Lending a helping hand: two governments can work together.

INTRODUCTION

States rely heavily on the federal income tax regime; however, they also reflect their own preferences, for example, by legislating deviations from federal taxable income. These differences in taxing systems have created a compliance and administrative burden that is exacerbated by the mobility of modern businesses and individuals and by the growth in businesses that operate across many state lines. Taxpayers have to deal with both state and federal tax systems, and the burden is even greater for multi-jurisdictional businesses as they deal with several states" tax regimes. Furthermore, economic inefficiencies can arise when changes in the federal law affect states (e.g., vertical externalities) or when changes in one jurisdiction have consequences on others (e.g., horizontal externalities). (1)

The simplest way to deal with the complexity and inefficiencies is to work towards a harmonized tax system, but political and practical problems with abandoning our federalist system make that difficult and unlikely. (2) An alternative is for the federal and state governments to cooperate in a way that maintains the essential desirable elements of tax autonomy but minimizes the compliance problems and economic distortions. Little research has been done on the appropriate level of cooperative interaction between federal and state governments in setting tax policy, but improvements to the current state of affairs are possible. For example, economic savings may be achieved on the compliance side, particularly with more uniformity (Fox and Swain, forthcoming), and technology improvements open up a vast array of possibilities for cooperative tax administration efforts.

The federal government has extensive interactions with state governments and provides various types of direct and indirect assistance across a wide spectrum of tax-related activities. For purposes of this paper, these interactions can be broadly characterized in three categories--fiscal assistance, de facto cooperation, and active cooperation. We begin with a description of the goals of effective federal and state cooperation, followed by a description of existing and planned cooperative efforts in each of the broad categories of federal/state interactions, (3) discuss some promising ongoing and planned efforts, and conclude with an evaluation of the existing state of affairs and where we might go from here.

GOALS OF A FEDERAL/STATE COOPERATIVE RELATIONSHIP

An ideal cooperative relationship should strive for the following goals: provide a policy framework for decision making, preserve tax autonomy at all levels of government, seek economies of scale, minimize compliance and administrative costs, and identify and promote mutually beneficial cooperative efforts. The starting point to improving the current system is to develop an effective framework for making tax policy decisions. At a minimum, the federal government should consider the impact of any federal tax changes on the entire tax system. Changes made at the federal level are particularly important as most states use the federal tax base as their own starting point. The federal government should quantify the impact of proposed legislation on state revenues and consider alternatives when the impact is expected to be significant. For issues that affect the efficiency of the tax system as a whole, the federal government should determine under what circumstances intervention in state tax matters should take place (promote horizontal equity, prevent tax planning abuses, etc.). Furthermore, states should also consider how their tax policies could affect other states--for example by directing taxable activity to domestic "tax havens" or by facilitating other types of tax competition.

Important benefits exist for allowing states to independently levy taxes, limited only by constitutional restrictions. Therefore, steps towards a more cooperative relationship, including more uniformity, should not sacrifice the essential desirable elements of autonomy regarding the tax base and rates. Independent tax autonomy allows for decentralized government operations and can result in greater efficiency gains for service delivery. Furthermore, subnational governments are often better equipped to respond to their citizens' demands.

State and federal governments should work together to streamline the tax assessment and collection process. The ease of transmitting information around the world opens up possibilities of developing economies of scale and minimizing compliance and administration costs. Data collection and sorting requires a significant up-front investment, but once collected, the data can be shared among all interested parties quickly and accurately. Several data-sharing initiatives are ongoing, but opportunities exist for new programs.

The federal and state governments can differ on taxable bases and tax rates; however, governments at all levels share common interests in identifying non-filers, uncovering illegal tax evasion schemes, streamlining the audit process, and collecting taxes owed. Identifying these and other common interests where working together can be mutually beneficial to all parties is a key underlying goal of intergovernmental cooperation. Plans are already under way to increase joint electronic filing efforts and to streamline the audit and collection processes.

CATEGORIES OF FEDERAL/STATE INTERACTIONS

Fiscal Assistance

The federal government provides an indirect financial subsidy to the states by allowing a federal deduction for state and local taxes paid. This fiscal assistance effectively subsidizes about one-third of the state taxes paid by taxpayers in the highest federal brackets. For businesses, almost all state and local taxes are deductible by businesses as taxes or as a cost of acquiring business inputs. Currently at the individual level, income, property, and sales taxes are deductible at the federal level, but only for taxpayers that are able to itemize. (4)

The deduction / subsidy is an important benefit to subnational governments, but not without a cost. Federal tax deductibility reduces the amount of income redistribution because it decreases the progressivity of the federal income tax system. (5) Itemizers effectively pay only a portion of their state tax, with the portion decreasing as the taxpayer's marginal rate increases. Therefore, the deduction helps high-income itemizers but provides little or no assistance to taxpayers in the lowest brackets or individuals who do not itemize. (6)

The deduction also potentially creates behavioral responses. First, if deductibility does not apply uniformly to all state and local taxes, governments will have an incentive to finance public goods and services with taxes that are deductible and have a lower real cost to state and local taxpayers. (7) For example, elimination of the deductibility of state and local sales taxes with the Tax Reform Act of 19868 may have given state and local governments an incentive to raise revenues from the still--deductible income and property taxes and decrease their relative reliance on the sales and use tax. The actual experience did not follow predictions as the sales tax continued to grow (Fox, 1998). Second, prior research shows that federal deductibility of state and local taxes increases the size of state and local governments because the deduction subsidizes the net cost of financing additional state and local spending (Gramlich, 1985). The federal policy makers should consider whether favoring some taxes over others and/or subsidizing local governments is a desirable side effect of the federal tax deduction. Feldstein and Metcalf (1987) suggest that the deduction may stimulate additional spending by governments with artificially low levels of public services and may be more cost effective than federal grants.

De Facto Cooperation--The Common Tax Base

In the U.S., the de facto adoption by most states of the federal income tax base is a key element of the federal/state policy framework. The agreement on the essential elements of what constitutes taxable income makes many other cooperative efforts possible. There are important differences between the federal and state tax regimes, but all but two corporate income taxing states (Arkansas and Mississippi) and the District of Columbia use federal income as starting point for their taxable base. A similar percentage of states use the federal individual income tax base as a starting point. On most broad measures, the percentage of states following the federal lead has increased over time. For example, in 2005, 93.4 percent of states used federal corporate income as a starting point versus only 56.1 percent in 1967 (Hildreth et al., 2005).

The essential agreement on most tax-base issues allows states to rely on federal codes, regulations, cases and rulings to resolve questions of law or interpretation. Relief from the heavy lifting of legislating and interpreting the detail necessary for a modern tax on income leaves state and local tax authorities free to focus on other matters. Even those states that have a starting point other than federal taxable income utilize the federal statutory scheme to resolve important questions of law. Joint audits and cooperation between audit departments, shared professional education, bilateral data exchange, and cooperation on tax shelter reporting are all possible because the fundamentals of taxing income rely on the same basic starting point.