Protecting revenue is critical to states because, unlike the federal government, they can’t spend much more than they take in. As states enter the 2012 fiscal year, lawmakers have slashed everything from Medicaid to education programs to prison budgets, since their revenue still hasn’t rebounded to pre-recession levels.

If some federal lawmakers have their way, those revenue problems could get worse.

Bills that would restrict the way state and local governments tax businesses now have more momentum than they've enjoyed in the past, with lawmakers considering proposals to cap taxes on everything from cell phone service to rental cars to online transactions. State and local leaders say that could compound their fiscal straits at a time when they’re just barely starting to recover.

“It’s pretty easy right now for Congress to take a ‘no tax’ stand on something when it doesn’t cost them anything and it doesn’t affect their ability to appropriate funds,” says Bruce Johnson, chair of the Utah State Tax Commission. “They can look like they’re doing something very pro-business for their constituents.”

Because state and local leaders must have balanced budgets, Washington policies that tie their hands could jeopardize that balance. Many state leaders now fear the precedent that would be set if any of the tax preemptions under consideration becomes law.

“We think local tax decisions should be made at a local level,” says Lars Etzkorn, program director with the National League of Cities, which opposes many of the preemptions. “If people don’t like the taxes imposed by the local governments, they have the local ballot box.”

The current lineup of bills has more to do with industry than ideology, with many carving out specific exemptions for certain types of businesses.

Cellular providers, for example, are pushing for a law that could prevent state and local governments from increasing taxes on their service for five years. More than half the members of the House of Representatives – including members of both parties – are co-sponsoring the bill, which was approved by the House Judiciary Committee earlier this month.

Another bill, also enjoying bipartisan support, would force localities to stop taxing rental cars at a rate higher than any other type of rental product. That would spell trouble for many localities, which rely on those taxes to fund big facilities like sports stadiums.

Satellite television providers argue that they’re being unfairly taxed at the same rate as cable providers, even though they have less of a physical impact on a community. They’re backing bipartisan legislation to reduce their state and local tax burden. And online travel companies are pushing for legislation -- which has not yet been introduced but may be in the pipeline -- that would let them pay taxes based on the lower, wholesale rate they pay for rooms, as opposed to the higher, retail rate they charge customers.

The result of the bills, if successful, would create a conundrum for state and local governments: swallow a decrease in tax revenues, or simply tax something else to make up for the lost funding. State leaders tell Governing that since they’ve already made deep cuts in recent years, they’d probably just shift the tax burden to others. Most likely to take the hit would be small, in-state businesses that lack the resources to fight for special tax status.

“It’s taking away local decision making,” Etzkorn says “They’re forcing local governments to raise another tax or cut something because of a selfish special interest group.”

The strategy represents a bit of a departure from another industry tactic: pushing business-friendly legislation through state legislatures. Now, with states trying desperately to protect their revenue streams, industry associations are making an end-run to Congress, which wouldn’t have to deal with the fallout of the tax restrictions and is happy to enjoy the political benefit of lowering taxes.

Interestingly, many of the bills have been introduced in Congress several times before but are only now gaining traction in the form of subcommittee hearings and favorable votes from the House Judiciary Committee. That’s largely because their supporters have now had time to work the key decision makers involved with the legislation. “It is kind of a testament to the amount of work that some of the supporters have done,” says Harley Duncan, a managing director of KPMG who previously served as secretary of the Kansas Department of Revenue.

To a degree, the bipartisan support of the bills belies the typical inclinations of both parties. State leaders say that Republican legislators -- who typically portray themselves as the protectors of state sovereignty -- are ironically undermining the states by intruding into their authority. Democrats, meanwhile, are touting revenue increases as a way to help address the federal government’s fiscal woes. But at the same time they’re backing bills that could cut revenue for states and localities.

“We’re wondering where are the people who understand and respect the different roles of state and federal governments,” says Verenda Smith, a senior manager with the Federation of Tax Administrators, which represents state tax offices. Some who follow the legislation speculate the push is primarily a tool to engender support – and campaign contributions – from the business community as the 2012 election approaches, and members of the House know that the legislation is unlikely to be as successful in the Senate anyway.

An aid with the House Judiciary Committee says the bills don’t interfere with states’ ability to determine tax rates and are designed to prevent a state from “discriminatorily taxing employees and businesses that have little connection to the state.” Backers of the bills also argue that businesses are reluctant to expand and invest because of the uncertainly of their future tax burdens. Simplifying those tax systems, they argue, would help those businesses gain the confidence to expand and create jobs.

But state leaders don’t buy that argument and cite studies that show little connection between the types of taxes being targeted and the growth of their corresponding industries. “It’s hard to say there’s a real burden on the national economy if [online travel site] Orbitz has to collect a sales tax on a service charge,” says Johnson, the Utah tax commissioner.

Among the category of bills, the biggest threat to states and localities is the Business Activity Tax Simplification Act, which has been introduced six times since 2003, but is now enjoying more success than it has in recent years. The bill prevents a state from imposing various taxes on a business that lacks a physical presence within its borders. It also codifies what, exactly, constitutes that physical presence. The legislation taps into the same question that’s fueled the ongoing debate regarding how and if online retailers like should be taxed by states. Supporters of the bill argue that it prevents businesses from being double taxed and would simplify an overly-complicated patchwork of rules.

But states vehemently oppose the proposal. The Congressional Budget Office estimated that a 2006 version of the bill would cost states and localities $3 billion annually, since businesses would intentionally restructure their operations to avoid taxation (state collected about $642 billion in general fund revenue in FY 2011). “It's hard money to replace,” Smith says, “even in the best of times.”

Under BATSA, many activities corporations already conduct would no longer be taxable, according to the influential Center for Budget and Policy Priorities. For example, an out-of-state restaurant franchisor like Pizza Hut wouldn't be taxable in a state, regardless of how many franchisees it had, nor would an out-of-state bank, even if it hired independent contractors to process loans. Opponents argue that the bill provides a roadmap to companies seeking to avoid paying state business activity taxes altogether and would be a net-loss to the states. Of all the tax preemptions being considered, Smith says, that is “the one that keeps you up at night.”

Others legislation addresses taxes in the digital age. One proposal would restrict how states and localities tax digital products. Supporters say that a digital newspaper shouldn’t be taxed at a different rate than a dead-tree newspaper, for example. Another proposal would permanently extend the Internet Tax Freedom Act, which, since 1998, has “temporarily” placed a moratorium on state and local taxes of Internet access.

In some cases, the legislation may be less controversial. “You resist some of these if you’re a state person, but there are others where there might be an appropriate role for the federal government in establishing the rules,” Duncan says. The Mobile Workforce State Income Tax Simplification Act, for example, would simplify the hodgepodge of rules across the country that address when to tax workers who pass through states temporarily in the course of business. The proposal would create one threshold: after 30 working days.

Critics say all these pre-emptions could be a recipe for a slew of lawsuits, since state and federal law will inevitably conflict. They highlight a 1976 federal law that prevented states and localities from taxing railroad property at a higher rate than other commercial and industrial property. That law gave railroads the ability to pursue claims in federal court, and state tax experts say 30 years of litigation still hasn't made the intricacies of that law clear. Meanwhile, if any of the preemptions take effect, states may challenge them on constitutional grounds. “It’s not their problem when the court cases start popping up two or three years down the road,” Smith says. “That’s left for the states and taxpayers to slog through.”

Bill Number Bill Name What it Does Status
HR 1860 Digital Goods and Services Tax Fairness Act Restricts how state and local governments tax digital goods and services, like online music and movies Subcommittee hearings held
HR 1439 Business Activity Tax Simplification Act Prohibits states from taxing an out-of-state entity unless it has a "physical presence" in the taxing state. Defines what constitutes that "physical presence." Approved by House Judiciary Committee
HR 1002 Wireless Tax Fairness Act Restricts how state and local governments tax mobile phone service Approved by House Judiciary Committee
HR 1864 Mobile Workforce State Income Tax Simplification Act Prohibits a state from taxing wages on employees who have worked in the state for 30 days or less Subcommittee hearings held
HR 1804 State Video Fairness Act Restricts how state and local governments tax cable and satellite television service (designed to protect satellite TV providers) Referred to House Judiciary Committee
HR 2469 End Discriminatory State Taxes for Automobile Renters Act Restricts how state and local governments tax rental car service Referred to House Judiciary Committee
S 135 Permanent Internet Tax Freedom Act of 2011 Makes an existing ban on state and local taxes of Internet access permanent Referred to Senate Finance Committee