By now, most Americans have filed their state tax returns. While many were fortunate enough to owe income to just a single state, some taxpayers had to grapple with the often-confusing process of filing a return in other states, then claiming the taxes paid to those states as a credit against their home state’s tax liability. While that’s irritating enough, a case that the Supreme Court is currently deciding whether or not to take up would determine if those states are allowed to effectively get away with double taxation.
Double taxation, or multiple taxation, occurs when two or more states tax the same income. The process of claiming credits against taxes paid to other states theoretically prevents this, ensuring that taxing rights are apportioned rather than duplicated.
But while the process is straightforward at the state level, the addition of city- or county-level taxes makes things more complicated. Past court decisions have clarified that these sub-jurisdictions can’t be left out of the calculation, but how exactly cities and states must apportion taxing rights is a less settled question.
That’s what Diane Zilka, a Philadelphia resident who commutes to Wilmington, Delaware for work, learned a few years ago. Because she lives and works in cities and states that have income taxes, she effectively pays four separate income tax rates when filing her state income taxes: 3.922 percent to Philadelphia, 3.07 percent to Pennsylvania, 1.25 percent to Wilmington, and 5 percent to Delaware.
As past Supreme Court decisions require, both sides agree that Zilka should receive a refund for the taxes she paid to Delaware and Wilmington. The exact form that refund should take, however, is the point of contention.
Philadelphia argues that cities provide refunds against taxes paid to other cities, while states provide refunds against taxes paid to other states. Consequently, the city agreed to provide Zilka with a credit for the 1.25 percent rate she paid to Wilmington against her 3.922 percent Philadelphia income tax.
But Zilka argues that city and state income tax rates should be considered holistically. Therefore, Zilka is requesting a credit for the combined 6.25 percent tax rate she paid to Wilmington and Delaware against the 6.922 percent combined rate she paid to Philadelphia and Pennsylvania.
That might sound like an esoteric tax administration dispute, but the outcome has a real financial impact to taxpayers. In Zilka’s case, Philadelphia’s interpretation results in her receiving a total credit worth only 4.32 percent of the combined 6.922 percent rate she paid to Philadelphia and Pennsylvania.
And Zilka has a point. Unlike states, which have their own constitutionally-designated powers, cities’ taxing powers are simply a devolution of a state’s own taxing authority. The constitutional distinction between a state and its sub-jurisdictions is effectively non-existent. And generally, when local governments have lower or no income taxes, they are simply passed revenue from the state government to fund their operations.
Should Philadelphia’s interpretation of the law stand, states would be able to squeeze more tax revenue out of residents who commute abroad if they keep their state and local tax rates roughly equal, rather than having a higher state rate. That’s a completely arbitrary way to impose greater tax obligations on taxpayers.
While Pennsylvania’s Supreme Court narrowly decided in favor of Philadelphia (with even a justice in the majority acknowledging that the result was unfair), the federal Supreme Court now has an opportunity to right this wrong. The Court can and should step in and make clear to states that they can divide their taxing powers between sub-jurisdictions however they like, but they cannot do so in a way that results in taxpayers being double-taxed.
