Yesterday at the colloquium we discussed Lilian Faulhaber's above-titled paper on certain recent tax cases in the EU and their possible broader implications. The cases concern tax benefits for charity, such as deductions by donors for charitable gifts. The European court, which in a distressing instance of acronym inflation has redubbed itself the CJEU (Court of Justice of the European Union) in lieu of being just the ECJ (European Court of Justice), also appears to have gotten badly muddled in adjudicating issues that, if they arose in the U.S. involving federal constitutional challenges to state-level tax rules, we would say involved claims of discrimination against interstate commerce. As many commentators have noted, the EU's "four freedoms" jurisprudence amounts to pretty much the same thing, at least if you also throw the "right to travel" in the U.S. Constitution.
This is a much vexed area in both U.S. and European jurisprudence. I weighed in on one piece of it more than twenty years ago in an AEI monograph, "Federalism in Taxation: The Case for Greater Uniformity." Used copies are available from Amazon, and indeed you can choose between the paperback edition, available for 1 cent here, and the hardcover, which is available for $139.75 here. Perhaps your choice will depend on who's paying, But I digress. In this monograph, I argued, mainly on political economy grounds, for income tax base conformity in state income taxes, even though variation in tax rates is a healthy aspect of fiscal federalism.
Just one more preliminary point before we get to the matter in hand. It's often said, with good reason, that one of the big problems in academics is that no one takes the time to read anyone else's work. This is overstated, of course, but by no means wholly untrue. The problem is that, when there's some big dispute in a topic that isn't closely related to your own current research interests, then, even if you know you ought to look into it more closely just to stay up-to-date, the opportunity cost of taking the requisite time can feel prohibitive. I am therefore unfortunately not in a position to determine what my own take would be (if fully versed) on a recent U.S. tax academic debate about CJEU tax jurisprudence - the smackdown (so to speak) between Michael Graetz and Al Warren on the one hand, and Ruth Mason and Michael Knoll on the other hand.
As partly summarized here, Graetz and Warren argue that the then-ECJ has been blundering around in a "labyrinth of impossibility" in its anti-discrimination tax jurisprudence, because it can't or won't coherently choose between "capital export neutrality" (CEN) and "capital import neutrality" (CIN) in assessing challenges to a given tax rule. Thus, suppose Germany has a higher tax rate than Italy, and there is some issue concerning cross-border investment from Germany to Italy. If the CJEU adjudicates the dispute by picking a supposed comparable out of a hat and then asking whether the provision at issue is discriminatory, we know one thing for sure. The investment CAN"T be taxed the same both as a low-tax purely Italian investment, and as a high-tax purely German investment. So once the court has picked its preferred comparable (without explaining its choice), it has effectively dictated the outcome of the inquiry, without either providing useful guidance for the next case or persuading savvy readers that it actually has a coherent rationale in mind.
The underlying point is that "neutrality" across all margins is impossible, once Germany and Italy don't have the same tax rules in all relevant respects (i.e., both rate and base). Now, if I were a CJEU judge, even leaving aside the fact that I think CEN and CIN are worthless standards, the use of which should be discouraged and perhaps even criminally punished (OK, I'm exaggerating here for effect), I'd like to think I could do better. In my view, an often key focus of the inquiry should be, not into the phantom of neutrality at one arbitrarily chosen margin or another, but rather into the underlying political economy concern that countries (or U.S. states) may be overly inclined to engage in covert protectionism. But this is neither to claim that this rubric will prove suitable all the time, nor that it will always yield clear answers, nor to dispute the Graetz-Warren analysis both of what the CJEU has actually been doing, and of the impossibility of developing any single-bullet approach that will be consistently satisfying even just on efficiency grounds.
Knoll and Mason argue that the CJEU both can follow a coherent standard and has in fact done so, based on an inquiry into what they call "competitive neutrality,” which, in the labor market setting, "prevents states from putting residents at a tax-induced competitive advantage or disadvantage relative to nonresidents in securing jobs." Graetz and Warren respond skeptically regarding both the efficacy and the actuality of this claimed single-bullet approach.
Anyway, on to yesterday's paper. Faulhaber convincingly argues that the CJEU has blundered in assessing claimed "four freedoms" violations in 4 related charity-related contexts, the easiest of which to parse is the following. In a case called Persche, the CJEU ruled that Germany could not deny charitable deductions for donations that provided alms in Portugal, given that it would have allowed the deduction had the alms been provided in Germany. This supposedly burdened the "free movement of capital."
To see how misguided this is, suppose we agree up front that the charitable deduction is a subsidy for doing good things (positive externalities, public goods creation, etc.) - rather than being an aspect of measuring income. Some people like to spend money in fancy restaurants, others like to give it to charity, and both expenditures are instances of consumption by the donor. Doing one rather than the other offers no differentiating information regarding how well-off one is, what is likely to be one's marginal utility of a dollar or Euro, etc. Or to put it differently, I might want to insure behind the veil against my having low rather than high earnings ability, but it's hard to see why I'd want to insure against having a taste for charitable giving rather than for something else. So the only potentially satisfying rationale for charitable deductions is to encourage and thereby increase the amount of the gifts.
The benefit of getting the deduction is therefore akin to what we often call "spending," to use the wrong but more popular terminology than the one I prefer (which is that it's an "allocative" rule that's been placed inside a mainly "distributional" system). So, if Germany has a 33 percent marginal tax rate and allows charitable deductions, my gift of $150 to a charity ends up costing me $100 and Germany $50. It is therefore effectively identical to the case in which Germany offers 50 percent matching grants for charitable gifts, so I directly give the charity $100 and Germany throws in an additional $50.
There is absolutely no question that Germany has, and under principles of fiscal federalism should have, the right to spend tons of money on its own, say, public schools, while spending zero on Portugal's public schools. So why should the outcome be any different just because Germany chooses to use the charitable deductions technology in a particular case? The only difference of real interest is that Germany, when it uses the charitable deduction, is effectively decentralizing the decision process regarding who gets what, permitting taxpayers to decide where particular Euros from the Germany Treasury go, at the price of being willing to put some of their own skin in the game. This might be a good technology or a bad one, in one setting or another - a topic that has its own little literature, and which we've covered in past years' colloquia, but it has no discernible relationship to the "free movement of capital." So the CJEU is chasing phantoms of supposed discrimination, and is merely arbitrarily burdening the use of a particular form of "spending."
In the U.S., by the way, though the issue is apparently unclear, states should have no constitutional difficulty in limiting charitable deductions to in-state activity, although many do not bother to do this, as they simply "piggyback" onto the federal measure of such deductions, which of course permit, say, a New Yorker to claim a charitable deduction for giving in Montana. And obviously, the federal charitable deduction itself is automatically operative across state borders. But as it is implicitly federally financed, this does not create a potential "race to the bottom" problem between New York and Montana in their willingness to allow what I would call subsidy spillovers.
There is a U.S. Supreme Court which held that Maine could not deny charitable deductions to in-state charitable activity that mainly benefited out-of-staters who were visiting. But that is very different from saying that Maine would be required to subsidize wholly out-of-state activity, just because it was providing subsidies in-state.
Faulhaber's paper nicely analyzes the underlying problem. One minor disagreement is that the paper frames the issue as one of "negative harmonization," and compares it to the issue of the EU's developing a "common consolidated corporate tax base" (CCCTB), which is an example of the approach I endorse in my AEI paper of creating identical tax bases even if there are different tax rates. But I regard these issues as quite different. For example, in the charitable deduction setting, no one is suggesting that all EU countries must "harmonize" their rules in the sense of having the same rule - rather, they are just being forbidden (however misguidedly) to adopt one particular approach that supposedly is improperly discriminatory. And once you have fiscal federalism in mind, no general case for greater rather than lesser harmonization emerges (e.g., my argument was founded on particular political economy claims).
Where else might the same problem arise in subsequent CJEU jurisprudence? Faulhaber notes that, say, home mortgage interest deductions that were limited to in-state would tend not to create the issue, because if a German buys a house in Portugal he or she probably becomes a Portuguese resident. But tax benefits for vacation homes, which the U.S. allows, might create the issue. The analysis is not necessarily the same, however, depending on how one parses the rationale for the tax benefit.
Likewise, suppose a U.S. state offered itemized deductions for a resident taxpayer's medical expenses, but only if they were incurred in-state. I would be far more skeptical of this than of allowing an in-state limitation for charitable deductions. The difference is that the medical deduction is probably best rationalized as a distributional rule (since healthcare outlays are relevant to wellbeing and marginal utility, even if unrelated to measuring "income"). So this would be less akin to, say, subsidizing only one's own public schools rather than those everywhere in the country, and more like, say, New York's deciding that only the cost of buying New York apples (rather than those from Michigan) can be deducted by New York State apple juice producers.
Perhaps, however, I am proving the Graetz-Warren point by resorting so freely to argument by analogy. These generally are not issues with clear and easy or first-best answers.
UPDATE: In discussing the Graetz-Warren verus Knoll-Mason debate in the literature on the CJEU, I appear to have given less than equal time to the latter side (although I was trying to be clear about not taking a stand). Just to even things out a bit, here is a link to an article in which Ruth Mason further explains her view of what the CJEU has done and could do.