Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.
Federalism, The Commerce Clause, and Discriminatory State Tax
Incentives: A Defense of Unconditional Business Tax Incentives
Limited to In-State Activities of the Taxpayer
Philip M. Tatarowicz*
* Partner and National Director of State and Local Tax Technical Services, Ernst & Young LLP, National Tax Department, Washington, D.C.; Adjunct Professor of Law, Georgetown University Law Center; Certified Public Accountant; Benedictine University, B.A. (Accounting & Business Economics), 1975; Northern Illinois University College of Law, J.D., 1978; Georgetown University Law Center, LL.M. (Taxation), 1983.
When a state or local tax incentive rewards a multistate corporation’s in-state activities without similarly rewarding its out-of-state activities, it ties the taxpayer’s effective tax rate to the choice of whether or not to conduct an activity within the state. This raises an important question under the dormant commerce clause that has not been answered by the U.S. Supreme Court. Specifically, does an unconditional state tax incentive limited to in-state activities of the taxpayer impermissibly discriminate against “protected commerce” in favor of local commerce? The following example illustrates the problem.
Suppose “State Alpha” and “State Beta” impose a ten percent tax on corporate income, and Alpha offers a credit equal to five percent of a taxpayer’s research and development (R&D) expenses incurred within its borders. “Taxpayer One” exclusively operates in Alpha and for the taxable period earned $200 of income while expending $100 on R&D. “Taxpayer Two” operates in Alpha and Beta where it likewise earned $200 of income and expended $100 on R&D, albeit equally divided between the two states.
Taxpayer One owes Alpha $15 of tax: $20 of tax ($200 x 10%) less the $5 ($100 x 5%) R&D credit. Its effective tax rate (ETR) is 7.5% ($15 ÷ $200).
Taxpayer Two owes Alpha $7.50 of tax: $10 of tax ($200 x 50% x 10%) less the $2.50 ($50 x 5%) R&D credit. In addition, Taxpayer Two owes Beta $10 of tax ($100 x 10%). Its ETR in Alpha is 3.75% ($7.50 ÷ $200); in Beta, 5% ($10 ÷ $200); and, overall 8.75% ($17.50 ÷ $200).
This Article outlines the “Permissible Burdens Theory” and the safe harbor it extends to select tax incentives from challenges under the dormant commerce clause. While acknowledging the Court’s caution that “virtually every discriminatory statute allocates benefits or burdens unequally,” the Permissible Burdens Theory argues that unconditional business tax incentives limited to in-state activities of the taxpayer are permissible if used by a state to primarily compete for economic development.
To illustrate the intended scope of the Permissible Burdens Theory and to contrast its consequences to other, more restrictive constitutional interpretations, this Article also reviews and critiques two different theories: the “Economic Distortion Theory” and the “Coercive Powers Theory.” Under the Economic Distortion Theory, most tax incentives would be impermissible, because tax incentives distort economic decision making in favor of in-state activity. Under the Coercive Powers Theory, tax incentives implicating the coercive (taxing) power of the states generally would be impermissible as well.To the extent a person wishes to challenge the authority of the states to offer tax incentives in their competition for economic development, such challenges are political in nature and their investigation, analysis, and resolution are best deferred to Congress. Absent congressional voice, tax incentives outside the safe harbor of the Permissible Burdens Theory are best left to the judicial process and its balancing of federalist interests in light of each controversy’s unique facts and circumstances.