California Snubs Free Trade

Monday, March 17, 2014

In the 1808 English case of Buchanan v. Rucker, Lord Ellenborough asked rhetorically, “Can the Island of Tobago pass a law to bind the rights of the whole world?” to which he answered, “no.” That question was posed about a law that allowed a plaintiff to summon all parties into court by posting a notice near the Tobago courthouse door. No is the correct answer, for persons who do not receive notice in the ordinary course of business should not be bound by judgments entered against them. But ironically, “yes” is the correct answer whenever notice is properly given, for only the courts of Tobago should decide the ownership of land in Tobago. But they should not decide title to land located elsewhere. Apparently, simple questions have complex answers.

California Goes Too Far

We have not come so far from Buchanan, whose main issue was raised by the recent Ninth Circuit decision Rocky Mountain Farmers Union v. Corey,which asks whether California’s Low Carbon Fuel Standard (LCFS) program should bind producers and shippers from other states. A sharply divided Ninth Circuit Court of Appeals, acting en banc, answered “yes” over seven dissenting votes. Now that California has spread its tentacles across the entire United States, the time has come for the Supreme Court to review the case.

Illustration by Barbara Kelley

The California legislative scheme empowers the California Air Resources Board (CARB) to set what are termed “well to wheel” standards to govern companies that transport fossil fuels into California. CARB controls the fuel “lifecycle” by rating all fuel, regardless of its place of origin, by its ”carbon intensity over all stages of production.” The simple proposition is that it is mistaken to measure the full carbon load of a given fuel solely at the tailpipe. What California supplies is a comprehensive rating system that captures all the energy emissions at each and every stage of production. Thus shipping fuel for long distances gets a worse score than shorter shipments of that same fuel, whether produced in California or not. In general, key fuels like ethanol will receive a worse score when shipped in from out of state.

The Dormant Commerce Clause

The constitutional challenge to this scheme rests on the application of the so-called Dormant Commerce Clause jurisprudence of the United States Supreme Court. One of the great purposes of the United States Constitution was to turn this nation into a single free trade zone to maximize the value of goods and services produced nationwide. That system blocks individual states from protecting their own interests by imposing artificial barriers to the entry of competitive goods from out of state. It is important that heavier burdens are not explicitly imposed on out-of-state goods and services than are placed on local goods, so that every state must follow a general nondiscrimination rule unless and until it demonstrates a strong health or safety justification, including ecological protection, for treating out-of-state goods differently from local ones.

It quickly becomes clear, however, that local protectionist impulses will be ineffectively constrained if states are allowed to manufacturer neutral rules that have disparate (i.e. heavier) impacts on out-of-state goods than local ones. Sometimes setting the right balance produces close cases. Thus a requirement that trains in interstate service be kept under a given length within one state may look like an innocuous requirement, but in the 1945 case ofSouthern Pacific v. Arizona, Chief Justice Stone held that that regulation put an impermissible burden on interstate commerce by slowing down the movement of trains within Arizona when conditions inside that state were no different from those in neighboring states. Justice Black dissented on the ground that the disputes over the safe lengths of trains should not be subject to judicial overview given the technical difficulties at hand. Indeed, just that argument had proved persuasive to Chief Justice Stone in the 1938 decision South Carolina State Highway Department v. Barnwell Bros, where it was demonstrated that safety loomed large given the tricky mountainous terrain in South Carolina.

As in these cases, the key element raised by Rocky Mountain is how actions taken in one state might bind behaviors in other states. California’s regulations explicitly subject foreign sources of, for example, ethanol to higher standards, under the claim that the differential is fully justified by the longer distance that fuel travels, whether across state lines or within California.

The legal issue is further complicated because it has long been held, as in the 1994 decision Oregon Waste Systems Inc., v. Department of Environmental Quality of Oregon, that a higher explicit surcharge on out-of-state waste stored in California is “virtually per se invalid” unless it is used precisely to offset some explicit cost differential. On the other hand, in 1970, the Supreme Court unanimously held in Pike v. Bruce Church that any set of facially nondiscriminatory regulations that have only ‘incidental effects” on interstate commerce are deemed valid, unless "the burden imposed on such commerce is clearly excessive in relation to the putative local benefits."

The dormant commerce clause thus adopts a near per se rule in some cases, and a balancing test in others. But what is striking about the former category of cases is that their simple fact patterns are worlds apart from California’s mammoth scheme of regulation in Rocky Mountain. For example, Oregon Waste involved an explicit differential tariff for storing local and foreign waste that was not justified by any provable cost differential. And Pike involved a burdensome requirement that prevented a grower of cantaloupes from shipping his produce from a nearby California facility in order to let state officials make sure they were labeled of Arizona origin. The per se test could not be used because Arizona could never require out-of-state cantaloupes growers to carry Arizona labeling.

A Fresh Start

It is very difficult to intelligently use this simple two-part classification to analyze California’s complex scheme, which is being challenged in Rocky Mountain. There is, however, a sensible way to attack the overall problem: the use of the Supreme Court’s case law on the state taxation of firms that engage in multistate activities. Those cases have long had to grapple with complex systems of taxation that involve more states than one, which provides a useful jumping off point for the analysis. That connection is fortified by the critical economic insight that taxation and regulation are often close substitutes for each other, given that each may offer disproportionate burdens on one group of firms to benefit a second group. This issue is of extreme importance in state taxation of firms that do business across the country, because it is always possible for states to skew their taxes in ways that benefit their own local firms, even when they use neutral rules.

Two cases illustrate the problem. The 1978 case from Iowa, Moorman Mfg. Co. v. Bair,deviated from the standard nationwide rule in multiple taxation cases that based the overall tax of any firm on three factors: its gross sales, its payroll, and its real estate within the given state. Out of this pack, only Iowa relied exclusively on gross sales within the state, in order to allow it to impose a steeper tax on the plaintiff, an out-of-state firm with substantial sales but little payroll and real estate within the state.

A divided Supreme Court held that Iowa was free to use that formula, which was neutral on its face. But the dissent had the stronger argument by noting how discretion in the form of taxation always opens up the stage for opportunism and confusion. Opportunism arises because each state can use the formula that best protects its local interest. Confusion arises because each firm must deal with multiple systems of taxation. A single uniform system of taxation avoids both these perils, without limiting the amount of revenues a state can raise from both local and out-of-state businesses.

A more sensible approach to state taxation was taken in the 1987 case, American Trucking Association v. Scheiner. Pennsylvania imposed a lump-sum axle tax on all trucks that used state highways regardless of the number of miles they drove. Although the tax did not explicitly discriminate between local and out-of-state firms, the per-mile incidence of the tax was far heavier on out-of-state vehicles, which used the Pennsylvania roads less than in-state companies. The purpose of these taxes was to repair and maintain highways, the damage of which correlates closely with the number of miles each truck drives. The formal equality of the Pennsylvania tax thus concealed a demonstrable cross subsidy.

Justice Stevens struck down the tax because it offended the dormant commerce clause. During the course of his opinion he noted that the Pennsylvania law flunked “the ‘internal consistency’ test under which a state tax must be of a kind that, if applied by every jurisdiction, there would be no impermissible interference with free trade.” In dealing with axle taxes, the result is clear. The uniform imposition of the wrong tax makes matters worse, not better, which is not the case if each state ties the level of taxation to the miles driven within the state.

Scheiner suggests the great dangers from California’s carbon tax regime. California does not have a monopoly on the complex schemes for well-to-wheel system of taxation. Nor is it clear that it has chosen the best regime for this purpose. The California tax could distort market behavior out of state, while inviting great confusion and uncertainty under some “internal consistency” test if other states choose different but permissible variations on the same theme. Their cumulative weight could paralyze the entire system of interstate transportation. The point is especially salient here because any dangers from carbon dioxide emissions are not confined to this or that state, but are always national, indeed global, in their consequences. That simple fact makes even national regulation difficult, and it renders local state-by-state regulation that much more mischievous.

Situations like this call for some uniform national rule that only Congress can provide. But Congressional decision could allow California, like Tobago, to bind the world. After all, only Congress can stop the proliferation of otherwise inconsistent state schemes to control carbon emissions. Once the dangers of unilateral action to the national economy are large, it no longer makes sense to analyze California’s regulation under a per se rule or a balancing rule, when it has elements of both.

The better result is to strike this program down on the grounds that its potential multiplicative effects require a federal presence to channel regulation into more productive and uniform paths. With pollution regulation, the end is clearly legitimate, but California’s choice of means is not, especially in a federal system. The Supreme Court should hear this difficult case and steer the federalism issue in the proper direction.