WASHINGTON — A majority of Supreme Court justices yesterday appeared to be leaning toward overturning a 2006 Kentucky appellate court ruling that found the state’s favorable tax treatment of its bonds unconstitutional.
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Chief Justice John Roberts maintained that if any changes are to be made to the century-old taxation practice, Congress, and not the courts, should make them.
“If it’s kind of a close question, leave it for Congress,” he said. “It’s never shown the slightest interest in addressing state tax exemption.”
If the court overturns the Kentucky decision, the status quo of the municipal market would be upheld, allowing 42 other states to continue with their taxing practices.
But if the court makes the Kentucky ruling the law of the land, it would drive the yields of all states’ bonds to the same level because all investors in any given state — whether their state decides to tax everything or tax nothing — will be indifferent to which bonds they own. The discriminating factor would become credit quality, market participants have said.
An unfavorable ruling for the market would also have a large impact on the $378.18 billion currently invested in the 686 state and national muni bond funds. About 462 state mutual funds hold $157.9 billion of assets while about 224 national funds hold roughly $220.3 billion, according to statistics compiled by the Investment Company Institute.
In the case, first brought in 2003 against the state’s revenue department by a retired couple, George W. and Catherine V. Davis, the Kentucky Court of Appeals found that it was clear that the state’s taxation system for bonds is “facially unconstitutional” because it affords more favorable taxation treatment to in-state bonds than to “extraterritorially” issued debt.
But yesterday, G. Eric Brunstad Jr., a lawyer with Bingham McCutchen LLP representing the Davises, had a hard time convincing the high court justices that the state’s discriminatory policy actually harms anyone. Though Brunstad contended that the state’s exemption is a “discriminatory barrier” against out-of-state bonds, Justice John Paul Stevens questioned his logic, arguing that it suggests the other 49 states are the victims of the Kentucky’s tax policy. Stevens noted that the attorneys general in all the other states filed a friend-of-the-court brief supporting Kentucky.
“The victims under your approach, as I understand it, are the 49 other states, and all of them seem to support your opponent in the briefs that were filed in this case,” Stevens said.
Brunstad agreed, but suggested the states were only supporting Kentucky because they do not want to file tax refunds.
C. Christopher Trower, the lead lawyer for Kentucky, echoed Roberts’s position that Congress is better suited to address the exemption, and that its inaction has given the practice its implicit approval.
“Should the court rush in where Congress has feared to tread?” he asked.
Tower also argued that the state has a right to encourage its residents to purchase its bonds since the proceeds would go toward developments that benefit its residents.
“Bonds are not issued by states to make a profit or to leverage their return on equity. They’re not created for investment opportunities on Wall Street. They’re issued to finance the essential work of government,” the lawyer said.
But Brunstad contended that there is “an ongoing low-level trade war that was started by New York in 1919,” when that state became the first to exempt bonds issued in-state from state taxation, a move that other states replicated to remain competitive.
“It’s a race to the bottom, with states saying we have to follow suit to level the playing field,” he said.
But Stevens said he thought residents would prefer in-state bonds, even without the exemption, because they would opt to support local projects.
Brunstad found some support in justices Samuel Alito, who questioned Kentucky’s tax practice and Anthony Kennedy, who agreed the state’s practice is unfair. Kennedy argued that local groups always favor protectionist policies and the commerce clause exists as a check on such discriminatory policies.
“There’s no doubt that this is explicit discrimination,” Kennedy said.
Though Alito suggested that he agreed with some of Kentucky’s arguments, he said that if the court accepts the state’s claim that the exemption is a permissible violation of the dormant commerce clause, it will render the court’s dormant commerce clause case law “utterly incoherent.”
The hour-long debate began with Alito questioning how private-activity bonds — which make up 20% of all bond issuance and are issued by municipalities on behalf of private owners — fit into Trower’s claim that bonds are issued for the public good.
The question stems from the court’s 6-to-3 decision in a recent case involving the dormant commerce clause, United Haulers v. Oneida-Herkimer Solid Waste Management Authority, in which the court expressed a willingness to allow governments to exhibit preference for themselves over out-of-state private competitors. Alito, Kennedy, and Stevens dissented from the ruling.
In the case, the court found that a New York county could force private waste haulers to use a publicly owned processing facility, even if the haulers could use a private facility in another state for a lower cost. The court ruled that a government could show preference to itself if it serves a public good.
Trower said despite private ownership, 80% of all private-activity bonds still go toward public projects, such as housing and hospitals, and can be considered public works.
The dispute was put to rest when Justice Ruth Bader Ginsburg said that the Davises never indicated that they held any private-activity bonds, and that the distinction, therefore, is not relevant to the case.
“Private-activity bonds are not at issue here,” she said.
Justices Antonin Scalia and Clarence Thomas were quiet during the arguments. Scalia commented only once, to make a wise crack reminding the court that he does not believe the dormant commerce clause actually exists. His comment suggested that he would not extend its reach against states, a perspective shared by Thomas, who has said in the past that he would strike down any commerce clause challenges.
Both justices, as well as Ginsburg, are expected to side with Kentucky, partly because all three signed a dissenting opinion in 1997 arguing that the commerce clause should not apply to non-profit groups.
Meanwhile, Brunstad also attempted to downplay the ramifications of a Davis ruling on the municipal bond market. Many market participants have warned of dire consequences if the current taxation system is declared unconstitutional. As a result, many have called for the court to consider the practical impact of their ruling.
But Brunstad said a Kentucky analysis found that if the state were forced to refund taxes obtained from out-of-state bondholders, it would amount to annual refunds totaling only about $4 million. “The sky is not going to fall,” he said.
Alan D. Viard, a resident scholar with the American Enterprise Institute who has argued that the tax exemptions are a net financial loss for state governments and was at the high court yesterday, said that only justices Alito and Kennedy appeared sympathetic with the Davises.
Though he opposes the favorable tax schemes as unconstitutional, “interstate commercial warfare,” he predicted that the Supreme Court will hand Kentucky a victory by overturning that state’s appellate court ruling.
“They will maintain the status quo of what is a seriously balkanized market,” Viard said, echoing the concerns expressed in a friend-of-the-court brief he filed in the case calling for a ruling against Kentucky.
But Kenneth B. Roberts, a partner at Hawkins Delafield & Wood LLP, said the court’s apparent reluctance to put an end to states’ preferential tax schemes is a good sign.
“It evidenced a knowledge of state financing and a willingness of at least several justices to consider these facts separate and apart from regulation of commercial activity as well as a general skepticism that this was just another tax case,” he said.
Kenneth Roberts added: “Brunstad’s argument was that this is undifferentiable from any other tax that has been reviewed under dormant commerce clause analysis, but a wide spectrum of justices were highly skeptical of that in this factual context.”
