I.R.S. Decision Not to Tax Certain Payments Carries Fiscal Cost

WASHINGTON — More than 20 state governments, flush with cash from federal stimulus funds and a rebounding economy, shared their windfalls last year by sending residents one-time payments.

This year, the Biden administration added a sweetener, telling tens of millions taxpayers they did not need to pay federal taxes on those payments.

That decision by the Internal Revenue Service, while applauded by some tax experts and lawmakers, could cost the federal government as much $4 billion in revenue at a time when Washington is struggling with a ballooning federal deficit and entering a protracted fight over the nation’s debt limit.

The I.R.S.’s ruling came after bipartisan pressure from lawmakers and was the latest move by the agency to forgo revenue this tax season.

In December, the I.R.S. delayed by a year a new requirement that users of digital wallets like Venmo and Cash App report income on 1099-K forms if they had more than $600 of transactions. That requirement, which was part of the American Rescue Plan of 2021, was projected to raise nearly $1 billion in tax revenue per year over a decade. The last-minute decision to delay it followed intense lobbying from business groups and political backlash directed at the Biden administration, which was accused of breaking its pledge not to raise taxes on people making less than $400,000.

Taken together, the moves by the I.R.S. run counter to two big economic issues bedeviling Washington — rapid inflation and concerns about the government’s ability to avoid defaulting on its debt.

Allowing residents to avoid paying taxes on their state rebates means more money in their pockets to spend at a moment when the Federal Reserve is trying to rein in consumer and business spending to cool rising prices. A report released on Friday showed that, despite the Fed’s efforts to slow the economy, personal spending sped up in January.

Government data released in December showed how “one-time refundable tax credits issued by states” were propping up incomes around the nation. More than 20 states enacted individual tax rate cuts or rebates last year. They were able to do so in part because of $350 billion that was allocated to states and cities as part of the $1.9 trillion stimulus package that passed in 2021 and left many states with record budget surpluses.

When tax filing season began in late January, the I.R.S. had yet to rule on whether the payments were taxable, confusing and frustrating millions of recipients — and their elected representatives. After the agency told taxpayers to hold off filing their returns as it made its decision, lawmakers from California and Colorado urged the I.R.S. to exempt the payments and not add to their constituents’ tax burden.

The agency quickly obliged.

Altogether, payments in 22 states subject to the I.R.S. decision totaled over $25 billion, according to a New York Times tally. That amounts to roughly $3 billion to $4 billion in lost tax revenue, according to back-of-the-envelope calculations from the conservative Tax Foundation and the nonpartisan Institute on Taxation and Economic Policy. (The precise amount is difficult to determine, given that the amounts and eligibility criteria for the payments vary widely from state to state.)

While that figure is just a small fraction of the $4.9 trillion of revenue the government collected last fiscal year and a tinier blip still compared with the $31.4 trillion of national debt, the agency’s decision comes as the Treasury Department is engaging in a series of accounting maneuvers to ensure the United States can keep paying its bills and avoid defaulting on its debt.

Last week, the Bipartisan Policy Center warned that the Treasury Department could exhaust those measures and run out of cash by early summer if Congress did not lift or suspend the nation’s borrowing cap. The think tank noted that the actual date when the United States would run out of cash was highly dependent on tax receipts, which are incredibly volatile given the state of the economy.

“In the event of much-lower-than-expected revenues through tax season, there is a small chance of a ‘too close for comfort’ situation prior to quarterly tax receipts due on June 15,” the policy center warned.

The I.R.S.’s past policies on taxing state payments have added to the complexity of the situation. In previous years, the I.R.S. deemed certain payments like annual dividends paid out to residents in Alaska as subject to federal taxes. But certain direct cash payments by states and cities responding to the coronavirus pandemic were deemed nontaxable in 2021.

In its guidance on state payments this season, the I.R.S. clarified that payments made by states “in general” should be included for federal taxation, but many of the payments made in 2022 were “related to general welfare and disaster relief” and thus exempt.

Still, experts broadly agreed that the I.R.S. had made the correct decision, given that it did not tax the federal government’s own stimulus checks, the cost of exempting the one-time state payments was fairly negligible and the delays had already added confusion to the filing season.

“The I.R.S. is right not to insist on strict applications of the rules given the need to resolve the uncertainty without further disruption,” said Jared Walczak, the vice president of state projects at the Tax Foundation.

Kim S. Rueben of the Tax Policy Center, a liberal-leaning think tank, said that the Biden administration had probably weighed the impact that taxing the payments would have on less wealthy Americans against the additional revenue that would be generated. Deeming the payments as taxable income, she said, might have affected eligibility for other government benefits like food stamps and Medicaid.

“The people that this is most useful for, in my mind, are lower-income families, who may not have had much of a tax liability in the first place,” she said.

Ultimately, the I.R.S. deemed payments from 16 states not taxable. Some rebates were narrowly tailored, like $35.5 million to about 59,000 families with children in Florida, while others covered nearly every taxpayer in a state, like the $9 billion paid to more than 31 million residents in California.

Taxpayers in Alaska do not need to report a one-time energy relief payment on their tax returns, but do need to report the regular dividend the state sends to residents.

Residents in four other states — Georgia, Massachusetts, South Carolina and Virginia — do not need to report payments if they take the standard deduction, but do if they itemize. The I.R.S. reasoned that these four states structured their payments as refunds, rather than rebates.

Mr. Walczak estimated that the affected filers in those four states accounted for just 2 percent of the payments’ value nationally, and he criticized the agency for having singled out those who itemize their taxes as arbitrary.

“It would be fair for taxpayers to ask why the I.R.S. did not make a blanket statement of nontaxability,” he said.