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Knoll argues Philadelphia wage tax unconstitutional in new essay

April 21, 2016

Professor Michael Knoll writes about the constitutionality of Philadelphia's wage tax in the University of Pennsylvania Law Review Online.
Professor Michael Knoll writes about the constitutionality of Philadelphia's wage tax in the University of Pennsylvania Law Review Online.
Professor Michael S. Knoll and his co-author Ruth Mason of the University of Virginia School of Law argue why the Philadelphia wage tax is unconstitutional in the latest issue of the University of Pennsylvania Law Review Online.

The centerpiece of Philadelphia’s tax system, the Philadelphia wage tax, is now facing a legal challenge that may render it unconstitutional — and deservedly so, according to a noted University of Pennsylvania Law School tax scholar.

In a new article, “Is the Philadelphia Wage Tax Unconstitutional? And If It Is, What Can and Should the City Do?” in the University of Pennsylvania Law Review Online, Penn Law professor Michael S. Knoll and his co-author Ruth Mason of the University of Virginia School of Law argue why the wage tax is, indeed, unconstitutional and examine the efficacy of possible alternatives.

“The Philadelphia wage tax — the nation’s first municipal wage tax — has long been criticized for driving jobs out of Philadelphia, and is clearly unconstitutional under recent U.S. Supreme Court precedent,” said Knoll. “The city, which will have to scrap or reform the tax in the coming years, should face the issue now and decide how to respond.”  

Knoll and Mason’s argument relies on the Dormant Commerce Clause of the U.S. Constitution. While the Commerce Clause gives Congress the power to regulate commerce among the states, the “dormant” Commerce Clause doctrine, the authors explain, has held that Congress’s power to regulate interstate commerce also implies that states, in turn, are precluded from interfering with interstate commerce.

Since 1939, Philadelphia has had a wage tax, and that tax is paid by residents of Philadelphia, even if they don’t work in the city, as well as by nonresidents who do work in the city. The wage tax reached its highest rate, 4.96% in 1983, Knoll and Mason explain in their article, and stayed there until the mid-1990s. The rate has been slowly, but steadily, decreasing since then.

“Accordingly,” Knoll and Mason write, “the Supreme Court has long interpreted the Commerce Clause to prohibit states from discriminating against out-of-state parties.”

Figuring out whether a state tax is discriminatory proved difficult in the past, they note, but the Supreme Court’s May 2015 tax discrimination case, Comptroller of the Treasury of Maryland v. Wynne, has provided an easy-to-implement test for discrimination.

Wynne revolved around a “county” tax in Howard County, Maryland. Residents paid a “county” tax of 3.2% on both their Maryland income and their non-Maryland income. The Supreme Court struck down the “county” tax on the ground that it violated the Dormant Commerce Clause, relying on what’s called the “internal consistency test.”

The Supreme Court explains that “Internal consistency is preserved when the imposition of a tax identical to the one in question by every other State would add no burden to interstate commerce that intrastate commerce would not also bear.”

In essence, Knoll and Mason write, the test directs a court to assume that every state has enacted in challenged state’s tax regime, then to determine if interstate commerce bears more tax than purely in-state commerce. This was the case in Maryland, and the Supreme Court struck down the tax as unconstitutional.

Under Wynne, Philadelphia’s wage tax, just like the “county” tax in Maryland, would be also be unconstitutional, write Knoll and Mason.

There are ways to make the wage tax constitutional, the authors explain, but they carry negative consequences. Raising the domestic tax rate to 7.3928% would pass allow the tax to pass the internal consistency test, but the sharp tax rise would likely discourage people from living in Philadelphia.

Eliminating the tax paid by nonresidents on income earned in Philadelphia would also work, but it would necessitate domestic and outbound tax increases, encouraging people to leave the city.

Eliminating the outbound tax would also necessitate tax increases, discouraging employment in Philadelphia. And Philadelphia granting a credit for taxes paid by Philadelphia residents to other jurisdictions — which is the plan Maryland enacted — would again necessitate raising tax rates, discouraging both living and working in Philadelphia.

The more fundamental question, the authors note, is whether the Philadelphia wage tax should ultimately be replaced with other taxes.

“In the next few years, the courts will likely declare the City wage tax unconstitutional,” Knoll and Mason write. “That threat is an opportunity for the City to modernize its tax system. Whether Philadelphia takes advantage of that opportunity remains to be seen.”

Knoll is the Theodore K. Warner Professor of Law & Professor of Real Estate, Co-Director of the Center for Tax Law and Policy, and Deputy Dean of the Law School. His scholarship examines how income tax laws affect business and investment decisions and proposes creative alternatives for how those laws could be redesigned.