Pre-emption: federal statutory intervention in state taxation.

Whereas the Constitution and federal statutes may place limits on state taxes, states may also relinquish taxing powers voluntarily through participation in agreements with other states. The Multistate Tax Compact (MTC) illustrates how such agreements can provide policy coordination mechanisms for the states when they so desire. The MTC, established in 1967, came into effect upon its adoption by seven states, and it has by now a total of 47 participating states. (2) Through the work of its Multistate Tax Commission, it facilitates common approaches to tax policy and administration, for example by promoting the familiar three-factor apportionment formula in the taxation of the income of multistate corporations. Because participation in the MTC is voluntary, it does not restrict state tax policies as strictly as federal statutes or the Constitution. As discussed in the next section, voluntary arrangements have both advantages and disadvantages relative to more binding forms of control over state tax policies.

Although the present paper focuses on federal statutes that affect state tax policies, it is worth bearing in mind that state constitutions and statutes define and regulate the taxing powers of local governments. Limitations on local property taxation, of which Proposition 13 in California is a famous example, are found in many states. Local governments in some states are authorized to collect taxes on the earnings of workers and on the profits of corporate and noncorporate businesses, whereas such taxes may not be permitted in other states. (3) In general, states may grant localities as much or as little "rate" and "base" autonomy as they wish--always subject, however, to oversight by the courts. Indeed, judicial interventions in local taxation can be extremely significant; in many cases, court decisions have mandated state legislative action leading to major restructuring of school finance systems. In one notable instance, a Missouri school finance case (Missouri v. Jenkins) led to a federal judicial override of state constitutional limitations on local property tax rates, found to be incompatible with the court's desired remedies for deficiencies in local schools (O'Leary and Wise, 1991). As evidenced by the rich literature on the impacts of property tax limitations, state limitations on local taxes (and the court decisions that in some cases may have brought about these limitations) may have far-reaching and possibly unanticipated consequences, affecting not only local expenditures but also the division of financing and expenditure responsibilities between states and localities (Silva and Sonstelie, 1995).

State control over local taxation is not examined further here, but this subject warrants further research attention. As the above brief remarks show, judicial and statutory controls over the fiscal policies of local governments pervade the U.S. federal system and are by no means confined to federal government control over state government policies. Systematic study of state-local statutory and constitutional fiscal regulation could shed significant light on the general federalism issue of higher-level government control over lower-level government fiscal policies.

THE PROS AND CONS OF POLICY AUTONOMY IN A FEDERATION

Constitutional constraints, federal legislation, and voluntary interstate agreements are alternative mechanisms that limit state government policymaking autonomy. Such restrictions have potential advantages as well as potential disadvantages. As discussed in the literature of fiscal federalism, decentralized policymaking in a federal system offers the potential for more efficient policy choices than those that would be chosen by "central planners" or higher-level governments. (4) In brief, the potential economic advantages and disadvantages of fiscal decentralization are not dissimilar to those of economic decentralization in general. Decentralized decisionmakers assess the benefits and costs of their actions in the light of the specialized information at their disposal, not necessarily available to higher-level decisionmaking units, and are motivated by the relatively narrowly focused interests to whom they are responsible rather than by a more diffuse responsibility to "society at large." When state and local government decisionmakers formulate fiscal and other policies, they are expected to be relatively highly attentive to the benefits and costs that those policies entail for the constituencies to which they are responsible, a focus that can lead to improved efficiency of decisionmaking from the viewpoint of society as a whole when the social benefits and costs of these policies are closely congruent with the benefits and costs to the residents of these states and localities. Decentralized decisionmaking may be relatively inefficient, however, when lower-level decisions generate significant costs and benefits for the broader society. In such cases, constraints on subnational government policy autonomy may enhance the overall efficiency of the federal system. As a classic illustration, state government interference with the free flow of interstate commerce, prohibited by the Commerce clause, could damage the national "common market" within which households and firms carry out their economic activities.

These basic considerations provide a framework for assessing the potential advantages and disadvantages of federal statutory controls over state tax policies. In cases where there is little reason to expect a state's policies to produce important consequences beyond its boundaries, whether favorable or unfavorable, the fundamental rationale for federal intervention is weak. When state policies produce significant external benefits or costs, on the other hand, corrective interventions may be useful. Note, however, that corrective actions need not entail federal pre-emption of state taxes or, indeed, any federal action at all. Formal and informal cooperative agreements among states provide one way in which socially beneficial or harmful policies may be encouraged or discouraged without any federal action at all. These agreements may be viewed as the federalism equivalents of Coasian negotiations and bargaining to internalize externalities (Coase, 1960).

Of course, as recognized by Coase, bargaining is a costly process, perhaps so much so that advantageous bargains sometimes cannot be struck. For instance, an interstate agreement to simplify the administration of sales taxes by limiting the number of commodity categories subject to exemptions or other special treatment and by establishing shared definitions of the commodities that fall into these categories could ease administrative and enforcement burdens throughout an entire federation. Arriving at such an agreement may be infeasible, however, if states haggle endlessly over fine distinctions of comparatively slight importance. In such instances, federal action may be needed to induce the states to adhere to a new and more efficient policy.

Federal inducements to the states take several different forms. Constitutional constraints are the most durable and inflexible of these. Pre-emptive federal statutes, though legally binding upon the states, can be amended or removed with much greater ease than constitutional constraints and can provide much more specific policy guidance than broad constitutional principles. Federal fiscal inducements, such as intergovernmental transfers, offer still another means through which state government policy-making can be influenced. Although intergovernmental transfers are not often viewed as mechanisms through which state tax policies are "regulated," transfer programs certainly may affect the levels and types of taxes chosen by recipient governments. In particular, formula-based grants that depend upon the "tax effort" or "tax capacity" of the recipient government create quite explicit incentives to alter tax policies.

Federal statutory restrictions on state taxes, thus, are one mechanism among many through which imperfect decentralized tax policymaking by state governments can potentially be improved. Along a spectrum that ranges from the least-coercive mechanisms, notably voluntary interstate agreements, at one end, to the most powerful of all mechanisms, constitutional constraints, at the other end, pre-emptive federal statutes occupy a middle ground. In cases where state-level policy choices produce significant spillover effects but the costs of coordination among the states are high, statutes may help the states to realize policy outcomes that are socially preferred but not attainable through the operation of the "invisible hand" of purely decentralized policymaking. Federal statutes can impose costs of their own, however, since they may produce policies that do not reflect the heterogeneous benefits and costs of policies in different states--the usual potential drawback associated with centralized policymaking. For this reason, federal pre-emption may be of greater value when it takes the form, as it typically does, of general procedural specifications (e.g., avoidance of double taxation, or general exemptions for classes of taxpayers) rather than detailed specifications of state tax policies (e.g., income tax rates cannot exceed 15 percent, or must be at least five percent). The latter, highly detailed policy specifications would destroy important features of state fiscal policy autonomy and would limit interstate variation in policies in response to the unique assessments of benefits and costs in individual states. Poorly designed and overly restrictive federal statutes can do more harm than good.