One Tax to Rule Them All: Rethinking Fiscal Federalism's Tax-assignment Problem

• Publication year: 2021
• Citation: Vol. 96

96 Nebraska L. Rev. 1. One Tax to Rule Them All: Rethinking Fiscal Federalism's Tax-Assignment Problem

One Tax to Rule Them All: Rethinking Fiscal Federalism's Tax-Assignment Problem

Peter A. Prescott(fn*)

TABLE OF CONTENTS

I. Introduction .......................................... 2

II. One Tax System to Rule Them All .................... 5
A. The Current System ............................... 6
B. The Proposed System .............................. 9
1. Tax Assignment ............................... 10
2. Intergovernmental Transfers ................... 13
3. Expenditure Responsibility .................... 17
C. Constitutional Viability ............................ 19

III. Analysis of the One Tax System Proposal .............. 24
A. Tax Policy Considerations ......................... 24
1. Economic Efficiency ............................ 25
2. Tax Administrative Complexity ................ 27
3. Equity ......................................... 33
B. Fiscal Federalism Considerations .................. 36
1. Tax-Specific Considerations .................... 37
2. Tax-Coordination Considerations ............... 42
3. Behavioral Economics and the Benefits of Interstate Governmental Competition .......... 50

IV. Other Alternatives .................................... 55
A. Uniform Taxpayer Nexus and Apportionment ...... 55
B. Full Uniformity Except Tax Rates ................. 56

V. Conclusions ........................................... 60

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I. INTRODUCTION

In J.R.R. Tolkien's The Lord of the Rings, the Dark Lord Sauron created the One Ring to enslave the leaders of the elves, dwarves, and humans.(fn1) On it, Sauron inscribed the latter half of this poetic warning: "One ring to rule them all, one ring to find them; One ring to bring them all and in the darkness bind them."(fn2) The intergovernmental tax system proposed here for the United States might well be described in the same way-one federal-level tax structure to "rule" (and largely replace) the fifty states' current tax structures. Because the proposed structure is centralized, it would better "find" multi-state taxpayers and it would more efficiently and effectively "bring" and "bind" their corresponding tax bases (e.g., taxable income) before converting those bases into tax revenue that would feed expenditures at the federal and state government levels.(fn3) To develop and support that proposal, this Article revisits fiscal federalism's tax-assignment problem using traditional tax policy considerations and with an eye toward reevaluating the conventional wisdom disfavoring centralized taxation in light of recent developments in the field of behavioral economics.(fn4)

Broadly speaking, fiscal federalism deals with "the vertical structure of the public sector" in order to "align[] responsibilities and fiscal instruments with the proper levels of government."(fn5) Taxes are one of those fiscal instruments, making the tax-assignment problem one aspect of the broader fiscal federalism dynamic.(fn6) In short, the tax-assignment problem addresses the assignment of taxing power and specific taxes to the proper level of government in a federal system.(fn7) While there are numerous other fiscal federalism issues (e.g., expendi-

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ture assignment and budgetary management in a federal system),(fn8) this Article focuses almost exclusively on the tax-assignment problem and only implicates those other issues when necessary to further the tax-assignment discussion.

At bottom, the proper assignment of taxes among the federal government and the fifty state governments is driven by the tradeoff between the benefits of having a centralized, uniform tax system and those created by intergovernmental tax competition in a decentralized system. The current U.S. system has centralized and decentralized aspects but tilts heavily toward the latter approach. Thus, each state is free to impose taxes that overlap with federal taxes (e.g., business income taxes) or target completely different tax bases (e.g., general sales taxes and property taxes).(fn9) The resulting mix of state and federal taxes creates a number of problems that are summarized here and explored in greater detail later. First, taxpayers are encouraged to reduce their aggregate state tax liability by rearranging activities to take advantage of variations in state taxing systems. More aggressive taxpayers may even lobby state legislators to create such tax-reducing variations in exchange for the taxpayers' agreement to move their economic activities into the state in question. Neither of these taxpayer behaviors is desirable because each involves a tax-driven distortion of the taxpayer's pre-tax activities that may result in suboptimal resource allocations. Second, the presence of fifty-one separate tax systems in the United States greatly increases aggregate tax administration costs for taxpayers and taxing authorities. For taxpayers, that lack of uniformity means more time and money spent preparing multiple tax returns, trying to understand multiple sets of tax rules, and planning to legally reduce their total taxes by navigating those rules. While the fifty-one federal and state tax administrators may be individually quite cost-effective, in the aggregate the parallel administrative operations needed to enforce their non-uniform tax systems are not. Finally, the lack of uniformity can create inequitable results among U.S. taxpayers because uneven tax systems will inevitably cause some similarly situated taxpayers to pay different tax amounts for no good reason. Furthermore, in the business arena, the uneven tax treatment from non-uniform tax systems can unfairly create competitive advantages that favor one business over another. Clearly, whatever the benefits of intergovernmental tax competition are, the costs of a decentralized tax system in the United States are considerable.

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Because there is ample reason to believe that those competition benefits are dwarfed by the costs outlined above, this Article proposes revising the United States' current multitiered taxation system to consolidate most taxing power at the federal level and to replace most state and local taxes with unconditional intergovernmental transfers that are funded out of the incremental federal-level taxes. Only real property taxes and license taxes would remain with the state governments. Note that, although one could certainly argue that the mix of taxes used in the United States could be improved,(fn10) this proposal ignores that separate and distinct issue by simply assuming that the current mix of state taxes will be consolidated with existing federal taxes (e.g., income taxes) or relocated to the federal level (e.g., sales taxes), as appropriate. From a tax-assignment perspective, this centralization is intended to improve the efficiency, cost effectiveness, and fairness of the overall tax system by increasing uniformity.

The remainder of the proposal is intended to preserve, to the extent possible, the benefits of decentralized government despite the newly centralized tax system. The broader fiscal federalism literature supports the conclusion that decisions regarding public goods and other governmental benefits should be made at the lowest level of government encompassing the benefit in question. Decentralizing these expenditure decisions should lead to the best alignment between a government's benefits and its residents' preferences for those benefits.(fn11) Thus, the proposed system retains the existing level of state and local expenditure decision-making to preserve that narrowly tailored fit of government benefits to the residents' preferences. The funds needed by the states to provide those benefits would come from unconditional intergovernmental transfers, maximizing the states' ability to customize governmental benefits without federal government interference.(fn12) While the U.S. Congress would retain the power to adjust the magnitude of those transfers, ideally the transfers should be fixed at constant amounts to increase the states' revenue stability and to better shield their provision of governmental benefits from localized economic ebbs and flows. Of course, the federal government would continue to provide its own set of governmental benefits (e.g., national defense) and would also continue to exert influence over state-provided benefits through the use of conditional intergovernmental transfers (e.g., matching federal funds for federally approved Medicaid

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services), just as it does under the current system.(fn13) Thus, the current system's customization benefits derived from decentralized governmental responsibilities are preserved and augmented by the new uniformity benefits derived from consolidating most taxes at the federal level.

Taken together, this Article's proposed mix of centralized fiscal instruments and decentralized government responsibilities delivers an improved U.S. tax system while striking the right fiscal federalism balance. Part II of this Article begins by briefly describing the United States' current federal and state tax system before providing a more detailed explanation of the proposed solution to fiscal federalism's tax-assignment problem. It closes by examining the proposed solution's viability under the U.S. Constitution. Part III analyzes and compares the proposed solution to the current system using principles drawn from the fiscal federalism literature and traditional tax policy considerations involving economic efficiency, equity, and administrative complexity. Importantly, several key fiscal federalism objections to centralized taxation, particularly when that approach is combined with decentralized governmental spending, are reconsidered in light of recent advances in the field of behavioral economics. Part III concludes with the determination that the proposed solution is an...