State lawmakers heading into next year’s legislative sessions will face a key decision: whether to exempt tips from taxation.
The Trump administration is pressing states to mirror new federal tax reductions by approving a range of tax breaks for individuals and businesses. These include deductions for tips, overtime pay, interest on car loans, and purchases of business equipment.
In some states, federal tax changes automatically flow through to state income taxes unless lawmakers choose to block them. In many others, however, state tax laws require legislatures to explicitly approve such changes before they appear on state tax returns.
As a result, workers in states that do not adopt the new provisions could avoid federal taxes on tips or overtime pay but still owe state taxes on those earnings.
States that fully align with Trump’s tax cuts could deliver hundreds of millions of dollars in yearly savings to residents and businesses. However, doing so could strain state budgets, particularly as states face rising expenses tied to new Medicaid and SNAP food assistance requirements included in the same federal law.
Most state legislatures convene in January. To apply the tax changes retroactively to 2025, lawmakers would need to act quickly so tax forms can be updated in time for filing season. Alternatively, states could choose to implement the changes starting in 2026.
So far, only a handful of states have taken action.
“States are generally taking a cautious approach,” said Carl Davis of the Institute on Taxation and Economic Policy.
Treasury pushes for rapid compliance
The tax legislation Trump signed on July 4 includes roughly $4.5 trillion in tax cuts spread over a decade.
The law introduces temporary deductions for tips, overtime pay, and interest on loans for U.S.-assembled vehicles, expands tax breaks for older Americans, and raises the cap on state and local tax deductions from $10,000 to $40,000. It also offers businesses major incentives, such as allowing immediate deductions for the full cost of equipment and research.
Individual income taxes are levied on wages and salaries in 41 states, while 44 states impose corporate income taxes.
Treasury Secretary Scott Bessent has urged states to “immediately conform” to the federal changes, criticizing some Democratic-led states for what he described as political resistance. However, many Republican-led states also have yet to decide whether to adopt the tax breaks.
Bessent argued that states declining to follow suit are leaving residents with higher tax bills and denying them meaningful financial relief, particularly for low- and middle-income households.
Some experts say the decision is more complicated. For example, a proposed IRS rule would extend the tip tax break to nearly 70 occupations, but many low-wage workers would still be excluded, according to Jared Walczak of the Tax Foundation.
Lawmakers, he said, must weigh whether the benefits justify the cost.
Limited adoption of tip and overtime exemptions
Under existing state tax laws, the federal exemptions for tips and overtime would have automatically applied in only seven states: Colorado, Idaho, Iowa, Montana, North Dakota, Oregon and South Carolina. Colorado, however, opted out of the overtime exemption before the federal law took effect.
Michigan became the first—and so far only—state to approve the tip and overtime tax breaks through legislative action, with implementation set for 2026. State officials estimate the overtime exemption will cost nearly $113 million this budget year, while the tip exemption will cost about $45 million.
To offset those losses, Michigan lawmakers rejected several federal corporate tax changes that the state treasury estimated would have reduced revenue by $540 million.
Republican state Rep. Ann Bollin said Michigan could not afford to adopt all the federal tax cuts while still funding infrastructure, public safety and education.
Arizona may be next to act. Democratic Gov. Katie Hobbs has urged lawmakers to adopt tax breaks for tips, overtime, seniors and vehicle loans, as well as increase the state’s standard deduction. Republican leaders in the state House have said they are prepared to pass the measures when the session begins Jan. 12.
Some states block corporate tax cuts
Beyond Michigan, lawmakers in Delaware, Illinois, Pennsylvania and Rhode Island have moved to prevent some or all of the federal corporate tax changes from taking effect at the state level.
In Illinois, a new law separating the state from part of the federal corporate tax provisions could save nearly $250 million, according to Democratic state Sen. Elgie Sims. He said the savings would help maintain funding for education, health care and other essential services.
Illinois Gov. JB Pritzker cited similar budget concerns in opposing the corporate tax breaks, noting that states are already facing financial pressure from other elements of Trump’s legislation, including higher costs for administering food assistance programs.
He said the decision to block the tax cuts was aimed at protecting state-funded programs amid what he described as growing financial demands from the federal government.