Are Targeted Incentives Constitutional?

Recently in Greenville, Michigan, Federal Mogul employees approved a new contract that contained more than $5 million in pay and benefit concessions in order to ensure that their plant remains in Michigan. Management at Federal Mogul had threatened to move to Mexico where it costs less to do business. The state offered additional incentives to help prevent Federal Mogul from moving. To date, the size of the incentive package has not been announced.

Economists have argued that such targeted incentives are unnecessary for economic growth and unfair to those who do not receive them. Some people are using the courts to try to thwart targeted incentive programs. Late last year the Mackinac Center described a case in Ohio that could change the way all 50 states try to lure business. An expanded version of the article appears below.

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 and tax breaks 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 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.

Establishing taxpayer standing to bring a lawsuit is a significant problem regarding challenging the Constitutionality of state tax incentives. Currently, to bring suit against the state, a taxpayer must have standing; they must show harm, caused from the state action, and different from the generalized harm suffered by other taxpayers. The requirement is designed to prevent abuse of the court system by limiting access to those with a specific and personal stake in the litigation. However, without taxpayer standing, citizens have almost no opportunity to challenge the Constitutionality of targeted tax incentives. In cases like Cuno, taxpayers lack standing because they can only show the kind of generalized harm suffered by fellow state taxpayers. With taxpayers shut out of court state tax incentives and their harmful side effects are insulated from judicial review.

One way to establish standing to challenge state tax incentives is to show a specific injury like the loss of income, job, or business, etc., caused by the state action. Also, Congress can grant standing through legislation. Targeted tax incentives can act as unconstitutional protectionism, harm the economic union of the states, and result in the kind of economic Balkanization that the Commerce Clause was intended to address. The Commerce Clause made unconstitutional the harmful “race to the bottom” effects of state protectionism that are analogous to the intent and effect of targeted state tax incentives. By establishing standing to bring suit either by showing either individual harm, or through a grant of Congress taxpayers could finally hold states accountable for targeted tax incentives.

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.

Michael LaFaive is director of fiscal policy, and Jeffery Weeden is an adjunct scholar with the Mackinac Center for Public Policy, a nonprofit research and educational institute.