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So, Can States Cut Taxes or Not?

The federal stimulus package provides $195 billion in aid to states but forbids them from using that money to pay for tax cuts. The law's language is broad enough to look like preemption.

Georgia Gov. Brian Kemp speaking.
Georgia Gov. Brian Kemp is one of a number of governors upset with the stimulus law, which blocks federal money from being used to pay for tax cuts even indirectly. (Elijah Nouvelage/Getty Images/TNS)
West Virginia Gov. Jim Justice wants to eliminate his state’s income tax. Joe Manchin, West Virginia’s senior U.S. senator, won’t let him.

Manchin sponsored a last-minute amendment to the $1.9 trillion federal stimulus that prohibits states from using direct federal aid to pay for tax cuts. It’s turned out to be one of the most controversial provisions in the entire, enormous package.

“He’s hurting his own people in the state of West Virginia,” Justice said last month.

Last week, West Virginia Attorney General Patrick Morrisey, along with a dozen other state AGs, filed suit to block the provision. Earlier, a group of 21 attorneys general had written to the Treasury Department, demanding clarification.

Most observers believe that the Treasury will interpret the law narrowly. Rather than seeking to claw back funds from any states passing tax cuts or credits, the feds are considered likely to challenge only those states that clearly use federal dollars to pay for them. “Nothing in the act prevents states from enacting a broad variety of tax cuts,” Treasury Secretary Janet Yellen wrote in a response to the AGs. “It simply provides that funding received under the act may not be used to offset a reduction in net tax revenue resulting from certain changes in state law.”

But the fact that the law blocks federal money from being used even indirectly to pay for tax cuts has state officials not just worried but angry. “Democrats in Washington and in the White House are not going to tell me, or the Georgia General Assembly, that we can’t cut taxes for hard-working Georgians,” Gov. Brian Kemp complained at a news conference last month.

The stimulus funnels tons of money through states and localities in areas such as education, health care and transit. It also provides $350 billion in aid not directed toward particular program areas, including $195 billion for states. The whole idea, from the federal point of view, is to maintain or increase state and local spending – not to cut taxes.

“It’s the indirect offset prohibition that opens up Pandora’s box,” says Jared Walczak, vice president of state projects at the nonprofit Tax Foundation. “That starts to look like a broad prohibition.”

That prohibition lasts as long as the stimulus dollars are spent, which will be into 2024. And there are limits, Walczak notes, on where and how states can spend federal aid. They can use the money to address pandemic and health needs, for example. While those are clearly ongoing, much of the cost of vaccine supply and distribution has been underwritten by the feds. Other costs in these areas have already been addressed by last year’s federal CARES Act, which some states struggled to spend.

About half the states have no revenue losses that they would be allowed to use federal funds to backfill. The stimulus money can also be used for certain types of infrastructure, such as water projects and broadband, but most infrastructure projects will (or won’t) be funded by the enormous infrastructure package President Biden introduced last week. 

States can also offer supplemental pay to essential workers, but given the fact that's a brand-new concept – states using money to pay for salaries of private-sector workers at businesses such as grocery stores – it’s not yet clear how many of them will try the idea.

“That’s your list,” Walczak says. “Even if states had a long wish list of things they’d love to do with a bit extra, they probably can’t do them with this money.”

States can send money to localities for certain purposes – but the act also requires cities or counties to put up matching funds of their own. It’s not certain whether local governments will be able to use their pots of federal money to match state expenditures.

Given all this, at least some states may find themselves in the unusual position of having surplus dollars, but not be able to cut taxes. Some states are still hurting financially, but overall state revenues ended up being flat in 2020, despite the nosedive last spring. Now, the economy is set to grow this year perhaps more rapidly than it has in decades.

Clever budget officers will still be able to find ways of moving money around. If states have excess funds, they should be able to figure out how to cut taxes without any indication that the revenue is coming out of the federal largesse. There’s always a creative offset available.

But the uncertainty means that state officials who want to cut taxes should wait on the rules coming from the Treasury. It’s just one area among many where states, cities and counties are trying to plan without yet having formal guidance from Washington.

“The United States Congress decided that there were many, many questions we could decide in 30 days,” says Gene Sperling, who is overseeing the stimulus rollout for the Biden administration.

Alan Greenblatt is a senior staff writer for Governing. He can be found on Twitter at @AlanGreenblatt.
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