Federal aid could hobble new state tax cuts and credits

A condition attached to $350 billion in relief for state and local governments by the American Rescue Plan Act (ARPA), P.L. 117-2 — that states may not use the money to offset their own tax reductions — may prove problematic, and is perhaps unconstitutional, tax practitioners said.

ARPA’s Coronavirus State Fiscal Recovery Fund appropriates $220 billion in fiscal year 2021 for states, U.S. territories, and Tribal governments to mitigate the fiscal effects of the COVID-19 pandemic, available through the end of 2024. Another $130 billion is earmarked for similar payments to cities, counties, and other local governments (Section 9901 of ARPA, Title IX, Subtitle M). The funds may be used for a broad range of state and local governmental costs and aid, assisting households, small businesses, and not-for-profit organizations. The money may be used for grants and premium pay to essential workers, infrastructure investments, and aid to pandemic-affected industries such as tourism, travel, and hospitality.

The funds may not be deposited into any pension fund. But an even broader, tax-related restriction has some state and local government leaders concerned. The money may not “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” (Social Security Act §602(c)(2)(A), as added by ARPA Section 9901).

Implementing the provision leaves much to interpretation, but conflicts between states’ own tax incentives and drawing upon the funds may be brewing, observers said.

“The timing of this provision will make it difficult for several states to figure out whether their current tax cut and relief proposals will cross the finish line this spring, if they want to be eligible for the ARPA funding, because some of these proposals could be construed as indirect offsets to revenue — even if planned prior to ARPA,” said Jamie Yesnowitz, CPA, principal and State and Local Tax leader in the Washington National Tax office of Grant Thornton LLP and a member of the AICPA Tax Executive Committee. 

Many states have enacted their own tax credits and other relief stemming from the pandemic or have introduced pending legislation. For example, in a law enacted March 5, Maryland expanded its earned income credit and created a new child tax credit, available in tax years 2020 through 2022 (Md. S.B. 218). The enactment date would appear to fall within the ARPA provision’s covered period, which began on March 3 and extends through 2024. Similarly, New Mexico’s S.B. 1 2021 was signed by its governor on March 3 and grants a $600 income tax rebate to families and individuals claiming the state’s working families tax credit, and, for businesses, establishes a holiday on gross receipts taxes for food and beverage establishments.

But much could hinge on how Treasury regulations will parse the new law. Although the federal legislation’s language is broad enough to potentially encompass even indirect offsets planned prior to ARPA’s enactment, measures such as New Mexico’s and Maryland’s could wind up being excepted, Yesnowitz observed. States might have known the federal funding was forthcoming, but not the exact amount they stand to receive, or of the law’s condition for receiving it.

“There’s a difference between obtaining federal funds and then enacting legislation cutting taxes in response, and enacting legislation cutting taxes as part of a planned relief measure before receiving the federal funds,” Yesnowitz said.

However, the ARPA provision doesn’t prevent states from lowering taxes, said Laura Schultz, executive director of research at the Rockefeller Institute of Government. “They just can’t use the funding to offset revenue losses that aren’t directly related to COVID-19 and its economic fallout,” Schultz said. “If a municipality received $5 million in ARPA funding and lowered property tax rates in the same fiscal year, they would need to clearly document that the entire $5 million was spent on allowable expenses such as investment in infrastructure, support for public transit, assistance to households, businesses, nonprofits, and impacted industries, and pay premiums to essential workers. The $5 million could not be used to pay for ongoing government operations that would have otherwise been reduced or eliminated to finance the unrelated property tax cut.”

Many practical difficulties loom in enforcing the restriction, said Antonio Di Benedetto, J.D., LL.M., founder and president of ABD Advisors in Boston and author of a forthcoming article in the JofA on state sales taxes. The provision would appear to cover the broad range of types of taxes that state and local governments impose, from income to sales and use to property taxes.

“How is Congress or Treasury going to administer, police, and prove that any legislative enactment is specifically tied to or associated with the money?” Di Benedetto asked. If the federal government took states to court over the provision, “I would argue the language of the legislation is sufficiently vague and unclear that it would be hard to prove specific correlations,” he added.

Even more fundamental is the question of the constitutional relationship between the federal government and the states with regard to their respective taxing authorities, he said.

“Most critically, states have the right to determine their own tax rules and laws without direct interference from Congress, unless it rises to the level of impacting interstate commerce or a federal issue is involved,” Di Benedetto said. “This legislation appears to impinge on states’ ability to govern themselves.”

On Wednesday, Ohio Attorney General Dave Yost filed a lawsuit on behalf of the state in federal district court against Treasury and officials including Treasury Secretary Janet Yellen requesting injunctive and declaratory relief against the provision, which the lawsuit dubs the “tax mandate.” Ohio has “no real choice” but to accept the estimated $5.5 billion available to it from the fund, but to do so, the state “must sacrifice its sovereign authority to set tax policy as it sees fit,” the lawsuit alleges.

More than 20 state attorneys general have signed on to a letter to Yellen dated Tuesday, asking her to confirm that the law “does not prohibit states from generally providing tax relief.”

Paul Bonner ( is a Tax Adviser senior editor.

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