The State Fight To Eliminate The Federal Restriction On Tax Cuts

Joseph Bishop-Henchman of the National Taxpayers Union Foundation discusses the litigation of a provision in the American Rescue Plan Act restricting states from using federal funds provided by the law to offset reductions in net tax revenue. 

This transcript has been edited for length and clarity.

David D. Stewart: Welcome to the podcast. I'm David Stewart, editor in chief of Tax Notes Today International. This week: the state of state tax cuts.

In March President Biden signed into law the American Rescue Plan Act of 2021. This $1.9 trillion relief package was designed to help boost the national economy and combat the effects of the pandemic. The new law also included $350 billion in aid for state and local governments, but it seemed to come with a catch: States could not use the federal funds to offset reductions in net tax revenue.

Since then a number of states have filed lawsuits challenging the provision, and the U.S. Treasury Department in May released guidance clarifying its stance. Where does this leave Treasury and the states today? What will come of these lawsuits? Here to talk about this is Tax Notes senior reporter Lauren Loricchio. Lauren, welcome back to the podcast.

Lauren Loricchio: Thanks for having me.

David D. Stewart: Let's start off with the American Rescue Plan Act. What does this law mean for states and localities? What does it say about states making tax cuts?

Lauren Loricchio: The law provided $350 billion in emergency funding for state, local, territorial, and tribal governments to respond to the COVID-19 pandemic. State and local governments asked for the funding to help address budget deficits and rising costs of providing services. The funding is pretty flexible, and can be used for a variety of things like covering public health expenses, budget deficits, etc.

But there's a catch: A provision added to the law at the last minute by Senate Democrats says the funds can't be used directly or indirectly to offset a reduction in net tax revenue. If states do, then they have to repay the funds to Treasury.

David D. Stewart: States were not particularly happy with this provision. Can you tell me about the ongoing legal fight? How many states are involved? 

Lauren Loricchio: There's been a lot of concern over what the provision means for state policymaking. Six federal lawsuits have been filed, mostly by Republican state attorneys general who want to block Treasury from enforcing the provision.

One suit was filed by Texas, Louisiana, and Mississippi; that's the latest one that was filed. Ohio was the first state to file a lawsuit. Arizona filed one. Missouri filed a lawsuit, which was dismissed, but the state filed a notice of appeal in that case. There's another suit that was filed by 13 states that's being led by West Virginia. Kentucky and Tennessee have filed a lawsuit as well.

The arguments vary in each lawsuit. This might be an oversimplification, but basically they're arguing that the provision is federal overreach because it prohibits states from cutting taxes and states should be able to set their own policies.

The federal government is arguing that the act doesn't prevent states from cutting taxes; it restricts the state's ability to use federal funds to offset a reduction in net tax revenue. They point out that states can turn down the funds.

David D. Stewart: The Treasury Department released some guidance on this issue in May. Can you tell me about that?

Lauren Loricchio: Sure. Treasury adopted an interim final rule May 10. It hasn't been finalized yet. It lays out a four-step framework for determining whether the funds have been used to offset a reduction in net tax revenue and it explains how the recapture provision works and how it's computed.

The tax practitioners I spoke with said the rule takes more of a holistic approach by allowing states to consider tax cuts in the context of their overall revenue picture. They said it's good that the rule contains a de minimis level and a safe harbor.

The de minimis level allows states to lower revenues by 1 percent of the baseline year without triggering the clawback. The safe harbor requires governments to compare the reporting year's actual tax revenue to the baseline year, which is 2019.

They also said it's good news that Treasury will allow organic growth to count toward offsetting tax reductions. But they said the process is very complicated and will be difficult for states to comply with, and that it will also be challenging for Treasury to enforce.

David D. Stewart: We're recording this on June 15. Can you tell me where things stand today?

Lauren Loricchio: The litigation continues. We'll just have to wait and see what the outcome of these cases will be.

David D. Stewart: You recently talked to someone about this. Can you tell me about your guest?

Lauren Loricchio: I spoke with Joe Bishop-Henchman, vice president of tax policy and litigation at the National Taxpayers Union Foundation. We discussed state litigation over the American Rescue Plan Act, and his organization's involvement in that litigation.

Joe, can you tell me what the National Taxpayers Union Foundation is, and what the organization's involvement has been in the state lawsuits filed over the American Rescue Plan Act?

Joe Bishop-Henchman: The National Taxpayers Union Foundation (NTUF) is the voice of America's taxpayers. NTUF and our sister organization the National Taxpayers Union have for decades worked to make sure that taxpayers are represented at the legislative negotiating table and are being informed about what's going on at the national and state levels about issues that affect them.

Every other lobbyist or lobbying group has lobbyists in Washington, D.C., and in state capitals. But oftentimes both current and future generations of taxpayers are left out, so NTUF and NTU fills that gap. I lead a project at NTUF called the Taxpayer Defense Center, which engages in litigation and other legal activities to support the overall mission.

You asked about the ARPA provision. Gosh, there's a lot I can go into there, but very briefly, earlier this year Congress passed a big law to provide rescue funds associated with the coronavirus pandemic relief, including additional rebate money and a bunch of changes. One of the provisions that was inserted at the last minute could be and has been argued to prohibit states from cutting their taxes through 2024.

The actual language is a bit of a tongue twister that doesn't really make much sense when you write it all out. But it says that states cannot "directly or indirectly offset a reduction in the net tax revenue," and then it picks up later, "or delays the imposition of any tax or tax increase." Whatever offsetting a reduction in the net tax revenue means, states can't use funds from the American Rescue Plan Act to do that.

Some people argued very quickly that because it says directly or indirectly, it means states can't do any tax cuts at all whether they're directly using the funds or indirectly using them. It created a whole bunch of chaos really quickly.

The Treasury Department was pestered by everybody to issue clarifying guidance. A bunch of bills were introduced in Congress to change or repeal the provision, and a bunch of lawsuits were filed. NTUF's been engaging in all of those, including filing briefs in each of the lawsuits.

Lauren Loricchio: How many lawsuits are there? Can you tell me a little bit about them?

Joe Bishop-Henchman: Sure. There's six so far. They've each been filed in a different judicial circuit.

I'm guessing the strategy is having different judicial circuits hear this case. For the Supreme Court to hear a case, most Supreme Court practitioners would say the best way to get the court to take a case is if there's different decisions in different circuits. If you really want it to be heard quickly, which a lot of people do on this because the clock is ticking, you have it being heard by as many judicial circuits as possible.

It's six different cases. Some of them are just one state suing the federal government. There's a lawsuit that has 13 states on it. When you add it all up, it's quite a few states that are challenging this provision.

Lauren Loricchio: Why do you think the provision is problematic?

Joe Bishop-Henchman: Well, nobody knows what it says. Even the Treasury Department, which has to enforce this provision, came up with guidance that is not a bad rule on how to make sure that ARPA funds are used properly and not used to finance on sustainable tax cuts or anything like that.

But if you really read the provision and read the guidance, they're narrowing the language of this provision. The language itself is either so vague to be unconstitutional for that reason, or it's so broad that it expands congressional power to basically be a supervisor of state tax policy for years come.

Those are the basis of the lawsuits there. As I mentioned, Treasury did issue some guidance, which cleaned up some areas. But the guidance essentially pretended the word "indirectly" was not in the statute, which makes sense. If they wrote guidance using the word "indirectly," it'd probably be unconstitutional.

Lauren Loricchio: You said the interim final rule clarified some things. What were some of the good things that it did?

Joe Bishop-Henchman: It clarified the process that Treasury is going to do.

What counts as a reduction in net tax revenue needed to be defined. There was fear that Treasury was going to set up some independent process, go by whim, or who knows what because the statute was very unclear on that.

But what the Treasury guidance says is they're going to rely on state submissions. That's good because states already track this and they're best positioned to be able to provide this information.

They also read very narrowly the question of what does it mean to offset this revenue? They're going to look at the gap in revenues between a base year and the subsequent year, and expect the state to explain any revenue drops.

If a state through natural revenue growth has more revenue one year than the past, they're probably going to be OK. The problem will be if a state does have a drop in revenue, which when you subtract out federal funds, quite a few states have had that in the last year due to the pandemic and the associated economic impacts.

The problem with that is you can't always explain a revenue gap. Let's say you have a state that has a billion-dollar drop in revenue. Sometimes you can explain that and sometimes you can't.

Sometimes if you cut taxes by $500 million and revenue drops by $500 million, that's a good explanation. But sometimes the economy just is the economy, and you have these revenue fluctuations that can't necessarily be ascribed to certain causes. That's a problem with the Treasury guidance.

What Treasury couldn't fix is the constitutional question of whether Congress can even pass this provision in the first place. They also can't necessarily fix if somebody were to sue to try to enforce this provision and decides to read the statute a different way.

What happens if they get a court to agree with them?

Lauren Loricchio: Your organization has filed some briefs in this case. Can you tell me about those and maybe some of the arguments that you're making?

Joe Bishop-Henchman: We make two key points.

One is the wording is so ambiguous that its enforcement will essentially be arbitrary. The Treasury guidance reinforces our position on that because Treasury essentially pretended the word "indirectly" was not in the statute. But it results in essentially an arbitrary interpretation of this provision, in which a future Treasury Department, or somebody suing, or who knows who, could certainly give a different definition.

This isn't just about, "Oh, they have this nonsense sentence in the law and so we need to sue about it." The reason this matters is because taxpayers, state governments, and the federal government deserve fair notice on what is permitted and what is not under the law.

When you have an ambiguous statute that doesn't provide that fair notice, there's ample precedent that says that such a vague statute essentially violates due process under the Constitution.

The second argument we made is that the term "indirectly," if you actually do enforce that and say any indirect use of this revenue for tax cuts, is everything. Six degrees of Kevin Bacon. Everything's connected with everything else, certainly when it comes to money and state budgets. It's very fungible.

If you applied that to its logical extent, then this is an unconstitutionally intrusive condition on state governments. We pretend budget allocations are very fixed and that a pot of money in one account is different from a pot of money in another account. But in reality, it's mostly a post hoc accounting exercise that we do to reconcile everything after the budget year has ended.

The real danger that we worried about is that any state that accepts federal funds and cuts taxes can be said to have indirectly used funds for that purpose, and therefore violates the provision. Treasury's guidance did not clearly say, "No, that's not the case."

That worrisome interpretation and an unconstitutional interpretation are still out there.

Lauren Loricchio: Are there any cases that you're watching more closely than others? Or any that you think you're going to see a decision in sometime soon?

Joe Bishop-Henchman: They have been moving very quickly. All of these cases were filed between March and May, not long after the provision was first enacted. We have one decision from a trial judge, and then another one that's likely to come soon.

There's the Ohio case in which the state asked for a preliminary injunction and the judge denied it. But in denying it, his explanation was, "You don't really want a preliminary injunction because that's not going to stop anything. What you want is a victory on the merits because what am I enjoining if you ultimately lose? And if you ultimately win, the injunction isn't going to have gotten you anything." Part of that was that Ohio is not actively working on a tax cut and they hadn't yet applied for ARPA funds.

But in explaining that, the judge really laid out his view that the phrases "indirectly, "offset," and "net tax revenue" don't really have discernible meaning.

Under the Constitution, Congress cannot offer states money on ambiguous terms. If it's going to attach conditions to federal funds to the states, it's got to be clear on what those conditions are.

Ohio feels pretty good that they're going to win at the trial level from that judge. That's what we're waiting on right now. Briefing's ongoing in that. Ohio is now asking for a permanent injunction. I think it's good likelihood that they're going to get it. Of course, the federal government will probably appeal after that.

The other case that's moving along pretty well is the one filed by the state of Missouri. The judge ruled against them on standing grounds, and said Missouri has not demonstrated it would suffer harm from this provision. The judge said, "The only way you'd violate this provision is if you used federal funds to offset a tax cut. That condition is permissible. Don't do that. And by the way, because Missouri is not cutting any taxes or hasn't said it's going to cut taxes, this case is premature. So, dismissed on standing grounds and on ripeness grounds that the case hasn't gotten to a point where it can be heard yet."

This was unexpected by both parties. I think both parties expected to argue about the merits of the provision, not to get tossed on the grounds that there's no conceivable way Missouri could be harmed by this provision.

In every previous case about unconstitutional conditions of federal funds to the states, there's never even been a dissenting opinion from a judge saying, "We shouldn't hear this case on standing or ripeness grounds." The judge really came up with something to kick the case out of his docket that no one's really done before.

Even in the big ticket cases like the Obamacare case, when that went to the Supreme Court, that involved a condition attached to Medicaid expansion funds and said, "If you don't take the Medicaid expansion funds, you lose all of your Medicaid money."

The question was, was that an unconstitutional condition? The majority of the Supreme Court said, "Yes. That was an unconstitutional condition." There was four dissenters who said, "No, that's not an unconstitutional condition." None of those nine justices said, "We shouldn't be hearing this case because of standing or ripeness."

The judge in his opinion didn't point to any precedent that supports that interpretation of things. It's really hard for me to believe that Congress provides funds, attaches a condition to it that says, "State, you can't do X, Y, or Z." A state says, "I want to do X, Y or Z. I don't think this is constitutional." Then a judge says, "You have no standing."

On May 18 Missouri said it's appealing to the Eighth Circuit and briefing's being done right now. It should be done in July. We'll see what the Eighth Circuit says about this standing decision.

Lauren Loricchio: What's an ideal outcome for taxpayers on this?

Joe Bishop-Henchman: I think the provision has got to go. I think there is a place for the Congress to put some kind of condition on federal funds to make sure that they're used wisely. I think it's very hard in this case because it really was this avalanche of money to the states that they didn't really need.

Some states were having budget issues. I feel like the amount of money provided was like 10 times the actual possible budget issues. Right now you've got states absolutely so flushed with cash and so limited on what to do with it. Maybe the whole ARPA state aid provision needs to be repurposed or redone to address that.

But this provision in particular really has to go because it's just so broad. This was put in by Sen. Joseph Manchin III, D-W.Va., along with the Senate Majority Leader Charles Ellis Schumer, D-N.Y. If what they were getting at was, "Don't take this $500 billion and permanently cut taxes to set up a structural deficit in your budget year to year, for years to come, that's understandable."

I haven't talked to Manchin about this, but at the time this was going on, his home state West Virginia was debating whether it wanted to repeal the state income tax. Maybe his concern was, "Oh man, they're going to use this money to repeal the state income tax. They'll be fine for a year, but then what are they going to do in year 2, 3, 4? So I better put something in to prevent that."

He went to, I don't know, somebody who doesn't know how to write these things and it ended up kind of sloppy and broader than that. There's a way to narrow it, to focus precisely on potential harms like that.

Right now this essentially says if you really enforce it based on what it actually says, at least the best interpretation I can find of it because it is very sloppy language, states can't cut taxes through 2024. Congress can't mandate that.

Lauren Loricchio: Do you expect states are going to prevail in these cases?

Joe Bishop-Henchman: I think they will in part because lots of states are just ignoring the provision and passing tax cuts. It's hard to see how they don't violate it. For instance, a lot of states automatically update their tax code to match federal law. But there's also states that have to manually do it every year.

California is one of those states. Every year they have to pass a bill saying the starting point of our state tax code is the federal tax code as of January 1, 2021. They have to update it from when it said 2020 to make it say 2021.

We suspended taxes on a certain amount of unemployment benefits at the federal level. If a state were to just make that one change in law from 2020 to 2021, it's a big tax cut for anybody who received unemployment benefits. If we're using ARPA funds for that, that violates the provision.

In fact, California recognized that. California, which is not a red state, wrote to the Treasury secretary and said, "Is what we're about to do legal under this provision?" Treasury Secretary Janet Yellen quickly wrote back and said, "Yes, it's legal." I'm glad she said that, but it's really hard to square that with what the statute says.

There's a lot of other tax cuts going on that may have been preplanned. There's states that are phasing down taxes over a period of years, or that have them based on revenue triggers.

Maryland passed a huge tax increase on digital advertising, and then suspended it for a year because it's engaged in litigation about it. Does suspending a new tax for a year count as a tax cut financed indirectly by ARPA funds? We may find out in court.

There's a lot of ambiguity about this. It's hard to see the federal government prevailing on all of these, especially since there doesn't seem to be much appetite to really wield the hammer on all of this.

Some people may think, "Oh, well, isn't that the end of the case?" But we don't want this hammer sitting out there for some future administration or somebody five years from now saying, "Oh, these tax cuts were all improperly passed," and going back and trying to recollect the revenue. There's a lot of danger with just letting this provision exist.

Lauren Loricchio: In terms of the provision, it's my understanding that it would be Treasury saying that states can't produce net tax revenue. It's not really saying you can't enact a tax cut. It's just saying you have to use the framework that they laid out in the guidelines. So they can enact a tax cut, but it can't reduce their overall net tax revenue. Right?

Joe Bishop-Henchman: That's what the Treasury guidance tried to say, which if that's where it sticks, there's some areas that need to be clarified further. But that's not a bad starting point.

The danger is if Treasury changes its mind or someone sues and says, "Yeah, that's Treasury's opinion, but judge, look at what the statute actually says."

Treasury guidance is not law. If someone can convince a judge that the law is clearer, that the law should supersede what Treasury tried to say it was, that's a big deal.

Lauren Loricchio: All right. Well, thank you so much.

Joe Bishop-Henchman: Pleasure to be here.