Feds to the Rescue?

An overview of Treasury guidance on state use of ARPA funds in the Tax Conference Committee generated more questions than answers but did seem to open the negotiation window wider for lawmakers in reaching agreement on a biennial budget.

On Monday, the Treasury Department released its highly anticipated “interim final guidance” for the use of American Rescue Plan funds.   Unsurprisingly, it prompted a speedy virtual visit to the tax conference committee from MMB Commissioner Schowalter to provide additional information, clarity and understanding on the guidance itself and its potential implications for the biennial budget.   While some additional information was gained on the federal relief, plenty of questions remain on how it gets factored into a deal.

The Commissioner remarked that while the guidance clearly helps in gaining greater understanding where and how funds can be used, there is still much to understand and interpret.  He gave a brief overview of the four “categories” of permissible uses with some examples.   He also reported the state’s allocation of the state fiscal recovery funds is now $2.833 billion -- about $250 million higher than what was originally anticipated.   (It’s important to remember there is an additional $3.2 billion or so for direct spending on COVID impacts in areas in which the state has overlapping or parallel general fund interest and effort -- like E-12 education.  Some of this “direct spend” requires state matching or maintenance of effort; some does not.)

That was not the only surprise.   One of the new features of this round of aid is funding to replace lost government revenue due to the pandemic to restore general government services.  It may not be akin to “LGA for state government,” but it clearly offers the most flexible potential use of federal rescue dollars.   Commissioner Schowalter observed that the guidance, method and calculations for determining “lost state revenue” results in a much larger sum than the approximately $500 million MMB had originally anticipated.  (Based on our own interpretation of the guidance and plugging some numbers into the federal formula, our crude calculation of “lost revenue” in the eyes of Treasury could be something more on the order of $1.9 billion.)    He also observed the money will be distributed in two equal tranches, one in the very near future, the other 12 months after that, and that eligibility for using the state’s fiscal recovery funds extends out to the end of 2024.

The fact that this is “interim final guidance” is also worth noting.   Treasury is asking for comments on these rules and included numerous questions at the end of each section of the 150-page document – many of which ask respondents for other ideas or additional conditions pertaining to the eligibility, use, and distribution of funds.   It’s difficult to believe this interim guidance that states are now using and relying on would materially change in final rulemaking.  Nevertheless, the interim rule declaration represents a window of uncertainty and the possibility of additional detail to come.

In light of the May 17 tax deadline, Senate Tax Chair Nelson focused like a laser beam on language that seems to unambiguously declare state federal conformity as an appropriate use of funds and identifying PPP loan forgiveness and changes to federal taxation of unemployment benefits as specific examples.   Commissioner Schowalter hedged saying that while the language makes clear this use “probably permissible” it is important to understand how Treasury is defining these terms before declaring we are good to go.   He said legislative and MMB staff need to continue “kicking the tires” to make sure know exactly if our conformity meets their standards.    He reflected on the fact that when CARES instructions came through last year it was months before fully understanding some of the strings and expectations accompanying the funding.   Chair Nelson said she was at a loss at what more needs to be understood.  House conferee Davids was more blunt saying, “it feels like executive branch is trying run the clock out” and argued the Governor is in the position of spending billions of dollars once again without any legislative input and approval. 

Testifiers and conferees did not get into any detail or discussion regarding one of the more complicated but highly relevant pieces of guidance:  the possible recoupment of federal funds from cutting taxes.  As we have noted before, around $270 million just in new and enhanced tax credits are in play in the Senate and House omnibus bills.  The Tax Foundation has a nice summary of the issues and new questions raised by guidance on this topic.  According to the guidance there are three ways to avoid claw backs – raise offsetting revenue, make offsetting spending cuts, or achieve economic growth which results in revenue collections above an inflation-adjusted, pre-pandemic state baseline after factoring in the tax cuts. 

Of particular interest is the language stipulating that reductions in spending to offset tax cuts cannot be in any area where state government has spent fiscal recovery funds as determined at the department, agency, or authority level.  The question immediately arises: what areas of government won’t be affected by the potential use of fiscal recovery funds at the agency or department level?   As the Tax Foundation remarks, “this represents a massive federal entanglement in state fiscal authority…rather than mitigating concerns addressed in pending litigation, Treasury appears to have created new ones.” They conclude, “while the new interim rules clear up several important questions, it raises new ones that will continue to keep state officials up at night.”

All this is further complicated by the fact that certain state actions might be able to be justified in different ways offering different financing approaches.  For example, enhancements to the state working family credit by definition reduce revenue for the state. But it (or at least the refundability portion of it) might be classified as a “direct spend” to support Treasury guidance in support of disproportionately affected demographic and socio-economic communities.   There is even a potential federal conformity argument.  In determining the federal earned income tax credit for 2021 the federal government is allowing taxpayers to use the greater of their 2019 or 2020 earned income - a provision mirrored in the House omnibus tax bill for the state’s WFC.

So, on top of the many policy issues orbiting budget discussions and the vast amounts of sand they offer the gears of negotiation, the role of federal rescue dollars - and all the financial engineering accompanying it -- in arriving at an agreement remains unclear.  However, it seems to us the expanded definition of revenue loss by Treasury and the greater flexibility these dollars offer widens the negotiation window for lawmakers.   We can envision a deal in June based on passage of a tax bill that includes full conformity, which would be about an $800 million hit, (most of it one time paid by fiscal recovery funds which are also one-time).   If (and that's a big if) our interpretation and guesstimate is correct, that would still leave around a billion to add to our existing $1.6 billion surplus for 22-23 budget purposes.    Moreover, the remaining $5 billion going to local governments and various state administered programs would seem to enhance the state’s flexibility.  

Building a base budget with a considerable amount of one-time money is certainly not without risk.   Anemic economic growth could result in recoupment of some federal dollars adding insult to injury.  But last biennial session we dipped a toe into this water by tapping into about $500 million of reserves to get to an agreement.   We have bet on the come before.   In our world of divided government marked by bipolar perspectives on fiscal matters we can expect to do it again.