Replies to Questions from Rep. Steve Cohen on State Taxation and Congressional Power

June 4, 2010

Following a hearing on the topic where we testified, Rep. Steve Cohen (D-TN), the chair of the House Committee on the Judiciary’s Subcommittee on Commercial and Administrative Law, sent several questions to which he requested replies.

Below are the questions and my answers.

Questions from the Honorable Steve Cohen, Chairman

1. In your written statement, you suggested that the states hardest hit by the recession are those that relied the most heavily on certain taxes. Assuming that your assertion is correct, what would you suggest to fill the revenue void for those states which have become most dependent upon the revenues from taxes on specific taxpayers and activities?

States must decide two things when developing a tax system: (1) how much revenue it should raise, and (2) how it should raise it. Different states will answer differently; some adopt a high-tax, extensive-service model, while others prefer a low-tax, small-government model. Whichever way a state opts for the first question – important question though it is – states should raise their revenue in a way that promotes simplicity, neutrality, transparency, and stability.

Some tax policies are better than others in this regard. Broad-based sales taxes, flat income taxes on a broad base, and corporate taxes with few credits and deductions for particular industries can do less harm to long-term economic growth than narrow sales taxes, income taxes on high earners, numerous credits and deductions from a high corporate income tax, and capital gains taxes. Excise taxes, particularly the gasoline tax, are among the most stable taxes. Property taxes, despite the bursting housing bubble, continue to rise and remain stable.

In our annual State Business Tax Climate Index, available at www.TaxFoundation.org, we rank each state on over 100 different tax policies that economic analysis has led us to conclude are either favorable or unfavorable.

This formula may not help in the short-term for a handful of states, such as California, Maryland, New Jersey, and Washington State. These states and a few others have expanded their spending commitments at a unsustainable rate, often by suggesting that someone else would pay for them (high income earners, corporations, out-of-staters, etc.). A correction of their overspending is likely the key to their fiscal recovery.

2. You advocate for Congress to restrain the states from taxing certain activities which may burden interstate commerce. Ms. Kerry Korpi, who testified on the second panel at the hearing, contended in her written statement that if Congress enacts just one piece of legislation preempting the taxing authorities of state and local governments, such legislation would encourage others to lobby for tax breaks. She suggested that such tax breaks would shift costs to other businesses and individuals. Please respond.

If one assumes that the purpose of federal tax powers is to hand out favors to those with whom you empathize, Ms. Korpi’s concern is a valid one. From my perspective, however, the purpose of Congress’s power under the Commerce Clause is to restrain states from parochially harming the interstate economy. Federal pre-emption of discriminatory, intrusive, or aggressive state tax policies is both necessary and a proper role for the Congress.

Assuming that it becomes harder for states to export their tax burdens to non-residents, state finances would improve as it would require those who consumed state services to pay for them instead of passing costs off to others. Alternatively, if tax burdens are reduced to the level that residents are willing to pay for, a net reduction in taxes will occur, benefitting businesses and individuals.

Many states do not do this, of course. States have a natural inclination to avoid direct taxes on voting residents, preferring to hide taxes, mislabel them, or impose them on nonresidents or out-of-state companies. Individuals pay all taxes, whatever they are called, and taxes imposed in this matter result in less oversight and greater fiscal irresponsibility.

3. In his written statement, Mr. Robert Ward, who testified on the second panel at the hearing, posed a question for Congress to consider when reviewing legislation affecting state taxation: “Should federal policy emphasize the benefits of interstate differences, including tax competition among the jurisdictions, or should national policy focus on the benefits to be obtained from greater uniformity among the states?” Please respond.

Both. Justice Brandeis once wonderfully observed that the states are the “laboratories of democracy,” and as I previously mentioned, states are free to pursue high-service or small-government models, or anything in between, and citizens are free to vote at the ballot box or with their feet. States also compete on proximity to raw materials or transportation centers, regulatory or legal structures, quality of education systems, and workforce skills, and proper tax competition is a legitimate end to allow states with a short-term deficiency in any of these areas to level the playing field. States can impose nondiscriminatory taxes on residents and set the rates at whatever they like without suggesting any constitutional implications.

There are good kinds of competition and bad kinds, however. The problems begin to arise when states begin taxing income, sales, or economic activity that crosses state lines. States naturally seek to grab more than their fair share, and are reluctant to collaborate on even the most mundane definitional or procedural rules. There is a role for Congress in curbing the states’ worst excesses (such as discriminatory taxation against nonresidents) and encouraging uniformity in key areas involving multiple states (such as apportionment rules and nexus standards).

For example, common agreement on uniform division of income came about in the late 1950s only after Congress threatened to impose a rule that most states would have hated. (That uniformity has since withered away.)

4. Many of the witnesses at the hearing mentioned the current plight of state and local governments. They provided studies which show that current trends still show that state and local governments will not see a complete turnaround for several more years. Some suggested that Congress’s passing legislation, such as the Cell Tax Fairness Act or the Business Activity Tax Simplification Act, or other state taxation bills, would further impede the turnaround. Please respond.

First, states are not innocent in their predicament, as I’ve mentioned; additional revenue will not begin to address the worst excesses in unfunded public pension plans, inflated employee compensation and staffing, overcommitted state budget resources, and unsustainable budget growth.

Second, the revenue at issue ranges from a few million dollars to tens of millions – more than I have on me – but ultimately a drop in the bucket in the state fiscal picture. The states will not live or die depending on the revenue from taxes on online travel companies. In some cases, such as occupancy taxes on online travel companies, any revenue a locality receives is a windfall, not less revenue from what they reasonably expect.

Third, and most importantly, the fact that any state relies on revenue from discriminatory taxes or policies that export tax burdens to nonresidents should not justify their continuation. Wrong is wrong, and the states that will be hurt in the short-term are those that currently do the most damage to their sister states and to the national economy.


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