Tax Breaks for Municipal Bonds

Supreme Court to hear state-bond arguments

The U.S. Supreme Court has agreed to take on a case that will determine the legality of states' continuing to exempt interest on their own bonds from residents' taxable income, while taxing the interest on bonds issued by other states. The ruling is expected to impact the municipal bond markets, which SIFMA estimates would affect 50,000 municipal-bond issuers throughout the nation.

Supreme Court to Address State Tax Breaks for Bonds
By LINDA GREENHOUSE
WASHINGTON, May 21 — In a case with the potential to rattle, if not reshape, the market for state and municipal bonds, the Supreme Court agreed on Monday to decide whether states can continue to exempt interest on their own bonds from their residents’ taxable income, while taxing the interest on bonds issued by other states.

The preferential tax treatment for in-state bonds is longstanding and very common, offered by nearly all the states that have an income tax. State and local governments issued more than $350 billion worth of bonds a year from 2002 to 2006.

The practice was, in fact, largely taken for granted until it was declared “facially unconstitutional” in January 2006 by the Kentucky Court of Appeals. That state court, ruling in a case brought by a Kentucky couple, George and Catherine Davis, who own bonds issued by other states, said the preferential tax treatment erected a barrier against interstate commerce in violation of the Constitution’s commerce clause.

In the only previous decision on the subject, an Ohio state appeals court upheld that state’s preferential treatment of bond interest, in a 1994 decision that the Supreme Court declined to review. The fact that two state courts now disagree on such a fundamental question probably led the justices to conclude that the issue required their attention.

The National Association of State Treasurers, without taking a bottom-line position, urged the justices to accept Kentucky’s appeal. “Only this court can resolve the uncertainty,” the state treasurers said, adding: “Regardless of the merits of the question presented, the federal Constitution should apply uniformly to all 50 states.”

The tax-exempt status of state and municipal bonds permits issuers to borrow money at a lower interest rate because investors are willing to accept lower returns in exchange for not having to pay taxes on the interest they receive. The tax-exempt feature is very appealing to investors, as reflected in the popularity of mutual funds that offer baskets of a single state’s public debt.
Kentucky filed its Supreme Court appeal, Department of Revenue of Kentucky v. Davis, No. 06-666, in November. Rather than act immediately, the justices held the case while they were considering how to decide another case about the permissibility of state preferences under the commerce clause.

On April 30, the court decided that case, United Haulers Association v. Oneida-Herkimer Solid Waste Management Authority, No. 05-1345. By 6 to 3, the court rejected a commerce clause challenge to a program in two upstate New York counties that required private haulers to deliver all solid waste to a single publicly owned landfill. It did not violate the commerce clause for the government to prefer itself over private-sector competitors, Chief Justice John G. Roberts Jr. wrote for the majority.

Ordinarily, once the court has decided a case, it sends back to the lower court any related case that it has been holding, so that the lower court can reconsider its ruling in light of the new Supreme Court decision. But in this instance, the justices evidently concluded that the solid-waste decision did not shed much light on what the commerce clause might have to say about preferential taxation of bond interest.

In recent years, the court has been fairly aggressive about reining in state policies that could be described as protectionist. Two years ago, for example, the justices invoked the commerce clause to overturn laws in New York and Michigan that gave preferential treatment to in-state wineries.

But the court is hardly of one mind, either on basic principles or their application. Two justices, Clarence Thomas and Antonin Scalia, do not accept the premise that the commerce clause, which in the constitutional structure is a grant of authority to Congress, imposes any limitation on activity by the states. On the other hand, the newest justice, Samuel A. Alito Jr., dissented last month from the solid-waste decision, writing that “the public-private distinction drawn by the court is both illusory and without precedent.”

In the latest case, Kentucky is raising an argument based on state sovereignty, objecting that the state court’s analysis of the commerce clause “commandeers Kentucky’s tax laws to subsidize other states’ public debt if it wishes to exempt its own debt from taxation.” In fact, the Kentucky Court of Appeals did not dictate a remedy for the constitutional violation it found. If the decision is upheld, the state will have the choice of exempting every state’s bond interest, or none.

The case will be argued in the fall, with a decision unlikely before next spring. That means that the municipal bond market could be unsettled for months, said Alan D. Viard, a resident scholar at the American Enterprise Institute and a former Federal Reserve Bank of Dallas economist.In another action on Monday, the court dismissed a class-action antitrust suit against three former regional Bell companies that control nearly all the country’s local telephone service. Voting 7 to 2, the court held in an opinion by Justice David H. Souter that the complaint failed to contain evidence of an illegal agreement to restrain trade sufficient to impose on the defendants the burden of undergoing pretrial discovery. The dissenters were Justices John Paul Stevens and Ruth Bader Ginsburg.

The case, Bell Atlantic Corporation v. Twombly, No. 05-1126, had been closely watched for continued signs of the court’s growing skepticism about complaints, in securities and antitrust litigation, that contain little more than bare accusations of wrongdoing. The plaintiffs in this case “have not nudged their claims across the line from conceivable to plausible,” Justice Souter said.

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municipal bond market, municipal securities, munis