Republican State Officials Bristle Over Tax Cut Prohibition in Covid Relief Bill

State and local government leaders lobbied congressional lawmakers for months to include direct aid for their jurisdictions in the coronavirus relief package approved earlier this month.

But a last-minute addition to the legislation, which prevents states from using the money to pay for tax cuts, has drawn the ire of Republican state officials. They say it goes too far infringing on the power of states to set their own fiscal policy and are asking the Treasury Department for more clarity on how the mandate will work.  

One state attorney general has already taken legal action. Ohio Attorney General Dave Yost sued the Biden administration this week over the limitation, saying it is unconstitutional and encroaches on his state’s autonomy over financial decisions. 

“The federal government should be encouraging states to innovate and grow business, not holding vital relief funding hostage to its preferred pro-tax policies,” said Yost, a Republican.

The $1.9 trillion American Rescue Plan includes $350 billion in direct funding for state, local, tribal and territorial governments. The law includes several restrictions on how states can spend the money, including requirements that it must be used to respond to the coronavirus pandemic or to restore services cut as a result of the disease outbreak. The money also cannot go toward shoring up  public pension funds.

The provision Ohio’s attorney general is challenging says that states and territories “shall not use” the aid funding “to either directly or indirectly offset” declines in “net tax revenue” that stem from policy changes that would reduce taxes. Prohibited types of tax reductions include those involving lower rates, rebates, deductions and credits, as well as delays in imposing taxes or tax hikes.

"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."

-The full wording of the controversial tax provision in the American Rescue Plan

In Yost’s motion for a preliminary injunction, he writes that while Congress has “significant leeway” to impose conditions on funding under federal Spending Clause authority, it may not use that power “to coerce the States into constraining their own sovereign authority.”

“While the line between strong encouragement (which is constitutional) and coercion (which is not) is not always bright, the Tax Mandate falls clearly on the coercive side of the line: the States have no real choice but to accept the Act’s funding and the conditions that come with it,” the court filing says.

Ohio isn’t the only state opposed to the spending limitations.

A coalition of 21 Republican state attorneys general wrote to Treasury Secretary Janet Yellen this week asking her department to provide further guidance on the spending mandate.

They say the language included in the bill “could be read to deny States the ability to cut taxes in any manner whatsoever.”

The letter outlines numerous proposals under consideration by state legislatures that could potentially run afoul of a broad interpretation of the provision. They include a West Virginia proposal to extend the Neighborhood Investment Tax Credit and increase the annual tax credit cap from $3 million to $5 million; an Indiana measure that would extend a tax credit for donations to public school foundations; and a Montana proposal to cut income tax rates for most earners.

The attorneys general ask for clarity on the issue by March 23 and hint at the possibility that they, too, will fight the provision in court, stating they will take “appropriate additional action to ensure that our States have the clarity and assurance necessary to provide for our citizens’ welfare through enacting and implementing sensible tax policies, including tax relief.”

The Treasury Department did not respond to requests for comment about the lawsuit.

Cutting taxes during a recession is bad policy and can set states up for financial distress in the future once the aid expires, wrote Nicholas Johnson, senior vice president for state fiscal policy at the left-leaning Center for Budget and Policy Priorities. He argues that the bill does not prevent states from cutting taxes overall, only if they do not make up for the cut elsewhere in their budget.

“A state could cut taxes for low-income families and raise them for wealthy ones, producing no net tax revenue reduction and no loss of federal aid,” Johnson wrote in an analysis of the provision.

But states are right to be concerned about the potentially broad federal authority outlined in the bill, said Jared Walczak, vice president of state projects at the Tax Foundation. 

“Given the narrow range of possible uses of the federal aid that could reasonably be interpreted as offsetting a tax cut, many states might be at minimal risk regardless of the tax policy choices they make,” Walczak wrote in a recent blog post. “However, the vague language of this prohibition has every state nervous and unsure of what it can do.”

He said the Treasury Department should provide additional guidance to states on what qualifies as indirectly offsetting a net tax cut.