American Rescue Plan Act: Bad Tax Policy For The States

As the saying goes, “The road to Hell is paved with good intentions.” 

That seems to be the case with section 602(c)(2)(A) of the American Rescue Plan Act (ARPA), signed into law by President Biden on March 11.

The subsection prohibits states from using funds disbursed under the act to “directly or indirectly offset a reduction in the net tax revenue” of a state through legislative or regulatory changes, or by administrative interpretation. This includes downward rate changes, rebates, deductions, credits, reductions through other means, or reductions caused by a delay in implementing a tax or tax increase.

Giving Congress the benefit of the doubt, it appears the intent was to simply prohibit states from using ARPA monies to fund, for instance, a tax cut.

Unfortunately, the law’s breadth threatens to leave state lawmakers unable to: pass new or amend existing tax legislation; issue new, or amend existing, regulations; and revise existing administrative interpretations.

The reason is that if the provision is interpreted broadly, any tax-related action that reduces revenue could be deemed by Treasury to have contravened the statute, thus exposing the state to ARPA’s statutory consequences, even if the reductions in question have nothing to do with ARPA.

The backlash from the states over ARPA’s potential effects was swift.

On March 16 the attorneys general of 21 states signed a letter delivered to Treasury Secretary Janet Yellen outlining their concerns and objections to the statute. The attorneys general did not mince words — the provision was blasted as “an unprecedented and unconstitutional intrusion on the separate sovereignty of the states through federal usurpation of essentially one-half of the states’ fiscal ledgers (i.e., the revenue half).”

Stephen P. Kranz of McDermott Will and Emery agrees.

“The intent may have been good,” he says, “but the language is a real mess. I can see Congress wanting to give stimulus funds [to the states] and wanting to make sure it goes where it’s intended, and not to fund tax cuts to high net income taxpayers. That makes sense. But the problem is the breadth of the language. A blanket prohibition on tax cuts prevents all policymakers [wherever they fall on the political spectrum], from accomplishing their goals.”

There are states trying to save their small businesses, such as restaurants, by allowing them to retain some portion of the sales tax on prepared food, thereby hoping to keep them afloat, doors open, and retaining staff, Kranz explains. Allowing restaurateurs to keep a portion of the tax, he points out, “is a tax cut.”

Depositing ARPA funds in a dedicated account, as states do with highway funds, won’t work either, Kranz finds, adding, “The problem is money is fungible. Even if a state has a separate account for COVID funds, to be used only for COVID relief, that means [the state] doesn’t have to spend money from the general fund [to provide that relief]. So you have excess money in the general fund. Why not cut taxes? But the direct or indirect language won’t allow a state to do anything that will reduce revenue, like shrinking the [tax] base, or changing [net operating loss] deductibility. That’s a timing question, and a state wouldn’t be allowed to extend their NOLs for a year. A state couldn’t give a tax credit because it reduces revenue.”

A 10th Amendment Issue

If the state legislatures’ hands are tied regarding making tax policy, does that implicate the 10th Amendment? The U.S. Supreme Court addressed this issue twice during the 1990s. New York concerned a series of 1985 congressional amendments to the Low-Level Radioactive Waste Policy Act. 

In particular, New York objected to three provisions:

(1) a provision that provided monetary incentives to states to implement the federal radioactive waste policy by authorizing states to enter into regional compacts for disposal of waste generated by compact states, or a single state could develop its own disposal facility;

(2) a provision that denied access to sites in other states or required payment of surcharges for compact and single states that failed to file an application for a disposal site; and

(3) a provision that required compact and single states that could not provide for waste disposal to — at the request of a waste generator — take title to, and possession of, all direct and indirect liability for damages incurred by the waste generator, if it refuses to take possession.

The Court found the first two provisions constitutional, as the provisions were within congressional power under the commerce and spending clauses. The third provision, however, was ruled unconstitutional as an intrusion on state sovereignty, thus violating the 10th Amendment.

“The constitution has never been understood to confer upon Congress the ability to require states to govern according to Congress’s instructions,” the Court held.

By compelling states to take title to, and possession of, the waste, the Court explained, Congress has “commandeered the states’ legislative processes” by forcing them to enact and administer a federal regulatory program, thus destroying any accountability state officials have to their citizens and Congress’s accountability to those same citizens.

Printz concerned the power of the federal government to require a state’s executive branch to implement and administer a federal program. The Brady Act amended the Gun Control Act of 1968, directing the U.S. attorney general to create a national instant background check system for firearm purchases. Until such time that the national system was operational, the act required the chief law enforcement officer in county jurisdictions to perform instant background checks under federal requirements.

As in New York, the Court said that the federal government cannot commandeer state executive branch officials to administer federal programs, just as it cannot commandeer the state legislative branch, citing, as in New York, issues of state and federal accountability to a state’s citizens.

Applying the principles above to the issue at hand, Kranz believes the ARPA provision is coercion under the 10th Amendment. The federal government may not be forcing states to act, as it did in New York and Printz, but it is preventing state legislatures from acting.

If a state does implement any tax legislation that results in a revenue deduction, there is no question, that under ARPA, it will be penalized for doing so.

Treasury’s Response

In a letter dated March 23, Yellen responded to the objections of the attorneys general.

First, she noted that it is well established that Congress may place reasonable conditions on how states must use federal funding for various specific purposes, such as highway construction and Medicaid. However, nothing in ARPA hampers a state’s ability to cut taxes, Yellen argues.

The only limitation, she adds, is that a state may not do so using ARPA funds as a revenue offset. In other words, a state may enact a tax cut or credit, or delay implementation of a tax, if the reduction of revenue is offset elsewhere in the tax code, perhaps by a rate increase or some other means, Yellen contends.

Further, she adds, the clawback provision does not require the state to return all funds allocated by the federal government. States need to return only those funds used as revenue offset.

On March 24 Yellen appeared before the Senate Banking, Housing, and Urban Affairs Committee regarding the provision. She was prodded to give a timeline within which Treasury would provide guidance to the states.

 Yellen responded that ARPA gives Treasury 60 days before it is required to distribute funds to states and that guidance would be forthcoming within that timeline.

Kranz is skeptical of Yellen’s response: “Yes, Treasury will issue regulations someday, but there are two problems with that. One, there are states that are going out of session in [less than two weeks], or they’re in short session. Every single day that goes by without Treasury regulations is another day of death in the state tax policy world. While there are some policymakers who’ve started make a move, for the most part, the tax policy world is frozen. Congress killed it, and Treasury won’t act on it. Second, how is the Treasury going to issue guidance? The statute, on its face, is very clear and broad. How do they legitimately say, ‘This is not what Congress meant?’ They can’t narrow it. Are they going to say they’ll never enforce it and not claw the money back from the states? [If Treasury does say that], then you have to trust them not to enforce it.”

Rather, the right answer here, he explains, is Congress has to fix it. “If a state cuts taxes, it has to raise taxes somewhere else. [So the] bill has to be revenue neutral. State tax policy doesn’t work that way. You don’t get tax provisions all in one bill, unless maybe it’s the budget bill,” Kranz says, adding that most of these policy choices “are stand-alone bills.”

In short, under ARPA, state legislators will have to come up with a new paradigm to accomplish a state’s business.

Conclusion

While it may have sounded like a good idea at the time, the ARPA provision prohibiting states from using stimulus funds to finance reductions in revenue has proven to be bad because of its breadth.

The provision has effectively frozen state tax policy because it ties state legislatures’ hands in making their own tax policy choices that may include a revenue reduction, on pain of losing badly needed stimulus funds. Judging from Treasury’s response to the states’ outcry, it appears that it does not understand the depth and complexity of the problem.

Fortunately, there is clear Supreme Court precedent that makes the ARPA provision likely violative of the 10th Amendment. To extricate the states from this dilemma, members of Congress have introduced legislation to repeal the provision.

Also, Treasury insists it will issue guidelines in the near future. However, even if the congressional effort is successful and Treasury manages to issue regulations within the timeline it has set, such efforts come too late to help state legislatures during this session.

Meanwhile, the state attorneys general who raised the issue with the federal government have taken their protest a step further: Many states have filed suit to have the provision nullified. Yet the outcome of these efforts, like those of Congress and the Treasury, comes too late for this session.

We can only hope that this matter is resolved before the next one.

[Editor’s Note: This article originally appeared in the May 3, 2021, issue of Tax Notes State.]