Today, the U.S. Treasury issued an interim final rule on the $350 billion in State and Local Fiscal Recovery Funds provided under the American Rescue Plan Act (ARPA). The proposed rule resolves several important questions but continues to involve the federal government in state finances at an extraordinary level. Most astonishingly, the rule may functionally prohibit states from offsetting net tax cuts through spending reductions, even though the rule purports to allow this and the ability to finance tax cuts through spending cuts seems an unambiguous state prerogative.

By way of background, state governments are set to receive $195.3 billion in fiscal relief under ARPA (the rest goes to local governments, tribal governments, and territories), equivalent to 20 percent of the annual tax collections of state governments. However, both State and Local Fiscal Recovery Funds can only be used for certain enumerated types of expenditures, and they specifically cannot be used to cut state taxes (there is no similar prohibition for localities), either directly or indirectly, or for deposits into pension funds. If some portion of the federal funds is deemed to have offset a net tax cut, Treasury would “recoup” the share of funding it deems to have been devoted to that purpose.

The prohibition on indirectly offsetting a state tax cut is vague and potentially quite expansive and has already yielded litigation arguing that the provision is unconstitutional because (1) states are required to act on the basis of impermissibly vague policies, (2) the financial inducements are unduly coercive, and (3) the provision is not germane to the broader bill, among other complaints. Litigants believe that the requirement that the provisions be unambiguous cannot be settled by guidance—which is not the same as the law itself—but even if one assumes otherwise, this proposed rule raises almost as many questions as it answers.

Crucially, Treasury proposes to use inflation-adjusted Fiscal Year 2019 tax revenue as a baseline for determining whether there has been a net tax reduction. This means that states can unequivocally cut taxes out of organic revenue growth. If a tax cut reduces revenue compared to what it would have been on a current policy baseline but revenues are still up in real terms, this does not violate the provisions of the American Rescue Plan Act and would not lead to a recoupment of any federal funds. This was an interpretation we had anticipated, but clarification on this point was extremely important and will come as a relief to many state policymakers. Notably, the intended measure of inflation does not appear to be specified.

To the extent that there is a net tax reduction—meaning both that a revenue-negative tax policy has been implemented and that the state experiences an overall reduction in tax revenues compared to baseline—the reductions would not be subject to recoupment provided the tax cuts were offset by money from one of three sources: organic growth (that is, financed out of revenue increases fueled by economic growth); increases in revenue elsewhere (tax increases in one area offsetting tax reductions in another); and certain spending cuts. The definition of which spending cuts qualified, or rather which ones don’t, is the great surprise of the proposed guidance.

Essentially, reductions in spending cannot be in any area where the state government has spent Fiscal Recovery Funds—determined at the department, agency, or authority level. This is true even if the budget reductions financing a tax cut are in no way being offset by Fiscal Recovery Funds, provided that any of those funds are used elsewhere in the department.

Imagine if, for instance, a state reduces the size of its drug enforcement budget within law enforcement and corrections agencies following the legalization of marijuana. At the same time, suppose that the Department of Corrections uses federal dollars to treat coronavirus cases in prisons, or the Department of State Police uses funding to offset salaries or provide supplemental pay for officers. In neither case would these federally financed expenditures in any way offset the savings from reduced drug enforcement, yet it appears that the federal government would prohibit using these savings to help finance a tax reduction, since they coexist in the same department or agency.

This is incredibly broad, particularly considering that these funds are likely to flow to such a wide range of departments and agencies. Functionally, accepting federal funds could mean that tax cuts could not be financed by any savings—no matter how far removed from the federal aid—in departments dealing with public health, public safety, education, social services, and certain infrastructure projects. This represents a massive federal entanglement in state fiscal authority. In this area, rather than mitigating the concerns addressed in pending litigation, Treasury appears to have created new ones.

Commendably, Treasury adopts a de minimis threshold for tax revenue changes to avoid creating headaches for states considering policies with only incidental revenue impacts. Treasury’s interim rule establishes that state revenues can be reduced by 1 percent of the FY 2019 baseline without triggering recoupment. This state harbor, however, appears to be a threshold, not an exclusion, meaning that a state with a 1 percent reduction in revenues would pay nothing, but a state with a 1.1 percent reduction would be on the hook for all 1.1 percent, not just the 0.1 percent above the safe harbor.

Treasury provides some additional details on how it would determine the amount of revenue forgone by tax cuts, moreover, but questions remain. Each year, state governments would be required to transmit to the federal government an account of all revenue-reducing changes and all covered spending reductions, with projections of revenue reductions associated with any tax change. Essentially, Treasury begins with states’ own estimates of revenue losses, introducing a lack of consistency, since some states are more conservative than others in their estimates.

States are prohibited from using dynamic scoring for this purpose; they cannot assume that these policies will result in positive macroeconomic effects that will offset some of the revenue losses scored on a static basis. Importantly, there is a revenue reduction cap: the federal government cannot recoup more than the amount of actual reductions in revenue against the inflation-adjusted FY 2019 baseline. States will also have an opportunity to seek reconsideration of Treasury decisions, introducing additional information—for instance, about spending cuts that were already planned prior to March 3, 2021. It is unclear, though, how much leeway this will provide states.

Expanding on a prior Treasury statement, the new guidance also establishes that conformity to recent changes in the Internal Revenue Code will not count as a net reduction in tax revenue even if they have that effect. This is true even if the state has static (fixed date) conformity and must affirmatively adopt new conformity legislation during the covered period. Exempting tax conformity is good news for states, but is also somewhat arbitrary.

A plain reading of the prior statement suggested that conformity to any new federal provisions would be covered, while the guidance speaks of “simply conform[ing],” which may mean that selective conformity to specific revenue-reducing provisions (like the exclusion of $10,200 in unemployment compensation benefits from the income tax) could count against a state but updating a conformity date to capture all changes (except those already excluded by prior statute) would be permitted. There is also no indication of what constitutes a “recent” change to the Internal Revenue Code. What would happen if a state belatedly conformed to revenue-reducing provisions of the Tax Cuts and Jobs Act?

Many states are currently finalizing their state budgets and are set to adjourn their legislative sessions for the year, if they have not done so already. States are also on the clock for making decisions about how to use the federal aid, with half of the funding (all of it for some states) arriving this month.

Federal lawmakers have put their state counterparts in an impossible spot, forced to budget under significant uncertainty surrounding an expansive claim of federal power. While some questions are likely to be left to the courts, many observers hoped that this eagerly anticipated federal guidance would give states the authority to enact their own fiscal policy with confidence. Unfortunately, while the new interim rule clears up several important questions, it raises new ones that will continue to keep state officials up at night.

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