Municipal bonds to remain state issue

The bonds are popular with many investors.

WASHINGTON (AP) — A majority of the Supreme Court appeared set Monday to uphold the right of states to tax interest on out-of-state municipal bonds while exempting their own bonds from taxation.

Such a ruling would avoid what some analysts warned would be major disruption in the $2.5 trillion muni bond market if the court chose to overturn the practice.

Forty-two states exempt some or all of their municipal bonds from income taxes, while taxing interest on bonds from other states. At issue is whether the practice is an unconstitutional interference with interstate commerce.

Eric Brunstad, a lawyer representing a couple in Kentucky who sued the state for taxing out-of-state bonds, argued that Kentucky’s tax policies amounted to a “discriminatory barrier” to the sale of bonds from other states.

“The victims under your approach,” Justice John Paul Stevens responded, “are the 49 other states, and all of them seem to support your opponent,” a reference to a court brief filed by the 49 states in support of Kentucky.

Chief Justice John Roberts, meanwhile, said “this is an area where Congress can regulate if it wants to, and it has never shown the slightest interest in interfering with state tax exemptions for their own bonds.”

Christopher Trower, an attorney representing Kentucky’s Department of Revenue, argued that providing tax breaks to in-state bonds doesn’t discriminate among private companies, but rather furthers a legitimate government goal of funding public infrastructure.

“This court has never held that a law which favors government ... rather than private business enterprises violates the dormant commerce clause,” Trower said. The dormant commerce clause, an outgrowth of the Constitution’s stipulation that only Congress can regulate interstate commerce, bars states from interfering with interstate commerce without congressional authorization.

States and local governments issue municipal bonds to finance the construction of roads, schools and other public infrastructure. Muni bonds are also exempt from federal taxes, which wouldn’t be affected by this case.

The bonds are popular with investors, particularly those from high-tax states. About 230 mutual funds with $210 billion in assets invest in muni bonds nationwide, according to the Investment Company Institute, a mutual fund trade association. There are another 481 single-state funds with $155 billion in assets, the ICI said.

The case began in April 2003, when a Kentucky couple, George and Catherine Davis, filed a lawsuit charging that Kentucky’s practice of taxing other states’ bonds while exempting its own is unconstitutional.

A Kentucky court ruled in favor of the Davises in 2006, becoming the first court to rule against the exemption since New York first gave its own bonds a tax break in 1919.

Justice David Souter indicated he was concerned about the impact that reversing such a widespread practice would have.

“We have an enormous market, the effect of interrupting which we really, as a court, cannot tell very much,” he said. “And that seems to me a very good reason to give the nod” to Kentucky.

The case is Kentucky v. Davis, 06-666. A ruling is expected by early next year.