Are Targeted Incentives Constitutional?

Should states be able to offer businesses tax breaks and other subsidies in order to lure them into locating a new plant within their boundaries? A case currently before the United States Sixth Circuit Court of Appeals will decide whether this practice — which favors some businesses at the expense of all the rest — is constitutional.

For decades now, policy-makers and state legislatures have been developing exotic schemes to lure businesses to their states, keep the ones they have, and "create" more jobs. Nationwide, these subsidies have reached an estimated annual value of nearly $50 billion.

The state of Michigan operates a number of such programs, including the Michigan Economic Growth Authority (MEGA), which has the power to grant tax credits to businesses. The Michigan Economic Development Corporation, the state’s quasi-public "jobs" agency, also gives out millions of dollars-worth of property tax abatements and oversees the state’s "renaissance zone" program, which provides tax relief to geographical areas of the state. This department has recently been the subject of state Senate hearings considering whether Michigan’s government should be in the business of trying to pick winners and losers in the marketplace.

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.

At least one scholar thinks that judges may end up splitting the baby on tax incentives, declaring some actions unconstitutional but allowing others to remain. Robert D. Plattner, a correspondent for State Tax Notes, writes that "if the taxpayer’s liability in the ‘home’ state would be higher if it invests elsewhere than if it invests in-state, the incentive violates the requirement of tax neutrality and is unconstitutional."

Plattner also argues that tax incentives that cause "spillover" tax relief are also unconstitutional. Spillover relief can occur when companies are given incentives to expand existing facilities rather than to build new ones. He argues that benefits from the tax relief may not be specific to the new part of the property (the expansion), but must abate the property tax on the older facility as well.

For example, in May of 2000, MEGA approved an incentive package valued at as much as $12.1 million for the Coca-Cola Company to expand its facility in Paw Paw. The company expanded an existing building and added a new one to house its wastewater treatment system. The tax credit portion of the deal was valued at over $5 million. But the company was also promised state and local abatements on its property, valued at $6.2 million.

According to Palmer, under this scenario, the tax credits would be unconstitutional if they made doing business in Michigan less expensive for Coca-Cola than it would be for the company to do the same business in a competing state. The property tax abatements would almost certainly be unconstitutional because the expansion won abatements for the entire property, not just for the new building and building expansion.

As state lawmakers debate the merits of government-sponsored economic development in Michigan’s economic future, they would be wise to remember that the court may render many of their actions moot. The plain-English reason isn’t hard to fathom: because it’s fundamentally unfair for government to grant advantage to one business and not to others. And if the Constitution is found to condemn the practice, states may well follow suit.

Note: Michael LaFaive is fiscal policy analyst for the Mackinac Center for Public Policy, a research and educational institute headquartered in Midland, Mich.