December 7, 2007

Is Tennessee's Hall Tax About to Be Declared Partially Unconstitutional?

Tennessee Department of Revenue Commissioner Reagan Farr told a joint legislative committee on business taxes Wednesday that he would recommend the state begin applying the Hall tax to income from in-state municipal bonds, which are currently exempt from the tax on stock and bond income, if a case pending before the U.S. Supreme Court is decided in favor of the plaintiff.

The case, Davis v. Kentucky Revenue Department, involves an interstate commerce clause challenge to Kentucky's levying its income tax on income from out-of-state bonds but not in-state bonds. Tennessee's Hall Tax has a similar structure - if you invest in bonds issued by a Tennessee municipality you don't pay the Hall tax on bond interest income, but income earned from bonds issued by other states and out-of-state municipalities is taxable.

The Davis plaintiffs claim that difference amounts to a violation of the U.S. constitution's interstate commerce clause, which prohibits states from regulating interstate commerce.

If the plaintiffs win, Kentucky would have to either start taxing income from in-state bonds, or stop taxing income earned from out-of-state bonds.

So too would Tennessee. Since the Hall tax is a significant portion of the state's revenue - it brought in $194 million in the 2005-06 fiscal year and was projected to bring in $216 million in the current fiscal year - you would have to think it is unlikely that the Bredesen administration will want to stop collecting the tax on out-of-state bond income, especially now that its over-spending has created a gap between the budget and the available revenue.

If the plaintiffs win in the Davis case, Farr said, and the Supreme Court leaves it to Kentucky and other states with similar tax structures to fix the problem, Farr said, "I would recommend that we tax all bonds equally" rather than give up the revenue from taxes on out-of-state bonds, and open the door to a flood of refund requests from taxpayers who were charged the unconstitutional tax on out-of-state bonds.

In other words, Farr is poised to recommend that the state legislature raise taxes on Tennesseans who earn income from in-state bonds if the plaintiffs win the Davis case.

For Republicans in the legislature, a recommendation from Farr to start taxing in-state bonds will be a great chance to stand firm for the Tennessee Republican Party "brand" on taxes by voting against taxing in-state bonds, which has the added bonus of being a two-fer vote because it is a vote against expanding income taxes.

The video above contains Farr's remarks within a five-minute discussion of the Davis case.

If the Hall tax as currently structured with the exemption for in-state bonds is unconstitutional, taxpayers who paid the Hall tax on income from out-of-state bonds are eligible for a refund for any such taxes paid in the past three years. Taxpayers who want to claim a refund on taxes collected unconstitutionally in 2004 would have to file by Dec. 31, 2007. Here's the catch - the Supreme Court may not issue its decision by then.

It is possible to file a preemptive claim. Consult your tax adviser.