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POLICY INSIGHT
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Latest Proposals Show Need for Rescue Plan’s State Tax Cut Restriction

Some state lawmakers have accelerated their push for tax cuts since Congress passed the American Rescue Plan two weeks ago, ironically showing why the new law’s provision that states lose a dollar of the new federal aid for every dollar they spend on new net tax cuts is necessary for a just recovery.

The Rescue Plan includes $350 billion in fiscal aid to state, local, tribal, and territorial governments, to support much-needed assistance to hard-hit families and communities and offset the pandemic’s impact on government revenues. But some governors and lawmakers are capitalizing on the new funding to propose tax cuts that would mostly benefit wealthier individuals and profitable corporations that don’t need help, which won’t speed an economic recovery.

Iowa’s Senate, for example, passed a bill to cut taxes over the next three years, with large benefits for profitable corporations, wealthy heirs, and high-income earners. Idaho’s legislature is considering a tax cut that would be worth 40 to 100 times as much for the wealthiest households as for middle- and lower-income households, on average. Oklahoma’s House passed bills to eliminate the corporate income tax over five years and cut personal income taxes. And West Virginia and Mississippi are considering eliminating their income taxes, which provide 40 percent and 31 percent of those states’ general fund revenues, respectively.

Some lawmakers are beginning to recognize that their state could face a double-whammy from cutting taxes: it would lose tax revenue directly and could also lose new federal funds needed to help the millions of people and businesses still struggling, cover other costs, and make up for lost revenues. That’s because the Rescue Plan includes a common-sense provision saying that if states cut taxes, they’ll have to repay the federal government dollar for dollar — as they would for any other unauthorized use of the money.

The Rescue Plan doesn’t stop states from cutting taxes; it just says they can’t use federal dollars to do that, either directly or indirectly. States can use the new funds to pay for the full range of state services like education, health care, and transportation, as well as to cover pandemic-induced costs. What they can’t do is expect the federal government to fill the budget gap they’d create by weakening their revenue system through tax cuts.

While a group of 21 Republican state attorneys general wrote Treasury Secretary Janet Yellen complaining that the provision is “unprecedented and unconstitutional,” their legal arguments are “beyond flimsy,” concludes Georgetown Law Center Professor David Super:

This kind of restriction might seem like common sense to some people: Just as Congress does not allow states to spend federal Medicaid dollars building marinas in the districts of powerful state legislators, so it is insisting that this aid money be used for its intended purpose: to help people. . . . Nothing in the Constitution entitles the states to transfers of federal funds. . . . And when Congress does grant aid, nothing in the Constitution prohibits legislators from imposing significant conditions on its use.

Secretary Yellen also pointed out that only net tax cuts run afoul of the rule. So, a state could cut taxes for low-income families and raise them for wealthy ones, with no loss of net tax revenue — and no loss of federal aid. Tax changes like this would also advance equity and help low-income families.

Even without the loss of federal aid, recessions are a terrible time for state tax cuts. Typically, the biggest benefits go to people and corporations that don’t need them, which is an especially bad idea at a time when many working families — particularly those in communities of color — face serious hardship. Worse, every dollar in state tax cuts is a dollar not available for the public services these families rely on, like health care, emergency assistance, and public education, which can be in even greater demand during a downturn.

Cutting state taxes now would repeat a mistake many states made in the wake of the Great Recession: by cutting taxes, they harmed families, undermined economic growth, and exacerbated economic inequality and racial injustice. Instead, states should address critical health and economic needs by targeting the new federal aid to those who need it most and by making their own investments to help build antiracist, equitable states.

The Treasury Department will issue guidance in coming weeks on how the Rescue Plan provision will operate, partly to ensure that states and localities can’t find loopholes in it. In the meantime, state lawmakers should think twice before pursuing tax cuts.