How federal policymakers account for the concerns of state and local governments in the formulation of federal tax policy.

In many cases where the federal tax base was narrowed, there were alternative approaches that would not have created conformity problems. For example, the incentives in the temporary bonus depreciation could have been achieved by a credit. Relief to the business sector in 2004 provided through the production activities deduction could have been provided through lower corporate tax rates. In each case, there were other reasons that were presumably compelling to lawmakers. In the case of bonus depreciation, a possible reason for choosing the deduction approach was that it was much more complex to restore investment tax credit language than to modify existing depreciation rules. Another possible reason for this choice is that, if the temporary provision was converted to a permanent one, the partial expensing rule was more neutral and a better stepping stone to a possible future shift to a consumption base. In the case of the production activity deduction, there was political pressure to focus as much of the tax benefit as possible on firms that were losing the export subsidy, whose finding of illegality by the World Trade Organization (WTO) was the reason for the 2004 legislation. In addition, the slowdown in manufacturing job growth contributed to a focus on providing the benefit to manufacturing and not to the service and trade sectors. Although many tax professionals criticized the provision on the grounds of adding to tax complexity and economic distortions, these issues may have been more compelling to policymakers.

One recent example in which conformity concerns were addressed was the Senate proposal to exclude dividends from federal gross income. Johnson (2003) pointed out that both Senator Nickles, the Budget Committee chairman, and Senator Grassley, the Finance Committee chairman, had pledged to craft language that would not cause a conformity problem. The provision ultimately adopted, however, was the lower rate on dividends originally proposed by the House.

More focus on conformity concerns prior to federal legislative enactment might raise the visibility of this issue, particularly if alternative approaches to accomplish the same goal were proposed that did not create conformity problems. And to the extent that the problem is the political difficulty in raising tax rates when the federal base is narrowed, more stability in the tax code would be helpful.

Goodman (1995) proposes a more far-reaching proposal: that the federal government and the states agree on a comprehensive common tax base and the federal government, in turn, would collect the state tax and remit it to the states. There would be substantial savings in tax administration as well as compliance by taxpayers and resolution of issues in the courts. But given the experience of other conformity initiatives, such as the streamlined sales tax, such a proposal seems a distant dream.

FEDERAL RESTRICTIONS ON STATES AND LOCAL TAXING AUTHORITY AND OTHER TAX-RELATED MANDATES

The final category of federal provisions affecting state and local governments is that federal provisions that could be termed tax-related mandates. While mandates may more commonly be thought of as spending requirements, since 1997, following the passage of the Unfunded Mandates Reform Act of 1995, federal legislative changes relating to state and local taxes are included in unfunded state mandate lists prepared by the Congressional Budget Office. Most of these provisions involve restrictions on state and local taxing authority. Some restrictions are explicit, such as the federal provision enacted in 1998 and extended in 2001 and 2004, disallowing new taxes on Internet access and multiple or discriminatory taxes on electronic commerce. This legislation had a complicated set of grandfathering provisions, exceptions, and issues, discussed in detail by Maguire and Noto (2007). For example, there were concerns that telecommunications via the Internet would be taxed, while those through other forms, such as cable, would not, resulting in an exemption for telecommunications.

This issue was also discussed in conjunction with concerns about sales and use tax collections on interstate sales through the Internet. The limits on the ability of states to collect sales tax from out-of-state sellers derive from court decisions, but proposals have been made, although not enacted, to permit collection for states that adopted the proposals under the Streamlined Sales Tax Project (SSTP). The SSTP would provide a uniform base and rate and make compliance by the firms easier. Bills introduced in this area (S. 2152 and S. 2153 in the 109th Congress) have had mixed benefits to state and local governments as they also make changes in other telecommunications taxes that might lose revenues.

Another issue related to taxation of out-of-state sellers is allowing states the ability to impose other taxes such as business activity taxes (largely corporate income taxes). Some federal legislation exists on the issue of extending taxes to out-of-state firms, dating from 1959 (see discussion in Faber (2006)), which defined certain actions that did not constitute nexus for purposes of sales of tangible personal property. Legislation was introduced in the 109th Congress (H.R. 2956 and H.R. 2721) to extend the treatment restricting nexus for sales of personal property to services and make other specific changes (Maguire, 2007).

The issues surrounding remote vendors and Internet sales are complex and beyond the scope of this paper, but one argument made by Mazerov (2001) is that the Internet access tax moratorium signals that Congress will not help with the fundamental problems of sales over the Internet and competition with "Main street" firms and will encourage "click and mortar" firms that have both regular stores and Internet operations to find ways of avoiding tax.

Federal restrictions were also imposed in 1995 (Faber, 2006) to prevent states from taxing pensions of non-residents earned in the states. This provision was clarified and extended to retirement income of partners in 2006.

Other studies cited in Faber (2006) have chronicled a variety of federal restrictions on state taxes. As indicated above, from 1997 to the present, CBO has been required to track unfunded mandates for state and local governments and indicate their significance, with tax restrictions included in the unfunded mandate definition. A brief review of these tax-related mandates provides an illustration of the kinds of interventions made by the federal government. Only two, in addition to the Internet provisions described above, were significant enough in size to exceed the threshold required in the Unfunded Mandates Act (slightly over $62 million per year in 2006). One provision, enacted in 2006, which is not a restriction on taxing authority but an administrative change, required that, beginning in 2011, all governments (federal, state, and local) impose a tax withholding of three percent of payments to their vendors and contractors. This provision was stimulated in part by a Government Accountability Office (2004) study that indicated many federal contractors had tax debts. This provision had been proposed in the Joint Committee on Taxation's Options (2005) report and was added in the conference agreement.

This change resulted in protests by state and local government organizations, particularly the National Association of Counties. Several issues, in addition to a general complaint that this provision was an unfunded mandate, were outlined in a National Association of State Budget Officers (2006) issue brief: administrative costs to the state and local governments, application limited to the public sector, lack of consultation, perceived need arising from a study of federal and not state and local contracts, inflating bids by three percent to cover additional costs, complexities regarding application to purchasing cards, and lack of detail. Since this provision was a withholding provision, that is, an advance payment of tax rather than a tax increase, the complaint that bids would have to rise by three percent is less than compelling. For a compliant contractor, the additional cost would be foregone interest on a tax payment which, because of estimated tax return rules, should have required relatively quick payment in any case, the additional cost to contractors should have been negligible. Thus, costs would have only risen by three percent if virtually all of the contractors were avoiding or delaying payment of federal (and presumably state and local) income taxes. Similarly, the argument that the instances of abuse related to federal contracts does not seem persuasive; only federal contracts were studied, but there is no reason to believe that lack of compliance did not also exist for state and local contractors. Some of the other arguments appear to have merit. Legislation has already been introduced to rescind this provision.