Pre-emption: federal statutory intervention in state taxation.

Constitutional constraints on state powers may also facilitate socially preferred outcomes. However, the stakes are much higher in this context, since the Constitution is much more difficult to amend than federal statutes. The consequences of policy errors at the constitutional level are highly durable. The same is true, though to a somewhat lesser degree, of judicial decisions based on constitutional interpretations. In general, these can only be altered by explicit constitutional amendments or by the slow process of revision of judicial opinion through sequences of litigation that sometimes culminate in important new constitutional interpretations. Constitutional constraints like the Commerce Clause provide durable commitments to fundamental principles and, thus, may be of immense value. Constitutional provisions that provide (or are interpreted to provide) detailed policy specifications risk the loss of benefits from decentralized policymaking and the imposition of the costs associated with policy centralization in the same way as federal statutes, only to a greater and more persistent degree.

To summarize, then, federal statutes may be most beneficial when they help states to solve coordination problems, enabling them to achieve desired policy outcomes that are not attainable either through completely decentralized policymaking or through voluntary cooperation among the states. Such statutes limit the policy autonomy of states, however, and, thus, can interfere with the potential gains from decentralized policymaking. The costs of federal statutory constraints that prescribe state tax policies in highly specific detail are likely to be much greater than those that reserve significant policy discretion for the states so that they can continue to adapt policies in response to ever-changing local conditions. By comparison with statutory interventions, constitutional constraints and their judicial interpretations entail still greater departures from decentralized policy autonomy.

These brief observations are intended merely to provide an overall perspective for the analysis of federal pre-emption of state tax policy. By no means do they provide a complete normative foundation for the formulation or evaluation of such pre-emptive statutes. Rather, they are intended to convey some insights from the economics of fiscal federalism that can contribute to a better understanding not only of the normative foundations for federal pre-emptions but of the use of such pre-emptions in practice. Let us now consider some specific instances of such statutes.

STATE TAXATION OF CONSUMPTION AND INCOME

This section discusses three important cases in which state taxing powers depend importantly on constitutional or legislative constraints. The first case concerns state taxation of sales by out-of-state vendors to in-state purchasers. The second case concerns the taxation of distributions from pensions and other forms of retirement savings under state personal income taxes. The third case concerns state taxation of the income of out-of-state corporations. In each case, federal statutes with important consequences for state tax policy have been enacted or are under consideration.

Sales and Use Taxation

Increased utilization of internet-based technologies for retail sales has focused new attention on state sales and use taxation. The US Supreme Court, in Quill Corp. vs. North Dakota (1992), held that states could impose sales taxes only on vendors physically present within their jurisdictions. This determination left states with the second-best alternative of relying on use taxes, imposed on purchasers, to tax mail-order and other interstate transactions. The increased convenience of such transactions afforded by new technologies gives rise to the potential for substantial losses of sales tax revenues. Some version of a "Streamlined Sales and Use Tax Act" (see McLure and Hellerstein (2004)) may offer the states an opportunity to tax sales more efficiently by providing explicit Congressional authorization for the imposition of state sales taxes on interstate transactions. At present, a number of states have joined the Streamlined Sales and Use Tax Agreement (SSUTA), a multi-state compact that aims to establish a workable framework for the enforcement of sales taxes on remote vendors. As of January 2007, 15 states (with a combined population of about 57 million residents) were full members of this compact and another six (total population of 24 million) were associate members, a level of participation that indicates substantial but less-than-unanimous state interest in this initiative (NCSL, 2007). Under the terms of this agreement, states establish low-cost administrative mechanisms through which taxes are collected on remote vendors at rates and with remittances corresponding the states in which purchasers are located, that is, on a destination basis.

There are several potential benefits to the states from adherence to such an agreement. Perhaps of greatest interest to state policymakers, such cooperation might allow states to obtain additional revenues by taxing transactions that presently escape taxation. From the viewpoint of policy evaluation, this is actually a somewhat secondary consideration, since the extra revenues could instead be obtained by raising tax rates on the existing sales and use tax bases or from other sources, just as any additional revenues that may be obtained from state cooperation in sales tax administration can be offset through the reverse of these actions. More important, from a policy viewpoint, is the effect of such an initiative on the efficiency and distributional effects of state sales taxes. The key potential benefit arises from avoidance of the distortions of economic behavior resulting from different effective rates of sales and use taxation. At present, this effective tax differential (attributable to low rates of use-tax compliance) provides households and firms with fiscal incentives to shift transactions, otherwise subject to sales taxation, to forms that are subject to use taxes. These fiscal incentives do not reflect underlying economic benefits and costs and, thus, produce economic inefficiencies. In addition, in order to simplify compliance and administration of sales taxes, the SSUTA aims to establish convenient technologies that would allow vendors to apply and remit appropriate taxes on sales to dispersed purchasers, potentially reducing the costs of sales tax administration in general. From a distributional viewpoint, successful implementation of a SSUTA would reduce the horizontal inequities that presently arise from differences in effective rates of sales and use taxes.

The emergence of the SSUTA illustrates the interplay between different institutions in the US federation. The Constitution, as interpreted by the Supreme Court in Quill, dictates that state taxing powers are limited in important respects. The states, through voluntary cooperation, may arrive at a mutual adjustment of their historically diverse sales tax regimes (including the local sales taxes that many states permit), which would facilitate the establishment of a nationwide sales tax administration mechanism that obviates the distortions arising from differentials in effective sales and use tax rates. Congressional action would apparently be required to implement any such agreement, since it would authorize the states to enforce tax collections on transactions involving remote purchases. (5) Indeed, Congressional action could authorize state taxation of transactions involving remote vendors even in the absence of any such prior interstate agreement.

However, the search for sales tax simplifications agreeable to all or many states, as embodied in the current or possible future versions of the SSUTA, promises to lower the administrative and enforcement costs that have figured prominently in Supreme Court decisions concerned with the burdens imposed by state taxes on interstate commerce. Interestingly, proposed Congressional legislation--e.g., the Sales Tax Fairness and Simplification Act (S.2152) and the Streamlined Sales Tax Simplification Act (S.2153), introduced in the 109th Congress--would enable the implementation of the SSUTA provided that sufficiently many states enter into the agreement. Such provisions in effect make the Congress into a "delegated enforcer" of state government policies, highlighting the role of Congress as a coordination mechanism for the states, as discussed in the third section.