Among the many provisions in the $1.9 trillion federal aid bill is a controversial restriction on using the federal funding to provide tax relief. Earlier this week 21 state attorneys general questioned the provision in a letter to the Treasury Secretary.
In a letter to Treasury Secretary Janet Yellen on Monday, they said the prohibition is “unclear, but potentially breathtaking” — airing concerns that any tax cut could be construed as taking advantage of the pandemic relief funds.
The attorneys general list over a dozen instances of states currently considering new tax credits or cuts that they believe could be jeopardized simply because of the relief funds.
“We ask that you confirm that the American Rescue Plan Act does not prohibit States from generally providing tax relief,” wrote the coalition, led by Georgia, Arizona and West Virginia.
Responding to concerns from state officials, the U.S. Treasury Department said Wednesday that states can cut taxes without penalty under a new federal pandemic relief law — so long as they use their own funds to offset those cuts.
A treasury spokesperson told The Associated Press that the provision isn’t meant as a blanket prohibition on tax cuts. States can still offset tax reductions through other means.
“In other words, states are free to make policy decisions to cut taxes – they just cannot use the pandemic relief funds to pay for those tax cuts,” the Treasury Department said.
The Wall Street Journal editorial board has weighed in on the controversy.
Ohio on Wednesday sued the Treasury to enjoin the mandate, and the case is an early test of progressive ambitions to upset the constitutional balance.
The $1.9 trillion bill marketed as Covid relief includes $350 billion in federal aid to states and localities. While states can use the money to increase spending, Congress decreed that they can’t use it to cut taxes. “A state or territory shall not use the funds,” the bill says, “to either directly or indirectly offset a reduction in the net tax revenue” from a new law or regulation.
Because the mandate applies to “indirect” revenue offsets, states are at risk of violating the law for any tax reduction “during the covered period,” which stretches through 2024. Ohio’s lawsuit by Attorney General Dave Yost argues that “this coercive offer of federal funds violates the Constitution.”
The editorial should be read in its entirety. The Ohio challenge appears to be well grounded. Interstate competition for job creation and investment often spurs innovation and government accountability,the WSJ points out.
Federalism fosters competition among states, a source of American dynamism. This provision takes direct aim at that feature by hobbling the ability of states to compete for business and investment through their tax codes unless they turn down massive federal relief.
The Ohio suit also cites corrosive effects on political accountability. The federal restriction on state tax cuts, the lawsuit says, “allows Congress to quietly impose its preferred tax policies without having to pay the full political price for doing so.”
The Tax Foundation has also examined the limitation on tax relief. Their key findings:
- The American Rescue Plan Act’s restriction on states’ Fiscal Recovery Funds being used to directly or indirectly offset a net tax cut is vague and raises difficult questions of interpretation and application. A broad interpretation of this prohibition may be unconstitutional.
- This restriction potentially implicates a wide range of tax decisions, not just rate reductions but also federal tax conformity, excluding unemployment benefits from income taxation during the pandemic, adjusting standard deductions, or awarding discretionary tax incentives.
- States will require answers to many questions, but particularly: (1) what constitutes a net tax reduction? (2) how is a net tax reduction determined to have resulted from a policy change? (3) which potential expenditures could be deemed to create fiscal capacity for a net tax cut? and (4) how would offsetting a tax reduction be defined, especially across multiple years?
- U.S. Department of Treasury guidance will be crucial as states seek to navigate this new environment.
Of course, if the provision is found to be unconstitutional, the guidance will not be needed.
Something to watch.