MSC considers: Does pension tax law create a graduated income tax?

If the Michigan Supreme Court accepts the argument that a state law to allow the taxing of pensions is constitutional, it will also be allowing a back-door means to achieve a graduated state income tax, said Eric Restuccia, of the Michigan Attorney General’s office during oral arguments this morning.

But on the other side of the argument, John J. Bursch, also with the Attorney General’s office, argued that there is no permanent irrevocable tax exemption for pensions, public or private, in the Michigan Constitution.

If the Michigan Supreme Court agrees with Bursch’s argument, the state will levy the income tax on pensions beginning Jan. 1, 2012.

A majority of the Legislature voted in favor of taxing pensions, including public pensions, and Gov. Rick Snyder signed the bill into law, PA 38 of 2011. Bursch said it was a response to the state’s budget deficit and double-digit unemployment. The Act would allow the state to tax pensions the same way that it taxes 401(k) distributions and would mean that pensioners “share the burden” along with all the other taxpayers.

But the constitutionality of the law has been challenged, so the governor asked the Michigan Supreme Court for an advisory opinion to determine:
•If reducing or eliminating the statutory exemption for public pension incomes as described in MCL 206.30 impairs or diminishes the contractual obligation regarding accrued financial benefits of a pension under Const 1963, article 9, section 24, or under article 1 section 10.
•Whether determining eligibility for income tax exemptions on the basis of total household resources, or age and total household resources, creates a graduated income tax in violation of the Constitution
•Whether determining eligibility for income tax exemptions based on date of birth violates equal protection of the law under the state Constitution or the 14th Amendment of the United States Constitution.

The Act “violates the public trust,” Restuccia said. Public employees have made decisions about retiring based the amount of their pensions, and how much their pension checks would be. Once they know what their pension benefits are, Restuccia said, “Then I have an expectation .. I know when I’ll retire.”

The law, if it is deemed constitutional, would limit the state’s current pension income tax exemption to retirees born before 1946, and would phase out public pension exemptions for those born after 1946, so that all pensions – public and private – would be taxable.

It also provides a sliding scale for pension income exemptions based on age and household income. For example, taxpayers who will be at least 67 years old next year would keep their exemptions. Public pensions for those taxpayers would be completely tax exempt. But private pension retirees would have capped pension exemptions of $45,120 per single filer and $90,240 for joint tax return filers.

Taxpayers between age 60 and 66 next year would have pension exemptions for both public and private pensions capped at $20,000 for single filers and $40,000 for married taxpayers. At age 67, the exemption would become a general income exemption with the same caps unless their total household resources exceed $75,000 for singles and $150,000 for married filers. The higher income pensioners would have no exemption.

Pensioners younger than 59 next year will have their pensions taxed. That applies to public and private pensions. But once they turn 67, they would get the $20,000 or $40,000 exemption, unless their total household resources are higher than $75,000 or $150,000.

That’s where Restuccia said the state is setting up a graduated income tax, which the Constitution prohibits.

“We have two sets of rules,” he said, because eligibility for the exemptions creates classes among citizens based on income. “You can’t manipulate the base so that the flat tax is graduated.”

Bursch said that the state does allow exemptions in two ways. First, there is the personal exemption. So if two families earn the same amount of money, one family has dependent children and the other does not, they pay a different amount of tax. Further, the state uses the federal adjusted gross income from federal tax returns to determine how much income the state can tax. The federal AGI also included exemptions that are in some cases income-based and there has never been a challenge to that system.

Restuccia also argued that giving married and single filers different exemptions violates the 14th Amendment, as does allowing different exemptions for taxpayers of different ages.

Aside from those differences, the Act violates Article 9, section 24 of the state Constitution because it reduces the benefit that public sector workers have already earned, Restuccia argued.

Further, he said, it violates public workers’ rights against impairment of contract because the state is taking back some of the workers’ benefits after they have already performed the work in their contracts.

Bursch said there is nothing in the Constitution that creates a permanent tax exemption for public pensions and if its ratifiers wanted to create it, they would have done so. For example, he said, judges’ pensions are protected in that way by the Judges Retirement Act.

Further, Bursch said, the benefit being paid to the pensioners is separate from the amount of tax collected. Tax does not diminish the benefit because the benefit is being paid as promised in the contract.

“Pensioners are still receiving 100 percent of their benefits,” he said. The concept of “accrued financial benefits” as described in Section 24 is “intentionally narrow.”

He added that if the age and income levels on the sliding scale violate the 14th Amendment or create a graduated income tax, eliminating those exemptions and applying the same tax to all pensioners would correct the problem.

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