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Federal Court Ruling May Hurt Tax Competition, State Tax Reform

10 min readBy: Chris Atkins

Fiscal Fact No. 16

The United States Court of Appeals for the Sixth Circuit recently ruled, in Cuno v. DaimlerChrysler,(1) that an Ohio investment taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. credit designed to enhance business-investment in the state violated the Commerce Clause of the U.S. Constitution because it discriminated against interstate commerce. On the other hand, the court also upheld a local property taxA property tax is primarily levied on immovable property like land and buildings, as well as on tangible personal property that is movable, like vehicles and equipment. Property taxes are the single largest source of state and local revenue in the U.S. and help fund schools, roads, police, and other services. abatement as consistent with the Constitution. The Cuno decision has far-reaching implications that threaten tax competition between the states and point toward court-imposed state tax uniformity.

The plaintiffs in Cuno challenged an Ohio investment tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. as well as a local property tax abatement that induced DaimlerChrysler to expand its operations in Ohio.(2) The plaintiffs alleged that the credits violated the Commerce Clause because they discriminated against interstate commerce by favoring in-state over out-of-state business expansion.(3) The court of appeals agreed, overturning a lower court ruling affirming the constitutionality of the disputed credit and abatement.

Ohio gives a non-refundable investment tax credit against the state’s franchise tax if a business “purchases new manufacturing machinery and equipment…provided that the new manufacturing machinery and equipment are installed” in Ohio.(4) Ohio also allows local governments to provide property tax abatements for businesses that agree “to establish, expand, renovate or occupy a facility and hire new employees, or preserve economic opportunities for existing employees” in impoverished areas.(5) Targeted investment tax credits and property tax abatements are tools that many states use to attract business investment and compete for job creation.(6)

By invalidating the investment tax credit, the court seemed to approve of the plaintiffs’ argument that the tax credit “…discriminates against interstate economic activity by coercing businesses already subject to the Ohio…tax to expand locally rather than out-of-state.”(7) The court also took notice of plaintiffs’ claim that “…the economic effect of the Ohio investment tax credit is to encourage further investment in-state at the expense of development in other states and…the result is to hinder free trade among the states.”(8) The court then ruled that, even though it was sympathetic to Ohio’s need to attract business investment, the tax credit ran afoul of the Commerce Clause because it was not equally available to in-state and out-of-state business expansion.(9)

Unlike the investment tax credit, the court upheld the property tax abatement against Commerce Clause attack. Plaintiffs charged that the abatement discriminated against interstate commerce because it required “…beneficiaries…to agree to maintain a specified level of employment and investment in the state.”(10) The court disagreed, ruling the abatement did “…not impose specific monetary requirements, require the creation of new jobs, or encourage a beneficiary to engage in an additional form of commerce independent of the newly acquired property.”(11)

The extensive panoply of federal and state investment tax credits, exemptions and subsidies have been criticized by economists and politicians across the spectrum as being everything from ineffective to “corporate welfare.”(12) Economists tend to view such incentives as violating the principle of tax neutrality, which says that tax policies should neither favor nor punish a particular industry or sector of the economy.(13) Irrespective of these criticisms, the implications of the court’s reasoning in Cuno extend far beyond Ohio’s investment tax credit, and threaten to strike at the root of state tax reform and tax competition, while even leaving a loophole for the complicated system of state tax incentives to continue in another form.

First, the court’s holding could be extended beyond targeted tax credits to more broad corporate tax reform or other efforts to increase state investment. In recent years, many states have changed their corporate income apportionmentApportionment is the determination of the percentage of a business’ profits subject to a given jurisdiction’s corporate income or other business taxes. U.S. states apportion business profits based on some combination of the percentage of company property, payroll, and sales located within their borders. formulas as a means of keeping in-state investment and attracting out of state investment.(14) For example, a state can make itself particularly attractive to manufacturers who sell to other states or countries by reducing its payroll and property factors while double-weighting the sales apportionment – or even moving to a sales-only factor as Iowa has done.(15)

The only differing impact on interstate commerce between a targeted investment tax credit and a move towards single-sales apportionment is probably the fact that the apportionment change would apply to all businesses while the tax credit only applies to those that purchase new capital (although apportionment changes have been found to spur the purchase of new capital in-state). While this distinction regarding to whom the change would apply may be—as a matter of law—crucial, one cannot be sure. Accordingly, tax reform agendas in the states could be imperiled by this decision.(16)

Second, the court attempts to limit its ruling to tax incentives and declare that direct state subsidies or grants made in an effort to increase in-state investment would not meet a similar fate as the investment tax credit.(17) Making a distinction between subsidies and tax incentives seems highly formalistic since subsidies can, in practice, discriminate against interstate commerce in precisely the same manner as tax incentives.(18) Ohio can bypass the Cuno ruling by simply changing the tax incentive program into an investment subsidy.

The mechanics of the court’s distinction here are somewhat similar to those present in the FSC/ETI debate between the World Trade Organization and the U.S. The WTO has ruled that U.S. tax credits to domestic exporters are an illegal export subsidy. In Cuno a federal court has ironically denied the state of Ohio in making tax changes to spur in-state business investment, while Congress is also trying to do exactly the same thing to spur in-country investment and compete for business with other nations. In this way, the federal court in Cuno is doing to Ohio what many EU nations want to do to Ireland and other countries in Europe who seek to attract business investment by lowering taxes.(19)

Third, the court glosses over the modern realities of state corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. es when it says that a business “…will receive no such reduction in tax liability if it locates a comparable plant and equipment elsewhere.”(20) It is perhaps true that Daimler would receive no reduction in its Ohio franchise tax liability by locating elsewhere,(21) but Daimler might pay fewer taxes wherever it chooses to expand. If another state, like Tennessee, were to offer lower taxes to Daimler to locate in that state, it seems reasonable to allow the state of Ohio to compete with Tennessee for Daimler’s business.(22)

In the marketplace, sellers compete not only on the price of goods but also on their features. Tax competition is no different. States such as Nevada, South Dakota, Washington, and Wyoming have chosen not to levy a corporate income tax. Those that do levy a corporate income tax should be free to design it in a manner they determine makes their state most competitive. The Cuno decision casts a dangerous shadow over the entire notion of tax competition among the states, and seems to point toward court-imposed tax uniformity in the future, a step the U.S. Supreme Court has explicitly refused to take in the past.(23)

To be sure, the current state system of tax incentives and subsidies creates dead-weight economic loss and violates the neutrality principle of sound tax policy. But, while it will undoubtedly put a damper on the states’ use of such incentives, the Cuno decision could have a chilling effect on tax competition between the states overall.

The states retain broad powers under the Constitution to organize their own tax systems, including the taxes and rates they charge to their own taxpayers. While there are, as there should be, limits on whom a state may impose its taxing jurisdiction, states must be given wide latitude in structuring the internal workings of their tax systems. Federal courts certainly have a role to play in protecting interstate commerce from state intrusion, but curtailing the ability of states to raise or cut taxes, indeed to compete for business investment, is antithetical to the spirit of the Commerce Clause itself.

1. 2004 Fed App. 0293P (6th Cir.).
2. Property tax abatements are rebates or deferrals on property tax. They are usually approved by local governments to spur economic development or other favored activities. 3. Most of the famous Commerce Clause cases involve a challenge to a state’s imposition of tax jurisdiction on an out-of-state business, not the granting of a tax burden or benefit to an in-state corporation. See, e.g., Geoffrey, Inc. v. South Carolina Tax Commission, 437 S.E.2d 13 (S.C. 1993); Quill Corp. v. Heitkamp, 504 U.S. 298 (1992); Container Corp. v. Franchise Tax Board, 463 U.S. 159 (1983); Complete Auto Transit v. Brady, 430 U.S. 274 (1977). All of these cases involved alleged, material harm to a specific business located out-of-state. The plaintiffs in Cuno, however, alleged hypothetical harm against interstate commerce in general.
4. See Ohio Rev. Code Ann. § 5733.33(B)(1).
5. See Id. at § 5709.62(C)(1).
6. The National Association of State Development Agencies (NASDA) tracks state economic incentive programs. See
7. Cuno, 2004 Fed App. 0293P at 7.
8. See Id. at 10.
9. Id. at 11.
10. Id. at 12.
11. Id. at 13.
12. See, e.g., Zenon X. Zygmont, Playing Favorites: Corporate Welfare in Oregon , Cascade Policy Institute (January 2001); Leslie Page, Corporate Welfare for the Politically Connected: The Story of Fannie Mae and Freddie Mac, Citizens Against Government Waste (2000); Ralph Nader, Cutting Corporate Welfare , Seven Stories Press (2000); “Five Ways Out”, Time Magazine (November 30th, 1998).
13. Some even seem to argue for locational neutrality, i.e. that the decision to locate a firm in a particular state should not be based on tax considerations.
14. Apportionment is the process of deciding how a multi-state business’ income is assigned to all the states in which the business has to pay tax. A business will typically apportion its income to each state by multiplying its total income by the percentage of property, payroll and sales in each state, then apply each state’s base and rate to that share of income. Apportionment is necessary because it keeps states from taxing more of a business’ income than can be logically attributed to activity in a particular state.
15. See Austan Goolsbee and Edward Maydew, Coveting Thy Neighbor’s Manufacturing: The Dilemma of State Income Apportionment, National Bureau of Economic Research, Inc. Working Paper 6614 (February 1999) (“Reducing the tax burden on payroll in the state by reducing the corporate rate or the payroll weight in the apportionment formula increases manufacturing employment significantly.”). Goolsbee and Maydew also find that “(o)n average, each of the jobs created in the state (from moving towards greater weight on sales in corporate income tax apportionment) seems to come directly from a job lost in other states.” The Supreme Court upheld a Commerce Clause challenge against Iowa’s single-sales factor apportionment in Moorman Mfg. Co. v. Bair, 437 U.S. 267 (1978).
16. Those states that want to improve interstate commerce, however, would presumably be free to embark on an aggressive tax-hiking agenda, donating their industrial base to other states with a more tax-friendly jurisdiction.
17. The court points to Supreme Court dictum stating that subsidies do not “ordinarily run afoul” of the Commerce Clause because they are not generally “connected with the State’s regulation of interstate commerce.” New Energy Co. of Ind. V. Limbach, 486 U.S. 269, 278 (1988).
18. In the language of the Cuno decision, subsidies would “discriminate against interstate economic activity by coercing businesses…to expand locally rather than out-of-state.” Cuno, 2004 Fed App. 0293P at 7.
19. See Joe Kirwin, EU Finance Ministers Call for Further Study of Consolidated Corporate Tax BaseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. Plan, 177 BNA Daily Tax Report G-3 ( 9/14/2004).
20. Cuno, 2004 Fed App. 0293P at 7.
21. One has to make a number of assumptions about nexus and apportionment to say with confidence that Daimler would not be reducing its Ohio tax liability by locating in another jurisdiction.
22. In today’s tax incentive and subsidy environment, other states are providing similar investment tax credits. See Tom Sharp, “State Mulling Impact of Court Ruling on Tax Credits to Businesses”, The Associated PressState and Local Wire ( 9/12/2004).
23. Moorman Mfg. Co., 437 U.S. at 279-280.