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

The other major provision, enacted in 2003, prevented states from imposing premium taxes on the Medicare prescription drug insurance plans. In addition to this provision and the extension of the pension provision to partners, one other unfunded tax-related mandate, of small size, was added in the Pension Protection Act of 2006. This provision allowed firms to automatically enroll individuals in deferred retirement plans such as 401(k)s, preempting state laws that require written permission to deposit earnings in a retirement plan. This idea was supported by economic research indicating that individuals were more likely to participate in an employer retirement savings plan if the default was automatic sign up. Such a provision was included in the President's Advisory Panel tax reform proposals. One provision that appeared to involve a successful compromise among state governments and business, however, was a provision to tax mobile phones based on the primary place of use (2000).

Several other smaller proposals prevented states from imposing fees and taxes, including ones on long-term-care insurance premiums of federal employees and retirees (2001), passenger facility fees (2000), Amtrak tickets (1997), and premiums for medical savings accounts (1997). Some were extraordinarily narrow: a provision preventing states from taxing individuals in the merchant marine who are operating in multiple waters but are not state residents (2000), a provision exempting payments from a fund established for the families of two officers killed in the U.S. Capitol from state gift taxes (1998), and a provision preventing taxation in the state with federal employees in Fort Campbell, and hydroelectric plants on the Columbia and Missouri rivers. These facilities border three states with no income tax--Tennessee, Washington, and South Dakota--and it seems likely that these provisions were aimed at reducing the tax burdens of these federal employees who live in states without income taxes. Finally, states were affected by a 2005 provision requiring states to conform to Internal Revenue Code Provisions involving bankruptcy, a 1999 provision imposing an excise tax on charitable recipients (which could include state and local entities) for certain abuses, a 1998 provision exempting certain native Alaskan land from property taxes (a provision that apparently mattered little since there was no state property tax and the land was not generally subject to local taxes), and the 1997 imposition of airline ticket taxes, which applied to state and local government purchases.

These provisions applied to a hodgepodge of issues, but with some constant themes: preventing states from imposing taxes on federal initiatives and dealing with multiple claimants to taxes. Most of these interventions have minor effects on state and local revenues, however.

CONCLUSION

The discussion of federal tax policy towards the states and localities reveal, as suggested by the title of this paper, both instances where federal policymakers are careful to preserve benefits for state and local governments and instances in which state concerns seem to be largely ignored. By and large, explicit subsidies for states and localities have been protected even when abuses have occurred, until those become so serious that action is required, as in the case of arbitrage bonds and private activity bonds. States continue to use general obligation bonds to engage in many activities that are essentially private in nature. Private activity bonds continue to make up a large share of federal income tax revenues lost due to interest exclusions. And, although the general sales tax deduction was eliminated in 1986, it was partially restored in 2004. That the restoration was viewed as a method of gaining votes from representatives of states without income taxes simply reinforces the importance of the states when explicit tax benefits are involved. Nor has the subsidy for state and local corporate income taxes been acknowledged, much less considered for reform.

Yet, at times, the concerns of state and local governments are given short shrift or apparently ignored entirely when the federal government is pursing other goals, including accommodating business interests, as in the case of restrictions on Internet fees, reducing the tax on dividends as a form of lowering the tax burden on corporate equity investment, dealing with abuses of government contractors, and favoring manufacturing firms through the production activities deduction. Nor has the federal government provided assistance in aiding the states in collecting their sales taxes on out-of-state vendors, although the states' hodgepodge of rules for taxable sales may be faulted in part for this outcome. In some of these cases, the implications for states were clearly discussed in the debate, but in others, they were virtually ignored.

If state and local governments are to protect their interests, a first step is greater vigilance regarding issues under discussion at the federal level that do not appear to have a direct impact. Could the states have had an effect on the debate about the production activities deduction or the choice of dividend relief rather than a corporate rate reduction? Certainly in the case of the production activities deduction, tax professionals were criticizing the provisions as providing both economic distortions and administrative complexity. The House proposal was to enact a corporate rate reduction. Could another voice have made a difference? Had state and local governments protested the proposal to require withholding on payments to contractors when the Joint Committee on Taxation included the proposal in their options package, would the provision have been restricted to the federal government?

Future federal tax legislation could continue to affect the states and localities. Unless the AMT is to affect many millions of taxpayers, it must be addressed in 2007. If left alone, more taxpayers will no longer be able to deduct state and local taxes. States could, however, be even more affected by the proposal to finance the fix of the AMT via a disallowance of state and local tax deductions, although history suggests that this is not likely to be the solution given the longstanding protection of these tax deductions. The resolution of the estate tax will also affect states. Moving to a consumption tax, as proposed in the Advisory Panels' plans, would cause a significant problem for the states in both conformity and tax administration as depreciation deductions would be replaced with expensing. We judge it unlikely that a move to a consumption tax base, although championed by many, is likely, given the dramatic transitional costs (Gravelle, 2006). Depending on which party has the political power, however, a move to further lower or eliminate taxes on dividends and capital gains seems a possibility that could increase state borrowing costs. Similarly, the administration continues to propose greatly expanding tax exempt savings accounts, which could compete directly with tax exempt bond preferences.

The current federal interest in reducing the tax gap (the difference between federal taxes owed and paid) could either harm or help states and localities. Improving income tax compliance for the federal government will also improve compliance for the states. At the same time, measures aimed at the tax gap could increase the three percent withholding level for contractors, which state and local governments opposed, and the Joint Committee on Taxation has suggested the option of requiring states to report property taxes to the IRS to increase compliance with itemized deductions. While this provision might be helpful to state and local income tax compliance, it would also impose an administrative burden on the states, with the net effects uncertain.

Acknowledgments

The views in this paper do not necessarily represent the views of the Congressional Research Service or the Government Accountability Office.

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