The three part test for tax credits – and the fourth part we should be asking

When we discuss government budgets, direct spending receives the most attention by far. Less noticed is the substantial expenditure on tax credits and incentives, what some have called the “submerged state.”

That inattention may have allowed several unconstitutional measures to sneak through in Oklahoma. At the end of 2010, outgoing Attorney General Drew Edmondson issued an opinion on the constitutionality of Oklahoma tax credits. The opinion was requested by Rep. David Dank, R-Oklahoma City, who chairs the House Revenue and Taxation subcommittee. An AG opinion does not have force of law–only a court can legally determine constitutionality–but it can provide guidance to lawmakers and the courts.

The AG said that to be constitutional an economic development tax credit must pass a three part test–it needs to (1) serve a public purpose; (2) be supported by adequate consideration; and (3) have adequate controls and safeguards. Public purpose has been defined by the courts as “affecting the inhabitants of the state or taxing district as a community, and not merely as individuals.” Adequate consideration means that the state must receive some concrete benefit from awarding the credit so that it does not constitute a gift. Finally, controls and safeguards are measures to ensure that the first two criteria are met or to revoke the credit if they are not.

An example of a credit not meeting this test was the coast to coast airline tax credit. The credit rewards investment in an airline that has obtained 20 letters of intent to use its nonstop transportation to the east or west coast. Establishment of such a service could be construed as a legitimate public need; however, because the credit could be awarded without the service actually being established, it met neither the public purpose nor the adequate consideration tests.

Similarly, the AG found that the Small Business Capital Formation Incentive Act and the Rural Venture Capital Formation Incentive Act don’t meet the public purpose test, because they reward investment in a business even if it does not result in actual benefit to the community.

The AG also considered transferable tax credits, which can be sold by the entity performing the economic activity that the credit rewards.  The opinion found that transferability was not unconstitutional in itself. However, some existing transferable tax credits do not pass muster, either because the original credit fails the three part test or the transferring is done in a way that prevents enforcement of the three part test.

As an example, the AG discussed a tax credit for rehabilitation expenditures. While it has safeguards on the original recipient, if someone who sold this credit was later found in violation of its terms, a reduction could not be enforced on the entity that purchased it. A credit for construction of energy efficient residential properties fails the test as well, because transferees can receive the credit even if the original taxpayer is out of business.

Some of the tax credits discussed above are temporarily suspended during the state’s budget crisis, but in the past they have cost Oklahoma more than $50 million per year. And if these are at all representative, it’s likely that there are more examples of wasteful or poorly monitored tax credits.

OK Policy has previously made suggestions on how to improve transparency and accountability of Oklahoma’s tax incentives, but our scrutiny should not stop at whether a tax credit is constitutional. By offering a credit of any kind, the state is spending money to advance a goal. We need to carefully consider if those funds would be better used elsewhere. As Andy Spiropoulos put it, “the money funneled to the industry wouldn’t have been otherwise stuck in a mattress – it would have been invested in something else.”

In her State of the State address, Gov. Fallin said that “only tax credits that create jobs will stay.” But simply creating jobs is not good enough. We need a fourth test–do they improve the state more than would investing that money in education, roads, health care, and other public needs? When state spending as a share of the economy is at a 30-year low, and with more cuts on the way, we need to ask whether we can afford any spending that does not go to the most crucial public services. If our children aren’t well-educated, no amount of subsidies to business will get them good jobs.