States Were Told They Can’t Use U.S. Covid-19 Aid to Cut Taxes. They Sued.

A last-minute provision added to the $1.9 trillion coronavirus relief package last month is leading to a showdown between states and the Treasury Department over the limits of the federal government’s fiscal authority.

The package, known as the American Rescue Plan, provided $195 billion for state governments to help offset soaring costs related to the pandemic and plug budget holes stemming from the economic downturn. Democrats added one important condition: States cannot use the money, directly or indirectly, to cut taxes.

Republican lawmakers and attorneys general argued the provision, which...