Could Maryland’s federal stimulus payment get slashed because of rule against tax cuts?

This article was republished with permission from WTOP’s news partners at Maryland Matters. Sign up for Maryland Matters’ free email subscription today.

This content was republished with permission from WTOP’s news partners at Maryland Matters. Sign up for Maryland Matters’ free email subscription today.

Maryland could lose a $200 million chunk of federal stimulus funding meant to shore up state government, as the result of a provision in the federal law meant to limit the use of the stimulus to fund tax breaks.

The U.S. Senate added language to the COVID-19 relief package prohibiting states and local governments from using the $350 billion in direct federal assistance “to either directly or indirectly offset a reduction in the net tax revenue” or delay the imposition of any tax or tax increase. The Maryland state government is set to receive $3.9 billion in direct federal aid.

But until the Treasury Department offers more detailed guidance on how it will interpret the new stimulus law, the provision is causing uncertainty in several states – including Maryland – where tax changes are under consideration.

If states accept stimulus money and push through tax benefits, the federal government could claw back the funding, Maryland fiscal leaders said.

So far this General Assembly session, lawmakers have passed two pieces of tax legislation – a state stimulus program that includes individual and business tax relief that became law on Feb. 15, and an extension of Earned Income Tax Credit to those who file taxes with Individual Taxpayer Identification Numbers.

That second bill passed the General Assembly in February, but was not signed by Gov. Lawrence J. Hogan Jr. (R), automatically taking effect without his signature on March 5.

The federal stimulus relief bill establishes a March 3 deadline for tax legislation that would be exempt from the prohibition.

Some of Maryland’s top leaders hope forthcoming Treasury guidelines will exempt that cut from the clawback provision.

If not, it could mean a double-whammy for the state’s coffers. The bill would forgo about $203 million in state revenues from the extension of the tax credit; and the federal government could decide to cut the state’s stimulus by the same amount.

The provision in the federal stimulus bill doesn’t entirely prevent state officials from cutting taxes. Some scenarios, such as slashing one tax but offsetting it with a tax increase, wouldn’t be a problem.

State and federal lawmakers could not immediately comment on the full extent of the provision’s impact, or whether Maryland would lobby for an exception through the regulatory process. Hogan’s office and the state’s budget office did not respond to a request for comment.

The Maryland Senate earlier this week put off consideration of several tax bills until there’s better guidance from the federal government. The House Appropriations Committee, which is tasked with the first round of amendments to the state budget this year, delayed final budget decisions by a few days until next week to learn more.

“I think it’s a little bit too early to know, we want to see how the Treasury interprets some of these provisions. And, you know, we want to make smart decisions with as much information as possible,” Senate President Bill Ferguson (D-Baltimore City) said Friday. “We’ll probably be more cautious than not when it comes to ongoing questions around tax credits or cuts, because we don’t want to jeopardize some of this federal support.”

Potential trouble spot

Tax policy experts describe a range of complex scenarios that could stymie budget officials and force them to pay back the federal dollars.

Jared Walczak of the Tax Foundation, a Washington, D.C.-based conservative-leaning nonprofit focused on tax policy, said one potential trouble spot is if states use the money to pay the salaries of employees already on the government payroll, such as public health workers.

Offering grants or assistance to businesses and individuals doesn’t affect existing budgetary expenses. But using the money for existing salaries, even related to the pandemic response, would be dicier if that savings is then offset with a tax cut, he said.

Another murky scenario?

If states decide to follow the federal policy change in another section of the new pandemic stimulus bill and make unemployment compensation benefits not subject to taxes.

“Will that count as a tax cut?” asked Kim Rueben, director of the state and local finance initiative at the Urban-Brookings Tax Policy Center, a joint venture of the liberal-leaning Brookings Institution and the Urban Institute.

Neither White House officials nor a spokesman for Senate Majority Leader Chuck Schumer (D-N.Y.) responded to requests for comment on the criticism and confusion surrounding the provision.

A defense of limits

Sen. Angus King had offered a defense of limitations on the state and local aid in an interview last month with The Washington Post, in which the Maine senator advocated for “a prohibition against voluntarily diminishing revenues.”

“We could distribute billions to the states, and they turn around and lower taxes — there are governors talking about that, and it’s not the point here,” said King, an independent who caucuses with Democrats.

Rueben said she believes the provision was intended to ensure that the money is being used for the pandemic-related challenges that those dollars are intended to address — and prevent states from having a revenue base that’s in worse shape when the federal aid ends.

Restrictions on federal aid to states aren’t unusual, Walzcak noted.

Some funds require matching state dollars, or even policy changes, such as federal highway dollars that are tied to adopting certain DUI laws. But there’s little case law on how far the federal government can go in such requirements, he added.

“We know the federal government can overreach … but there’s not a clear definition of where that line is,” Walzcak said.

Options for states

States that don’t like the limitation do have options: They could decline to accept the federal money.

Adam Michel, a tax policy analyst with The Heritage Foundation, a conservative think tank, has urged states to reject the aid, arguing in an op-ed piece that the “dangers of permanently expanded state budgets and the possibility of the Treasury Department’s micromanagement of states’ fiscal decisions outweigh the benefits.”

States also could file lawsuits. Walczak said he believes the provision could ultimately end up in court, though that may take some time. States have until 2024 to spend the federal dollars.

Brian Sigritz, director of state fiscal studies for the National Association of State Budget Officers, said state officials are in the “information-gathering stage” just days after the bill was signed into law.

Some of the state tax cuts proposed ahead of the bill’s approval were targeted tax cuts for individuals and businesses, while others were broad cuts designed to be phased in over a number of years, Sigritz said.

“The provision will have an impact on some of those proposals but right now, it’s unclear the exact impact,” he said.

It’s not clear how quickly Treasury officials will release any guidance on how states can spend the pending dollars and how exactly the rules against tax cuts will work. An agency spokesman did not respond to emailed questions.

Rueben said that while the tax policy limitations may cause headaches, it’s likely a preferable challenge for officials to sort out than the one they were facing a year ago, as COVID-19 infections were rising and revenue projections plummeting.

“The fact that they are trying to figure out an infusion of money and what that means, compared to being really afraid of the catastrophic nature of what the shutdowns might mean … I think it’s easier to breathe,” she said.

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