The U.S. Department of the Treasury’s interim final rule for the coronavirus state and local fiscal recovery funds discusses allowable uses of the funds (see here and here). It also details what the funds may not be used for.

Jurisdictions may not use the money to make contributions to rainy day funds or to make extra payments into pension funds to reduce unfunded liabilities. (The 2021–23 operating budget appropriates $800 million to reduce the unfunded liability in the Teachers’ Retirement System plan 1, but that appropriation comes from the general fund–state, not the coronavirus state fiscal recovery fund.)

Additionally, states may not use the funds to directly or indirectly offset tax cuts. This provision of the American Rescue Plan Act has drawn lawsuits from states. The guidance specifies that if states use the funds to offset tax cuts, they will have to return that amount—not their full allocation from the funds. Further,

A recipient government would only be considered to have used Fiscal Recovery Funds to offset a reduction in net tax revenue resulting from changes in law, regulation, or interpretation if, and to the extent that, the recipient government could not identify sufficient funds from sources other than the Fiscal Recovery Funds to offset the reduction in net tax revenue.

Other sources could include organic revenue growth, tax increases, and certain spending cuts (if made in an agency that did not receive fiscal recovery funds).

Part of the process of determining the amount of any net tax reduction is to look at actual tax revenue. If the state’s tax revenue in one year is more than the state received in FY 2019 (adjusted for inflation), “the recipient government will not be considered to have violated the offset provision because there will not have been a reduction in net tax revenue.”

The Tax Policy Center has more here. Jared Walczak of the Tax Foundation writes about the guidance, and its “massive federal entanglement in state fiscal authority,” here.