States question whether new federal relief law rules out tax cuts

Everyone knows it's windy
The provision doesn’t entirely prevent state officials from cutting taxes. Some scenarios, such as slashing one tax but offsetting it with a tax increase, wouldn’t be a problem. (Photo by Samuel Corum/Getty Images)

WASHINGTON — President Joe Biden’s massive pandemic relief law pumps a welcome infusion of federal aid into state and local government coffers — but one brief section is raising questions about whether states are barred from cutting their own taxes if they accept the federal help.

The Senate added language to the COVID-19 relief package prohibiting states and local governments from using the $350 billion in direct federal assistance “to either directly or indirectly offset a reduction in the net tax revenue” or delay the imposition of any tax or tax increase.

That provision doesn’t entirely prevent state officials from cutting taxes. Some scenarios, such as slashing one tax but offsetting it with a tax increase, wouldn’t be a problem.

But until the Treasury Department offers more detailed guidance on how it will interpret the new law, the provision is causing uncertainty, particularly in places like Iowa, where tax cuts already are in the works.

Some Republicans in Washington and state capitals have criticized the provision as an unprecedented string attached to the federal dollars. The conservative Heritage Foundation has gone so far as to call on states to reject the federal assistance, even though bipartisan leaders of the National Governors Association have said direct aid is “essential” for states.

“Democrats in Washington and in the White House are not going to tell me, or the Georgia General Assembly, that we can’t cut taxes for hard-working Georgians,” Georgia Gov. Brian Kemp, a Republican, said at a press conference Wednesday, according to the Georgia Recorder.

Sen. Pat Toomey, (R-Pa.), who opposed the overall bill and sending more direct aid to state and local governments, said in a Fox Business interview, that the provision is a “dramatic expansion in the size of state and local governments that the federal government will control.”

Potential trouble spot

Tax policy experts describe a range of complex scenarios that could stymie budget officials and cause them to be in jeopardy of having to pay back the federal dollars.

Jared Walczak of the Tax Foundation, a D.C.-based conservative-leaning nonprofit focused on tax policy, said one potential trouble spot is if states use the money to pay the salaries of employees already on the government payroll, such as public health workers.

Offering grants or assistance to businesses and individuals doesn’t affect existing budgetary expenses. But using the money for existing salaries, even related to the pandemic response, would be dicier if that savings is then offset with a tax cut, he said.

Another murky scenario?

If states decide to follow the federal policy change in another section of the new pandemic stimulus bill and make unemployment compensation benefits not subject to taxes.

“Will that count as a tax cut?” asked Kim Rueben, director of the state and local finance initiative at the Urban-Brookings Tax Policy Center, a joint venture of the liberal-leaning Brookings Institution and the Urban Institute.

Neither White House officials nor a spokesman for Senate Majority Leader Chuck Schumer, (D-N.Y.), responded to requests for comment on the criticism and confusion surrounding the provision.

A defense of limits

Sen. Angus King had offered a defense of limitations on the state and local aid in an interview last month with the Washington Post, in which the Maine senator advocated for “a prohibition against voluntarily diminishing revenues.”

“We could distribute billions to the states, and they turn around and lower taxes — there are governors talking about that, and it’s not the point here,” said King, an independent who caucuses with Democrats.

Rueben said she believes the provision was intended to ensure that the money is being used for the pandemic-related challenges that those dollars are intended to address — and prevent states from having a revenue base that’s in worse shape when the federal aid ends.

Restrictions on federal aid to states aren’t unusual, Walzcak noted.

Some funds require matching state dollars, or even policy changes, such as federal highway dollars that are tied to adopting certain DUI laws. But there’s little case law on how far the federal government can go in such requirements, he added.

“We know the federal government can overreach … but there’s not a clear definition of where that line is,” Walzcak said.

Options for states

States that don’t like the limitation do have options: They could decline to accept the federal money.

Adam Michel, a tax policy analyst with The Heritage Foundation, a conservative think tank, has urged states to reject the aid, arguing in an op-ed piece that the “dangers of permanently expanded state budgets and the possibility of the Treasury Department’s micromanagement of states’ fiscal decisions outweigh the benefits.”

States also could file lawsuits. Walczak said he believes the provision could ultimately end up in court, though that may take some time. States have until 2024 to spend the federal dollars.

Brian Sigritz, director of state fiscal studies for the National Association of State Budget Officers, said state officials are in the “information-gathering stage” just days after the bill was signed into law.

Some of the state tax cuts proposed ahead of the bill’s approval were targeted tax cuts for individuals and businesses, while others were broad cuts designed to be phased in over a number of years, Sigritz said.

“The provision will have an impact on some of those proposals but right now, it’s unclear the exact impact,” he said.

It’s not clear how quickly Treasury officials will release any guidance on how states can spend the pending dollars and how exactly the rules against tax cuts will work. An agency spokesman did not respond to emailed questions.

Rueben said that while the tax policy limitations may cause headaches, it’s likely a preferable challenge for officials to sort out than the one they were facing a year ago, as COVID-19 infections were rising and revenue projections plummeting.

“The fact that they are trying to figure out an infusion of money and what that means, compared to being really afraid of the catastrophic nature of what the shutdowns might mean … I think it’s easier to breathe,” she said.

Laura Olson
Laura covers the nation's capital as a senior reporter for States Newsroom, a network of nonprofit outlets that includes Nevada Current. Her areas of coverage include politics and policy, lobbying, elections, and campaign finance.