In The

Supreme Court of the United States



Secretary of the Treasury

Decided April 20, 1988

Justice O’Connor, Dissenting


South Carolina v. Baker, 485 U.S. 505 (1988), was a United States Supreme Court case in which the Court ruled that section 310(b)(1) of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) does not violate the Tenth Amendment to the United States Constitution.

Topic: Federalism*Court vote: 7–1
Note: No other Justices joined this opinion.
Holding: Section 310(b)(1) of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) does not violate the Tenth Amendment to the United States Constitution, nor violates the doctrine of intergovernmental tax immunity by taxing the interest earned on unregistered state bonds.
Citation: 485 U.S. 505 Docket: 94–origAudio: Listen to this case's oral arguments at Oyez

* As categorized by the Washington University Law Supreme Court Database

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JUSTICE O'CONNOR, dissenting.

The Court today overrules a precedent that it has honored for nearly 100 years and expresses a willingness to cancel the constitutional immunity that traditionally has shielded the interest paid on state and local bonds from federal taxation. Henceforth the ability of state and local governments to finance their activities will depend in part on whether Congress voluntarily abstains from tapping this permissible source of additional income tax revenue. I believe that state autonomy is an important factor to be considered in reviewing the National Government's exercise of its enumerated powers. Garcia v. San Antonio Metropolitan Transit Authority, 469 U. S. 528, 469 U. S. 581 (1985) (O'CONNOR, J., joined by Powell and REHNQUIST, JJ., dissenting). I dissent from the decision to overrule Pollock v. Farmers' Loan & Trust Co., 157 U. S. 429 (1895), and I would invalidate Congress' attempt to regulate the sovereign States by threatening to deprive them of this tax immunity, which would increase their dependence on the National Government.

Section 310(b)(1) of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), 26 U.S.C. § 103(j)(1), provides that the interest paid on state and local bonds will be subject to federal income tax unless the bonds are issued in registered form. The Court readily concludes that Congress could have prohibited outright the issuance of bearer bonds without violating the Tenth Amendment. Ante at 485 U. S. 511 -513. But regardless of whether Congress could have required registration of the bonds directly under its commerce power, I agree with the Court that Congress may not accomplish the same end by an unconstitutional means. Ante at 485 U. S. 515 -516. In my view, the Tenth Amendment and principles of federalism inherent in the Constitution prohibit Congress from taxing or threatening to tax the interest paid on state and municipal bonds. It is also arguable that the States' autonomy is protected from substantial federal incursions by virtue of the Guarantee Clause of the Constitution, Art. IV, § 4. See Merritt, The Guarantee Clause and State Autonomy: Federalism for a Third Century, 88 Colum.L.Rev. 1, 70-78 (1988) (arguing that judicial enforcement of the Guarantee Clause is proper).

The Court never expressly considers whether federal taxation of state and local bond interest violates the Constitution. Instead, the majority characterizes the federal tax exemption for state and local bond interest as an aspect of intergovernmental tax immunity, and it describes the decline of the intergovernmental tax immunity doctrine in this century. But constitutional principles do not depend upon the rise or fall of particular legal doctrines. This Court has a continuing responsibility "to oversee the Federal Government's compliance with its duty to respect the legitimate interests of the States." Garcia, supra, at 469 U. S. 581 (O'CONNOR, J., joined by Powell and REHNQUIST, JJ., dissenting). In my view, the Court shirks its responsibility because it fails to inquire into the substantial adverse effects on state and local governments that would follow from federal taxation of the interest on state and local bonds.

Long-term debt obligations are an essential source of funding for state and local governments. In 1974, state and local governments issued approximately $23 billion of new municipal bonds; in 1984, they issued $102 billion of new bonds. Report of Special Master 20. State and local governments rely heavily on borrowed funds to finance education, road construction, and utilities, among other purposes. As the Court recognizes, States will have to increase the interest rates they pay on bonds by 28-35% if the interest is subject to the federal income tax. Ante at 511. Governmental operations will be hindered severely if the cost of capital rises by one-third. If Congress may tax the interest paid on state and local bonds, it may strike at the very heart of state and local government activities.

In the pivotal cases which first set limits to intergovernmental tax immunity, this Court paid close attention to the practical effects of its decisions. The Court limited the government's immunity only after it determined that application of a tax would not substantially affect government operations. Thus in the first case to uphold federal income taxation of revenue earned by a state contractor, this Court observed that "neither government may destroy the other nor curtail in any substantial manner the exercise of its powers." Metcalf & Eddy v. Mitchell, 269 U. S. 514, 269 U. S. 523 -524 (1926). When this Court extended its holding to the case of a state tax on a federal contractor, it expressly noted that the tax "does not interfere in any substantial way with the performance of federal functions." James v. Dravo Contracting Co., 302 U. S. 134, 302 U. S. 161 (1937). In upholding the application of the federal income tax to income derived from a state lease, this Court decided that mere theoretical concerns about interference with the functions of government did not justify immunity, but that "[r]egard must be had to substance and direct effects." Helvering v. Mountain Producers Corp., 303 U. S. 376, 303 U. S. 386 (1938). In Helvering v. Gerhardt, 304 U. S. 405 (1938), this Court upheld the application of the federal income tax to income earned by a state employee, because there is

[no] immunity when the burden on the state is so speculative and uncertain that, if allowed, it would restrict the federal taxing power without affording any corresponding tangible protection to the state government.

Id. at 304 U. S. 419 -420.

The instant case differs critically from the cases quoted above because the Special Master found that, if the interest on state and local bonds is taxed, the cost of borrowing by state and local governments would rise substantially. This certainly would affect seriously state and local government operations. The majority is unconcerned with this difference, because it is satisfied with the formal test of intergovernmental tax immunity that can be distilled from later cases. Under this test, if a tax is not imposed directly on the government and does not discriminate against the government, then it does not violate intergovernmental tax immunity. See ante at 485 U. S. 523.

I do not think the Court's bipartite test adequately accommodates the constitutional concerns raised by the prospect of applying the federal income tax to the interest paid on state and local bonds. This Court has a duty to inquire into the devastating effects that such an innovation would have on state and local governments. Although Congress has taken a relatively less burdensome step in subjecting only income from bearer bonds to federal taxation, the erosion of state sovereignty is likely to occur a step at a time.

If there is any danger, it lies in the tyranny of small decisions -in the prospect that Congress will nibble away at state sovereignty, bit by bit, until someday essentially nothing is left but a gutted shell.

L. Tribe, American Constitutional Law 381 (2d ed.1988).

Federal taxation of state activities is inherently a threat to state sovereignty. As Chief Justice Marshall observed long ago, "the power to tax involves the power to destroy." McCulloch v. Maryland, 4 Wheat. 316, 17 U. S. 431 (1819). Justice Holmes later qualified this principle, observing that "[t]he power to tax is not the power to destroy while this Court sits." Panhandle Oil Co. v. Mississippi ex rel. Knox, 277 U. S. 218, 277 U. S. 223 (1928) (Holmes, J., joined by Brandeis and Stone, JJ., dissenting). If this Court is the States' sole protector against the threat of crushing taxation, it must take seriously its responsibility to sit in judgment of federal tax initiatives. I do not think that the Court has lived up to its constitutional role in this case. The Court has failed to enforce the constitutional safeguards of state autonomy and self-sufficiency that may be found in the Tenth Amendment and the Guarantee Clause, as well as in the principles of federalism implicit in the Constitution. I respectfully dissent.

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