Pre-emption: federal statutory intervention in state taxation.

INTRODUCTION

The extent to which subnational governments can independently choose their fiscal (and other) policies is a critical issue in any federation. In the United States, state governments enjoy a high but not unlimited degree of discretion in choosing their tax policies. For instance, although many states have elected to impose taxes on retail sales, personal income, and corporation income, others have not. Different states define taxable personal income, corporate income, and retail sales in different ways and subject these bases to taxation at different rates. The tax policies chosen by counties, municipalities, school districts, and other local governments vary substantially among and within states. These and other variations in state and local tax policies show that subnational governments in the United States possess substantial fiscal autonomy. These governments are not, however, completely free to pursue whatever tax policies they wish. In particular, state tax policies, and the tax policies of their subsidiary local governments, must respect fundamental constraints imposed by the US Constitution, as interpreted by the courts. Furthermore, state taxes are sometimes also constrained by federal statutes. The objective of the present paper is to examine such federal statutory "pre-emption" of state taxation in general and to discuss some important specific instances in which current or proposed federal statutes do (or may in the future) affect state tax policies.

To start the discussion, the second section provides a concise overview of existing federal statutes that regulate state tax policies. It also explains some of the ways in which state tax policies are affected by non-statutory controls, including constitutional constraints. The third section discusses pre-emption within the context of the economic analysis of federalism, comparing it with some of the alternative forms of control over state taxation outlined in the second section. The fourth section analyzes the role of pre-emption in three important specific areas of state tax policy: retail sales taxation of remote vendors, the taxation of tax-sheltered retirement distributions under state personal income taxes, and limitations on the powers of the states to tax the incomes of corporations not located within their boundaries. The fifth section provides a brief summary and conclusion.

CONSTRAINTS ON SUBNATIONAL TAXING POWERS IN THE US FEDERATION

The taxing powers of state governments are subject to a number of important constraints. Some of the most fundamental of these derive from the Constitution. Others are the result of federal legislation. States may also act voluntarily to restrict their taxes, for example by coordinating their policies with other states.

The Commerce Clause (Article 1, Section 8) authorizes Congress to regulate interstate commerce. As interpreted by the courts, the Commerce Clause also means that states cannot "regulate" or interfere with interstate commerce. The precise meaning of this "negative" or "dormant" commerce clause is the subject of continuing controversy, as illustrated recently by the case of DaimlerChrysler v. Cuno, but generally it is widely understood to preclude explicit tariffs on interstate trade and other state policies that would similarly undermine free trade among the states. (1) In addition to the Commerce Clause, the exercise of state taxing powers must also respect other constitutional requirements, including the right of due process guaranteed by the Fifth Amendment.

While the Constitution places some limits on state policies, it may also grant significant policy authority to the states, even if only implicitly. It may do so, first, through the imposition of limits on the powers of the federal government, potentially leaving some scope for the exercise of state authority. Other constitutional provisions also appear to make at least some allowance for nontrivial state powers. In particular, the Tenth Amendment grants some rather ill-defined residual authority "to the states respectively, or to the people." Although judicial interpretations of the Commerce Clause, the Preamble (establishing the union of the states in order to "promote the general welfare"), and other constitutional provisions have diluted this residual authority over time, there nevertheless seems to be a general "presumption of innocence" with respect to state and local taxation, in the sense that "what is not prohibited is allowed." In practice, the states enjoy considerable "rate autonomy" in that they may freely raise or lower the rates of constitutionally permissible taxes, at least within wide boundaries. Furthermore, they possess significant "base autonomy" in that they may elect or decline to utilize specific types of taxes (on retail sales, whether tangible or intangible, on business incomes, on real and personal property, on fuels, on vehicles, and so forth). Like the federal government, they may generally define tax bases as they wish, as illustrated by the many state-specific adjustments that are commonly made to federal adjusted gross income when determining taxable income for state personal income tax purposes. The states may also obtain revenues from a wide variety of nontax sources. Indistinct though its boundaries may be, the residual taxing authority of the states granted by the Constitution evidently accommodates nontrivial diversity in state and local revenue structures.

In addition to the fundamental limitations imposed by the Constitution, state taxing powers are constrained by federal legislation. The Federation of Tax Administators (FTA) (2005) provides a convenient inventory of federal statutes regulating state taxation, identifying 28 separate laws that prohibit or restrain certain specific types of state taxation. These statutes are quite diverse, but most can be characterized as pertaining to tax situations involving either "horizontal" (interstate) or "vertical" (federal/state) intergovernmental fiscal interactions.

The "horizontal" category includes statutes that affect the power of states to tax individuals or businesses whose activities have some multi-state dimension. Several statutes govern state taxing powers for businesses or workers involved in interstate transportation or communications. For example, some of these statutes prohibit state sales/gross receipts or per-head taxes on businesses or consumers in airline, rail, and bus transportation. Others insure that the incomes of transportation workers, whose duties may take them to several different states in the normal course of their employment, may be taxed only in their states of residence. All of these statutes have the effect of limiting the ability of states to impose taxes on activities directly involved in or closely related to interstate trade. The 1998 Federal Internet Tax Freedom Act (ITFA) and its successor, the 2004 Internet Tax Nondiscrimination Act (ITNA), prohibit state governments from taxing internet access. Since internet access facilitates interstate (and global) communication, these laws can be viewed in part as attempts to prevent states from imposing taxes that could interfere with such communication and with the interstate commerce that it may spawn.

Other federal statutes apply more generally to economic activities involving interstate commerce, rather than to specific industries linked closely to such commerce. For example, Public Law 104-95, enacted in 1996, prevents states from imposing taxes on pension distributions and other deferred compensation received by former residents, such as households that move to other states upon retirement. In the realm of corporate income taxation, Public Law 86-272, passed in 1959, prevents a state from imposing taxes on the income of a corporation if its only connection with the state is that it sells tangible products there or solicits such sales. These two statutes are discussed in more detail in the fourth section below.

In addition to statutes that affect state taxation of multistate activities, there are laws that constrain their taxing authority with respect to federal government resources and policies. Several of these "vertical" pre-emptions limit the powers of states to tax personnel connected with the federal government. For example, the incomes of personnel on a military base are subject to tax in their states of residence. Other statutes limit the power of states to tax members of Congress or of federal employees generally, the activities of government enterprises, and Federal Reserve Banks. Sometimes these laws provide for exemption from state taxation, whereas in other cases they impose uniformity or non-discrimination requirements that insure that federal employees are not subjected to differentially high taxation. Another federal statute prohibits states from collecting sales taxes on food purchased using Food Stamps. This statute insures that state taxes cannot impinge upon and possibly interfere with this federally financed program.