December 1, 2003

Are States' Economic Development Tax Incentives Unconstitutional?

Reader Ben Cunningham sent me a link to an interesting article on the web site of the respected Mackinac Center for Public Policy that explores where tax rebates and other incentives offered by various states to lure new businesses might violate the Commerce Clause of the U.S. Constitution.

But a far more important development is Cuno, et.al. v. Daimler Chrysler, in which the plaintiffs argue that such incentives violate the Commerce Clause of the U.S. Constitution. The case was filed by a number of parties, including two Michigan residents, and is aimed also at the state of Ohio and the city of Toledo.

The Cuno case is described as a "true test case" because it was brought largely to test the constitutionality of such programs. In March 2000, attorneys for the plaintiffs filed suit over a $300 million incentive package the state of Ohio offered to DaimlerChrysler in exchange for maintaining long-standing jeep production in Toledo, instead of opening a new plant in Michigan, just over the border.

The suit alleges that Ohio's granting of property tax abatements and/or tax credits to DaimlerChrysler represents a violation of Commerce Clause restraints.

...

According to plaintiff counsel Peter Enrich, the Commerce Clause was designed to prohibit state regulation and tax policy from interfering with economic activity between the states. For example, one state may not raise barriers to competition with another state in order to protect its own interests.

But what about the power of a state being used to advance its own interests at the expense of another state? Does this not also constitute undue interference, on the part of that state, with interstate commerce? Enrich argues that the United States Supreme Court has "consistently struck down on Commerce Clause grounds, state tax breaks or benefits that discriminate against out-of-state economic activities or interstate enterprises." In other words, when one state provides financial incentives to a business to build or expand a facility within its borders, and those incentives make the investment less costly than it would otherwise be if it were invested in another state, the incentive is unconstitutional.

On the other hand, in their brief before the court, defendant's attorneys argue that the Commerce Clause "does not require that all states maintain the same taxing system and rates." In other words, incentives are just part of the states' overall tax structures. Michigan may have a lower overall income tax burden, but the fact that a business locating in Michigan has lower taxes than one locating in Ohio doesn't constitute discrimination against Ohio. Defendants argue that the Commerce Clause only prohibits states from erecting barriers to commerce. For instance, Ohio may not impose tariffs on Michigan-manufactured Cadillacs to protect Ohio-made Hondas.

Back in the early 1990s, when I was a reporter for the Nashville Business Journal, I wrote a series of stories exploring how Kentucky's more aggressive use of tax incentives was helping that state land a lot of new manufacturing company projects for which Tennessee was also on the short list. (None of the stories are online - this was before Al Gore invented the Internet.)

One key Kentucky incentive, called KREDA, allows eligible businesses to receive a 100 percent credit against the Kentucky income tax liability on taxable income generated by the project. In plain English, what it meant is that a company building a new plant in an economic distressed county could keep all of the state income tax paid by its new employees and use it to finance the construction of the new plant.

Tennessee, which did not and still does not have a state income tax (other than a tax on certain investment income), found it very hard to compete. Ultimately, the stories written by myself and fellow NBJ reporter Bill Lewis (who later became NBJ's editor, and now is a business reporter at The Tennessean) led to then-Gov. Ned McWherter reforming the state's economic development incentives. Though Tennessee's offerings remained far less generous than Kentucky's, they seemed to tilt the playing field somewhat back in Tennessee's favor. Key Tennessee incentives include state funds to pay for infrastructure improvements (rail lines, roads, utilities and such) for new plants and for communities to prepare new sites for industry, and funds for worker training. Those, combined with the state's excellent central location, good work force, low taxes and such, helped make Tennessee one of the leading states for economic development in the 1990s, with momentum that continues still.

The Mackinac Center for Public Policy article raises the possibility that the U.S. Supreme Court could strike down states' economic-development tax incentives and subsidies as a violation of the Commerce Clause. I hope not. Because if they do it is a short step from there to a future ruling declaring that all states must have identical tax codes, so that none would tax less and therefore be more attractive to businesses or individuals in other states.

After all, differing tax codes cause some people who live near a state border to leave their own state and shop in a neighboring state, don't they? Isn't that a case of a tax code influence interstate commerce?

The right view in my book is that the Commerce Clause was intended to prevent states from enacting punitive taxes and regulations on interstate commerce but was not intended to forbid states from deciding for themselves how to tax commerce within their own borders. And if such state tax codes are percieved by businesses and individuals in other states to be less onerous than the tax code in their own state, and they decide to relocate, or drive across the border to shop, the state with the more-onerous tax code has, after all, the constitutional right to lower taxes.

That view of the Commerce Clause protects an environment in which states compete to keep taxes low. Re-interpreting the Commerce Clause to outlaw economic development tax incentives removes the incentive for states to keep their taxes low. It also might create a perverse incentive for states to raise taxes. Why? Because other states would also have to do raise taxes in order to not run afoul of the Commerce Clause. State legislatures would see no downside to raising taxes, especially on business, since all other states would be forced to do likewise (and have no reason not to) and politicians from coast to coast would promise all sorts of new programs funded by the flood of new revenue, and tout those - instead of low taxes and generous tax incentives - as "economic development" lures. Another step on the road to cradle-to-grave socialism.

UPDATE: Michael Williams says "federalism is an application of competitive market principles to government," and calls for scaling back the Commerce Clause via repeal of the 17th Amendment, which replaced the selection of senators by state legislatures with the direct election of senators by the people of each state.