What is tax discrimination?

Author:Mason, Ruth

ARTICLE CONTENTS INTRODUCTION I. NONDISCRIMINATION IN EU TAXATION A. Goals of the EU B. ECJ Interpretations of Tax Discrimination C. Two Cases II. TOWARD A COHERENT CONCEPTION OF TAX DISCRIMINATION A. Some Caveats 1. Economic Efficiency 2. Labor, Not Capital 3. Assumptions 4. What We Mean by Welfare 5. Why These Benchmarks ? B. Locational Neutrality C. Leisure Neutrality D. Competitive Neutrality 1. Source Taxes 2. Residence Taxes 3. Maintaining Competitive Neutrality E. Simple Guidelines for Tax Neutrality F. Limits on Judicial Authority To Impose Tax Neutrality G. Resolving Cases Using the Benchmarks III. EU NONDISCRIMINATION AS COMPETITIVE NEUTRALITY A. Interpretive Arguments 1. The Goals of the EU Treaties 2. The Language and Structure of the Treaty a. Avoiding Construing Treaty Provisions as Superfluous b. Consistency in Interpreting the Fundamental Freedoms c. The Language of the Fundamental Freedoms 3. ECJ Nondiscrimination Doctrine a. "Direct Effect" b. Tax Cases c. Distinguishing the ECJ's "Nondiscrimination" and "Restrictions" Jurisprudence B. Normative Arguments 1. Welfare Promotion 2. Increased Predictability 3. Promotion of Representation Reinforcement and Political Unity 4. Avoidance of Legislative Decisions C. Settling Open Questions 1. Comparing Absolute Tax Rates 2. Progressive Taxation 3. Double Benefits and Burdens 4. A Way out of the Labyrinth IV. TAX NONDISCRIMINATION IN THE UNITED STATES CONCLUSION INTRODUCTION

States may be accused of "tax discrimination" when they tax outsiders differently from insiders, where "insiders" refers to nationals, resident individuals, and resident companies. (1) Stating the tax nondiscrimination principle is deceptively simple: tax likes alike. For example, suppose a resident and a nonresident both earn $100,000 in the same jurisdiction. At first blush, a principle of tax nondiscrimination would seem to require that the resident and nonresident be taxed the same. But differences between insiders and outsiders, such as their usage of government services, may justify differences in their tax treatment. Accordingly, before we can conclude that treating such taxpayers differently is discriminatory, we must first understand what values the nondiscrimination principle promotes.

So far, however, judges, government officials, and scholars have failed to clearly articulate the value or values that legal prohibitions of tax discrimination promote. That failure has provoked commentators to describe the concept of nondiscrimination adopted by the European Court of Justice (ECJ) as "baffling," (2) "theoretical and arcane," (3) and "incoherent." (4) Similarly, commentators describe the U.S. tax discrimination cases as "slippery" (5) and in need of a "principled approach." (6) And the Supreme Court has labeled its own tax discrimination jurisprudence a "quagmire" (7) and a "'tangled underbrush.'" (8)

Lack of a clear definition has not prevented prohibitions of tax discrimination from appearing in (or being read into) statutes, constitutions, and international treaties. (9) For example, the Supreme Court interprets the dormant Commerce Clause to prohibit tax discrimination by U.S. states. (10) Similarly, the ECJ has interpreted the fundamental freedoms of the Treaty on the Functioning of the European Union (TFEU) to prevent tax discrimination by EU member states. (11) Explicit prohibitions of tax discrimination also appear in every U.S. income tax treaty currently in force, (12) and the influential model tax treaties of the Organisation for Economic Cooperation and Development (OECD), (13) the United States, (14) and the United Nations (15) all dedicate an article to tax discrimination. Finally, prohibitions of tax discrimination appear in major multilateral and regional trade agreements. (16)

Although the concept of tax discrimination is ill-defined and poorly understood, its influence seems continually to expand. It has become particularly important in the EU, where tax cases constitute about 10% of the ECJ's caseload. (17) The ECJ has relied upon the nondiscrimination concept to justify invalidating longstanding tax practices, prompting harsh criticism from scholars and tax officials. (18) For example, the ECJ held that an EU member state could not categorically deny an EU national earning income within its territory but residing in another member state the same deductions for personal and family expenses that it allowed to its own residents. (19) The court held such denials discriminatory notwithstanding the fact that the practice is widespread internationally and expressly permitted under tax treaties. (20) In interpreting the Privileges and Immunities Clause, the U.S. Supreme Court has drawn the same conclusion: a U.S. state cannot categorically deny personal tax benefits to residents of other U.S. states. (21) Spurred by these judicial decisions, tax officials and scholars have begun to scrutinize the nondiscrimination concept intensely. (22) Notwithstanding this scrutiny, a clear definition of tax discrimination has failed to emerge. This continuing lack of guidance leaves government officials to develop tax policies and taxpayers to make business decisions in a highly uncertain legal environment.

Although legal limits on tax discrimination are widely viewed as promoting economic efficiency, there is no consensus regarding what efficiency value they promote. As this Article explains, economists and policymakers traditionally have evaluated cross-border tax policies under two competing efficiency criteria: capital export neutrality and capital import neutrality. (23) A law is capital-export-neutral when it does not distort the allocation of capital across states. (24) In contrast, a law is capital-import-neutral when it does not differently distort the savings-consumption tradeoff across taxpayers residing in different states. (25)

In an influential recent article in this Journal, Professors Michael Graetz and Alvin Warren argued that the ECJ's approach to tax discrimination cases is fundamentally inconsistent. (26) As support for this claim, Graetz and Warren pointed to the fact that the ECJ has imposed nondiscrimination obligations on both states taxing in a source capacity and states taxing in a residence capacity. (27) In international tax parlance, the source state is the state where the taxpayer earns income, while the residence state is the state where the taxpayer resides. But a capital export neutrality construction of nondiscrimination would impose nondiscrimination obligations only on residence states, whereas a capital import neutrality construction of nondiscrimination would impose nondiscrimination obligations only on source states. (28) Graetz and Warren argued that the ECJ's imposition of nondiscrimination obligations at both source and residence did not appear to pursue either neutrality principle. Making matters worse in their view, by imposing nondiscrimination obligations at both source and residence, the ECJ seemed to evince an intention simultaneously to achieve both capital export neutrality and capital import neutrality. But, as Graetz and Warren correctly point out, it is impossible for states to achieve both kinds of efficiency benchmarks simultaneously unless they harmonize their tax rates and bases. (29) Accordingly, because the ECJ has repeatedly held that EU law does not require tax harmonization on the grounds that such harmonization would invade the member states' tax autonomy, (30) imposition of nondiscrimination obligations at source and residence seemed not only to serve no clear efficiency goal, but also erected, in Graetz and Warren's terms, a "labyrinth of impossibility." (31) Similarly, although Graetz and Warren did not address the issue, tax discrimination doctrine in the United States is susceptible to the same criticism, since U.S. courts have interpreted the Constitution to place nondiscrimination obligations on states taxing in both source and residence capacities, while at the same time holding that the Constitution does not require states to harmonize their taxes. (32)

In this Article, we provide a way out of this "labyrinth of impossibility" by offering a new efficiency benchmark that is consistent with imposing nondiscrimination obligations on both source and residence states. We draw on recent scholarship by economists Michael Devereux, Mihir Desai, and James Hines to formulate a new version of nondiscrimination, one we call "competitive neutrality." (33) A tax law is competitively neutral when it does not distort the matching of owners with investments (or workers with jobs). Viewed in this way, a tax system is competitively neutral if it maintains a level tax playing field between resident and nonresident taxpayers. As a result, competitive neutrality formalizes the intuition that the nondiscrimination principle is about promoting competition.

Part I provides background on tax discrimination and uses examples from ECJ case law to illustrate the kinds of state tax practices that give rise to discrimination challenges. Part I also shows that a clear conception of the principle of tax nondiscrimination has failed to emerge.

Part II provides three alternative interpretations for tax discrimination. Because we analyze labor taxation, in Part II we translate the traditional tax efficiency benchmarks, which were developed to analyze capital taxes, into the labor tax context. We call the labor analogue of capital export neutrality "locational neutrality," because it obtains when taxes do not distort the allocation of labor across states. We call the labor analogue of capital import neutrality "leisure neutrality," because it obtains when taxes do not differently distort the work-leisure tradeoffs faced by taxpayers residing in different states.

In Part II, we provide the first formal account of what it would mean to interpret the nondiscrimination principle to require locational neutrality or leisure...

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