The American Rescue Plan (ARP) sends $350 billion to state and local governments with very few strings attached. Unlike the CARES Act, which originally restricted spending to pandemic-related expenses, states can use ARP dollars to respond to the public health emergency, replace lost tax revenue, offset the pandemic’s negative economic effects, or invest in infrastructure.
But states cannot use ARP money to fund tax cuts or contributions to their public employee pension plans. A state that does risks losing every federal dollar spent in violation of the rule.
Ohio’s attorney general immediately sued the Biden Administration over this restriction, and 21 other Republican attorneys general threated legal action over what they called “the greatest invasion of state sovereignty by Congress in the history of our Republic.”
That’s a bit much considering states can avoid the rule by simply turning down the money, just as some did with the Affordable Care Act’s Medicaid expansion.
Further, as Treasury Secretary Janet Yellen wrote in response to the state attorneys general, the ARP provision (like many other congressional conditions) governs only these specific federal dollars, and “nothing in the act prevents states from enacting a broad variety of tax cuts.”
Still, the legislative language is broad enough that all 50 states are eagerly awaiting official guidance from Treasury on what they can and cannot do. Because there are numerous ways and reasons to cut taxes.
Why is there a state tax cut restriction?
Federal aid isn’t solely about replacing lost tax revenue, it’s also about boosting economic growth during a downturn. State and local governments spend a lot of money on education, infrastructure, and workforce development, all economic drivers, and the spending often directly translates into jobs. This is why economists say state and local aid has great “bang for the buck.”
What doesn’t deliver much economic impact are income tax cuts for high-earners (who did well during the pandemic) and deposits into pension funds. Congress wants the dollars it sends to states to ripple through the economy, not land in a person’s or government’s bank account.
And a lot of states are currently looking at tax cuts: Mississippi and West Virginia want to completely eliminate their income tax, and prominent Republicans are pushing large income tax cuts in Arizona, Arkansas, Georgia, Idaho, Iowa, Kansas, Missouri, Montana, Nebraska, New Hampshire, Oklahoma, South Carolina, and Utah.
But here’s the complexity: This list includes a wide range of tax policy changes from states in very different fiscal situations.
State tax cuts are not created equally
Take Utah and West Virginia, for example. Utah’s modest legislation would restore a dependent exemption and create credits for military pensions and Social Security income. Meanwhile, West Virginia’s plan is so ambitious that the governor said, “DisneyWorld may become a reality for West Virginia.”
The two state’s pandemic budget situations are also critically different. In the second, third, and fourth quarters (combined) of 2020—when the pandemic was most likely to affect state coffers—Utah’s tax collections were 8 percent higher than in the same period in 2019, and its governor is now proposing substantial new spending. Meanwhile West Virginia’s state tax collections were 4.3 percent lower over the same period, and its governor is continuing budget cuts passed last year.
Bottom line: Utah could spend every ARP dollar it gets and still have the fiscal space to reduce taxes, but it’s hard to see how West Virginia makes its tax cut work without the ARP money.
And this variation plays out across the states. Idaho is in good fiscal shape; Oklahoma is not. Georgia is considering a small increase to its standard deductions; Kansas has a costly tax plan.
Democrats like tax cuts, too
Keep in mind that the ARP itself was a massive tax cut, just one targeted at low-income workers and families.
With similar goals, Maryland significantly increased its earned income tax credit (EITC) and made it available to undocumented immigrants. But, because the latter became law after ARP’s March 3 deadline, it might violate the tax cut restriction. And any state planning to expand its EITC (Colorado), create a child tax credit (Connecticut), or make all unemployment benefits not taxable (District of Columbia) after March 3 could hypothetically trigger the restriction.
Or how about the ARP’s $10,200 federal tax exemption for 2020 unemployment benefits? Some states will automatically conform to this rule, but others need to pass legislation for the exemption to become part of their code. That’s presumably an outcome Congress supports, but it is also a tax cut.
Waiting on Treasury guidance
As states wait on guidance, Treasury does not have an easy job.
A blanket restriction on all state tax cuts could block policy that aligns with the “rescue” part of the American Rescue Plan. And a restriction based on total revenue changes would be challenging to implement given how the pandemic continues to scramble state finances.
But we know states will have to report how they used their ARP funds and how they changed their revenue sources. Treasury will probably find a way to let states show that they spent federal dollars as Congress intended. This would let states expand their EITCs and allow fiscally secure states like Utah to cut taxes, while only the most egregious misbehavior would force a federal clawback of ARP dollars. Sorry, West Virginia Disney.
