Taxing State and Local Government Production: Economic and Legal Perspectives

The Internal Revenue Service has held that the section 115 exclusion from taxation of the gross income state and local governments earn from public utilities or from the exercise of any "essential governmental function" applies to any income that accrues to them. This provides an incentive for government to produce public goods and services rather than contracting with private firms, although the incomplete contract literature suggests economic welfare might be enhanced by private production. Examination of the Constitutional limitations on taxation of states and the difficulties of applying the essential governmental function test suggests any tax Congress levies must be subject to limitations implicit in the Tenth and Eleventh Amendments that require specificity. A starting point for such a tax structure might be the unrelated business income tax currently levied on the activities of tax-exempt organizations. Congress might focus on those activities that the incomplete contract literature suggests would be better provided by private firms and that are financed with charges and fees.