State Tax Shelters and U.S. Fiscal Federalism

Over the past two decades, litigation has exploded over state corporate tax shelters. In the typical transaction, taxpayers devise corporate structures so as to shift income (most commonly income from intangible assets) to low or no tax jurisdictions. Much of the literature on these transactions has focused on whether and how states should combat corporate tax avoidance behavior. State courts across the country have opined on various tax shelters, and Congress has considered legislation restricting the states' authority to tax income from these transactions. This essay takes a somewhat different perspective, situating the problem of state tax shelters within the broader context of optimal design of institutions of fiscal federalism. Viewed through that lens, state corporate tax shelters are better understood not as tax avoidance schemes (or, rather, not merely tax avoidance schemes) but rather as a symptom of our flawed intergovernmental fiscal structure. State tax shelters are just one manifestation (and not the most serious manifestation) of the difficulty of taxing corporate income in a multijurisdictional setting. At the same time state tax shelters have proliferated, revenue from state corporate income taxes has fallen off sharply, but for reasons going far beyond the shelter phenomenon. The core problem is one of tax assignment - i.e., which taxes should be assigned to which level of government? A more rational approach, consistent with the basic principles of fiscal federalism, would be to increase federal corporate income tax rates by some small percentage and distribute the revenues generated by that supplemental corporate income tax to the states.