President Clinton signed legislation Wednesday that bars California and other states from taxing pension incomes of former residents, in what is believed to be the first assault on so-called source taxes that overall bring more than $500 million annually to California.
The bill, which goes into effect for the 1996 tax year, means that any former California resident who earned a pension while living here will not have to pay California taxes on pension income he or she receives when living in another state. That could result in a significant savings for many because of California's relatively high tax rates.
Indeed, many Californians move to states with no income tax at all, such as Nevada, which made paying the California taxes all the more onerous.
The legislation was championed by Sen. Harry Reid (D-Nev.), who contended that states increasingly have sought to boost revenue through dubious taxes on nonresidents.
"Thousands of retired Nevadans are getting notices from California and other states to pay this dubious 'source tax,' " Reid said late last month, shortly before Congress completed action on the bill.
He and other proponents of the bill argued that nonresidents were unable to benefit from any of the state's public services, so they shouldn't be subject to its taxes. However, California countered that the taxes were due because the pension money was earned while the recipients were California residents and tapping the state's government services and resources. The income was exempt from tax when these individuals were residents because they chose to put the money in tax-deferred retirement plans.
Even though California estimates it will lose $25 million in annual revenues as a result of the new law, state officials are not overly concerned. The amount is a relative drop in the bucket compared with overall tax revenues.
But California officials are worried that the bill could touch off similar laws that would attack the state's ability to collect taxes from other nonresidents. And these taxes are substantial.
In 1992, the most recent year for which statistics are available, 512,000 nonresidents paid more than $500 million in income taxes to California. These taxes are levied on out-of-state entertainers, who give concerts here or come to shoot a film in Hollywood.
They're also levied on professional athletes who play road games in California. And they're assessed on consultants, attorneys and anyone else who arguably earns a portion of his or her income--no matter how small--in the Golden State.
Some critics of source taxes say the worst part about them is that the state determines its tax rate by looking at a person's worldwide income, not just the income earned here.
For example, a baseball player earning $1 million a year and playing two of 50 games in California would owe tax on $40,000 (two-fiftieths of $1 million) in income that was derived from games played here. However, the player's tax rate would be based on his overall earnings, which puts him in the state's highest tax bracket. He'd pay 11.2% of his California-derived earnings in state taxes. The final bill: $4,480.
"Source taxes as a whole are a much bigger issue--and much bigger problem--for the state of California," said Jim Shepherd, spokesman for the Franchise Tax Board in Sacramento. The pension bill "basically said these people are not California residents. They are not partaking of California services. Why should they have to pay an income tax? And, certainly, the issues are very similar."
About 25,000 former Californians--mainly teachers and other government employees--who have retired out of state currently comply with the state's demand to pay tax on their pensions. These former residents will still have to pay 1995 taxes, due this April. However, they will not have to pay California taxes on pension income received in 1996 and beyond.
California officials say they believe far more people should have been paying the pension tax and didn't.
"We believe the people who paid the tax were just the tip of the iceberg," Shepherd said. "We knew we were not catching all the people who were subject to it."