Pre-emption: federal statutory intervention in state taxation.

In 1959, the Supreme Court (Northwestern States Portland Cement Co. v. Minnesota) determined that a state could impose income taxes on a corporation if it solicited sales there, irrespective of whether it engaged in any production activities, owned any property, or employed workers In the state. Within months, Congress passed PL 86-272, which prohibits a state from levying such taxes on a corporation if it is only involved in the solicitation of sales for tangible products within the state and if such sales are filled by deliveries from outside the state. This law, thus, allows a corporation to sell its tangible products in a state without exposure to the state's corporation income tax.

PL 86-272 implies a significant restriction on state taxing powers, all the more so as states have moved toward reliance on apportionment rules in which sales are the main determinant of the taxable share of corporate income. The fact that the statute mentions only tangible products presents a special complication, as it leaves open the possibility that states can tax the incomes of corporations that derive revenues from intangibles, such as royalties, even if they have no physical connection with the state. Indeed, the Supreme Court of South Carolina has specifically ruled that such taxes are permissible (Geoffrey Inc. v. South Carolina Tax Commission, 1993). The economic consequences of this asymmetric treatment of tangibles and intangibles are potentially quite significant, although this complex issue cannot be thoroughly analyzed here (see Wildasin (2000, 2002), McLure and Hellerstein (2004), and references therein for further discussion). What is of particular interest for present purposes is the role of a pre-emptive federal statute. In this case, as in the sales tax case, a Supreme Court ruling had an important impact on state taxing powers. Whereas the Supreme Court imposed significant limitations on state sales taxation in Quill, it offered a seemingly expansive interpretation of state powers to tax corporation income in Northwestern States. In the latter case, Congress acted swiftly to exercise its own powers to regulate interstate commerce by enacting PL 86-272 and, thus, removing the taxing powers that the states were held by the Supreme Court to possess. Because this law referred specifically to tangible products, the current status of state taxing powers with respect to income derived from intangibles is open to dispute.

This matter could be clarified by further Supreme Court rulings, although such rulings could presumably be superseded by additional congressional action as happened in 1959 after the ruling on Northwestern States. Indeed, new legislation need not await further court rulings. As an example, the Business Activity Tax Simplification Act of 2003 (BATS) (McLure and Hellerstein, 2004) would have further restricted state taxing powers by limiting state corporation income taxes only to corporations that are physically present within their boundaries. Logically, legislation along these lines may be seen as a natural complement to PL 86-272: if revenues derived from the sale of tangible products do not alone make a corporation's income subject to tax within a state, it is seems anomalous for it to be taxable solely because it derives revenues from intangibles. On the other hand, logical consistency would also be served by the repeal of PL 86-272, so that states could tax the incomes of all corporations that derive revenues from any sources at all, whether tangible or intangible. The scope of state corporation income taxation depends heavily on the resolution of these issues.

CONCLUSION

As is clear from the illustrative cases discussed in the fourth section, federal statutes can have major impacts on state taxation. Sales, personal income, and corporation income taxes are three of the most important components of state tax structures. The ability of the states to utilize each of these taxes has been affected (or may soon be affected) in major ways by existing or proposed federal statutes. Federal pre-emption is, however, only one part of the institutional structure within which state tax systems must operate. Important court decisions have in some cases expanded and in some cases restrained the scope of state taxing powers. In some instances, court decisions have triggered contrary federal legislative action (PL86-272), while in other cases Congress has been willing to accept the impact of judicial rulings (Quill). Perhaps stimulated in some cases by judicial rulings and, in others, by Congressional inaction, states occasionally undertake important tax coordination initiatives on their own, as illustrated by the Multistate Tax Compact and the Streamlined Sales and Use Tax Agreement. Thus, the Constitution (as interpreted by the courts), federal legislation, interstate cooperative efforts, and independent state action interact continuously against the backdrop of economic and technological change to determine how state governments are financed. This is a very complex dynamic institutional process and, for students of federalism, a deeply interesting one.

Within this institutional context, federal statutes occupy a kind of middle ground. They control the taxing powers of the states with the force of law and, once enacted, their impact on the states is inescapable. Unlike constitutional constraints, however, these statutes can in principle be altered comparatively easily should circumstances arise in which Congress would wish to do so, and new statutes can be implemented with far greater ease than amendments to the constitution or, perhaps, revisions of judicial doctrines of constitutional interpretation. (The fact that PL86-272 has not been revised in nearly a half century attests to the fact that federal statutes may, nonetheless, be very durable.) On the other hand, federal legislation is much less flexible than cooperative agreements among the states, which can be altered without Congressional action and to which state adherence is discretionary. Voluntary compacts, thus, impose comparatively modest constraints on state tax policy. Such compacts would appear to be most useful to the states when they must deal with particularly complex problems under rapidly changing circumstances, that is, when the commitment to a rigidly fixed policy entails a high risk of policy error.

The literature of fiscal federalism has identified some of the important advantages and disadvantages of decentralized government policymaking in a federation. Federal statutory controls over state policymaking provide one means by which some of the disadvantages of decentralization may be avoided or minimized without undermining its advantages. Further detailed analysis of the benefits and costs of specific statutes, such as those described in the fourth section, would be of great interest from the viewpoint of normative policy evaluation. An equally interesting challenge for future research is to understand why and under what conditions Congress elects to intervene in state tax policy matters and when it instead steps into the background, allowing other institutions--the states themselves, acting independently or cooperatively, as well as the Constitution, as interpreted by the courts--to play more decisive roles. Many contributions to the literature of fiscal federalism offer potential insight into this issue but, to the author's knowledge, it has not so far been the subject of systematic analysis by economists. Further investigation of this topic can shed important light on the development of policy in a complex and dynamic institutional context.

Acknowledgments

This paper is based on remarks presented at the Spring 2007 NTA meetings in Washington. I am grateful to the editor and to conference participants for helpful comments but retain responsibility for any errors.

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