RALEIGH – When last I discussed Supreme Court cases dealing with state tax breaks and targeted economic incentives, the news wasn’t at all good.
At that point, in May 2006, the U.S. Supreme Court had just dismissed a lower-court ruling striking down incentives offered by Ohio governments to Daimler-Chrysler. In reversing the famous Cuno ruling, the Supreme Court did not comment on the plaintiffs’ claim that selective tax incentives violate the interstate commerce clause of the U.S. Constitution. Rather, the Supremes simply ruled that the plaintiffs did not have standing to sue in the federal court.
At the same time, a North Carolina Superior Court judge had dismissed a challenge to the incentives offered to Dell to locate a plant in Forsyth County. More troublesome was that he had applied the same standing test that federal courts often do – which would have blocked not just much incentives litigation but other constitutional claims in the future by wronged North Carolina taxpayers.
Fortunately, the North Carolina Supreme Court subsequently upheld the right of taxpayers to sue in state courts to protect their rights under the state constitution. And now, the U.S. Supreme Court has another opportunity to rule in favor of tax fairness and neutrality in a case involving state taxation of government bonds.
Like most other states with income taxes, including North Carolina, Kentucky applies its tax to the interest its residents earn on state and local bonds they own except for those issued by Kentucky state and local authorities. The idea is to encourage investors to keep their money within the state. But by punishing those who choose to invest elsewhere, the state is arguably violating the commerce clause, which prevents states from creating what amounts to protectionism within the free-trade zone that is the United States.
The Washington-based Tax Foundation has a helpful briefing paper on the dispute (not yet online, I’ll add the link when it is) and filed an amicus brief back in September. While I don’t buy the Foundation’s attempt to distinguish between the Cuno case, where it was on the wrong side, and the Kentucky v. Davis case, it does do a good job of explaining why tax exemptions for in-state muni bonds ought to be considered in violation of the constitution. More broadly, it makes the case for a standard it calls “competitive neutrality.”
To be consistent with the constitution and the underlying principle of free trade among the states, the Tax Foundation’s Joseph Henchman argues, governments can offer “welcome mats” to firms to induce them to do business within their jurisdictions, but cannot impose “exit tolls” on those who choose to do business across rather than within state lines. This competitive-neutrality standard, he continues, would forbid “laws that impose tariff-like punishment on out-of-state activity to protect native industry, but authorizing laws that seek to encourage the formation and deployment of new labor and capital. State laws that tax or otherwise penalize activity that occurs out-of-state, while protecting in-state activity from similar burdens, would be impermissibly discriminatory.”
I think this concept is an interesting one, and I hope it prevails in the Kentucky case. If tax breaks for in-state muni bonds were struck down as unconstitutional, it probably would not have a huge effect in dollar terms for any taxpayer or government jurisdiction. But an important principle would have been upheld – that while states (should) enjoy a wide latitude to fashion their own public policies, they cannot transgress federal constitutional limitations – limitations that, like the commerce clause, are in the constitution precisely because the Framers meant to outlaw protectionism and encourage interstate competition on the basis of real economic value delivered to willing consumers, not on the basis of artificial advantages created by state governments.
Come to think of it, that’s why targeted tax incentives – but not interstate differences in broadly applied tax rates – should also be struck down as unconstitutional. Perhaps we’ll get there one of these days.
Hood is president of the John Locke Foundation.