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ARPA’s Tax Mandate Ruled Unconstitutional by Appellate Court

5 min readBy: Abir Mandal

The Fifth Circuit has affirmed states’ authority over their respective 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. policies and has asserted that the offset clause—often called the “Tax Mandate”—of the American Rescue Plan Act (ARPA) has enough fiscal impact on a state’s budget so as to be coercive, as opposed to incentivizing. The ruling follows prior case law under which the US Supreme Court has interpreted the Spending Clause of the US Constitution as allowing for mild fiscal incentives to advance federal policy goals but has frowned upon conditions to federal transfers to the states that are an outsized proportion of a state’s finances.

In its decision, the Fifth Circuit ruled that the District Court for the Northern District of Texas was correct in forbidding the enforcement of the offset clause, detailed in Section 802(c)(2)(A) of ARPA, concluding that the harm to the petitioning states would be irreparable and immediate. In State of Texas v. Yellen, the federal government had appealed the lower court decision in favor of the petitioners—the states of Mississippi, Texas, and Louisiana—who argued that this section violated the limitations of Congress’s authority under the Spending Clause. Affirming the decision, the Fifth Circuit ruled that even if the clause was found to be constitutional by the Supreme Court on a later date upon appeal, the funds could always be recovered and therefore the injunction until that date was appropriate.

ARPA’s Section 802(c)(2)(A), as signed into law in March 2021, states:

A State or territory shall not use the funds provided under this section or transferred pursuant to section 803(c)(4) of this title 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.

Attorney General Lynn Fitch of Mississippi, along with the attorneys general for Louisiana and Texas, filed suit in the District Court in May 2021, arguing that the clause in contention commandeers the States’ sovereign authority over their tax policies and violates the Constitution’s Tenth Amendment. They further argued that its language is ambiguous and not reasonably related to encouraging post-pandemic economic recovery. Noting that the funds ARPA allocated to Texas, Louisiana, and Mississippi “amount to 13%, 7%, and 31%, respectively, of each state’s 2021 budget,” the plaintiffs contended that the transfers were substantial enough for the states to not have a realistic option of declining the conditions mandated along with them and forgoing the money.

The Fifth Circuit agreed there were at least two concrete injuries. In addition to being coerced to surrender their constitutionally central rights to set their own tax policy, including cutting taxes, the states also face a substantial threat of recoupment of funds under section 802(e) of ARPA, if the Treasury were to find on a future date that the states violated the offset clause. While the federal government argued that the fear of future harm has been “put to rest” by subsequent policy clarifications on the clause, the Court disagreed, asserting that even this consequent narrowing of scope served only to lower the magnitude of injury to the states and did not eliminate injury itself.

In addition, the Treasury’s clarifications do nothing to relieve the clause of its “ambiguousness” with respect to its governance of state revenues, rather than expenditures, which might have fallen under the “general welfare” provision of the Spending Clause. Since money is fungible, while disagreeing with the District Court’s conclusion that the clause completely prohibited tax cuts, the Fifth Circuit instead asserts that the states would have no way of knowing one way or the other until the Treasury provided its own view. This flies in the face of the Supreme Court directive that all conditions imposed on a state by the federal government be unambiguous, allowing its government to understand clearly the consequences of participation in any funds transfer scheme, which amounts to a contract between the state and federal administrations [South Dakota v. Dole, 483 U.S. 203 (1987)]. The Fifth Circuit used contract law to further cement its judgment, citing the Eleventh Circuit in its conclusion that “the problem of indefiniteness is not always a mere issue of construction . . .; it may go to the validity of the contract itself.”

Having found in this manner, the Fifth District further stated that the offset clause was clearly severable from the rest of the ARPA, which may continue to function independently, and confirmed the permanent injunction on its implementation. It is not clear at this time whether the federal government intends to appeal this ruling with the Supreme Court, given that in a January 4, 2024, letter, the Department of Justice declined to seek review of the similar Eleventh Circuit decision.

In 2022, Governor Tate Reeves (R) signed the Mississippi Tax Freedom Act into law, adopting a 4 percent flat rate tax to be phased in over four years, which at about $500 million, represents the largest tax cut in state history. Texas, which has no income tax, nevertheless provided $18 billion dollars in property taxA property tax is primarily levied on immovable property like land and buildings, as well as on tangible personal property that is movable, like vehicles and equipment. Property taxes are the single largest source of state and local revenue in the U.S. and help fund schools, roads, police, and other services. relief to taxpayers in 2023, and has plans to cut its sales taxes. Louisiana also lowered its top marginal tax rateThe marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by total income earned. A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax. to 4.25 percent starting from the 2022 fiscal year. While each state has a strong case that they can afford these rate reductions out of own-source revenue growth and that they are not relying on ARPA funding to do so, the ambiguity of the statute is such that all these measures could have fallen under the scrutiny of the Treasury had the injunction not been confirmed.

In many respects, this recent opinion feels like old news. The Texas case it affirms was decided in 2022, and a district court made a similar ruling regarding Kentucky and Tennessee as early as September 2021. Moreover, facing congressional pressure and legal challenges, Treasury regulations narrowed the interpretation of the Tax Mandate, and the Treasury has not sought to enforce against states which cut taxes in ways that could be sustained by own-source revenue growth. This dramatically increased the salience of the provision, but none of it lessened the importance of having clarity on how much control the federal government can exercise over state fiscal policy.

While it is encouraging to see lower courts affirming states’ authority over their own finances, the lack of an objective standard delineating when a federal law ventures into coercion over states, as opposed to merely an inducement means that such contentious laws will be passed again and again, requiring litigation and subsequent judicial action. The Supreme Court has attempted to navigate these boundaries in cases like National Federation of Independent Business v. Sebelius (2012) and South Dakota v. Dole (1987). Congress cannot, of course, set the boundaries beyond what the Constitution allows—but it could promote clarity by adopting provisions setting a clear line to guide and interpret future policymaking and regulatory actions.

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