Democrats’ Stimulus Bill May Block States from Suspending Taxes on Unemployment Benefits

This is the second post in a series NTU is publishing on the American Rescue Plan (ARP), the $1.9-trillion COVID relief bill supported by President Biden and House and Senate Democrats. The series seeks to examine what’s next for Congress and taxpayers regarding many aspects of this significant legislation. Here are the others, on Child Tax Credit expansion, premium tax credit expansion, direct payments, and Employee Retention Tax Credit expansion.

The $1.9 trillion American Rescue Plan (ARP) sets up millions of struggling Americans for an unpleasant surprise -- a heftier than expected state tax bill. Due to the economic shock caused by the pandemic, millions have collected unemployment benefits since last March. While Congress decided to shield the bulk of these benefits from federal taxation, it may have simultaneously prohibited states from doing the same.

According to press reports, as Senate negotiations drew to a close, Majority Leader Chuck Schumer (D-NY) inserted a provision in the massive bill that prevents states from using federal funds to “either directly or indirectly offset a reduction in the net tax revenue” through 2024. This followed shortly after the Senate included language to exempt the first $10,200 in unemployment benefits from federal taxation.

The net result is unfortunate for millions of Americans who collected benefits, many of whom had little or no taxes withheld from their checks. Now states may no longer have the ability to provide relief to these individuals.

Fortunately, some states had already taken action to address this problem. Delaware suspended state taxes on unemployment benefits, but did so only for 2020. The state is now prohibited from doing the same for 2021, despite the fact that tens of thousands of its residents remain unemployed.

Other states, like Maryland and Arkansas, suspended state taxes on unemployment benefits for 2020 and 2021, but more than half of states continue to collect taxes on unemployment. Residents of Hawaii, D.C., and other jurisdictions where pending legislation could have provided similar tax relief, no longer have cause for optimism.

While the reprieve on federal taxes is welcome news for individuals who have been hit hardest by the pandemic, Congress’s decision to block states from providing similar tax protections to their residents is unfortunate. The provision also has far-reaching implications. It could prevent states like West Virginia and Mississippi from continuing ongoing efforts to reform their state tax codes. And because the provision extends through 2024, it blocks pro-taxpayer reforms far beyond the expected end of the pandemic.

As my colleague, Joseph Bishop-Henchman describes, the provision could “be so all-encompassing as to be unconstitutional commandeering of state policy.” In other words, if it’s not repealed by Congress, it ought to be challenged and overturned in the courts.