Intergovernmental Tax Immunity — McCulloch's Legacy and Limits

One of the foundational principles of American constitutional law — established in McCulloch v. Maryland (1819) — is that the power to tax is the power to destroy. Maryland had imposed a tax on the notes issued by the Bank of the United States, a federal institution; the Supreme Court held the tax unconstitutional. Chief Justice Marshall's reasoning: the federal government's constitutional supremacy requires that states not be able to use their taxing power to destroy federal instrumentalities. A state cannot do indirectly through taxation what it cannot do directly through regulation. From this foundation evolved a broader intergovernmental tax immunity doctrine — an implied constitutional principle that neither the federal government nor the states may impose taxes that directly burden the governmental operations of the other sovereign. For much of the 19th and early 20th centuries, the doctrine was expansive: states could not tax federal employees' salaries, and the federal government could not tax state and local government employees' salaries. The 1930s and 1940s substantially narrowed the doctrine: the Supreme Court held that the federal government can tax state employees' salaries (Helvering v. Gerhardt, 1938) and that states can tax federal employees' salaries (Graves v. New York ex rel. O'Keefe, 1939), as long as the tax is non-discriminatory. Today, the doctrine's core principle — that states may not discriminatorily tax the United States or its instrumentalities, and the United States may not discriminatorily tax state governmental operations — is established. But the blanket immunity that Marshall's McCulloch rhetoric suggested has been substantially replaced by a more modest rule: non-discriminatory taxes on activities related to federal or state operations are permissible; taxes specifically targeting federal or state instrumentalities because of their governmental character are not.

Current Law (2026)

Legal Authority

• U.S. Const. art. VI, cl. 2 — Supremacy Clause: federal law is supreme over conflicting state law — structural basis for federal immunity from state taxation
• U.S. Const. art. I, § 8 — Necessary and Proper Clause — federal instrumentalities created under this power are immune from state taxation that would destroy them
• McCulloch v. Maryland, 17 U.S. 316 (1819) — Maryland's tax on the Bank of the United States unconstitutional; "the power to tax involves the power to destroy"; states cannot tax federal instrumentalities
• Collector v. Day, 78 U.S. 113 (1871) — (Effectively overruled) Federal income tax could not be applied to a state judge's salary; early recognition of reciprocal state immunity — later abandoned
• Panhandle Oil Co. v. Mississippi ex rel. Knox, 277 U.S. 218 (1928) — State gasoline tax applied to gasoline sold to U.S. Navy struck down; the economic burden fell on the federal government
• Helvering v. Gerhardt, 304 U.S. 405 (1938) — Federal income tax applies to salaries of employees of the Port of New York Authority (state instrumentality); non-discriminatory federal taxes on state employees are constitutional
• Graves v. New York ex rel. O'Keefe, 306 U.S. 466 (1939) — New York income tax may be applied to a federal employee's salary; Collector v. Day overruled; non-discriminatory state taxes on federal employees are constitutional
• United States v. New Mexico, 455 U.S. 720 (1982) — Federal contractors are not federal instrumentalities for tax immunity purposes; New Mexico gross receipts tax on contractors performing work for the United States does not violate intergovernmental tax immunity
• Davis v. Michigan Department of Treasury, 489 U.S. 803 (1989) — Michigan's tax exemption for state government employees' pensions but not federal employees' pensions violates the doctrine of intergovernmental tax immunity; discriminatory taxation of federal employees is unconstitutional even if the overall tax is non-discriminatory

Key Mechanics

Intergovernmental tax immunity operates as a constitutional constraint in two directions: federal immunity from state taxation and state immunity from federal taxation. Federal immunity from state taxation: states cannot impose taxes that directly burden the federal government — its property, its operations, or its instrumentalities. The immunity is absolute for direct taxes on federal property or operations; it does not protect federal contractors or third parties who deal with the federal government unless those parties are themselves federal instrumentalities. Under United States v. New Mexico (1982), federal contractors working on government projects are NOT immune from state tax — they can be taxed by the state even if the economic burden is ultimately passed to the federal government. Non-discrimination rule for individuals: states may tax federal employees' income so long as the tax applies non-discriminatorily to all employees regardless of employer. But if a state exempts its own employees' pensions while taxing federal employees' pensions, it violates intergovernmental tax immunity under Davis v. Michigan (1989). State immunity from federal taxation: states and their instrumentalities are not generally immune from non-discriminatory federal taxes; federal income tax applies to state employees' salaries (Graves, 1939), and federal excise taxes apply to state government purchases unless Congress expressly exempts them. Congress has exempted interest on state and local government bonds from federal income tax (26 U.S.C. § 103) as a policy matter — not a constitutional requirement. The practical result: the constitutional doctrine is narrow (protecting against discriminatory or direct-burden taxation) while the bulk of the intergovernmental tax relationship is determined by statutory exemptions.

How It Works

The Foundation: McCulloch v. Maryland

The intergovernmental tax immunity doctrine begins with McCulloch v. Maryland (1819). Maryland imposed a tax on notes issued by any bank not chartered by the state — which in practice applied only to the Second Bank of the United States. James McCulloch, the Bank's cashier, refused to pay the tax; Maryland sued.

Chief Justice Marshall's opinion addressed two questions: Did Congress have the power to charter a national bank? (Yes — under the Necessary and Proper Clause.) Could Maryland tax the Bank? (No.) The second holding gave the doctrine its famous formulation: "the power to tax involves the power to destroy." If a state could tax a federal institution, it could tax it out of existence. The supremacy of the federal government — established by the Constitution's text and structure — means that states cannot use their taxing power to impede or burden the federal government's constitutional operations.

Marshall acknowledged the principle was not absolute: "We are not driven to the perplexing inquiry... so unfit for the judicial department, what degree of taxation is the legitimate use, and what degree may amount to the abuse of the power." The constitutional limit is not on the amount of taxation — a very small tax might be constitutional — but on the discrimination against federal instrumentalities because of their federal character. A tax that specifically targets the federal government or federal institutions, or that imposes on them burdens not imposed on comparable private entities, is constitutionally suspect.

The Doctrine's Expansion and Contraction

Following McCulloch, the Court initially read the doctrine expansively. Collector v. Day (1871) extended a reciprocal immunity to state governments: if states cannot tax federal instrumentalities, the federal government cannot tax state instrumentalities. The Court therefore held that a state judge's salary was immune from federal income tax. This reciprocal immunity expanded: federal employees' salaries were immune from state income taxes, and state employees' salaries were immune from federal income taxes.

By the 1930s, the scope of the reciprocal immunity had become unwieldy and economically significant. The Revenue Act of 1938's conflict with state employees receiving tax exemptions on federal government work generated political friction. The New Deal Court reconsidered the doctrine's scope.

Helvering v. Gerhardt (1938): The Port of New York Authority (PNYA), jointly operated by New York and New Jersey, employed engineers whose salaries were challenged as immune from federal income tax. The Supreme Court upheld the federal tax. The test shifted from whether the entity was a state instrumentality (which would trigger immunity) to whether the tax was specifically targeted at state functions and would meaningfully impair state operations. Non-discriminatory income taxes on employees of state instrumentalities do not impair state sovereignty because the tax burden falls on the employee, not directly on the state.

Graves v. New York ex rel. O'Keefe (1939): New York sought to tax a federal employee's salary; the employee claimed immunity under the reciprocal doctrine. The Supreme Court overruled Collector v. Day and held that non-discriminatory state income taxes on federal employees' salaries are constitutional. Chief Justice Stone's majority held that the test should not be whether the economic incidence of the tax can be traced to the federal government — any tax on anyone ultimately affects others — but whether the tax places a direct burden on the federal government itself.

After Graves and Gerhardt, the reciprocal immunity for salaries was effectively eliminated. Both federal employees' salaries and state employees' salaries can be taxed by the opposite sovereign, as long as the tax is non-discriminatory.

The Modern Doctrine: Discrimination vs. Non-Discrimination

The key modern distinction is between discriminatory and non-discriminatory taxes:

Non-discriminatory taxes — taxes that apply equally to all taxpayers (federal employees, state employees, private employees; federal contractors, state contractors, private contractors) — are generally permissible. A state sales tax that applies to everyone, including federal employees making purchases in their official capacity, does not violate intergovernmental tax immunity simply because federal employees are among those taxed.

Discriminatory taxes — taxes that specifically target the United States, federal instrumentalities, or federal operations because of their federal character — violate the doctrine. Davis v. Michigan Department of Treasury (1989) is the leading modern case: Michigan exempted state and local government employees' pensions from state income tax but did not exempt federal employees' pensions. The Supreme Court struck down this discriminatory exemption — Michigan was treating federal employees less favorably than state employees for no reason related to state regulatory policy. The discrimination itself was the constitutional violation.

The Davis rule: if a state exempts its own employees from a tax while taxing comparably situated federal employees (or vice versa), the differential treatment is unconstitutional unless it is justified by non-tax-related reasons (different regulatory programs, different constitutional structures). Symmetry is required: a state that taxes federal employees must tax state employees at the same rate, and vice versa.

Federal Contractors and the Limits of Immunity

United States v. New Mexico (1982) addressed the scope of immunity for federal contractors — private companies performing work for the federal government. New Mexico imposed a gross receipts tax and a use tax on federal contractors operating within the state; the United States claimed the taxes were unconstitutional burdens on the federal government.

The Supreme Court rejected the federal government's position. Federal contractors are not federal instrumentalities for immunity purposes. The fact that a tax ultimately increases costs for the federal government (by raising what contractors charge) does not make the tax a "direct burden" on the United States. The immunity doctrine protects the United States itself — not everyone who does business with the government. Federal contractors have their own separate legal existence; they pay taxes on their own revenues; and if those taxes increase the price the government pays for services, that is not constitutionally different from any other market factor affecting government procurement costs.

State and Local Bond Interest: Statutory, Not Constitutional

One of the most practically significant aspects of intergovernmental tax immunity in modern law is the exemption of state and local bond interest from federal income tax — a provision in the Internal Revenue Code (26 U.S.C. § 103). The Supreme Court in South Carolina v. Baker (1988) held that this exemption is not constitutionally required — states do not have a constitutional immunity from federal taxation of their bond interest. Congress may remove the exemption if it chooses.

The 26 U.S.C. § 103 exemption is entirely statutory. Congress has chosen to exempt state and local bond interest because doing so reduces states' borrowing costs (investors will accept lower yields if the interest is tax-exempt) and facilitates state and local government capital formation. The constitutional doctrine does not require this exemption — it is a policy choice Congress has made.

The municipal bond exemption matters enormously in practice: the billions of dollars of state and local government borrowing that funds schools, roads, water systems, and hospitals every year depends partly on investors' willingness to hold lower-yielding tax-exempt bonds rather than taxable private securities. If Congress eliminated the exemption, states' borrowing costs would rise significantly.

How It Affects You

If you are a federal employee paying state income taxes: Non-discriminatory state income taxes on your federal salary are constitutional — you have no immunity claim for a state income tax that applies equally to all wage earners in the state. However, if your state exempts its own public employees' pensions while taxing your federal pension, Davis v. Michigan gives you a constitutional claim. Challenge discriminatory state tax treatment of federal employees or federal pensions: the state must treat federal employees as favorably as comparable state employees. Contact the Department of Justice's Tax Division or consult a federal tax attorney if you believe your state is applying discriminatory tax treatment to federal employee compensation.

If you are a government contractor or vendor to the federal government: Your business is not a federal instrumentality and has no constitutional tax immunity claim based on the fact that you work for the federal government. State and local taxes (sales taxes, gross receipts taxes, property taxes) apply to your business activities even when you are performing federal contracts. However, many federal contracts include clauses specifying how state and local taxes are handled — some contracts allow you to pass through state tax costs to the federal government; others do not. Review your contract's terms regarding state tax treatment.

If you are a state or local tax official: The Davis non-discrimination principle requires symmetrical treatment of federal and state government employees. You may not exempt state employees' pensions from state income tax while taxing federal employees' pensions; you may not exempt state government property from local property taxes while taxing federal property on different terms. Your tax system must treat federal and state governmental operations with symmetrical treatment. Non-discriminatory taxes that apply to all taxpayers equally — including federal and state employees — are constitutional. Consult state tax counsel before implementing any differential treatment of federal employees or federal operations.

If you are a state or local government official managing bond-financed projects: The exemption of state and local bond interest from federal income tax (26 U.S.C. § 103) significantly reduces your borrowing costs — investors accept lower yields on tax-exempt bonds, which reduces the interest rate you pay. This exemption is statutory, not constitutional, meaning Congress could eliminate or modify it. Track federal tax legislation: any change to the municipal bond exemption would significantly affect your cost of capital for infrastructure and public works projects. The Tax Cuts and Jobs Act (2017) eliminated the exclusion for advance refunding bonds and limited some uses of tax-exempt bonds; these restrictions increased financing costs for some state and local government projects.

State Variations

Intergovernmental tax immunity is a federal constitutional doctrine. State variation arises primarily through:

State taxation of federal activities: States vary in how aggressively they try to tax federal operations and federal employees. Some states have historically sought to apply broad taxes to federal contractors and federal operations, generating litigation over the New Mexico limits on contractor immunity. Other states have proactively enacted exemptions for federal activities to avoid litigation and maintain cooperative federalism relationships.

State property tax exemptions: Federal government property is exempt from state and local property taxes under the federal property tax immunity doctrine (distinct from but related to intergovernmental tax immunity). Payments in Lieu of Taxes (PILT) from the federal government to local governments compensate localities for lost property tax revenue from federal lands. States with large federal land holdings (Alaska, Nevada, Utah, Wyoming) have ongoing negotiations about PILT levels.

State bond tax exemption programs: States may choose to exempt other states' municipal bond interest from state income tax as a matter of comity or policy — or they may not. Many states exempt only their own bonds' interest from state income tax, taxing interest from other states' bonds. After South Carolina v. Baker, this state-to-state discrimination in bond tax treatment has been challenged; the constitutional question of whether Davis-style discrimination principles apply to reciprocal state bond tax treatment has not been definitively resolved.

Pending Legislation

• Municipal bond exemption changes: The federal exemption for state and local bond interest (26 U.S.C. § 103) is periodically proposed for modification in budget and tax legislation; eliminating or capping the exemption would raise federal revenue but increase state and local borrowing costs.
• Federal property tax reform: Periodic proposals to reform PILT programs and adjust federal payments to localities for federal land holdings; the intergovernmental tax immunity doctrine limits states' ability to tax federal land but does not require federal payments, which are entirely statutory.
• Contractor tax treatment: Proposed simplification of federal contracting rules related to state and local tax pass-through provisions; under New Mexico, states may tax contractors performing federal work, but contractors and the federal government negotiate how those taxes are reflected in contract pricing.

Recent Developments

• 2017 — Tax Cuts and Jobs Act: Eliminated the tax exemption for advance refunding bonds (using new bonds to retire old bonds before their call date) and imposed new limitations on private activity bonds; these changes raised financing costs for some state and local infrastructure projects and generated ongoing litigation about the boundaries of the statutory exemption and the intergovernmental immunity doctrine.
• 2020 — COVID-19 fiscal relief: CARES Act and ARPA provided direct federal payments to state and local governments; the intergovernmental immunity doctrine does not affect direct federal-to-state transfers, but the scale of federal fiscal intervention raised questions about federalism and conditionality that implicate the broader intergovernmental constitutional framework.
• 2024–2026 — Federal building tax litigation: Litigation continues in several jurisdictions over whether state or local governments can impose special assessments, environmental fees, or other charges on federal property that would be unconstitutionally discriminatory under the Davis framework; the Supreme Court has not granted certiorari on the most recent circuit conflicts.