Interstate Trade Wars, Taxes, and the Dormant Commerce Clause

by Neil H. Buchanan

Last Wednesday, Professor Dorf's Verdict column and Dorf on Law post responded to Justice Scalia's dissent in the Supreme Court's 5-4 decision in Comptroller of the Treasury of Maryland v. Wynne.  Professor Dorf chose to focus on that dissent, in which Justice Scalia had offered one of his trademarked overstatements about the Dormant Commerce Clause (DCC), calling it "a judicial fraud."  Professor Dorf concluded that it is not, and that if Justice Scalia thinks that it is, then much of Scalia's work (re, say, anti-commandeering or state sovereign immunity) must similarly be fraudulent.

Nonetheless, Professor Dorf constructed his column and post last week not as defenses of the DCC itself.  As he put it, "[o]ne might reasonably think that the DCC is on balance a bad idea or has taken a wrong turn or something of that sort," and he concludes that "[n]one of this is to say that one cannot criticize any particular DCC rule or even the DCC doctrine as a whole."  Here, I will not critique the DCC overall, but I will consider whether the particulars of the Wynne case suggest that the doctrine was misapplied.

The George Washington Law Review recently began an online affiliated journal called On the Docket. in which GW faculty write short pieces responding to recent Supreme Court cases.  Last week, I wrote a response to Wynne, because it is a tax case, noting a particularly odd standing problem that the Court ignored, and showing how that unresolved standing issue led to an even more puzzling remedies problem.  Interested readers are invited to click on that (blog-length) piece at their leisure, but I will not discuss those arguments further here.

At the end of that piece, I also noted that the Wynne majority failed to solve the DCC-inspired problem that supposedly motivated the justices to hold against Maryland in the first place.  Before explaining that argument more completely, however, it is necessary to explain the tax provisions at issue in that case.

Most states tax incomes, and those states that do so generally tax the incomes of their residents, along with the incomes of nonresidents whose income is earned in the state.  In order to prevent "double taxation" -- a gross misnomer that I plan to discuss in my Dorf on Law post later this week -- states give their residents a credit for taxes paid to another state.  Thus, if a resident of Illinois earned all of her income in Ohio, and Ohio levied a tax of $20,000 on that income, then Illinois would reduce its resident's state taxes by $20,000.  (If Illinois's tax on the relevant income were $20,000 or less, then the tax liability to Illinois would be zero.)

Maryland ran a similar system, with a slight twist.  Maryland's state income tax is formally levied as a progressive-rate-structure state-level tax, along with a single-rate county add-on tax.  Residents of Howard County, where the Wynnes live, could pay a maximum marginal tax rate of 5.75% to the state, plus a uniform 3.2% rate to the county.  As an administrative matter, the county tax is actually paid to the state, using the same tax forms that one uses to determine state tax liability.

The twist is that Maryland provides the out-of-state tax credit only on its state-level tax computations, but not on the county add-on taxes.  The Wynne majority held that this violated the DCC.  The five-justice coalition concluded that the failure to credit out-of-state taxes was an example of one state discriminating against interstate trade, "the quintessential evil" that the DCC was designed to avoid.  After all, if Maryland is setting up its system such that a resident will end up paying more in total taxes (to Maryland and to other states combined) if she earns any of her income in another state, then Maryland must be engaging in a "trade war"-like effort to discriminate against interstate trade.

As I noted above, and in my piece in On the Docket, the problem with the Court's holding is that it does not actually prevent the quintessential evil that supposedly motivates the majority.  Specifically, the majority explicitly would allow Maryland to choose to eliminate the out-of-state tax credit entirely.  Doing so would be even more discriminatory toward out-of-state trade, because taxpayers like the Wynnes would face an 8.95% tax on out-of-state income, not 3.2%.  This passes muster under the DCC, says the majority, because it is "internally consistent," that is, it would not cause cross-border discrimination IF all other states adopted it.  Justice Scalia rightly mocks this as an "imaginary" benefit from applying the DCC.

Now, one might object that Maryland would never even consider eliminating the credit for all out-of-state income, because that would imply a tax increase on many Marylanders, which would be politically unpopular.  Similarly, that Maryland's state taxes are higher than, say, Virginia's does not raise DCC concerns, even though Maryland's system discourages Virginians from doing business in Maryland, on the theory that Maryland's legislature made a "tough choice" in slightly discouraging business from out-of-staters in order to provide the level of services to Marylanders that the political system could support.  There would, apparently, be no "race to the top" in which states increase their taxes to harm interstate trade, meaning that cross-border discrimination is only a problem if it actually threatens to create a multistate series of retaliatory measures, with each state trying to take an advantage over another.  Such retaliatory frenzies, after all, were a large part of the motivation to replace the Articles of Confederation with the Constitution.

But what is the "retaliation" that other states might have considered, in response to Maryland's system?  Repealing their state tax credits for out-of-state-sourced income would similarly impose higher taxes on their own in-state residents, which would be similarly politically inconvenient.  According to the Maryland high court's decision in this case, Maryland's current bifurcated system was adopted (sort of by accident) in 1975, yet there has been no evidence in the four decades since then that other states have even considered retaliating.  If a trade war is brewing, it is on a very slow burn.

One might object, however, with a classic slippery slope argument, saying that the courts are required to police the smallest possibility of one state's taking advantage over others, in order to prevent things from getting out of hand.  As Professor Dorf described the modern defense of the DCC, in his Verdict column:
"Congress lacks the capacity to keep track of and override all of the laws that discriminate against or unduly burden interstate commerce that may be enacted by any of the fifty states and thousands of local governments. The judicially enforceable DCC thus operates as a kind of default principle. The courts presume that Congress would preempt such state and local laws if it had the capacity to do so."
That justification, however, is inconsistent with reality.  (To be clear, Professor Dorf took no position on that justification.  He simply described it.)  The DCC does not eliminate all burdens on interstate commerce, as the Wynne decision itself shows.  (Again, the Wynne majority blessed a system that would be discriminatory in practice.)  Moreover, consider all of the ways in which states routinely compete with each other, in openly retaliatory ways.  The Court has allowed "race to the bottom" tax competition among states, in which corporations play different states against each other, allowing the corporations to receive taxpayer dollars.  If the concern is that state legislators are going to be induced by interstate competition to enact policies that are ultimately unwise (such as beggar-thy-neighbor tariffs, a la pre-Constitution U.S. states), then this kind of effort to use tax and spending policies to disadvantage other sovereign states should also be a concern.

Moreover, states are permitted to engage in "tax exportation," which is the snarky term for figuring out ways to tax people who are passing through the state.  Hotel taxes, airport taxes, and so on are essentially ways for state legislatures to empty the wallets of people who cannot vote the legislature out of office.  Why would the courts not get involved, even though this is clearly discriminatory?  Apparently, because the modern DCC is not actually a method by which the courts implement a high-alert, anti-slippery slope version of the anti-trade war principle.

Or perhaps the idea is to prevent things from getting too far out of hand.  Congress has the power (within some limits) directly to require the states to be consistent in their tax policies.  It has not done so, even though its inaction does allow states to act in ways that are mutually self-defeating.  There is a sort of negative version of this inaction, which Professor Dorf explains in his column:
"The fact that Congress has the power to override a judicial ruling finding a DCC violation acts as a failsafe in case the presumption fails.  And the fact that Congress only very rarely exercises that power shows that in applying the presumption embodied in the DCC, the courts have done a pretty good job of approximating what Congress would do to combat state-versus-state protectionism if it had the capacity."
That is, we could read congressional inaction to reverse the courts' DCC rulings as proof that Congress broadly agrees that not all discriminatory actions by state legislatures need to be blocked.  Yet that is not a reason to say that all of the Court's DCC decisions are presumptively correct, nor is it a reason to read all congressional inaction as an endorsement of the Court's DCC jurisprudence.  The best that we can say is that Congress is not upset enough with the status quo to do anything about the marginal cases, one way or the other.  But that means that, if the Court presumes to be acting as Congress's failsafe, it has to have a decent reason to adopt a DCC that allows some blatantly discriminatory behavior while disallowing something as minor as Maryland's now-disallowed system.