Last week, the New Jersey Tax Court ruled that the state could proceed with its efforts to skirt federal protections and impose business taxes on out-of-state internet sellers. At first glance, that may seem like another dry decision for tax nerds to argue about in the niche publications we silo them into for the protection of polite society. But at its core, it is a manifestation of a fundamental vulnerability in our system of government that gets at why, today, we refer to a Constitution and not the Articles of Confederation.
That may sound a tad overwrought. Yet ever since we kicked out the last Redcoat, we have grappled with a recurring problem of governance: how do we have a federalist system without allowing states to play out the tragedy of the commons? In other words, how do you stop states from taxing each other’s residents to the detriment of the country at large?
After all, politicians get rewarded for spending money and punished for taxing their constituents. Taxing people who are not your constituents and using that revenue to spend money on people who are is like a political cheat code.
The Interstate Income Act of 1959
Aside from the Constitution itself, which came about in no small part due to widespread recognition of the need to prevent destructive interstate trade wars and tariffs, one of the most significant restrictions on states’ ability to do this is the Interstate Income Act of 1959 (sometimes called P.L. 86-272). It is a federal law that is about as straightforward as a tax law gets: essentially, it prohibits states from imposing income taxes on out-of-state businesses solely because they solicit orders and ship products into that state.
Counterintuitively, this is a protection that is not very important to retail giants like Amazon or Walmart, which have enough nationwide presence that they have tax liability all around the country whether the Interstate Income Act is in force or not. Moreover, they have enough resources and in-house accounting expertise to handle filing and paying taxes nationwide.
Small- to medium-sized businesses, do not. The internet can be a tremendous boon to small online sellers, allowing them to reach customers all over the country. If that means requiring them to be just as familiar with the quirks of New Jersey’s tax system as their home state’s, that’s a problem. It’s an existential one if you add in 40+ other states’ tax systems, not to mention local jurisdictions.
Unfortunately, New Jersey is not the only state pushing forward with these aggressive efforts to get around taxpayers’ protections under federal law. States like California, Massachusetts, and New York have all undertaken similar efforts, and small businesses face similar threats and challenges in the sales tax realm.
The list of states most prone to try to tax nonresidents is, not coincidentally, nearly identical to the states that lose the most residents to interstate migration. States experiencing a persistent exodus due to uncompetitive tax policies are reacting not by trying to become more competitive, but by trying to tax more people who live elsewhere.
A central theme of the work we do here at NTUF’s Center for State Competitiveness is monitoring this trend and trying to keep it in check. Overtaxed taxpayers in tax-happy states have one recourse: leaving. When states can tax them even after they do that—be it in the form of taxing nonresident businesses, pied-à-terre taxes, wealth taxes, exit taxes, or anything else—taxpayers lose even that means of making their voices heard.
But states that are migration winners need to recognize that this push toward taxing more nonresidents is ultimately going to hurt them more than help them. After all, if states can tax taxpayers anywhere in the country, the advantage of competitiveness will be minimized.