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UNLEASH THE INCENTIVE WARRIORS?

June 06, 2005

It's tax incentive day over at the TaxProf's place. The good professor links to two pieces on the debate.

David Brunori of Tax Analysts is dismayed at Congressional efforts to overturn the Cuno decision that outlawed Ohio's targeted tax credit system ("Helping States to Hurt Themselves").

The Tax Foundation Blog, on the other hand, says Cuno is bad law and should be overturned (Cuno v. DaimlerChrysler: A Pyrrhic Victory for Economic Neutrality).

I agree with the Brunori article, so we haven't a lot to add to it. The Tax Foundation piece has some thoughts we address in the extended entry below.

The Tax Foundation summarizes its arguments:

Whatever one thinks about the economic efficacy of state tax incentives, ongoing analysis of Cuno reveals that the ruling suffers from three fatal flaws. First, the discrimination rule in the opinion cannot logically be limited to the most egregious forms of state corporate incentives. Second, the opinion allows state tax incentives to continue in the form of direct cash subsidies. Third, the opinion also allows state tax incentives to continue but only if they are granted to out-of-state companies. Those who are convinced that state tax incentives are harmful would be mistaken in accepting Cuno as the remedy.

OVERLY BROAD?

The Foundation seems to say that there is no tax discrimination so egregeous that it rises to the level of a commerce clause violation; any tax policy is in some way discriminatory, and therefore no lines can be drawn at all:

Moving to single-sales factor apportionment is equally discriminatory, since it only benefits those with existing or expanded physical investment in Ohio, discriminating against those who choose to invest out-of-state. There is simply no way to distinguish, on discrimination grounds, between Ohio’s investment tax credit and more general tax practices like rate reductions or single-sales apportionment.

Of course the Supreme Court long ago held that single factor taxation - allocating taxable income among states on the basis of sales alone - is not a commerce clause violation (whether it is wise or not is another issue). The court held that it wasn't so irrational a way to determine the tax base of a multistate company as to be a commerce clause violation.

A tax credit for in-state facilities, by contrast, isn't a way of apportioning a tax base; its a direct subsidy that occurs after the tax base is apportioned. From a layman's point of view, it seems that such distinctions can be drawn without great difficulty.

The second legal problem with Cuno is that the court, while striking down investment tax credits as incentives for in-state investment, gave its blessing to the use of direct subsidies.9 Whether the state gives a tax credit or a direct cash subsidy will be of little account to businesses; the impact on the bottom line will be the same. The race will still be on, with businesses seeking direct cash payments or other in-kind benefits, rather than tax incentives. The means by which the states compete will change, but the game will be the same.

This might be a more sound argument. Still, subsidies have to be re-enacted annually, and are therefore less likely to be an institutional form of discrimination against out-of-state companies. But eliminating subsidies sounds fine to me.

The third legal problem with Cuno deals with pre-existing tax liability. The court took special notice of the fact that the Ohio investment tax credit allowed DaimlerChrysler to reduce its pre-existing tax liability, but only if it invested in new machinery in Ohio. The impact on pre-existing tax liability, in the court’s opinion, worked a subtle coercion that forced DaimlerChrysler to expand in Ohio as opposed to other states, since DaimlerChrysler had other income-generating facilities in Ohio. Absent this pre-existing tax liability, the court would have upheld the investment tax credit, as it did with a property tax abatement also challenged in the case

The court here was distinguishing between tax credits on the income tax base and a property tax exemption. A taxpayer who gets a property tax exemption in one state isn't so discriminated against because he wouldn't be paying property tax anyway if he had instead bought out-of-state property. It's not unreasonable to distinguish this from discrimination on an already apportioned income tax base.

Cuno threatens to impose some discipline on tax incentives that the states seem unable to apply to themselves. Congress could use the case as leverage help the states stop the pointless incentive wars -- wars the Tax Foundation agrees are unwise. Perhaps its legal reasoning compels it, but it still seems odd that the Tax Foundation wants Congress to re-arm the incentive warriors.

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