Promoting the ability of citizens of any state to engage in interstate commerce is a fundamental goal of the United States Constitution, and retaliatory taxation theoretically advances that goal. The problem, however, is that retaliatory taxation blatantly discriminates against nonresidents of the taxing state. Such discrimination cuts in the opposite direction, making it more difficult for those nonresidents to engage in interstate commerce. Yet, retaliatory taxation of insurance companies persists and has even been deemed constitutional due in part to the Supreme Court’s nuanced interpretation of federal law regarding insurance companies. This interpretation holds that “insurance” does not fall under the purview of the Commerce Clause and thus is not a concern of traditional state tax jurisprudence that polices how states tax interstate commerce.
Retaliatory taxation might thus be said to occupy a quirky niche in the state tax world, one that is not overly concerning or impactful and that has largely escaped the attention of commentators. However, as the modern Supreme Court has consistently retreated from policing state taxation of interstate commerce, and as Congress fails to exercise its authority to do the same, states have begun to take matters into their own hands and to adopt or propose retaliatory taxation to address long-standing tax policies of other states. Specifically, in 2018 Connecticut adopted a retaliatory taxation measure designed to combat New York’s “convenience of the employer” approach to sourcing personal income. New York’s policy sources an employee’s income to New York if the employer is based there even if the employee works outside of the state, so long as the employer does not direct the employee to perform work outside of the state. New York’s policy bucks the majority approach, which sources an employee’s income to the physical location of the employee. Connecticut’s retaliatory taxation measure adopts the convenience of the employer approach, but only for nonresidents from states—like New York—that use the convenience of the employer approach; otherwise Connecticut sources income to the physical location of the employee. In 2023, New Jersey adopted a retaliatory measure similar to Connecticut’s.
This Article takes this new round of retaliatory taxes as an opportunity to consider the future of state taxation of interstate commerce from both a doctrinal point of view and a practical one. As the world and the economy continue to change—particularly as physical presence in any particular jurisdiction becomes less important in the digital age—disputes among the states about the proper taxation of interstate commerce are likely to arise. With the freedom that the states currently enjoy to tax interstate commerce, those disputes are likely to express themselves in different tax policies and retaliatory taxation.
If a retaliatory taxation measure is challenged in court, the limits of constitutional doctrine will be tested. Because the purpose behind retaliatory taxation is not protectionist, but rather to promote the ability of domestic taxpayers to engage in interstate commerce, it arguably can survive constitutional challenges under the Equal Protection Clause, the Privileges and Immunities Clause, and even the Commerce Clause and its dormant aspect. While not certain, it is fair to expect the Supreme Court to permit the states to engage in retaliatory taxation.
In the absence of congressional action, such permission effectively passes the responsibility for regulating interstate commerce to the states. Or, alternatively put, it recognizes that the states have concurrent authority with Congress to regulate interstate commerce under the Constitution. Congress’ decrees are supreme, of course, but congressional inaction would not meaningfully restrict the states’ abilities to regulate interstate commerce. Only other constitutional restrictions on state action—such as those prohibiting economic protectionism—restrict the states in this context; the states may otherwise promote the national marketplace as they see fit until Congress overrides them.
Under this position regarding state authority over interstate commerce, retaliatory taxation emerges as perhaps the best tool of the states to self-police the potentially burdensome tax policies of other states. It provides a forceful means of combating those tax policies, while also preserving the offending state’s sovereignty in taxation. It also allows the states to demonstrate consensus or, at a minimum, some level of agreement with certain tax policies. That information could be useful to other states or even federal actors if they do decide to enter the fray.
However, the use of retaliatory taxation comes at a high cost. Interstate taxpayers are subject to higher tax burdens as a result, while states enact tax policies that they do not prefer. It also invites disagreement and conflict between the states. As a result, states should use the tool cautiously. This Article will explain what retaliatory taxation is, how it might pass constitutional scrutiny, and the costs and benefits of using it to police state taxation of interstate commerce. But the theme of this Symposium is the future of state taxation, and the thrust of the Article is to provide a warning for what that future looks like in the absence of federal action to set the boundaries of state taxation of interstate commerce. The only true way to avoid a world full of retaliatory taxation (or worse) is for federal actors to take a meaningful role in preserving the national marketplace.
II. Retaliatory Taxation
The term “retaliatory taxation” can evoke strong feelings, particularly for those in a federal union such as the United States where a free-flowing national marketplace is the expectation. The United States Supreme Court has often articulated this expectation when describing the underlying purpose of the Commerce Clause as the prevention of the “economic Balkanization” of the states. Alexander Hamilton laid the ground for this expectation in the Federalist No. 7, where he described the catastrophic effects to the union and national marketplace should the states be permitted to protect their own economic interests at the expense of other states. The mere thought of states imposing taxes to retaliate against one another calls to mind this exact form of Balkanization.
With such strong expressions of antipathy towards states retaliating against each other, one might expect retaliatory taxation to exist solely in the world of the hypothetical, prevented not only by the Constitution and the Supreme Court but also by the self-interest of the people of the United States. However, this is not the case; retaliatory taxation has been in existence since at least the late 1800s, blessed by the Supreme Court as constitutional in certain contexts. And, spurred by changes in the legal and economic landscapes, some states have recently enacted new retaliatory taxation measures.
This Part describes both the long-standing and new retaliatory taxation measures of the states in an effort to offer a clear understanding of what constitutes “retaliatory taxation.” At a high-level, “retaliatory taxation” can be defined as taxation by one state of nonresident taxpayers that is dependent on, and responsive to, the tax laws of the nonresident’s home state. Retaliatory taxation is not enacted for its own sake, but rather as a tool to influence the policies of other states.
A. Retaliatory Taxation of Insurance Companies
Though the history of retaliatory taxation begins long before 1945, that year is an important one. In 1945, Congress passed the McCarren-Ferguson Act, which delegated tax authority over interstate insurance business from Congress to the states, effectively allowing the states to tax insurance companies as they saw fit without worrying about a federal override when the taxes fell on interstate insurance. In other words, the states were left to their own devices to divvy up the interstate insurance tax base. Those devices have included retaliatory taxation.
Virtually every state imposes premium taxes on insurance companies. Under these taxes, insurance companies pay some rate of tax on the amount of premiums attributable to the taxing state. The rates vary among the states, and most states have engaged in retaliatory taxation in response. To understand how a typical retaliatory taxation measure works in this context, consider a taxing state, State A, imposing a premium tax on an insurance company domiciled in State B but doing business in State A. Under its retaliatory taxation measure, State A would subject the nonresident insurance company to tax at State B’s tax rate if State B subjects insurance companies to a higher tax rate on their premiums than State A does. In other words, State A changes its tax rates on nonresident insurance companies if—and only if—their home state has a higher premiums tax rate than State A has. These provisions do not work in reverse; they do not lower tax rates on nonresident insurance companies when their home state has a lower rate than the taxing state.
Despite the fact that these retaliatory taxation measures cause the taxing state to impose higher tax rates on some nonresident insurance companies than the rates imposed on domestic insurance companies, the Supreme Court has upheld them as constitutional. Two primary grounds for the Supreme Court’s position exist, as articulated in the 1981 Western & Southern case: first, that Congress had granted the states the right to regulate and tax interstate insurance unencumbered by the federal government, and second, that these measures were rationally related to furthering the legitimate state interest in “promoting the interstate business of domestic insurers by deterring other states from enacting discriminatory or excessive taxes.”
In so holding, the Court observed that the states generally are not prohibited from trying to influence the policies of other states and viewed the retaliatory taxation of insurance companies as a tool for such influence. This characterization of retaliatory taxation proved to be important; in a later case, the Court struck down an Alabama statute that imposed higher tax rates on nonresident insurance companies than the rates imposed on domestic insurance companies. Alabama attempted to save its tax by aligning with Western & Southern and claiming that it had a legitimate purpose for its discrimination in trying to promote domestic business. The Court rejected that argument and distinguished Alabama’s tax from California’s tax at issue in Western & Southern. California had attempted to advance the interstate activities of its domestic industry by deterring excessive taxes on interstate actors whereas Alabama simply tried to create a domestic industry through excessive taxation of foreign taxpayers. Alabama had engaged in the “very sort of parochial discrimination that the Equal Protection Clause was intended to prevent.”
B. Retaliatory Taxation of Remote Workers
Retaliatory taxation has long been cabined to the realm of interstate insurance taxation. However, increased attention to the way that states tax interstate workers has caused retaliatory taxation to arise more recently in the context of interstate income taxation, particularly the sourcing of personal income.
Spurred on by the COVID-19 pandemic and the concomitant rise of remote work, a handful of states have begun to reconsider how they source personal income for tax purposes. Instead of continuing with the traditional approach which looks to the physical location of the worker to determine where the income is earned, some states shifted to sourcing income to the location of the employer. In so doing, these states claimed the income of remote workers as within their jurisdiction to tax when the workers’ employers were located in the taxing states, even though the remote workers themselves were physically located in another state. This approach mirrored the long-standing approach of New York, which is embodied in its so called “convenience of the employer” rule. That rule sources personal income to the location of the employer unless the worker is directed by the employer to work elsewhere.
These recent changes in sourcing personal income proved controversial (and remain so), leading to an immediate challenge before the Supreme Court. New Hampshire is home to many workers who are employed by Massachusetts-based employers; before the pandemic, those New Hampshirites would physically commute into Massachusetts but, after the rise of remote work, many of them no longer made that physical trek. Massachusetts changed its sourcing rules to an employer-based approach, which meant those same New Hampshirites that had been commuting into Massachusetts for work but were now logging in from their homes would continue to pay income taxes to Massachusetts on the income earned from Massachusetts-based employers. New Hampshire alleged this shift was unconstitutional and bad policy, but the Supreme Court declined to take the case, leaving the matter unsettled.
Perhaps in response to the lack of guidance from the Supreme Court both relating to the New Hampshire case and to earlier denials of similar challenges to New York’s convenience of the employer rule, at least two states have taken matters into their own hands by turning to retaliatory taxation. Connecticut and New Jersey (not coincidentally close neighbors of New York) have enacted laws that source personal income to the location of the employer for individuals working for employers in Connecticut or New Jersey if the worker’s home state sources personal income to the location of the employer. Otherwise, the personal income would be sourced to the physical location of the employee. Simply put, if a nonresident’s home state uses a convenience of the employer approach to source personal income, then—and only then—Connecticut and New Jersey will apply that same approach to the nonresident’s personal income. In Connecticut and New Jersey, the tax laws that apply to a nonresident working in the state are dependent on the sourcing rules of the nonresident’s home state.
Interestingly, New Jersey’s law also offers tax credits for New Jersians that are able to successfully challenge their tax obligations in other states. To qualify, the New Jersey resident would have to have paid an income tax to another state, be denied a refund for that payment, and obtain a final judgment from a court of that other state refunding the taxes paid on “income derived from services rendered while the resident taxpayer was within New Jersey.” In such a case, the taxpayer would normally be subject to New Jersey taxes on their income not taxed in the other state, so the bill provides the taxpayer with a refundable tax credit of 50% of the amount of taxes refunded by the other State. The purpose of this law, as articulated by lawmakers and seemingly clear on its face, is to influence the policies of other states—specifically to discourage other states from adopting the convenience of the employer approach to sourcing personal income.
C. Retaliatory Taxation as a Tool
Though the pool of examples of retaliatory taxation is fairly limited, the retaliatory taxation measures that do exist share common aspects. First, the measures apply only to nonresident taxpayers. Second, retaliatory taxation measures activate only when the nonresident taxpayer’s home state imposes taxes in a way counter to the taxing state’s preferences. Thus, retaliatory taxation measures do not necessarily have uniform effect on all nonresident taxpayers, the effect differs depending on how other states impose their taxes. Finally, retaliatory taxation measures impose the offensive provision of the nonresident’s home state’s law on the nonresident. The limited application of retaliatory taxation measures to only nonresidents from states with offensive taxes (to the retaliating state) and the tying of the retaliation to the actual laws of the other state indicate that a major—if not primary or only—goal of retaliatory taxation is to influence the policies of other states regarding interstate actors.
Because the states are co-equal sovereigns within the federal union, State A is unable to directly change the policies of State B. State A might seek congressional action or a federal judicial decision to limit State B’s policies that affect interstate actors, but if the federal government does not act, State A’s options are limited. Retaliatory taxation may be one of the few options State A has to affect policy in State B. If State A disagrees with the tax policy of State B applying to interstate actors, then imposing the tax policy of State B on State B residents who are engaged in interstate commerce serves as a tool to force State B to reckon with its tax policy.
The core of the tool is political accountability. By exposing State B residents to the full extent of their state’s policy, State A lawmakers might spur policy changes in State B through pressure from State B’s voters. If those State B residents agree that State B’s tax policies are too burdensome on nonresidents and the State B law is changed, then State A will have achieved its goal of reducing barriers to its domestic taxpayers engaging in interstate commerce. Further, State A sends a clear message to State B and other states that might follow State B that it does not agree with State B’s policies. Knowing that State A is willing to implement retaliatory taxation, other states might be discouraged from adopting State B’s policies and State B legislators might reconsider their policies simply by receiving such forceful feedback from another state.
Indeed, the experience of retaliatory taxation in the interstate insurance context provides at least anecdotal evidence that these measures can affect how states tax interstate actors. The tax rate on interstate premiums has remained remarkably stable for decades, hovering around a range of two to three percent. Some commentators and insurance industry representatives have attributed this stability at least partially to the presence of the states’ retaliatory taxation measures; indeed, some go so far as to advocate for the measures to ensure this rate stability. However, one academic study failed to establish retaliatory taxation as the cause of the rate stability, finding instead that tax base expansion was more responsible.
Even so, the experience of at least one state confirms the potential effectiveness of retaliatory taxation as a tool to promote interstate commerce. In New York, when the state legislature considered raising premium tax rates, its domestic insurance companies lobbied to keep the tax rate for nonresident insurance companies the same while simultaneously increasing the tax rate (and thus tax burden) on themselves. In other words, the domestic insurance industry willingly assumed an increased tax burden for their in-state activities to ensure that the tax rate on nonresident insurance companies was not increased. Such an increase would have triggered retaliatory taxation from other states, seriously impairing the domestic insurance companies’ ability to engage in interstate commerce. Therefore, the presence of retaliatory taxation measures ultimately encouraged New York to internalize the burdens of raising taxes rather than placing some of that burden on interstate actors.
Today, Connecticut and New Jersey may be bellwethers of future state efforts to use retaliatory taxation. The lack of federal action on the issue of sourcing personal income spurred these states into action, and other states may follow on this issue and others where federal intervention is lacking. The retaliatory taxation of insurance companies occupies a unique niche of state and local taxation, but the practice has survived for decades and may offer some insight into the viability of new retaliatory taxation measures such as Connecticut’s and New Jersey’s new income tax sourcing regimes. Given the potential growth of retaliatory taxation, the next Part considers whether the practice is within the states’ constitutional authority before the final Part examines whether retaliatory taxation is appropriate if constitutional.
III. The Constitutionality of Retaliatory Taxation
While retaliatory taxation may be a potential tool of the states to self-police taxes that affect interstate actors, the tool would be unavailable if it is deemed unconstitutional. The discriminatory nature of retaliatory taxation places the practice in the crosshairs of the Equal Protection Clause, the Privileges and Immunities Clause, and the dormant Commerce Clause doctrine. However, there is reason to believe that retaliatory taxation could survive constitutional challenges. The modern Supreme Court has grappled with and redefined its role in policing state taxation of interstate commerce by removing itself from the space. This trend should not be overlooked when considering how the Court might approach challenges to retaliatory taxation; it would be reasonable to expect the Court to hesitate to overturn state tax measures, even retaliatory taxation measures. This Part will consider the likelihood of retaliatory taxation surviving constitutional scrutiny under each of these clauses, coming to the conclusion that retaliatory taxation can survive such scrutiny.
A. Retaliatory Taxation Under the Equal Protection Clause
At first blush, one might expect the Equal Protection Clause to prohibit retaliatory taxation, which by its nature discriminates against nonresident taxpayers because of the tax policies of their home state. However, discrimination in state taxation—even discrimination with respect to interstate commerce—is only subject to rational basis review under the Equal Protection Clause. Taxpayers engaged in interstate commerce are not a protected class for equal protection analysis. Therefore, the Supreme Court has only asked whether there is a legitimate governmental interest that is rationally related to a tax measure that discriminates against interstate actors.
As seen in the cases considering the retaliatory taxation of insurance companies, the Court has determined that (1) promoting domestic insurance companies’ ability to engage in interstate commerce by combating burdensome taxation of other states is a legitimate governmental interest, and (2) retaliatory taxation is a rational means of promoting that interest. In fact, the Court explicitly stated that seeking to influence the policies of other states with its own policies did not render the taxing state’s actions illegitimate. Therefore, retaliatory taxation of insurance companies has passed equal protection analysis.
However, the Court has made clear the limits of the equal protection analysis in this context. Not all discrimination against interstate commerce will pass constitutional muster because not all such discrimination furthers a legitimate governmental interest. Taxes imposed solely to punish out-of-state taxpayers or promote in-state taxpayers at the expense of those out-of-state taxpayers typically does not further a legitimate governmental interest and is not constitutional.
Thus, to survive equal protection analysis, retaliatory taxation should be designed to promote the ability of the retaliating state’s domestic taxpayers to engage in interstate commerce. That is to say, the state must be acting to promote interstate commerce, even if only for its own domestic taxpayers. Retaliatory taxation imposed to protect the national marketplace—as opposed to protecting or promoting purely intrastate activities—is permissible under the Equal Protection Clause.
Connecticut and New Jersey’s retaliatory taxation of remote workers should survive equal protection scrutiny. Both have accused New York’s continued enforcement of the “convenience of the employer” rule—which effectively implements employer-based sourcing of personal income—of being both bad policy and potentially unconstitutional. Finding no respite in the courts or from Congress, the states moved to influence New York (and other states that have adopted or might adopt a convenience of the employer rule) through retaliatory taxation. Importantly, both states—and New Jersey in particular through its tax credit for successful litigation against convenience of the employer rules—have strongly indicated that the purpose behind their retaliatory taxation measures is to promote the ability of their domestic taxpayers to engage in interstate commerce. These measures sync up with retaliatory taxation in the insurance context already sanctioned by the Supreme Court and should withstand challenges brought under the Equal Protection Clause.
B. Retaliatory Taxation Under the Privileges and Immunities Clause
Once the analysis moves past the Equal Protection Clause, the constitutional status of retaliatory taxation becomes murkier. In the context of retaliatory taxation of insurance companies, the Supreme Court has dismissed claims under the Privileges and Immunities Clause with the conclusion that the protections of the Clause do not apply to corporations. The Court has not been called on to consider claims by individuals against retaliatory taxation. Still, under the same understanding of the governmental interest at issue in the equal protection analysis, it is possible that retaliatory taxation would survive substantive analysis under the Privileges and Immunities Clause. This is not to claim that retaliatory taxation will survive the Privileges and Immunities Clause, but that it could.
The Privileges and Immunities Clause requires that the states afford “the citizens of each state . . . all privileges and immunities of citizens in the several states.” In the Federalist No. 42, James Madison explained that the Clause was meant to ensure that citizens of one state, while in another state, would not be denied the greater privileges of that other state when their home state provided less. Despite the breadth that might have been read into the meaning of “privileges and immunities,” the Supreme Court has interpreted the Clause to apply only to certain “fundamental” rights. However, the Court has found that the right of nonresidents not to be subject to higher tax burdens than residents is a fundamental right protected by the Clause.
In contemporary state and local tax jurisprudence, the Privileges and Immunities Clause has rarely surfaced, primarily because other parts of the Constitution—particularly the Interstate Commerce Clause and its dormant aspect—provide taxpayers with more protection from state tax actions. When the Court has considered challenges under the Privileges and Immunities Clause, it has offered the states more leeway than might be expected to abridge the fundamental right to equal tax burdens.
Two themes arise in the case law in this regard. First, the Privileges and Immunities Clause does not require exact tax equality among citizens and noncitizens. The Clause protects against unequal burdens, not unequal forms, of taxation; as long as the noncitizen is asked to pay tax on substantially similar grounds as the citizen, no constitutional concerns exist. The difficulty of applying such a standard aside, the standard allows for differential rules as long as noncitizens are not asked to shoulder a heavier burden than citizens. Many state tax challenges brought under the Privileges and Immunities Clause have been dismissed under these principles—the differential treatment of noncitizens and citizens has not resulted in a practically significant discrimination.
Second, where there is meaningful discrimination, the Privilege and Immunities Clause nevertheless permits it when the taxing state has a substantial reason for doing so and the discrimination bears a close relationship to that reason. The Court has indicated that the “substantial reason” part of this analysis is satisfied when the state demonstrates “perfectly valid independent reasons” for the discrimination apart from simply wishing to export tax burdens to out-of-staters. As the Court has put it, “the purpose of that clause . . . is to outlaw classifications based on the fact of non-citizenship unless there is something to indicate that non-citizens constitute a peculiar source of the evil at which the statute is aimed.”
In evaluating the closeness of the discrimination’s relationship to the reason for it, the Court has asked whether the state could achieve its goals by a “less restrictive means.” Importantly, the standard of review under the Privileges and Immunities Clause is more demanding than that under the Equal Protection Clause; the state must prove its purpose and the relationship of the discrimination to achieving that purpose. However, the Court has recognized that “[t]he inquiry must . . . be conducted with due regard for the principle that the States should have considerable leeway in analyzing local evils and in prescribing appropriate cures.”
By its own admission, the Court has struck down state laws under the Privileges and Immunities Clause “only when those laws were enacted for the protectionist purpose of burdening out-of-state citizens.” Reading in the negative, when a nonprotectionist purpose (i.e., a “perfectly valid” independent purpose) underlies a state law, the law could survive the Privileges and Immunities Clause where there is no less restrictive means of achieving the state’s purpose. Retaliatory taxation arguably fits this mold.
Retaliatory taxation imposes a higher burden on noncitizens than citizens, but with the purpose of promoting domestic taxpayers’ ability to engage in interstate commerce by combating burdensome taxes. As noted, this purpose has been deemed legitimate in the context of the Equal Protection Clause analysis. Assuming a state can prove that purpose for its retaliatory taxation measure, that purpose should also satisfy the requirements of the Privileges and Immunities Clause. The Court has already established that retaliatory taxation is a reasonable means of achieving this purpose, so the only additional question to ask in the Privileges and Immunities Clause context is whether there is a less restrictive means for the state to accomplish its goals.
Less restrictive alternatives are not immediately apparent within the principle of respecting state sovereignty that the Court has articulated. A state has no authority to actually change another state’s policies that it disagrees with, and measures such as public relations campaigns are unlikely to be considered (or suggested by the Court). Perhaps the most promising among less restrictive alternatives would be for the taxing state to (1) lobby the offending state, (2) increase the tax burden on all taxpayers, or (3) provide tax credits or other subsidies to domestic taxpayers subject to burdensome taxes on interstate commerce. However, lobbying would significantly increase the burden on the taxing state to influence the offending state and would directly entangle the taxing state in the political processes of the offending state. Such entanglement may threaten principles of state sovereignty and comity. Increasing the tax burden on all taxpayers would restrict interstate commerce even more while forcing a policy choice on the taxing state. Providing subsidies would only incentivize the original offensive tax policy, not combat it. Additionally, to provide subsidies, the taxing state would need to make up the lost revenue somewhere, potentially through higher taxes on everyone, including noncitizens.
In contrast, retaliatory taxation is a fairly limited response—it does not affect all noncitizens, only those from certain states. It does not directly entangle the taxing state in the offending state’s political processes, instead it seeks to inform political actors within the offending state of the scope of the offending state’s policies. Retaliatory taxation also does not require the offending state to act, it is merely persuasive, though it has more force behind it than other forms of lobbying. Given that the Supreme Court is deferential to state choices about how to exercise their sovereignty to address local ills (especially in matters of taxation), the Court may not wish to deny a state the ability to engage in retaliatory taxation when the state proves the weaknesses of other means of promoting domestic taxpayers’ ability to engage in interstate commerce.
At a higher level, retaliatory taxation directly addresses a concern underlying the Privileges and Immunities Clause in a way that might make it particularly compelling as a means for the taxing state to achieve its goals. The Supreme Court has observed that the Privileges and Immunities Clause is protective of noncitizens because they have no voice in the taxing state’s legislature; those noncitizens’ only relief is that which “they could secure through their own State.” This observation was made under the assumption that such relief would take the form of retaliation from the noncitizens’ home state against the taxing state, but in the context of retaliatory taxation, the noncitizens’ home state may relieve their burden by changing its own law. In other words, noncitizens have a much stronger voice in the case of removing the burdens of retaliatory taxation than they do in other cases of discrimination. This turning of the tables may persuade the Court that retaliatory taxation is the least restrictive means of promoting domestic taxpayers’ ability to engage in interstate commerce by combating burdensome taxes.
On the other hand, in analyzing the Privileges and Immunities Clause, the Court has observed that “to prevent [retaliation] was one of the chief ends sought to be accomplished by the adoption of the Constitution.” This observation clearly places retaliatory taxation in a suspect position. However, the Court’s observation was made in a specific context. The Court was rebuking New York’s argument that its discriminatory treatment of noncitizens could be permitted if the other states simply did the same thing to New York citizens. The Court was saying that retaliation, in and of itself, cannot absolve a discriminating state of its discrimination; the Court was not saying that retaliation is an inappropriate tool for promoting domestic taxpayers’ ability to engage in interstate commerce. In other words, the Court has determined that a state may not enact a discriminatory law that would provoke retaliation, but it has not addressed whether a state could enact retaliatory taxation to further a valid independent purpose. This line is thin but important.
In sum, the case for sustaining retaliatory taxation under the Privileges and Immunities Clause should be more difficult than under the Equal Protection Clause. Statements of the Court regarding burdening nonresidents place retaliatory taxation in a facially uncomfortable position under the Privileges and Immunities Clause, and the Clause demands a stricter standard of review than under the Equal Protection Clause. However, the Court’s jurisprudence establishes that discriminatory taxes can survive this review when the states can demonstrate a valid purpose for the discrimination and that no lesser restrictive means of achieving that purpose exist. Given the blessing of retaliatory taxation in the equal protection context, along with a contemporary Supreme Court sympathetic to returning power to the states in matters of state taxation of interstate commerce, a successful defense of retaliatory taxation should not come as a surprise. The final hurdle for a retaliatory taxation law would be the Interstate Commerce Clause and its dormant aspect.
C. Retaliatory Taxation Under the Interstate Commerce Clause
The Interstate Commerce Clause affirmatively grants Congress the authority to regulate commerce among the states. However, as the Supreme Court has recognized, when Congress fails to act under its Interstate Commerce Clause authority—as it mostly has in the context of state taxation—the states might fall into harmful competition with one another and threaten the national marketplace. To stave off such competition, and to prevent protectionist state actions specifically, the Supreme Court has articulated the dormant Commerce Clause doctrine. This doctrine polices state actions made in the absence of congressional action. The judicial check of the dormant Commerce Clause doctrine extends to the world of state taxation, where the Court seeks to prevent states from overburdening those engaged in interstate commerce. However, the contemporary Supreme Court, somewhat skeptical of the scope of the dormant Commerce Clause doctrine, has retreated from policing state tax actions under the doctrine. Given federal inactivity in this area, retaliatory taxation very well may survive under the Commerce Clause.
1. The Affirmative Interstate Commerce Clause
As noted, Congress has the express authority to regulate commerce among the states. This is a plenary power of Congress; the states are bound by any decisions of Congress in this area, and the Supreme Court has recognized that Congress has the authority to declare constitutional state actions affecting interstate commerce that the Court has determined to be unconstitutional under the dormant Commerce Clause doctrine.
The reason for this grant of power to Congress is straightforward and related to the restrictions placed on states by the Privileges and Immunities Clause. In Federalist No. 7, Alexander Hamilton explained the need: without federal oversight, the states would jealously protect their economic interests, to the detriment of each other and the national economy. When one state regulated (or taxed) interstate commerce in a way that advantaged its intrastate actors or encouraged interstate actors to remain in the state, other states would predictably retaliate, setting off a chain of state actions that would result in the destruction of the national marketplace and the union as a whole. History had already proven Hamilton’s point: the union between the states under the Articles of Confederation had failed, in part due to this scenario regarding commerce among the states.
Congress has been fairly reserved in exercising its authority under the Interstate Commerce Clause to regulate state taxation, typically acting only with respect to specific industries that have inherent multistate characteristics, like railroads and air travel. Congress has not explicitly addressed retaliatory taxation, but the Supreme Court has read Congress’ delegation to the states of authority to regulate and tax interstate insurance business to permit the practice in that area. As a result of Congress’s inaction under the Commerce Clause with respect to state taxes, the Supreme Court—pursuant to the dormant Commerce Clause doctrine—has served as the primary federal regulator of state taxes that fall on interstate commerce.
2. The Dormant Commerce Clause Doctrine
From the early days of the country, the Supreme Court has read the Commerce Clause to contain a dormant aspect. The idea behind the dormant Commerce Clause doctrine is that the Commerce Clause, in affirmatively granting Congress the power to regulate interstate commerce, implicitly places some limitations on how states may regulate that commerce. The Supreme Court has assumed the role of articulating those implicit limitations. Even casual observers of the Supreme Court are likely to know that the dormant Commerce Clause doctrine is controversial, though it has long survived criticism.
The dormant Commerce Clause doctrine has been applied in both the regulatory context and in the taxation context. In the regulatory context, the Court has required that state regulations not effectuate a state’s economic isolation or protectionism through discrimination towards interstate commerce. State regulation that discriminates on its face against interstate commerce is thus virtually per se unlawful. However, even facially valid regulations might run afoul of the doctrine if those regulations discriminate in their effect or place an undue burden on interstate commerce. Whether a law imposes an undue burden is determined under the so-called Pike balancing test by weighing the state’s interest in the regulation against the burden placed on interstate commerce and by asking if the state could accomplish its goal in a less burdensome manner.
In the taxation context, the Court has articulated a four-pronged test (the “Complete Auto test”) for determining whether a state tax action survives under the dormant Commerce Clause doctrine. As the Supreme Court recently articulated, the test provides that:
[W]e will sustain a tax against a Commerce Clause challenge so long as the “tax [1] is applied to an activity with a substantial nexus with the taxing State, [2] is fairly apportioned, [3] does not discriminate against interstate commerce, and [4] is fairly related to the services provided by the State.”
Over time, the Court appears to have elided the prongs into each other or other standards such as those under the Due Process Clause. In so doing, the Court has clearly understood that it was advancing state sovereignty in matters of interstate taxation by removing itself from policing those actions. As the result of these elisions, commentators have argued that the Complete Auto test now functionally boils down to only the fair apportionment and antidiscrimination prongs.
The fair apportionment prong requires two things: that the tax in question be internally consistent and that it be externally consistent. A tax is internally consistent if it would not result in multiple taxation of a multistate taxpayer if every state applied the exact same tax. A tax is externally consistent if it is not “out of all appropriate proportion” to the taxpayer’s activities in the taxing state. Though formal, the tests of internal and external consistency are not particularly restrictive. As Professors Hellerstein and Swain note, “the Court has never invalidated an apportionment formula on its face on constitutional grounds.” The continuing value of this prong is that the internal consistency test demonstrates a particular type of discrimination against interstate commerce; thus, it supports the antidiscrimination prong.
Turning to the antidiscrimination prong, the dormant Commerce Clause restricts states from discriminating against interstate commerce. This protection could develop—and arguably has developed—in two ways, which mirror the well-established economic antidiscrimination goals of capital import neutrality and capital export neutrality. Capital import neutrality occurs when a state taxes residents and nonresidents in the same manner. Achieving capital import neutrality ensures that residents and nonresidents conducting the same activities are on the same footing tax-wise in the taxing state. Capital export neutrality, on the other hand, occurs when residents of a state are taxed the same regardless of where they conduct their activities. Achieving capital export neutrality ensures that residents of a state are on the same footing tax-wise regardless of whether they conduct their activities in the state or out of the state. As commentators have observed, absent uniform taxation by all states, achieving both capital import neutrality and capital export neutrality at the same time is not possible.
Supreme Court cases interpreting and applying the antidiscrimination prong of the Complete Auto test appear to have adopted both goals depending on the context, with the ultimate goal of preventing protectionist state tax actions that would promote intrastate commerce over interstate commerce. Perhaps unsurprisingly, in cases brought by nonresidents against a taxing state, the Court has followed the goal of capital import neutrality—of treating residents and nonresidents similarly. In these cases, the Court has indicated that state taxes that facially discriminate against interstate commerce for protectionist purposes are “virtually per se illegal.” The Court has described protectionist laws as those that disrupt interstate commerce by advantaging domestic commerce within the state, encouraging interstate activity to be brought fully within the taxing state. The capital import neutrality frame is important in this context to ensure that nonresidents with no formal political power are not subject to the whims of residents.
When residents have challenged their states’ taxes as discriminatory against interstate commerce, the Court has recently turned to the antidiscrimination element of the internal consistency test, arguably adopting a goal of advancing capital export neutrality—that is, of ensuring that the resident is subject to the same tax burden regardless of where they conduct their activities—to weed out protectionist policies. In 2015’s Comptroller of Treasury of Maryland v. Wynne, the Court struck down Maryland tax laws that only provided a partial credit for Maryland residents for taxes paid to other states. Using the internal consistency test, the Court demonstrated that Maryland residents would be subject to higher tax burdens if they engaged in interstate commerce than if they engaged solely in intrastate commerce. In other words, Marylanders’ tax burdens were not the same based solely on where they earned income. The Court viewed this type of law as unconstitutionally protectionist. Indeed, Professors Knoll and Mason have articulated in detail how the internal consistency test is perfectly designed to weed out protectionist state actions.
The Court has also recognized that facially neutral state taxes can have a discriminatory effect on interstate commerce or may subject that commerce to an undue burden. Such taxes might not survive dormant Commerce Clause analysis. In the cases concerning nondiscriminatory laws, the Court has recently alluded to the Pike balancing test as the mechanism for policing state taxation of interstate commerce because that test can be used to uncover undue burdens placed on interstate commerce. Many commentators have predicted that the Pike balancing test will be very permissive in the realm of state taxes, making the finding of an undue burden on interstate commerce from a state tax action unlikely unless there is some less burdensome alternative for the taxing state.
In this vein, the Supreme Court recently decided the National Pork Producers Council case. In that case, litigants asked the Court to apply the Pike balancing test, with the law’s challengers asking the Court to find that California had unduly burdened interstate commerce by requiring that all pork sold in the state have been raised in certain conditions, and the law’s defenders asserting that California’s action in restricting the sale of pork to animals raised in what the law deemed more humane conditions was permissible, even though it affected farms in other states with looser regulations. In a disjointed opinion, a majority of the Court determined that California’s pork-market regulation was permissible. Though the Justices reached no consensus on the correct application of the Pike balancing test, the Court was clear that it did not wish to upset California’s duly enacted law simply because it had effects on interstate commerce. While California’s law is not retaliatory in nature, National Pork Products serves as a potential indicator of whether retaliatory taxes are likely to survive constitutional scrutiny given that retaliatory taxes also seek to advance the taxing state’s policy preferences.
Thus, at a high level, the Supreme Court has positioned the federal courts to police the state taxation of interstate commerce only in the most extreme cases, such as where a violation of due process has occurred, where a state has facially discriminated against interstate commerce for protectionist reasons, or where the burden on interstate commerce is so excessive that it defies justification. These cases are seemingly subject to standards of equal protection, the internal consistency test, and Pike balancing; in other words, the dormant Commerce Clause standards for taxation are substantively no different than those for other state actions affecting interstate commerce.
3. Retaliatory Taxation Under the Dormant Commerce Clause Doctrine
As just described, the contemporary dormant Commerce Clause analysis for taxes is driven by the antidiscrimination prong of the Complete Auto test, which the Court has begun to blur with elements of the internal consistency test, while referencing Pike balancing as a secondary consideration. Under the internal consistency test and the Pike balancing test, retaliatory taxation can survive challenges under the modern dormant Commerce Clause doctrine.
The internal consistency test asks whether a state’s tax would necessarily impose a higher tax burden on interstate commerce than intrastate commerce if every other state adopted an identical tax. Given that retaliatory taxation increases tax burdens on out-of-state taxpayers, a retaliatory taxation measure might be expected to fail the test. However, the very nature of retaliatory taxation would save such measures under the internal consistency test. A retaliatory taxation measure only activates when another state imposes an objectionable tax that differs from the baseline rate or rule of the taxing state. If every state imposed the same baseline taxes on interstate actors, then there would be no reason for the retaliatory measure to kick in. Interstate taxpayers would not be subject to a higher tax burden than intrastate taxpayers. Therefore, retaliatory taxation should easily pass the internal consistency test.
However, retaliatory taxation seems inherently discriminatory, and of course it is under a capital import neutrality frame—nonresidents are treated differently than residents with respect to the same activity. Still, the discrimination that the Court has been concerned about under the dormant Commerce Clause doctrine is discrimination that effectuates economic protectionism. The application of the internal consistency test demonstrates that retaliatory taxation is not inherently protectionist. The laws themselves demonstrate the legitimate purpose of promoting domestic taxpayers’ ability to engage in interstate commerce, not of shielding off the domestic market from outsiders. In other words, retaliatory taxation may survive the antidiscrimination analysis because retaliatory taxation is a reaction to burdens another state places on interstate commerce rather than an independent imposition of such burdens.
This understanding of “protectionist” discrimination in the dormant Commerce Clause context is in line with the Equal Protection Clause cases regarding retaliatory taxation and the conclusion reached above under the Privileges and Immunities Clause. The Western & Southern Insurance Company Court observed that pressure from one state on another’s policies might implicate the Commerce Clause even if the measure creating that pressure survived under the Equal Protection Clause, which may suggest that the Commerce Clause jurisprudence has not yet reached the articulated equalization of the requirements of the other clauses. However, it is reasonable to expect that the current Court would move the dormant Commerce Clause requirements in that direction. The Court could further limit the scope of review under the dormant Commerce Clause doctrine by continuing to interpret its requirements in line with other constitutional doctrines, and eliding the antidiscrimination prong of the Complete Auto test with the already established equal protection and Privileges and Immunities standards would be a natural step in that direction.
Alternatively, the Supreme Court might follow its approach in Wynne and adopt the antidiscrimination goal of capital export neutrality when considering retaliatory taxation. A capital export neutrality frame would provide retaliatory taxation with more stable footing. The Supreme Court has not directly rejected the capital export neutrality frame in its cases involving nonresidents, and adopting the frame would grant the states more leeway in matters of interstate taxation.
Retaliatory taxation promotes capital export neutrality (and thus under this frame is not facially discriminatory towards interstate commerce) in two ways. First, it equalizes the tax treatment of the in-state and out-of-state activities of residents of the state being retaliated against. If Georgia imposes a retaliatory tax on Alabama residents, those residents will be subject to the same tax burdens regardless of whether they conduct their activities in Alabama or in Georgia. One state’s retaliatory taxation cannot achieve perfect capital export neutrality in this way, but it does partially advance that goal.
Second, if retaliatory taxation is successful in removing the offending state’s objectionable tax policy, retaliatory taxation equalizes the tax burdens on the in-state and out-of-state activities of the retaliating state’s residents. Again, this success will not perfectly achieve capital export neutrality, but it does advance that goal, albeit indirectly. Thus, under a capital export neutrality frame, retaliatory taxation appears to pass the facial discrimination bar.
This discussion of facial discrimination against interstate commerce eclipses an underlying point worth bringing to the fore. Retaliatory taxation does not blindly impose higher taxes on nonresidents. Instead, the higher taxes are tied to the nonresidents’ state’s adopted tax policy. As explained in the context of the Privileges and Immunities Clause, this connection relieves concerns about unfairness to those nonresident taxpayers because the more burdensome tax policy is one that their state has adopted. In theory then, those nonresident taxpayers have some political voice to affect the policy. This point is important when contextualizing the impact of the Court’s statements that facial discrimination is “virtually per se illegal”—the Court has been concerned about the lack of political voice for nonresidents in the taxing state. The discrimination inherent in retaliatory taxation is not necessarily the type of discrimination the Court has been or will be concerned about.
Assuming retaliatory taxation passes the facial discrimination analysis, it is not wholly out of the constitutional woods. By its nature, the burden of retaliatory taxation will fall more heavily on interstate actors than intrastate actors, calling for the application of the Pike balancing test to determine if that burden is undue. Under the Pike balancing test, the first inquiry is whether the state is advancing a legitimate local interest. Taxation being a fundamental power, it is difficult to imagine a tax failing on this inquiry, even a retaliatory taxation measure. In any event, as recognized in the equal protection context, states have a legitimate interest in promoting their domestic taxpayers’ ability to engage in interstate commerce by combating burdensome taxes of other states.
With a legitimate governmental interest behind it, retaliatory taxation should pass the next part of the test: balancing that interest against the burden on interstate commerce. In fact, because taxation is such a fundamental power, it is improbable that the exercise of that power would be outweighed by the burden placed on interstate commerce. Further, since the Court has noted that retaliatory tax measures also seek to promote participation in interstate commerce by the taxing states’ residents, such laws may be viewed as having an offsetting benefit (or at least intended benefit) of advancing interstate commerce. The remaining question would be whether the state could have achieved its goals though a less burdensome means.
The answer to that inquiry may depend on the nature of the retaliatory taxation measure, but considering the interest of promoting domestic taxpayers’ ability to engage in interstate commerce, less burdensome alternatives are not readily apparent, as discussed in the context of the Privileges and Immunities Clause. A state has no authority to actually change another state’s policies that it disagrees with, and retaliatory taxation is a fairly limited response—it does not affect all out-of-state taxpayers, only those from certain states. Subsidizing domestic taxpayers who engage in interstate commerce might enable them to engage in interstate commerce, but it does nothing to combat other states’ burdensome taxes and might incentivize even more burdensome taxes while stretching the resources of the home state.
Given the nonprotectionist purposes underlying retaliatory taxation, one can reasonably expect that retaliatory taxation may well survive contemporary challenges under the Commerce Clause. Combined with a permissive reading of the limitations placed explicitly on the states by the other parts of the Constitution such as the Equal Protection Clause and the Privileges and Immunities Clause, the retreat of the Supreme Court from policing the states under the dormant Commerce Clause doctrine opens the door for the states to use retaliatory taxation to self-police their taxation of interstate commerce.
In fact, there is also a more fundamental argument supporting the constitutionality of retaliatory taxation. If the Supreme Court is unwilling to police state taxation of interstate commerce and Congress remains passive in exercising its authority under the Interstate Commerce Clause, then the states must police themselves, as discussed further in the following Part. Retaliatory taxation may be the most effective means of self-policing for the states, and restricting the availability of retaliatory taxation could throw the taxation of interstate commerce into a deeper chaos than allowing the practice.
IV. Promoting Interstate Commerce Through Retaliatory Taxation
When considering whether retaliatory taxation has a role to play in regulating interstate commerce, there are two main inquiries: first, should the states be acting to police each other’s taxation of interstate commerce, and second, if so, is retaliatory taxation an appropriate tool to do so? To the first inquiry, the states have long been recognized to have power to regulate interstate commerce, and the Supreme Court has removed restrictions on that authority in recent years, specifically with respect to state taxation. To the second inquiry, retaliatory taxation is a volatile tool, but it has some upside in that it can be used both to discourage forms of taxation that might disrupt interstate commerce and also to promote uniformity in state taxation of interstate commerce. Indeed, the experience of retaliatory taxation in the context of interstate insurance implies some ability to influence states away from becoming outliers. However, retaliatory taxation invites conflict between the states, which could result in harms to taxpayers, the states, and the national marketplace.
A. States as Regulators of Interstate Commerce
As a primary matter, the proper role of retaliatory taxation in the United States is heavily dependent on whether the states are regarded as legitimate regulators of interstate commerce or not. Some parts of the Constitution, particularly the Equal Protection Clause and the Privileges and Immunities Clause, clearly contemplate that states have authority over interstate actors, in that those parts of the Constitution outline the scope of that authority by requiring it to be exercised in a certain manner. However, the states’ authority to regulate interstate commerce has been much more controversial.
The Constitution contains an affirmative grant to Congress of the power to regulate interstate commerce but is silent as to the states’ power to regulate interstate commerce. This affirmative grant of power to Congress and accompanying silence regarding the states leaves space for a spectrum of positions regarding the states’ authority over interstate commerce: at one end, the states have no power to regulate such commerce, at the other end, the states have full power to regulate interstate commerce (though such power would defer to conflicting Congressional regulations via the Supremacy Clause). In the middle, the states possess partial power to regulate interstate commerce whereby they are unable to act in certain cases even in the absence of Congressional action.
All three positions have been adopted at various points in time in the Supreme Court’s jurisprudence regarding state taxation of interstate commerce. However, in its contemporary jurisprudence, the Court has rejected the idea that the states have no authority over interstate commerce and has trended towards the position that states have broad authority to regulate interstate commerce in the absence of congressional action. This trend is justifiable on traditional tax policy measures of equity, efficiency, and administrability, particularly in the context of the modern world and economy.
Equity demands that similarly situated taxpayers be treated the same. As far as the basic jurisdictional question of whether states should have authority to tax people engaged in interstate commerce is concerned, states have the authority to regulate a person once that person has some minimum connection with the state. The primary difference between intrastate actors and interstate actors is the multijurisdictional nature of interstate actors’ activities. But the jurisdiction question is concerned with minimum connections with the taxing state, not whether the person might have connections with another state. Therefore, to treat taxpayers equitably, states must have authority over interstate actors connected to them. To deny this jurisdiction would provide an unfair advantage to interstate actors.
Focusing on the states’ authority over interstate activities, as opposed to interstate actors, leads to a similar conclusion. To deny a state the authority to tax activities occurring within its jurisdiction would create an unfair imbalance between interstate and intrastate activities. One might claim that the nature of interstate activity is different than that of intrastate activity because the interstate activity is likely to be regulated by multiple states, which could put it at a disadvantage to an intrastate activity. This difference is one of quantity of contacts with the taxing state, rather than quality. In other words, each state should only have authority over the activities occurring in its state, meaning that part of the interstate activity would be beyond the power of the state, lessening the risk of overregulation. As a corollary, interstate activities draw on the resources of multiple states, giving them an advantage over intrastate activities that should be accounted for in this context by affording all of those multiple states some jurisdiction over the activities.
On the efficiency measure, granting the states broad tax authority in the absence of congressional action ensures that they are able to enact their preferred tax policies. Of course, those tax policies can—and often do—conflict, creating unintended consequences for interstate taxpayers. However, states have incentives not to drive interstate taxpayers out of their state, and therefore can be expected to react to those unintended consequences to stabilize at an ideal policy. If they are unable to do so, or have differing views of the ideal policy, congressional action serves as a backstop for aggrieved taxpayers. But the potential need for Congress to sort out competing tax policies does not erode the core idea that the states should have authority to tax interstate commerce in the absence of congressional action.
As the Supreme Court has often noted, the judicial capacity to determine appropriate regulation of interstate commerce is low. The Court has often made this observation in the context of deferring to congressional decisions, but permitting broad exercises of state power over interstate commerce allows elected officials—albeit at the state level—to pick the appropriate balance of winners and losers in the interstate context. Because those elected officials have more resources and leeway to make these decisions, the administrative burden is less than it would be for judicial actors.
Some might object that one state should not have the authority to regulate interstate actors on the grounds that that state will act in a self-interested manner to the detriment of the national economy, increasing the administrative burden on the federal government or other states to counter such actions. Certainly, this is a risk of providing states with broad authority over interstate commerce. However, this risk is mitigated by ensuring that the states only have the authority to regulate interstate commerce that is connected with their state; they cannot regulate all interstate commerce. Additionally, the federal government (and as will be discussed, other states) may also intervene to corral rogue states.
Additionally, determining what is “detrimental to the national economy” is precisely the difficult political question underlying the Court’s unease with these cases. If the states act too far out of line, Congress is the appropriate authority to correct their actions, and by allowing the states to act, the Supreme Court can force Congress’ hand. At the end of the day, elected officials would craft the rules for taxing interstate commerce.
In the context of administrability, it is important for taxpayers to understand their obligations before they act, otherwise, they are subject to unnecessary risk and costs of compliance. In the absence of congressional action, interstate actors may not be certain as to their obligations. Allowing the states broad authority to tax interstate commerce allows for the rules regarding interstate commerce to be set. Of course, those rules may differ from state to state, creating a different source of compliance costs and complexity for interstate actors.
One might counter that allowing states no or limited authority over interstate actors in the absence of congressional action would reduce compliance costs for interstate actors arising from conflicting state regulations, and thus should be the preferred approach. However, that reduction in compliance costs comes at the expense of equity and efficiency goals. Interstate taxpayers would have a massive advantage over intrastate actors, one that has long been dismissed as inappropriate. Further, the rise of interstate commerce means that the states are continuously affected by actors in interstate commerce; to deny them authority over those actors all together would be a serious affront to the states’ sovereignty, eroding the states’ abilities to enact their preferred policies.
Allowing states broad authority to tax interstate commerce in the absence of congressional action is justifiable as a policy measure. This is not to say that it is the only justifiable answer to the question, but a broad grant of authority advances certain equity, efficiency, and administrability goals, though the costs of the grant are likely to fall on interstate actors. However, by limiting a state’s tax authority over interstate commerce to that commerce that occurs within the state—as the Constitution does—the worst harms that might befall interstate taxpayers are mitigated. In any event, the Supreme Court has trended towards loosening restrictions on the states’ authority to tax interstate commerce, and that trend should be expected to continue in the immediate future.
B. The Value of Retaliatory Taxation
If states can legitimately tax interstate commerce in the absence of congressional action, is retaliatory taxation an appropriate way of doing so? Given the understanding that people’s right to engage in interstate commerce is fundamental, but also that those engaging in interstate commerce must still bear their share of state taxation, the problems that arise from granting states broad authority over interstate commerce can be generally described as follows. First, states may act in a protectionist or burdensome manner to disadvantage interstate actors. Second, states may enact different rules regarding interstate commerce that could conflict, generating complexity and unintended consequences for interstate commerce. These problems can be easily corrected by federal action, but in the absence of federal action, the problems can be addressed—perhaps surprisingly—by retaliatory taxation.
1. Retaliating Against Protectionist or Burdensome Tax Actions
With respect to the first problem, protectionist and burdensome tax measures disrupt the flow of interstate commerce. Such tax measures advantage intrastate commerce over interstate commerce and may be achieved by imposing relatively large tax burdens on interstate commerce occurring in the state and relatively low tax burdens on purely intrastate commerce. For instance, a state might try to protect its local bookselling industry by imposing a sales tax on books sold by out-of-state vendors at a rate of 50% while only imposing a sales tax on books purchased from in-state vendors at a rate of five percent. The cost to consumers of books bought in interstate commerce would be higher than the cost of books purchased in intrastate commerce, making it difficult to engage in that form of interstate commerce in that state. Thus, protectionist tax measures disrupt the flow of the national marketplace by imposing an undue tax burden on interstate actors.
Federal action could address protectionist state tax actions (and such corrective federal action is not all that uncommon), but in the absence of federal action, retaliatory taxation can serve as one of the more powerful tools individual states have to shield their domestic taxpayers from the protectionist actions of other states. The Supreme Court has recognized the value of retaliatory taxation in the context of the taxation of insurance companies when it observed that retaliatory taxation was reasonably related to the legitimate state goal of promoting domestic taxpayers’ ability to engage in interstate commerce. Retaliatory taxation enables a state to force a sister state’s residents to confront the burdens that sister state’s tax measures place on interstate commerce. If completely successful, the retaliating state will have eased the burdens on its domestic taxpayers’ ability to engage in interstate commerce (and potentially those burdens on taxpayers of other states).
A state tax measure need not necessarily be protectionist to burden interstate commerce to a degree that discourages people from engaging in interstate commerce. Here, Congress and the federal judiciary is significantly less likely to get involved, as specifically demonstrated by the Pike balancing line of cases. Whether a particular burden on interstate commerce is “undue” and needs to be addressed is very much in the eye of the beholder, and where a state feels that a sister state has crossed the line, retaliatory taxation provides the first state with a means of expressing that sentiment and urging correction. The remote work issue is emblematic of this kind of situation. Some states view the convenience of the employer approach as unduly burdensome on interstate commerce, while others do not. By enacting retaliatory taxation measures, those states troubled by the approach force their sister states to recognize the burdens of the approach and encourage them to change their policies. Again, the successful retaliating state will have eased the burdens on taxpayers’ ability to engage in interstate commerce.
As discussed earlier, some states appear to have been persuaded not to adopt higher premiums tax rates on interstate insurance in order to avoid retaliatory taxes on their domestic insurance companies. These states were persuaded by lobbying from their domestic insurance companies, the exact result that retaliatory taxation measures are designed to achieve. In at least one known instance, those domestic insurance companies absorbed the tax burden that would have fallen on nonresident insurance companies by accepting increases in the taxation of their in-state activities. In this way, the domestic companies avoided burdensome taxation by other states and simultaneously eased the tax burden of nonresident companies. States like New York promoted interstate commerce at the expense of intrastate commerce at least partially due to the effects of retaliatory taxation.
As discussed further below, retaliatory taxation is not a perfect tool for addressing protectionist or burdensome taxes, but promoting the ability of a group of taxpayers to engage in interstate commerce is a benefit in our federal system. As noted, the founders and the Supreme Court both highlight the fear that the Union could fall apart were the national marketplace not adequately protected. Allowing states the ability to combat tax actions of each other that they perceive as detrimental to interstate commerce is one way of protecting the national marketplace that allows the Supreme Court and Congress to take a less active role in the endeavor. There are costs of such deference from federal authorities, discussed below, but the value exists nonetheless.
2. Retaliating to Achieve Uniformity
Promoting the ability of one state’s domestic taxpayers to engage in interstate commerce may not be the biggest benefit provided by retaliatory taxation. Taking the concepts expounded above further, assume State A objects to State B’s tax policies and adopts a retaliatory taxation measure in response. If other states also object to State B’s tax policies, then they can band together with State A and impose retaliatory taxation measures against State B, making it all the more likely that State B residents will realize the burdens that State B is placing on interstate commerce. As those State B residents find it harder and harder to engage in interstate commerce, they may eventually persuade their legislators to change the State B tax policies. Alternatively, if more states agree with State B’s tax policies than agree with State A’s, then State A’s retaliatory taxation regime may be of limited effect in influencing State B to change. State A’s actions may even persuade other states to retaliate against State A in an effort to get State A to back off its assault on a popular interstate tax policy. States that have not adopted a policy one way or the other may be persuaded to go along with the majority of other states.
In any event, retaliatory taxation can have a unifying effect on the interstate tax policies of all of the states. In most cases, uniformity in interstate taxation is a major benefit to taxpayers and the national marketplace. Uniformity reduces the complexity of engaging in interstate commerce and thus tends to reduce the compliance costs imposed on interstate actors. This reduction in the costs of engaging in interstate commerce smooths the flow of the national marketplace, giving more people the ability to engage in interstate commerce. This result is more equitable than a system where only taxpayers with significant resources are able to engage in interstate commerce because they can afford the costs of compliance (which tend to be flat regardless of a taxpayer’s revenue). Additionally, the easier it is to engage in interstate commerce, the more taxpayers are able to efficiently allocate their activities, leading to less deadweight loss on the national economy. To the extent that retaliatory taxation can promote national uniformity in interstate taxation, it generates value.
In this way, retaliatory taxation can work similar to multistate compacts—agreements among states to coordinate tax policies and practices. Retaliatory taxation is a less formal measure than multistate compacts are, which should be expected to make it easier for the states to express their concerns through retaliatory taxation. This expression can have value, not only to other states trying to determine what their own policies should be, but also to the federal government, should it decide to act to restrict how the states tax interstate commerce. For instance, the Supreme Court appeared to take into account the widespread adoption of retaliatory taxation in the case of insurance companies when deciding that the retaliatory taxation of insurance companies was an appropriate practice for states to engage in. Professor Erbsen observes that the Court in other contexts appears to have been swayed to uphold, as consistent with the Constitution, what may have appeared to be constitutionally-questionable practices because of the failure of states to object and/or the widespread adoption of similar practices. Thus, if federal authorities wish to defer to the states on decisions about how interstate commerce should be taxed, allowing retaliatory taxation can provide valuable information about preferred policies. But again, that information comes at a cost.
C. The Costs of Retaliatory Taxation
Although the Supreme Court has validated retaliatory taxation in the case of insurance companies, one need only examine that taxation to identify the costs associated with retaliatory taxation. Both interstate taxpayers and states suffer under retaliatory taxation regimes, with concomitant damage to the national marketplace.
Interstate taxpayers suffer two primary harms from retaliatory taxation. First, they are subjected to significant complexity as they try to determine what their tax burden is in each state. Further, complexity is a burden that may fall inequitably on taxpayers; those taxpayers with more resources are more likely to be able to bear the costs than those with less resources. The experience of interstate insurance companies bears this out, as they must sort through not only each state’s premium tax but also whether or not a retaliatory taxation measure applies. Commentary on the difficulty of this task is not in short supply, and should be taken seriously. The increased costs of compliance place an additional burden on those interstate taxpayers affected by retaliatory taxation.
Second, interstate taxpayers subject to retaliatory taxation are subject to higher taxes than they otherwise would be. Retaliatory taxation works by matching the taxing state’s tax burden to the burden imposed by the nonresident’s home state, but only when that tax burden would be higher. Indeed, the effectiveness of a retaliatory taxation measure lies in its ability to persuade nonresidents to lobby their home states for lower tax burdens on interstate commerce, and higher taxes can be persuasive. Asking interstate taxpayers to bear these costs places them in an unequal position to intrastate taxpayers, raising equity concerns.
States also bear the costs of retaliatory taxation, primarily in the form of an erosion of sovereignty that results from not being able to enact preferred policies. States that are retaliated against face pressures to change their tax policies from their preferred policies. Doing so may result in some deadweight loss for that state, as it would shift from a preferred policy to a less-preferred policy. That shift may generate greater national benefits that outweigh the loss to the individual state, but the burden would fall to that individual state. Additionally, the retaliating state also must adopt tax policies that it does not prefer in order to achieve its goal. Given that retaliatory taxation is a response to another state’s tax policy, the retaliating state presumably does not prefer to impose a higher tax burden on interstate actors as an initial matter. Thus, the retaliating state’s tax policy is not its preference, resulting in some burden on that state.
Such erosion of sovereignty pushing the states into second-best policy choices may not be terribly concerning. After all, by agreeing to be part of the federal union, the states have already conceded that they do not have complete sovereignty. Making policy tradeoffs in this regard to preserve the union and their position in it thus should be expected. However, it is worth recognizing who bears the burdens of retaliatory taxation.
Whatever the value of retaliatory taxation is, it is clear that the cost of realizing that value falls on interstate taxpayers and the states. Those costs are likely to erode the smooth functioning of the national marketplace, something that the founders and the Supreme Court have historically feared would undermine the union between the states. The seriousness of these harms indicates that retaliatory taxation should be used cautiously.
D. The Efficacy of Retaliatory Taxation
Apart from the more direct harms of retaliatory taxation just discussed, reasons exist to be wary of the true value of retaliatory taxation as a means of protecting the national marketplace. First, retaliatory taxation may be more powerful in the hands of larger states. Those states with greater taxable activity or a larger population of taxpayers have a bigger stick to wield, as smaller states would suffer more from adopting policies that would incur retaliation from larger states. On the flip side, the effects of smaller states’ retaliatory taxation regimes would be less meaningful for a larger state that could absorb those effects. In short, retaliatory taxation would be much more effective if both sides had the same capabilities. Thus, retaliatory taxation may be a severely inequitable tool for achieving benefits for the national marketplace.
That said, the effects of retaliatory taxation from smaller states might be larger than expected. Groups of smaller states can band together, as they may have similar economic interests to protect from the larger states. Additionally, the higher tax burdens placed on larger state residents under retaliatory taxation regimes from smaller states may be enough to spur the larger state’s lawmakers into action. Retaliatory taxation need only produce enough of an effect to persuade lawmakers not to adopt certain tax policies, nothing more. That effect may differ depending on the tax policy and which taxpayers are affected. Even so, it seems likely that retaliatory taxation is an easier tool for larger states to rely upon.
A second concern regarding the effectiveness of retaliatory taxation as a tool to protect the national marketplace is that the states may not act in a manner that best preserves the national marketplace. Federal lawmakers and the Supreme Court theoretically can react to changes in the world to better adjust the rules for taxing interstate commerce. The states can as well, but a lock-in effect might be expected when states are acting against each other. Many states may prefer the status quo to innovative approaches, making outlier states subject to larger risks. Effectively, new approaches to taxation might be punished by the other states before the approaches are allowed to take effect. In this vein, powerful lobbyists may be able to influence state legislators to retaliate against innovative tax policies that they do not like, potentially allowing special interests in other states to affect the policies of the target state in an outsized manner.
As a final note, if the experience of the states with retaliatory taxation in the context of insurance companies is any guide, then retaliatory taxation measures can be expected help achieve some measure of uniformity in the taxation of interstate actors. That uniformity is likely to be narrowly tied to the policies addressed by retaliatory taxation. However, the ripple effects of retaliatory taxation measures may include more retaliatory taxation measures being adopted by other states, increased complexity in other parts of the states’ tax codes, and increased tax burdens on domestic taxpayers. If these ripple effects are serious enough, then states should be hesitant to adopt retaliatory taxation measures.
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In the end, retaliatory taxation offers states a tool to influence each other’s tax policies that affect interstate commerce. To the extent that the tool is used to make it easier for certain taxpayers to engage in interstate commerce or to push towards uniformity in interstate tax policies, retaliatory taxation generates benefits. However, there is reason to believe that retaliatory taxation may not be the most equitable or effective tool to bring about those benefits. Apart from those concerns, retaliatory taxation imposes direct costs that cut against the benefits it can generate. Even so, retaliatory taxation is one of the few tools states have to protect their citizen’s ability to access and compete in the national marketplace in the absence of federal action. If the federal authorities choose not to get involved in matters of state taxation of interstate commerce, retaliatory taxation by the states themselves is likely to play a role in policing such taxation.
V. The Future of State and Local Taxation
The theme of The Tax Lawyer—Northwestern Pritzker School of Law, State and Local Tax Symposium in 2023 was the future of state and local taxation, and the future predicted by this Article is messy. A system of retaliatory taxation to protect the national marketplace is far from ideal. It imposes significant costs on interstate taxpayers and the states for gains that might be fleeting. In other words, it is an inefficient means of achieving the economic union that is core to the constitutional design of the United States.
However, a system of retaliatory taxation is not the worst situation; if the states were given completely free rein to tax interstate commerce, unchecked by the federal government and sister states, then highly burdensome and protectionist taxes would arise, if history is any lesson. Thus, the story of retaliatory taxation is a story of what happens when the federal government fails to police the states when they tax interstate actors. There is no question that Congress has the power to dictate the terms on which the states may tax interstate commerce, but Congress has been reluctant to do so in any sweeping manner.
In the absence of congressional action, the Supreme Court has traditionally stepped into the role of policing state taxes on interstate commerce through the dormant Commerce Clause doctrine. This doctrine has always been controversial, and in contemporary jurisprudence in particular, the Court has retreated from restricting state tax actions under the dormant Commerce Clause doctrine, which has opened the door for retaliatory taxation measures to be upheld. This retreat has also shifted responsibility to the states themselves to maintain the national marketplace, working within the limitations explicitly imposed on their power by the Constitution.
The constitutional limitations explicitly imposed on the states include those found under the Equal Protection Clause and the Privilege and Immunities Clause. In the context of state taxation of interstate commerce, these limitations may prove weaker than expected. The state tax power is viewed as fundamental, and the Supreme Court has been wary of disrupting that power, granting states leeway even to discriminate against interstate commerce when a state has a legitimate purpose for doing so. The Court has recognized that a state wanting to promote its domestic taxpayers’ ability to engage in interstate commerce by removing burdens on those taxpayers is such a purpose.
Once the legitimacy of that purpose is recognized, then the question of means becomes central. As uncomfortable as the conclusion may be, retaliatory taxation is one of the few tools—if not the only tool—that a state has to achieve that goal unilaterally (i.e., without the cooperation of the offending state, such as through a multistate compact). Retaliatory taxation respects the sovereignty of the taxing state, while also affording the state whose citizens are subject to the retaliatory taxation the choice to remove those burdens or to continue with its preferred policy. If enough states side with one state or the other, something close to a national consensus could arise as states are pressured to conform to one approach to taxation. The mere lobbying of legislators in sister states and the subsidization of domestic taxpayers are unlikely or unable to achieve such results. This is not to oversell the effectiveness of retaliatory taxation; the experience in the realm of insurance premium taxes demonstrates how roughly retaliatory taxation achieves its goals. However, it is not clear that any other available method would more effectively allow an aggrieved state to push back against the undesirable tax policy of another state.
Thus, the warning of this Article for the future of state and local taxation is a warning about federal abdication of responsibility for maintaining the national marketplace. Congress and the Supreme Court must not fully remove themselves from this task, lest tax policy for interstate commerce be dictated in important ways by a system of retaliatory taxation. Indeed, states and taxpayers alike should encourage Congress to take a more proactive role in defining the contours of state taxation of interstate commerce, particularly as interstate commerce becomes ever more prevalent and less tied to any fixed location in the digital age.
As the Supreme Court considers future challenges to state taxes on interstate commerce, it must thoughtfully weigh the effects of abandoning the dormant Commerce Clause doctrine. If the Court wishes to rely more on explicit provisions of the Constitution, such as the Privileges and Immunities Clause, it must be careful when laying out the scope of those provisions for application to the modern world. Specifically with respect to the Privileges and Immunities Clause doctrine, that endeavor likely requires extending the Clause’s protections to corporate entities and bolstering restrictions on taxation that discriminates against interstate commerce. The Court could make clear that one state may not discriminate against residents of another state in order to equalize the tax burdens on those residents’ intrastate and interstate activities; achieving such equity should be a task solely for the home state. In any event, the Privileges and Immunities Clause doctrine as it currently exists likely is not up to the task of protecting the national marketplace from tax measures like retaliatory taxation. The Court must not cavalierly shift its state and local tax jurisprudence from the dormant Commerce Clause to the Privileges and Immunities Clause.
For now, retaliatory taxation continues to dominate only the niche area of state taxation of interstate insurance business. But the practice is sprouting in the context of sourcing personal income from remote work, an issue thrust into the spotlight by developments in technology, global events, and the national economy. If retaliatory taxation is not brought into check now, the practice may be expected to propagate as states continue to modify their tax policies to adapt to a changing world.