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States Were Told They Can't Use Covid Aid to Cut Taxes. They Sued. — Update

By Kate Davidson 

WASHINGTON -- A last-minute provision added to the $1.9 trillion coronavirus relief package last month is leading to a showdown between states and the Treasury Department over the limits of the federal government's fiscal authority.

The package, known as the American Rescue Plan, provided $195 billion for state governments to help offset soaring costs related to the pandemic and plug budget holes stemming from the economic downturn. Democrats added one important condition: States cannot use the money, directly or indirectly, to cut taxes.

Republican lawmakers and attorneys general argued the provision, which would apply for three years, is overly vague, unconstitutional and would unfairly penalize states in good fiscal health. Five states have filed lawsuits seeking an injunction against the provision -- the first hearing is scheduled for the end of the month -- and Republicans in Congress have introduced legislation to repeal it.

Meanwhile, state officials and tax-policy experts are pressing Treasury Secretary Janet Yellen to clarify how broadly her agency will interpret the legislation, and what will happen to states that run afoul of the law. The need for guidance is urgent for many states that must complete their budgets before the fiscal year begins on July 1.

"It is potentially a significant restriction on state fiscal authority, and some of that may come down to the Treasury guidance," said Jared Walczak, vice president of state projects at the conservative-leaning Tax Foundation. "If this became a broad restriction, that raises serious constitutional questions."

As the virus began to spread last year, widespread lockdowns triggered business closures and millions of layoffs that weighed on state tax revenue, while spending on jobless benefits, healthcare and other social services rose.

But not all states experienced the revenue shortfalls that most initially feared. About half have seen tax collection increase, thanks in part to the strength of the housing and stock markets, which boosted property and income-tax revenues, and a surge of federal aid such as stimulus checks and enhanced jobless benefits that propped up consumer spending.

Some states with strong revenues, including Idaho, Utah, Arizona and North Carolina, are weighing tax cuts for the coming fiscal year. Those plans are now complicated by the American Rescue Plan, which says any state that accepts the federal aid may not use it "to either directly or indirectly offset a reduction in the net tax revenue" of that state. Some states argue that provision interferes with their right to set their own fiscal policy.

One issue is how the federal government defines "indirectly." If states use federal aid to pay police officers and firefighters, for example, then use the savings to lower taxes, that could be considered an indirect tax cut, Mr. Walczak said.

It is unclear how far that logic would extend. Among the questions states have asked: Would policy changes, such as new tax incentives for businesses, be considered indirect tax cuts?

West Virginia's Legislature has considered a bill that would extend a tax credit for charitable donations to nonprofit organizations and increase the annual cap from $3 million to $5 million -- a change that would reduce state revenues.

"To this point, we have been very dissatisfied with Treasury's response" to questions, West Virginia Attorney General Patrick Morrisey said in a statement. He outlined his concerns in a letter last month with 20 other state attorneys general.

Mr. Morrisey has filed a joint lawsuit with several other state attorneys general in federal court in Alabama seeking to block the provision.

"West Virginia is a sovereign state with the power to independently reduce its citizens' tax burden and decide how taxpayer funds are spent, " he said.

In a response last month to the letter from the attorneys general, Ms. Yellen said nothing in the act prevents states from enacting "a broad variety of tax cuts." Rather, it says the federal aid money cannot be used to offset a reduction in net tax revenue, she said in a March 23 letter. If states cut taxes but find another way to replace the lost revenue, that wouldn't violate the provision, she said.

But Ms. Yellen has acknowledged that defining what it means to use the aid as a revenue offset is tricky. "Given the fungibility of money, it's a hard question to answer," she told the Senate Banking Committee on March 24.

The Treasury last week clarified that states that take steps to conform with federal tax-law changes -- including recently enacted tax relief for unemployed workers -- won't be considered to have violated the prohibition on tax reduction. Ms. Yellen has said the Treasury is working quickly to provide additional guidance.

Phil Berger, the GOP leader of the North Carolina state Senate, said he has no concerns, based on Ms. Yellen's March 23 letter, that tax cuts proposed by Republican state lawmakers will run into problems under the new federal law. North Carolina Republicans want to reduce the personal income-tax rate, increase the amount of income not subject to taxes and increase the child tax credit. The state's tax revenues have risen between 2.5% and 5% since the start of the pandemic, according to data from the Urban Institute.

"We fully have the capacity to reduce taxes in the way that we have proposed," Mr. Berger said, "and will not have to rely on the federal dollars in order to do it."

Tax-policy experts and congressional Republicans want more certainty. Sens. Mike Crapo (R., Idaho) and Mike Braun (R., Ind.), and Reps. Kevin Brady (R., Texas) and Dan Bishop (R., N.C.), have each introduced separate measures in Congress to overturn the language.

Joe Bishop-Henchman, vice president of tax policy and litigation at the National Taxpayers Union Foundation, said the Treasury guidance should make clear what baseline the agency will use to determine whether there has been a net reduction in tax revenue and who will make the determination. The foundation is a nonprofit research group affiliated with a conservative organization.

Mr. Bishop-Henchman also called on Ms. Yellen to clarify that state tax-law changes announced or enacted before the American Rescue Plan was passed won't be subject to the provision and to specify what action the Treasury will take if it finds a state has violated the provision.

"If they do all the things we recommend in the letter, I think everyone will be happy with it, but it may not change the fact that this provision probably exceeds what Congress can constitutionally do," he said. "And Treasury cannot do anything about that."

Write to Kate Davidson at kate.davidson@wsj.com

 

(END) Dow Jones Newswires

April 14, 2021 12:04 ET (16:04 GMT)

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