The COVID-19 relief bill signed into law by President Biden contains a provision that could prevent states from using federal aid to create new tax incentives or provide new tax incentives under existing programs.
The $1.9 trillion American Rescue Plan Act of 2021 (P.L. 117-2), signed March 11, includes $350 billion in aid for state and local governments. It also contains a provision that prevents states or local territories from using the funds 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.”
There is a question about how the provision — which is centered on the restriction on indirect offsets — will be applied.
“Congress probably wanted to prevent states from cutting taxes on the wealthy as a result of the receipt of federal stimulus funds, but the provision is much broader than that,” Katie Quinn of McDermott Will & Emery told Tax Notes March 15.
Quinn, a state and local tax attorney, said the provision is the biggest federal overreach she has seen in her career and one that the states and taxpayers should be concerned about. “We are thinking through all of the various implications, but this provision will have unintended consequences and I expect it will be challenged,” she said.
Jared Walczak of the Tax Foundation said he thinks it is “reasonable for Congress to restrict the direct use of federal aid to facilitate state tax cuts, but the restriction on indirect offsets is vague, expansive, and, if applied too broadly, quite likely unconstitutional.”
John Mozena of the Center for Economic Accountability told Tax Notes he thinks the bill would prohibit states from creating any new tax credit or rebate programs until the end of 2024 if they want to keep the federal aid. Another plausible reading is that states couldn't hand out new tax abatements under existing programs, he said.
Mozena, who coauthored a policy brief with Mercatus Center research fellow Michael Farren last year proposing that Congress could use its authority under the commerce clause to require state and local governments to contractually forgo future targeted economic development subsidies, said he thinks the provision is a good thing.
“Overwhelmingly the research is that these targeted tax abatements just don’t work . . . they are at best ineffective and at worst harmful,” Mozena said. Economic development subsidies are a bad idea anytime but especially so when states have myriad demands on their budgets and face disruptions to their tax revenue streams, he said. “This is a terrible time to be promising away revenues for no good reason."
According to Mozena, states that create new tax credit programs between the bill's effective date and 2024 will have to repay the federal government the net amount of however much tax revenue they lose to those programs, making the tax abatements essentially cost twice as much.
The provision was also welcomed by economic development watchdog Good Jobs First, which has offered solutions for ending bidding wars for incentives among the states. “We think this idea of using federal money as a carrot to get states to do the right thing, including not waste tax money on needless incentives, is a smart thing to do,” Executive Director Greg LeRoy told Tax Notes.
Meanwhile, taxpayers are awaiting guidance from the Department of the Treasury on how the provision will be interpreted. Treasury’s interpretation of the prohibition on indirect offsets will likely determine whether the law is challenged, according to tax experts.
“Narrow guardrails designed to prohibit shell games would give states little reason to complain and few grounds for litigation. But if Treasury guidance is vague or adopts a broad interpretation which binds state fiscal policy for three years, that would be ripe for a constitutional challenge under the anti-commandeering doctrine," Walczak said.
Treasury did not respond to a request for comment by press time.
Arkansas Gov. Asa Hutchinson (R) said in a statement to Tax Notes, “We are reviewing and waiting for additional guidance. We have tax cuts already being considered, and I expect we will continue to pursue tax cuts that are consistent with my previously submitted balanced budget.”
Matt Boch of Dover Dixon Horne PLLC said he wouldn’t be surprised if states hold off on further tax cuts or tax relief until there is more guidance. For example, he said, the Arkansas legislature was preparing to work through some incremental tax exemptions and credits, but “those may be held up to wait for guidance on this issue, which could be problematic since the legislature had planned to adjourn in mid-to-late April.”
“It is ironic that so much of federal COVID-19 relief has been through the tax code, and now the federal government seems to be telling states not to do the same,” Boch added.
Walczak said that under the bill, states can spend the aid on only a few expenditures, most of which could not reasonably be interpreted as indirectly facilitating a tax cut. He said complexities could arise if states use some of the money to pay public health or public safety officials' salaries or to cover first-year revenue losses.
“At that point, there are questions about whether that portion of the aid could be clawed back, and whether it would matter if the tax reduction could be afforded out of revenue growth. The questions arise when use of the funding offsets general fund expenditures, reducing a state's own outlays,” Walczak said. There could also be federal tax code conformity issues, he added.
Meanwhile, Sens. Mike Crapo, R-Idaho, and James E. Risch, R-Idaho, announced the introduction of a bill that would prevent the federal government from banning tax cuts. They argue that the provision would allow states to provide tax relief but only at a "punishable cost” and that it “serves no useful purpose, other than to convey the message that tax cuts are not favored by the federal government.”
“If a state like Idaho wants to provide tax relief in the interest of economic recovery, and to help people return to earning their livelihoods, the American Rescue Plan says it will be financially punished by the federal government,” Crapo said. “This infringes on states’ authority to design their own fiscal policies, and invites partisan politics into federal and state relations.”