EVENTS

Date:	Monday, May 2, 2005
Time:	9:00 AM -- 12:00 PM
Location:	Wohlstetter Conference Center, Twelfth Floor, AEI 1150 Seventeenth Street, N.W., Washington, D.C. 20036

May 2005

State Tax Incentives for Business: Healthy Competition or "Race to the Bottom"?

States and even local governments routinely seek to attract businesses through tax incentives, credits, or exemptions. In one of many pending legal challenges, a federal appeals court has declared that many such measures constitute an impermissible, discriminatory interference with interstate commerce. This decision in Cuno v. DaimlerChrysler has prompted a now-pending request for Supreme Court review, as well as demands for federal legislation that would regulate the permissible scope of state tax competition for business. What do Cuno and its consequences entail for state governments, businesses, and taxpayers--and for the federal architecture? Are tax incentives and exemptions a healthy form of state competition or a destructive industrial policy race to the bottom? Leading experts and participants in the judicial and legislative arenas will discuss the legal, economic, and political aspects of the controversy.

Panel I: Was Cuno Right?

Michael S. Greve
AEI

What are the rules of the game that make state competition productive rather than destructive? Historically the answer has been that we try to settle for a few basic conventions. One of them is free entry and exit; another is the general norm of nondiscrimination which is embodied in several constitutional provisions and in one important inference from the constitutional structure, the dormant Commerce Clause. It has never been quite clear how these rules are supposed to operate in any given context, the most recent of which is the question of state incentives and state tax abatements for businesses that choose to locate within a given state. The latest focal point of this debate has been Cuno v. DaimlerChrysler, in which the Sixth Circuit Court of Appeals sustained some tax incentives and barred others as prohibited by the dormant Commerce Clause.

Once upon a time in the United States, states competed on many margins, from environmental standards to labor standards and so forth. Much of that continues, but on the other hand, there are in many areas pervasive federal minimum standards that choke off competition. Stymied on one front, states or jurisdictions start monetizing the competition that once took place on other margins and competing with tax incentives or selective tax abatements. While wishing for the old competition, one must ask, is this better than nothing? Or should we think about some other rules of the game?

Peter D. Enrich
Northeastern University School of Law

In the Cuno case, the vast bulk of Ohio’s incentive package consisted of two tax breaks: the investment tax credit, which allowed businesses to reduce their corporate income tax by $0.135 cents for every dollar of new machinery and equipment that they placed in use at the site; and a ten-year exemption from all taxes on personal property associated with the plant, conditioned on the employer agreeing to meet certain levels of overall investment and certain levels of employment at the facility. This is how business is done in America today, and for a company to locate a major facility without doing so would be irresponsible.

Through the Commerce Clause, however, regulation of interstate commerce belongs to the federal government. States cannot use their tax systems or their regulatory systems in ways that favor in-state economic activity over out-of-state or interstate activity or discriminate between the two. Ohio’s attempted investment tax credit clearly discriminated by creating a system under which two identical businesses, each doing business and paying taxes in Ohio, would be taxed differently if one located a facility in the state. Similarly, the property tax abatement offered a promise of preferential treatment in exchange for further commitments to economic activity in the state. The Sixth Circuit found the former unconstitutional but found the latter not coercive enough to violate the Constitution. We have asked the Supreme Court to review the Sixth Circuit’s finding concerning the property tax portion, and the defendants will be petitioning for review of the decision regarding the investment tax credit.

Nothing about the Commerce Clause or the Cuno decision suggests that states cannot compete for business by changing their rates of tax or by changing the basic structure of what they tax in ways that may make them more hospitable to business. Certainly, nothing affects their ability to provide improved infrastructure, education, or services of the kinds that make the most difference to businesses. What they cannot do is tailor their tax systems to target benefits narrowly on those businesses that target their state for economic activity. That is the kind of measure that raises problems of discrimination and distortion. The Commerce Clause does and should set limits.

Brannon P. Denning
Cumberland School of Law

Was Cuno defensible and was it a faithful application of existing case law? Yes. A line of cases, all decided fairly close to one another, furnished ample authority for the court to conclude that tax laws that coerce taxpayers into committing to economic activity are discriminatory in a constitutionally impermissible sense and violate the dormant Commerce Clause doctrine. But should the principles and cases that were applied be reexamined or narrowed in some way? Yes.

Law professors who have addressed this question acknowledge that they arrive at the conclusion of impermissibility by reading those previous cases for all that they are worth. The Supreme Court may not read with so broad an eye. But more importantly, the problem with reading these cases for all that they are worth is that you expand the notion of discrimination to the point of uselessness. As Professor Edward Zelinsky argues, if courts proceed down the Cuno road, no state tax law would withstand a dormant Commerce Clause challenge, and direct subsidies could also be in constitutional danger. This critique suggests that the Court needs to revisit the concept of discrimination and provide a better definition that is less susceptible to relentless expansion and more helpful for lower courts.

It is important to remember that nothing would have happened to DaimlerChrysler’s taxes if they had located that plant in Michigan, and that this tax incentive was available both to domestic and foreign corporations on an equal basis. On the other hand, the notion of discrimination as coercion is troubling. Under the argument in Cuno, had DaimlerChrysler not had an existing plant in the state and been lured into the state by the exact same set of incentives, there would be no constitutional problem because the coercion principle operates only on existing taxpayers. So by the logic of the case, two similarly situated corporations could be offered the same set of incentives, but if one already existed in the state and the other did not, the former would pass constitutional muster, while and the latter would fail.

Panel II: Economics and Federal Legislation

Loren Chumley
Tennessee Department of Revenue

Taxpayers want certainty, and while taxes may not be the deciding factor when locating, businesses want to know what the bottom line on the balance sheet is going to be. As we lose manufacturing jobs overseas and citizens ask our governor where they are going to get their next paychecks, we work to put together a package showcasing Tennessee as an attractive place to do business. Tax incentives are one of many tools in our arsenal.

Tennessee has fairly run-of-the-mill tax incentive programs. We do a jobs tax credit program that is available based on a certain amount of capital investment and the creation of twenty-five jobs. We expanded that program last year to allow a business to qualify if it created fewer than twenty-five jobs, if it had the appropriate capital investment, and if those jobs paid a higher-than-average wage in that particular state. We also have a qualified headquarters facility program, and we are working to help transition former manufacturing employees into the technology jobs that are more prevalent in our society today and are higher paying. At the end of the day, from the state perspective, what is important is the ability to put these programs on paper and to present them to companies who can then know where they stand.

Each state is different. Tennessee made a choice that it was not going to have a personal income tax, but we have a franchise and excise tax on businesses that comprises about 12 percent of our tax base. We are also a very heavy sales tax state. Roughly 61 percent of our tax comes from the sales tax, and it is a high rate, anywhere between 9.25 and 9.75 percent. Business pays quite a chunk of that. States make these choices and try to balance them to be competitive; so when a court decision disrupts our attempts, it does put us in a somewhat curious position. Not only do we have to wonder whether our tax incentives are in doubt as a result of the Cuno decision, but we also have to wonder what the remedy for that would be for those companies who have already come based on a pledge they would qualify for these incentives.

John P. James
Lommen, Nelson, Cole & Stageberg

In recognition of the human condition, we in the United States have emphasized the separation of powers. The legislature decides what taxes we are going to have and what characteristics determine how much each business and individual must pay. The executive administers the tax function; the judiciary decides the disputes. Minnesota has tampered with that structure by allowing the executive branch to determine the beneficiaries (and the benefits) of the state’s tax incentive programs. The result is a hodgepodge of over 900 effectively tax-free zones, and a list of multimillion-dollar deal-makers, from the governor’s office on down, operating with delegated authority. If that is not a gross violation of the separation of powers, I do not know what is.

Long-term tax giveaways and business beauty contests go to the very core of the conceptual framework of American society because they undermine the integrity of the tax system, starting with the revenue-raising capacity. We in Minnesota do not know how much money we are going to give away--we have simply licensed our economic development directors to go to town. Then there is the moral authority of the tax system which is in no small amount of trouble in the United States. We depend upon voluntary compliance, and selective enforcement undermines the respect necessary for the system to function. Finally, discriminatory treatment saps the pressure to have a better tax system for all business.

We have sent the foxes to guard the henhouse. We have economic development directors and businesses interested in trading in future state tax dollars. But this is not supposed to be a partnership. There is supposed to be a distinction between government and business, especially when it comes to taxation. There is a huge potential for corruption and for just plain getting it wrong; government is widely thought not to be very good at picking economic winners and losers. In this case, they get to pick “winners” by handing out millions of dollars of benefits off budget and with very little accountability.

Kevin Thompson
Council on State Taxation

In Cuno, the court used the dormant Commerce Clause to strike down Ohio’s investment tax credit on the basis of congressional silence; in the absence of a federal law on an issue of interstate commerce, the court reserves the authority to interpret the void. If Congress, however, wants to come back and trump the court’s decision by passing a law, they have the power to do so. Late last session, Senators George V. Voinovich (R-Ohio) and Mike DeWine (R-Ohio) introduced legislation which would grant authority to the states to offer the manufacturing and equipment incentive at issue in the case.

The business community is looking for a broader solution from Congress that would restore the debate to the state capitols and remove it from the federal government, in this case the federal judiciary system. The simple goal of the federal legislation we would like to see is to affirm the authority of the states to offer tax incentives for economic development purposes if they so choose. If Congress does pass a bill, states would still be free not to offer incentives and to structure their tax affairs as they see fit. And if there were an unconstitutional tax incentive on the book in a state, it would still be challengeable under state law or under existing Commerce Clause jurisprudence.

If a broad bill were to be introduced, the approach should be to give some certainty to companies who have been relying on these credits and to allow the decisions to be made in the states. That is what we are looking for from Congress and what the businesses, Senator Voinovich, and other interested state and local groups have been working on as far as legislation in the past couple of weeks. To date there has been no bill introduced. We are still working and hope that there will be some legislation introduced shortly to give businesses and states alike a measure of certainty.

AEI research assistant Kate Rick prepared this summary.