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The Negotiated National Tax

September 14, 2008

The Negotiated National Tax offers states the opportunity to “opt out” of
the federal income tax system. If a state chooses to negotiate its tax burden
with the federal government, that state’s wage earners would be exempt from
federal individual income tax. In place of federal income tax on individuals, the
state would be the one making payments to the federal government.
The primary benefit of the Negotiated National Tax is innovation. States
are far better suited to determine the appropriate mix of taxes for their citizens.
The cultural and economic differences between Louisiana and New York could
not be more profound. Why shouldn’t their respective tax systems be designed
to reflect these differences?
How It Works
• Each of the 50 states, and the territories, negotiates annually with the
federal government to determine that state’s tax burden for the year.

• The state is then responsible for collecting the tax in any way it sees fit
and for making payments to the federal government.
• If the negotiation with any individual state is unsuccessful, then the wage
earners within the state default back to a national income tax, similar in
structure to today’s income tax, with rates set by the federal congress.

Benefits
• The NNT would stimulate innovation. We don’t need to wait for the
federal congress to come up with a new tax code because each of the
states could experiment. Presumably, states with successful tax programs
would be copied by others.

• The NNT introduces some new checks and balances into the tax code.
– The federal congress can influence the system by adjusting the federal
income tax rate to either encourage or discourage state’s participation
in the NNT.
– Federal earmarks and unfunded mandates would have an additional
level of scrutiny during the tax negotiation.

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Discussion
The Negotiated National Tax offers states the opportunity to “opt out” of the
federal income tax system. If a state chooses to negotiate its tax burden with
the federal government, that state’s wage earners would be exempt from federal
individual income tax. In place of federal income tax on individuals, the state
make payments to the federal government according to the terms of the annual
agreement between that state and the federal government.
The primary benefit of the Negotiated National Tax is innovation. A “one-
size-fits-all” individual income tax structure is the only viable option for federal
lawmakers. The states are far better suited to determine the appropriate mix of
taxes for their citizens. Each state already has its own unique tax code and tax
collectors, so there would be very little extra burden on the existing bureaucracy.
In fact, the federal IRS could be substantially reduced in size.

How the Process Works

The concept of a negotiation is simple. Webster’s definition of negotiating is “to
confer with another so as to arrive at the settlement of some matter.” In the case
of the NNT the negotiation would be conducted between teams of negotiators,
one representing the interests of a state government and another representing
the interests of the federal government.

The Scope (What taxes are covered?)

Chris Edwards of the CATO Institute breaks federal taxes into two categories:
hidden and visible1 . The division is intended to be realized from the perspective
of the wage earner when reviewing documents such as a paystub where tax
information is readily available. The major visible taxes are the individual
income tax and the employee portion of federal payroll taxes. The major hidden
taxes are the employer portion of federal payroll taxes and corporate income tax.
“Payroll taxes” in this discussion are commonly known as Social Security and
Medicare.
The NNT is intended to replace the federal individual income tax. Other
taxes could be added to the system as it proves to be viable and beneficial to the
nation’s economy. Including payroll taxes into the NNT, for example, would lift
a huge burden from the backs of small business owners who are today saddled
with the administrative responsibility of collecting them on behalf of the federal
government.
A minor complication arises when a person earns wages in two different
states. What happens to this wage earner if one state has reached agreement
with the federal government but the other state has not? This situation is
really no different than existing law. The employer in the NNT state would
1 Chris Edwards, “Options for Tax Reform,” The CATO Institute, Policy Analysis No. 536,

February 24, 2005, available at www.cato.org.

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not withhold federal tax, but would withhold state tax. The employer in the
non-NNT state would withhold both state and federal tax.

The Process
To get a sound basis for the process that would be used by the state and fed-
eral governments to reach agreement, let’s work backwards. For purposes of
discussion, let us assume that the federal tax calendar does not change. The
federal fiscal year ends in September, but individual income tax is computed
and reconciled on a calendar year basis. So employers, software developers,
state and federal revenue departments, and others need to know whether a
state has reached agreement with the federal government to participate in the
NNT before, say, October 1 of the prior year. Three months may seem like an
inordinately short amount of time to make necessary preparations, but consider
that all of the federal and state tax collection systems are already in place. The
makers of accounting software, for example, need only to program the tax codes
as they always have and “flip a switch” when a state’s decision on the NNT is
made.
Going backwards in time from October 1, it would make sense that states
and the federal government should be finalizing negotiations in late summer
of the year prior to enactment. This time period happens to coincide with the
traditional time frame for federal budget negotiations, so it would be natural for
the NNT negotiations to factor into Congress’ estimates of next year’s federal
income.
If the state and federal negotiators can’t reach agreement by October 1,
the state defaults to the traditional federal individual income tax. As is the
case today, the tax is collected by the employer. If many states cannot reach
agreement we will enter the next year with a large federal IRS. If all states reach
agreement we will have a much smaller IRS – a net federal savings.
The agreement with federal negotiators allows the states to negotiate not
only the magnitude of the state’s tax payments, but also the timing. Florida,
for example, may benefit from making larger payments in winter when their
sales tax base is stronger. Other states may see advantages to other payment
schedules. This flexibility may present unforeseen opportunities to optimize
both federal and state treasuries.

The Negotiating Teams

Presumably, the states would be represented by some mix of negotiators as
prescribed by state law. The federal negotiating team should consist of repre-
sentatives of the executive branch (e.g. the IRS) and the legislative branch (e.g.
the CBO), as well as a few representatives from the other states.
The makeup of the negotiating teams might be best illustrated by way of
example. Selecting the state of Montana for the hypothetical scenario, the
members of the State negotiating team might be set by law to be two members
appointed by the Governor, the Chair and Ranking Minority Member of the

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Joint Legislative Finance Committee, and the Attorney General. The federal
negotiating team might be comprised of two permanent IRS officials assigned
to Montana, two permanent CBO officials assigned to Montana, and rotating
appointments from the governors of the states of California and Maine. The
state representatives might change every year.
The makeup of the federal team should be chosen to include representation
from the revenue side (the IRS), the expenditure side (the CBO) and some
members to ensure parity and fairness (the state representatives).

What Strategies Could Be Expected?

Some of the goals of each of the negotiating teams can be explored with relative
certainty. The state team will seek to maximize the return on its federal tax
bill and to improve the state’s cash flow by optimally timing the tax payments
to the federal government. The federal team will seek to adequately fund the
anticipated expenditures while taking into account the proportion of those ex-
penditures directly and uniquely benefiting the state they are negotiating with.
Congress would influence the negotiation both directly and indirectly. Congress
can indirectly influence the negotiation by setting the “default” tax rate either
so high that states have an imperative to negotiate better rates or so low that
concluding a successful negotiation is moot. The “default” tax rate is the in-
dividual income tax rate that the state’s wage earners will be charged if the
negotiation is unsuccessful.
Earmarks and “unfunded mandates” would get a more granular screening
through the negotiation process. For example, federal negotiators could say to
state negotiators, “If you want federal funding for a large project in your state
your tax bill will be 2% higher than without it.” Or, in the case of unfunded
mandates, let’s examine a hypothetical case where the federal congress has
passed a bill mandating that 2% of all electricity consumed in each state must
be solar. Negotiators for the State of Maine could say, “We would need two
times more solar panels than Arizona in order to meet this requirement. We
either need a tax break or an alternative.”

Benefits
Under the NNT, benefits accrue to both state and federal interests. In fact, the
combined benefits of the NNT should help to eliminate inefficiencies, stimulate
growth, and make the US economy more competitive.
Some of the benefits are:
• The federal revenue stream would be more predictable. This would help
the Treasury Department do a better job of managing our nation’s debt.
• The states would have more flexibility in competing for growth and stan-
dard of living. Some states will choose to focus on income and property
taxes, other states will choose to focus on sales tax. The decision can
be based upon the state’s current economic base and future development

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plans. This experimentation cannot be accomplished on a national level.

It would naturally lead to innovation and perhaps a whole new tax code
that is better suited to the 21st century economy.
• The state will have a more direct voice in matters of federal expenditures.
States could say very plainly, “We don’t want this program and we won’t
pay for it.” Of course the federal congress wins this discourse, as it does
in today’s reality, but the NNT would give the states a more direct venue
to voice opposition to unwanted programs.
• State representatives to the federal congress would be more closely aligned
with the goals of state officials and citizens. These representatives would
be keenly aware of the sticking points in the negotiation over taxes and
could tailor their votes accordingly.
• There would be a more visible and productive discussion of unfunded fed-
eral mandates. Currently these types of discussions are relegated to the
web pages of organizations like the National Conference of State Legisla-
tures2 . Imagine what might happen in the public consciousness if all 50
state negotiations were stuck on one federal issue!
• There would be more visible and productive discussion of earmarking. The
topic is currently viewed mostly as a joke by the public at large. “Pork”
projects are routinely held up to ridicule in the press. Under the NNT
federal negotiators could, in some small measure, hold states accountable
for the pork they receive.

1 FAQ [under development]

What is the Negotiated National Tax? The Negotiated National Tax is a
proposal that eliminates the federal individual income tax and replaces
it with state taxes that could be income, sales, property or any mix of
these or other taxes. The states are then responsible for remitting tax
payments to the federal government. The underlying premise is the state
is best equipped to know which taxes are most appropriate for its citizens
and economy. The federal government still gets its money, but it’s not a
“one-size-fits-all” solution like today’s federal income tax.
What if the federal government and a state can’t reach agreement? If
a state can’t reach agreement with the federal negotiators, then the wage
earners in that state simply revert back to the federal income tax. Busi-
nesses are responsible for collecting the taxes in those states just as they
are today. There are no new forms or procedures to put in place. They
already exist.
2 See http://www.ncsl.org/standcomm/scbudg/manmon.htm.

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What if I receive wages in two different states? Again, this is no differ-

ent than today’s system. The employers in both states are required to
collect the appropriate taxes.
How can the NNT help both federal and state governments? Isn’t it true
that there has to be a winner and a loser in a negotiation? The answer
is no, both parties can win. This win-win is possible because of the same
priciples at work in modern portfolio theory. Let’s use Alaska as an ex-
ample. Their tax base is strongly dependent on oil revenues. When the
price of oil goes up their tax revenues go up. What if Alaska asked federal
negotiators to tie their tax bill to the price of oil? This would benefit
Alaska, but how would it benefit the federal government? Federal nego-
tiators could then go looking for situations that minimize their risk and
maximize their returns. In this hypothetical example, the federal negotia-
tors might say to themselves, “American-made cars seem to sell well when
oil is cheap and poorly when oil is expensive.” They could then offer the
State of Michigan a deal. They could tie Michigan’s tax bill to auto sales.
This would help Michigan, and the federal government has minimized its
risk. When oil is cheap the Fed gets less money from Alaska but more
money from Michigan and vice versa.

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