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SHAPIRO v. BAKER

November 5, 1986

Peter SHAPIRO, Essex County Executive, Plaintiff,
v.
James A. BAKER, III, Secretary of the Treasury of the United States, Defendant



The opinion of the court was delivered by: FISHER

 Presently before the court is defendant's motion for reconsideration, pursuant to Fed.R.Civ.P. 60(b) *fn1" and local rule 12(I), *fn2" of an order that denied defendant's motion for a judgment on the pleadings pursuant to Fed.R.Civ.P. 12(c). For the reasons set forth below, defendant's motion for reconsideration and judgment on the pleadings is granted.

 The fundamental facts of this case were adequately set forth in the court's opinion dated June 17, 1986, and need not be restated here. The issue to be decided is whether Essex County's ability to raise revenue, a function of government, was hampered by 26 U.S.C. § 86 *fn3" thus violating the principle of intergovernmental tax immunity, a principle developed and narrowed in a long line of cases beginning with Pollock v. Farmers' Loan & Trust Co., 157 U.S. 429, 15 S. Ct. 673, 39 L. Ed. 759 (1895). The court allowed plaintiff to establish a record for trial.

 Defendant argues that the court erred in refusing to accept recent Supreme Court precedents which establish that tax immunity applies only if the legal incidence of the tax is placed on the challenging governmental entity. Secondly, defendant states that the court erred in failing to determine that 26 U.S.C. § 86 does not impose a tax on interest income paid by local governments. Defendant's contention is that immunity can apply only where the legal incidence of the tax is laid directly on a local government. Thus, because 26 U.S.C. § 86 does not impose a direct tax on the interest income generated by the issuance of municipal bonds, the tax immunity claimed by plaintiff is inapplicable.

 Plaintiff's argument is that intergovernmental tax immunity is applicable in this case because, even if section 86 does not impose a direct tax on the interest income derived from the purchasing of municipal bonds, section 86 does impose an indirect tax placing a substantial burden upon the county government's function to raise revenue. Plaintiff considers this an infringement upon the sovereignty of the states in violation of the tenth amendment to the United States Constitution and also in violation of article I section 8 of the Constitution.

 Section 86 provides that social security benefits to be included in the gross income of a taxpayer for a taxable year will be limited to the lesser of (1) one-half the social security benefits received, or (2) one-half the excess of the sum of the taxpayer's adjusted gross income, interest on obligations exempt from tax, and one-half of the social security benefits received over the appropriate base amount. S.Rep. No. 98-21, 98th Cong., 1st Sess. 26, reprinted in 1983 U.S.Code Cong. & Ad.News 143, 168. Included in the equation to compute modified adjusted gross income is "interest received or accrued by the taxpayer during the taxable year which is exempt from tax." 26 U.S.C. § 86(b)(2)(B). It is section 86(b)(2)(B) that is the source of the controversy.

 The principle that the federal government may not tax the interest from municipal bonds, as stated previously, stems from Pollock v. Farmers Loan & Trust Co., wherein the Court faced an angry stockholder who owned shares of stock in the Farmers Loan & Trust Co. and who wanted the Court to enjoin the bank from paying income taxes on income earned from the interest on municipal bonds the bank purchased from the City of New York. 157 U.S. at 432-33, 15 S. Ct. at 674-75. The Court adopted the principle of intergovernmental tax immunity in instances where the tax is levied directly against the state and thus imposes a burden on the state's ability to raise revenue by borrowing. The Court held that

 
"the right to tax the contract to any extent, when made, must operate upon the power to borrow before it is exercised, and have a sensible influence on the contract. The extent of this influence depends on the will of a distinct government. To any extent, however inconsiderable, it is a burthen on the operations of government. It may be carried to an extent which shall arrest them entirely. . . . The tax on government stock is thought by this court to be a tax on the contract, a tax on the power to borrow money on the credit of the United States, and consequently to be repugnant to the Constitution." Applying this language to these municipal securities, it is obvious that taxation on the interest therefrom would operate on the power to borrow before it is exercised, and would have a sensible influence on the contract, and that the tax in question is a tax on the power of the States and their instrumentalities to borrow money, and consequently repugnant to the Constitution.

 Pollock v. Farmer's Loan & Trust Co., 157 U.S. at 586, 15 S. Ct. at 691 (quoting Weston v. Charleston, 27 U.S. 449, 2 Pet. 449, 468, 7 L. Ed. 481).

 The precedential weight of Pollock was doubtful from the start. The sixteenth amendment to the Constitution, ratified in 1913, states that "'the Congress shall have power to lay and collect taxes on incomes from whatever source derived, without apportionment among the several States and without regard to any census or enumeration.' This clear language makes the fact that income is derived from interest on state or local obligations constitutionally irrelevant." South Carolina v. Regan, 465 U.S. 367, 406, 104 S. Ct. 1107, 1129, 79 L. Ed. 2d 372 (1983) (Stevens, J., concurring in part and dissenting in part). At every opportunity, the Court has rejected the intergovernmental tax-immunity theory. *fn4" For example, in Helvering v. Gerhardt, 304 U.S. 405, 58 S. Ct. 969, 82 L. Ed. 1427 (1938), the Court held the United States could tax the salaries of state employees. In so holding, the Court said

 
if every federal tax which is laid on some new form of state activity, or whose economic burden reaches in some measure the state or those who serve it, were to be set aside as an infringement of state sovereignty, it is evident that a restriction upon national power, devised only as a shield to protect the states from curtailment of the essential operations of government which they have exercised from the beginning, would become a ready means for striking down the taxing power of the nation. . . . Once impaired by the recognition of a state immunity found to be excessive, restoration of that power is not likely to be secured through the action of state legislatures; for they are without the inducements to act which have often persuaded Congress to waive immunities thought to be excessive.

 304 U.S. at 417, 58 S. Ct. at 974 (citation and footnote omitted). The theory for the intergovernmental tax immunity was again rejected in Graves v. New York ex rel. O'Keefe, 306 U.S. 466, 59 S. Ct. 595, 83 L. Ed. 927 (1939), wherein the Court held that a state could tax the salary of a federal employee. The Court reasoned that

 
so much of the burden of a nondiscriminatory general tax upon the incomes of employees of a government, state or national, as may be passed on economically to that government, through the effect of the tax on the price level of labor or materials, is but the normal incident of the organization within the same territory of two governments, each possessing the taxing power. The burden, so far as it can be said to exist or to affect the government in any indirect or incidental way, is one which the Constitution presupposes, and hence it cannot rightly be deemed to be within an implied ...

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