Fiscal Fact No. 24
I. The Aftermath of Cuno
The Sixth Circuit’s decision in Cuno v. DaimlerChrysler1—invalidating an Ohio 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. for in-state investment as discrimination against interstate commerce—has taken the 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. policy world by storm. Federal legislation was introduced last fall to reverse the Sixth Circuit decision.2 Numerous analysts have also grappled with the opinion since its release.3
The investment tax credit struck down in Cuno gave a corporation a tax credit against its Ohio corporate franchise tax liability. The condition on receiving the credit was purchasing and installing machinery at an Ohio production facility. The credit was at the center of the state’s effort to get DaimlerChrysler to open a new production plant in Ohio.
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.
II. The Economics of State Investment Tax Credits
One of the guiding principles of sound tax policy is that taxes should be neutral to all economic activity, meaning that “taxes should aim to raise revenue with a minimum of economic distortion, and should not attempt to micromanage the economy.”4 In simpler terms, this means that tax policy should not create incentives for business to engage in one type of activity, such as manufacturing, over another type of activity, such as retailing, but should treat different types of economic activity in a consistent fashion.
The first-order effects of targeted tax credits narrow the 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. and require lawmakers to maintain artificially high tax rates on other taxpayers to generate sufficient revenue to offset losses from the credits. These rates undermine the competitiveness of the business sectors bearing the tax burden and stymie their job-creating ability. Thus, while a state may enjoy job growth in the sector that receives the tax benefits, it may suffer job losses in other sectors.
Tax credits, by narrowing the tax base, also make the tax system more vulnerable to fluctuations in the economy. A tax base that exempts certain sectors of the economy will not generate sufficient revenues if the tax-bearing sectors of the economy experience a decline in productivity or output. A broader-based system is better suited to generate revenues even when several of the underlying economic sectors are not productive.
Finally, tax credits make the tax system more complex. A cottage industry of accountants and lawyers is required to comply with the complicated tax system caused by too many credits. This channels resources away from capital and labor investment and results in lower output and productivity.
III. Legal Problems with Cuno
While most economists agree that a broad-based, low-rate tax system is the best way for states to compete for business investment, there is not universal agreement that federal courts, or Congress, should step in and put a stop to the targeted tax credits at the heart of the Cuno decision. Indeed, there is a strong case to be made that states are free to set their own tax policies, even if those policies are economically inefficient. Tax competition is at the heart of our federalist system. Competitive pressure from other states, working through the ballot box, will change our state tax systems for the better.
The irony of the Cuno opinion is that it imperils broad-based state tax reform while simultaneously allowing the system of state tax incentives to continue in different or slightly altered forms. Three separate legal problems with the Cuno ruling blunt its impact on the system of state tax incentives. Cuno is not the answer for those who want the states to stop carving special incentives into their tax codes.
The first problem with Cuno is the over breadth of the decision itself. The Sixth Circuit held that Ohio’s investment tax credit discriminated against interstate commerce because the credit was not available for investments made in other states. What the court failed to take into account, however, is that all state tax policies are contingent on activities that occur in-state and thus all discriminate, in some sense, against interstate commerce. Cardozo School of Law professor Edward Zelinsky, acknowledging this fact, writes that “(i)f Cuno is correct, virtually no state tax policy…is immune from Commerce Clause challenge. Indeed, if Cuno is correct, virtually no state government activity is secure from a Commerce Clause challenge.”5
For example, a general tax rate reduction would benefit all companies with Ohio taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. . Income arising from activity in other states would likely be sourced to that state, not back to Ohio. A rate cut is therefore discriminatory in some sense, favoring those with enough Ohio activity to generate taxable income.
Moving to single-sales factor 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. 6 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.
The over breadth of the Cuno rule can also be seen when applying it to other tax credits. There is no great outcry against tax credits for day-care services, but such a law in Ohio would be questionable after the Cuno ruling. Under this law, Ohio provides a nonrefundable tax credit for businesses that provide day-care for the children of employees, but only if the day-care center is licensed in the state of Ohio.7 This naturally excludes Ohio taxpayers who happen to pay for day-care at facilities in other states. This is discrimination, but it is discrimination that makes sense. Ohio lawmakers do not want to provide tax benefits for activity that does not in some way benefit the citizens of Ohio.8
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.
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 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 also challenged in the case.10
This part of the court’s opinion is curious, because the Ohio investment tax credit can only be carried forward, not back as some credits allow.11 Thus, the credit can at best only offset a mixture of tax liability from existing investments and tax liability generated by new investments. Contrary to the court’s assertion, the profitability of the new investment will directly limit the value of DaimlerChrysler’s investment tax credit.
This focus on pre-existing tax liability also leads to another odd result. Under the Cuno rule, Ohio would be free to offer an investment tax credit to out-of-state businesses (without pre-existing tax liability) but would be barred from offering a similar credit to its resident businesses (with pre-existing tax liability). Surely the Commerce Clause cannot be read to require discrimination against resident investors in favor of out-of-state investors.12
All means are not equally suited to achieve our desired ends. Those who want to simplify the complex system of state tax credits, deductions and other inducements need to think twice before embracing Cuno as a policy solution. Not only does Cuno fail to stop the bidding war between states and localities for business investment, but it also applies to legitimate tax policies that are naturally, but not unconstitutionally, discriminatory. Cuno may have good policy intentions, but it’s not good law.
1. 2004 Fed App. 0293P (6th Cir.).
2. See, e.g., Jobs Investment Act of 2004, H.R. 5427, 108th Cong. (2004); S. 2881, 108 th Cong. (2004).
3. See, e.g., Michael Mazerov, The 6 th Circuit Cuno Decision Voiding Ohio’s Investment Tax Credit: Modest But Helpful “Arms Control” in the “Economic War Between the States,” Center on Budget and Policy Priorities ( February 18, 2005); Robert D. Plattner, Cuno Confirms Constitutional Infirmity of Many State Business Tax Incentives, 2004 State Tax Today 225-6 (November 22, 2004); Edward Zelinsky, Cuno v. DaimlerChrysler: A Critique, 2004 State Tax Today 192-2 (October 4, 2004); Chris Atkins, Federal Court Ruling May Hurt Tax Competition, State Tax Reform, Tax Foundation Fiscal Fact (September 20, 2004).
4. Tax Foundation Principles of Sound Tax Policy, located at http://www.taxfoundation.org/general.html.
5. See Zelinsky, supra note 3. See also Edward Zelinsky, Restoring Politics to the Commerce Clause: The Case for Abandoning the Dormant Commerce Clause Prohibition on Discriminatory Taxation, 29 Ohio Northern Univ. L. Rev. 29 (2003).
6. Apportionment formulas are used to determine how much tax a corporation pays to each state in which it has operations, with the corporation paying tax based on its proportion of property, payroll and sales in each state.
7. See Ohio Rev. Code Ann. § 5733.36.
8. Cf. Mazerov, supra note 3, at 5 (“It seems likely that many state legislators and governors would not want to run the risk of being forced in the future to forgo revenues to subsidize out-of-state investment and would seek to repeal their 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. credits…”).
9. 2004 Fed App. 0293P at 11 (“…subsidies do not ordinarily run afoul of the Commerce Clause because they are not generally connected with the State’s regulation of Interstate Commerce.”) (internal citations omitted).
10. 2004 Fed App. 0293P at 14 (“Unlike an investment tax credit that reduces pre-existing income tax liability, the personal property exemption does not reduce any existing property tax liability.”).
11. See Ohio Rev. Code Ann. § 5733.33(D).
12. See Zelinsky, supra note 3, at 3 (“Why should the Commerce Clause deny DaimlerChrysler an Ohio investment tax credit because of its old Ohio plant while the clause permits a credit for new investment to an otherwise identical competitor without an extant facility in Ohio?”).