States do not pay federal income tax to the federal government on the revenue they collect through taxes, fees, and public services. They do pay federal taxes as employers, including Social Security and Medicare contributions on their payrolls, and they have narrower obligations around excise taxes and information reporting. So the question of whether states pay taxes to the federal government has a two-part answer: not on their governmental revenue, but yes on their workforce.
The Income Tax Exemption on State Revenue
Section 115 of the Internal Revenue Code is the rule that keeps state revenue outside the federal income tax. It says that gross income does not include income from any public utility or the exercise of an essential governmental function that accrues to a state, a political subdivision, or the District of Columbia.1Office of the Law Revision Counsel. 26 USC 115 – Income of States, Municipalities, Etc That language sweeps in most of what a state does: collecting income and sales taxes, charging tolls, running water systems and public hospitals, operating state universities, and issuing licenses.
The IRS treats the general exemption from income tax as the defining federal tax difference between government entities and other taxpayers.2Internal Revenue Service. Government Entities and Their Federal Tax Obligations A state does not file an income tax return on the money it takes in through its taxing power. That revenue stays with the state.
The phrase doing the work in Section 115 is “essential governmental function.” Not every dollar a state entity earns is protected. If a state-created entity runs an operation that looks and behaves like a private business without a clear public purpose, that revenue can lose its shielded status. The line between a governmental function and a commercial venture matters, and it comes up more often than most people expect.
Why the Federal Government Cannot Tax States Directly
Section 115 is the statutory expression of a constitutional idea that predates the modern tax code. Two sovereigns sharing the same territory cannot function if one can drain the other through taxation. In McCulloch v. Maryland (1819), Chief Justice John Marshall wrote that “the power to tax involves the power to destroy” while striking down Maryland’s tax on the Second Bank of the United States.3National Archives. McCulloch v Maryland 1819 Later cases extended the same logic in the other direction, protecting state activity from federal taxation.
The modern rule, refined by decisions like South Carolina v. Baker (1988), is narrower than the older doctrine. States themselves cannot be taxed directly by the federal government. Private parties who do business with a state can be taxed, even when the economic burden falls indirectly on the state, so long as the tax does not single out state activities for worse treatment. In practical terms, a state employee’s salary is fully subject to federal income tax, but the state’s own revenue is not.
Payroll Taxes States Pay as Employers
The exemption on governmental revenue does not carry over to a state’s role as an employer. Every state with people on its payroll owes federal payroll taxes under the Federal Insurance Contributions Act. The state withholds the employee’s share of FICA from each paycheck and pays a matching employer share on top of that.2Internal Revenue Service. Government Entities and Their Federal Tax Obligations
The employer’s share breaks down this way:
- Social Security: 6.2% of each employee’s wages, up to $184,500 in 2026.4Internal Revenue Service. Topic No 751 Social Security and Medicare Withholding Rates5Social Security Administration. Contribution and Benefit Base
- Medicare: 1.45% of all wages, with no cap.4Internal Revenue Service. Topic No 751 Social Security and Medicare Withholding Rates
For a state worker earning $80,000, the state contributes $6,120 in employer-side payroll taxes each year. Multiplied across hundreds of thousands of employees, the amounts are significant. These are employment costs, structured the same way a private company’s payroll taxes are structured, not taxes on the state’s governmental revenue.
Coverage rules can vary within the same agency. Since July 2, 1991, Social Security coverage has been mandatory for state and local employees who are not members of a qualifying public retirement system and are not already covered by a voluntary Section 218 agreement with the Social Security Administration.6Social Security Administration. Mandatory Social Security and Medicare Coverage7Social Security Administration. Section 218 Agreements Mandatory Medicare coverage applies to anyone hired after March 31, 1986.
Sovereign immunity does not shield a state from IRS deposit penalties. The penalty for late payroll tax deposits scales the same way it does for private employers:8Internal Revenue Service. Failure to Deposit Penalty
- 1 to 5 days late: 2% of the unpaid deposit
- 6 to 15 days late: 5%
- More than 15 days late: 10%
- After an IRS notice demanding immediate payment: 15%
Interest also accrues on the unpaid amount.
Federal Unemployment Tax Does Not Apply to States
A state’s role as an employer stops short of the Federal Unemployment Tax Act. Section 3306 of the Internal Revenue Code excludes service performed in the employ of a state or any political subdivision from the definition of covered employment for FUTA purposes.9Office of the Law Revision Counsel. 26 USC 3306 – Definitions Private employers pay FUTA to fund the federal-state unemployment insurance system, but state governments do not.
State employees are not left without unemployment benefits. States run their own unemployment insurance programs funded by taxes on private employers within their borders, and state workers who lose their jobs can typically claim benefits from those programs.
Federal Excise Taxes on State Purchases
Federal excise taxes apply to specific goods, including motor fuel, certain vehicles, and tobacco. When a state buys these items for its exclusive governmental use, it generally owes no federal excise tax. Section 4221 provides that no manufacturer’s excise tax is imposed on a sale to a state or local government when the goods are for the government’s exclusive use.10Office of the Law Revision Counsel. 26 USC 4221 – Certain Tax-Free Sales
The exemption depends on documentation. It typically requires certification at the point of sale. When a state agency pays the tax at purchase without providing the paperwork, it can claim a refund afterward using IRS Form 8849, filing on Schedule 1 for fuel. The claim must be filed within three years from the close of the taxable year in which the fuel was used.11Internal Revenue Service. Form 8849 Claim for Refund of Excise Taxes In many cases, the registered credit card issuer or fuel vendor handles the refund process rather than the government purchaser.
The exemption applies only when the purchase is genuinely for governmental use. Fuel bought for a commercial activity that does not qualify as an essential governmental function is taxed the same as it would be for a private buyer.
Tax-Exempt Bonds and Federal Revenue Forgone
State sovereignty also produces a benefit on the borrowing side. Under Section 103 of the Internal Revenue Code, gross income does not include interest earned on any state or local bond.12Office of the Law Revision Counsel. 26 USC 103 – Interest on State and Local Bonds The tax break belongs to the investor who buys the bond, but the effect is to let states borrow at lower interest rates than private issuers.
Not every state bond qualifies. Section 103 carves out private activity bonds that primarily benefit private businesses, arbitrage bonds that let a state profit by investing proceeds at a higher yield than it pays out, and bonds not issued in registered form. Within those limits, tax-exempt municipal bonds save state and local governments substantial borrowing costs each year, with the federal government effectively subsidizing state infrastructure by forgoing revenue on the interest.
When State Revenue Loses Its Protection
Section 115’s exemption hinges on income from an essential governmental function.1Office of the Law Revision Counsel. 26 USC 115 – Income of States, Municipalities, Etc A state-owned water utility clearly qualifies. A state-run lottery distributing proceeds to public education likely qualifies. When a state-created entity operates in ways that look indistinguishable from a private business, though, the protection can erode.
The IRS scrutinizes state-affiliated entities that generate revenue from activities competing with private businesses or serving primarily private interests. The analysis focuses on whether income truly accrues to the state from a governmental function or whether the arrangement is a commercial enterprise wearing a governmental label.
States also carry federal compliance obligations even where they owe no tax themselves. A state agency that pays independent contractors and vendors must issue Forms 1099 like any other payer. If a payee fails to provide a valid taxpayer identification number, the state must apply federal backup withholding at 24%. These are not taxes on the state, but they are federal obligations that carry penalties for failure.
The overall picture is a protected but bounded space. States pay no federal income tax on their governmental revenue, borrow at lower rates through tax-exempt bonds, and stay outside the FUTA system entirely. As employers they carry the same FICA obligations as any private company, and once a state’s activity crosses into commercial territory, the tax code treats it with progressively less deference.