Court Set To Uphold State Bond Tax Set-Up

By Christopher S. Rugaber
Associated Press
Tuesday, November 6, 2007

A majority of the Supreme Court yesterday appeared set 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 maintain the status quo in the $2.5 trillion municipal bond market. 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, an attorney representing a Kentucky couple 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.

Justice John Paul Stevens responded that under that view, the victims in the case are the other 49 states, "and they all support your opponent," he said. The 49 states filed court papers supporting Kentucky.

Chief Justice John G. Roberts Jr. said that "this is an area where Congress can regulate," but it has never taken steps to prevent states from providing preferences to their own bonds.

States and local governments issue the bonds to finance the construction of roads, schools and other public infrastructure.

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

The case began in April 2003, when the Kentucky couple, George and Catherine Davis, filed a lawsuit claiming 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.

Kentucky appealed to the Supreme Court, arguing that its tax system is not unconstitutional because it does not discriminate against out-of-state businesses, and it furthers a legitimate government goal of financing public projects.

A ruling is expected by early 2008.

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