Synopsis of Statement of James C. Smith

April 17, 1997

The due process clause requires that the state have some connection with the income it seeks to tax. This is in essence a nexus requirement; the state must establish a nexus with any income that it seeks to tax. Either residence of the taxpayer or source of the income is a sufficient nexus. The source theory of income taxation stems from the general dominion that the states have over all persons, property, and business transactions within their borders. The state, in addition to asserting dominion, protects the persons who earn income, their property, and the activities they pursue within the jurisdiction. The modern federal immunity doctrine, as implied from the Supremacy Clause of the Constitution, does not circumscribe the source theory of state income taxation. Neither Oregon nor Kentucky is acting improperly when it taxes the income of federal nonresident employees who work at in-state facilities.

Congress plainly has the authority to enact H.R. 865 and H.R. 874. The power exists under the Commerce Clause because the movement of employees across state boundaries for employment purposes is within the stream of interstate commerce. Power also can be found under the Necessary and Proper clause of the Constitution on the ground that the grant of tax immunity will support the federal objectives served by the two facilities.

From the standpoint of policy and federalism, it is debatable whether Congress should immunize the nonresident employees at the two facilities from state income taxation. These employees are not being subjected to double taxation, and there are no unusual administrative burdens connected with the filing of their state tax returns or the calculation and collection of the proper tax. Moreover, from the standpoint of efficiency or tax neutrality, it is desirable that employees who work at the facilities bear the same income tax burden, regardless of which state they choose to live in.

Congress should grant tax immunity only if it finds that unique circumstances involving the facilities demonstrate the absence of benefits provided by the taxing state. There should be a strong presumption that the state provides substantial benefits with respect to all income earned within its borders. Federal immunity should not be granted merely based on a showing that most nonresident employees at the two facilities do not appear to benefit very much from the presence of state government or proximity to areas of the state adjoining the facility. Congress should intervene only if clear and uncontradicted evidence is presented that the federal nonresident employees do not receive and are not entitled to receive meaningful benefits.

Statement of James Charles Smith

on

State Taxation of Non-resident Employees at

Certain Federal Facilities

H.R. 865 and H.R. 874

Before the

Subcommittee on Commercial and Administrative Law

of the

Committee on the Judiciary

United States House of Representatives

April 17, 1997

I am James Charles Smith, Professor of Law at the University of Georgia, where I have taught for the past thirteen years. I am honored by the invitation to appear before this Subcommittee to testify. I am not appearing on behalf of any client, public or private, but solely to present my own professional views on the subject. At the end of this statement, I have included my curriculum vitae and a disclosure statement referencing a grant.

While I teach and write in several different areas, I have written one book dealing with income taxation. Samansky & Smith, Federal Taxation of Real Estate (1997). In addition, I have written two articles, with Professor Walter Hellerstein as co-author, that deal specifically with a number of interstate problems raised by state income taxation. Hellerstein & Smith, State Taxation of Nonresidents' Pension Income, Tax Notes, July 13, 1992; Smith & Hellerstein, State Taxation of Federally Deferred Income: The Interstate Dimension, 44 Tax L. Rev. 349 (1989).

CONSTITUTIONAL POWER OF STATES TO TAX NONRESIDENTS' INCOME

The due process clause requires that the state have some connection with the income it seeks to tax. This is in essence a nexus requirement; the state must establish a nexus with any income that it seeks to tax. Obviously, a state cannot tax an individual who has never resided in or earned income in the state. A line of Supreme Court cases describe two fundamental but alternative predicates for state power to tax income: residence and source. Receipt of income by a resident is universally recognized as a proper basis for taxation. When a state taxes the income of its resident, the theory is that the rights and privileges of residence justify taxing all of the resident's income, even if some or all of it is earned from out-of-state sources.

The source theory of income taxation stems from the general dominion that the states have over all persons, property, and business transactions within their borders. The state, in addition to asserting dominion, protects the persons who earn income, their property, and the activities they pursue within the jurisdiction. See Shaffer v. Carter, 252 U.S. 37, 50-51 (1920) (state may constitutionally tax nonresident who conducts business or carries on occupation within state).

From these two theories of taxing jurisdiction emerge the settled constitutional principles that a state may tax residents on their income from all sources and nonresidents on their income from sources within the state. These constitutional principles are reflected in the state statutes that generally tax residents on all of their income wherever earned while taxing nonresidents on their income derived from sources within the state.

Historically the source rationale was limited by the doctrine of governmental tax immunity, but this is no longer true. In McCulloch v. Maryland, 4 Wheat. 316 (1919), Chief Justice Marshall announced the doctrine of federal immunity from state taxation, derived from the supremacy clause of the Federal Constitution. Subsequent decisions interpreted federal immunity broadly, and in Dobbins v. Commissioners of Erie County, 16 Pet. 435 (1842), the Court invalidated a state tax on the income of federal employees. Under the principle of intergovernmental immunity, state employees were similarly immunized from federal taxation. This century the Court has substantially narrowed the scope of federal tax immunity as implied under the Constitution. In 1939, Congress enacted the Public Salary Tax Act to impose federal income tax on the wages of state employees, at the same time consenting to state income taxation of federal employees. 4 U.S.C. § 111. The Supreme Court promptly upheld the Congressional decision, overruling Dobbins to permit state income taxation of federal employees provided that the tax does not discriminate against the government or its employees. Graves v. New York ex rel. O'Keefe, 306 U.S. 466 (1939).

Thus, the modern federal immunity doctrine does not circumscribe the source theory of state income taxation. The state has the power to tax all income earned by persons within the state. The source of the income does not matter. With respect to employment income, this means that the type of employment and the identity of the employer is not material. Since 1939 states have generally treated nonresidents who work in-state the same, whether they are private-sector employees, state employees, or federal employees. When states have on occasion discriminated against federal employees in their tax regime, those employees have received protection on both federal statutory and federal constitutional grounds. E.g., Davis v. Michigan Department of Treasury, 489 U.S. 803 (1989) (invalidating state income tax on federal pensions when state did not tax pensions of state workers).

Applying these principles to H.R. 865 and H.R. 874, this means that neither Oregon nor Kentucky is acting improperly when it taxes the income of federal nonresident employees who work at in-state facilities. The states are only following well-established principles that have been in place and non-controversial for many decades. Nonresidents are properly taxable on the basis of source. Indeed, no principle is more firmly established, both internationally and domestically, than the power of a taxing sovereign to tax income on the basis of source, regardless of the political relationship of the income earner to the taxing jurisdiction. The well recognized power that the United States and the states assert over nonresidents and foreign corporations reflects this deeply rooted rule of international and domestic law and practice. Thus, if Congress chooses to enact H.R. 865 and H.R. 874 or a similar measure, the reason or justification is not to restrain the states from engaging in practices that exceed the proper scope of their tax jurisdiction.

POWER OF CONGRESS TO RESTRICT STATE TAXATION

Congress has the authority under the Commerce Clause to prohibit state taxation of nonresidents' income in appropriate cases. The transactions at issue are within interstate commerce. Long ago a person's decision to live in one state while working in another state may have been viewed as personal in nature and not as "commerce," but modern Supreme Court cases define commerce expansively. See City of Philadelphia v. New Jersey, 437 U.S. 617, 622 (1978) ("commerce" includes all objects of interstate trade; movement of solid or liquid waste is commerce); United States v. South-Eastern Underwriters Ass'n, 322 U.S. 533 (1944) ("commerce" includes fire insurance contract).

Commerce clause jurisprudence is divisible into two main bodies of doctrine. First, there is a series of cases involving persons or things that travel, in a physical sense, from one state to another. Here, the subject matter is often said to be in the "stream of interstate commerce." Second, there are the cases involving a local activity, occurring with a single state, that is said to affect interstate commerce. In the local activity area, the Supreme Court held in 1995 Congress cannot prohibit a person from possessing a gun in a school zone. United States v. Lopez, 115 S. Ct. 1624 (1995) (federal criminal statute (the Gun-Free School Zones Act) regulated an intrastate activity that did not have a substantial effect on interstate commerce.). Lopez does not in any way address the parameters of the stream of interstate commerce, and there is no reason to believe the Court will depart from a broad interpretation of which interstate transactions are said to involve "commerce."

Under H.R. 865 and H.R. 874, Congress would regulate the economic relationship between a state and a nonresident who is employed by the Federal Government in that state. The movement of employees across state boundaries for employment purposes clearly is within the stream of interstate commerce. The power of Congress to preempt state taxation of interstate commerce is well-established. E.g., Aloha Airlines v. Director of Taxation of Hawaii, 464 U.S. 7 (1983) (sustaining federal preemption of state tax on gross receipts from sale of air transportation); Arizona Public Service Co. v. Snead, 441 U.S. 141 (1979) (sustaining federal preemption of state tax on generating electricity sold out of state, where tax discriminates against out-of-state market).

Apart from the Commerce Clause, it appears that Congress has authority to grant tax immunity under the "Necessary and Proper" clause of the Constitution. See Dameron v. Brodhead, 345 U.S. 322 (1953) (tax immunity conferred by Soldiers' and Sailors' Civil Relief Act is "necessary and proper" to power of Congress to raise and support armies). The theory is that granting tax immunity for nonresident employees at the two facilities supports the purposes for which the facilities are operated.

CONSIDERATIONS OF TAX POLICY

Congress plainly has the power to immunize specified federal employees from state income taxation. The important question is whether from the standpoint of tax policy Congress should do so. The standard tools of tax policy analysis address the equity, efficiency, and administrability of the tax laws.

A. Equity.

1. Voluntary Choice of Residence and Employment Location. One argument that might be made on behalf of the proposed legislation is that the Federal Government has assigned its employees to work at the out-of-state facility and these employees would work within their state of residence but for the government's decision. The employees have no control over where the federal facility is situated. In essence, this argument seeks to extend a key part of the Soldiers' and Sailors' Civil Relief Act of 1940, 50 U.S.C. App. § 574, to other employees. Section 574 of that act prevents states from taxing the compensation of nonresident military personnel who are stationed in state. The purpose of the Act is to protect servicemen from negative state tax impacts that could follow from compliance with base assignment orders when, obviously, they have little or no control over where they must go. The Act also recognizes the high degree of public service and sacrifice involved in military service. The Supreme Court upheld the Soldiers' and Sailors' Civil Relief Act from constitutional attack in Dameron v. Brodhead, 345 U.S. 322 (1953).

For reasons analogous to those underlying the Soldiers' and Sailors' Civil Relief Act, in 1977 Congress deprived the states of power to tax compensation earned by Members of Congress. 4 U.S.C. § 113. A Member of Congress who maintains a residence for the purpose of attending sessions of Congress may not be taxed on his or her federal salary by the state where the residence is located.

Congress thus has intervened twice in the past to deprive the states of their source-based jurisdiction to tax nonresident federal employees. Are the federal employees who work at the facilities specified in H.R. 865 and H.R. 874 similarly situated? Are the bills desirable for analogous policy reasons? In my opinion, the analogies that may conceivably be drawn to the two precedents for Congressional intervention are not persuasive. Except for military employment, federal employment should be seen from the employee's perspective as a matter of personal choice, just as it is for other employees generally. In the private sector, persons often find they must accept employment in another state which may impose a relatively high state income tax. Whether they move to the state of their employment or remain nonresident and commute across a state border, they must pay state income tax based on source. In addition, employers often transfer employees to new job locations, and when this has an adverse state income tax effect the private sector employee must bear that burden or resign from the job.

Similarly, it strikes me that the immunity granted to Members of Congress is not analogous to the proposed grant in H.R. 865 and H.R. 874. A person who serves as a Member of Congress must attend sessions in Washington D.C., and Members of Congress must come from all 50 states. This unique circumstance distinguishes it from the general context of federal employees who commute across state lines to work. Moreover, this legislation serves the salutary purpose of putting all Members of Congress on an equal footing, bearing in mind that most but not all Members represent states that are distant from Washington D.C. and thus generally must acquire a second personal residence.

2. Scope of the Benefit Principle. As discussed above, state taxation of nonresidents' income based on source is justified by the principle that the state provides the nonresident with ample benefits while the income is earned in the state. Those benefits include use of the roads, police and fire protection for person and property, and the availability of the judicial system to protect contract rights and property rights. This benefit principle explains why it is equitable for a government to tax nonresidents. Because the government incurs costs to protect the nonresidents' income producing activities, it is just and proper that the nonresidents pay taxes to defray those costs.

In our tax system, both at the state and federal level, it is important to recognize that the benefit principle has functioned as an underlying assumption, not as a working limitation with teeth. In other words, it is presumed that the state has provided substantial benefits with respect to all income derived from in-state sources. Individual taxpayers cannot avoid taxation by showing they have in fact received no benefits from the state. There is no matching of benefits and tax burdens on a case by case basis. A person who pays taxes in an amount greatly in excess of government benefits he receives or is entitled to receive is not entitled to a refund or other tax relief. Part of the explanation for this "loose fit" between burden and benefit is administration. It would be a nightmare if a multitude of taxpayers could claim tax relief based on a showing that their tax bill substantially exceeded their consumption of government services or benefits. The other part of the explanation has to do with redistribution of wealth. The income tax system has redistributional effects. This is inevitable in our income tax system, both at the state and federal level, given that tax payments are channelled into the general budget of the government. While the extent and direction of redistribution may at times be controversial and is a legitimate subject for political examination, redistribution of some sort is inevitable in our income tax system.

In support of H.R. 865 and H.R. 874, a potential justification is that the employees at the two federal facilities receive few or no benefits from the States of Kentucky and Oregon, respectively. I am not presently familiar with the characteristics of the two federal facilities so I am not able to evaluate the factual predicate for this justification. I do not know whether any of the nonresident employees travel on state roads to commute to work; whether some of the employees engage in other in-state activities off the federal facility (such as shopping) before or after work; whether the state provides fire or police services or any other services with respect to the federal facility; or whether nonresident employees are entitled to resort to state courts to protect their income, property, or person with respect to their employment or events occurring at the federal facility.

Answering the question of state-provided benefits may turn in part on how the federal facilities are classified. With respect to most federal lands, the federal government and the state both have jurisdiction. Properties known as "federal enclaves" are those acquired pursuant to the Jurisdiction Clause of the Constitution, art. I, § 8, cl. 17, which grants Congress "the power to exercise exclusive Legislation in all cases whatsoever" over properties purchased from states with their consent. In the Buck Act of 1940, Congress made the decision to waive immunity for federal enclaves, permitting state taxation of the income of workers at federal enclaves on the same basis as workers at other federal properties. See Hellerstein & Hellerstein's Cases and Materials on State and Local Taxation 972-974 (6th ed. 1997). In the Buck Act, the decision was made that state taxation should not depend on how the federal government acquired the property, and that states should not be penalized in the taxing jurisdiction by having consented to the sale of state lands to the federal government. This policy decision appears sound, and there is the risk that a close examination of the benefit principle as applied to federal facilities may serve to undermine this decision.

My position is that the presumption that the state provides substantial benefits with respect to all income earned within its borders should be a very strong one. Federal immunity should not be granted merely based on a showing that most nonresident employees at the two facilities do not appear to benefit very much from the presence of state government or proximity to areas of the state adjoining the facility. Congress should intervene based on the lack of benefit only if clear and uncontradicted evidence is presented that the federal nonresident employees do not receive and are not entitled to receive meaningful benefits.

In terms of equity, the key question for these bills is one of line drawing. Are the federal employees at the two facilities addressed by the bills in a unique situation, or are there many other nonresident employees, either public sector or private sector, who are similarly situated? I see potential difficulties here. With respect to federal employees, consider the following: Is it relevant that state lines bisect the two facilities specified in H.R. 865 and H.R. 874, or is a nonresident employee who crosses a state boundary that adjoins a federal facility in the same position in terms of proper tax treatment? What about the nonresident who crosses the state line, drives a very short distance on a state road and then enters a federal facility? Is the benefit of very little use of one state road de minimis or significant? What if the commute to the facility is on a federal highway, not a state road? Does it matter that states finance road building and repair with a gasoline sales tax, not with the state income tax?

3. Double Taxation and Credits. There is no problem of "double taxation" with respect to the status quo, with Oregon and Kentucky taxing the income of nonresident federal workers who work in those states. With respect to income taxation, the problem of double taxation arises when more than one sovereign has jurisdiction to tax the same income. The widespread availability of a tax credit substantially solves the problem of an unfairly high tax burden stemming from two states taxing the same pension income. All states with income taxes presently provide credits for residents who earn income from sources in other states. Different states use different formulas for calculating the credit, and sometimes the credit will be less than the tax paid to the source state. While the granting of credits is not mandatory under the due process clause, it seems likely to continue for the foreseeable future. Moreover, an argument can be made that the dormant commerce clause requires the granting of tax credits for residents' source income from other states. If the receipt of earned income from work in another state is within the scope of interstate commerce, the Supreme Court cases that apply the "internal consistency" doctrine suggest that a credit is necessary in order to avoid an undue burden on interstate commerce. See Hellerstein, Is "Internal Consistency" Foolish?: Reflections on an Emerging Commerce Clause Restraint on State Taxation, 87 Mich. L. Rev. 138 (1988).

Forty states impose broadly based income taxes. Therefore, most federal employees who commute across state lines to work file two state income tax returns and receive a credit from their state of residence. Washington imposes no income tax, and Tennessee does not tax employment income. Thus, the nonresident employees covered by H.R. 865 and H.R. 874 do not file resident tax returns and for this reason do not receive tax credits. While it may be true that residents of Washington and Tennessee, because they have chosen not to tax income, must impose other taxes, this is not a problem of "double taxation." If, however, those states are persuaded that their residents who pay income tax to another state should receive a tax credit, they could devise one. For example, the state could grant a homeowner a property tax credit based on proof of payment of an out-of-state income tax. Looking at aggregate state tax burdens, this could serve to put the resident living in a no-income-tax state on an equal footing with one who lives and works in states with income taxes.

B. Efficiency.

Efficiency is offended if the tax system provides incentives for employees to engage in behavior that they would not have engaged in but for the tax system rules or characteristics. The concern is one of tax neutrality. Ideally, the tax system (here, how the tax systems of two neighboring states mesh) should not cause employees to alter their behavior with respect to their decision where to live. In the context of the bills, the issue is what effect the measures will have on the workforce at the two specified federal facilities. I have no data as to the residence classifications of the employees at the two facilities. Obviously, both Oregon and Washington residents work at the Columbia River facility, and both Kentucky and Tennessee residents work at Fort Campbell. My prediction is that, if Congress enacts the legislation, over time this will affect the proportions of in-state and out-of-state employees. Oregon workers at the Columbia River facility will be tempted to move to Washington; Kentuckians who work at Fort Campbell will consider a move to Tennessee. By moving, they in effect receive a pay increase equal to their present state income tax burden. I cannot say whether many or few workers will move. Obviously many factors other than income tax burdens heavily influence a family's decision of where to live, and there are transactions costs (such as selling a home) that are deter moves designed primarily to avoid state taxes.

For the same reason, passage of the bills should inhibit the rate at which Washington residents who work at the Columbia River choose to relocate to Oregon. As it stands now, a Washington resident who works at the facility and who for some reason would prefer to live in Oregon can move, knowing it will not increase his tax burden. With the legislation, that Washington resident would have to trade off his preference to live in Oregon against the income tax cost.

C. Administrability of the tax laws.

In 1995, Congress enacted legislation to restrict state income taxation of nonresidents' pension income. State Taxation of Pension Income Act of 1995. The principal justification for this measure was that the states, in taxing retirement income of nonresidents, were not able to overcome substantial practical problems of calculation, allocation, and monitoring. As a consequence, enforcement was haphazard. Most states did not attempt to collect tax from nonresident retirees, and in the states that did attempt enforcement, equity concerns were raised because enforcement tended to concentrate more on state and federal employees more than on private-sector employees. Congress thus intervened to restrain the states from trying to solve administrative problems that appeared to be intractable.

For similar reasons, in 1990 Congress granted tax immunity to employees of interstate railroads and motor carriers. Amtrak Reauthorization and Improvement Act, Pub. L. No. 101-322, codified at 49 U.S.C. §§ 11502, 14503. Here the concern was with transportation workers who regularly spend time in many states being confronted with the duty of filing multiple state income tax returns. An Amtrak worker assigned to the Washington D.C. - Atlanta route might conceivably have to file returns in all states where the rails run. Congress decided that, were states to pursue their jurisdiction in cases such as this, it would be an undue burden for such employees.

These types of concerns of administrability are not present here. For each employee who would be affected by H.R. 865 and H.R. 874, only two states are involved: the state of residence and the state where the federal facility is located. Presently the nonresident employees must file only one state income tax form; unlike the pension context, there is no burden of taxpayers having to report income and file in several states.

In the pension context, another administrative concern was that to compute the tax properly when more than one state was involved, it was necessary to analyze the retiree's pay history for his entire career, and these records were sometimes not available or readily accessible. Here, where the issue is taxation of current earned income, not retirement pay, there are no similar problems related to recordkeeping or computation of the tax.

James Charles Smith

Hearing on H.R. 865 and H.R. 874

Before the

Subcommittee on Commercial and Administrative Law

of the

Committee on the Judiciary

United States House of Representatives

April 17, 1997

DISCLOSURE STATEMENT - FEDERAL GRANT

I have received a grant from the German Marshall Fund of the United States for up to DM 7,000 (German currency) to support lectures that I will give at Regensburg University, Germany, during June 1997. The lecture topic is Basic Principles of Modern Property Law: A Comparative Approach.

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