In trying to prevent his own state from using federal relief funds for tax cuts, Senator Joe Manchin may have turned the American Rescue Plan into a legal mess. Part of the law is $350 billion for local governments, including some $200 billion for states alone. Manchin, aware of the tax reform efforts in West Virginia and other states, wanted a provision that barred states from using federal relief funds to pay for tax cuts.
But a strict reading of the provision would suggest that it prevents states from doing a wide range of things, including uncontroversial reforms or changes to enacted plans. That is likely not what Manchin intended. But the provision, which prevents states from using relief funds to “directly or indirectly” offset reductions in net revenue, might have that effect. It was likely phrased this way since state funds are fungible, and a ban on using relief funds directly to offset revenue reductions could be circumvented. Yet the word “indirectly” creates far more issues than it solves.
As currently conceived, the West Virginia proposed tax reform would cut the state income tax rate but attempt to offset the revenue reduction by increasing other tax rates. Even if the offsets do not precisely cancel the revenue reductions, the state would have been just fine even before the American Rescue Plan, even with the pandemic, as West Virginia ended 2020 with a $28 million surplus and $240 million in reserves.
As the key amendment from Manchin is written, however, neither West Virginia nor any other state could not seek to use its budget surplus for tax cuts. To do that, states would have to turn down the massive federal cash infusion, or about $500 million plus their share of nearly $170 billion divided among the states based on the respective number of unemployed workers. For West Virginia, which budgeted under $5 billion in spending for 2021, turning down around $1 billion is simply not an option.
It is not just tax reform efforts this provision could stifle. While the federal government made the first $10,200 of unemployment income tax free for individuals and double that sum for couples, the provision would prevent states from doing the same. It could also prevent states from refilling their unemployment insurance trust funds, which have been badly depleted by the pandemic. In addition, it might even prevent states from delaying the enactment of tax increases passed before the coronavirus relief bill was approved by Congress, such as the digital tax efforts in Maryland.
The provision is almost certainly unconstitutional if strictly interpreted. It has been ruled in the past that Congress can place conditions on federal funds sent to states but that they cannot be coercive. The Supreme Court ruled that the Affordable Care Act mandate that states increase Medicaid or risk losing federal funds was unconstitutional, and the provision in the American Rescue Plan is far more comprehensive in its effects.
States have now signaled an unwillingness to accept such a major federal encroachment on state policymaking. More than 20 states have sent the joint letter to Treasury Secretary Janet Yellen demanding clarification, and Ohio Attorney General Dave Yost has also filed one preliminary injunction against the provision. In West Virginia, Governor Jim Justice himself called the measure “childish” and declared that he does not condone it.
The administration does not seem eager to defend such a hamstringing of state policymaking. The Treasury Department has now affirmed that states may indeed enact tax cuts so long as they do not use federal relief funds. Yet even with the administration not taking a hard line, the law as written still represents a hurdle for any proposals that reduce net revenue.
Ironically, the provision is somewhat of an admission of how unnecessary the massive amount of local relief was. Such a cash infusion could have been justified had states actually lost an average of 8 percent of revenue as initially feared, but revenue declined by less than 1 percent on average. If states were truly desperate for cash, there would be no need to prevent them from putting federal relief funds toward any new tax cuts.
This affair, no matter how it turns out, will go down as a failure of federal policymaking. Even if states ignore the provision, or if Congress moves to repeal it, government officials will have spent valuable time overcoming and litigating this hurdle instead of delivering relief to Americans.
Andrew Wilford is a policy analyst at National Taxpayers Union Foundation.