For the most part, the government does not pay taxes. Federal agencies are shielded from state and local taxation under the Supremacy Clause, and state and local governments are excluded from federal income tax on revenue tied to essential governmental functions. That said, governments do pay in several situations: they owe payroll taxes on the wages of their employees, they pay environmental compliance charges where Congress has waived immunity, and the people who work for them pay income tax on their salaries like anyone else.
Why One Government Cannot Tax Another
The rule against one level of government taxing another comes from an 1819 Supreme Court decision, McCulloch v. Maryland. Chief Justice John Marshall wrote that states have “no power, by taxation or otherwise, to retard, impede, burden, or in any manner control” federal operations.1Cornell Law School. The Intergovernmental Tax Immunity Doctrine The doctrine that came out of the case, intergovernmental tax immunity, runs in both directions. States cannot tax federal operations, and the federal government cannot tax state operations. The logic is simple: the power to tax is the power to destroy, and letting one government tax another would let it price the other out of existence.
Federal Property and Purchases Are Exempt from State Taxes
States cannot impose property taxes on federally owned land, which covers roughly 635 to 640 million acres nationwide.2U.S. Department of the Interior. S. 434 Military bases, national forests, federal courthouses, and post offices all sit off the local tax rolls. That leaves a hole in the budgets of counties where federal land dominates the map.
Congress fills part of that hole through Payments in Lieu of Taxes (PILT). The Department of the Interior distributes these payments each year to jurisdictions that host federal land. In 2025, PILT payments totaled $644.8 million to more than 1,900 local governments.3U.S. Department of the Interior. Payments in Lieu of Taxes PILT is a voluntary appropriation, not a tax, and Congress can adjust or eliminate it. The formula is based on federal acreage and population, not on the property tax revenue a county would otherwise have collected, so the payments rarely make a jurisdiction whole.
Federal purchases are similarly exempt from state sales tax. All 50 states and U.S. territories honor the exemption for goods billed directly to a federal agency through centrally billed accounts on government purchase cards.4GSA SmartPay. GSA SmartTax Leading Practices and Lessons Learned for State Taxes When an employee uses a card that bills to the employee personally rather than to the agency, some states will still charge sales tax.
State and Local Governments Are Exempt from Federal Income Tax
The immunity runs the other way too. Section 115 of the Internal Revenue Code excludes from gross income any revenue a state or local government earns from a public utility or an essential governmental function.5Office of the Law Revision Counsel. 26 USC 115 – Income of States, Municipalities, Etc. School district revenue, transit fares, water and sewer charges, and tax collections all fall inside the exemption.
The phrase “essential governmental function” does carry limits. When a government-owned entity operates in a way that looks more like a private business than a public service, its income may fall outside the protection. The IRS looks at whether the activity serves a public purpose and whether the income accrues to the government itself rather than to private parties. The closer an operation gets to a commercial enterprise distributing profits, the weaker the case for exemption.5Office of the Law Revision Counsel. 26 USC 115 – Income of States, Municipalities, Etc.
Excise taxes work on similar principles. State and local governments are generally exempt from manufacturer’s excise taxes on articles they buy for exclusive government use.6Office of the Law Revision Counsel. 26 USC 4221 – Certain Tax-Free Sales Congress carved out exceptions: the exemption does not reach excise taxes on vaccines, coal, or gas-guzzler vehicles even when the buyer is a state or local government.7Internal Revenue Service. Publication 510, Excise Taxes Governments that buy fuel with the excise tax included can claim refunds using IRS Form 8849, or buy certain fuels tax-free by giving the distributor an exemption certificate.
Municipal Bond Interest Is Federally Tax-Exempt
State and local governments get another significant tax break through the municipal bond market. Under Section 103 of the Internal Revenue Code, interest earned on state and local bonds is excluded from the bondholder’s gross income for federal tax purposes. Because investors do not owe federal tax on the interest, they accept lower yields than they would demand on taxable corporate bonds. The savings flow to the government issuer, cutting the cost of financing schools, highways, and water treatment plants. The exemption does not apply to private activity bonds outside specific qualifying rules, nor to arbitrage bonds.8Office of the Law Revision Counsel. 26 USC 103 – Interest on State and Local Bonds
Governments Pay Payroll Taxes on Their Employees
Tax immunity disappears at the payroll window. Federal, state, and local agencies that employ workers owe the employer’s share of Social Security and Medicare tax under FICA: 6.2% of wages for Social Security and 1.45% for Medicare, for a total of 7.65%.9Office of the Law Revision Counsel. 26 USC Chapter 21 – Federal Insurance Contributions Act Agencies also withhold the employee’s matching share and report the amounts quarterly on IRS Form 941, just like a private employer.10Internal Revenue Service. Instructions for Form 941 (03/2026)
The federal government has been subject to FICA since 1983. The statute is emphatic: no general tax exemption granted to a federal instrumentality can override the FICA obligation unless it specifically references the FICA statute by section number.9Office of the Law Revision Counsel. 26 USC Chapter 21 – Federal Insurance Contributions Act
State and local governments took a different route. They enter voluntary agreements with the Social Security Administration under Section 218 of the Social Security Act to bring specific groups of employees into the system.11Social Security Administration. Voluntary Agreements for Coverage of State and Local Employees The result is uneven. About 6.5 million state and local government workers — roughly a quarter of the workforce — are not covered by Social Security through their current job.12Social Security Administration. Pensions for State and Local Government Workers Not Covered by Social Security Teachers are the largest affected group. Workers in those jobs typically pay into a public pension system instead of Social Security, which matters a great deal for retirement planning.
Environmental Compliance and Other Waived Immunities
Congress has voluntarily waived federal immunity in specific areas. The Clean Water Act requires every federal department and agency to comply with state and local water pollution requirements “in the same manner, and to the same extent as any nongovernmental entity including the payment of reasonable service charges.”13Office of the Law Revision Counsel. 33 USC 1323 – Federal Facilities Pollution Control The Clean Air Act and the Resource Conservation and Recovery Act contain similar waivers.
Under these statutes, a federal military installation can be required to pay state environmental compliance fees, hold state pollution permits, and answer to state enforcement. The President can exempt a specific facility if compliance would compromise paramount national interests, but that exemption is limited to one year at a time and cannot rest on a lack of funding alone.
Government Workers Pay Income Tax
The exemption belongs to the government entity, not to the people on its payroll. Every government employee, from the President to a county clerk, owes federal and state income tax on their salary. Their wages are personal income, and they file annual returns like anyone else.
The one meaningful carve-out is for members of the Armed Forces in designated combat zones. Enlisted members, warrant officers, and commissioned warrant officers can exclude all military pay earned during any month they served in a combat zone, even if they were present for a single day of that month. The exclusion covers basic pay, reenlistment bonuses signed in the zone, hostile fire pay, and income from selling leave accrued during combat service. Commissioned officers face a cap set at the highest rate of enlisted pay plus hostile fire pay for each month in the zone; anything above that stays taxable.14Internal Revenue Service. Tax Exclusion for Combat Service The exclusion applies only to income tax. Combat zone pay is still subject to Social Security and Medicare withholding.