As we approach summer and policymakers in most states work to wrap up budget approvals for the fiscal year starting July 1st, it is becoming increasingly obvious that state governments are facing mounting budgetary headwinds due to rising costs and anemic revenue growth. The health of state budgets should concern investors because policymakers in states under fiscal stress typically will seek to be more efficient in how they spend money. This could mean some states cut discretionary spending, defer capital investments, or perhaps even invest in technology solutions that yield meaningful cost savings and allow agencies to do more with less.
States haven’t had to grapple with fiscal stress this severe since before COVID, thanks to the influx of federal pandemic funding in 2020 and 2021, which not only significantly increased available revenues for state and local budgets but also led to record increases in tax collections in 2021 and 2022. Data from the Federal Reserve Bank show that state tax revenues grew by only 4.3% over the subsequent three years, suggesting that annual state tax revenue growth has been running below the rate of inflation for the last few years.
This lack of growth in state tax revenues was not a problem for most states in 2023 or 2024 because they had built up substantial reserves from the influx of tax revenues and federal funds in the prior three years, but by 2025, this continued lack of revenue growth was causing problems. Several states struggled with passing balanced budgets for FY26 in 2025. Things were so bad with respect to Pennsylvania’s structural deficit and political infighting on how to address it that lawmakers approved the budget 135 days late, more than three months into the fiscal year. North Carolina’s situation is even worse, as lawmakers have not yet passed a budget for the fiscal year starting July 1, 2025, and have only avoided a government shutdown because state agencies can operate under continuing resolutions that keep agency spending flat with the prior fiscal year.
While several states had problems passing budgets last year, things are far worse for lawmakers this year. In 2025, ten states were trying to figure out how to pass a balanced FY26 budget. Now, in 2026, no fewer than 14 states are grappling with structural deficits for the upcoming fiscal year, and many of the states on this list are the same ones that had trouble passing a balanced budget the prior year. A number of the more obvious examples are as follows:
| State | Budget pressure example |
| California | The state faces annual deficits over the next few years, which Governor Newsom addresses by drawing down reserves, and critics suggest the state still runs a $10 billion structural deficit each year. |
| New York | The state faces an average annual deficit of more than $10 billion by 2030 due to increased spending on social programs such as Medicaid. |
| Illinois | The state faces multibillion-dollar structural deficits and large unfunded pension liabilities, which lawmakers address with short-term fixes that merely meet immediate needs. |
| Florida | Rising Medicaid costs and decelerating economic growth are making it more difficult for the state to balance its budget, and there are concerns surrounding projected budget deficits starting in FY28. |
| Pennsylvania | The state faces a $6.9 billion deficit in FY27, and it is unclear how this will be resolved. Tapping the state’s Rainy-Day Fund, legalizing adult-use marijuana, and new taxes on “skill games” have been floated as potential solutions. |
These budgetary deficits aren’t unique to state governments, as policymakers in many counties and city governments are facing similar challenges. This kind of fiscal stress has also been experienced in previous years, most notably during the Great Financial Crisis, when state tax collections at all levels of government were under significant pressure in 2008 through 2010 and only recovered in 2011 when state tax collections grew by 8%.
What makes things a bit different this time around is that states are not just experiencing fiscal pressures during a period when the economy is doing reasonably good and not because of some kind of economic contraction. A few of the forces negatively impacting state budgets include:
- Persistent inflation and rising fuel prices are putting pressure on consumer spending and consumer sentiment.
- The escalating cost of healthcare consistently increases the cost of Medicaid and employee healthcare spending and crowds out spending on other budget priorities.
- Federal policy shifts included in the One Big Beautiful Bill Act related to Medicaid, the Supplemental Nutrition Assistance Program (SNAP), and other federally funded programs are shifting more costs that used to be covered by the federal government onto state budgets.
Given the changing financial fortunes of states and even local governments, it is imperative that investors understand the fiscal situation of the specific jurisdictions they are most exposed to, to understand the potential risks they face. Not all jurisdictions are experiencing the same economic pressures, and some are in a far better position to weather a few years of financial stress than others. And even when a state or city is under severe financial stress, not all spending is created equal. Some spending is seen as absolutely essential and is immune to cuts, while other kinds of spending are seen as either partially or entirely discretionary, and at risk of being cut. The devil is in the details. Knowing exactly what levers policymakers can pull to deal with fiscal pressures is critical to understanding the risks investors face.
Read more from Capstone’s Special Situations team:
TSA Privatization Opens the Door for Private Security
The Budget Squeeze: When State and Local Revenue Falls and Federal Funding Disappears
The Coming SLG Boom
