First: If you only had Philadelphia local tax taken out on your W2 and not PA state tax, then you do not need to file a PA return at all. Needing to file a PA return is for people that have had PA state tax withheld incorrectly. Not having to file two returns is the benefit of having the reciprocal agreement between states.
You are being double taxed - you just haven't paid the second tax yet. When you actually file your NJ return, that is when you are going to be double taxed on the same income - once for the wage tax in Philadelphia and then again on your New Jersey return for the same income. This is why New Jersey allows you to take this credit against these taxes paid directly on your NJ tax return. This is also why - after you enter the taxes paid - you may not see a full credit for the amount of local taxes paid to Philadelphia on your New Jersey return, because you only get a credit for the amount that is actually causing double taxation.
You can see this scenario/explanation laid out in the NJ tax return instructions - the key word here that may help explain is "subject" - even though you haven't already paid your NJ tax out of pocket on your W2, your income is still subject to NJ tax on your return. Thus, making this double taxed income.
Income From Philadelphia or Other
Pennsylvania Municipalities. The
Reciprocal Agreement between Pennsylvania
and New Jersey (see “Income From
Pennsylvania” above) does not apply
to the wage or income tax imposed and
collected by the City of Philadelphia or
any other municipality in Pennsylvania.
Therefore, income subject to both New
Jersey income tax and any municipal
wage or income tax may be included on
Line 1, Schedule A
http://www.nj.gov/treasury/taxation/pdf/current/1040i.pdf (page 42 inside the pdf)
See the rest of this answer for instructions on entering these taxes paid and receiving the credit -
Local taxes are not covered by the reciprocal agreement between NJ and PA, so you don't get a direct refund of these taxes from PA. However, you can use these taxes as the basis for a Credit Paid to Other State. So, instead of getting a refund from PA for the taxes paid, you can use the taxes paid to reduce your NJ tax liability (and thus get a larger refund from NJ).
You will need to enter this information in the NJ program, however. Look for the screen below (see first screenshot) - you will want to select "Work on Credit" when you get to this screen (if you already went through this screen, then you might get a screen that says "Summary of Other Taxes Paid" instead of the screen below).
The next screen you will select PA and then the next screen is where you will select what type of local tax you paid. Pay close attention to this PA specific screen (you will likely need to check one of the small checkboxes and then select No. After you hit No, you will be prompted to fill out the information for what local tax you paid and how much. The program will then calculate a credit for you on your NJ return based on the taxes paid to the locality in PA.
Note: You might not get a full credit for the whole amount of taxes paid - this is normal, the calculation accounts for the double taxation effect and doesn’t necessarily give you an entire credit for the amount paid.
