McCulloch v. Maryland turns 200 this March. And the landmark 1819 decision — perhaps best remembered for Chief Justice John Marshall’s observation that “the power to tax involves the power to destroy” — continues to cast a long shadow over state efforts to collect tax revenues from federal government entities and their employees. Dawson v. Steager, scheduled for argument on December 3, is the latest in a line of Supreme Court cases implicating the doctrine of intergovernmental tax immunity that McCulloch set forth. And although the court’s decision in Dawson will not be nearly as momentous as McCulloch, it could help to clarify the limits of the states’ power to tax.
At its most basic level, Dawson is a dispute about whether former federal law-enforcement officials owe West Virginia state income tax on their retirement benefits. Petitioner James Dawson, a retired U.S. marshal, alleges that West Virginia discriminates against federal law-enforcement retirees like him because it allows them to claim only a $2,000 income tax exemption while some former state and local law enforcement officials can exempt their entire pensions. The state’s Supreme Court of Appeals ruled against Dawson, emphasizing that most West Virginia state and local government retirees are subject to the same tax treatment as Dawson and that the former law-enforcement officials eligible for full exemption constitute only two percent of all state pensioners. According to the state supreme court, the benefit that West Virginia has accorded to a “very narrow class” of state and local law-enforcement retirees “was not intended to discriminate against former federal marshals.”
At a more fundamental level, the dispute in Dawson is about the meaning of McCulloch v. Maryland in modern times. The narrow holding of McCulloch — that a state cannot impose a tax on the notes of the Bank of the United States while exempting notes issued by state-chartered banks — is clear enough. But the Bank of the United States has been defunct since 1836, so that narrow holding has limited relevance. Much more important today — at least in dollar terms — are McCulloch’s implications for the roughly two million federal employees and almost as many federal retirees who live in states that impose income taxes.
Until the 1930s, the Supreme Court understood McCulloch to mean that states had no power to tax the wages of federal workers. But in the 1939 case Graves v. New York ex rel. O’Keefe, the court rejected that view and held that a state could apply a “non-discriminatory general tax upon the incomes of [federal] employees.” Two weeks after the Graves decision, Congress passed the Public Salary Tax Act of 1939, now codified at 4 U.S.C. § 111, in which it consented to state taxation of federal officers and employees so long as “such taxation does not discriminate against such officer or employee because of the source of such compensation.” In this way, the intergovernmental tax immunity doctrine evolved from a rule of mandatory exemption to a rule of nondiscrimination, which is arguably what Marshall intended in the first place.
Yet the argument over state taxation of federal employees’ income did not end in 1939. The issue came to a head again 60 years later in Davis v. Michigan Department of the Treasury. In an 8-1 decision, the court in Davis held that Michigan violated the doctrine of intergovernmental tax immunity and 4 U.S.C. § 111 by imposing its state income tax on retirement benefits received by former federal employees while exempting benefits paid to retired state and local government employees. (Along the way, the court in Davis clarified that the intergovernmental tax immunity doctrine and 4 U.S.C. § 111 are “coextensive,” making it unnecessary to distinguish between the two.)
Davis established the rule that if a state taxes federal employees or retirees more heavily than its own current or former workers, it must show that there are “significant differences between the two classes” that justify the differential treatment. The court has applied that rule in only two subsequent cases. First, in 1992, the court held that Kansas violated the intergovernmental immunity doctrine when it taxed veterans on their military retirement benefits but exempted state and local government pensions. Then in 1999, the court sustained an Alabama county’s occupational tax that applied equally to federal and state court judges but exempted nongovernment attorneys. Now for the first time in nearly two decades, the court will revisit the issue of intergovernmental tax immunity once more.
In Dawson’s telling, this case is Davis redux. There is “no doubt,” Dawson says, that West Virginia’s income tax regime imposes a heavier burden on federal law-enforcement retirees than on “favored” state retirees. And it is “undisputed,” Dawson adds, that there are no significant differences between U.S. marshals and the state and local law-enforcement officers who are eligible for a total exemption under state law. That, says Dawson, should be case closed. Perhaps to underscore just how straightforward he thinks this should be, Dawson limits his opening brief to 33 pages — remarkably succinct by Supreme Court standards.
The solicitor general, participating as a friend of the court in support of Dawson, frames the issue somewhat differently. According to the solicitor general, the intergovernmental tax immunity doctrine prohibits a state from taxing federal employees more heavily than “similarly situated” state employees. While certain state and local law enforcement retirees in West Virginia are entitled to full exemption (including at least some state troopers and deputy sheriffs), others — including county sheriffs and capitol police — receive the same $2,000 exemption as Dawson. On the solicitor general’s view, Dawson’s case turns on whether former federal marshals are more similar to the state retirees who enjoy total exemption or to the state retirees entitled to the $2,000 writeoff. The solicitor general asks the justices to send the case back so that West Virginia courts can determine which class of state retirees is most comparable to Dawson.
West Virginia counters that there is no discrimination, intentional or otherwise, against federal retirees under its state income tax, and no need to remand for further proceedings. The state reiterates that Dawson gets the same tax treatment as 98 percent of state and local retirees — and even more favorable treatment than private-sector pensioners. West Virginia argues that the concern that animated McCulloch — that states would use their taxing power to interfere with federal functions — is therefore not implicated here.
One might wonder why West Virginia has gotten itself into this mess in the first place. After all, if it wants to give a preference to retired state troopers and deputy sheriffs, it can simply increase their pension benefits rather than granting them a tax exemption. To illustrate, an individual with $30,000 of taxable income will owe roughly $1,000 in West Virginia state income tax, so instead of paying pension benefits of $29,000 to a retired state trooper and then exempting her from state taxes, West Virginia could just pay the retired trooper $30,000 with no tax exemption. It would seem that the trooper would come out just the same, and the state’s intergovernmental tax immunity problem would go away.
The catch is that state retirement benefits are subject to federal income tax, while state tax benefits are not. So by granting retirees a state tax exemption rather than paying them more and taxing them more, West Virginia can — in most cases — reduce its retirees’ federal tax bills. The court in Davis noted this point in explaining why the intergovernmental tax immunity doctrine continues to matter, notwithstanding the fact that states always have the legal option to augment their retirees’ pensions without providing a similar bonus to former federal workers. As the court there observed, one function of the doctrine is to prevent a state from benefiting its own employees “at the expense of the federal treasury.” This effect of the doctrine is especially significant now that the December 2017 federal tax law limits the deduction for state and local taxes and expands the standard deduction — changes that make a state tax exemption considerably more attractive than a state pension bonus for most retirees.
Of course, the McCulloch court did not intend the intergovernmental tax immunity doctrine to serve as a defense of the federal income tax base. After all, the first federal income tax would not be enacted for another four decades. Yet it is not unusual that a doctrine fashioned for one reason may go on to serve another. Marshall would surely be surprised by the turn his doctrine has taken, but ever the advocate of a strong central government, he might not be entirely displeased.
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