Democrats Are Waltzing Toward an Easily Avoidable Political Disaster With Their COVID Bill

At the moment, Democrats in Washington appear to be in danger of sleepwalking their way toward a major policy and public relations debacle.

The problem? With tax season underway, millions of Americans who lost their jobs thanks to the coronavirus crisis might soon discover that they unexpectedly owe thousands of dollars to the IRS. Lawmakers could prevent this wave of surprise tax bills by adding a fix to the $1.9 trillion coronavirus relief package that’s currently moving through Congress. But so far, efforts to do so seem to be stalling out.

A senior Democratic aide told me that, as of now, he thought the chances legislators would act were “slim to none,” and described the failure as “political malpractice.”

While unemployment benefits have long been considered taxable income, recipients are often unaware of that fact until it’s time to file. Under normal circumstances, this is not necessarily a disaster, since people tend to stay on unemployment for relatively short stints of time. But the past year has been different. A historic number of households fell back on unemployment insurance to survive the pandemic, and some have collected well over $10,000 or even $20,000 in aid thanks to the enhanced benefits Congress enacted.

Already stories are beginning to trickle in from people who have hit send on their returns, only to be blindsided by a tax bill. Take this example, courtesy of a great piece from HuffPost reporter and Slate Money co-host Emily Peck:

Julie Evans thought she’d get a refund from the IRS this year, so she got to work on her taxes first thing in January. A former administrative assistant, Evans was out of work for all of 2020. To save money, she is living with her adult children in Kent, Washington, and scraping by on unemployment benefits. “The idea of $400 or so [refund] was enticing,” she said. 

Instead, Evans got a shock: a $1,600 tax bill. “I don’t know where I’m going to come up with the money,” the 59-year-old told HuffPost.

It is not entirely clear how many households will be affected by this issue, but a recent report by the Century Foundation suggests the total could be quite large.

By law, states are required to give applicants the choice to withhold some of their unemployment benefits for tax payments. Some people turn down the opportunity, either because they need the money immediately or because they simply fail to notice the option. But in the bureaucratic fog of the pandemic, some states didn’t offer withholding at all for federal unemployment benefits created specially for the crisis.

Ultimately, the Century Foundation report’s authors estimate that states only withheld taxes on 40 percent of jobless payments, meaning a whole lot of people could unknowingly owe money.

It does not take a political savant to figure out why this is problematic. From the standpoint of basic decency, struggling families don’t need the hardship of a surprise tax bill. From the standpoint of economic policymaking, it doesn’t make any sense to tax back billions in unemployment benefits while simultaneously spending massive amounts of money on a new round of aid. And from the standpoint of pure politics, people are obviously going to be pissed off if they get whacked with a tax bill they can’t pay, or if their new stimulus check essentially gets eaten by the IRS. Voters are going to feel angry and cheated, and as one after another is paraded across cable news, it could well undo a lot of the goodwill the COVID bill might otherwise generate for Democrats and the Biden administration.

Again, some Democrats are trying to head off this issue before it potentially explodes by including a fix in the $1.9 trillion COVID relief bill currently making its way through Congress. Senate Majority Whip Dick Durbin and Iowa Rep. Cindy Axne, for instance, introduced legislation that would forgive taxes on up to $10,200 in unemployment benefits. But the House Ways and Means Committee chose not to include the provision. And it’s unclear, at best, whether the idea will make it into the Senate version. “While there is support for tax forgiveness, there are many priorities members are fighting for,” another Democratic aide told me. “Conversations are ongoing.”

Why wouldn’t Democrats just fix this? Part of the answer has to do with the arcane rules governing budget reconciliation, the procedure Democrats are using to skirt the filibuster and pass their COVID bill with just 50 votes in the Senate. Under the process, each committee is assigned a section of the legislation, along with a ceiling on what they are allowed to spend. If the Senate wanted to add a UI tax fix, the chamber’s Finance Committee would have to cut something else from its section of the bill, since the issue would fall under its jurisdiction. And finding things to cut is tricky.¹

But there might be one obvious place where Democrats could trim. At the moment, Democrats are planning to give state and local governments $350 billion in unrestricted aid to help patch up their budgets, on top of additional money for schools and transit. As I wrote last week, that’s likely a bit more than they need at this point, and conveniently, the state and local funding is assigned to the Senate Finance Committee section of the bill. Democrats could almost certainly get away with shrinking the pot by $50 billion, which is how much Goldman Sachs estimates Americans will owe in taxes on their jobless benefits. If it turns out states do need more help down the line, Democrats can add it to a bill next year.

If Congress fails to act, it’s possible that the Biden administration could step in. The Century Foundation report argues that the unemployment benefits passed to deal with the pandemic never should have been considered taxable to begin with because the IRS code excludes government payments made “in connection with a qualified disaster in order to promote the general welfare.” Under the Trump administration, the Treasury Department decided that unemployment benefits were subject to tax anyway. But under the new regime of Secretary Janet Yellen, it could potentially reverse course.

So far, the White House hasn’t shown any signs that it’s willing to do so. Instead, Democrats seem to be ambling toward a completely foreseeable and utterly avoidable self-own.