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Rudy Meets The Three Stooges

I spent a lot of time around Rudolph Giuliani in the 1980s, when he was Manhattan’s U.S. attorney and I was a reporter covering him. I knew him as a smart and shrewd man, not easily outmaneuvered by anyone, let alone by the Three Stooges.

Yet that is exactly what happened when New York Gov. George Pataki, state Senate Republican boss Joseph Bruno and Assembly Democratic chief Sheldon Silver decided to repeal New York City’s “commuter” income tax on certain nonresidents. The incident casts light on some of the slimier aspects of state and local taxation.

You probably know the background. Competing candidates in a Senate race in suburban Rockland County sought to pander to local voters by proposing to repeal the commuter tax. In an ordinary year this idea would go nowhere, but this year the city finds itself with a $2 billion budget surplus. Bruno and Silver each decided to back their party’s candidate by raiding the city cookie jar, since doing so costs them nothing. Pataki went along because he thinks George W. Bush just might put a New York governor on the GOP presidential ticket next year, and, toward that end, a little buff and shine on the tax-cutting credentials couldn’t hurt. And also because Giuliani, a Republican, endorsed Democrat Mario Cuomo against Pataki in the latter’s first run for governor.

So, overnight, the Stooges blew a hole in the city budget and tax system. Giuliani, among others, promised to sue. I expected a more creative response from the mayor. Something like repealing the city income tax for city residents, too, and throwing the city’s entire budget into the laps of Moe, Larry and Curly. At this writing, mind you, the Stooges are two months late in delivering the state’s own budget, the 15th consecutive year they and their forefathers have missed the April 1 deadline.

Your New York City general obligation bonds are worth less now, since credit markets have to account for the city’s reduced financial cushion against any future slowdown in the economy. For that matter, the state’s credit probably is damaged also, given the cavalier way in which the commuter tax was repealed. Not that the Stooges care. If they were worried about credit ratings, we would have a timely state budget.

But the real damage is to the state’s tax climate, not its credit rating. The commuter tax repeal was just the latest example of what I call “sue me” tax legislation: A law that probably is invalid, but which is passed in the hope or expectation that nobody will go to the expense of getting it thrown out. This kind of lawmaking promotes contempt for the entire tax system and, in the long run, helps undermine it by eroding voluntary compliance.

For New Yorkers Only

Even if repealing the commuter tax was a dumb idea, New York lawmakers probably had every right to do it — if they did it for everybody. But they did not. As enacted, the commuter tax repeal only applies to people who live in New York state. Those who live in New Jersey, Connecticut or elsewhere and work in New York City are still supposed to pay the tax.

Once this issue reaches a judge, it will take about a nanosecond to overrule such blatant discrimination against out-of-state workers. The Stooges know this, which is why the repeal legislation went so far as to specify that if the courts strike down the New Yorkers-only repeal, then the repeal will apply to everyone. But in the meantime someone has to go to court, and a lot of other someones have to be careful to file appropriate refund claims, lest the statute of limitations prevent them from getting what is due them.

Why put everyone to the trouble? To do Giuliani a small favor, apparently. By letting him pretend for a while that the repeal applies only to New Yorkers, the cost of repeal can be estimated at $210 million a year. The tab will rise to $360 million once the repeal includes everyone, but by then we may be in a new fiscal year.

Another reason is that by continuing to withhold the tax from out-of-staters, the city at least gets the interest-free use of their money from the date they are paid until after they file their tax returns. And, even better, some taxpayers can be counted on to overlook a refund claim or file it after the statute of limitations expires, thus allowing the city to keep money it never should have collected in the first place.

In this case it was obvious from day one that the law would be challenged and, in all likelihood, struck down. But it simply continues a long line of lower-profile legislation that, while of dubious validity, stays on the books for years.

Days Worked At Home

Consider the way New York (state and city) treats nonresident employees who work at home. Suppose a New Jersey software engineer comes to Manhattan for a one-hour monthly staff meeting and, otherwise, spends 22 hours a day chugging coffee and writing code in his home office. New York’s regulations treat that employee as having earned all of his income in New York, because he did not necessarily have to work at home. Convenience (or practicality) does not count. Even if the employer did not give the programmer an office, New York would consider the income to be earned here because the employer could have given the programmer an office. The state basically assumes the facts it wants.

To my amazement, this rule has been on the books for many years and has survived challenges, including some on Constitutional grounds, all the way up to the Court of Appeals (New York’s highest court). Of course, this is the same Court of Appeals that upheld the state’s rule denying alimony deductions to nonresidents, only to be reversed by the U.S. Supreme Court last year. New York and many other state courts have historically been slow to strike down their own state’s tax laws. Until the U.S. Supreme Court decides to look at whether a state can tax a nonresident based on where it thinks she could have worked, rather than where she actually worked, the New York provision stands.

Or consider capital losses. New York follows the federal rule that allows deductions for capital losses up to the amount of capital gains, plus $3,000. For nonresidents, the state only considers transactions that relate to New York property. Example: an individual earns $100,000 in salary in New York, has $25,000 in capital gains from the stock market, and has a $20,000 loss on the sale of a piece of land upstate. Assume no deductions.

If the individual is a New York resident, his taxable income is $105,000. Because investment gains from the stock market are taxable only by an individual’s home state, we would expect taxable New York income of $80,000 if this individual is a nonresident. However, I recently had an auditor take the position that if the individual is a nonresident, his income subject to New York tax is $97,000. Why is New York taxable income so high? Because the salary of $100,000 is New York income but the gain on stocks of $25,000 is not, and so the capital loss on New York land is limited to $3,000. The remaining $17,000 of New York capital loss is carried forward to future years, which does no good whatsoever if the taxpayer quits his New York job and has no further contact with the state. New York would have taxed the nonresident on $97,000 of income even though his total New York income was only $80,000.

Hint to fellow professionals: When I mentioned the Lunding case, which struck down New York’s nonresident alimony rules, the auditor backed down and allowed the full capital loss deduction to my nonresident client. The alimony rule and the capital loss rule are in closely related subsections of the New York tax law.

New York does not have a monopoly on discriminatory tax legislation. Connecticut, for example, takes the bizarre position in its regulations that if a nonresident leaves a Connecticut job and receives payments under a covenant not to compete, those payments have a Connecticut source and are subject to tax. But the U.S. Constitution requires that states have an actual connection, called nexus, with nonresidents in order to impose tax. A covenant not to compete yields a payment for refraining from an activity (employment) that might give rise to nexus. It is not a payment for past services rendered in Connecticut. If a nonresident sits at home in New Hampshire, refraining from competing with his former employer in Hartford, how can this create nexus and taxing jurisdiction in Connecticut?

My all-time favorite discriminatory tax law, however, comes from Massachusetts. The Bay State taxes interest from deposits in Massachusetts banks at 5.95%, while imposing more than twice that tax —12% — on interest from bank deposits outside the state.

One would gather that this regime is designed to protect the Bay State’s banks from competition from money center (read New York) institutions. How such protections can square with the U.S. Constitution’s Commerce Clause, which gives Congress the sole power to regulate interstate commerce, simply escapes me. Maybe the courts make allowances for Massachusetts because the Red Sox lost Babe Ruth.