High Court: Taxing Out-of-State Muni Bonds Is OK

The Supreme Court overturns a lower court decision by ruling that it is constitutional for states to give a tax break on muni bonds issued within their borders.

Municipal bonds have been making headlines lately, moving from the muni bond scandal in San Diego to the Securities and Exchange Commission’s investigation into JPMorgan’s bidding practices to Moody’s announcement that it plans to rate the bonds on the same scale as corporate debt. Now the Supreme Court has joined the fray, finding that it is constitutional for states to offer a tax break on muni bonds issued within their borders.

Indeed, the interest on muni bonds, which are held by individuals and corporations, is taxed differently depending on the state in which the bond is issued. Some states do not tax the interest on public bonds issued within their borders; others do. Kentucky is a case in point: the interest on bonds issued by Kentucky and its political subdivisions is exempt from tax, whereas interest on municipal bonds of other states and their political subdivisions is taxable.

The Supreme Court recently decided whether this differential tax scheme offended the Constitution’s Commerce Clause, and in reversing the lower court’s decision from which an appeal was taken, ruled that it did not, in Department of Revenue of Kentucky v. Davis_US_ (2008). Here’s why.

The “Dormant” Commerce Clause

The Supreme Court, with Justice David Souter writing for the majority, noted that the modern law of the so-called dormant Commerce Clause is driven by concern about “economic protectionism” — regulatory measures that are designed to benefit in-state economic interests by burdening out-of-state competitors. However, the framers’ distrust of the “economic Balkanization” that such protectionism could engender was limited by their “Federalism” — an approach that favored a degree of local autonomy.

Under the resulting protocol, within which a balancing of these conflicting imperatives is sought, the Supreme Court is required to ask whether a law discriminates against interstate commerce. A discriminatory law is, virtually, per se invalid and will survive only if it advances a legitimate local purpose that cannot be served by reasonable, nondiscriminatory, alternatives.

Permissible Discrimination

Nevertheless, when a state or local government enters the market “as a participant,” it is not subject to the restraints of the Commerce Clause. This exception reflects a basic distinction between states as market participants and states as market regulators.* Moreover, a government function is not susceptible to standard dormant Commerce Clause scrutiny, owing to its likely motivation by legitimate objectives distinct from economic protectionism. (See United Haulers Association, Inc. v. Oneida-Herkimer Solid Waste Management Authority_US_ (2007).)

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