MTC Wrong on Benefit Principle’s Application to Nexus Debate

August 20, 2007

We’ve written extensively on nexus (see here for a primer and here for more in-depth research), arguing that physical presence is a better nexus standard than economic presence, especially given the realities of the 21st century economy. With the Supreme Court refusing to hear a case on nexus earlier this year, we recently wrote that the ultimate resolution of the issue now firmly rests in the halls of Congress.

A few weeks ago, at the annual conference of the National Conference of State Legislatures (NCSL) , we got a preview of what the congressional debate will look like. Joe Huddleston, Executive Director of the Multistate Tax Commission (MTC), launched a full broadside at the concept of physical presence, opening his remarks concerning the subject by sarcastically saying “Give me a break.”

After expressing his disdain at physical presence, Mr. Huddleston did eventually give a few policy reasons why it should be rejected in favor of economic presence. He relied heavily on the fact that companies selling into a state benefit from the protections and services provided by the market state (chiefly roads and police), specifically pointing to the fact that a seller can use the courts of the market state to enforce a sales contract, and that these benefits justify the imposition of tax on the company.

I was not persuaded by his reasoning. I found four policy problems with the conclusion that companies should be forced to pay tax to a state because they get the benefit of using that state’s services, including the use of its courts to enforce sales contracts:

  • First, the benefit principle is not the chief benchmark of sound tax policy and is not listed in our principles of sound tax policy. While some economists think that it is an important policy benchmark, it is certainly not the sole benchmark. Saying that a company benefits from services in the market state says nothing about whether subjecting it to tax there would be consistent with other tax policy benchmarks like simplicity, transparency, neutrality, and growth-promotion. Accordingly, the benefit principle cannot serve as the sole justification for imposing either physical or economic presence as a nexus standard.
  • Second, the benefit principle, as articulated by the proponents of economic presence like Mr. Huddleston, proves far too much. Take, for example, a producer who ships from Illinois to a customer in Ohio. The goods are shipped through Indiana, benefiting from Indiana’s transportation system and potentially benefiting from police protection if the goods are stolen in Indiana. If Ohio gets to tax the producer’s income because it provides police, roads and courts, shouldn’t Indiana also get to tax producer’s income since it provides police and roads? In the 21st century integrated economy a number of states provide services that benefit common commercial transactions. If the benefit principle is the sole benchmark then shouldn’t all those states get to tax the producer too? There could be a theoretical reason why the benefits a market state provides would allow them to tax producers but not other states that give benefits to producers, but so far no proponents of economic presence have articulated them.
  • Third, it is speculative to say that a producer will use courts in the market state to enforce a sales contract, or that a producer will use police services when it ships goods to the market state. These things may happen but they are far from certain. Why, then, should speculative benefits “count” for nexus purposes? The benefit principle typically tries to match taxes paid with actual, not speculative, benefits received. Roads are more of an actual benefit to producers, and they are typically paid for through a gasoline tax levy (though the gas tax does not perfectly capture road benefits), not a direct tax on the business itself.
  • Finally, the physical presence rule itself is actually a better way to tax producers based on the actual benefits they receive from state and local government services. The state in which the producer is physically located is providing a number of actual benefits to the producer for which it can, under the benefit principle, require taxes paid in return. All other states, including the market state, provide either speculative benefits or actual benefits (e.g. roads) that are paid for through the levy of other taxes.

All told, though, Mr. Huddleston didn’t seem very interested in having a policy debate about nexus. It seemed like the idea of physical presence was so outrageous to him that he could not engage in a serious policy discussion about it. While this does not bode well for the tenor or tone of the coming nexus debate in Congress (the MTC is an influential voice in Congress on state tax issues), it does provide further evidence that only Congress can solve the nexus issue in a rational way.


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