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Should Congress Authorize States to Continue Giving Tax Breaks to Businesses?


Last year, the federal Sixth Circuit Court of Appeals ruled that the investment tax credit granted against Ohio’s corporate income tax violates the Commerce Clause of the U.S. Constitution. Cuno v. DaimlerChrysler was the latest in a long line of court decisions holding that state tax laws that provide tax advantages to in-state business activity sometimes illegally discriminate against interstate commerce. The Court agreed that the credit unfairly “coerce[s] businesses already subject to the Ohio [income] tax to expand locally rather than out-of-state.” The decision was explicitly based on a comprehensive legal theory of discriminatory state aid to businesses set forth in a law review article co-authored by the leading expert on the impact of the Constitution on state taxation, Professor Walter Hellerstein of the University of Georgia.

Cuno is now on appeal to the U.S. Supreme Court. However, identical bills have been introduced in the Senate and House to short-circuit the appeals process, reverse Cuno, and affirmatively authorize state and local governments to continue granting a wide array of economic development-oriented tax incentives to businesses. The legislation is the “Economic Development Act of 2005” (S. 1066/H.R. 2471), sponsored by Ohio Senator George Voinovich and Ohio Representative Patrick Tiberi.

The Economic Development Act is structured as a statement that explicitly protects from a Commerce Clause challenge all state and local tax incentives, followed by seven exceptions to that protection. These exceptions are complex and ambiguous; for example, one provides that the bill does not protect a “tax incentive earned with respect to one tax [that] can only be used to reduce a tax burden for or provide a tax benefit against any other tax that is not imposed on apportioned interstate activities.”

Complexity aside, enactment of the Economic Development Act would not be in the national interest for the following reasons:

It encourages a zero-sum game . A substantial economics literature finds that the kinds of tax incentives voided by Cuno have at most a small, marginal impact on business investment decisions. Indeed, the federal government abandoned its investment tax credit nearly 20 years ago because policymakers realized it was stimulating more real-estate tax shelters than productive investment. To the extent that state corporate tax credits affect business decision-making at all, they chiefly affect where jobs are located rather than the number of jobs created. This is close to a “zero-sum game” for the country as a whole, and the states collectively would be better off if all states were prohibited from offering these kinds of credits.

It harms national productivity by impairing education funding . Giving tax breaks to businesses to attract investments and jobs from other states is actually worse than a zero-sum game with respect to the national interest. The kinds of tax credits disallowed by Cuno have seriously eroded the state corporate income tax as a source of revenue. In turn, the loss of revenue is impairing the ability of states to fund education, infrastructure improvements, worker retraining, and other public services that make a vital contribution to healthy state economies and a productive national economy. At a time when there is growing evidence that the educational attainment of foreign nations is gaining on or surpassing that of the United States — particularly in scientific and technical fields — and when states are struggling to meet their commitments under the No Child Left Behind Act, it is difficult to understand why federal policymakers would wish to enable states to give away their limited tax bases in an effort to steal jobs from their neighbors.

It blocks an effective curb on the “race to the bottom.” It is extremely difficult for individual states or localities to stop offering corporate tax credits unilaterally; elected officials do not want to be vulnerable to charges that they did not do everything in their power to attract and retain jobs in their states. Many public officials state quite openly that they believe that granting tax incentives is not a cost-effective economic development strategy but feel they have no choice but to offer them so long as other jurisdictions do. While “state sovereignty” in tax policy is generally desirable as a matter of principle, states are not sovereign in any meaningful sense when corporations are able to pit them against each other in ever-more-costly bidding wars for the latest auto or computer assembly plant.

It discourages across-the-board tax cuts for businesses . Many free market-oriented economists oppose efforts by states and localities to lure or retain companies with tax incentives. Rather than picking “winners and losers,” these economists encourage states to keep their taxes on businesses as low as possible for all businesses. If all states were foreclosed from offering corporate income tax credits as a result of U.S. Supreme Court affirmation of Cuno, some states might well follow this course of action. As observed by a spokesperson for the conservative National Taxpayers Union, “The one silver lining in this [ Cuno] ruling might be that states might be encouraged to have more broad-based, low-tax systems rather than taking piecemeal approaches to lure firms.”

It opens a “Pandora’s Box” of additional discrimination against interstate commerce . There is substantial potential for federal legislation reversing Cuno to make the problem of discriminatory interstate tax competition worse. States have a long history of deliberately using their tax systems to give in-state businesses an unfair competitive advantage over out-of-state businesses. A healthy national marketplace demands that a line be drawn somewhere between state tax policies that discriminate against interstate commerce and those that do not. The Economic Development Act draws that line in a way that would seem to sanction new forms of discrimination. Under the bill it appears that a state could — as just one example — provide a corporate income tax deduction for wages paid to employees working within the state while denying such a deduction for employees working outside the state. Such a law would almost surely be unconstitutional in the absence of an enacted S. 1066/H.R. 2471. While this legislation was drafted much more carefully than a version introduced last year, it still has left open numerous opportunities for states to discriminate against interstate commerce in ways that would be widely recognized as both unfair and economically damaging.

It is not a permanent solution . Given the vast array of state tax laws and the determination of economic development officials to manipulate their states’ tax policies in ways that advantage in-state business interests, it is unlikely that any federal law can draw the line between discriminatory and non-discriminatory tax incentives in a way that will be sustainable for a significant period of time. Congress is likely to have to constantly revisit and update any legislation it enacts to address this issue once it decides to intervene. Moreover, such legislation is unlikely to suppress litigation against tax incentives to a significant degree since there are ample state law grounds for such litigation in many states.

Corporations have become adept at pitting states against each other to obtain large reductions in their tax obligations by raising the possibility of in-state investments or hinting that they are contemplating downsizing or leaving a state. Interstate tax competition has reached the point where it has become a quintessential “tragedy of the commons” phenomenon. It is damaging to the interests of society as a whole because it is seriously eroding the revenues state and local governments need to fund education, infrastructure, and other public services that actually do make them attractive places to do business and that also enhance national productivity. At the same time, granting economic development tax incentives is perceived by policymakers in individual jurisdictions to be either in their self-interest, or at least something that they dare not refrain from doing.

The Cuno decision will by no means eliminate interstate economic development competition, or indeed even interstate tax competition. Nor should it; competition that takes the form of offering all businesses the greatest value of public services for their tax dollars is appropriate and provides incentives to improve the efficiency of government for businesses and individuals alike. Cuno has the potential to channel interstate competition in such a productive direction by removing from the states’ economic competition arsenals a set of weapons — corporate income tax credits — that provide almost no “bang for the buck” with respect to job creation.

If the Supreme Court ultimately sees fit to allow the Cuno decision to stand, there are strong policy grounds for Congress doing so as well. At the very least, the enactment of the Economic Development Act seems ill-advised until such time as the Court takes final action on the case. Supreme Court affirmation of Cuno could potentially delineate the line between legal and illegal interstate tax competition with greater clarity than will the complex and ambiguous provisions of S. 1066/H.R. 2471.