High Court Allows State Tax Breaks For Bonds

By Robert Barnes
Washington Post Staff Writer
Tuesday, May 20, 2008

The Supreme Court yesterday ruled that states may offer special tax breaks for investing in their municipal bonds, a holding that averts what might have been a calamitous upheaval in the bond market.

All 50 states had asked the court to uphold Kentucky's system of exempting its residents from paying taxes on the interest from the state's own bonds, while taxing the income from investing in securities from other states. There are 42 states with such programs.

A Kentucky court ruled that such a scheme ran afoul of the Commerce Clause and its protection of interstate commerce, but the Supreme Court disagreed in a 7 to 2 vote.

Justice David H. Souter said the issuance of bonds to pay for roads, schools, water and sewage treatment plants and other public service projects is a "quintessentially public function" with a "venerable history" and made clear that the court was reluctant to change such an entrenched system.

"Financing for long-term municipal improvements would thus change radically if the differential tax feature disappeared," Souter wrote.

The ruling was welcomed in the bond market, which has been through a tumultuous period as the credit crisis spread to products traditionally considered virtually risk-free and drove up the cost of borrowing for many state agencies and local governments.

"This is definitely good news for the muni market -- it removed one of the major items that has been overhanging in the market," said Dan Loughran, who oversees tax-exempt bond funds for Oppenheimer Funds. "If the ruling didn't go this way . . . single-state muni bond funds would have had no economic rationale to exist."

States say that the taxing scheme is vital, especially to small states, in marketing their bonds. Kentucky, like most jurisdictions, exempts interest on its bonds from income taxes, while taxing interest on bonds from other states. Kentucky residents George and Catherine Davis said that was impermissibly discriminatory and sued to receive a refund.

The court said Kentucky's law was not protectionist but simply promotion of a public function. "There is no forbidden discrimination because Kentucky, as a public entity, does not have to treat itself as being substantially similar to the other bond issuers in the market," Souter wrote.

Justices Anthony M. Kennedy and Samuel A. Alito Jr. disagreed.

"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," Kennedy wrote.

The states that had asked the court to take the case said an adverse ruling would have caused massive problems, including a complicated system of paying refunds to investors.

The ruling did not touch on so-called private-activity bonds, which governments offer for nongovernmental entities such as hospitals. Souter wrote in a footnote that "it is best to . . . leave for another day any claim that differential treatment of interest on private-activity bonds should be evaluated differently" from municipal bonds.

Staff writer Tomoeh Murakami Tse in New York contributed to this report.

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