The Effectiveness and Constitutionality of State Tax Incentive Policies for Locating Businesses: A Simple Game Theoretic Analysis

By just about any measure, tax incentive programs to attract businesses are popular state economic development policies. Meyer and Hassig report that forty-seven of forty-eight states they surveyed adopted at least one tax incentive for locating businesses between 1991 and 1993. In 1994 and 1995, at least thirty-three states enacted additional location incentive programs or expanded existing programs. The popularity of these policies, however, is initially puzzling because they have been "one significant factor behind the shrinkage of business taxes from one-half of state tax revenues in the 1950s to only a quarter by 1990." Why do states enact incentive programs in spite of their adverse fiscal impact? The answer to this puzzle, as is now well known, is found in the incentive structure that states face when competing with each other for a tax base. Namely, states face an incentive structure akin to the so-called "prisoners dilemma," in which individually rational behavior is nonetheless collectively irrational. Because of this pathological incentive structure, state authorities cannot and will not end incentive policies on their own. In order to end tax competition, states must have the help of an outside enforcement mechanism, such as courts. There are two doctrinal routes that constitutional attacks on state tax incentives might take. The first and most discussed doctrinal possibility is use of the dormant Commerce Clause. The second, less-considered, doctrinal possibility is use of the Equal Protection Clause. This Article develops a simple game theoretic model of interstate political economy to consider these doctrinal alternatives. It concludes that the dormant Commerce Clause does not offer a viable route of attack on state incentives, but that surprisingly, the Equal Protection Clause does. The "policy ineffectiveness" result of the model that state tax incentive programs do not affect the geographical distribution of businesses combined with recent Supreme Court decisions on the matter imply that the programs do not violate the dormant Commerce Clause. Nonetheless, while the model implies that the interstate implications of state tax competition do not raise constitutional problems under the Commerce Clause, the same cannot be said for the intrastate implications of these programs under the Equal Protection Clause. While it might be conceded that (as shown below) state incentive programs create tax classifications that discriminate against intrastate capital, it is not difficult to understand why an Equal Protection attack on the programs has been largely ignored in the legal literature. After all, it is well known that the mere demonstration of tax discrimination ordinarily triggers no serious constitutional questions under the Equal Protection Clause, because courts accord tax classifications highly deferential scrutiny under the clause. The analysis developed below, however, demonstrates that because of the perverse incentive structure that states have to enact tax incentive programs for mobile businesses, state political processes cannot ordinarily be expected to remedy the problem. Thus, although the classifications concern an economic subject matter, their enactment results from a restricted political process that triggers heightened judicial scrutiny under the process rationale articulated in footnote four of United States v. Carolene Products Co. and in other constitutional areas. The existence of a suspect legislative incentive structure thus reverses the presumption of constitutionality that courts ordinarily accord tax classifications, with the implications that courts would reject the constitutionality of many state incentive programs.