Walter Hellerstein
Professor of Law
University of Georgia
Athens, Georgia

This paper is adapted from an article entitled "Commerce Clause Restraints on State Business Development Incentives," which is co-authored with Dan T. Coenen and which appears in the May 1996 issue of the Cornell Law Review.

This paper considers the restraints that the Commerce Clause of the U. S. Constitution imposes on the states' provision of tax incentives to encourage industrial location within their borders. The Commerce Clause by its terms is no more than an affirmative grant of power to Congress "to regulate Commerce with foreign nations, and among the several States, and with the Indian Tribes." From the very beginning of our constitutional history, however, the U.S. Supreme Court expounded the view that eventually became central to our whole constitutional scheme: The doctrine that the Commerce Clause, by its own force and without implementing congressional legislation, places limits on state authority and that these limits may be enforced by the courts.
Under this so-called "dormant" or "negative" Commerce Clause jurisprudence, the U.S. Supreme Court has articulated a number of constraints confining the states' power to tax activities affecting interstate commerce. Perhaps the most fundamental of these is the rule that prohibits state taxes that discriminate against interstate commerce. The concept of discrimination is not self-defining, and the Court has never precisely delineated the scope of the doctrine forbidding discriminatory state taxes. Nevertheless, the central meaning of discrimination as a criterion for adjudicating the constitutionality of taxes affecting interstate commerce emerges unmistakably from the Court's numerous decisions addressing the issue: A tax that by its terms or operation imposes greater burdens on out-of-state goods, activities or enterprises than on competing in-state goods, activities or enterprises will be struck down under the Commerce Clause.

State tax incentives as state tax discrimination: general principles

State tax incentives, whether in the form of credits, exemptions, abatements or other favorable treatment typically possess two features that render them suspect under the rule barring taxes that discriminate against interstate commerce. First, state tax incentives single out for favorable treatment activities, investments or other actions that occur within the taxing state. Indeed, if state tax incentives were not limited to in-state activities, they would hardly be worthy of the appellation "state" tax incentive.
Second, state tax incentives, as integral components of the state's taxing apparatus, are intimately associated with the coercive machinery of the state. They therefore fall comfortably within the universe of state action to which the Commerce Clause is directed. While "[t]he Commerce Clause does not prohibit all state action designed to give its residents an advantage in the marketplace," the Supreme Court observed in New Energy Co. v. Limbach, 486 U.S. 269 (1988), it plainly applies to "action of that description in connection with the State's regulation of interstate commerce." The Court has recognized in scores of cases that state tax laws affecting activities carried on across state lines are "plainly connected to the regulation of interstate commerce." Oregon Waste Systems, Inc. v. Department of Environmental Quality, 114 S. Ct. 1345 (1994).

State tax incentives as state tax discrimination: case law

The Court's treatment of state tax incentives suggests that the constitutional suspicion surrounding such measures is well justified. Over the past two decades, the Court has considered four taxing schemes involving measures explicitly designed to encourage economic activity within the state. In each case the Court invalidated the measure and did so with rhetoric so sweeping as to cast a constitutional cloud over all state tax incentives.
In Boston Stock Exchange v. State Tax Commission, 429 U.S. 318 (1977), the Court struck down a New York stock transfer tax scheme that provided reduced rates for stock transfers when the sale of the stock was made through a New York rather than out-of-state broker. The state contended that the tax break for local stock sales was merely an incentive designed to assist the New York brokerage industry. The Court acknowledged that states are free to "structur[e] their tax systems to encourage the growth and development of intrastate commerce and industry," but held they may not do so by means that discriminate against interstate commerce. By providing a tax incentive for sellers to deal with New York rather than out-of-state brokers, the state had, in the Court's eyes, "foreclose[d] tax-neutral decisions." Moreover, it had done so through the coercive use of its taxing authority. As the Court noted, "the State is using its power to tax an in-state operation as a means of requiring other business operations to be performed in the home State."
In Bacchus Imports, Ltd. v. Dias, 468 U.S. 263 (1984), the Court struck down an exemption from Hawaii's excise tax on wholesale liquor sales that was confined to sales for two locally produced alcoholic beverages. It was "undisputed that the purpose of the exemption was to aid Hawaii industry"--in one instance, "to 'encourage and promote the establishment of a new industry,'" in the other, "'to help' in stimulating 'the local fruit wine industry.'" These lofty purposes, however, could not sanctify a tax incentive that unmistakably defied the prohibition against taxes that favor in-state over out-of-state products. However legitimate the goal of stimulating local economic development, the Court explained, "the Commerce Clause stands as a limitation on the means by which a State can constitutionally seek to achieve that goal."
In Westinghouse Electric Corp. v. Tully, 466 U.S. 388 (1984), the Court struck down an income tax credit designed to "'provide a positive incentive for increased business activity in New York State.'" The credit varied directly with the extent of the taxpayer's New York export-related activities. The Court found that New York's effort to encourage export activity in the state suffered from constitutional infirmities similar to those that had disabled New York's earlier effort in Boston Stock Exchange to encourage brokerage activity in the state. Like the reduction in tax liability offered to sellers of securities who effectuated their sales in New York, the reduction in tax liability offered to exporters who effectuated their shipments from New York "'creates ... an advantage' for firms operating in New York by placing 'a discriminatory burden on commerce to its sister States.'"
Finally, in New Energy Co. v. Limbach, 486 U.S. 269 (1988), the Court struck down an Ohio tax credit designed to encourage the production of ethanol in the state. The credit was granted against the state's motor fuel tax for each gallon of ethanol sold as a component of gasohol, but only if the ethanol was produced in Ohio or in a state that granted similar tax benefits to Ohio-produced ethanol. The Court observed that the credit "explicitly deprives certain products of generally available beneficial tax treatment because they are made in certain other States, and thus on its face appears to violate the cardinal requirement of nondiscrimination."

State tax incentives as state tax discrimination: analysis and implications

Taking the Court at its word

A literal reading of the Court's opinions might well suggest that all state tax incentives are unconstitutional. After all, it is the rare state tax incentive that results in "tax-neutral decisions" made "solely on the basis of nontax criteria." (Boston Stock Exchange, 429 U.S. at 331.) Consider state income tax incentives. Almost no state income tax incentive--and there are hundreds of them across the country--meets the Court's ostensible requirement of strict geographic neutrality. Alabama, for example, provides an income tax credit for new investment, but only if it occurs in Alabama; Alaska provides an income tax credit for investment in gas processing and mineral development facilities, but only if they are built in Alaska; Arizona provides an income tax credit for taxpayers that increase research activities in Arizona; Arkansas provides an income tax credit for any motion picture production company that spends more than a specified amount producing films in Arkansas; California provides an income tax credit for qualified equipment placed in service in California; Colorado provides an income tax credit for investment in qualifying Colorado property. One could continue to proceed alphabetically through the states with similar examples.
By providing a tax benefit for in-state investment that is not available for identical out-of-state investment, these incentives skew a taxpayer's decision in favor of the former. Each such incentive--in purpose and effect--"diverts new business into the State." (Westinghouse, 466 U.S. at 406.) Put another way, these incentives deprive out-of-state investments "of generally available beneficial tax treatment because they are made in ... other States, and thus on [their] ... face appear[] to violate the cardinal requirement of nondiscrimination." (New Energy, 486 U.S. at 274.)
A similar analysis jeopardizes almost every sales and property tax incentive designed to encourage economic development in the taxing state. Yet most states offer just such incentives. Some states provide sales and use tax exemptions (or credits or refunds) for sales of property purchased for construction of new or improved facilities within the state; others give favorable sales or use tax treatment to property purchased in connection with the relocation or expansion of a business in the state; still others provide sales and use tax exemptions for property used in an enterprise zone in the state. Similarly, a number of states provide property tax incentives for new or expanded facilities in the state. Given the near universality of state sales taxation in this country, and the true universality of local property taxation, sales or property tax breaks for investment within the state or locality affect many taxpayers' business location decisions. All other things being equal, a rational taxpayer will allocate its resources in a manner that maximizes its after-tax profits; hence it will steer its investments toward the states which offer such tax benefits. Sales and property tax incentives, like income tax incentives, are therefore subject to attack on the ground that they offend the "free trade" purposes of the Commerce Clause by inducing resources to be allocated among the states on the basis of tax rather than nontax criteria.

An alternative reading of the Court's opinions

The astonishing implications that a literal reading of the Court's opinions would signify raises the question whether these opinions can and should be read less expansively. In my judgment, the answer to both questions is yes. My view rests in part on an instinctive sense that virtually all state tax incentives cannot really be unconstitutional. Such incentives, after all, constitute long-standing, familiar and central features of every state's taxing system. Even more important, a somewhat narrower interpretation of the Court's opinions is more consonant with accepted dormant Commerce Clause policy and the core rationales of the incentive decisions themselves.
In my judgment, two core principles, which I identified at the outset of this discussion, underlie the Court's state tax incentive decisions and should guide their proper interpretation. First, the provision must favor in-state over out-of-state activities; second, the provision must implicate the coercive power of the state. If, but only if, both of these conditions are met, should courts declare the tax incentive unconstitutional.
All four of the Court's tax incentive decisions fall comfortably within this analytical framework. First, in each of the four cases, the state favored in-state over out-of-state activities: in-state over out-of-state sales in Boston Stock Exchange; in-state over out-of-state production in Bacchus and New Energy; and in-state over out-of-state exportation in Westinghouse. Second, in each of the four cases, the coercive power of the state gave the tax incentive its bite. In Boston Stock Exchange, taxpayers would pay higher stock transfer taxes unless they engaged in in-state sales. In Bacchus and New Energy, taxpayers would pay higher liquor wholesaling or motor fuel taxes unless they sold products manufactured in the state. In Westinghouse, taxpayers would pay higher income taxes unless their subsidiaries shipped their exports from within the state.
That each of these cases comes out the same way under the in-state-favoritism/state-coercion approach reveals that it provides no panacea for state taxing authorities. At least one significant category of tax incentives, however, should escape invalidation: those tax incentives which are framed not as exemptions from or reductions of existing state tax liability but rather as exemptions from or reductions of additional state tax liability to which the taxpayer would be subjected only if the taxpayer were to engage in the targeted activity in the state. In my view, such incentives neither favor in-state over out-of-state investment (except in a sense that should be constitutionally irrelevant) nor do they rely on the coercive power of the state to compel a choice favoring in-state investment.
For example, a real property exemption for new construction in a state, or a sales tax exemption for the purchase of property in the state, favors in-state over out-of-state investment only if one takes account of the taxing regimes of other states and assumes that a tax would be due if the property were constructed or purchased in such other state. But the Court generally has refused to consider other states' taxing regimes in determining the constitutionality of a state's taxing statutes. As the Court has explained, "[t]he immunities implicit in the Commerce Clause and the potential taxing power of a State can hardly be made to depend, in the world of practical affairs, on the shifting incidence of the varying tax laws of the various States at a particular moment." (Freeman v. Hewit, 329 U.S. 249 (1946).) If a state's taxing statute must stand or fall on its own terms, a real property tax exemption for new construction, or a sales tax exemption for the purchase of property in a state, would pass muster because no additional tax liability could be presumed to result from new construction or the purchase of property outside the state. By contrast, each of the tax measures at issue in the Court's tax incentive cases resulted in differential tax liability that was created entirely by the state's own taxing regime, depending on whether the taxpayer engaged in in-state or out-of-state activities.
Beyond the lack of a constitutionally significant favoritism for local over interstate commerce, a property tax exemption for new construction, or for in-state purchases, does not implicate the coercive power of the state, at least not in a way that can fairly be characterized as "the State's regulation of interstate commerce." (New Energy, 486 U.S. at 278.) By adopting such an exemption, the state is saying, in effect: "Come to our state and we will not saddle you with any additional property or sales tax burdens. Moreover, should you choose not to accept our invitation, nothing will happen to your tax bill--at least nothing that depends on our taxing regime."
The state's posture in such circumstances stands in contrast to its posture in the tax incentive cases the Court has confronted in the past. In each of those cases the state was saying, in effect: "You are already subject to our taxing power because you have engaged in taxable activity in this state. If you would like to reduce those burdens, you may do so by directing additional business activity into this state. Should you decline our invitation, we will continue to exert our taxing power over you as before, and your tax bill might even go up." These two messages are very different. The latter, but not the former, reflects a use of the taxing power to coerce in-state business activity.

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