In Comptroller v. Wynne, the U.S. Supreme Court held that Maryland’s income tax system violated the dormant commerce clause.
Maryland’s Income Tax System
Like many states, Maryland taxes all of the income earned by all of its residents, regardless of the geographic source from which it’s earned. Typically, when states do this, they provide a tax credit for the taxes paid on the income earned from sources outside of the state of residence, because many states (including Maryland) typically tax income earned within their borders. What made Maryland’s system unusual was that it refused to give this foreign tax credit for the portion of the Maryland state income tax that was allocable to the counties—tax of as much as 3.2 percent that was collected by the state but then paid to the counties. Maryland imposed this “county” tax on the income its residents earned from all sources, with zero tax credit provided, even if the income was earned from another state and was fully taxable in that other state. At the same time, Maryland taxed all income that was earned from Maryland sources by non-residents and imposed a special “non-resident” tax on this income, which was equivalent to the county tax referenced above.
The effect was higher taxation paid by taxpayers who earned income from outside the state. For example, take two taxpayers, Anne and Beth. Anne earns all of her income from a partnership that operates only in Maryland. Beth earns all of her income from a partnership that operates both inside Maryland and in nine other states—assume she earns only 10 percent of her income from inside Maryland. Anne pays the Maryland county tax of 3.2 percent on all of her income and pays no tax to any other state. Beth is treated the same way on the 10 percent of her income earned within Maryland. However, on the remaining 90 percent of her income that she earns from outside of Maryland, Beth pays both the state income tax to the state where the income was earned and pays the 3.2 percent county tax in Maryland with zero tax credit for the taxes she pays to the states where the income was earned. Thus, for 90 percent of her income, Beth pays state income tax to two different states with zero tax credit—leading to a tax rate substantially higher than Anne’s solely because Beth engages in interstate commerce, whereas Anne doesn’t.
Five Controversial Issues
Given the discrimination against interstate commerce presented by Maryland’s refusal to give a tax credit, one might wonder what could be interesting or controversial about this case. A lot, it turns out. Here are five questions and some summary answers that help show why.
1. Why was a case that involved obvious double taxation of interstate commerce decided by only a 5-4 margin? Partly, the dissent reflects the hostility Justices Antonin Scalia and Clarence Thomas have to the whole concept of a “dormant commerce clause” – or as Justice Scalia colorfully calls it, the “imaginary commerce clause” or “synthetic commerce clause,” which he labels a “judicial fraud.” Justice Scalia would grudgingly follow it only to the strict limits of certain holdings worthy of stare decisis; Justice Thomas would abandon it altogether. While intellectually fascinating, it’s unlikely those views will be in the judicial ascendance.
Justice Ruth Bader Ginsburg’s dissent (joined by Justices Elena Kagan and Antonin Scalia) would have upheld Maryland’s tax system based on the proposition that the Court had never invalidated a state’s income tax imposed on the natural persons who are its actual residents. This dissent distinguished the precedents relied on by the majority as having applied to corporations and to gross receipts taxes, not to personal income taxes imposed on individual residents. Based on the special relationship between a state and its individual residents, the benefits provided by the state to those residents and the ability of those residents to vote for different tax systems, the dissent would have held that the Constitution doesn’t invalidate a state’s personal income tax just because it may lead to some double taxation on its residents by refusing to give a tax credit for taxes paid to another state. Moreover, the dissent effectively showed that even the majority decision would permit state systems that impose greater tax burdens on interstate commerce than on intrastate commerce.
2. What is the “internal consistency” test? The key to the majority’s decision was that Maryland tax system flunked the “internal consistency” test. That test asks whether interstate and intrastate commerce would be taxed equally if every state adopted the same system as the system being challenged. Because Maryland chose both to tax residents on all their income from all sources (a “residence” based tax) without a full tax credit for taxes imposed by other states on a source basis, and chose to tax income earned from Maryland sources by non-residents (a “source” based tax), the effect was to create a system that was neither purely residence-based nor purely source-based. If every state adopted such a hybrid system without providing tax credits for each other’s source based taxation, then citizens who engaged in interstate commerce would pay a higher overall tax than citizens who engaged in purely intrastate commerce. So Maryland’s system flunked the “internal consistency” test.
The dissent agreed Maryland’s system flunked the “internal consistency” test, but said that test shouldn’t be applied to income taxes imposed on natural persons who are state residents. Moreover, the dissent pointed out that it’s perfectly possible for all states to impose taxes that pass the “internal consistency” test, yet result in double taxation that discriminates against interstate commerce. Suppose half the states impose pure residence-based taxes with no foreign tax credits for source-based taxation, and half impose pure source-based taxes with no credit for residence-based taxation; each system is internally consistent and hence constitutional; but the result is higher taxation of interstate commerce than taxation of intrastate commerce.
'No Such Rule of Priority'
3. Are states required to give their residents a foreign tax credit for taxes paid to other states that impose source-based taxation? The dissent argued that the majority effectively required: “a State taxing based on residence to 'recede' to a State taxing based on source.” The majority responded: “We establish no such rule of priority.” According to the majority, while Maryland could cure its system by giving the foreign tax credit sought by the Wynnes, “we do not foreclose the possibility that it could comply with the Commerce Clause in some other way.” By the same token: ”we do not decide the constitutionality of a hypothetical tax scheme that Maryland might adopt because such a scheme is not before us.” Thus, the majority suggests but doesn’t confirm that Maryland could cure its unconstitutional system either by giving the tax credit the Wynnes sought or by eliminating its source-based taxation. By being vague on this point, the majority also didn’t squarely address the dissent’s hypothetical, that is, when internally consistent state tax regimes together impose a greater tax burden on interstate than intrastate commerce, would that survive review under the dormant commerce clause? More cases may be needed to answer that. In the meantime, most states may avoid review by giving sensible tax credits that avoid the problem.
4. Are Maryland residents who were denied foreign tax credits in the past entitled to refunds? While the Court left open precisely how Maryland could fix its system, that open question should be purely for what the prospective fix will be. The Wynnes won their case, so they’re entitled to the tax credit they sought for past years. Likewise, other Maryland taxpayers who sought refunds on this basis (or who seek them now for past years that are still open) should be entitled to those refunds. If Maryland tried to avoid this by abolishing its source-based tax and paying a refund to all non-residents whose income was taxed in Maryland, it would be dodging the result successfully sought by the Wynnes. Going forward, however, Maryland may need to assess which fix is less costly and whether abolishing the source-based tax is worth the risk of another constitutional challenge.
5. Residence versus source: future battles? It’s worth noting that in the same term that it struck down Maryland’s failure to give its residents a tax credit for source-based taxes imposed by other states, Justice Anthony Kennedy’s concurrence in Direct Marketing Ass’n v. Brohl¸575 U.S. __ (2015), sent a strong signal that the Court may be willing to reconsider the “substantial nexus” restrictions it placed on source-based taxation in Quill Corp. v. North Dakota, 504 U. S. 298, 311 (1992), potentially broadening state power to tax out-of-state retailers. For this reason and in light of the questions left open by Wynne, the competing claims of residence-based taxation and source-based taxation are likely to surface in future cases.
As fascinating as such future cases will be, one wonders if such problems would best be solved by the more prosaic route of a State Model Act, adopted across the country, which struck an appropriate balance between residence-based and source-based taxation, perhaps with Congressional blessing under the non-dormant commerce clause. At least Justices Scalia and Thomas would vote for that.