Increasing state-level taxation drains revenue for both states and the federal government.

In theory, the tax cannibalization problem may occur whenever state governments and the federal government levy taxes on overlapping tax bases. We demonstrate that the tax cannibalization problem currently does occur with respect to state-level taxes on corporate income and capital gains, and possibly also ordinary income. n9 Specifically, we show that state governments' current top tax rates on these bases impose large, wasteful costs through tax cannibalization. [*299]

Extrapolating from the existing empirical literature, we develop a model showing that a typical state's top corporate income and capital gains tax rates generate surprisingly large economic waste. n10 We propose federal-level reforms that could eliminate much of this economic waste while still maintaining the current levels for state governments' revenues and distribution. Through enacting these reforms, the federal government could produce a "win, win, win" for the federal government, state governments, and taxpayers.

Let us now briefly elaborate the nature of the tax cannibalization problem with an example of state-level corporate income taxes. State-level corporate income taxes are currently vulnerable to a variety of distortionary responses that shrink the states' corporate income tax bases. These distortionary responses include various forms of tax avoidance and tax gaming. It is useful to divide these distortionary responses into two conceptual categories.

The first conceptual category consists of distortionary responses that involve taxable activity relocating to other states. We label this category as "horizontal distortions." Because horizontal distortions involve taxable activity relocating across state lines, but remaining within the United States, horizontal distortions do not necessarily shrink the federal government's corporate income tax base. Important examples of horizontal distortionary responses to state-level corporate income tax rates include corporate taxpayers shifting their physical presence and sales activities from states that levy higher corporate income tax rates to states that levy lower corporate income tax rates. n11

The second conceptual category consists of the remaining distortionary responses that do not involve taxable activity relocating to other states. We label this category as "vertical distortions." In contrast to horizontal distortions, vertical distortions do typically shrink the federal government's corporate income tax base. Important examples of vertical distortionary responses to state-level corporate income tax rates include corporate taxpayers shifting real investment activities abroad, corporate taxpayers shifting reported profits to subsidiaries in foreign jurisdictions, corporate taxpayers shifting from equity financing to debt financing, and [*300] business taxpayers shifting from the use of corporate forms to partnership forms. n12

Vertical distortionary responses are the primary source of the tax cannibalization problem. Because vertical distortionary responses shrink both the state government's corporate income tax base and the federal government's corporate income tax base, vertical distortionary responses to state-level corporate income tax rates deprive the federal government of tax revenue.

Moreover, the federal government levies much higher tax rates on the bases of corporate income, ordinary income, and capital gains, than do any state governments. Consequently, the federal government suffers much greater harm from vertical distortionary responses to state-level tax rates on these bases than do the state governments setting these tax rates.

When vertical distortionary responses to a state government's tax rate deprive both the federal government and other states' governments of revenue, in the aggregate, we refer to this as "tax cannibalization." Throughout the remainder of this Article, we explain how tax cannibalization currently biases state governments' tax policy decisions and thereby results in large-scale economic waste.

Indeed, we approximate that - because of tax cannibalization - the top corporate income and capital gains tax rates in some states currently exceed their national revenue-maximizing levels. In other words, reducing these tax rates could actually increase the overall tax revenues raised (in the aggregate) by the acting state government, the federal government, and other state governments.

There are at least three reasons why the tax cannibalization problem is especially severe in the context of fiscal federalism in the United States. n13 First, state governments mostly piggyback on the federal government's tax-base-definition rules for corporate and personal income taxes. Second, the federal government currently levies tax rates on these bases that are amongst the highest in the world. Third, under the federal government's current tax-base-definition rules, the corporate income and capital gains tax bases are rather vulnerable to tax avoidance and tax gaming responses. The combination of these three factors results in state-level tax rates on corporate income and capital gains generating very large tax cannibalization.