Federal Appeals Court Strikes Down Targeted Tax Incentive in Ohio

Published November 1, 2004

Tax incentives that states across the country have used to retain businesses and attract new business investment are illegal, according to a ruling issued September 2 by the 6th U.S. Circuit Court of Appeals in Cincinnati. In the same decision, the court upheld as consistent with the Constitution a local property tax abatement.

The ruling stems from an investment tax credit Ohio gave DaimlerChrysler AG in 1998 to build a Jeep manufacturing plant in Toledo. The judges ruled the tax credit gave the firm preferential treatment to entice it to locate in Ohio rather than in other states, and therefore violated the interstate commerce clause of the U.S. Constitution, which aims to keep states from favoring in-state businesses over out-of-state firms.

The 6th U.S. Circuit Court of Appeals has jurisdiction in Kentucky, Michigan, and Tennessee, as well as in Ohio.

On September 14, DaimlerChrysler filed for a rehearing, backed by amicus briefs filed by more than a dozen organizations, including the Council on State Taxation, the State of Ohio, and the United Auto Workers, said Diann Smith, general counsel for COST, a nonprofit trade association with about 550 member corporations, including DaimlerChrysler. She said she expects a decision on the request for rehearing by mid-October.

The suit was filed by a dozen taxpayers and three small businesses, with the backing of independent presidential candidate Ralph Nader.

Incentives Impede Interstate Commerce

Ohio granted DaimlerChrysler a $281 million incentive package for its Toledo plant, which opened in 2001 and employs about 3,800 workers. The court found tax incentives granted by the State of Ohio–worth about $70 million–were improper.

Plaintiffs in the case, filed as Cuno v. DaimlerChrysler, argued a targeted investment tax credit “discriminates against interstate economic activity by coercing businesses already subject to the Ohio … tax to expand locally rather than out-of-state.” 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.”

“In short, while we may be sympathetic to efforts by the City of Toledo to attract industry into its economically depressed areas, we conclude that Ohio’s investment tax credit cannot be upheld,” Judge Martha Craig Daughtrey wrote for the unanimous three-judge panel.

“The business that chooses to expand its local presence will enjoy a reduced tax burden, based directly on its new in-state investment,” she wrote, “while a competitor that invests out-of-state will face a comparatively higher tax burden because it will be ineligible for any credit against its Ohio tax.”

The plaintiffs also attacked local property tax abatements, but the court upheld the abatements, ruling they do 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.”

Decision Imperils State Tax Reforms

The ruling calls into question the use of state tax incentives to lure business investment, according to some legal analysts. Nearly all states have used tax incentives to compete with one another for auto plants and other major business projects, sometimes getting into bidding wars over the size of the incentive packages.

“One of the troubling aspects of the 6th Circuit opinion,” said COST’s Smith, “is that they don’t make clear, and there doesn’t appear to be, a legitimate distinction of how [targeted tax incentives] offered by a state would be different from a state that chooses to have a lower or no income tax. The problem is there is not a principled analysis about where the line should be drawn.”

Smith said the ruling does not clearly explain why local tax abatements, which made up the bulk of the incentive package, are acceptable.

“This ruling has put tax incentive packages at some risk and creates a great deal of confusion in the industry,” Smith said.

“And the decision says that straight subsidies are fine,” Smith noted. “That’s another distinction that doesn’t make a lot of sense, legally.”

In an analysis of the ruling issued September 21 by the Tax Foundation, staff attorney Chris Atkins wrote, “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.’ 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.

“Irrespective of these criticisms,” Atkins noted, “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.”

States May Be Able to Evade Restrictions

Atkins said many states have changed their corporate income apportionment formulas to keep in-state investment and attract out-of-state investment. Most states apportion corporate income using a weighted formula that takes into account several factors, such as sales, payroll, and property. A typical formula might be weighted 75 percent sales, 12.5 percent payroll, and 12.5 percent property. By changing the weightings, a state can make itself more or less attractive from a tax standpoint.

“For example,” said Atkins, “a state can make itself particularly attractive to manufacturers who sell to other states or countries by reducing its payroll and property [tax apportionment] factors while double-weighting the sales apportionment or even moving to a sales-only factor as Iowa has done.”

With a sales-only factor, sales are defined based on the buyer’s location. Increasing out-of-state sales would reduce the amount of taxable income, because more income would be apportioned outside the state. If property and payroll are used to apportion income, increasing in-state property or payroll would assign more income to the state and increase the tax.

“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),” Atkins wrote.

“While this distinction regarding to whom the change would apply may be as a matter of law crucial, one cannot be sure,” Atkins noted. “Accordingly, tax reform agendas in the states could be imperiled by this decision.”

Atkins also said targeted subsidies and grants could be called into question.

“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,” he said. If that distinction remains, “Ohio can bypass the Cuno ruling by simply changing the tax incentive program into an investment subsidy.”

May Thwart State Tax Competition

Atkins noted states have widely varying tax policies and some states, such as Nevada, South Dakota, Washington, and Wyoming, have no corporate income tax. He worries the Cuno ruling “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.

“To be sure, the current state system of tax incentives and subsidies creates deadweight economic loss and violates the neutrality principle of sound tax policy,” Atkins said. “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.”

“This decision is a major blow against the most insidious form of corporate welfare: the extortionate demands by large companies for subsidies from cowering cities and states, all desperate to attract or retain investment in troubled economic times,” Nader said in a statement after the ruling.

Michael LaFaive, director of fiscal policy at the Mackinac Center for Public Policy in Michigan, said the Cuno ruling also calls into question the constitutionality of the Michigan Economic Growth Authority (MEGA), created in 1995 to offer targeted tax relief to a limited number of companies. MEGA has offered more than $1.7 billion in Single Business Tax relief for more than 200 projects, according to LaFaive. That figure does not include the value of local tax abatements, job-training subsidies, and other incentives offered to firms in addition to their MEGA credits.

“Lawmakers should focus on legal, sound economic policies, like broad-based tax cuts, now that the Michigan Economic Growth Authority might be found unconstitutional,” said LaFaive, who has opposed the MEGA since its inception.

Steve Stanek ([email protected]) is managing editor of Budget & Tax News.