Does the American Rescue Plan Ban State Tax Cuts?

Senate amendments to the American Rescue Plan Act (ARPA) prohibit using any of the $350 billion in State and Local Fiscal Recovery Funds to cut taxes, but many are concerned that states which accept the funds could be prohibited from implementing taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. cuts between now and 2024—an astonishing level of federal interference in states’ fiscal affairs. Is this alarm warranted? It’s complicated, but state policymakers have reason to be concerned.

It is possible to imagine several scenarios where tax cuts could be permitted, but in practice, many state tax cut proposals could run afoul of the federal legislation even if most observers wouldn’t consider the cuts to have relied on the federal aid.

The American Rescue Plan Act allocates $350 billion to state and local governments, $195.3 billion of it to state governments. State-by-state allocations are detailed here. Crucially, states have only seen revenue declines of $2 billion, making the state aid component 116 times overall losses. Some states have experienced meaningful revenue declines. But many don’t have losses to offset, so they would have to identify other ways to spend a large infusion of one-time money.

Some might like to use the money for tax relief. The Senate amendment prohibits that. There are other restrictions too, raising serious questions of how states are supposed to spend all this money if they can only use it in limited ways.

It’s reasonable for Congress to want states not to spend what are ostensibly COVID-19 relief dollars to cut taxes, though given how disproportionate the Recovery Funds are to needs, and the other limits placed on expenditures, it’s also reasonable for states to wonder what else to do with the money. The real problem, though, isn’t the direct prohibition on spending some of the $350 billion on tax relief, but on broad language about indirect funding of tax relief that could capture tax reforms which aren’t actually reliant on the American Rescue Plan funding at all.

The restriction: “A State or territory shall not use the funds provided under this section or transferred pursuant to section 603(c)(4) to either directly or indirectly offset a reduction in the net tax revenue of such State or territory resulting from a change in law, regulation, or administrative interpretation during the covered period that reduces any tax (by providing for a reduction in a rate, a rebate, a deduction, a credit, or otherwise) or delays the imposition of any tax or tax increase.”

This is broad language. Let’s consider several scenarios and ask whether the American Rescue Plan Act would impede a state’s ability to set its own fiscal policy with regard to tax reform.

Scenario 1: A state reduces one tax, fully offset by increased revenue generated by another tax or fee.

This is almost certainly permissible for a state which has accepted Recovery Funds. There is no plausible use of funds, either directly or indirectly, to facilitate a shift from one tax to another.

Scenario 2: State rate cuts are funded either by a commensurate spending reduction or by capturing revenue growth.

This too seems consistent with the federal legislation since the tax cut is self-contained. If, for instance, state revenues (not counting the federal relief) grew by $250 million and the state put $200 million toward a tax reduction, it would be difficult to argue that the reduction was facilitated, even indirectly, by federal funds, unless the state continued to grow government by using the federal aid to cover general governmental expenditure growth of more than $50 million (the residual). The same analysis should apply if a state cut spending and returned the money through tax cuts, provided the spending cuts were adequate to the task and not supplemented by federal relief.

But complications arise quickly, because policy never happens in a vacuum. The mere existence of the federal relief adds a wrinkle, discussed in Scenario 3.

Scenario 3: State rate cuts are provided for in a balanced manner—using revenue offsets, capturing growth, or making spending cuts—but the state used Recovery Funds to pay public health officers.

States are authorized to use the aid to cover economic and public health costs of the pandemic and pandemic response, language similar to the authorization for Coronavirus Relief Fund assistance under the CARES Act. Assuming the same applies here, states will likely be permitted to pay the salaries of public health and public safety officials who have some role in pandemic response, even if they would have been employed anyway. But what if states take advantage of that relief and then cut taxes?

If this facilitates the tax cut, it is likely prohibited. In a simplified example, if a state found a way to apply $100 million of Recovery Funds to existing budgeted expenditures and then used that to cover a one-time $100 million tax cut, this would be inconsistent with the law. But what if the state had the resources to cut taxes separately from using this aid, which is available to all states with no other strings attached, regardless of budget situation? Does that preclude them from cutting taxes?

It may well do so. Receiving federal aid reduces the need for state expenditures. If the tax cut captures all the unspent dollars, then arguably it indirectly relies on the federal aid, even if the cut could have been made without it. If, however, the state maintains an unspent reserve equal to the federal aid expended (to avoid using it to cut taxes), what then? One could argue that the state’s fiscal strategy involved setting aside some savings, and that this couldn’t have been accomplished without the federal aid, ergo indirect assistance was rendered to the tax cut. Or one might think this connection too weak and that the tax cut is permissible. It may come down to Treasury guidance.

And this is, realistically, the median scenario. Any state with a net tax cut, even if fully offset with spending reductions or through forgone revenue growth, operates in a world in which some benefit was received through federal aid, and it will always be possible to argue that political decisions could have been different absent that aid. Functionally, this begins to look like a restriction on tax cuts for many states accepting the money.

Note, however, that use of Recovery Funds is already restricted to set purposes, most of which would not offset spending within the operating budget (e.g., grants to and programs for affected individuals and businesses, supplemental pay for essential workers, or the select capital projects authorized to receive these funds). The spending that could be deemed potential indirect aid to tax cuts, and which could potentially be clawed back, would be the backfilling of revenue losses (not even an issue in many states) and use of the funding to cover the salaries of public health and public safety officials.

Scenario 4: Multiyear tax cuts already adopted before enactment of the federal law continue to phase in rate reductions.

The federal legislation prohibits “a change in law, regulation, or administrative interpretation during the covered period that reduces any tax,” so it would seem that a multiyear phasedown would be exempt from the prohibition, even if implementation occurs during the covered period (now through 2024). Tax triggers should also be safe, even if they require an administrative determination that certain revenue targets have been met, since this would just be an application of existing state law.

However, the American Rescue Plan Act only allows the relief to be spent for express purposes, including covering revenue losses specifically stemming from the pandemic. Therefore, it does not seem likely that a state could use additional revenue from the federal law to trigger a cut, since it would not be available as an offset. If a cut could be triggered through revenue gains independent of the federal relief, a triggered tax cut would likely stand.

Scenario 5: A state accepts aid in 2021, sees substantial revenue growth, and cuts taxes in 2023.

This one is also difficult. What if a state has revenue needs from 2020, uses federal aid to balance the budget, and then does quite well in subsequent years? Does accepting federal relief in 2021 tie lawmakers’ hands until the end of 2024, or are such cuts not facilitated, either directly or indirectly, by the relief? The aid being for one fiscal year and the cuts coming out of another fiscal year budget which does not benefit from relief is an argument for tax relief being permissible, but here too, there’s no clear-cut answer.

Such federal entanglement in state fiscal policy is highly significant, and even raises constitutional questions. Under the Anti-Commandeering Doctrine, the federal government cannot require states to adopt or enforce a federal law, and there are limits on using federal aid to oblige states to take certain actions. This doesn’t prevent the federal government from attaching strings to the use of federally-provided resources, but if accepting that money ties states’ hands in ways that would otherwise violate the principles of fiscal federalism—the federal government cannot ordinarily prohibit states from cutting taxes—this raises serious constitutional questions.

Some states are in good shape economically and may wish to cut taxes this year or in subsequent years. State aid in the American Rescue Plan Act is not restricted to states with budgetary needs or revenue losses. Even states with multibillion-dollar surpluses can use aid for eligible expenditures, and it would be extremely dubious for the federal government to allow such states to do almost anything with their revenue growth—except cut taxes.

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