Academic journal article Northwestern University Law Review

Tax Cannibalization and Fiscal Federalism in the United States

Academic journal article Northwestern University Law Review

Tax Cannibalization and Fiscal Federalism in the United States

Article excerpt

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Introduction

It has long been recognized that the design of federal tax law strongly influences state tax policy choices.1 What has not been appreciated is how the current structure of federal tax law incentivizes state governments to adopt tax policies that inflict costs on the federal government, at the expense of national welfare.2 In other words, the federal government currently incentivizes state governments to adopt tax structures that literally devour the federal government's tax revenues. To date, there has been little appetite for reform. 3

This Article's explication of the tax cannibalization problem builds on recent economics literature on vertical externalities. The economics literature has used the term "vertical externalities" to indicate when some of the costs or benefits of a state-level tax policy decision affect the federal government rather than the state making the tax policy decision (or vice versa).4 Over the past two decades, economists have developed several theoretical accounts of vertical externalities.5 Yet this economics literature has primarily focused on the questions of whether different tiers of government tax too much or too little and promote too much or too little distribution.6 The economics literature has not as of yet analyzed the implications of vertical externalities for the important, more designoriented questions of what state governments choose to tax or how state governments structure and implement their tax systems.

Likewise, the prior tax legal literature contains only limited discussion of how vertical externalities might result in tax cannibalization; the literature has instead focused on questions related to whether different tiers of government tax too much or too little and promote too much or too little distribution.7 Thus, neither the prior tax legal nor the economics literature has analyzed the implications of vertical externalities for critical questions related to how the design of federal tax law biases state governments' tax policy decisions.8 This Article begins to fill that gap.

In theory, the tax cannibalization problem may occur whenever state governments and the federal government levy taxes on overlapping tax bases. We demonstrate that the tax cannibalization problem currently does occur with respect to state-level taxes on corporate income and capital gains, and possibly also ordinary income.9 Specifically, we show that state governments' current top tax rates on these bases impose large, wasteful costs through tax cannibalization.

Extrapolating from the existing empirical literature, we develop a model showing that a typical state's top corporate income and capital gains tax rates generate surprisingly large economic waste.10 We propose federallevel reforms that could eliminate much of this economic waste while still maintaining the current levels for state governments' revenues and distribution. Through enacting these reforms, the federal government could produce a "win, win, win" for the federal government, state governments, and taxpayers.

Let us now briefly elaborate the nature of the tax cannibalization problem with an example of state-level corporate income taxes. State-level corporate income taxes are currently vulnerable to a variety of distortionary responses that shrink the states' corporate income tax bases. These distortionary responses include various forms of tax avoidance and tax gaming. It is useful to divide these distortionary responses into two conceptual categories.

The first conceptual category consists of distortionary responses that involve taxable activity relocating to other states. We label this category as "horizontal distortions." Because horizontal distortions involve taxable activity relocating across state lines, but remaining within the United States, horizontal distortions do not necessarily shrink the federal government's corporate income tax base. …

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