WASHINGTON - Kentucky and 41 other states can continue taxing interest on out-of-state municipal bonds while exempting interest on their own bonds without violating the Constitution, the Supreme Court ruled yesterday in a 7-2 decision.

The decision, which reverses a Kentucky appellate court ruling and favors the state over George and Catherine Davis, who sued the state for trying to tax the interest earnings on their out-of-state bonds, concluded that Kentucky's differential tax practices on bonds does not discriminate against interstate commerce, but rather promotes the financing of essential governmental services.

While the ruling in Dept. of Revenue of Kentucky v. Davis upheld the century-old taxation practice and the market status quo in its decision, the court left the door open to possible future challenges revolving around private-activity or conduit bonds issued by governmental entities for a private borrowers.

Justice David Souter, writing the majority opinion, said that since the constitutionality of varying state tax practices for private activity bonds were not argued by either party of the case, this is a matter "best set aside." The Davis' did not have any private-activity bond holdings.

Only the American Enterprise Institute and its resident scholar Alan D. Viard argued in a friend-of-the-court brief that private-activity bonds are a stronger example of commercial discrimination by a government because they benefit private parties. No known cases are pending that specifically address private-activity bonds.

Souter indicated that even if such challenges to private-activity bonds arise, the court might not rule any differently. "We must assume that it could disrupt important projects that the states have deemed to have public purposes," he said in a footnote to the ruling.

In the decision, the high court pointed to several factors that indicated that differential state taxation practices are a long-held and nationally agreed-upon method of ensuring that states can issue the debt needed to finance their essential governmental functions. The justices also suggested that they were reluctant to hand down a decision that would upend a large portion of the municipal market.

"It would miss the mark to think that the Kentucky courts, and ultimately this court, are being invited merely to tinker with details of a tax scheme," the seven justices said. "We are being asked to apply a federal rule to throw out the system of financing municipal improvements throughout most of the United States."

The case revolved around the dormant section of the commerce clause, which, according to most legal interpretations, suggests that only Congress can erect barriers to interstate trade and is meant to prevent economic protectionism - actions taken to promote instate trade and burden out-of-state competitors.

However, the seven justices found that Kentucky's tax practice does not favor in-state commerce to disadvantage competitors, but rather to finance the "cardinal civic responsibilities" of the state to "protect ... citizens' health, safety, and welfare."

To support that argument, the court referenced the results of competitive bond sales from last year that financed the construction of a hospital, a prison and a school. They also noted that about two-thirds of capital expenditures by state and local governments are financed with municipal bond proceeds.

"Bonds place the cost of a project on the citizens who benefit from it over the years, and they allow for public work beyond what current revenues would support," Souter wrote.

In defending their stance, the Justices relied heavily on one of their previous decisions, in the United Haulers Assn., Inc. v. Oneida-Herkimer Solid Waste Management Authority case, saying it presented "a firm basis for reversal here."

In that case, the court ruled that a local government could require private haulers to process their waste at a publicly owned facility, even if the haulers could process it at a lower cost at a private facility in another state. The court ruled 6-3 in that case that a government could show preference for itself if it served a public good.

Souter said in the Davis opinion that if waste management is a public good, that logic applies to muni bonds with "even greater force," since "the issuance of debt securities to pay for public projects is a quintessentially public function."

Souter and the other Justices in the majority opinion compared the issuance of bonds to finance projects with purchasing a house with a loan paid off in monthly installments.

The court also found particularly compelling a friend-of-the-court brief filed on behalf of Kentucky by the attorneys general for the other 49 states.

"Nearly every taxing state believes its public interests are served by the same tax-and-exemption feature, which is supported in this court by every one of the states [with or without an income tax] despite the ranges of relative wealth and tax rates among them," Souter said in the majority opinion. "These facts suggest that no state perceives any local advantage or disadvantage beyond the permissible ones open to a government and to those who deal with it when that government itself enters the market."

In forming their opinion, the justices also took into account the market ramifications of banishing the widely practiced tax exemption for instate bonds. Souter noted that upholding the lower court decision would likely result in the disappearance of the vast majority of single-state mutual funds, which often hold the bonds of weaker municipal issuers.

The court also found that the states' desire to keep in place the preferential practices, despite the fact that they often lose more in tax revenue than they save in interest expenses, shows that these practices were not intended to gain a competitive advantage.

"The unanimous desire of the states to preserve the tax feature is a far cry from the private protectionism that has driven the development of the dormant commerce fclause," Souter wrote.

Despite the fact that most of the justices ruled in favor of Kentucky and against the Davis', the case produced a number of separate opinions. Several justices decided to concur with only part of the Souter ruling, or concurred with Souter but for a different set of reasons altogether.

Chief Justice John Roberts and Justices Ruth Bader Ginsburg, Antonin Scalia, and Clarence Thomas concurred with Souter's ruling, except for the portion of the ruling where he discussed Kentucky's status as a market participant that both sets taxes and issues bonds in accordance with those taxes. While Souter contended that Kentucky's tax policy was a way to regulate the market for civic purposes, the other justices stated that they did not believe that point was necessary to form the opinion. They argued that the court need only rely on the United Haulers ruling.

Also, Scalia and Thomas both used their individual concurrences to emphasize that they do not believe in the dormant commerce clause and, as a result, cannot find Kentucky in violation of it.

Justices Anthony Kennedy and Samuel Alito dissented from the majority opinion. In their dissent, which was penned by Kennedy, they argued that the majority's conclusion that Kentucky could uses taxes to prefer its own bonds as part of its "cardinal civic responsibilities" is overly broad.

"It is difficult to identify any state law that has come before us that would not meet the court's description," they said.

Furthermore, they argued that basis for the majority opinion is wrong because the differential tax practices on bonds do not affect Kentucky, but rather the holders and traders of its bonds.

Kennedy also wrote that if the court was afraid of disrupting the market because interstate discrimination has been entrenched in most states for nearly a century, it should have stated that as the basis for its decision. The court could then have achieved the same goal without setting a dangerous precedent that makes it easier for other states to engage in economic protectionism, he said.

Since the majority upheld the practice on the grounds that it furthers public good, the court has opened itself up to additional requests to legitimize trade barriers, Kennedy argued.

"This market perhaps can absorb the costs of discrimination; our jurisprudence, unless the decision stands alone as an anomaly, cannot," Kennedy said. "Today, the court weakens the preventative force of the commerce clause and invites other protectionist laws, thus risking further dislocations and market inefficiencies based on the origin of products and commodities that should be traded nationwide and without local trade barriers."


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