Source: https://mobile.minneapolisfed.org/publications/annual-reports/congress-should-end-the-economic-war-among-the-states
Timestamp: 2019-04-22 10:00:42+00:00

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Recently, St. Louis, Mo., pursued an aggressive economic development initiative to lure a professional football team, at a cost to state and local taxpayers estimated as high as $720 million. Last year, Amarillo, Texas, decided to undertake an aggressive economic development initiative using a different strategy. Some 1,300 companies around the country were each sent a check for $8 million that the company could cash if it committed to creating 700 new jobs in Amarillo.
What is so remarkable about these two initiatives is that they are not remarkable. Competition among states for new and existing businesses has become the rule rather than the exception. A 1993 survey conducted by the Arizona Department of Revenue found that states' use of subsidies and preferential taxes to retain and attract specific businesses is widespread. The survey found that half the states had recently enacted financial incentives to induce companies to locate, stay or expand in the state. Targeted businesses have ranged from airline maintenance facilities, automobile assembly plants and professional sports teams to chopstick factories and corn processing facilities.
While states spend billions of dollars competing with one another to retain and attract businesses, they struggle to provide such public goods as schools and libraries, police and fire protection, and the roads, bridges and parks that are critical to the success of any community. Surely, something is wrong with this picture! As Justice Cardozo suggested, the framers of the Constitution had something different in mind in granting Congress the power to regulate interstate commerce under the Commerce Clause. The objective was to create an economic union, particularly by ending the trade war among the states that prevailed under the Articles of Confederation. However, it was the Supreme Court, not Congress, that applied the Commerce Clause to end the trade war among the states.
In this essay we argue that it is now time for Congress to exercise its Commerce Clause power to end another economic war among the states. It is a war in which states are actively competing with one another for businesses by offering subsidies and preferential taxes. While the Court has not confronted the constitutionality of states engaging in these activities, it has expressed the view that these activities may be "admirable," and it would probably find that they fulfill a legitimate local public purpose. Economists reach a much different conclusion. They find that there is a role for competition among states when it takes the form of a general tax and spend policy. Such competition leads states to provide a more efficient allocation of public and private goods. But when that competition takes the form of preferential treatment for specific businesses, not only is it not "admirable," it interferes with interstate commerce and undermines the national economic union by misallocating resources and causing states to provide too few public goods. Moreover, the success of a state in attracting and retaining particular businesses is not a mitigating circumstance.
Economists have found that while the production of private goods is best left to market forces, the production of public goods should be the principal role of government because the market fails to produce enough public goods. The reason the market fails is that since people cannot be excluded from consuming public goods, charging people for what they consume is difficult. It is often impossible to say if and how much of a public good a person consumes. How much does one consume of a healthy environment, or national defense or a lighthouse beam? A private firm producing a public good might try to survey the citizens of its community to uncover how much each consumes of a public good and charge accordingly. However, knowing they will be charged based on how much they say they benefit from the public good, and knowing they will get to consume as much as they want, regardless of the charge, people will tend to understate the benefits. Moreover, private firms could not enforce payment for such goods even if they knew how much to provide. Consequently, left to the market, too few public goods, if any, will be produced.
We turn to the government, then, to finance and provide for the use of public goods. Government, by its very nature, can solve the financing problem for it has the power to appropriate funds from its citizens (the power to tax) for the provision of public goods. Solving the provision problem of public goods is more difficult.
For state and local governments there is a form of intergovernment competition that guides them to provide the right amount of public goods. This type of competition among government entities has been compared to the invisible hand that guides private business to produce the right amount of private goods.
When states compete through subsidies and preferential taxes for specific businesses, the overall economy suffers. From the states' point of view each may appear better off competing for particular businesses, but the overall economy ends up with less of both private and public goods than if such competition was prohibited.
State and local officials often boast about the new businesses they have attracted, the old ones they have retained and the number of jobs they have created. And in many instances these officials should boast. They have either managed to maintain their tax base by enticing a local business to stay or they have added to their tax base by enticing an out-of-state business to relocate. As long as the subsidies and preferential taxes given to a business are worth less than the revenue the business will contribute to the state over its operating years, the citizens of the state are better off than if their state officials had not played this competitive game. The state has more jobs and hence more tax revenue to pay for public goods than if it had not competed.
But even though it is rational for individual states to compete for specific businesses, the overall economy is worse off for their efforts. Economists have found that if states are prohibited from competing for specific businesses there will be more public and private goods for all citizens to consume. To illustrate this point, we will consider several possible outcomes of this competition.
Each business that is enticed to relocate represents a potential loss of efficiency for the overall economy and hence less output, less tax revenue and fewer public and private goods. To be more concrete, let us suppose a company chooses to relocate its manufacturing plant from a warm climate state, like Louisiana, to Alaska, even though its operating costs are substantially higher in a cold weather climate. We will assume that the company is more than fully compensated by Alaska for the move and for the additional operating costs. However, it now takes more resources for this company to produce the same quantity of output in Alaska than it did in Louisiana.
In general, it can be shown that the optimal tax (the tax that distorts the least) is one that is uniformly applied to all businesses. Allowing states to have a discriminatory tax policy, one that is based on location preferences or degree of mobility, therefore, will result in the overall economy yielding fewer private and public goods.
State competition for specific businesses involves one additional loss that could make those already mentioned pale by comparison. We have assumed that states have the information to understand the businesses they are courting; that is, their willingness to move, how long they will stay in existence and how much tax revenue they will generate. In practice, states have much less than perfect information. Assuming all states are so handicapped, they will on average end up with fewer jobs and tax revenues than they had anticipated, and at times the competition may not even be worth winning.
Despite the fact that state deals have gone sour, some may still be tempted to argue that competition among states for specific businesses will lead to a good outcome for the overall economy. Some may be tempted to make this argument because it seems, as we argued earlier in this essay, people can vote with their feet (or vote policymakers out of office). Hence, if people are unhappy with their state's economic development strategy, there is an internal political check. People, however, may not be unhappy with these strategies--the state is acting in their best interest. Not to compete, while other states are, may be detrimental to a state's economy. Moreover, there may not be a place to go because all states may be competing. For this type of competition there is no invisible hand (or more accurately, no invisible foot) to lead states to do what is best for the country.
To understand why this problem cannot be left to the courts, it is important to know something of the history and purpose of the Commerce Clause and the role that the courts played in its evolution and application.
The Commerce Clause contains an ambiguity: It gives Congress the power to regulate interstate commerce but does not expressly prohibit the states from interfering with interstate commerce. To address this ambiguity, the Court developed a doctrine known as the "dormant" or "negative" Commerce Clause, which it applies, in the absence of congressional action, to strike down state laws that it has determined excessively burden interstate commerce.
Therefore, if the Court were to consider the constitutionality of a state subsidy or preferential tax to attract or retain businesses, one would expect it to hold that subsidies or preferential taxes impose no burden on interstate commerce. Even if the Court were to decide that such a state subsidy or tax preference burdens interstate commerce, it would weigh that burden against what it would undoubtedly regard to be a legitimate local public purpose, attracting and retaining businesses.
In any case, the Court may not wish to act because Congress has remained silent. The failure of Congress to speak to an issue can have a profound effect on the Court. When Congress remains silent after the Court has clearly expressed a position in the area of interstate commerce, the Court is likely to regard that silence as tacit approval. Therefore, the Court, having clearly expressed the view that state subsidies to attract and retain businesses do not interfere with interstate commerce, including twice during its 1993-94 term, may take the silence of Congress to be tacit approval.
The power of Congress under the Commerce Clause is so sweeping that to enact legislation to prohibit the states from using subsidies and preferential taxes to compete with one another, it need only make a finding, formal or informal, that such subsidies and taxes substantially affect interstate commerce. The Supreme Court will defer to such a congressional finding if there is any rational basis for the finding. No Supreme Court decision in at least the past 50 years has set aside federal legislation on the ground that Congress did not have a rational basis for such a finding. The Court has recognized that the power of Congress under the Commerce Clause even extends to intrastate activities that have a substantial effect on interstate commerce. Moreover, Congress can legislatively supplement, revise or overturn any of the Court's decisions under the dormant Commerce Clause doctrine.
But what is true of individuals acting in their own interest is not necessarily true of state governments acting on behalf of their local citizens. Competition among governments based on their general tax and spend policies leads to a better outcome for the overall economy. However, when that competition takes the form of preferential financial treatment for specific companies, the overall economy is made worse off. Such competition results in a misallocation of resources and, in particular, too few public goods.
Competition among states for specific businesses is commonplace and growing more costly. Most states today have put in place some type of economic development program to attract and retain businesses. While some state officials have questioned the economic wisdom of this type of competition, there is little likelihood that the states will successfully establish either formal or informal non-compete agreements, because it appears that the incentive to cheat is too great.
Only Congress, with its sweeping constitutional powers, particularly under the Commerce Clause, has the ability to end this economic war among the states. And it is time for Congress to act.
Burstein is executive vice president and general counsel of the Federal Reserve Bank of Minneapolis and Rolnick is senior vice president and director of Research. The authors wish to acknowledge the invaluable assistance of Thomas Holmes, economist, Federal Reserve Bank of Minneapolis, and Gary Spiegel, a senior at the University of Minnesota Law School. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.
 Baldwin v. G.A.F. Seelig, Inc., 294 U.S. 511, 523 (1934).
 John Helyar, "Beat Me in St. Louis," Wall Street Journal , January 27, 1995, at 1A.
 Jane Seaberry, "Amarillo Lures Business With $8 million Checks," Dallas Morning News , September 13, 1994, at 1D. Until this economic development initiative, Amarillo was best known for its farming, ranching and flat terrain.
 William Schweke et al., "Bidding for Business: Are Cities and States Selling Themselves Short?," 18 (Corporation for Enterprise Development, Washington, D.C. 1994).
 Unless the context clearly indicates otherwise, all references to "state" or "states" are intended to include local government units as well. For purposes of the Commerce Clause it should not make any difference whether subsidies and preferential taxes are offered by states or local governmental units. Most, if not all, subsidies and preferential taxes are offered by the local government under state enabling legislation, and part of the cost of the benefit is, directly or indirectly, borne by the state.
 Metropolitan Life Insurance Company v. Ward, 470 U.S. 869, 879 (1985).
 For a formal analysis of this proposition, see Thomas Holmes, "The Effects of Tax Discrimination When Local Governments Compete for a Tax Base," Research Department Working Paper 544, Federal Reserve Bank of Minneapolis, 1995.
 Holmes (1995) finds that, in general, the overall economy is worse off when states use preferential tax treatment to attract or retain businesses. In those cases where the overall economy might be better off, the net gain is very small and turns negative if the tax on immobile firms becomes too high.
 Most of our discussion about the judiciary's role in effectuating the Commerce Clause concerns the U. S. Supreme Court, which we will sometimes refer to as "the Court." Although the Court reviews only a very small number of all the cases involving the Commerce Clause, its holdings are controlling in the absence of federal legislation on the subject. Occasionally, however, we will make more general references to "the courts," which apply decisions of the Court on the Commerce Clause to the cases before them. The term "the courts" will usually include both federal and state courts. Our use of the terms "the Court" and "the courts" is deliberate and the difference in meaning should be clear from the context within which the term is used.
 U.S. Const. art. I, sec. 8, cl. 3.
 West Lynn Creamery, Inc. v. Healy, 114 S. Ct. 2205, 2214 (1994).
 Metropolitan, 470 U.S. at 879.
 The term "hold" or "holding" refers to the specific issue being decided by the Court. For example, in the West Lynn Creamery case the Court held that the Massachusetts tax on fluid milk unconstitutionally discriminated against interstate commerce. The holding of the Court should be distinguished from observations the Court makes in its opinions. Although such observations may be persuasive evidence of how the Court or a particular justice might rule in a future case before the Court, the observation cannot be cited as authority for a legal proposition.
 See, e.g., Federal Baseball Club of Baltimore, Inc. v. National League of Professional Baseball Clubs, 259 U.S. 200 (1922). In this case, the Court held that professional baseball was exempt from antitrust legislation because it was not engaged in commerce among the states. No one today would seriously argue that professional baseball is not engaged in commerce among the states; nevertheless, the Court has never overturned that decision, in part because Congress has been silent on the issue.
 McCarroll v. Dixie Lines, Inc., 309 U.S. 176, 189 (1940), (Justices Black, Frankfurter and Douglas dissenting).
 See United States v. Lopez, 2 F. 3d 1342, 1363 (5th Cir. 1993), cert. granted 114 S. Ct. 1536 (1994).

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