It's standard these days to say that most issues shouldn't be decided in Washington, D.C. Both major party platforms in the last election emphasized the virtues of local control, and the phrase is a mantra for many in the Bush administration. Notwithstanding the ignoble history of states' rights and all the social progress brought by national power, it's clear that local is in and national is out.
But even if one thinks it's important to preserve state independence, the states themselves should be concerned about being cut loose. Consider the recent brouhaha over the unexpected ripple effect on the states caused by Congress's revision of the federal estate tax. As the National Governors Association said in protest, the changes "would cut states' share of revenues from the estate tax at a time when most states are facing budget cuts." The dispute nicely illustrates the interdependencies between states and the national government, and why strict separatism may burden states more than it benefits them.
To understand the controversy, a bit of background is necessary. For much of the nation's history, estate taxes were the exclusive domain of states. They were even used as a way of competing for wealthy individuals -- states seeking rich residents adopted constitutional amendments promising no estate tax liability.
In 1916, facing an increasing need for new revenue as America prepared for World War I, the federal government sought to tax transfers of property upon the deaths of its citizens. Not surprisingly, state officials did not take kindly to the federal intrusion. But they came to think otherwise when, in 1926, state and federal officials reached what is known in estate tax circles as the "Compromise." The federal government allowed states to take most of the first "bite" out of estate tax liability by permitting taxpayers to credit, within limits, the state death tax payment against their federal estate tax liability.
The Compromise largely ended the old interstate rivalries; with everyone subjected to the same national system, and a federal credit for taxes owed locally, states no longer had much incentive -- or leverage -- to duel.
Indeed, most states now limit their residents' estate tax liability to the maximum credit the federal rules allow for state death taxes -- so the state death tax doesn't add to a taxpayer's total tax liability, and the state and federal governments split the revenues. This form of the state death tax, known not so affectionately as a "sponge" tax (because it is specifically tied to the federal credit amount), exists in 38 states (including Maryland and Virginia), and the District of Columbia.
The states soon realized that a federal estate tax had other benefits. By "piggybacking" off the federal levy, states could rely on the feds for collection and enforcement. It turned out to be a good deal for the states: They got tax revenue without substantial administrative costs and without incurring the political wrath of their residents. For decades, the tax money has rolled in. In many states, it comprises between 2 and 4 percent of total revenue. That's a large chunk of change.
The new tax law (its official title is the "Economic Growth and Tax Relief Reconciliation Act of 2001") dramatically changes that relationship. It reduces the credit for state death taxes by 25 percent in 2002, 50 percent in 2003, and 75 percent in 2004, then repeals the credit entirely in 2005. The timing of the changes particularly galls the states. The new law stops the flow of death tax revenues through the state credit in 2005, while the federal estate tax remains in place until 2010, when it is repealed for one year. That means that for years 2006 through 2011, revenue that once would have partly gone to the states now goes entirely to the federal government. Through this clever maneuver, and over the objection of the governors, states must now effectively shoulder about one-quarter of the revenue cost of paring back and repealing the federal estate tax.
Now if one really believes in separate spheres, the states should have no cause for complaint. The feds can tax as they wish, and so can the states. Neither is obliged to the other. State governments regain the control they lost decades ago.
That may be a fine theory, but, in practice, separatism in estate taxing will make the states big losers -- to the tune of somewhere between $50 billion and $100 billion over the next 10 years, according to the National Governors Association's estimates. And while states could go back to the pre-1916 world of exclusive state estate tax regimes, that would be politically costly in the extreme and much more difficult administratively.
This interdependence between federal and state government extends to a wealth of other taxes and programs. Many states piggyback off federal rules and calculations for determining state income tax liability for individuals and corporations. Often, a change in the federal income tax substantially changes the relative tax burdens of residents of different states. That happened in 1986, when Congress repealed the federal deduction for state and local sales taxes. And the train runs both ways: For example, the wholesale adoption by the states of "limited liability companies" statutes significantly changed the landscape for federal taxation of businesses that are not publicly traded.
The dispute over the estate tax shows that the call for exclusive state and federal domains is simplistic and unrealistic. In too many areas, states and the federal government are inevitably and beneficially dependent upon one another. Proponents of local control too often forget this point. Indeed, that is part of what's so troubling about the Supreme Court's recent efforts to protect states. The court, too, wants to distinguish, as it puts it, between "what is truly national and what is truly local," and has struck down a number of federal laws as a result. States should be wary of such separatist logic.
Consider the case that started the Court's recent federalism floodtide: New York v. United States. That legal dispute arose because only a few states had allowed the creation of low-level radioactive waste sites. These states rightly feared that other states would send their waste to them; under federal law, they could not discriminate against out-of-state waste or enter into interstate compacts without congressional approval. Congress, at many states' request, responded by requiring each state either to store waste generated within its borders or to contract for storage in other states. New York officials contended, however, that Congress could not impose such a requirement. In 1992, the Supreme Court agreed, striking down the statute in the name of protecting state autonomy. But it's a strange notion of state autonomy that limits the federal government's ability to protect some states from the irresponsible actions of others.
The point is simple: National power is as much a component of state power as a threat to it. So while it's all well and good to talk about local control, it's not wise to think of a nation divided into neat spheres of federal and local authority. And if you are inclined to think otherwise, just ask the states' governors. Thanks to the new administration, they have a separate sphere of taxing power to themselves, and they don't like it one bit.
David Barron is an assistant professor at Harvard Law School and co-author of a casebook on state and local government law. Eric Zolt is director of the International Tax Program at the law school and a visiting professor.