CPI), given all the federal funding cutbacks. The overall labor market itself is stable but fragile — somewhat frozen in place with both less hiring and less firing in the private sector — so public employee unions have lost their pay bargaining leverage with many employers.
This would be a good year to lock down multiyear contracts with 3 percent cost-of-living increases that should be fair to all sides including taxpayers. Although inflation might again raise its ugly head if Washington politicians overplay their economic stimulus, that’s unlikely to matter too much before 2027. By then, the deflationary impact of AI-induced productivity and a resulting national labor surplus could be a big CPI offset.
All of this makes 2026 an ideal year for long-term forecasting and planning: At least for the time being, there is a better confidence interval for baseline projections that extrapolate from today’s level of business as usual. It’s a perfect time to reset budget reserve levels, establish a new five-year capital budgeting and financing plan, put pensions and other post-employment benefit plans on a stronger footing, and play the long game in public finance.
Those are the primary known knowns. The known unknowns are more diverse, some of them political in nature, while others are more industry-specific. They range from the potential downstream impact of tariff litigation and politics, to interest rate trends, to the speed of AI technology, to retirement plan investments.
Tariff Politics and Economics
The actual impact of tariffs on the economy is now largely resolved: Prices are creeping higher, but not by as much as economists and political adversaries projected. The CPI is probably running hotter by a percent or so as a result of tariffs, and there likely are more price increases for goods coming in 2026 as a result of tariffs in the 15 percent range. But the overall fiscal impact on state and local revenues, budgets and labor costs is within the range of “manageably modest” this year.
The single most controversial and potentially impactful unknown on the national stage right now is how the three branches of government ultimately dispose of the president’s “liberation day” tariffs in coming months. No matter what transpires in the courts, the president will still have authority to invoke new tariffs (many at the 15 percent level) under other indisputable legal authorities. So the salient longer-term fiscal issue becomes which tariffs will prevail in years to come. But what about 2026?
There is one other tariff-related scenario to keep in mind: the potential for a partisan gambit to legislate a “Trump tariff dividend” to finesse the judicial system. It would certainly be a crafty way to address this year’s “affordability” issue amid the midterm campaigns. Even the president’s opponents would probably favor issuing checks to households by an act of Congress over refunds to companies and importers under court orders. The latter would be Robin Hood in reverse.
Whether such a ploy could win a filibuster-proof Senate majority (or a budget reconciliation vote) is obviously open to question. But don’t underestimate the president’s ability to magnanimously wangle a wave of $2,000 Trump-autographed checks to households before November. That money could quickly be spent, which would boost state and local sales tax revenues and inject local budget windfalls of $10 billion nationwide, assuming that half of these checks are spent on taxable goods and services. That would amount to a 2 percent increase in those state and local revenues in the 12 months following distributions, potentially the largest single swing factor in many jurisdictions’ upcoming budgets — enough to be meaningful locally, though notably in the form of nonrecurring revenues.
Rates and Yields
2026 looks to be a year when most workers, savers and pensioners tread water while most business owners, partners, executives and company investors continue to grow wealth. Despite constant media attention to worries about a stock market bubble, historical indicators would suggest that with a few exceptions market traders’ ebullience has not yet reached the stage of hype and exuberance that portend an economywide collapse like the 1999 dot-com crash or the 2008 mortgage securities fiasco. So pension funds and retirement savings plans are probably safe for at least another year. Meanwhile, let’s take a quick look at cash management and the muni bond market.
This year will bring important changes to the Federal Reserve system, as the president gets his new pick for chairman and will likely try to pack the rest of the board with followers who consistently push for yet-lower interest rates — possibly bumping its short-term federal funds rate down closer to the national inflation rate. But there is only so much room for money market yields to further decline before the bond vigilantes reactivate, driving up borrowing costs. Even so, a normal, upward-sloping yield curve is likely to prevail throughout 2026, so treasurers and cash managers who can put their money to work for a year or two will likely come out ahead of those who stay ultra-short for the sake of liquidity; for most, the big opportunities to outperform the overall market have already passed them by.
Nonetheless, treasurers and their advisers who strongly suspect or fear that a monetary policy error is coming — if, for example, the president prevails in cramming the fed funds rate down to a level well below the inflation rate — should consider locking in their operating cash portfolios in 18- or 24-month Treasury notes while also selling gobs of long-term muni bonds this year before any monetary inflation returns. The State of the Union rhetoric may give clues for whether to anticipate and address this risk.
While they are busy marching in place in the money markets, treasurers will be well advised to work through their professional associations to lobby actively for pending legislation to expand FDIC insurance limits on transaction accounts. There is no reason taxpayers should suffer if municipalities’ payroll and big-ticket payments are jeopardized by unsuspected bank failures.
Emerging and Recurring Issues
Perhaps foremost among the known unknowns is how artificial intelligence will reshape not only markets but also the workplace, yet one aspect is clear enough: 2026 is too early for AI applications to be material budgetwise. Finance professionals will do well to prepare themselves to use new AI tools, but the nature of industrial technology is that it will be delivered first to private companies where it boosts profits the fastest. Later there will be rollouts to public agencies of fintech and AI applications that are tested and proven elsewhere, so the “early learner and fast follower” mantra will be sufficient for this year at least.
That said, the AI industry is a hog for electric power, which could easily make it the bull’s-eye for “affordability” politics. Letting the industry push the incremental cost of supplying data center power onto local residents is a recipe for voter revolts and grassroots ballot initiatives. It’s an interesting case of economic externalities for local agencies to address by requiring economic impact statements. Local land-use approvals should be conditioned on these facilities paying a hefty rate surcharge in order to stabilize local residents’ bills. That’s called tiered pricing. At the state level, public utility commissions will certainly face mounting pressure for stiff industrial-use power-pricing surcharges to keep consumer rates from skyrocketing.
Meanwhile, a few states will continue to explore and debate various forms of wealth taxes, high-income surtaxes or other ways to extract more revenue from One Percenters. Absent a stiffer minimum-tax regime at the federal level, these populist proposals will keep popping up, but most will prove infeasible or unsuccessful politically in the face of the usual dire warnings of “millionaire flight.”
On other fronts, some of them perennial, it’s fair to say that governmental financial reporting needs an overhaul, what with digitization of financial data soon to come and a lot of rethinking about what’s a better model for general financial reporting to citizens and policymakers versus what the accountants crank out for muni bond investors who want the entire kitchen sink and its plumbing as well. GASB Statement No. 103 becomes effective this year in its effort to make management’s summaries more succinct and relevant. But don’t look for anything dramatic beyond that this year.
Likewise, don’t expect much change in pension-land. Most trustees would be well advised to crystalize some of their recent market gains by trimming risk exposure, tightening up their unfunded amortization schedules to apply portfolio profits there, and baking in more risk-offset assets into their portfolios. They should be wary of sexy, new asset-based financing schemes that will keep trying to wangle their way into pension portfolios, escalating risks of fueling a new credit bubble.
For the defined-contribution community, this will be the year of mounting noise about alternative investments, but most plan overseers will only tiptoe into that idea by allowing a few alts and annuities in their target date funds while they study the issue this year. Cynics would say that every speculative fad needs a horde of end-game bag holders, and naive retirement savers make perfect targets for dumping the fat cats’ stale leftovers. You’ll know it’s a market bubble — and probably time to cash profits — when firefighters start bragging about alternative investment gambits in their 457 accounts, but 2026 is still too early for that.
Beyond this multivariate outlook for state and local finance, most of the other possible outcomes and trends for the new year involve unknown unknowns and higher degrees of conjecture. For 2026, let’s stick to what’s reasonably foreseeable and map out durable strategies to make the most of what’s already obvious or probable.
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 advice.
