Compensatory Tax Laws

Until the United States Constitution became law in 1789, each state operated as a sovereign entity loosely held together by the Articles of Confederation. Reluctantly, the states ceded certain powers to the federal government under the Constitution. One of those powers was the right to regulate commerce among the several states, referred to as the Commerce Clause. Today, the government applies the Commerce Clause to prevent states from enacting compensatory tax laws that restrict interstate commerce.

A compensatory tax is levied by a state on the transactions of businesses and individuals domiciled in another state or another country to balance the tax burden on domestic businesses and residents already subject to state taxation. For example, many states have a sales tax that might motivate people or companies to purchase goods and services from vendors located in states without a sales tax. To offset this competitive imbalance, these same states also levy a use tax on the merchandise or services purchased out-of-state. The use taxes are usually equivalent to the sales tax to eliminate any competitive advantage.

The Commerce Clause resides in Article 1, Section 8, Clause 3 of the U.S. Constitution and gives the federal government the right to regulate interstate commerce. On the other hand, the states contend the federal powers are too broadly applied and cite the Tenth Amendment as the states' authority to impose compensatory taxes. The Tenth Amendment to the U.S. Constitution was drafted to limit the spread of federal authority and to reserve for the states all powers not specifically granted to the federal government by the U.S. Constitution.

Over the years, the U.S. Supreme Court has consistently upheld the government's right under the Commerce Clause to prevent states from imposing compensatory taxes that discriminate against businesses primarily engaged in interstate commerce in favor of local intrastate businesses. The courts have presided over the issue of when a legal tax incentive become tax coercion in violation of interstate commerce. The U.S. Supreme Court has ruled that in certain instances the Commerce Clause does remove the states' power to regulate commerce but in other situations, states share equal taxing authority.

A state compensatory tax that appears to be discriminatory may be legal if the levy that is imposed on a particular class of out-of-state companies is substantially equal to an identifiable existing state tax on in-state companies of the same classification. At the time of publication, few compensatory taxes have met this court-imposed standard. As a general rule, compensatory taxes have been struck down as unconstitutional by the Supreme Court because they violate the interstate commerce provision of the Commerce Clause in the Constitution.