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December 10, 2018

Auctioning the Upzone: A New Strategy for Inducing Local-Government Compliance with State Housing Policies

By Christopher Elmendorf and Darien Shanske

[Cross-posted from Legal Planet]

California’s housing policies–a topic that for years received precious little attention from state officials–has suddenly become the Golden State’s hottest political and policy issue.  The California Legislature passed no fewer than 15 new housing bills in 2017, and then doubled down on that accomplishment by enacting 16 more laws in its just-concluded 2018 session.  Taken together, they represent incremental (if not sweeping) progress in addressing California’s chronic housing shortage.

With California Governor-elect Gavin Newsom about to take office, attention turns to if and how he will deliver on his campaign pledge to create 3.5 million new housing units by 2025.  Legal Planet colleagues Ethan Elkind and Meredith Hankins have recently weighed in on the topic.  Here’s a slightly different take on these same housing issues, courtesy of U.C. Davis academics:

In January of 2018, California State Senator Scott Wiener shocked the political firmament with a bill that would have zoned every tract of land in the state near a bus, rail, or ferry stop for 8-10 story buildings. His bill, SB 827, was soon watered down and then defeated, but not before launching a national debate about housing costs, “NIMBYism,” and the critical importance of increasing residential density near mass transit.

Though SB 827 was uniquely far-reaching, it was not a one-off. Sen. Wiener has introduced a very similar successor bill, SB 50, for the 2019-2020 legislation session, and a state senator in Washington has floated a proposal to establish density minimums around transit stations in the greater Seattle region. Out of the limelight, state housing agencies and to some extent state courts are also pressing local governments to allow denser housing.

The debate thus far about state-mandated upzoning has centered on questions about the proper balance between statewide vs. local interests. An equally if not more important question has received too little attention: what will it take to get local governments—the entities that actually issue building permits—to comply with the state’s policy? SB 827 did nothing to displace local control over permitting, design standards, demolition restrictions, impact fees, affordable-housing requirements, and more. SB 50 is no different. If the bill passes, localities that don’t want tall buildings near a transit station could make them incredibly difficult to build.

The history of state efforts to make local governments allow more housing is a history of mostly minor interventions that were met, swamped, and defeated by local champions of the status quo. A bold, state-led upzoning program is unlikely to achieve very much unless it is paired with an equally bold mechanism to secure local governments’ cooperation.

Two of us have just posted a new white paper proposing such a mechanism. We argue that states should confer on local governments a right to auction the new development rights created by upzoning pursuant to state policy. Local governments that comply with state policy (and whose upzone-plus-auction plan is approved by a state agency) would recoup the development value thereby created. This is akin to a state subsidy for local compliance, but it comes at no cost to the state’s budget, and, critically, the size of the subsidy—that is, the revenue generated for the local government through the auction—would depend on the credibility of the local government’s commitment to allowing development in the upzoned area. Our proposal would also facilitate state monitoring of local land-use regulation, as the price at which development-allowances trade would provide a forward-looking signal about otherwise hidden or obscure local barriers to development.

Though the notion of auctioning the right to develop housing may seem strange, our proposal has a near analogue in existing transferable development rights (TDR) programs. The principal difference is that TDR programs reallocate development value among landowners, whereas our model would reward local governments for upzoning and permit streamlining.

Our proposal also resembles California’s cap-and-trade regime for greenhouse gas emissions. Just as the owner of a power plant who wishes to burn fossil fuels must purchase emissions allowances for the carbon dioxide that would be released, so too would a landowner who wishes build in the expanded zoning envelope have to acquire and redeem “development allowances.” Each development allowance would permit its owner to build, say, 100 square feet of housing in excess of the baseline, up to a maximum defined by the new zoning map. To illustrate, imagine a parcel of 2500 square feet that had been zoned for a floor-to-area ratio of two, i.e., two square feet of housing for every square foot of lot size. Let us stipulate that after upzoning, the maximum floor-to-area ratio is eight. This means that the owner of the parcel, who previously could build no more than 5000 square feet, may now construct as many as 20,000 square feet. But to obtain a permit to build 20,000 square feet, she would have to acquire and redeem 150 development allowances ([20,000 – 5000]/100 = 150).

To protect landowners’ reasonable expectations, the state legislature should carefully define the development baseline—that is, the minimum level of development for which local governments maynotdemand development allowances. A landowner who seeks only to build something similar to what most others have already built should not have to pay for the privilege. Nor should local governments make landowners pay for the density allowed under longstanding zoning classifications. Accordingly, we recommend defining the baseline as the greater of (1) the typical density of parcels that have already been developed for housing within the local government’s territory, and (2) the locally permitted density for the parcel in question as of the date of the state law authorizing the auctions.

We acknowledge that courts and legal commentators have often resisted the idea of putting zoning up for sale. A generation ago, the economists William Fischel and Robert Nelson argued that local governments should have more or less unfettered discretion to sell rezoning for cash. Their proposals went nowhere. Liberals generally regard the sale of zoning as corrupt, and conservatives see it as extortionate. If local governments could profit from selling development rights, wouldn’t they just ban all development everywhere to obtain maximum leverage for negotiating upzones?

Our proposal sidesteps the usual zoning-for-sale objections, because it vests authority to approve the rezoning (plus auction) in a different government than the one which profits from it. Local governments could only sell those development rights created by upzonings that advance the state’s policies, and with the approval of the state’s housing agency. The state policy of promoting dense development near transit would continue to be shaped by environmental, economic, and equity goals, not the prospect of filling state-budget holes with auction revenues (the state wouldn’t pocket the revenues). Moreover, state lawmakers could easily allay concerns about “exploitative downzoning” by setting a development baseline that precludes local governments from requiring landowners to redeem allowances if they merely seek to develop at previously-allowed densities. In a legal challenge, the public-profit aspect of our scheme could be defended not as a way of raising revenue, but as a rational means by which the state fosters local-government compliance with its policies.

This is not to say that the right to auction development rights is an absolutely surefire bet for wrangling local governments into compliance with state housing policies. Our white paper considers various legal and policy objections. But new tools are clearly needed if existing residential neighborhoods are to be rezoned and repurposed for substantially denser housing. The development-rights auction belongs in the mix.

September 18, 2018

Blue State Republicans Fret Over 'Tax Reform 2.0' -- rightly so

By Darien Shanske and Dennis Ventry

[Cross-posted from The Hill]

The new tax bill, “Tax Reform 2.0,” is here, and it makes permanent the $10,000 cap on the state and local tax deduction (SALT) created by the Tax Cut and Jobs Act (TCJA) in December 2017.

Meanwhile, Republican politicians from districts where high percentages of taxpayers will be affected by the cap are wary of making the cap permanent. A deeper dive into theories of taxpayer psychology and tax policy indicates these politicians are right to be concerned.

First, consider how the cap will shrink refunds or increase tax bills for millions of taxpayers.

Early next year, Jane fills out her tax return using her preferred commercial tax prep software. She enters her property tax information, expecting, as in prior years, that her federal tax liability will drop considerably. But she surpassed the SALT cap of $10,000 when she previously entered her $12,000 in-state income taxes paid.

Under prior law, and when added to her $8,000 in property taxes, Jane would have received a $20,000 federal tax deduction. But the new law caps her deduction at $10,000, and so she loses the value of the additional $10,000 deduction.

How much does she lose? If she’s in the 24-percent tax bracket, Jane is worse off by $2,400, either resulting in a smaller refund or more tax.

And it gets worse for higher-income taxpayers. If Jane had a total of $110,000 in SALT paid rather than $20,000, she would lose the value of the additional $100,000 deduction. Since Jane would likely be in the top tax bracket of 37 percent, she’d owe $37,000 more in taxes.

Beyond the sting of owing more in tax, Jane also may feel that she is being punished for doing the right thing: opting to pay more in state and local taxes in exchange for better state and local public goods.

Research indicates that dismay at this tax change might be quite politically salient to the taxpayer when making voting decisions. Compare the large — and explicit — jump in tax liability described above to an increase in withholding taxes from periodic paychecks.

Moreover, millions of taxpayers are likely to react negatively to their higher-than-expected tax liability even if some of those same taxpayers pay lower taxes in the aggregate due to other changes in the law.

Indeed, the SALT cap is arguably already impacting property owners in jurisdictions whether they itemize or not because itemizing home buyers understand that their future property taxes will no longer be deductible over the cap and are accounting for that change in their home-buying budgets.

Homes are typically a taxpayers’ largest asset and voters can be aggressive in voting to protect the value of that asset.

Retaining the SALT cap is also fraught with political peril because taxpayers are sensitive to the reality and perception of procedural and substantive fairness. It is unlikely that the partisan, rushed, secretive and demonstrably flawed processes that produced TCJA and now Tax Reform 2.0 are going to be perceived as fair.

As for substantive fairness, Republicans have claimed repeatedly that most taxpayers will receive lower tax bills. But it is hard to explain why two-earner families in a handful of states should not get a tax cut on account of the SALT cap, to say nothing of the unequal political valence of the jurisdictions targeted by Congress with a tax increase.

It is possible for voters to be convinced by more abstract tax policy arguments. And politicians are to be commended when they pursue the correct policy and endeavor to persuade their constituents. But the policy arguments for the SALT cap are feeble.

One argument is that the cap is progressive in that wealthier taxpayers are affected by it. But the cap was embedded in a very regressive bill. A tax change that only subjects a small sliver of wealthier taxpayers — though not the wealthiest — to higher taxes is not fair.

Another unpersuasive argument is that the SALT cap corrects for the fact that low-tax states were subsidizing high-tax states through the deduction. For starters, this kind of inter-state accounting is corrosive to our polity.

Worse, it leaves out a key piece of information. Specifically, the states that have the most taxpayers affected by the cap are among the wealthiest states and thus are net “givers” to our common government. Capping the SALT deduction makes these states’ relative contribution even higher.

Another argument is that a full deduction for state and local taxes might not be appropriate as a matter of tax principle. Fair enough, but it’s incongruous in the context of a tax bill loaded with tax policy blunders and deviations from income tax principles, most notably new code section 199A, the so-called passthrough deduction, which is a bacchanal of unprincipled and regressive income tax policy.

Phase 2.0 will make this blunder permanent, so the claim that the SALT cap is a principled change rings quite hollow.

In any event, a more typical approach to situations where it is uncertain how much of a deduction is proper would have involved using a percentage cap, like 50 percent. Limiting the SALT deduction in such a way would have been unpopular as well, but it would have been principled. Other principled options exist.

Perhaps the biggest political danger posed by the SALT cap is that it could create millions of apostles carrying a simple message: Ultimately, very few taxpayers will receive their promised tax cut from Republican tax changes.

This is because borrowing trillions of dollars (with interest) to reduce taxes does not a tax cut make. While taxpayers at the very top of the income ladder will realize huge tax savings both now and in the future, the rest of us will ultimately face higher tax bills and/or fewer vital services.

The millions of taxpayers paying more in taxes next year due to the SALT cap are just the harbingers.

Darien Shanske and Dennis Ventry are professors at the University of California, Davis, School of Law. Shanske's areas of academic interest include taxation, particularly state and local taxation, local government law, public finance and political theory. Ventry is an expert in tax policy, tax practice and tax filing and administration.

 

 

July 30, 2018

States Should Conform to -- and Improve -- the New Federal Tax Provisions Meant to Counter Base Erosion

By Darien Shanske

[Cross-posted from Medium]

The United States used to tax multinational corporations (MNCs) on the basis of their worldwide income, except that most foreign source income would only be taxed when actually repatriated to the United States. This structure naturally created considerable incentive to strip income out of the United States and then not to repatriate it.

Now, thanks to the TCJA, the United States is ostensibly only going to tax MNCs on their US source income. This shift to a so-called territorial system means, of course, that MNCs will continue to have incentive to shift income abroad in order to avoid US tax. The TCJA has two separate provisions meant to counter this: GILTI and BEAT. One question for the states is whether they should conform to these provisions. I think the answer is yes. I also think it is clear that states should improve these provisions when they adopt them.

There is a preliminary question as to whether states can — as a matter of federal constitutional law — conform to these provisions. I think the answer is again yes, but the details of the state law will matter a great deal.

Not everyone agrees. For instance, the STAR Partnership, argues here that:

“Under the prior federal tax system, States generally did not include foreign income in their own tax bases, for both policy reasons and Constitutional limitations. States should continue to respect these policy and Constitutional rationales and avoid taxation of foreign income by excluding these provisions from their business tax bases.”

In short, according to a group of top state and local tax lawyers and policy wonks — who are quite explicitly representing the “business community” — states should not and cannot conform to the federal provisions meant to prevent base erosion. It is true that states do not tax foreign source income (in general) and that it is a tricky policy and constitutional question whether they can and/or should, but is it true that this is what states would be doing if they tax the repatriation or conform to GILTI or BEAT?

Consider some well-known and curious facts about the income of MNCs. First, there are some jurisdictions that are just unbelievably profitable for corporations. As Torslov, Wier and Zucman put it: “Foreign corporations . . . have extremely high profitability ratios in tax havens, e.g., 800% in Ireland. . . . By contrast, and strikingly, in almost all non-haven countries foreign firms are less profitable than local firms. Thus, there is a clear trace in global macro data of shifting from high- to low-tax affiliates, in such a way that profitability is systematically over-stated in tax havens and under-stated elsewhere.”

Many of those some super-profitable jurisdictions also house profits worth many multiples of their GDP, which would seem to be a real head scratcher. For example, the profits of US controlled subsidiaries in the Cayman Islands represented over 1000% of that island’s GDP in 2014. It is of course not possible for firms to earn profit in a jurisdiction many times the size of the jurisdiction’s economy.

We know why this money is taking a Caribbean vacation and we also know which legal structures got it there — see here for example.

In short, there was already a great deal of base erosion, and the two new provisions of federal law we are discussing are meant to counter it. (Indeed, there is a good argument that these provisions are roughly consistent with the anti-base erosion principles championed by the OECD.)

If a state were to conform to these base protection provisions or tax the repatriation, then a state is not — counter to the STAR Partnership — trying to tax “foreign” income, but trying to protect domestic income from being stripped out of their tax base.

This fact has an important legal implication. Again, it is true that the legal questions would be trickier for states looking explicitly to tax foreign income. Matters are different if a state is trying to tax domestic income and is simply trying to craft rules that lead to a better reflection of domestic income. As to designing their own tax systems to tax domestic income, states have a lot of leeway.

So, states can conform to these federal backup taxes and they should, but it is important to note that they should and could also improve these taxes. For more on how states should tax the repatriation, see here and kudos to NJ for doing so.

Here are a couple of examples of possible improvements to the backup provisions that are drawn in particular from Rebecca Kysar and Dan Shaviro. GILTI stands for “global intangible low taxed income” and the intuition behind the provision, consistent with the evidence above, is that certain low-tax jurisdictions are suspiciously profitable. Therefore, GILTI income is income that is earned beyond the normal expected return on an investment. There are numerous complexities involved in GILTI, many of which are not resolved, but for our purposes we can note that GILTI assumes a normal rate of return of 10%, which is rather high. A straightforward fix that a states could adopt would be conform to GILTI but use some lower rate tied to actual normal returns — perhaps a long-term corporate bond rate +2%. That would make the rate 6% at the moment.

As for the BEAT, the “Base Anti-Erosion Tax,” this is a minimum tax much like the Alternative Minimum Tax (AMT) for individuals. The idea is that a primary way of shifting income abroad is for MNCs to take large deductions for payments to related foreign corporations — say a US corporation paying a foreign affiliate in a low-tax jurisdiction for the use of intellectual property. The BEAT requires an MNC to add such payments back into the tax base; that broader base is then subject to a 10% rate. If the resulting tax liability is greater than the regular liability, then the taxpayer pays the minimum. As with GILTI, the BEAT has many design flaws. For instance, the BEAT only kicks in for relatively large corporations ($500 mn plus in gross receipts); it would make a lot of sense for states to adopt the BEAT, but at a lower threshold.

The TCJA emerged from such a flawed process that even its most reasonable ideas, like GILTI and the BEAT, are deeply flawed. (Again, don’t take my word on it, ask Kevin Brady.) And the states will be negatively impacted if the TCJA encourages MNCs to strip out even more income because the GILTI and the BEAT are ineffective. So, at a minimum, states should conform to these provisions and ideally they should improve them, but it should be remembered that improvements need not be through tinkering with the mechanics of these provisions.

The states pioneered an anti-income stripping regime that I would argue is simpler and likely more effective than even an improved GILTI and BEAT: mandatory worldwide combination using the single sales factor. This approach does not require the government to identify a particularly problematic form of income or deduction, which can have unexpected and undesired consequences. Instead, all income is income, and income is apportioned according to where an MNC makes its sales. We know that it is unlikely that an MNC makes many sales to final consumers in tax haven jurisdictions. Currently, no states require mandatory worldwide combination, but many permit taxpayers to choose it. If a state is unwilling to require worldwide combination, then an appealing option would be to conform to GILTI and the BEAT, with improvements, and then permit MNCs to choose if they would not prefer the simplicity of worldwide combination.

 

July 23, 2018

Maryland’s Generic Drug Pricing Law Is Constitutional: A Recent Decision Misunderstands The Structure Of The Industry

By Darien Shanske and Jane Horvath

[Cross-posted from Health Affairs]

Maryland’s price gouging law, a first-in-the-nation state law, would protect consumers from egregious price hikes of certain generic and off-patent brand drugs made by three or fewer manufacturers. Bills based on the Maryland template are moving through a number of other state legislatures. On April 13, 2018, a split three-judge panel of the US Court of Appeals for the Fourth Circuit ruled that the Maryland law, HB 631, enacted in 2017, is unconstitutional based on the court’s interpretation of case law concerning the Dormant Commerce Clause (DCC).

However, the decision is wrong for numerous reasons, many of which were very cogently explained in a lengthy dissent. The Maryland attorney general has requested an en banc review, which is when all judges in the circuit review a decision made by a single three-judge panel. With luck, the entire circuit will get it right.

We will focus here on how this decision is based on a misunderstanding of how the US drug market and supply chain operate.

The Constitutional Doctrine At Issue: Dormant Commerce Clause

The Commerce Clause of the Constitution gives the US Congress the power to regulate commerce between the states. The DCC places limits on a state’s ability to disrupt interstate commerce. The primary focus of DCC doctrine is preventing state discrimination against out-of-state businesses. A secondary concern is preventing state laws that unduly burden interstate commerce. A tertiary concern is preventing states from regulating activity occurring out-of-state—extraterritorially. (For more information about these, the DCC, and state drug cost policy, please see this white paper.)

The Maryland price gouging law (HB 631) addresses generic and off-patent brands that are on the World Health Organization list of essential medicines and manufactured by three or fewer companies. When a drug is produced by only a few manufacturers, the producers can easily launch drugs at high prices, maintain high prices, and increase prices dramatically. High prices of important essential medicines that become unaffordable leave consumers with few, if any, treatment alternatives. This deeply problematic scenario is not just imagined, as both the Government Accounting Office and the US Senate Special Committee on Aging wrote reports detailing the problem. This is the problem the Maryland law addresses.

The generic drug industry sued based on two DCC issues. The first is that the HB 631 law violates the DCC by regulating industry financial transactions outside of Maryland—that is, the charge is that Maryland is regulating extraterritorially. Second, the industry claims that the Maryland law places an “undue burden” on interstate commerce.

Note that there was no argument that the Maryland law would somehow protect the Maryland drug industry, preventing such protectionism is the core concern of the DCC. Nevertheless, the majority of the Fourth Circuit panel found that the Maryland law failed on the secondary and tertiary aspects of the DCC—undue burden and extraterritoriality, respectively. As we will now explain, the court decision seems to have not considered how the pharmaceutical market works.

The Maryland Law Does Not Impose An Undue Burden On Interstate Commerce

The majority opinion found that the Maryland law placed an undue burden on interstate commerce. In the classic cases of undue burden, a state places a heavy burden on interstate commerce of a company or industry for a trivial reason. For instance, in one case, a state required trucks to use an unusual type of mud flap when driving in the state. The Maryland law is nothing like this. First, most obviously, the law is regulating something extremely important—namely generic drug prices—when no one else is doing so, and there is clearly a consumer health and safety issue.

Second, what Maryland is asking the generic drug industry to do is nothing as burdensome as stopping their trucks at the border and making them change their mud flaps. Rather, drug prices are already a product of an enormously complicated set of financial transactions that cross geographies. These financial transactions already vary based on where the product is made and the geography into which it will be sold.

For example, drug manufacturers will negotiate discounts with specific hospitals, health systems, or health plans. Who negotiates with whom depends on the importance of the payer/purchaser in the national or regional market, the product market competition, the importance of the product to company revenue, and other factors. If the negotiation with a hospital results in an on-invoice discount, the manufacturer has to have a financial process to ensure that the wholesaler does not lose money since the wholesaler buys the product from the manufacturer and distributes it nationally or regionally to different buyers (including more local distributors that would get the product to the hospital).

So manufacturer discount negotiations at a very local level—the hospital for instance—drive multiple financial transactions in distant geographies. Manufacturer discount rebate agreements (as distinct from on-invoice discounts) with a health plan also result in financial transactions in a state other than the corporate office of the health plan. This is all part of the business model, and these are only some of the interstate financial transactions required for individual companies to compete in the market. The necessity of working directly in many markets would be particularly important for products with three or fewer competing manufacturers—these are the products subject to the Maryland law—because this is a scenario in which price competition can move market share and profits.

Thus, given the structure of the pharmaceuticals market, and particularly the market for the regulated products, the Maryland law would hardly impose a burden, much less an undue one.

The Maryland Law Does Not Regulate Extraterritorially

The Fourth Circuit also found that the Maryland law violated the extraterritoriality doctrine. This doctrine is a bit variable, but the core rule is simple: A state cannot regulate conduct in another state. Clearly, Maryland was not trying to do this but trying to secure essential drugs at a reasonable price for its citizens. It is true that in so attempting to protect its citizens, there would possibly be a small impact on current transactions wholly out of state, but if this is the test for whether a state can regulate in our interconnected economy, then states cannot regulate much of anything. And, indeed, the decision was wrong on the law of extraterritoriality for just this reason, namely that it would undermine virtually all state regulations. For more on the doctrine, see here.

But perhaps one could defend the Fourth Circuit decision by noting that an effect on interstate pricing was especially likely because of the structure of the drug industry. This analysis, though superficially appealing, has to be rejected because, once again, Maryland is not creating a new or unique effect on interstate pricing. Even in the absence of the HB 631 law, the industry responds to the various limits that different payers put on reimbursement to generic drug dispensers. For example, each and every health plan and all Medicaid programs set their own maximum allowable costs (MACs) for generics and off-patent brands. MAC is just a term for setting dispenser reimbursement limits; it is the average of the prices among the competitors. Maryland health plans and Maryland Medicaid each set their own MACs for their own set of generic products. Furthermore, these various payment limits in Maryland are different from what each health plan in Virginia and Delaware set, all of which can require manufacturers to adjust prices for any one geography through financial transactions that likely occur out of state. This is day-to-day activity in the industry, indeed, it could be very difficult to sort out any small impact of the Maryland law because it would be completely in the mix of the current interstate pricing activity in response to payer limits on pharmacy and provider drug reimbursements—limits that can change weekly or monthly at a payer’s discretion.

So, if the Fourth Circuit’s analysis were correct, then any industry with a complicated business model that crosses state lines could not be regulated by the states. Even more peculiar, if an industry were not so organized, all an industry would need to do is tie itself in knots to escape regulation by the states. It can’t be that the constitutional power of states to protect the health of its citizens diminishes because a firm’s business model produces interstate ripples whenever a state tries to regulate its actions.

In the analogous area of state taxation, it is well-established that a state cannot subject an interstate business to double taxation (relative to an instate business) on account of how the state organizes its own tax system. However, if an interstate firm suffers from double taxation because of permissible decisions made by two states individually, then that is just a necessary byproduct of living in a federation where subnational units have substantial taxing and regulatory power.

But perhaps it makes a difference that part of the complexity here is a result of federal law? If the argument is that a federal law relating to generic drug prices preempts state regulation of prices charged to its citizens, then that is indeed a serious argument. The generic drug industry did not raise this issue precisely because there is no such federal law. Therefore, the court’s finding must rest on the argument that when a federal regulatory regime that does not regulate the prices of drugs that are available in Maryland and other states (because there is no federal law regulating generic drug prices) but does indirectly create possible interstate price linkages (because of federal programs such as Medicaid), then the states are not allowed to regulate those drug prices as if the federal government had preempted state regulation directly. Stating the argument clearly is to reveal how little sense it makes and also, not coincidentally, why it is not the law. There is an entire body of law—preemption—that considers when a federal law preempts a state law, and there is a presumption against preemption. Federal courts are not supposed to be in the business of finding creative ways to prevent states from protecting their citizens.

The structure of the pharmaceuticals market is opaque, as is US Supreme Court case law about the Dormant Commerce Clause. However, knowledge of the market is absolutely key to assessing state laws relative to the DCC. We do not think their decision will stand the test of time once it is understood how this complex market actually functions. 

 

July 23, 2018

Wayfair as a Federalism Decision

By Darien Shanske

[Cross-posted from Medium]

Some first impressions, including pondering how this decision intersects with NCAA v. Murphy

In the end, not a single justice would stand up for the rule of Quill, which rule was that a state can only impose a use tax collection obligation on a vendor if it has a physical presence in the state. All the justices agreed that it was the wrong rule, even apparently, when first imposed in 1967. So then why was this a 5–4 decision?

The four dissenters argued that stare decisis should protect the Quill rule nevertheless because it is an old rule that Congress can change. I take the key part of the majority response to be the following:

While it can be conceded that Congress has the authority to change the physical presence rule, Congress cannot change the constitutional default rule. It is inconsistent with the Court’s proper role to ask Congress to address a false constitutional premise of this Court’s own creation. Courts have acted as the front line of review in this limited sphere; and hence it is important that their principles be accurate and logical, whether or not Congress can or will act in response. It is currently the Court, and not Congress, that is limiting the lawful prerogatives of the States.

This seems exactly right to me and I have argued as much (see here and here). And it is of course not surprising that Justice Kennedy is arguing that federalism values establish a pro-state power default and that it is untenable for a federal court to erect a barrier to state power based on a mistake.

But note that the dissent in Wayfair was written by Chief Justice Roberts, who, in another context wrote: “The dormant Commerce Clause is not a roving license for federal courts to decide what activities are appropriate for state and local government to undertake …” The issue in that case, United Haulers, was whether a public utility could force local users to use its services, and Chief Justice Roberts held for the majority that it could. Justice Alito wrote a powerful dissent in that case and was joined by Justice Kennedy. Justice Alito again joined Justice Kennedy in Wayfair. Thus, according to these two justices, a pro-state constitutional default does not protect local flow control ordinances, but does protect the ability of states to impose a use tax collection obligation. For Chief Justice Roberts, the reverse is apparently true, though in his case he would note that stare decisis was what weighed against the states in the use tax context. (The counter to this is that United Haulers also essentially overturned a precedent, a point well made by Justice Alito in his dissent.)

So Wayfair did hinge on federalism values, I believe, but in a quite complicated way that will require additional unpacking, especially in light of NCAA v. Murphy. This decision, authored by Justice Alito, and joined by Justices Roberts, Kennedy, Thomas, Kagan and Gorsuch, struck down a federal law that made it unlawful for states or their subdivisions to authorize betting on sporting events. The majority thought that this decision followed from the anti-commandeering principle, namely that Congress cannot “issue orders directly to the States.”

As was immediately noted, a broad interpretation of NCAA v. Murphy puts into question numerous federal laws that also restrict the kinds of laws that state legislatures can pass. Such laws are particularly numerous in the field of taxation, where Congress has imposed special rules relating to mobile phones, railroads, pensions etc. And yet both sides in Wayfair seem to agree that Congress could step in and regulate how states can impose a use tax collection obligation. But would not the relevant federal law be, in effect, a prohibition on state legislative power?

This question has been very ably debated by Daniel Hemel, Brian Galle, Rick Hills, Jeff Schmitt and Ilya Somin among others. It seems to me Wayfair is a pretty strong indication that the Court did not mean to undermine the ability of Congress to restrict state taxing power — within limits. Still, Murphy says what it says and so I will add one more way that the Court — and first courts — can reasonably limit Murphy.

In Murphy, Congress was weighing in on a contentious policy matter involving regulating individual conduct on which there is a limited federal interest. The majority in Murphy signals as much in its first line: “Americans have never been of one mind about gambling…” I think that Justices like Kennedy and Alito, relative hawks in other dormant Commerce Clause cases, would argue that preventing balkanization of the national marketplace is a very different matter from imposing a one-size fits all rule about sports betting. Protecting the national marketplace is a core concern of the Commerce Clause and indeed of our whole constitutional order, a point made particularly well by Brain Galle. I know that this kind of analysis is mushy and that the Court in Murphy instead focused on the issue of whether or not the federal government is regulating a private actor, but that rubric does not work to explain how and why Congress can act to limit state taxing power post Wayfair.

Focusing on the importance and centrality of the federal interest means, in effect, that the Court is applying a kind of proportionality analysis, a very common method of deciding constitutional cases, though not in our tradition (at least not explicitly). I think applying some form of the proportionality principle is the right answer not only to the question posed by Murphy, but also to the question posed by Quill/Wayfair. The Court in Wayfair does not explicitly shift to a kind of balancing test (in particular, Pike balancing), but its retention of a “substantial nexus” standard without much further guidance seems to invite the states to engage in balancing. Clearly, a remote vendor can now be asked to collect the use tax even without a physical presence, but, just as clearly, remote vendors can only be asked to do so if there is sufficient nexus. Thoughtful balancing of the legitimately opposing interests is therefore the way forward.

July 23, 2018

State Options After Wayfair


By Darien Shanske (with David Gamage and Adam Thimmesch)

[Cross-posted from Medium]

In Wayfair, the Supreme Court overturned the bright-line physical presence rule imposed by Quill. A state can now require an out-of-state vendor to collect the use tax even if that vendor does not have a physical presence within the state. The underlying standard governing when states can impose a use tax collection obligation remains the same: there must be a “substantial nexus.” But what constitutes a substantial nexus? The Court does not give any general guidance, but does make it clear that this standard was satisfied in this case. Alas, the Court’s reasoning as to this case is reasoning is ambiguous. Here is the key paragraph:

Here, the nexus is clearly sufficient based on both the economic and virtual contacts respondents have with the State. The Act applies only to sellers that deliver more than $100,000 of goods or services into South Dakota or engage in 200 or more separate transactions for the delivery of goods and services into the State on an annual basis. S. B. 106, §1. This quantity of business could not have occurred unless the seller availed itself of the substantial privilege of carrying on business in South Dakota. And respondents are large, national companies that undoubtedly maintain an extensive virtual presence. Thus, the substantial nexus requirement of Complete Auto is satisfied in this case.

The first sentence of this paragraph suggests that two inquiries are relevant to nexus: (1) a taxpayer’s economic returns from a state and (2) its activities directed toward a state. The second and third sentences of this paragraph suggest that the South Dakota thresholds require sufficient “economic contacts” for substantial nexus. The fourth sentence, emphasizing the size of respondents, focused on the so-called “virtual contacts” that large, national e-commerce vendors create through their extensive marketing and web presences.

What this paragraph does not do is to address precisely when small sellers have a substantial nexus. What if a small seller has exactly 200 sales, worth $20,000? Given this uncertainty, our advice for states at the moment would be to put in place thresholds similar to South Dakota’s. If they wanted to be better insulated from challenges from very small sellers, and likely at minimal revenue loss, we would suggest adopting even higher thresholds. This would be especially true for non-SSUTA states.

Alas for states looking for guidance, there is more ambiguity in the next paragraph of the opinion. The Court remanded the case to the lower courts to consider other possible challenges to the South Dakota law, including, apparently Pike balancing, which is odd considering that the substantial nexus test is a test for taxes and Pike balancing is a test for regulations. Here is the paragraph:

South Dakota’s tax system includes several features that appear designed to prevent discrimination against or undue burdens upon interstate commerce. First, the Act applies a safe harbor to those who transact only limited business in South Dakota. Second, the Act ensures that no obligation to remit the sales tax may be applied retroactively. S. B. 106, §5.Third, South Dakota is one of more than 20 States that have adopted the Streamlined Sales and Use Tax Agreement. This system standardizes taxes to reduce administrative and compliance costs: It requires a single, state level tax administration, uniform definitions of products and services, simplified tax rate structures, and other uniform rules. It also provides sellers access to sales tax administration software paid for by the State. Sellers who choose to use such software are immune from audit liability.

Though we agree that Pike balancing should apply, we wish the Court would have explained why it should apply. Furthermore, and more importantly for states, the Court does not offer any guidance as to which of these aspects of South Dakota’s law is the most important. Crucially, it may not be too difficult for a state to emulate South Dakota’s thresholds, but it might be very difficult for a state to join the SSUTA or otherwise simplify its tax system in a comparable manner.

Our advice here is that states that cannot engage in substantial simplification — and perhaps even states that can — should offer meaningful vendor reimbursement for compliance costs and/or offer free compliance software that immunizes vendors who rely upon it. (One of us discussed this first approach at length in a prior article here; and two of us discussed this second approach in a prior essay here.)

We do not think that these approaches are necessarily required by the Court’s opinion; substantial enough simplification of a state’s sales and use tax, roughly equivalent to that required by the SSUTA, should suffice. But we do think that adopting one of these approaches makes for good, sensible policy. If, for whatever reason, a state wants to retain a more complicated sales and use tax system or simply does not wish to conform their sales and use tax system with that of other states, then it is only fair that states compensate vendors for the costs they incur in collecting sales and use taxes.

January 19, 2018

States Should Tax the Over Two Trillion Dollars About to Be Deemed Repatriated (But Many Are Not Going To If They Do Not Act)

Here is the Why and the How (roughly)

By Darien Shanske

[Cross-posted from Medium.]

Under its pre-2018 international tax regime, the United States attempted to tax the income of multinational corporations on the basis of their worldwide income. To take a non-random example, the United States sought to tax Apple on its income earned all over the world. The old US international tax regime did permit multinational firms to defer payment of tax on the income they earned oversees - defer until the firm brought the money home. So, until Apple Germany sent home its profits to Apple US, those profits would not be subject to tax. Naturally, Apple and other multinationals let a lot - like over 2 trillion dollars a lot - of income hangout abroad.

One strategy, used for instance in 2004, to bring this money home to the US was to offer a special low rate. Repatriate now and pay 5.25% rather than the usual 35% rate. The tax law just passed, commonly referred to as the Tax Cuts and Jobs Act (TCJA), but actually having no name, applies much stronger medicine. Kind of. The TCJA deems all of this income to be repatriated and then applies a tax rate of 8% or 15.5%. The Joint Committee on Taxation estimates that this provision will raise $338 billion over ten years (see bottom of page 566 of the PDF). To return to Apple, this one company alone expects to pay $38 billion on $252 billion in repatriated earnings.

Given that there was no good reason for the tax on this income to have been deferred, this deeming provision is arguably pretty sensible. Alas, several other aspects of this part of the law make it a travesty, as so much else is in The Act with No Name. First, if this income was going to be deemed returned anyway, why not subject it to the actual rate that was avoided (35%) or at least the new very low rate (21%)? Second, this is one-time money. The Obama Administration had planned to commit the money from repatriation to infrastructure, including capitalizing an infrastructure bank. Instead, the Act with No Name uses this one time money for short-term and likely ineffectual economic stimulus.

But all is not lost. As Daniel Hemel has already explained, states should tax the deemed repatriation. The basic reason to do so is the same reason that the states should generally act to undo as much of this law as possible. It is terrible policy; it is squandering our national wealth for no discernible reason. Let's return to infrastructure. On top of the lost opportunity costs from spending this one-time money wisely, and thanks to the Act's exploding the federal debt, the federal government has only made itself less able to serve as a partner to the states in financing infrastructure. States should act to use this one-time money to do the right thing and establish their own infrastructure banks or finance other capital projects. (One other idea: states should consider using the money to start a climate science institute the way California started a stem cell science institute when the federal government dropped the ball in that area during the Bush II years.)

The states should also tax these repatriated earnings because it is efficient for them to do so. Ordinarily, states need to worry about taxpayer response. If this were another tax amnesty, then a state might worry that local firms would not repatriate their foreign earnings at all if the state imposed too high a tax. Or perhaps firms might move. But these earnings are coming home no matter what, and this year. Further, deemed repatriation is a one-time event as the United States fundamentally changes its approach to international taxation. The United States is shifting to a territorial system. The US will not even attempt to tax multinationals on their worldwide income in the future. (To use jargon, this is a rather inelastic tax base.)

States can tax this deemed repatriation, but their current tax systems are not designed to do so - or at least not well. New York just recently reported that it expected to net very little from this repatriation (see pp. 28-29). The details must await another time (or at least the appendix to this blog post), but it should not be surprising that state tax systems are not designed to effectively deal with the deemed repatriation. Consider the tax rate. The rate that states apply to the deemed repatriation should be pretty high. Again, multinationals cannot avoid repatriating this income. But state corporate income tax rates are set taking interstate competition into account. A state that usually taxes corporate income at 5% might well consider a 20% rate on the deemed repatriation appropriate - after all a 20% rate captures most of the windfall given to the corporations by the federal Act.

An even bigger issue is that states generally permit multinational corporations to choose to have only their income generated from the US subject to tax. This is called a "water's edge" election. Again, in the usual context of interstate competition, this makes sense. The law governing this election is complex and differs between states. Suffice it to say that these laws in many cases will permit multinational corporations to avoid paying state corporate income tax on much of their repatriated earnings.

So states should pass new laws that explicitly cope with this situation. (I get into the weeds of what this law might look like in the appendix.)

But can states do this? The answer, I believe, is yes - but with an explanation. States cannot reach out and tax extraterritorial value, but states can tax an apportioned share of the business income of a multinational corporation. They can also tax the non-business income of a corporation at the place of commercial domicile. What does this mean? Take Apple and California. California can say that it is going to tax Apple on its worldwide income, but subject to a reasonable formula that apportions that income to California. Only income generated by Apple as a unitary business can be apportioned. Income earned by Apple in some other way, say as investment income, can be taxed by a business' commercial domicile. In this case, this would also be California.

Apportionment is generally done by a formula. States will typically choose an apportionment formula appropriate to their competitive position. A market state like California apportions the income of multi-state corporations on the basis of sales. A big resource state like Montana only uses the location of sales for 1/3 of its formula, but also uses the location of property and payroll. But in the context of this one time deemed repatriation provision, states need not be overly concerned with choosing a competitive formula. Thus an apt formula might be: The income from the deemed repatriation should be apportioned on the basis of historical sales or property and payroll or state population, which ever is higher.

(As a backstop, the law might provide that any income found not to be apportionable is still subject to allocation.)

But can the rate on this repatriated income be higher than for other corporate income? I think there are good arguments that it can be. After all, states often have different rates for different kinds of income and even different kinds of businesses. See, for example, here and here. And this is leaving to the side the different effective rates that corporations pay based on any credits they might receive - or any penalties that might be imposed. If states can and do have higher taxes on less mobile businesses, on financial businesses and can impose significant penalties, then it seems that a state can also impose a higher rate on this repatriated income, which is a kind of like an immobile windfall, kind of like a financial asset and, though accumulating this revenue was not illegal, the extremes of deferral that some firms went to can be viewed as a kind of behavior that a state could reasonably want to discourage by applying a rate higher than would have been applied if the income had been brought back earlier.

To sum up, states should impose a special tax on the deemed repatriation at a high rate with a favorable apportionment formula. There will be litigation, of course, but I think the states will win.

Appendix

A first cut at some in the weeds issues. First, one should remember that in a case challenging state taxes in this context, the burden is heavily on the taxpayer. This might turn out to be very important.

Second, one might wonder if states really can change their tax systems to reach this income. Interconnected corporations often dividend income to one another and, when they do, the receiving corporation is often entitled to a "dividends received deduction" on the theory that the corporation sending the income has already been subject to tax. One might think the situation is different when the dividend is coming from abroad, and the matter is tricky, but in at least most cases the Supreme Court has held that domestic and foreign dividends must get similar treatment. Thus, if this repatriation is just a big dividend, then states probably cannot subject it to a special rate. But, unlike in 2004, the deemed repatriation is not categorized by the federal law as a "dividend." Rather, the deemed repatriation is another type of income that multinational corporations can create - "Subpart F Income." Don't ask what that is, but do note that it is not a dividend. Many - perhaps most (feel free to email me with information on this)- states do not tax Subpart F income either, as is the case in NY, but the states could and without violating the equal treatment of dividends rule. For a model of what this could look like, look no farther than California's special rule for the taxation of Subpart F income. (See in particular Cal. Rev. and Tax Code Sec. 25110(a)(2)(A)(ii)). Yes, this is obscure stuff. At least one analysis by a consultant to the California Senate Committee on Governance and Finance seems to agree with my take. This is the analysis of SB-337 (Bates)). California's approach is still far from optimal, but it seems to be the very least that states should do.

 

December 8, 2017

I attempt a principled defense of the House approach to SALT repeal

(Spoiler Alert: I fail)

By Darien Shanske

[Cross-posted from Medium.]

The tax reform plan that just passed the House of Representatives repeals the SALT deduction, except for $10,000 in property taxes. The Senate plan would repeal the deduction outright, though there appears to be a chance that the final Senate bill will move closer to the House position. Numerous commentators have weighed in on both plans and, in general, the consensus is that neither plan is very well conceived. There are at least three main lines of criticism, all of which I largely agree with. First, per Daniel Hemel (and many others), on basic income tax principles there is a sound argument that some portion of the deduction should be maintained for individuals because these taxes do not pay for personal consumption, and so the Senate plan simply fails on that ground. There is also a good argument that the deduction is justified for businesses, though note that retaining the deduction for businesses but eliminating it for individuals leads to incentives for individuals to take the SALT deduction at the business level. Perhaps, as David Kamin explains, this problem has now been addressed, though, as he also notes, the current legislation does not take into account numerous possible responses by the states to eliminating the individual deduction.

Second, as to which set of taxes - state or local - have the better claim to be retained as a deduction on income tax principle, the better argument is for state income taxes and not property taxes, which are typically local. This is because, as Gladriel Shobe has argued here and here, there is a stronger argument that local property taxes are prices paid to consume local amenities rather than state level taxes. The House proposal therefore gets matters backwards from an income tax principle (and distributive) perspective.

A third important critique is to note that eliminating the deduction, when combined with other aspects of the Republican plans, amounts to a tax increase specifically targeted to certain parts of the country. This is just not good for our polity.

But can anything positive be said about this? I can almost make an argument in favor of the House approach as to the property tax. That I can't in the end illustrates, in yet another way, the incoherence and meanness of these proposals. Back in 2012, I argued that there was a good argument for the federal government to repeal the SALT deduction except for the property tax component. My argument was not based on income tax principles, but on the proper role of the central government in a federation. One of those roles is maintaining stability and generally optimizing the revenue system of all of the component governments. It is axiomatic that the property tax is a relatively efficient tax that should be assigned to local governments to finance local public goods. The forty years since California's Proposition 13 has also made it clear that states and localities were reducing their reliance on the property tax - in part because of the liquidity problems commonly associated with the tax. There was therefore, I thought, a good argument that the federal government should intervene to make the property tax relatively cheaper so as to nudge its continued - or even increased - use.

The current House proposal bears some resemblance to what I had in mind and yet I still think the House proposal is not a good idea. Why? For one thing, from the perspective of 2017 I realize that my argument missed at least two big points. First, my underlying assumption was that the federal government would be continuing to carry out another of its key roles - redistribution. Eliminating the SALT deduction in order, in part, to pay for the ACA, or at least prevent cuts to the ACA and other social insurance programs, seemed reasonable distribution-wise in 2012. Indeed, I argued that encouraging the use of the relatively stable property tax actually benefits the less well-off precisely because, as David Gamage has shown, they are the ones most likely to suffer from sharp state and local budget cuts during a recession.

By contrast, in the current context, the proposal is to eliminate or reduce the SALT deduction as part of a spectacularly regressive tax reform proposal that is part of a still broader attempt to sharply reduce the role of the federal government in taking care of the less fortunate. Making it more difficult for the states to care of the very people that the federal government is abandoning - or trying to abandon through, for instance, dismantling the ACA - is deeply wrong. (If we were in the midst of a deep recession, then there would be an independent argument for a fiscal stimulus, but this is not the case.)

In 2012, I also underestimated state resilience (not everyone did). Back then it seemed that California, for example, would not, as a matter of politics, increase its state-level income and sales taxes and, even it could, I didn't think enough could be raised to right the ship. But California did raise its income tax twice, and in a progressive way, and the state currently has built up a significant rainy day fund. Without doubt, California still has fiscal challenges and it would be much better for the state to rely more on the property tax, but I was wrong to think that this was the only way forward. In short, I overestimated the problem to which my proposal was a solution.

In any event, if the House plan were serious about reviving the property tax on fiscal federalism grounds, it would not proceed by means of preserving the deduction in the way that it does, especially in the context of a plan that also doubles the standard deduction. As an itemized deduction that is only worth anything beyond the new larger standard deduction, there is unlikely to be much shift in state or local political economy under the House plan. A way to achieve such a shift would be to make a portion of the property tax an above-the-line deduction, as it was briefly in 2008-09. Though still problematic for the reasons noted at the outset, that would at least represent a coherent - and less regressive - choice to advance a policy goal through advantaging the property tax. Needless to say, I do not expect this to happen.

 

December 8, 2017

Another way states can counter a partial repeal of the SALT deduction

(This expedient could possibly even improve state public finance in the long term.)

By Darien Shanske

[Cross-posted from Medium.]

There have been numerous important discussions of how states might respond to the repeal of the SALT deduction. David Kamin lists some of them here; he also notes that these possible (likely?) responses should be taken into account by the JCT because they will reduce the revenue gains that the federal government is expecting.

I should like to sketch out one additional state response. Suppose the House approach to the SALT deduction were to become law. This means that the deduction would be eliminated except for $10,000 in property taxes. A certain group of taxpayers will now find themselves with less than $10,000 in property taxes to deduct, but lots of state income taxes that they can no longer deduct. To be specific, suppose a taxpayer has $5,000 in property taxes that they can still deduct, but $8,000 in income taxes that they cannot. If $5,000 of the income tax liability could be shifted into the property tax then the taxpayer (and the state) would not be leaving a deduction on the table. This could be done, of course, just by increasing property taxes and reducing income taxes. As it turns out, even if increasing property taxes is on balance a good idea, it is one that is highly fraught politically and has big implications for state-local relations. Also, as the current experience with drive-by tax reform is continually illustrating, major changes to tax systems should not be done quickly. See here for some of the issues raised by a shift to property taxes.

But a state with an income tax need not engage in a prolonged debate about increasing its property tax in order to maximize the value of the SALT deduction for its citizens. In broad strokes, all a state needs to do is formally increase its property taxes so that citizens can get the maximum deduction, but then in effect hold taxpayers harmless by means of the state's income tax.

Here is what this might look like a little more specifically. The state can authorize its localities to impose a special property tax supplement up to $10,000 so as to assure all taxpayers maximize their SALT deduction (if they end up itemizing). Next, the state creates a generous property tax circuit breaker in its income tax. The circuit breaker could work like this: to the extent the property tax burden as a percentage of a taxpayer's income is greater than it was in 2017 - and that increase is a result of a special supplemental property tax - then that additional property tax is forgiven. To be sure, there would be many details to work out (such as coordinating the timing of local property tax collection with the state income tax), but I think the mechanism is sound. An additional refinement could be to make certain that some small portion of the new property tax is in fact collected by the locality so that the whole structure is respected.

I should add that I believe that states (really localities) should increase their use of the property tax in general and that generous circuit breakers are an important way to make this possible. See my argument here. One would hope that the fact that this self-help proposal for the states is also a reasonable idea on its own would make it more attractive.

 

November 30, 2017

Some Thoughts on California's Fiscal Constitution

by Darien Shanske

[Cross-posted from SCOCAblog.]

The California Supreme Court currently has at least two cases relating to California's fiscal constitution on its current docket;[1] two were decided this summer.[2] The phrase "fiscal constitution" is a term of art that designates all the many provisions of the constitution that dictate how governments can raise and spend money. The fiscal constitution of the federal government is very sparse. The fiscal constitution of the state of California is enormously lengthy and complicated. Many of its provisions date to 1879 and are contained in the thirty-six sections of Article XIII, but also see the twenty-three sections of Article XVI. Proposition 13-the proposition that limited property taxes and made numerous other changes-added Article XIIIA. Proposition 4, passed in 1979 in order to advance the "spirit of Proposition 13," added Article XIIIB. Proposition 218, passed by the voters in 1996 and also seeking to backstop Prop 13, added Articles XIIIC and XIIID. Proposition 26, passed by the voters in 2010, and also meant to backstop Proposition 13, amended Articles XIIIA and XIIIC.

Given the volume, complexity and relative recentness of some of these propositions, it is certain that the California Supreme Court will grapple with many more cases involving California's fiscal constitution. These cases are enormously consequential, as they directly implicate how California and its local governments can fund not only basic governmental services, but also price the use of natural resources, such as water. Despite the importance of the topic, there has not been much scholarly attention devoted to how to interpret state fiscal constitutions (and, yes, other states do have law similar to those in California, though none so far as I know has a set of overlapping laws quite so challenging). A lot has been written about whether the provisions are wise policy and/or achieve their goals, but these valuable normative and empirical discussions are of little use when it comes to giving direction to courts grappling with what the provisions before them mean.

This neglect would perhaps be justified if there were no broader perspective to be taken on these provisions. It could be that each court in each state is on its own to do the best job it can given using a combination of the usual exegetical tools-some mixture of text, history, and purpose. In an article forthcoming in the Rutgers University Law Review, I argue that such an ad hoc approach is not justified.[3] In the rest of this post, I will briefly summarize my argument and add some specific reasons why California's fiscal constitution should be approached in the manner I sketch out.

The specific issue I consider is the distinction between taxes and fees. The fiscal constitutions of California, like that of many states, limit the ability of governments to raise taxes. These same constitutions typically do not impose similar limits on the ability of governments to impose a fee, say a building permit fee. But what if a locality chose to levy a gigantic building permit fee and used the proceeds to fund general services? Such a fee would-and should-be considered a "hidden tax" and thus subject to the same limitations as ordinary taxes.

But how high is too high when it comes to fees? In many cases-say fees for water use-the fees must be set high enough to fund major capital expenditures or there will not be a water system to provide water. And do we think higher fees for excessive use of water should be construed to be a constitutional problem? This seems indicated by these provisions because the marginal cost of the additional water is no higher for an excessive user. Yet if tiered pricing meant to encourage conservation is a problem, then there might not be any water left in the water system. What about basic service for poorer users at a discount; does not the provision of such a service mean that other ratepayers are paying too much? But if poorer users would not use the service at all if charged market rates, why might it not be perfectly rational to charge them less if the marginal cost of the additional services was very low? Do we think that airplane passengers who pay full price are subsidizing a customer who pays less for an empty seat on a plane that is about to leave?

Courts are not well situated to answer these questions, but in some states[4]-not yet California[5]-the courts seem to have taken the position that the constitutional distinction between taxes and fees leaves them no choice but to undertake searching substantive review of the fees set by state and local governments. But there is another-better-way, namely for courts primarily to engage in procedural review of the ratemaking process. Such review has real teeth and is well within judicial competence. Most importantly, as I argue, requiring such review is actually a better interpretation of these fiscal provisions.

In general, procedural review is a better interpretation of the provisions of state fiscal constitutions because such review was the norm of the preexisting common law of public finance. In fact, modern administrative law, with its emphasis on procedural review, largely grew out of a critical response to the U.S. Supreme Court's undertaking substantive review of rates set by an expert agency.

Courts properly presume that preexisting common law was known to the proponents of a proposition; courts also presume that terms that had a meaning under the preexisting common law retain that meaning when they become codified unless there is some explicit evidence to the contrary. These presumptions-canons-are proper because assuming knowledge of the preexisting law is consistent with the rule of law value of predictability.

California's fiscal constitution is particularly amenable to a procedural interpretation for several reasons. First, the California courts regularly apply the relevant canons of interpretation, such as that proponents are presumed to have knowledge of the law.[6] Second, the key provisions of California's fiscal constitution explicitly embrace whole phrases of the preexisting common law.[7] Third, California's fiscal constitution manifests a great deal of explicit concern with following proper procedures.[8] This includes shifting the burden of proof to the government.[9]

To be sure, it could be that California's fiscal constitution imposes lengthy procedures, a burden shift, and heightened substantive review. But there is no explicit evidence of such and thus I argue that the application of appropriate canons and analytic superiority should move the court to a procedural interpretation.

As the cases come down, I plan to check back in and offer some assessments of where we are and where we might go.

[1] City of San Buenaventura v. United Water Conservation Dist., (2015)185 Cal. Rptr. 3d 207, review granted and opinion superseded June 24, 2015; Citizens for Fair REU Rates v. City of Redding, (2015) 233 Cal. App. 4th 402, review granted and opinion superseded Apr. 29, 2015.

[2] California Cannabis Coalition v. City of Upland, (2017) 3 Cal. 5th 924; Jacks v. City of Santa Barbara, (2017) 3 Cal. 5th 248.

[3] Shanske, Darien, Interpreting State Fiscal Constitutions: A Modest Proposal (June 19, 2017). Rutgers L. Rev., forthcoming. Available at SSRN: https://ssrn.com/abstract=2989313.

[4] Yes I am looking at you Michigan and Missouri. See Zweig v. Metro. St. Louis Sewer Dist., (2013) 412 S.W.3d 223; Bolt v. City of Lansing, (1998) 587 N.W.2d 264.

[5] More or less. See Silicon Valley Taxpayers Ass'n, Inc. v. Santa Clara Cty. Open Space Auth., (2008) 187 P.3d 37 (imposing a de novo standard of review).

[6] In re Harris, (1989) 775 P.2d 1057, 1060 (en banc) ("[T]he voters who enact [an initiative] may be deemed to be aware of the judicial construction of the law that served as its source.").

[7] See the emphasis on "reasonableness" in Cal. Const. art. XIIIC § 1(e).

[8] See e.g., Cal. Const., art. XIIID, § 6.

[9] See, e.g., Cal. Const., art. XIIIC, § 1(e) (flush language).