Saturday, December 3, 2011

Michigan Supreme Court Upholds Most of Public Act 38 of 2011 (regarding taxation of pension income); Strikes Down Exemptions Phased-Out Based on Income

Governor Snyder requested an advisory opinion of the Michigan Supreme Court of the constitutionality of PA 38 because of the need to have greater certainty in our state’s budgetary planning. The Court rendered its opinion in “In re REQUEST FOR ADVISORY OPINION REGARDING CONSTITUTIONALITY OF 2011 PA 38”, State of Michigan Supreme Court, No. 143157, Filed November 18, 2011, available online at

This blog posting summarizes the Court findings and their rationale, along with its ramifications. (Note that a complete discussion on the impact of PA 38 on seniors is contained in my blog posting “Tax Reform: Repeal of the MBT and Impact on Seniors”, updating my June 12, 2011 posting with the same title.)

The Court held:

  1. Reducing or eliminating the statutory exemption for public-pension incomes as set forth in MCL 206.30 does not impair accrued financial benefits of a “pension plan [or] retirement system of the state [or] its political subdivisions” under Const 1963, art 9, § 24;

    Rationale: Article 9, section 24 of the Michigan Constitution says nothing about whether pension benefits can be taxed. Article 9, section 2 says, “The power of taxation shall never be surrendered, suspended or contracted away.” The “accrued financial benefits” referred to in section 24 were interpreted to be limited to the deferred compensation embodied in the pension plan. That is, the “deferred compensation” protected as a  “contractual obligation” by section 24 is the pension payments themselves earned by the retiree, while the tax exemption is something distinct and is not the subject of section 24. Thus, there is no contractual right to tax-free pension benefits.
  2. Reducing or eliminating the statutory tax exemption for pension incomes as set forth in MCL 206.30 does not impair a contractual obligation in violation of Const 1963, art 1, § 10 or US Const, art I, § 10(1). 

    Rationale: A fundamental principle of the jurisprudence of both the United States and this state is that one legislature cannot bind the power of a successive legislature. There is a strong presumption that statutes do not create contractual rights. The Court has maintained that absent some clear indication that the legislature intends to bind itself contractually, the presumption is that a law is not intended to create private contractual or vested rights but merely declares a policy to be pursued until the legislature shall ordain otherwise. The Legislature has not indicated any such intention to bind itself, therefore the Legislature is free to change the tax exemption.
  3. Determining eligibility for income-tax exemptions on the basis of date of birth as set forth in MCL 206.30(9) does not violate the equal protection of the law under Const 1963, art 1, § 2 or the Fourteenth Amendment of the United States Constitution;

    Rationale: The United States Supreme Court has made it clear that, unless a classification warrants some  form of heightened review because it
    jeopardizes exercise of a fundamental right or categorizes on the basis of an inherently suspect characteristic, the Equal Protection Clause requires only that the classification rationally further a legitimate state interest. The  Court stated that the right to a tax-free pension was not a constitutional right, much less a “fundamental right”. Further, the Court stated that age has never been held to constitute a “suspect” class, and therefore the states may discriminate on the basis of age without offending the Fourteenth Amendment if the age classification in question is rationally related to a legitimate state interest. The Court discerned a clear rational related to a legitimate state interest. Therefore, there is no violation of equal protection determining eligibility for exemption based on date of birth.
  4. Determining eligibility for income-tax exemptions and deductions on the basis of total household resources as set  forth in MCL 206.30(7) and (9)  does create a graduated income tax in violation of Const 1963, art 9, § 7; and

    Rationale: Article 9, section 7 of the Michigan Constitution provides, “No income tax graduated as to rate or base shall be imposed by the state or any of its subdivisions.”  A graduated income tax is generally understood to be a tax on income that imposes a proportionately greater tax burden on the earnings of higher-income taxpayers than on that of lower-income taxpayers. It was uncontested by the parties that the provisions at issue do not create an income tax graduated as to “rate” because all individual taxpayers will be required to pay a flat 4.35 percent income tax.  Instead, the issue was whether the provisions create an income tax graduated as to “base” because only certain taxpayers, depending on their income levels, will be entitled to (1) the $3700 personal exemption and (2) to the $20,000 or $40,000 deduction.

    A taxpayer’s  “base” consists of his or her net taxable income and exemptions and deductions reduce a taxpayer’s base by reducing the amount of a taxpayer’s income subject to taxation. Income-based exemptions and deductions (ones to which taxpayers are or are not entitled solely as a function of their incomes) result in an income tax that is graduated as to base, which can occur even when all income is taxed at a flat rate. Since both the phase out and ultimate extinction of the both the personal exemption and the $20,000/$40,000 exemption were based solely on income, they violated the prohibition of a graduated income tax.

    It is noteworthy that the Court found no distinction between an exemption based on income vs. “household resources”. Also, the Court cited previous Court opinions upholding the constitutionality of the real property tax credit which is income dependent because it was “in effect a property tax rebate the employs the income tax as a vehicle for its reconciliation” and because the rebate may be received whether any income tax is owed or not. Some may view that as a “distinction without a difference”, but that is the current Court stance.

    It may also be noted that, for people born before 1946, private pensions will continue to not be taxed if under the current exemption threshold of $45,120 for single filers and $93,240 for joint filers (indexed to inflation). The constitutionality of this provision was not challenged, but appears to be just as subject to question as the two provisions that were struck down on the basis of instituting a graduated income tax.

  5. Pursuant to MCL 8.5, the unconstitutional portions of 2011 PA 38 can reasonably be severed from the remainder of the act, which is constitutional with respect to all the issues raised.

    Rationale: Whether the entire PA 38 could stand when a part was found unconstitutional was a question because the act contains no severability clause. Nonetheless, the Court was convinced that severing these unconstitutional provisions is not inconsistent with the manifest  intent of the Legislature. It therefore excised only those offending sentences and kept the remainder of the act.

Ramifications of the Court ruling: The primary impact will be the loss of revenues to the state of somewhere around $60 million in fiscal year 2011-12 and an estimated $91 million in fiscal year 2012-13. Recent estimates of actual revenue collections in the fiscal year closed on September 30, 2011 show substantially more “surplus revenue” than the loss of revenue in the current fiscal year created by the Court ruling. Therefore, the Legislature will likely not make any near-term adjustments, but rather simply deal with the revised projections in the budget discussions for the 2012-13 budget after the first of the year.

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