State taxation of nonresidents' pension income : hearing before the Subcommittee on Commercial and Administrative Law of the Committee on the Judiciary, House of Representatives, One Hundred Fourth Congress, first session, on H.R. 371, H.R. 394, and H.R. 744, June 28, 1995 online

tified and left.

Mr. Gekas. All right. What we will do is proceed with the next
panel and accommodate him when he should arrive. We thank our
colleagues, and we will proceed expeditiously with consideration of
the final version of this legislation.

Mrs. VucANOViCH. Thank you very much. I appreciate it.

Mr. Gekas. The next panel consists of a single witness. Prof.
James C. Smith of the University of Georgia School of Law. We
welcome him to the hearing and invite him to proceed with his tes-
timony. We have a copy of his prepared statement which we will
make a part of the record, without objection.

STATEMENT OF JAMES C. SMITH, PROFESSOR OF LAW,
UNIVERSITY OF GEORGIA SCHOOL OF LAW

Mr. Smith. Thank you, Mr. Chairman and members of the com-
mittee. I am honored by the invitation to return again to testify on
the important issues being discussed today. I do not represent any
client, public or private. I am here solely to present my own profes-
sional views on the subject.

Due process under the Constitution means the State must have
some connection with the income it taxes. There are two bases for
State taxation, both grounded in Supreme Court cases. Under the
residence theory, a resident is taxable on all income, wherever
earned. Under the source theory, a taxpayer is taxable on all in-
come from sources within the State.

States that tax the pension income of their former residents are
not exceeding the proper scope of their taxing authority. Due proc-
ess is satisfied for two reasons. The person had the rights and
privileges of residence while he or she earned the income, and
under the source theory of taxation the income was generated by
the performance of personal services within the State. It does not
matter that the tax is assessed after the resident has permanently
moved to another State and is no longer receiving benefits from the
State where the pension was earned. The State provided the person
with ample benefits while the income was being earned in the
State.

Moreover, the State that taxes a former resident when pension
payments are made is simply recovering revenues that were lost
earlier due to the State's policy decision to permit deferral of rec-
ognition. The State could have taxed the pension rights prior to re-
tirement when they were earned.

Even though the States are using their tax powers properly, Con-
gress may legitimately elect to restrict the States. Congress has the
authority under the commerce clause to prohibit State taxation of
nonresidents' pension income.

To explain my opinion, it may be helpful to take a brief look at
a recent landmark case from the U.S. Supreme Court. In April
1995, the Court decided United States v. Lopez, perhaps the most
important case interpreting the commerce clause in more than 50
years, since a line of cases sustaining New Deal legislation.



22

Lopez holds that Congress cannot prohibit ft- person from possess-
ing a gun in a school zone. Does Lopez mean that Congress cannot
limit State taxation of nonresidents' pension income? No. Lopez is
clearly distinguishable from our situation. Lopez is a change in di-
rection in a line of cases involving a local activity, occurring within
a single State, that is said to affect interstate commerce.

The activity being regulated under the proposed Federal pension
legislation is the economic relationship between a State and its
former resident. The transactions at issue are within the stream of
interstate commerce. Both the person who has retired and the pen-
sion payments have crossed State lines.

Equity and efficiency are two primary tax concerns, and in this
context, both equity and efficiency mean that a State which decides
to tax the pensions of its continuing residents should also tax the
pensions of its former residents. Otherwise, there is the risk that
retirees who elect to stay in State will pay a tax that is not borne
by the retirees who have moved elsewhere. This offends both equity
and efficiency.

When the taxpayer retires to a State that taxes the pension in-
come, the possibility of double taxation arises. This is not a major
problem because virtually all States with broad-based income taxes
give a credit to a resident who pays tax to a source State.

The critical issues raised by State taxation of nonresident pen-
sion income are practical, not constitutional or theoretical. States
lack the constitutional power to tax that part of a nonresident's
pension income that reflects accumulations after the taxpayer
changes his or her residence. Thus, States generally cannot tax 100
percent of pension payments made to former residents. They must
limit their tax to the income that was earned by the retiree in the
State or that was accumulated while the retiree was a resident of
the taxing State.

In addition, when a person works in more than one State prior
to retirement, there is greater complexity. States must have a
mechanism for tracing the precise amount of the pension income
that is properly attributable to each taxing State. As a practical
matter, the necessary records may not exist, and, even if they do,
the task will often be very hard.

Although these difficulties may justify the proposed congressional
restriction, there is the risk that States may react to such legisla-
tion by amending their tax laws to accelerate the recognition of re-
tirement income.

States do not have to follow the Federal tax rules for deferring
the recognition of pension income. They may either repeal deferred
recognition as a general matter, taxing pension income as it ac-
crues, for example, when contributions are made to a pension plan,
or they may seek to tax departing residents on their accrued pen-
sion income during the year they change their residence.

Thank you. I will be very happy to answer any questions.

[The prepared statement of Mr. Smith follows:!

Prkpared Statement of James C. Smith, Professor of Law, Georgia
University School of I.aw

I am James C. Smith, Professor of Law at the University of Georgia, where I have
taught for the past eleven years. I am honored by the invitation to appear before



23

this Subcommittee to testify. I am not appearing on behalf of any client, public or
private, but solely to present my own pro lessional views on the subject.

While I teach and write in several different areas, I have written one book dealing
with income taxation. In addition, I have written two articles, with Professor Walter
Hellerstein as coauthor, that deal specifically with the interstate problems raised by
State taxation of deferred income. Hellerstein & Smith, State Taxation of Non-
residents Pension Income, Tax Notes, July 13, 1992; Smith & Hellerstein, State Tax-
ation of Federally Deferred Income: The Interstate Dimension, 44 Tax L. Rev. 349
(1989). I am submitting both articles for inclusion in the record.

Constitutional Power of States To Tax Nonresidents' Pension Income

For a number of years. Congress has considered a variety of bills that have sought
to bar States from taxing the pension income of their former residents. The first key
question raised by such bills is whether States that tax the pension income of their
former residents are properly exercising their powers. In particular, what if any lim-
itations does the federal Constitution place on States when they tax their former
residents' pension income? To phrase this another way, do former residents have a
constitutional right that their pension income not be taxed by their former State?

Due process, broadly speaking, requires that the State have some connection with
the income 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 de-
scribe two fundamental but alternative predicates for State power to tax income:
residence and source. 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. Receipt of income by
a resident is universally recognized as a proper basis for taxation. See New York
ex rel. Cohn v. Graves, 300 U.S. 308, 312-13 (1937) (State may constitutionally tax
resident on rents from land located in other State and on interest from mortgage-
backed bonds located in other State).

The source theory of income taxation stems from the general dominion that the
States have over all persons, property, and business transactions within their bor-
ders. The State, in addition to asserting dominion, protects the persons who earn
income, their property, and the activities they pursue within the jurisdiction. See
Shatter v. Carter, 252 U.S. 37, 50-51 (1920) (State may constitutionally tax non-
resident 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 non-
residents on their income from sources within the State. These constitutional prin-
ciples 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.

The problem at hand, Stated generally, is how tax deferral fits in with the resi-
dence theory and the source theory of tax jurisdiction. States plainly possess the
power under the due process clause to tax income derived from sources within the
State, even if the income is recognized years later when the taxpayer no longer has
any connection with the State. Whatever may be the practical problems in collecting
a tax on such income, the constitutionally sufficient nexus that the State has with
the income when it was earned does not evaporate merely because the income earn-
er has severed his ties with the State and the State has chosen to postpone taxation
of the income for policy reasons.

There is no sound theoretical basis for depriving States where deferred pension
income is earned of the right to tax such income when it is recognized for federal
income tax purposes merely because the retiree no longer resides in the taxing
State. In fact, as a matter of theory, the opposite strategy is desirable. If States tax
the deferred pension income of their continuing residents when it is federally recog-
nized, in principle they should likewise tax the pension income of former residents
to the extent it represents income earned while the taxpayer resided in the taxing
jurisdiction.

Power of Congress To Restrict State Taxation

Commerce Clause. Congress has the authority under the Commerce Clause to pro-
hibit State taxation of nonresidents' pension income. The transactions at issue are
within interstate commerce. Long ago a person's decision to move to another State
and a person's receipt of pension payments 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) ("com-
merce" includes all objects of interstate trade; movement of solid or liquid waste is



24

commerce); United States v. South-Eastern Underwriters Ass'n, 322 U.S. 533 (1944)
("commerce" includes fire insurance contract).

In April 1995, the United States Supreme Court decided United States v. Lopez,
115 S. Ct. 1624 (1995), perhaps the most important case interoreting the commerce
clause in more than 50 years, since a line ot cases sustaining New Deal legislation.
Lopez, a five-to-four decision, holds that Congress cannot prohibit a person irom pos-
sessing a gun in a school zone. The Court Tound that the federal criminal statute
(the Gun-Free School Zones Act) regulated an intrastate activity that did not have
a substantial effect on interstate commerce.

Does Lopez mean that Congress cannot limit State taxation of nonresidents' pen-
sion income? I am confident that the answer is no. Commerce clause jurisprudence
is divisible into two main strains. First, there is a body of cases involving persons
or things that travel, in a physical sense, from one State to another. Here, the sub-
ject 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. Lopez is a local activity case, not one addressing the
parameters of the stream of interstate commerce.

Unlike Lopez, the activity being regulated under the proposed federal pension leg-
islation is the economic relationship between a State and its former resident. Both
a person and a thing have crossed State lines. The taxpayer who is shielded by the
legislation has moved from one State to another. Subsequently, the income that is
being protected by the federal legislation moves interstate, from the State where it
was earned or where the retirement plan is administered to the State of the retiree.
The money moves by mail, electronic transfer between banks, or via some other
interstate instrumentality. This money is in the stream of interstate commerce.
Even if the transfer of money is not ' commerce" itself, surely it affects interstate
commerce because it impacts purchasing power of retirees in their new States. It
afTects markets in their new States. To the extent tax is paid to their State of
former residence, they have less money to use, enjoy, or invest where they now live.

Tenth Amendment. A Tenth Amendment argument could be raised under New
York V. United States, 505 U.S. 144 (1992), that Congress may not exercise its com-
merce power directly to regulate the States, but must limit its exercise to the regu-
lation of individuals who are engaged in interstate commerce. New York held that
Congress could not regulate the interstate disposal of low level radioactive waste by
requiring that States regulate waste in accordance with Federal specifications.
Moreover, Tenth Amendment concerns may be heightened to the extent that Con-
gress prohibits States from taxing the pension income of former State employees.
See Garcia v. San Antonio Metropolitan Transit Authority, 469 U.S. 528 (1985) (five-
to-four decision), overruling National League of Cities v. Usery, 426 U.S. 833 (1976)
(five-to-four decision).

Like New York, the proposed act to restrict State taxation of nonresident pension
income does not primarily regulate private individuals; rather, it directly requires
that the State refrain from taxing certain interstate transactions. For other reasons,
however, a broad interpretation of New York so as to jeopardize the proposed prohi-
bition of State taxation of nonresidents' pension income seems highly unlikely. New
York focused on the Federal government ordering the States to regulate in a certain
manner, rather than displacing State regulation. An afiirmative command that the
State adopt a particular regulatory scheme intrudes much more on State sov-
ereignty than denying the State authority to regulate a certain matter. Desoite
some expansive language in the Court's opinion in New York, it seems doubtful that
the Court intended to fashion a new limit on the well-established Congressional
power to preempt State regulation or taxation of interstate commerce. Such a rule
would necessitate the overruling or severe limitation of a good many Supreme Court
precedents. 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 trans-
portation); Arizona Public Service Co. v. Snead, 441 U.S. 141 (1979) (sustaining fed-
eral preemption of State tax on generating electricity sold out of State, where tax
discriminates against out-of-State market).

Reasons Advanced for Congressional Intervention

The objections publicly made to date against State taxation of former residents'
pension income seem to encompasses two strains of thought. First, only those per-
sons who have the right to vote ought to be subject to tax; and second, those who
are taxed ought to receive some benefits from the government's expenditures of tax
revenues. As to the first point, there is no constitutional link between the right to
vote and the duty to pay tax. Persons who lack the right to vote due to nonresidence
are nonetheless properly taxable on the basis of source. Indeed, no principle is more



25

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 relation-
ship 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.

The second line of attack — that the State of former residence does not provide
benefits for the taxpayer — is also unpersuasive. It is true, of course, that a retiree
who has completely severed his ties with his State of former employment may in
fact receive no benefits from his tax payments after his retirement. But this misses
the mark because it looks to the wrong point on the time continuum. Instead, the
time period during which income was earned is the key. The State provided the non-
resident with ample benefits — in the form of roads, police and fire protection, and
other governmental services — while the income was being earned in the State. The
fact that the income is taxed at a time when the nonresident is no longer receiving
benefits frum a State does not mean that such benefits were never received. Thus,
when States tax the pension income that nonresidents have earned in the State,
there is no denial of the "benefit" principle on which source taxation ultimately
rests.

Moreover, it is a strange conception of fairness in taxation that would prevent a
State from taxing income earned within its borders, and with respect to which the
State has presumably accorded substantial benefits, merely because the State has
permitted the taxpayer to defer recognition of such income. After all, deferral of rec-
ognition is a matter of legislative grace. The State could have taxed the pension
rights prior to retirement, when they were earned. Had it done so, thereby recoup-
ing a fair share of the costs of government while the taxpayer was still a resident
and still employed, no objection on the basis of lack of benefit or fairness could con-
ceivably have arisen. Instead, following the federal model of pension taxation, the
State deferred the tax obligation to the future, when the retiree receives pension
payments. To strip the State of its power to tax such income because it has accorded
the taxpayer the additional benefit of deferral cannot be supported as a matter of
tax equity.

Tax Policy Considerations

Proponents of a congressional ban on State taxation of nonresidents' pension in-
come have failed to address meaningfully the real issue, i.e., what is the appropriate
treatment of the taxpayer who moves interstate from the standpoint of sound tax
policy? Tax policy analysis requires an inquiry into the equity, efficiency, and ad-
ministrability of the tax system.

Equity and Fairness. In terms of equity, the key question is whether a retiree who
moves out of State after retirement and a retiree who continues to reside in his
State of employment after retirement are similarly situated. Is this a distinction
that justifies differential tax treatment for these two retirees' deferred employment
income? The answer is no. Both taxpayers earned income while residents of the
same State, both enjoyed the same access to benefits provided by that State, and
both profited by the same deferred recognition rules for retirement income. The per-
sonal choice each taxpayer makes about where to retire should not have State tax
consequences in so far as the pension income already earned. The issue is not about
income that either or both taxpayers will earn after retirement or after a change
of residence.

But unless the former State of residence seeks to tax the pension income of former
residents, there is great risk that the in-State retiree and the out-of-State retiree
will have disparate tax impacts. Taxpayers who remain a resident of their State of
employment after retirement will pay State income tax on their pension income
when and as it is federally recognized. However, the pension income of taxpayers
who relocate is often not subjected to an equivalent tax by their State of retirement.

Disparate Treatment of Public Sector and Private Sector Employees. There are
published reports, including testimony at prior congressional hearings, that the
States that presently seek to tax the pension income of nonresidents are much more
aggressive in pursuing former State employees (including employees of political sub-
divisions) rather than private-sector employees. This-practice, assuming it can be
documented, raises equity concerns.

Whether such a practice is equitable or fair depends upon which groups of tax-
payers we consider to be similarly situated. One comparison is between State em-
ployees who retire out-of-State and State employees who remain intrastate. These
groups are similarly situated, and in principle if the in-State retirees are taxed on
their deferred pension income, the out-of-State retirees should be taxed likewise.



26

From this standpoint, the State practice of aggressive pursuit of its former employ-
ees who now reside out-of-State in laudable in terms of equity and fairness.

The other comparison is between nonresident State employees and nonresident
private-sector employees, and here the practice described above raises substantial
tax policy concerns. These groups are, I believe, similarly situated. Taxpayers in
both groups earned income from in-State sources, the taxation of which was de-
ferred! In both cases, taxpayers who benefitted from deferral should have had the
expectation that the State would tax the pension income later, upon receipt. More-
over, there is no statutory basis for the States to discriminate between these two
groups. State income tax statutes generally impose tax on the income of non-
residients from all sources within the State, regardless of whether the source is pub-
lic or private. If State tax authorities make no consistent efTorts to tax the pension
income of private-sector former residents, this group receives the benefit of de facto
tax forgiveness.

State tax administrators may attempt to justify the differential treatment by
pointing out enforcement is easier for former State employees because the State it-
self pays the pension and has all the relevant employment records — no information
need^be acquired from third-party employers. This explanation may be satisfactory
as a short-term, temporary expedient; it may not be feasible to require that a State
immediately enforce its tax code against both groups. In my opinion, however, a
long-term strategy of taxing the pension income of nonresident former State employ-
ees while forgiving tax on the pension income of nonresident private sector employ-
ees is unfair to the State employees.

Double Taxation and Credits. When the taxpayer retires to a State that taxes the
pension income, the possibility of double taxation arises. The widespread availability
of a tax credit substantially solves the problem of an unfairly high tax burden stem-
ming 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 some-
times 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 negative commerce clause requires the granting of tax credits for
residents' source income from other States. If the receipt of pension 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 Com-
merce Clause Restraint on State Taxation, 87 Mich. L. Rev. 138 (1988).

Efftciency. Efficiency is offended if the pension income of retirees who move inter-