The Supreme Court, in a ruling that could limit state efforts to encourage local businesses, ruled yesterday that Alabama cannot give preferential tax treatment to insurance companies located in the state.

At a minimum, the ruling appears to call into question tax schemes in 32 states that have "domestic preference taxes" on premiums collected on life and casualty insurance policies.

Taxes collected in those states exceed $2 billion a year, according to one life insurance expert. He said it is impossible to determine how much those collections would be reduced if out-of-state insurance companies paid the same lower rates that in-state insurance companies pay.

In a 5 to 4 ruling, the court said that the tax violates the equal protection clause of the Constitution. Justice Lewis Powell, writing for the majority, said Alabama could not justify higher taxes on out-of-state insurance companies as a means of promoting local business or encouraging investment in Alabama.

But four dissenting justices, in an opinion written by Sandra Day O'Connor, said the "doctrine adopted by the majority threatens the freedom not only of the states but also of the federal government to formulate economic policy."

The vigorous dissent joined two of the court's most conservative justices -- O'Connor and William Rehnquist -- and its two most liberal -- Thurgood Marshall and William Brennan.

O'Connor said that the equal protection clause applies to a state's economic decisions only when an action is totally arbitrary or offensively discriminatory. She said "the Alabama law at issue here serves legitimate state purposes through concededly rational means, and thus is neither invidious nor arbitrary."

Harvard University law professor and constitutional expert Laurence Tribe said that the majority decision seems to be less broad than the dissenters argued. He said the court addressed only the "abstract question" of whether encouraging local companies and investment "are legitimate objectives to pursue by discriminating against out-of-state companies."

"In very few instances," Tribe said, are those the only purposes a state could cite in justifying discriminatory taxation.

But Franklin Young, a legal expert with the American Council of Life Insurance, said encouraging local business and investment appear to be the "most basic and obvious" justifications for discriminatory taxation.

Tribe also said that the majority did not address the second test of whether the Alabama law violated the equal protection clause -- whether the law itself is "rationally related" to its purpose. The majority remanded the case to Alabama courts where, presumably, the state could try to present other purposes to justify the tax statute.

Alabama collects 1 percent of all premiums received by state-chartered insurance companies with headquarters in the state. For other insurance companies, which write 75 percent of the insurance policies in the state, the tax is 3 percent on life insurance premiums and 4 percent on property-casualty premiums. Depending upon how much of its assets an out-of-state insurance company invests in Alabama it could reduce the premium tax by up to 1 percentage point. It could never reduce the tax to the level paid by an in-state insurance company.

Metropolitan Life Insurance Co. of New York and the Prudential Insurance Co. of New Jersey brought suit against Alabama when the state denied their request for refunds of the tax differential they paid between 1977 and 1980. State courts, up to the Alabama Supreme Court, ruled that the state tax law did not violate the equal protection clause of the 14th Amendment to the Constitution.

The majority said that Alabama's desire to encourage local businesses by more heavily taxing out-of-state companies "constitutes the very sort of parochial discrimination that the equal protection clause was intended to prevent."

O'Connor, writing for the dissenters, said that the McCarron-Ferguson Act specifically exempted insurance regulation and taxation from laws prohibiting states from interfering with interstate commerce.

The McCarron-Ferguson Act and previous Supreme Court decisions "explicitly sanctioned the very parochialism in regulation and taxation of insurance that the court's decision holds illegitimate," O'Connor wrote.