                    SUPREME COURT OF ARIZONA
                             En Banc

CLARK J. KERR and BILLIE SUE      )   Arizona Supreme Court
KERR, husband and wife, SUSAN     )   No. CV-03-0110-PR
MORAN, STEVE ALLEN and JOHN       )
UDALL, individually and as        )   Court of Appeals
representatives of the class      )   Division One
comprised of federal employees    )   No. 1 CA-TX 00-0023
who paid Arizona income taxes on  )
federal retirement contributions  )   Arizona   Tax Court
during one or more of the years   )   Nos. TX   97-00119
1984 to date,                     )        TX   97-00131
                                  )        TX   97-00150
            Plaintiffs-Appellees, )
                Cross-Appellants, )
                                  )   O P I N I O N
                 v.               )
                                  )
MARK J. KILLIAN, in his capacity )
as Director of the Arizona        )
Department of Revenue, the        )
ARIZONA DEPARTMENT OF REVENUE OF )
THE STATE OF ARIZONA,             )
                                  )
           Defendants-Appellants, )
                 Cross-Appellees. )
__________________________________)
                                  )
STATE OF ARIZONA ex rel., the     )
ARIZONA DEPARTMENT OF REVENUE,    )
                                  )
             Plaintiff-Appellant, )
                  Cross-Appellee, )
                                  )
                 v.               )
                                  )
CLARK J. KERR and BILLIE SUE      )
KERR, husband and wife,           )
                                  )
            Defendants-Appellees, )
                Cross-Appellants. )
__________________________________)
                                  )
CLARK J. KERR and BILLIE SUE      )
KERR, husband and wife; and       )
their ATTORNEYS, BONN, LUSCHER,   )
PADDEN & WILKINS, CHARTERED and   )
O'NEIL, CANNON & HOLLMAN, S.C.,   )
                                  )
      Counterclaimants-Appellees, )
                Cross-Appellants, )
                                  )
                 v.               )
                                  )
STATE OF ARIZONA ex rel., the     )
ARIZONA DEPARTMENT OF REVENUE,    )
                                  )
      Counterdefendant-Appellant, )
                  Cross-Appellee. )
                                  )
__________________________________)

        Appeal from the Superior Court of Maricopa County
                         Arizona Tax Court
           The Honorable William J. Schafer, III, Judge
               The Honorable Susan R. Bolton, Judge

                  REVERSED IN PART AND REMANDED


          Opinion of the Court of Appeals, Division One
                    204 Ariz. 485, 65 P.3d 434

                         VACATED IN PART


BONN & WILKINS, CHARTERED                                   Phoenix
     By: Paul V. Bonn
          Randall D. Wilkins
          D. Michael Hall
          Brian A. Luscher

and

O’NEIL, CANNON & HOLLMAN, S.C.                      Milwaukee, WI
     By: Eugene O. Duffy
Attorneys for Appellees, Cross-Appellants

TERRY GODDARD, ATTORNEY GENERAL                             Phoenix
     By: Michael P. Worley
Attorneys for Appellant, Cross-Appellee




                                  2
H U R W I T Z, Justice

¶1         The question in this case is whether Arizona’s income

tax scheme violates the intergovernmental tax immunity doctrine

because   it    effectively    subjects   federal     employees’      mandatory

retirement     contributions   to   current    taxation,      while   deferring

taxation of similar contributions by state and local employees.

We conclude that the state income tax code does not discriminate

against federal employees because of the source of their pay or

compensation, and thus does not violate the intergovernmental

tax immunity doctrine, codified in 4 U.S.C. § 111(a) (2000).

                                     I.

¶2         This case has a long and complicated procedural and

substantive history.     This litigation commenced in 1989 and has

been the subject of five prior reported appellate opinions.1                 We

begin with a review of the “long strange trip”2 that brought this

case here.




     1
          See Kerr v. Killian, 204 Ariz. 485, 65 P.3d 434 (App.
2003) (“Kerr V”); Kerr v. Killian, 201 Ariz. 125, 32 P.3d 408
(App. 2001) (“Kerr IV”); Kerr v. Killian, 197 Ariz. 213, 3 P.3d
1133 (App. 2000) (“Kerr III”); Kerr v. Waddell, 185 Ariz. 457,
916 P.2d 1173 (App. 1996) (“Kerr II”); Kerr v. Waddell, 183
Ariz. 1, 899 P.2d 162 (App. 1994) (“Kerr I”). We refer in this
opinion to these previous opinions by the parenthetical
shorthands above.
     2
          Grateful    Dead,    Truckin’,      on   American    Beauty   (Warner
Bros. 1970).

                                      3
                          A.        The Federal Tax Code

¶3            This    controversy         has       its    origins       in    several       arcane

provisions of the federal tax code.                            Under various sections of

the   Internal       Revenue    Code,      including            I.R.C.    §§    401    and    403,

governmental        employers       may    choose         to    establish      “contributory”

retirement      plans.          A    typical          plan       requires       employees         to

contribute      a     portion       of     their          income     to       the     plan    (the

“employee’s      contribution”)           and       the    employer       then       contributes

additional funds (the “employer’s contribution”).

¶4            In the abstract, both the employee’s and employer’s

contributions would seem to be current taxable income to the

employee; the former comes out of the employee’s salary, while

the latter is plainly a benefit conferred by the employer as a

result   of    the    employee’s          labor.          See    generally          I.R.C.    §   61

(defining     gross     income       as    “all       income       from       whatever       source

derived”).      But, in what has aptly been termed “one example of

the dominance of form over substance in the tax code,” Howell v.

United States, 775 F.2d 887, 887 (7th Cir. 1985), federal tax

law   distinguishes       between         the       employee’s       and       the    employer’s

contributions.         An employer’s contribution to a retirement plan

“qualified” under I.R.C. §§ 401(a) and 403(a) is not treated as

taxable income for the employee until the plan pays benefits to

the employee.          See Howell, 775 F.2d at 887.                             An employee’s

contribution to a retirement plan, however, is generally treated


                                                4
as current taxable income to the employee, even if the employee

is mandated to make the contributions out of his current pay.

See   generally   United       States      v.     Basye,    410    U.S.   441,    449-50

(1973)     (treating         contributions            to    retirement         plan     as

“anticipatory     assignments         of     income”).       The    employee     is    not

taxed,    however,     on    the     eventual     distributions         from   the    plan

corresponding to his taxable contributions.                    See I.R.C. § 72.

¶5          In 1974, Congress complicated the situation further by

enacting Pub. L. No. 93-406, 88 Stat. 825 (1974), codified at

I.R.C. § 414(h)(2).           Section 414(h)(2) provides that if a state

or local governmental employer “picks up” employee contributions

to    a   plan    qualified          under       §§   401(a)       or   403(a),       “the

contributions     so        picked    up     shall     be   treated       as    employer

contributions,” and thus not subjected to current income tax.

The Internal Revenue Service has established two criteria that

must be met before a state or local government can “pick up”

employee contributions:

      First,   the    employer   must    specify    that   the
      contributions,    although   designated    as   employee
      contributions, are being paid by the employer in lieu
      of contributions by the employee.           Second, the
      employee must not have the option of choosing to
      receive the contributed amounts directly instead of
      having them paid by the employer to the pension plan.

Rev. Rul. 81-35, 1981-1 C.B. 255.




                                             5
                        B.      Arizona’s Income Tax Scheme

¶6           In 1979, Arizona adopted federal adjusted gross income

(“AGI”)     as    the    starting       point       for   computing            Arizona         taxable

income.      1978       Ariz.     Sess.       Laws,    ch.      213,       §    2    (codified      as

amended     at    Arizona       Revised       Statutes         (“A.R.S.”)            §    43-1001(2)

(Supp. 2003) (“‘Arizona gross income’ of a resident individual

means the individual’s federal adjusted gross income for the

taxable     year,       computed        pursuant          to     the       internal            revenue

code.”)).         The    income     tax       statutes         list    a       series      of    items

Arizona taxpayers must add to, or may subtract from, federal AGI

to reach their Arizona taxable income.                            See A.R.S. § 43-1021

(Supp.     2003)   (listing        twenty-seven           additions);               id.   §    43-1022

(listing twenty-nine subtractions).

¶7           At the same time that the legislature adopted federal

AGI   as    the    starting        point       for    calculating              Arizona         taxable

income, it also amended the state tax code to allow state and

local      employees         to    subtract           their       mandatory               retirement

contributions from Arizona gross income.                         1978 Ariz. Sess. Laws,

ch. 213, § 2 (codified at A.R.S. § 43-1022(2) (Supp. 1978)).

Under      the     version        of      §     43-1022(2)             adopted            in     1978,

“[c]ontributions         made      to     the       state      retirement             system,      the

judges’ retirement fund, the public safety personnel retirement

system or a county or city retirement plan” could be subtracted




                                                6
from        the    employee’s       Arizona        gross     income.3         In    1982,   the

legislature             added     mandatory        contributions         to    the     elected

officials’ retirement plan (“EORP”) to the list of subtractions.

1982 Ariz. Sess. Laws, ch. 126, § 2 (codified at A.R.S. § 43-

1022(2)           (Supp.    1982)).           In       1986,    contributions         to    the

corrections officer retirement plan (“CORP”) were added to the

list.        1986 Ariz. Sess. Laws, ch. 325, § 3 (codified at A.R.S. §

43-1022(2) (Supp. 1986)).4

¶8                In    addition     to   allowing         subtractions        from    Arizona

taxable           income    of     employee        contributions         to    the     various

retirement plans, Arizona law also provided until 1989 that all

benefits paid to employees under those plans could likewise be

subtracted.             See A.R.S. § 43-1022(3) (Supp. 1988).                      Thus, state

and local employees could avoid Arizona taxation altogether on

retirement             benefits,     regardless         of     whether    these       benefits

derived            from         employers’         contributions          or        employees’

contributions.             In 1989, however, Davis v. Michigan Department

of Treasury, 489 U.S. 803 (1989), held that a similar Michigan

statute violated principles of intergovernmental tax immunity,

by favoring retired state and local governmental employees over

        3
          We refer in this opinion to the Arizona state
retirement system as “ASRS” and the public safety personnel
retirement system as “PSPRS.”
        4
          The same law removed contributions to the judges’
retirement fund from the list of permitted subtractions, as that
fund had been combined with EORP. See A.R.S. § 38-802 (2001).

                                                   7
federal employees, who were not allowed to deduct retirement

benefits from their taxable Michigan income.

¶9                The Arizona legislature promptly reacted to Davis by

amending A.R.S. § 43-1022(3) to eliminate benefits received from

state       and    local       retirement     plans          from     the   list    of    permitted

subtractions            from    Arizona     gross           taxable    income.5          1989    Ariz.

Sess. Laws, ch. 312, § 12.                    The same statute also removed from

the list of statutory subtractions contributions to ASRS, EORP,

and   county         or    city    retirement           plans.          Id.        In    1991,        the

legislature removed mandatory contributions to CORP and PSPRS

from its list of subtractions from Arizona gross income.                                          1991

Ariz.       Sess.       Laws,    ch.   155,     §       8    (retroactively         effective         to

January 1, 1991).

¶10               Thus, for tax years after 1990, Arizona law has not

provided          for     subtraction         from          gross     income       for    mandatory

employee contributions to any state or local retirement plans

and   it     has     treated      benefits      received            from    federal,          state   or

local plans similarly.                  This did not mean, however, that all

employee          contributions        were    immediately             subjected         to    current

Arizona tax.



        5
          At the same time, the legislature amended § 43-1022 to
allow the annual deduction of up to $2500 of retirement benefits
received by the taxpayer from either state or federal retirement
systems. 1989 Ariz. Sess. Laws, ch. 312, § 12 (now codified at
A.R.S. § 43-1022(2) (Supp. 2003)).

                                                    8
¶11         Beginning    in   1985,       the    legislature        had   enacted

statutes authorizing certain state retirement plans to “pick up”

employee contributions pursuant to I.R.C. § 414(h)(2).                      1985

Ariz. Sess. Laws, ch. 294, § 4 (now codified at A.R.S. § 38-

736(B)    (2001)   (authorizing   ASRS     pick      up));   1985   Ariz.   Sess.

Laws, ch. 309, § 4 (now codified at A.R.S. § 38-810(E) (2001)

(authorizing EORP pick up)); 1986 Ariz. Sess. Laws, ch. 325, § 1

(now codified at A.R.S. § 38-892 (2001) (authorizing CORP pick

up)).     Prior to 1989, ASRS and EORP had already opted to pick up

employee     contributions     pursuant         to     §     414(h)(2);     these

contributions were therefore not included in federal AGI, and

thus not subject to current Arizona tax, notwithstanding the

elimination of the previous subtractions in 1989.6

¶12         Although CORP had received legislative authorization

to pick up employee contributions in 1986, it did not elect to


      6
          In addition to the subtractions from income previously
set forth in A.R.S. § 43-1022(2) for contributions to state
retirement plans, the statutes governing ASRS and EORP have long
provided that member contributions “are exempt from state,
county and municipal taxes.” 1953 Ariz. Sess. Laws, ch. 128, §
22 (now codified at A.R.S. § 38-792(A) (2001) (ASRS)); 1985
Ariz. Sess. Laws, ch. 309, § 4 (now codified at A.R.S. § 38-811
(2001) (EORP)). The same statutes also previously exempted from
state taxation benefits received from these funds; those
exemptions were removed in 1989 in the same law that eliminated
the authorization for subtractions from income. See 1989 Ariz.
Sess. Laws, ch. 312, § 6 (ASRS); id. § 8 (EORP).     Presumably,
the legislature did not remove the exemption of the member
contributions in 1989 in light of the preexisting pick ups under
§ 414(h)(2) by ASRS and EORP.



                                      9
do so immediately; its pick up was first effective on July 1,

2000.     PSPRS did not receive legislative authorization to pick

up employee contributions until 1999, 1999 Ariz. Sess. Laws, ch.

50, § 4; 1999 Ariz. Sess. Laws, ch. 327, § 22 (now codified at

A.R.S. § 38-843.01 (2001)), and its election was effective at

the same time as CORP’s.7            Thus, throughout the period from 1989

to 2000, the thousands of state and local employees covered by

these     two    plans     paid    current     Arizona      income   tax   on   their

employee contributions.8

                             C.     The § 1983 Action

¶13          Respondents are Arizona taxpayers, each of whom was

employed by the federal government and who paid state income

taxes on mandatory contributions to federal retirement plans.

See   Kerr      I,   183   Ariz.    at   4,    899   P.2d    at   165.     In   1989,

respondents filed a class action under 42 U.S.C. § 1983 against



      7
          Until 1989, the statutes governing CORP and PSPRS,
like the statutes then governing ASRS and EORP, provided that
both benefits received from, and employee contributions to,
these plans were exempt from state taxation.      A.R.S. § 38-852
(1985) (PSPRS); A.R.S. § 38-896 (Supp. 1986) (CORP).      In 1989,
the legislature removed the exemption for benefits from these
statutes. 1989 Ariz. Sess. Laws, ch. 312, § 9 (PSPRS); id. § 10
(CORP).   In 1991, the legislature removed the exemption for
employee contributions from the governing statutes.     1991 Ariz.
Sess. Laws, ch. 155, § 2 (PSPRS); id. § 6 (CORP).
      8
          As of June 30, 2001, some 26,520 state employees were
enrolled in PSPRS and CORP. Resp. Sep. App. Tab 9. This number
was approximately thirteen percent of the total state employee
population. Id.


                                          10
the Arizona Department of Revenue (“ADOR”) and ADOR officials,

alleging      that   Arizona’s     income    tax   scheme   violated    the

intergovernmental tax immunity doctrine codified in the Public

Salary Tax Act of 1939, 4 U.S.C. § 111(a), by treating the

employee      contributions   of   federal   employees   differently   than

those of state employees.          Kerr I, 183 Ariz. at 4, 899 P.2d at

165.9       Respondents challenged both former A.R.S. § 43-1022(2),

under which all employee contributions (even if not picked up by

employers) could be subtracted from Arizona taxable income, and

the use in current § 43-1001(2) of federal AGI as the base for

Arizona taxable income, because it allowed state employees whose

contributions were picked up to avoid current taxation.           Kerr I,

183 Ariz. at 5, 899 P.2d at 166.

¶14           The tax court held that the former version of § 43-

1022(2) violated § 111(a).          Id. at 13-14, 899 P.2d at 174-75.

It rejected, however, the taxpayers’ attack on § 43-1001(2),

holding that any disparity resulting from the application of

I.R.C. § 414(h)(2) to determine federal AGI did not violate the

intergovernmental tax immunity doctrine.           Id. at 14-15, 899 P.2d

at 175-76.       The court of appeals affirmed the tax court with

respect to former § 43-1022(2), id. at 16-17, 899 P.2d at 177-

        9
          The putative class included respondents and all
Arizona taxpayers employed by the federal government who paid
state income tax on their mandatory retirement contributions.
Kerr I, 183 Ariz. at 4, 899 P.2d at 165.



                                      11
78, but reversed with respect to § 43-1001(2), holding that the

effect    of    adopting       federal       AGI    was    to   discriminate         against

federal employees in favor of state employees whose employers

had picked up the employee contributions.                         Id. at 14-15, 899

P.2d at 175-76.

¶15            After ADOR petitioned for review we vacated Kerr I and

remanded for reconsideration in light of National Private Truck

Council,      Inc.     v.   Oklahoma        Tax   Commission,     515    U.S.     582,      585

(1995), which held that before suing under § 1983, plaintiffs

must    first       exhaust    all    “adequate     remedies.”          On     remand,      the

court    of     appeals       held    that    these   plaintiffs         had    failed      to

exhaust their state administrative remedies and remanded to the

tax court with instructions to dismiss the § 1983 action.                                Kerr

II, 185 Ariz. at 467, 916 P.2d at 1183.

                                D.      The Refund Suit

¶16            At    the    same     time    that   they    instituted         the   §   1983

action,    respondents         filed    administrative          claims    with       ADOR    on

behalf of themselves and the class requesting refunds based on

Arizona’s allegedly unconstitutional tax scheme.                          See Kerr III,

197 Ariz. at 215 ¶ 6, 3 P.3d at 1135.                       An ADOR hearing officer

held that the agency had “no legal authority to pass on the

legality of the statutory scheme or to recognize a class refund

claim.”       Id.     Respondents appealed to the Board of Tax Appeals

(“BOTA”), which held that neither ADOR nor BOTA had authority to


                                              12
entertain class refund claims.                Id. ¶ 7.      As to respondents’

individual claims, BOTA held that the adoption of federal AGI in

§ 43-1001(2) did not violate the intergovernmental tax immunity

doctrine and therefore refused to grant refunds for tax years

after 1990.       See Kerr IV, 201 Ariz. at 129 ¶ 11, 32 P.3d at 412.

BOTA, however, held that those respondents who were parties to

the    administrative      proceedings      should    be   granted    refunds      for

taxes paid on their mandatory contributions from 1985 through

1990.       Id. at 128-29 ¶ 11, 32 P.3d at 411-12.10                 The governor

thereafter directed ADOR to make refunds for the tax years from

1985    to    1990   to   all   taxpayers     who    had   filed   timely    refund

claims, whether or not they were parties to the administrative

action.       Id. at 129 ¶ 12, 32 P.3d at 412.11

¶17            Respondents then sought review of the BOTA rulings in

the tax court.       That court denied respondents’ motion to certify

a class consisting of “all current and former federal employees

who    paid    Arizona    income   taxes    on   contributions       they   made   to

       10
          In June 1998, the tax court awarded respondents’
attorneys twenty percent of each refund as fees.   The court of
appeals affirmed that award. Kerr III, 197 Ariz. at 220, 3 P.3d
at 1140.
       11
          ADOR later ruled that “taxpayers who were taxed on
mandatory   retirement    contributions   to   retirement   plans
maintained by the federal government” for tax years prior to
1991 and who timely filed amended returns, refund claims, or
protective claims, were entitled to a refund of excess amounts
paid in those years.    Ariz. Individual Income Tax Ruling 98-1,
available at http://www.revenue.state.az.us/rulings/itr98-1.htm.



                                         13
United   States      Government       retirement       plans     from   1984     to   the

present who have not received refunds of such taxes.”                          Kerr IV,

201 Ariz. at 129 ¶ 13, 32 P.3d at 412.                     The court also denied

the taxpayers’ “alternative motion to certify a class of all

federal employees who filed timely refund claims for one or more

years from 1991 to the present.”                 Id.     The tax court, however,

held that the use of federal AGI as the Arizona tax base in §

43-1001(2)     violated         §    111(a)     because     its    effect      was     to

discriminate      against       federal       employees     in     favor    of    state

employees.     Id.    ADOR appealed and respondents cross-appealed.

¶18         In Kerr IV, concluding the reasoning of Kerr I was

“incomplete and ultimately incorrect,” 201 Ariz. at 130 ¶ 18, 32

P.3d at 413, the court of appeals rejected respondents’ attack

on § 43-1001(2) and thus rejected any claims for refunds for tax

years after 1990.          Id. at 131 ¶ 22, 32 P.3d at 414.                 The court

held that the Arizona taxing scheme did not violate § 111(a),

because it did not discriminate “‘because of the [federal or

state] source of pay or compensation.’”                   Id. (quoting 4 U.S.C. §

111(a)).        Kerr       IV       concluded     that     the     Arizona       scheme

“distinguishes       not   between      state    and     federal    employees,        but

rather between all those whose employers make or pick up their

mandatory contributions and all those whose employers do not.”

Id. ¶ 26.




                                          14
¶19          With respect to tax years 1985 through 1990, Kerr IV

affirmed     the     tax      court’s          conclusion      that   certification          of    a

class of those whose refund claims had been denied would be

redundant and unnecessary.                     Id. at 133 ¶¶ 33-34, 32 P.3d at 416.

As to those in the putative class who had not filed written

refund    claims,         relying         on    Arizona     Department        of    Revenue       v.

Dougherty, 198 Ariz. 1, 6 P.3d 306 (App. 2000) (“Ladewig I”),

the court of appeals held that the tax court acted within its

discretion in denying class status to those taxpayers who had

failed to exhaust applicable statutory administrative remedies.

Kerr IV, 201 Ariz. at 133 ¶ 35, 32 P.3d at 416.

¶20          Shortly after the court of appeals issued Kerr IV, we

held in Arizona Department of Revenue v. Dougherty, 200 Ariz.

515, 29 P.3d 862 (2001) (“Ladewig II”), that a class action can

be    used      as   a    vehicle         for     bringing      and   exhausting         certain

administrative             claims.                Respondents         then         moved      for

reconsideration          of    the    class       action       rulings   in    Kerr     IV   with

respect to tax years 1985 through 1990 in light of Ladewig II;

they     also     sought      reconsideration             of    the   court        of   appeals’

substantive rejection of their claims with respect to tax years

after 1990.

¶21          The         court       of        appeals     granted       the       motion     for

reconsideration and issued the opinion now under review, Kerr V,

204 Ariz. 485, 65 P.3d 434.                       In Kerr V, the court of appeals


                                                  15
held that its analysis in Kerr IV rested on a “narrow, mistaken

application of the literal language of 4 U.S.C. § 111.”                       Id. at

491 ¶ 23, 65 P.3d at 440.            Because the effect of § 43-1001(2)

for tax years after 1990 was to require federal employees to pay

current     Arizona   income   tax   on      their   mandatory     contributions,

while deferring such taxation for state and local employees, the

court of appeals held that United States Supreme Court case law

interpreting § 111(a) mandated that the Arizona scheme be struck

down    unless   it   was   justified     by    “‘significant       differences’”

between these classes.         Id. (quoting Davis, 489 U.S. at 815-16).

Finding none, Kerr V concluded that § 43-1001(2) violated the

intergovernmental tax immunity doctrine.                  Id. at 493-95 ¶¶ 28-

37, 65 P.3d at 442-44.         As to class action issues, the court of

appeals determined that it was best to allow the tax court “a

fresh look” in light of Ladewig II, and remanded to the tax

court for reconsideration of these issues.                  Id. at 496-97 ¶ 46,

65 P.3d at 445-46.

¶22          ADOR     petitioned        for      review         only     on      the

intergovernmental tax immunity issue.                We granted review because

of    the   obvious   statewide   importance         of   the   issue.    We    have

jurisdiction pursuant to Article 6, Section 5(3) of the Arizona

Constitution, Arizona Rule of Civil Appellate Procedure 23, and

A.R.S. § 12-120.24 (2003).




                                        16
                                         II.

¶23         The    intergovernmental         tax    immunity   doctrine       has    its

genesis in M’Culloch v. Maryland, 17 U.S. (4 Wheat.) 316 (1819),

which held that Maryland could not impose a tax on the Bank of

the United States.       See Davis, 489 U.S. at 810.              Until 1938, the

doctrine     was   expansively      interpreted        to    prohibit    state       and

federal    governments       from   taxing     the    salaries    of    the    other’s

employees.        See Jefferson County v. Acker, 527 U.S. 423, 436

(1999), and cases cited therein.

¶24          In the late 1930s, however, the doctrine underwent a

significant “contraction,” id. at 436 n.6, at the hands of the

Supreme Court.       First, in Helvering v. Gerhardt, 304 U.S. 405

(1938), the Court held that the federal government could tax the

salaries of employees of the Port of New York Authority.                            Then,

in Graves v. New York ex rel. O’Keefe, 306 U.S. 466 (1939), the

Court expressly overruled a number of prior decisions and held

that a state’s imposition of an income tax on the salaries of

federal    employees     placed     no   unconstitutional         burden       on    the

federal    government.         Since     Graves,       the   Supreme     Court       has

proclaimed    “a    narrow    approach    to       governmental   tax    immunity.”

United States v. New Mexico, 455 U.S. 720, 735 (1982).                        Case law

after Graves has made plain that the doctrine “barred only those

taxes that were imposed directly on one sovereign by the other




                                         17
or that discriminated against a sovereign or those with whom it

dealt.”    Davis, 489 U.S. at 811.

¶25            In its decisions contracting the intergovernmental tax

immunity doctrine, the Supreme Court has “recognized that the

area      is        one     over         which        Congress       is    the      principal

superintendent.”             Jefferson County, 527 U.S. at 425.                         Shortly

after Graves was announced, Congress adopted the Public Salary

Tax Act of 1939, “the primary purpose of which was to impose

federal    income          tax    on    the    salaries       of    all   state    and    local

governmental         employees.”              Davis,     489       U.S.   at    810.         But,

“concerned that considerations of fairness demanded equal tax

treatment       for       state        and    federal     employees,”          Congress      also

expressly waived in § 4 of the 1939 Act “whatever immunity would

have otherwise shielded federal employees from nondiscriminatory

state taxes.”             Id. at 812.          Section 4, codified at 4 U.S.C. §

111(a),    provides          that       “[t]he   United       States      consents      to     the

taxation       of    pay    or    compensation          for    personal     service       as    an

officer or employee of the United States,” but only “if the

taxation does not discriminate against the officer or employee

because of the source of the pay or compensation.”                                      Section

111(a)    thus       “codified         the    result     in    Graves,”    and     foreclosed

subsequent            broader           judicial         interpretation            of          the

intergovernmental tax immunity doctrine.                             Davis, 489 U.S. at

812.     The Supreme Court has held that the immunity provided in §


                                                 18
111(a)     is      “coextensive           with            the     prohibition            against

discriminatory      taxes           embodied     in       the     modern    constitutional

doctrine of intergovernmental tax immunity.”                         Id. at 813.

                                               A.

¶26         The    initial          inquiry     under       §     111(a)    is     whether      a

challenged      state    tax        discriminates         against        federal       employees

“because of the source” of their compensation.                              If the alleged

discrimination is not because of the federal source of income,

but rather for some other reason, there is no violation of the

intergovernmental tax immunity doctrine.                          See Jefferson County,

527 U.S. at 442-43 (holding that a facially nondiscriminatory

Alabama occupational tax exempting those who held licenses under

other    state     or     county        laws        did     not     violate        §     111(a),

notwithstanding the fact that the plaintiff federal judges could

never    qualify        for        exemption,       because        the     tax     “does      not

discriminate against federal judges in particular, or federal

officeholders in general, based on the federal source of their

pay or compensation”); Cheatham v. Eagerton, 703 So. 2d 389, 391

(Ala.    Civ.    App.    1997)        (holding      that        exemption    of    state      law

enforcement officers’ per-diem subsistence allowance from state

taxation did not violate § 111(a), notwithstanding that federal

officers     received         no    comparable        allowance,         because        the   tax

scheme does not discriminate because of the “source” of the pay

or compensation).


                                               19
¶27         When the state scheme does discriminate because of the

federal    source      of    pay,    the    cases     require      a    second       level     of

analysis.        Imposition of a heavier burden on federal employees

because     of    the       source    of       pay   may      be   justified            only   by

“significant differences between the two classes.”                                 Davis, 489

U.S. at 815-16 (quoting Phillips Chem. Co. v. Dumas Indep. Sch.

Dist., 361 U.S. 376, 383 (1960)).                    In determining whether this

standard    of     justification           is    met,      decisions         in    the     equal

protection field “are not necessarily controlling.”                               Id. at 816.

Rather, the inquiry is whether the inconsistent tax treatment

“is    directly        related       to,    and      justified         by,        ‘significant

differences between the two classes.’”                        Id. (quoting Phillips,

361 U.S. at 383-85).

                                                B.

¶28         The opinion below passed quickly over the first level

of    analysis    required       under     §    111(a).        The     court       of    appeals

apparently started from the premise that because the adoption of

federal    AGI    as    the    Arizona      income      tax    base     in    §     43-1001(2)

effectively required respondents to pay current tax on their

employee contributions while deferring taxation for state and

local employees whose contributions had been picked up under

I.R.C. § 414(h)(2), the Arizona scheme necessarily discriminated

against respondents because of the federal source of their pay.

Kerr V, 204 Ariz. at 440-41 ¶ 24, 65 P.3d at 491-92.


                                                20
¶29           We reach a contrary conclusion.                  At the outset, it is

worth     noting      that    every      Supreme     Court      decision     cited    by

respondents in which a state tax was found to violate § 111(a)

or the intergovernmental tax immunity doctrine involved a tax

statute       which    discriminated        on     its     face    against     federal

employees or federal property.                 For example, in Davis, Michigan

law provided a deduction for retirement benefits paid by the

state or its political subdivisions, but not for benefits paid

by others, including the federal government.                      Davis, 489 U.S. at

805; id. at 814 (“It is undisputed that Michigan’s tax system

discriminates in favor of retired state employees and against

retired federal employees.”).               Similarly, the Kansas tax scheme

struck down in Barker v. Kansas, 503 U.S. 594 (1992), provided a

statutory deduction for benefits received by various state and

federal       retirees,      but    no   deduction       for   military    retirement

benefits.       Id. at 596.          And, the Texas scheme invalidated in

Phillips      expressly      treated     lessees    of    state    land    differently

than other lessees, including lessees of federal property.                           361

U.S. at 379-80.           Thus, each of these cases quickly concluded

that    the    challenged      tax    scheme     discriminated      because    of    the

federal source of pay, and focused almost exclusively on whether

such    discrimination        was    justified     by     significant      differences

between the disadvantaged federal plaintiffs and the advantaged

class.


                                           21
¶30           In     contrast,          §     43-1001(2)            contains      no    overt

discrimination against any taxpayer because of the source of

pay.        Every Arizona taxpayer, whether employed by the federal

government, the State, a political subdivision, or a private

employer,      begins     with    federal         AGI   as    the    Arizona      income    tax

base.       And, in contrast to the situation that obtained for tax

years       before    1991,       Arizona         law    no     longer      provides        for

subtraction        from   that     base       of     contributions         made    by   state

employees, while denying such subtraction to federal employees.

¶31           Respondents        have       not     identified       any   Supreme      Court

decision in which a facially neutral state tax scheme was found

to have violated the intergovernmental tax immunity doctrine.

Respondents’ citation to Memphis Bank & Trust Co. v. Garner, 459

U.S. 392 (1983), as an example of such a case is unavailing.12

The Tennessee business tax at issue in Memphis Bank, like the

Arizona income tax code, started with a federal AGI base.                                   Id.

at 394 & n.3.         But a Tennessee statute then added to the base

all     income     derived       from       obligations       of     states    other       than


       12
          Memphis Bank did not involve an income tax, and thus
did not interpret § 111(a). Rather, the statute involved was 31
U.S.C. § 742, which allows nondiscriminatory franchise or other
non-property taxes to be imposed on federal obligations or
interest therefrom. Memphis Bank, 459 U.S. at 395-96. However,
because § 742, like § 111(a), is a “restatement of the
constitutional rule” of intergovernmental tax immunity, the
analysis under each section is functionally the same.    Id. at
396-97.


                                               22
Tennessee.            Id.         Because      federal       AGI       already     included

obligations        of     the    United     States,        see   I.R.C.     §    103,      the

Tennessee law thus provided an express exemption from taxation

for    income      from   bonds       issued   by   Tennessee      and    its    political

subdivisions,         while     taxing     similar    obligations         issued      by   the

United       States     and     all    other    states.          Id.      The    Tennessee

statutory scheme thus expressly differentiated between interest

received on that state’s obligations and all other obligations,

including those of the federal government.13

¶32           Respondents        argue     that     even    if   there    is     no    facial

discrimination in § 43-1001(2), we must examine the “practical

operation” of the Arizona scheme.                     See Phillips, 361 U.S. at

383.        We agree.         If the inevitable consequence of a facially

neutral state tax code were that federal employees were taxed

differently than similarly situated state employees because of

the source of their income, or if the distinctions drawn in the

state       code   were       “only    a   cloak     for     discrimination           against

federally funded [pay or compensation],” Barker, 503 U.S. at

604-05, § 111(a) would plainly invalidate such a scheme.                                   But

this is not such a case.               In “practical operation,” § 43-1001(2)

does not require that federal employees be taxed differently

       13
          Kraft General Foods, Inc. v. Iowa Department of
Revenue, 505 U.S. 71 (1992), upon which respondents also rely,
is even further afield.       That case did not interpret the
intergovernmental tax immunity doctrine, but rather the Foreign
Commerce Clause, U.S. Const. art. 1, § 8, cl. 3.

                                               23
than    state    employees       with     respect     to      mandatory       retirement

contributions.          Arizona      taxes   the    employee        contributions       of

those state employees whose contributions have not been picked

up by their employers in precisely the same fashion as it treats

the employee contributions of federal employees.

¶33           The distinction is not simply theoretical; it has had

real practical effects on Arizona taxpayers.                         As noted above,

from 1990 through 2000, the majority of the tax years covered by

this litigation, the employee contributions of the thousands of

state and local employees covered by PSPRS and CORP were not

picked up, and each of these employees therefore paid current

state   tax     on    those    contributions.            While   the      treatment     of

numerous state and local employees in a fashion identical to the

allegedly       disadvantaged        federal       employees        may      not   itself

conclusively         prove    that   a   state     scheme     does     not    violate    §

111(a), it surely demonstrates that the Arizona scheme is not

simply a “cloak for discrimination.”

¶34           More     importantly,       nothing        in   the    Arizona       scheme

discriminates between taxpayers based on the federal or non-

federal source of income; the distinction is instead based on

whether a particular governmental employer has voluntarily opted

to pick up the employee contributions and treat them as employer

contributions.           Section     414(h)(2)      is     permissive;        it   treats

employee contributions as employer contributions for federal tax


                                          24
purposes     only    if    the    employer       voluntarily           opts   for       such

treatment.

¶35        Respondents          argue    that        because     §     414(h)(2)        only

authorizes state and local governmental employers to pick up

employee     contributions,       the    effective        distinction         in    §   43-

1001(2) between those employers who pick up and those who do not

necessarily     discriminates          against       federal     employees.             This

argument, however, takes far too narrow a view of the national

government    and    the   choices      it     has    made.       Section       414(h)(2)

simply gave state and local employers the option to choose to

pick up; without advance federal authorization, they could never

choose to do so.          The federal government, however, already had

that option and, through its legislative branch, can exercise

that option at any time it desires.                    In “practical operation,”

the federal government has thus far simply voluntarily opted not

to pick up, just as some state employers voluntarily so opted in

Arizona throughout the 1990s.             Once the state employers made the

choice to pick up, their employees’ contributions were treated

identically     to     those      of    governmental            employers       who     had

previously made this election.               When and if the federal employer

makes the same choice, Arizona tax law will treat its employees’

contributions in an identical fashion.

¶36        In    short,     §     43-1001(2)         is   not    a     subterfuge        for

discrimination       against     respondents         because      of    their      federal


                                          25
source    of     pay,    nor    is     Arizona’s       treatment    of     respondents’

employee contributions a necessary consequence of their federal

status.       Rather, the difference is not who pays the employees,

but the voluntary choice made by the employer as to whether the

contributions should be picked up.

¶37           Cases     dealing      with    military       retirement     benefits   are

particularly instructive on this point.                        Barker invalidated a

Kansas     tax       scheme     which       allowed        subtraction      of   various

retirement       benefits,       both       state    and     federal,     from   taxable

income, because the statutes did not permit benefits received by

retired federal military personnel to be deducted.                          Barker, 503

U.S. 594.        In contrast, Cooper v. Commissioner of Revenue, 658

N.E.2d 963 (Mass. 1995), decided some three years after Barker,

upheld    a    Massachusetts         statutory       scheme    which      exempted    from

taxation       retirement       benefits         received    from   any    governmental

pension       fund      to     which       the      taxpayer    contributed       during

employment, while taxing benefits received from all other plans.

The    federal       military     retirement         pension    system     involved    no

employee      contributions,         and     all    military    retirees      were    thus

subjected to Massachusetts income tax on their benefits.                         Id. at

964.     The “practical operation” of the Massachusetts plan, at

least with respect to military retirees, was thus identical to

the Kansas scheme.            Nonetheless, Cooper held that any differing

treatment of military retirees from other government retirees in


                                              26
Massachusetts was not because of the “source of pay,” but rather

because the federal government had designed their plan as non-

contributory.           Id.      Because      all    non-contributory       plans       were

treated     equally      —    even    though        virtually     all     Massachusetts

employees       now     participated         in     contributory        plans14    —     any

differing       treatment       was   not     because       of   the    source     of    the

military retirees’ income, but rather because of a separate,

non-pretextual, distinction.                Id.15

¶38         The same is true here.                   Arizona tax law effectively

distinguishes         between    taxpayers          whose    governmental     employers

choose     to    pick    up     employee       contributions       and     those       whose

governmental employers do not choose to do so.                         That distinction

is not “because of the source” of the employee’s compensation



      14
          Massachusetts established its contributory retirement
system in 1936 and 1937. Cooper, 658 N.E.2d at 965. Thus, it
was doubtful that any current state retiree participated in a
non-contributory system, although the Supreme Judicial Court so
assumed for purposes of analysis in Cooper.      Cf. Filios v.
Comm’r of Rev., 615 N.E.2d 933, 936 (Mass. 1993) (noting
theoretical possibility that state employee participants in old
non-contributory plans were still alive).
      15
          Respondents argue that Cooper is no longer good
authority because the Massachusetts legislature has since
changed the statutory tax scheme to exempt military retirement
pay from state taxation.   See Mass. 1987 Legis. Serv., ch. 139
(amending Mass. Gen. Laws Ann. ch. 62, § 2(a)(2)(E)).       But
nothing in the federal governmental tax immunity doctrine
prevents a state from exchanging one non-discriminatory scheme
for another, and we do not ordinarily infer any invalidity in a
statute from subsequent legislative amendment.



                                             27
and therefore does not run afoul of the intergovernmental tax

immunity doctrine.16

                                     III.

¶39          For   the   reasons   above,   we    hold    that   the   court    of

appeals erred in Kerr V in concluding that the application of §

43-1001(2)    to   respondents     violated      the    intergovernmental      tax

immunity doctrine codified in § 111(a).                We therefore vacate the

opinion below insofar as it so held and reverse the judgment of

the tax court to the same extent.                Because ADOR did not seek

review of that portion of the opinion below remanding the class

certification issue with respect to tax years 1985 through 1990

to the tax court for further consideration in light of Ladewig

II, we do not address that portion of the opinion below.17                  This




      16
          Because we conclude that use of federal AGI as the
Arizona tax base in § 43-1001(2) does not violate the
intergovernmental tax immunity doctrine, we do not need to
consider whether in this case any discrimination is justified by
substantial   differences    between   respondents   and   state
governmental employees.   Cf. Witte v. Dir. of Rev., 829 S.W.2d
436 (Mo. 1992) (upholding Missouri tax scheme which imposed
current taxation on employee contributions to federal Civil
Service Retirement System, while deferring taxation to other
retirement plans, because of plaintiffs’ failure to show a lack
of significant differences between the two classes).
      17
          Our disposition of the intergovernmental tax immunity
issue moots any question as to whether class certification
should have been granted with respect to claims relating to tax
years after 1990.

                                      28
case       is   remanded   to   the   tax    court   for   further   proceedings

consistent with this opinion.




                                       Andrew D. Hurwitz, Justice


CONCURRING:


                                                 _
Charles E. Jones, Chief Justice


                              ______
Ruth V. McGregor, Vice Chief Justice


                                                 _
Michael D. Ryan, Justice


                                                 _
John Pelander, Judge*




       *
      The Honorable Rebecca White Berch recused herself; pursuant
to Article VI, Section 3 of the Arizona Constitution, the
Honorable John Pelander, Judge of the Court of Appeals, Division
Two, was designated to sit in her stead.

                                            29
