EASY CASES MAKE BAD LAW

Recently, I had the opportunity to thumb through a law student's Contracts textbook. In that volume, a quotation contained in a case caught my eye. In considering a theme for this month's article, I recalled the quotation and thought it particularly appropriate to the case discussed in this article. In the case of Diamond v. University of Southern California, 89 Cal. Rptr. 302,11 Cal.App.3d 49 (1970), an Appellate Court of California criticized its own holding by stating:

"We have, admittedly, taken the easy way out and decided ... on the basis of a simple principle . . . The day may come when that principle . . . will be successfully questioned in another (case), similar in structure, . . . when that day comes, the court concerned with the case can easily confine this decision to its own peculiar facts by noting that easy cases make bad law."

Last month, the United States Supreme Court took the easy way out of a case involving a major consideration of public policy. Unfortunately, it may be difficult to successfully question this case in another action and will be much more difficult to dismiss it by saying "easy cases make bad law."

State of South Carolina v. Baker,
__ U.S. __, 56 U.S.L.W. 4311
(April 20, 1988)

This case could best be described as the "Pandora's Box case." From the opinion rendered by the United States Supreme Court in the case, it is obvious that neither of the litigants expected to find what the Supreme Court held when they lifted the lid to look inside.

In 1984, the State of South Carolina, with leave of the Supreme Court, filed an original action challenging a provision of the Tax Equity and Financial Responsibility Act of 1984 (TEFRA). The issue presented to the Court was whether the provisions of TEFRA which required registration of state and local bonds in order to retain the tax exempt status of interest paid on the bonds was constitutional. Some four years later, the Supreme Court responded by not only finding the section constitutional, but also holding that it, is constitutional to tax the interest on all bonds issued by state and local governments.

Subsequent to the filing of the complaint, the Supreme Court chose a Special Master, the Honorable Samuel J. Roberts, to take testimony in the case and file his report and recommendations with the full Supreme Court. The report of the Special Master and the exceptions filed by the State of South Carolina to that report provided the Supreme Court with the cannon fodder necessary to extend its ruling beyond the narrow issues presented by the complaint. It is apparent from a reading of the opinion that neither South Carolina nor Secretary Baker expected or intended that the Supreme Court would reach the issue of constitutionality of interest on bonds of state and local governments. But, that is exactly what happened.

The source of the doctrine that interest paid on state and local government bonds is exempt from taxation originates in the case of Pollock v. Fanners Loan & Trust Company, 157 U.S. 429, which interpreted the Tenth Amendment to the United States Constitution. That case effectively barred the federal government from taxing not only debt obligations of state and local governments but also prohibited the taxation of income derived from any contract or association with the government of a state or its political subdivisions. The theory behind the ruling was that any taxation imposed by the federal government on these types of transactions would result in an increased cost to the governmental party to the contract which was prohibited by the Tenth Amendment. However, as the opinion of Justice Brennan in this case notes, in the years since the 1895 opinion the Supreme Court has chipped away at the outer edges of the doctrine enunciated in Pollock. According to Brennan, "the only pre-modern tax immunity for parties to government contracts that has so far avoided being explicitly overruled is the immunity for recipients of governmental bond interest."

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A substantial portion of the opinion is dedicated to the recantation of holdings in other cases which resulted in the chipping away of the Pollock doctrine. The holding of the court is best summarized by the following:

"We thus confirm that subsequent case law has overruled the holding in Pollock that state bond interest is immune from a non-discriminatory federal tax. We see no constitutional reason for treating persons who receive interest on government bonds differently than persons who receive income from other types of contracts with the government, and no tenable rationale for distinguishing the costs imposed on states by a tax on state bond interest from the costs imposed by a tax on the income from any other state contract. . . . the owners of state bonds have no constitutional entitlement not to pay taxes on income they earn from state bonds, and states have no constitutional entitlement to issue bonds paying lower interest rates than other issuers."

In so holding, the court ignores suggestions by both South Carolina and the Secretary that Pollock not be overruled. In fact, the opinion briefly addresses the suggestion by Treasury Secretary Baker:

"The Secretary and the Master, however, suggests that we should uphold the constitutionality of Section 310 without explicitly overruling Pollock because Section 310 does not abolish the tax exemption for state bond interest entirely but rather taxes the interest on state bonds only if the bonds are not issued in the form Congress requires. In our view, however, this suggestion implicitly rests on a rather mischievous proposition of law.. . . We thus decline to follow a suggestion that would force us to embrace implicitly a proposition of law far more controversial than the current validity of Pollock's ban on taxing state bond interest, . . ."

As an alternative, Justice Brennan suggests that the states and their political subdivisions should resort to the "national political process" to find "their protection from congressional regulation" and "not through judicially defined spheres of unregulable state activity." This alternative is attacked by Justice O'Connor in her dissent filed with the opinion. Quoting Professor Lawrence Tribe of the Harvard School of Law, she writes,

"Although Congress is taking 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)."

The overall tone of the dissent by Justice O'Connor indicates her understanding of the problems of state and local government finance, which probably originate from her experience as a state legislator.

According to Justice O'Connor, it is her feeling that the true issue in the case was not reached in a proper manner.

"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.' (citations omitted) In my view, the court shirks its responsibility because it fails to inquire into the substantial adverse affects on state and local governments that would follow from federal taxation of the interest on state and local bonds."

The dissent continues by pointing out the volume and uses of tax exempt financing in this country and repeats the finding of the Special Master that states would have to increase the interest rates paid by them for borrowings by 28% to 35% if the interest is made subject to federal income tax. Justice O'Connor then points out that the previous opinions interpreting the intergovernmental tax immunity doctrine have considered the practical effects of the actions under review and asserts her feeling that the court has failed to consider the potential impact in this case. Concluding, she writes,

"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.' (citations omitted) Justice Holmes later qualified this principle observing that '[t]he power to tax is not the power to destroy while this Court sits.' (citations omitted) If this Court is the

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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."

In addition to the dissent of Justice O'Connor, Chief Justice Rehnquist and Justice Stevens concur with the result, however both indicate in their concurring opinions that the majority goes too far in its holding. According to the Chief Justice, "this well-supported conclusion that Section 310(b)(l) [the registration requirement] has a de minimus impact on the States should end, rather than begin, the Court's constitutional inquiry." In his concurrence. Justice Stevens, although agreeing with the outcome, suggests similar concerns to those voiced by Justice O'Connor by writing "it should be emphasized, however, that neither the Court's decision today, nor what I have written in the past, expresses any opinion about the wisdom of taxing the interest on bonds issued by state or local governments." Clearly, the majority in the case did not consider the potential impact of additional financial burdens on state and local government that may be affected by the decision. The overruling of the Pollock intergovernmental tax immunity doctrine spells the end of the constitutional protection previously thought to exist against federal income taxation of the interest on state and local government debt obligations. The route chosen by the majority to reach this conclusion suggests, not that the protection did not exist, rather that the passage of time and the erosion of the Pollock doctrine leads to a logical next step of overruling Pollock with finality. However, as Justice O'Connor has pointed out, the opinion of the court fails to consider the necessity of Constitutional protection of the States from a future tax reform frenzy that may result in taxation of interest on state and local government bonds. The immediate impact to state and local governments will probably be minimal. Right now, the bond markets, government officials and legislators all profess their determination to protect state and local governments from the additional burden of increased costs resulting from taxation of interest on state and local government bonds. However, with the passage of time, that vigilance may wane and the political climate may become such that taxation of this interest will be considered. It will be at that time when state and local governments must marshall their forces to, as Justice Brennan recommends, petition the national political process to avoid such a consequence.

This case, questioning a single provision of a single law, could have been decided without resort to the sweeping changes made by the court. Maybe the case was too easy for the court to consider without a full review of the constitutional doctrine supporting the principle. In any event, this case is one that suggests that the California Appellate Court was correct — easy cases do make bad law. •

May 1988 / Illinois Municipal Review / Page 11