FRBSF Economic Letter
2005-11; June 3, 2005
Are State R&D Tax Credits Constitutional? An Economic
Perspective
Policymakers at both the state and
local level have long used tax incentives, in some form
or other, to entice firms to locate or stay in their communities.
While some economists have raised serious concerns about
whether such incentives lead to socially wasteful "tax
competition," a federal appeals court decision in
September 2004 has raised serious doubts about whether
some are even constitutional. The ruling focused particularly
on tax credits for physical investment, but it may have
opened the door for legal challenges to other special state
tax provisions pertaining to "favored" business
activities.
One such activity is research and development
(R&D).
Currently, over half of all U.S. states have some form
of R&D tax credit, and policymakers in many of these
states regard them as a key element in promoting high-quality
job growth and productivity growth. Thus, the question
of whether these credits could be challenged and eventually
ruled unconstitutional is of vital importance.
This Economic
Letter discusses how the unique economic nature of R&D
may bear on the question of the constitutionality of state
R&D tax credits. In particular, I discuss
the conditions laid out by the U.S. Supreme Court for determining
the constitutionality of a state tax credit and how economic
research can play a critical role in assessing whether
these conditions are met.
The dormant Commerce Clause
The
case Cuno, et al. v. DaimlerChrysler, et al. No. 01-3960,
U.S. 6th Circuit Court of Appeals (2004) (hereafter, Cuno)
involved a legal challenge to a set of tax breaks, including
an investment tax credit, established in 1998 by the city
of Toledo and the state of Ohio as a way to encourage DaimlerChrysler
to keep its Jeep plant in Toledo and not relocate to another
state. The U.S. Court of Appeals of the 6th Circuit ruled
that this tax credit violates the "dormant Commerce
Clause." The dormant Commerce Clause is a doctrine
inferred by the U.S. Supreme Court from the Commerce Clause
(clause 3) in Article I, Section 8 of the U.S. Constitution,
which empowers the U.S. Congress to regulate interstate
commerce. The inference is that, because the Commerce Clause
explicitly grants the U.S. Congress the power to enact
legislation pertaining to interstate commerce, by implication
it bars states and localities from doing so (this same
legal principle underlies the recent Supreme Court ruling
concerning direct-to-consumer shipments from out-of-state
wineries).
The U.S. Supreme Court has established a number
of requirements that a tax statute must satisfy in order
to be considered
constitutional under the dormant Commerce Clause. The
requirement at issue in the Cuno case is that "the
tax does not discriminate against interstate commerce." The
Court has found that a tax discriminates if it "tax[es]
the products manufactured or the business operations
in any other State" (Boston Stock Exchange v.
State Tax Commission, 429 U.S. 1977). It is crucial to note that
both economically and legally, a tax credit or exemption
is equivalent to a negative tax, and hence discrimination
via tax credits is as invalid as discrimination via positive
taxes, a point made in the Cuno decision: "The fact
that a statute 'discriminates against business carried
on outside the State by disallowing a tax credit rather
than imposing a higher tax' is therefore legally irrelevant....Indeed,
economically speaking, the effect of a tax benefit or
burden is the same" (Cuno, citing Supreme Court
decision Westinghouse Elec. Corp. v. Tully, 466 U.S.
1984).
The 6th Circuit Court went on to say: "In
general, a challenged credit or exemption will fail
Commerce Clause
scrutiny if it discriminates on its face or if, on
the basis of 'a sensitive, case-by-case analysis of purposes
and effects,' the provision 'will in its practical
operation
work discrimination against interstate commerce,...,
by providing a direct commercial advantage to local
business." (Cuno,
citing Supreme Court decisions West Lynn Creamery
v. Healy, 512 U.S. 1994 and Bacchus Imports
v. Dias, 468
U.S. 1984).
The Court also mentioned one caveat: A state's discriminatory
tax policy may be valid if "it advances a legitimate
local purpose that cannot be adequately served by reasonable
nondiscriminatory alternatives" (New Energy
Co. of Ind. v. Limbach, 486 U.S. 1988, quoted in Cuno).
The
6th Circuit Court concluded that the Ohio investment
tax credit violated the dormant Commerce Clause since
the credit lowered the Ohio (franchise) tax burden
for companies
only if the investment was done in Ohio. The legal
rationale behind the ruling appears to apply specifically
to tax
credits; other state tax provisions, such
as property tax exemptions or general corporate income
taxes have
been
judged by the Supreme Court to be constitutionally
valid. Interestingly, the Supreme Court has established
that
the dormant Commerce Clause is not applicable to states'
use
of direct subsidies as opposed to tax credits, despite
the economic equivalence of subsidies and credits.
Given the ruling regarding tax credits on physical
investments in a state and the fact that state R&D tax credits
similarly apply only to R&D performed within the state,
it is easy to see how state R&D tax credits also could
be challenged for violating the dormant Commerce Clause.
Below, I examine whether R&D tax credits are discriminatory
and how they relate to the caveat about "legitimate
local purpose"—two issues that will be crucial when
and if legal challenges to state R&D tax credits do
occur.
Are R&D tax credits
discriminatory?
From a legal perspective, the discrimination question
turns on whether one state's R&D tax credit has a detrimental
impact on the R&D activity of other states (for example,
those with lower or no credits). Such a tax credit may
have little or no impact insofar as companies are unable
or unwilling to relocate R&D activities from one state
to another because of, for example, high labor and capital
relocation costs, substantial benefits from co-locating
R&D activity with existing manufacturing facilities
and/or company headquarters, or a lack of taxable earnings
in other states. In such instances, a state's R&D tax
policy may not violate the dormant Commerce Clause.
R&D
tax credits may have an impact insofar as companies are
willing to relocate. Consider, for example, large multinationals,
which may have R&D facilities in multiple states (and
earn taxable income in multiple states) and hence may find
it nearly costless to shift funding and activities from
one facility to another based on beneficial (detrimental)
changes in R&D tax policy in the state where the latter
(former) facility is located. In that case, the state's
R&D tax policy may violate the dormant Commerce Clause.
Although
observing such intrafirm reallocations of funds (activities)
and the rationale behind the locational choices
of R&D facilities is virtually impossible, the presence
of such effects can be detected in cross-state panel data
using econometric techniques. Wilson (2005) investigates
this issue and is able to detect a quantitatively important
impact, on average, of a state's R&D tax credit on
R&D activity in other states. Thus, to the extent that
R&D activity qualifies as commerce, this research would
seem to support the argument that R&D tax credits do,
in their "practical operation," "work discrimination
against interstate commerce."
Do R&D credits advance
a "legitimate purpose unachievable by nondiscriminatory
means"?
This question actually consists of three separate and
important questions.
(1) Is there a legitimate purpose of
state R&D tax
credits? One argument that proponents of state R&D
tax credits frequently cite is that R&D performed
within the state generates positive productivity spillovers
to
other firms in the state. Indeed, a large body of both
theoretical and empirical economic research has found
that such spillovers do occur and, moreover, that they
are localized
to a large extent (see, e.g., Jaffe, Henderson, and Trajtenberg
1993). Thus, economic research appears to give some support
to the position that promoting in-state R&D does
have a legitimate purpose, at least with regards to local
spillovers.
(2) Are the credits effective in achieving
this purpose?
Again, economic research provides some guidance. Though
very little research has been done on R&D tax credits
at the state-level, several studies have looked at
the efficacy of federal R&D tax credits, both in
the U.S. as well as other countries (Hall 1993 and
Bloom,
Griffith,
and Van Reenen 2002). These studies generally find
that R&D tax credits do significantly spur private
R&D
investment. A typical result is that an R&D tax
credit that reduces the effective cost of R&D by
1% leads to an increase in R&D in the long run
of at least 1%. The findings of Wilson (2005), however,
suggest that
the
bulk of this response, at least at the state level,
is actually due to firms shifting R&D funds from
other states to take advantage of the reduction in
costs rather
than to an increase in the R&D funding for labs
already in the state.
(3) Can this purpose be achieved
by an alternative
that does not discriminate via tax policy against out-of-state
activity? The empirical research on this issue is informative
but not conclusive. Some studies have pointed to the
various economic factors and policies that foster an
environment
favorable to innovation and R&D activity, such
as state education policies, infrastructure (e.g.,
a stable electrical
grid), a low business cost environment (e.g., low energy
costs, low worker's comp costs), and favorable employment
laws (e.g., "covenants not to compete").
Each of these are nondiscriminatory policies that may
encourage
in-state R&D activities. Whether they are as effective
at doing so as R&D tax credits is an empirical
question that has not yet been answered.
Conclusion
Clearly, economic research plays a vital role in assessing
the legal validity, with regard to the dormant Commerce
Clause, of tax provisions. In fact, U.S. Supreme Court
decisions have explicitly called for empirical cause-and-effect
analysis to help determine whether a tax provision violates
this Clause. In any deliberation concerning the constitutionality
of state R&D tax credits, such economic analysis would
seem particularly vital given the unique nature of R&D
investment. In particular, R&D activity is far less
tied to any particular location than physical investment,
so R&D may be more easily relocated from one state
to another in response to differential R&D tax credits.
This feature seemingly favors the legal argument that state
R&D tax credits are discriminatory "in practical
operation" and not just statutorily. R&D investment
is also unique in that its output—knowledge—has positive
externalities to other firms (and consumers). The extent
to which these externalities stay within the state where
the R&D is performed is both an interesting academic
issue as well as a critical issue for the question of constitutionality
of state R&D tax credits. If it were shown that these
externalities are extensive and could only be generated
by R&D tax credits, then such credits might still be
deemed valid. Some economic research into these questions
has been conducted, though much more remains to be done.
References
Bloom,
Nick, Rachel Griffith, and John Van Reenen. 2002. "Do
R&D Tax Credits Work? Evidence from a Panel of Countries
1979-97." Journal of Public Economics 85(1) pp.
1-31.
Hall, Bronwyn. 1993. "R&D
Tax Policy during the 1980s: Success or Failure?" In
Tax Policy and the Economy 7, pp. 1-35. Cambridge and London:
MIT Press.
Jaffe, Adam B., Rachel Henderson,
and Manuel Trajtenberg.
1993. "Geographic Localization of Knowledge
Spillovers as Evidenced by Patent Citations." Quarterly
Journal of Economics 108(3) pp. 577-598.
United
States Supreme Court Reports. Various issues.
Wilson,
Daniel. 2005. "Beggar Thy Neighbor? The
In-state vs. Out-of-state Impact of State R&D
Tax Credits." FRBSF Working Paper 2005-08.
Opinions expressed in this newsletter
do not necessarily reflect the views of the management
of the Federal Reserve Bank of San Francisco or of the
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