Lawmakers Face Budget Crunches, Tough Decisions to Close Expected Shortfalls

This is one in a series of five articles examining key debates that will unfold in the nation’s statehouses in the year ahead.

After two years of relative stability, 2025 marks an inflection point for many state budgets. Although tax revenue has declined nationwide since the record highs of 2021 and 2022, most states had large surpluses and leftover federal aid that helped lawmakers pass budgets with a minimum of fuss in 2023 and 2024.

Now, however, lawmakers face tougher budget decisions as the post-pandemic transition period ends.

State budget stresses are more widespread than they have been at any time since at least 2020. That means many officials who were spared fiscal challenges over the last four years will have to begin the more difficult work in 2025 legislative sessions of setting priorities, scrutinizing spending, and seeking new sources of revenue. Immediate budget challenges remain far from universal—in many places, the strong economy has helped revenue collections remain resilient—but even states that are doing well in the short term may need to prepare for tighter years ahead.

Widespread imbalances

Signs of stress are not just popping up in states with chronic budget challenges. States with comparatively strong recent fiscal records face difficult years too.

In Maine, officials project around a $637 million structural deficit in the general fund for the upcoming biennium, two years after forecasts showed a structural surplus. In Colorado, revenue estimates show a $750 million budget gap for fiscal year 2026, just months after lawmakers adopted a mix of spending increases and tax cuts. And in Washington state, revenue estimates are falling below expectations, and a November memo from Pat Sullivan, the director of Washington’s Office of Financial Management, estimated the state’s shortfall for the next two two-year budget cycles at $10 billion to $12 billion.

“We will face significant challenges in meeting all our obligations in our next budget,” Sullivan said in a September statement. “ There are some tough fiscal choices ahead.”

What makes the budget stress most concerning is not its magnitude—most of the reported shortfalls appear manageable in size—but rather its timing in the economic cycle. With job gains steady, unemployment low, and the national economy still growing, states do not face shortfalls because of a temporary downturn. Rather, in many states, forecasts show structural deficits, with ongoing revenue at risk of chronically falling short of ongoing spending after recent tax cuts and spending increases. As a result, even states that can balance this year’s budgets with relative ease will need to keep an eye on whether their decisions could make future problems worse. Long-term budget assessments published in fall 2024 in California, New York, and Pennsylvania all show large future deficits.

In Florida, the real pain is not expected to start for another year or two. A three-year Florida forecast released in September showed that, absent corrective actions, the state will face a deficit in fiscal 2027 that will grow to nearly $7 billion in fiscal 2028. Although the state has approved a mix of spending increases and tax cuts in recent years, the looming prospect of deficits could lead to austerity moves. “The party is going to slow down, if not stop,” Dominic Calabro, president and CEO of Florida TaxWatch, told The Bond Buyer.

Reserve decisions

Perhaps the easiest way for states to deal with budget shortfalls this year would be to lean on their reserves. Almost all saved part of their pandemic windfall in both formal rainy day funds and as leftover cash in their general funds. These reserves remain substantial, though collectively they are not as large as they were a year ago. Policymakers could use reserves to close shortfalls, but doing so risks just delaying the hard choices necessary to balance their budgets.

In Iowa, for example, tax cuts have crimped collections. The state’s latest estimate shows general fund revenue falling from $9.8 billion in fiscal 2024 to $9.2 billion in fiscal 2025 and then $8.7 billion in fiscal 2026—not enough to pay for existing programs and services. But, anticipating that the tax cuts will fuel growth that ultimately increases collections, Iowa Department of Management Director Kraig Paulsen has signaled that the state plans to use its reserves rather than just cut its way to budget balance.

Even in states without shortfalls, policymakers will have to decide what portion of their reserves to spend. Ursula Parks, a former director of Texas’ Legislative Budget Board, told Pew that the state will enter its 2025 session with tens of billions of dollars saved between its ending balance from the fiscal 2024-25 biennium and its rainy day fund—but there will be no shortage of demands for these dollars. Just as they did in the last biennial session, lawmakers are likely to consider dedicating some of the money to long-term needs such as improvements to the energy grid, water infrastructure, and broadband access. Other priorities include private school vouchers and expanded local property tax cuts.

Tax shift

Several states, especially those in the West and Midwest, are also expected to consider plans to reduce local property taxes in 2025. However, the era of widespread state tax cuts appears to be ending, with only a few states, such as Mississippi and Montana, planning to consider major income tax relief. Last year, the pace of cuts slowed considerably as states paused to see the effects of the changes—many of which are being implemented incrementally over multiple years—before contemplating additional cuts.

Instead, Jared Walczak, vice president of state projects for the Tax Foundation, predicted in a conversation with Pew that “comprehensive tax reform becomes part of the conversation in a way that it simply didn’t have to be in recent years.” With tighter budget conditions, if lawmakers want to reduce some taxes, they will have to pair these cuts with increases to make up for lost revenue.

Louisiana offered an early preview of this dynamic in November 2024, when lawmakers adopted a far-reaching plan that included both major tax cuts—lower income tax rates and the elimination of the corporate franchise tax—and significant revenue-raising measures, including higher sales tax rates and reduced tax breaks.

Spending pressures

States also face growing pressure on the spending side of the ledger as a result of rising costs and decisions to boost spending. Many budget debates will center on how to manage these costs, especially in the two largest areas of state spending: K-12 education and Medicaid.

In Colorado, for example, policymakers may experience fiscal whiplash. In 2024, lawmakers celebrated that, for the first time in 14 years, they had provided the level of education funding envisioned by the state constitution. Maintaining that commitment, however, may prove difficult because recent tax cuts and other spending demands—including from Medicaid—have contributed to a budget deficit.

Similarly, New York punted on major changes to education and Medicaid in 2024, but both issues will be back in 2025 as the state continues to face deficits. On Medicaid, much of the focus will center on rising spending for in-home long-term care.

Furthermore, states face the prospect of needing to address not only their own fiscal challenges, but also those of local governments. Although states generally tried to use temporary federal aid for temporary spending, many municipalities, school districts, and transit agencies had little choice but to spend the money on ongoing operating costs. Now, many of those governments face fiscal cliffs and are looking to states for help.

In Illinois, Chicago-area transit agencies face a $730 million shortfall for fiscal 2026, and lawmakers will debate a plan that pairs additional funding with organizational reforms intended to save money—including consolidating the Chicago Transit Authority with other local transit agencies. Similarly, Chicago Public Schools and other districts are asking lawmakers for help closing significant budget gaps caused by the expiration of federal pandemic school aid. With improving credit ratings, Illinois has begun digging itself out of the deep hole caused in part by decades of public employee pension underfunding and a more-than-700-day impasse that left the state without an enacted budget from 2015 to 2017. But local government challenges could now impede that progress, as could growing state deficits.

‘Touch and go’

Taken as a whole, state leaders will need to square their desire to maintain recent tax cuts and spending increases with more challenging fiscal realities. To see how these debates might play out in 2025, one place to look is the smaller group of states—including Arizona, California, and Maryland—that faced budget shortfalls in 2024.

These states did not generally undo the big-ticket policies they had adopted over the last few years, such as Arizona’s 2021 flat income tax or Maryland’s 2021 school funding law. Nor did they empty their reserves, although both California and Maryland tapped them to a degree. Instead, their strategies for closing the gaps included some genuine cuts (such as California reducing the size of its state workforce and Arizona slashing funding for higher education and water importation), targeted revenue-raising measures (such as Maryland’s increased cigarette taxes and transportation fees), and budget maneuvers aimed at deferring financial strain.

States with shortfalls this year may employ a similar playbook. If they do, one big question will be whether these targeted actions are sufficient to get their budgets on a sustainable course or whether policymakers will simply be setting themselves up for a repeat of the problems in 2026.

In this regard, Maryland’s November forecast, suggested that solutions will not be quick or easy. Even after last session’s budget balancing measures, legislative analysts found that the state’s structural deficit has grown to the point that the “long-term outlook is worse than during the Great Recession.”

In contrast, Arizona received more encouraging news in October when the nonpartisan Joint Legislative Budget Committee staff projected that, unlike the previous year, the state did not have a shortfall over the three-year forecast window. Despite that top-level finding, the forecast included warning signs. Revenue was barely able to support projected spending, leaving little room to pay for rising costs—or to restore the cuts from last session.

Robert Robb, a former columnist for the Arizona Republic, told Pew that over the long term, he is optimistic that Arizona will continue to be a magnet for people and economic growth and its budget will reflect this strength. But for the next few years? “It’s going to be touch and go,” Robb said.

Josh Goodman works on The Pew Charitable Trusts’ state fiscal policy project.