INSIGHT: The Genius of the Commerce Clause and Why It Still Matters

The enactment of the new international provisions of the Tax Cuts and Jobs Act (P.L. 115-97) (TCJA) probably marks the most significant transformation of the taxation of foreign transactions and businesses by the U.S. since the first enactment of the Internal Revenue Code in 1913.

As has been documented in many other places by others and us, since all states rely upon the federal income tax law as the basis of their own income laws, states are now wrestling with whether and how these new provisions should be incorporated into their tax laws. Just because the states regularly conform to the federal tax laws as they change doesn’t mean they can or should.

One critical question states should address is whether our foundational document, the U.S. Constitution, allows them to follow the federal treatment? One of the significant provisions of the U.S. Constitution is the Commerce Clause set forth in Article I, Section 8, Clause 3. The clause is quite short and simply states that the United States Congress shall have power “To regulate Commerce with foreign Nations, and among the several States, and with the Indian Tribes.” Since its ratification, the courts have recognized that the Commerce Clause has both an active part by which the Congress itself can pass laws regulating commercial activity among the states and a dormant component.

Since Justice Marshall first penned it in the early 1800’s, the courts have also consistently recognized a “dormant Commerce Clause” by which the courts will stand in and stop state activities which discriminate against, or impose an undue burden on, interstate or foreign commerce. Just a few weeks ago, Justice Alito reiterated this in Tennessee Wine and Spirits Retailers Assn. v. Thomas (Tennessee Wine & Spirits) in striking down a Tennessee law requiring at least two years of residency to obtain a liquor license because it unconstitutionally discriminated against interstate commerce.

While there are many cases and articles describing why we have a Commerce Clause, we think it deserves reminding what the Framers were thinking when they wrote the clause back in the 1780s, why it was so critical to the establishment of our federal system of government and why it still is relevant today.

James Madison along with Alexander Hamilton and John Jay, drafted a series of essays which appeared in prominent newspapers at the time of the Constitution’s drafting and ratification by the state legislatures. Compiled and known as The Federalist Papers, they provide explanations written by the authors of the U.S. Constitution which were intended to educate and persuade the American people of the various provisions of the Constitution and why the states needed to ratify it. Even today, the Justices of the Supreme Court regularly look to The Federalist Papers to divine the meaning and the context behind various constitutional provisions.

In The Federalist No. 42, in considering the powers “to regulate commerce among the several States,” Madison first called attention to the deficiencies in the Articles of Confederation. The first written constitution of the United States, the Articles focused on maintaining state sovereignty at the expense of a weak federal government and posed seemingly insurmountable issues that eventually led some to believe the American experiment of self-government would fail. A major symptom of the nation’s weak federal government was its inability to regulate interstate or foreign commerce which lead to economic squabbles among the states. Madison describes states negotiating separately with foreign countries on trade, enacting protectionist provisions, and retaliating against each other by levying tariffs, fees, and taxes on commerce coming from other states to favor and promote business activities in their home states. The Framers wanted to change all this under the U.S. Constitution. According to Madison:

“A very material object of this power [regulating foreign commerce] was the relief of the States which import and export through other States, from the improper contributions levied on them by the latter. Were these at liberty to regulate the trade between State and State, it must be foreseen that way would be found out to load the articles of import and export, during the passage through their jurisdiction, with duties which would fall on the makers of the latter and the consumers of the former. We may be assured by past experience, that such a practice would be introduced by future contrivances; both by that and a common knowledge of human affairs, that it would nourish unceasing animosities, and not improbably terminate in serious interruptions of the public tranquility.”

Madison’s wording from the 1780’s about “terminating in serious interruptions of the public tranquility” is nothing short of expressing his very real concern that wars would erupt among the States unless discriminatory treatment among them and with foreign trade was limited. To further his point, Madison identified 18th century Switzerland and The Netherlands as peaceful nations where communities were not permitted to “establish imposts disadvantageous to their neighbors,” and contrasted these nations with Germany, which at the time, did not enforce its law prohibiting princes and states from laying tolls or customs on bridges, rivers, or passages without the consent of the emperor and the diet—and the practice “produced there the mischiefs which have been foreseen here.”

Simply put, Madison argued that under the system the Framers envisioned in the Constitution, the federal government certainly can discriminate against foreign commerce in the design of its taxes (i.e., “imposts”). However, as subnational members of that federation, states cannot discriminate against foreign commerce—except with “general permission,” by which he meant the consent of the federal government through acts of the U.S. Congress.

Hamilton, too, articulated similar concerns. In Federalist No. 22, addressing the need to consolidate regulation of commerce in the federal government, just like Madison, he cites to the then present day problems facing the German principalities:

“The interfering and unneighborly regulations of some States, contrary to the true spirit of the Union, have, in different instances, given just cause of umbrage and complaint to others, and it is to be feared that examples of this nature, if not restrained by a national control, would be multiplied and extended till they became not less serious sources of animosity and discord than injurious impediments to the intercourse between the different parts of the Confederacy. “The commerce of the German empire [footnote deleted] is in continual trammels from the multiplicity of the duties which the several princes and states exact upon the merchandises passing through their territories, by means of which the fine streams and navigable rivers with which Germany is so happily watered are rendered almost useless.” Though the genius of the people of this country might never permit this description to be strictly applicable to us, yet we may reasonably expect, from the gradual conflicts of State regulations, that the citizens of each would at length come to be considered and treated by the others in no better light than that of foreigners and aliens.” (emphasis added)

Without imposing such a limitation on the states, both Madison and Hamilton appear to be expressing their very real fear that the imposition of discriminatory taxes by the states on interstate and foreign commerce would lead to wars and disputes just as was occurring in German principalities during the late 1700s. In contrast, Madison seems to clearly envision the states of the U.S. being bound together in a federation like Switzerland or The Netherlands which at the time (and even today) were bastions of free trade among the members of the federation and no member of those federations treated foreign commerce differently without the express consent of the federation itself.

Even though states can’t impose discriminatory taxes on each other, why shouldn’t they impose their own tax on foreign income that the federal government is already taxing? U.S. Supreme Court Justice Clarence Thomas (consistently, no champion of the dormant Commerce Clause) provides a meticulously sourced history of what was in the minds of the Framers on trade in his 1997 dissent in Camps Newfound/Owatonna Inc. v. Town of Harrison. He spends many pages describing what the relation of the U.S. states to each other was like before the Constitution, supporting his view that the Import-Export Clause limits discriminatory state taxes, not the Commerce Clause. However, aside from his legal reasoning, the history he provides regarding what the Framers meant by “imports” and “exports”—with substantial evidence that imports and exports were not just items sent to and from foreign nations, but also items sent to and from other states—is very enlightening as to why the Framers believed that states can’t impose their taxes in the same way the federal government can. The result, according to Justice Thomas, appears to be that under the U.S. Constitution the federal government can take actions which result in discrimination against interstate and foreign commerce, but the Framers believed that the states simply cannot discriminate and more importantly, should not.

This concept played out in Kraft General Foods, Inc. v. Iowa Department of Revenue, in which the Court held that Iowa violated the Foreign Commerce Clause of the U.S. Constitution and unconstitutionally discriminated against foreign commerce by simply conforming to the federal dividend received deduction. This resulted in it taxing dividends received from foreign subsidiaries differently than dividends received from domestic subsidiaries which, in the Court’s view, was completely contrary to the objectives of the Commerce Clause to provide for free and non-discriminatory treatment of commerce, both interstate and foreign. These Constitutional limitations on the ability of the states to discriminate against foreign commerce should be at the very heart of the debate on state conformity to the new federal international tax provisions, such as the transition tax, GILTI, and others. The Constitution doesn’t appear to impose any limits on the ability of the federal government to tax GILTI or repatriated income, but, under the U.S. Constitution, do the states have the authority to impose taxes on this income derived from foreign organized businesses? The debate is far from over and scholars vary widely in their opinions on this matter. It is likely that it will be years before the question is answered by the courts. In the interim, we should look back to Madison’s and Hamilton’s concerns almost 250 years ago that it is not in our nation’s best interest to allow discriminatory state tax treatment of interstate and foreign commerce.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

The views expressed are those of the authors and do not necessarily reflect the views of Ernst & Young LLP or the global Ernst & Young organization. This article is provided solely for educational purposes; it does not take into account any specific individual or entity’s facts and circumstances. It is not intended, and should not be relied upon, as tax, accounting, or legal advice.

Steven Wlodychak is a principal. He is the state and local tax leader of EY’s Center for Tax Policy. Rebecca Helmes is a manager with the Indirect (State and Local) Tax practice of Ernst & Young LLP in Washington, DC.