I’m not sure exactly where this absurd theory got started, but perhaps its origin lies in those sections of the tax code that define the term “state” for various purposes. Section 7701(a)(10), for example, says:

26 U.S.C. § 7701(a)(10)

The term “State” shall be construed to include the District of Columbia, where such construction is necessary to carry out provisions of this title.

Some people try to infer from sections such as this one that where the tax code uses the word “State,” it means only the District of Columbia, and so only District residents are required to pay taxes. But the key word in the section is include. This word, as a dictionary will tell you, means “to take in or comprise as a part of a whole.” And just in case the dictionary definition isn't clear enough, the statute itself nails down this point:

26 U.S.C. § 7701(c)

Includes and including.--The terms "includes" and "including" when used in a definition contained in this title shall not be deemed to exclude other things otherwise within the meaning of the term defined.

So section 7701(a)(10) just tells us that the District of Columbia is a part of what the tax code means by the term “State.” It doesn’t exclude things "otherwise within the meaning" of the the term “State.” In other words, the term “State” retains its natural meaning—referring to one of the States of the Union—but it also, for purposes of the tax code, includes the District of Columbia, even though the District is not really a State.

Another law sometimes cited in support of this argument is 4 U.S.C. § 111, which is not part of the tax code at all. In this section the federal government states its consent to have the incomes of federal employees taxed by states. This section is necessitated by an old legal doctrine of “intergovernmental tax immunities.” Under this doctrine, there was once some doubt about the ability of state governments to tax the incomes of federal employees. This statute takes care of that problem.

The error in the argument of those who cite this statute is plain. The statute says that the incomes of federal employees may be taxed by states. Does it say anything about those who are not federal employees? No. It doesn’t apply to them one way or another. It is a false conclusion to say that, because there happens to be a statute that provides that federal employees may be taxed, people who are not federal employees may not be taxed. The statute doesn’t say that. It just has no effect on those who are not federal employees. It doesn’t subject to them to income tax (other statutes do that), but neither does it relieve them of income tax.