Sixteen states were lined up in front of the Supreme Court on June 18, blindfolded, and offered a last cigarette. But when Justice Clarence Thomas pulled the trigger, none of them fell.

Ruling 7 to 2 in Harper v. Virginia Department of Taxation, the court, in an opinion written by Thomas, said states that had unlawfully taxed the pension benefits of federal retirees must provide retroactive relief.

Rating agency officials said the ruling had no immediate credit implications for the 16 states, but that they would continue to monitor the situation as it unfolds.

The Supreme Court's decision stemmed from its 1989 ruling in Davis v. Michigan, in which the justices said states may not tax the pension income of federal retirees while exempting from taxation the retirement benefits of former state workers.

In the Harper case, by making the ruling in the Davis case retroactive, the court raised the specter that 16 states with tax provisions similar to those struck down in Michigan would have to make massive refund payments.

The potential liability of the 16 states "is on the order of $2 billion," according to a brief filed in the Harper case by the State and Local Legal Center.

Virginia's liability alone is more than $460 million, state officials have said.

Virginia is far from alone. Arizona faces a potential liability of $261 million, South Carolina could be on the hook for $200 million, and North Carolina could have to plunk down $140 million.

Georgia and Wisconsin each face a $100 million refund liability, and Iowa may have to fork over $50 million.

The Supreme Court stopped short of mandating refunds, however, giving Virginia and the other states an opportunity to dodge the bullet.

"We do not enter judgment for petitioners ... because federal law does not necessarily entitle [the retirees] to a refund," Thomas said.

Thomas said states may be able to avoid refunds altogether if they had provided a meaningful opportunity" for taxpayers to withhold payments and to challenge the validity of the tax.

If not, said Thomas, the states are obligated under the U.S. Constitution to "provide meaningful backward-looking relief."

Even then, the Supreme Court said, the states retain flexibility. Instead of refunds to federal retirees, for example, a state could extend a tax exemption to the pensioners. Or, the state could revoke the exemption for state employees - anything that creates a non-discriminatory tax system.

Because the court did not mandate refunds, rating agency officials said, the financial blow to states could be well below the estimated $2 billion. And they say the impact may not be felt for some time.

"We don't see any immediate implications," said Hyman C. Grossman, a Standard & Poor's Corp. managing director. Grossman noted that the court ordered the Virginia Supreme Court to determine whether the state provides an adequate "pre-deprivation" process for taxpayers to appeal their levies and then decide upon a remedy.

"We don't think there will be a one-year $400 million problem" for Virginia, Grossman said.

Other rating analysts said the ruling appears to give states a good deal of latitude in crafting a remedy.

Less Costly Remedies

James Dearborn, an assistant vice president at Moody's Investors Service, said state courts "can find remedies that cost a lot less than refunds."

Claire G. Cohen, executive vice president at Fitch Investors Service, agreed.

"My understanding to this point is that the ruling was about as good a ruling as the states could have gotten," Cohen said. "It leaves a lot of options open for the states. I'm not looking for huge financial implications."

George W. Leung, a managing director at Moody's Investors Service, said Moody's is discussing the Harper ruling with officials in Virginia and other affected states. But Leung said it is too early to tell what the ultimate impact will be, noting that remedial issues will be dealt with in the lower courts.

As states come up with remedies for their Harper liability, Moody's will incorporate them into their credit analysis, Leung said.

For her part, Cohen said she views it as unlikely that the lower courts will demand massive refunds.

"It seems to me that courts aren't likely to precipitate a cataclysm," Cohen said. "I would assume that as they come up with an appropriate remedy, they would tend not to cause a financial calamity."

She noted that the Virginia Supreme Court has twice ruled in the Harper case that refunds are not necessary, rulings that were based at least in part on the financial hardship refunds would cause the state. The rulings prompted the appeal to the U.S. Supreme Court by the federal retirees.

State officials themselves are confident of vindication. The day the court issued its ruling, Virginia Attorney General Stephen D. Rosenthal said the issue of remedy "has never been litigated, never been decided before in this state. This case is far from being over."

Analysts may be expressing little concern over the Harper ruling, but the dissenters in the case, Justice Sandra Day O'Connor and Chief Justice William H. Rehnquist, warned that state treasuries could be drained.

O'Connor said the court had imposed "crushing and unnecessary liability on the states, precisely at a time when they can least afford it." O'Connor complained that the refund liability facing states "is more than just disproportionate; it is unconscionable.

"Finally and perhaps more important, this burden will not fall on some thoughtless government official or even the group of retirees that benefited from the offending exemption," O'Connor said. "Instead, the burden falls squarely on the backs of the blameless and unexpecting taxpayers of the affected states who, although they profited not at all from the exemption, will now be forced to pay higher taxes and be deprived of essential services."

At the nub of O'Connor's discomfort with the majority's decision was the issue of whether the Davis ruling in 1989 contained a new principle of law. For almost 50 years, a number of states operated under the unchallenged assumption that they could provide preferential tax treatment to state retirees.

Clearly Unfair

Not until the Davis case did it become clear to states that treating state retirees better than federal retirees was illegal under federal law. Consequently, said O'Connor, the Davis ruling was "sufficiently debatable in advance as to fall short of being clearly foreshadowed. "Because states had no way of knowing that their systems were illegal until after Davis was decided, O'Connor said, Davis should not be applied retroactively.

But Justice Anthony Kennedy, who wrote the Davis decision, said in a concurring opinion in Harper that the Davis ruling was based on a federal law that has been on the books for decades.

Joined by now-retired Justice Byron R. White, Kennedy said that "this court is not free to mitigate any financial hardship that might befall Virginia's taxpayers as a result of their state government's failure to reach a correct understanding of the unambiguous dictates of federal law."

The court's decision in the Harper case - to make the Davis ruling retroactive - was based in large part on one line in the Davis decision. In Davis, the court said, "The state having conceded that a refund is appropriate in these circumstances, to the extent appellant has paid taxes pursuant to this invalid tax scheme, he is entitled to a refund."

From that one line, the Supreme Court in Harper concluded that the Davis court had reached the issue of remedy. "Far from reserving the retroactivity question, our response to the appellee's concession constituted a retroactive application of the rule announced in Davis to the parties before the court," Thomas said.

The court went well beyond the narrow issue of whether Davis should be applied retroactively, however. Announcing a new rule on retroactivity, the court said, "When this court applies a rule of federal law to the parties before it, that rule is the controlling interpretation of federal law and must be given full retroactive effect in all cases still open on direct review and as to all events, regardless of whether such events predate or postdate our announcement of the rule."

In a written analysis of the ruling in the June 28 issue of CreditWeek Municipal, Standard & Poor's noted that the court's new retroactivity rule "may be applied to other civil cases in areas such as zoning and condemnation or environmental issues affecting state and local governments."

The court's ruling in Harper is likely to be a hot topic for some time, but its impact may not be fully felt for years.

Cohen of Fitch said that once the lower courts decide upon a remedy, their rulings may well be the subject of further litigation. "It might be years before all this comes to pass," she said.

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