Monday, May 27, 2024

Forget The Numbers, Or Why HB 1002 Violates The Dormant Commerce Clause

In what should come as no surprise to anyone who has read BHR for more than about two days, my legal background tends to be the prism through which I view 99% of policy questions. The 1% of the time it does not, however, is when my business and economics background rears its ugly head.  Such was the case when I approached the concept of a capital gains cut back in July and throughout my opposition to the actual HB 1002.

Sadly, in my economic ranting, I failed to account for the triumverate of (1) Ed Garner pulling his best Sally-Field-as-Norma-Rae impression, (2) “tax cuts” being the new black, and (3) the impact of a wave of Tea Party legislators who understand basic econ about as well as my dog understands German techno-pop. (He finds Olaf Henning’s “Cowboy und Indianer” indecipherable.)

My failure to account for this left me unprepared for the possibility that it would pass.  However, as I was talking to my wonderfully astute wife about the passage Wednesday night, she asked the one question that I’d neglected to ask myself when this bill was first prefiled:

Can they do this?  Legally, I mean — can they charge different tax rates just because one is in-state?

Suddenly, I flashed back to St. Louis, circa 2003, and my 1L con law class: dormant commerce clause.  No, they can’t put in a tax like this, and it’s not even really debatable; the case law is direct, on-point, and unequivocal in these situations.

Wait…allow me to back up.

Let’s look at what the bill does in terms of its actual effect.  I’m not talking about jobs created or costs or anything like that — just plain, old fashioned “what’s it do?” After its effective date, HB 1002 will make investments in Arkansas businesses by Arkansans more financially attractive than investments in non-Arkansas companies by exempting profits from the sale of the former from taxation while not exempting the latter.  I think we can all agree on this much.

Take it a step further, however.  From the companies’ point of view, in practical terms, this bill makes it more difficult for out-of-state companies to attract investment dollars from Arkansans.  All else being equal (which is a fiction that proponents of this bill seem comfortable working under), an out-of-state company will have to offer a return on investment greater than the 4.9% tax for it to be worthwhile for Arkansans to invest in it.  In effect, the bill discriminates against out-of-state companies by subjecting investments in them by Arkansans to a burden that intrastate companies do not face.

That discrimination is where we run into trouble.

Most everyone is familiar with the concept of the Commerce Clause (Art. I, § 8, cl. 3) of the U.S. Constitution, which gives Congress the power to regulate commerce “with foreign Nations, and among the several States, and with the Indian Tribes.”  This has been interpreted as both an affirmative power that Congress possesses and a negative converse that prohibits economic protectionism by barring states from passing laws designed to benefit in-state economic interests by burdening out-of-state competitors.  See Associated Industries of Mo. v. Lohman, 511 U.S. 641, 647 (1994).

The rationale for this rule is to “prevent a State from retreating into economic isolation or jeopardizing the welfare of the Nation as a whole, as it would do if it were free to place burdens on the flow of commerce across its borders that commerce wholly within those borders would not bear.”  Okla. Tax Comm’n v. Jefferson Lines, Inc., 514 U.S. 175, 179-80 (1995).  To that end, state laws that discriminate against interstate commerce on their face are virtually per se invalid.  See Oregon Waste Systems, Inc. v. Dept. of Environmental Quality of Ore., 511 U.S. 91, 99 (1994).  Such measures will only survive the when they advance a legitimate local purpose that cannot be adequately served by reasonable nondiscriminatory alternatives.  Dep’t of Revenue v. Davis, 553 U.S. 328 (2008).

In the context of state tax laws, the dormant commerce clause has a long and clear history of invalidating discriminatory taxes.  “A discriminating tax imposed by a State operating to the disadvantage of the products of other states…is, in effect, a regulation in restraint of commerce among the States, and as such is a usurpation of the power conferred by the Constitution upon the Congress.” Walling v. Michigan, 116 U.S. 446, 455 (1886).  “[I]t is clear that discriminatory burdens on interstate commerce imposed by regulation or taxation may …violate the Commerce Clause.”  Camps Newfound/Owatonna, Inc. v. Town of Harrison, 520 U.S. 564, 578 (1997).  “The negative or dormant implication of the Commerce Clause prohibits state taxation … that discriminates against or unduly burdens interstate commerce.”  General Motors Corp. v. Tracy, 519 U.S. 278, 298 (1997).

When undertaking a dormant commerce clause analysis, “the first step … is to determine whether [the tax] regulates evenhandedly with only incidental effects on state commerce, or discriminates against interstate commerce.” See Fulton Corp. v. Faulkner, 516 U.S. 325, 331 (1996).  A state tax is treated as discriminatory under the dormant commerce clause where it taxes a transaction or incident more heavily when it crosses state lines than when it occurs entirely in-state. See id.

Under this definition, HB 1002 is without question a discriminatory tax.  As mentioned above, the effect of this bill is that it becomes more expensive for Arkansans to invest out of state than in-state, and it becomes more difficult for out-of-state companies to sell securities to Arkansans than for in-state companies to do the same.  From either perspective, this law “taxes a transaction or incident more heavily when it crosses state lines than when it occurs entirely within the State.” Chemical Waste, supra.

For a discriminatory tax to survive scrutiny under the dormant commerce clause, it must be a “compensatory tax,” designed simply to make interstate commerce bear a burden that intrastate commerce already bears.  Fulton Corp., supra. To be a compensatory tax, at the bare minimum, (1) the measure must identify the intrastate tax burden for which the State tax is attempting to compensate, (2) the tax must  roughly approximate — but not exceed — the tax on intrastate commerce, and (3) the interstate event being taxed must be substantially equivalent to the intrastate activity that is being compensated for.  Oregon Waste, supra.

I note that no one has actually suggested that HB 1002 is a compensatory tax for dormant commerce clause purposes, and the bill accordingly fails all three prongs mentioned above.  The bill also fails as a compensatory tax because the purpose stated for HB 1002 — to encourage investment here and bring jobs here — is not something for which Arkansas may otherwise burden interstate commerce.

Where a state tax (1) discriminates against interstate commerce on its face by giving preferential treatment to in-state businesses, and (2) it cannot be sustained as a compensatory measure designed to make interstate commerce bear a burden already borne by intrastate commerce, the tax violates the dormant commerce clause.  See Fulton Corp, supra. HB 1002 discriminates against interstate commerce by giving preferential treatment to in-state investments, and it cannot be sustained as a compensatory measure by any stretch of the imagination.  It therefore violates the dormant commerce clause and cannot stand.

In discussing this post with a colleague, he mentioned that Rep. Garner had addressed the constitutionality argument at the House Revenue & Tax Committee hearing, dismissing it as a strawman.  Rep. Garner’s argument, it seems, is that HB 1002 imposes a differing tax that is no different than the differential tax treatment currently applied to in-state and out-of-state municipal bonds.  According to Rep. Garner, because such a differential municipal bond taxing scheme was upheld by the U.S. Supreme Court, he and his “think tank” think that HB 1002 will similarly pass constitutional muster under the same scrutiny.

What Rep. Garner fails to realize is that there is a critically important difference between taxes imposed on capital gains and those imposed on municipal bonds.  In the former situation, the state is creating a discriminatory tax that applies to transactions between private parties; in the latter, because municipal bonds are (by definition) sold by the state or a political subdivision of the state, the state is a “market participant.”

Stated a little more clearly, in HB 1002, the state is attempting to treat a capital investment by Mr. Smith into Arkansas Corp. differently than it treats the same investment in California Corp.  The state has no role in the purchase or sale of the capital asset; it merely collects the tax.  In a municipal bond scenario, however, the state is treating an investment in itself by Mr. Smith differently than it treats an investment in another state.

In fact, in the very U.S. Supreme Court case Rep. Garner opaquely mentioned in committee, Dep’t of Revenue v. Davis, 553 U.S. 328 (2008), the Court explained this important distinction.

Some cases run a different course, however, and an exception covers States that go beyond regulation and themselves “participat[e] in the market” so as to “exercis[e] the right to favor [their] own citizens over others.” This “market-participant” exception reflects a “basic distinction . . . between States as market participants and States as market regulators, [t]here [being] no indication of a constitutional plan to limit the ability of the States themselves to operate freely in the free market.” “[W]hen a state or local government enters the market as a participant it is not subject to the restraints of the Commerce Clause.”

Davis, supra, at 339 (internal citations omitted).

The Davis court continued, holding that the sale of municipal bonds by a political subdivision makes the state a market participant.  In language that best illustrates the difference between Davis and HB 1002 (and illustrates why Rep. Garner’s argument on this point is wholly without merit), the Davis court wrote:

But there is no ignoring the fact that imposing the differential tax scheme makes sense only because Kentucky is also a bond issuer. The Commonwealth has entered the market for debt securities[.] It simply blinks this reality to disaggregate the Commonwealth’s two roles and pretend that in exempting the income from its securities, Kentucky is independently regulating or regulating in the garden variety way that has made a State vulnerable to the dormant Commerce Clause.

Davis, supra, at 344-45 (internal citations omitted) (emphasis added).

As an alternative basis for upholding the differential tax treatment, the Davis court found that selling bonds to raise money for improvements was a traditional government function, and that a state tax exemption that favors such a function “without any differential treatment favoring local entities over substantially similar out-of-state interests” does not discriminate against interstate commerce for purposes of the dormant Commerce Clause. Id. at 343.  It would defy logic to argue that HB 1002 is “without any differential treatment favoring local entities over substantially similar out-of-state interests.”  By HB 1002’s very terms, it seems to create a differential treatment.

Based on all of the foregoing, HB 1002 is a discriminatory tax that burdens interstate commerce, and it must fail the dormant commerce clause analysis.  This is not an issue of nuanced interpretation, nor one that lends itself to strong counterargument.  The jurisprudence is what it is, and it absolutely precludes this kind of tax.  Passage of the law virtually guarantees a lawsuit that Arkansas will lose.

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