Reacting to the Supreme Court’s decision to hear Davis v. Kentucky Department of Revenue, AEI Resident Scholar and former Federal Reserve Bank of Dallas economist Alan D. Viard made the following observations about the case challenging Kentucky’s policy of taxing interest on out-of-state municipal bonds while exempting interest on home-state municipal bonds:
- The Supreme Court should uphold the lower court’s ruling in favor of the taxpayers and allow the free interstate movement of funds in the municipal bond market. Forty-two other states follow Kentucky’s practice of taxing interest on home-state municipal bonds more favorably than out-of-state municipal bonds. These policies encourage investors to inefficiently concentrate their holdings in home-state bonds. More than 1,000 single-state municipal bond mutual funds holding $160 billion in assets have been established to facilitate such concentration. While Treasury and corporate-bond money flows freely across international borders, a big chunk of municipal-bond money is trapped inside state lines. These tax policies flout the constitutional rule that states are not allowed to thwart interstate trade, including the interstate flow of funds.
- A decision for the taxpayers would have sweeping implications. If the Supreme Court rules in favor of the taxpayers, it will force Kentucky and the other forty-two states to make some difficult decisions. States may be required to refund taxes paid on interest on out-of-state bonds or to retroactively tax interest on home-state bonds. The values of outstanding municipal bonds will rise or fall, depending on states’ response to the ruling.
- A decision for Kentucky would also have important implications. The state argues that it has the unrestricted power to use tax policy to discourage interstate transactions, so long as it (or one of its municipalities) is a party to the transaction. If the Supreme Court accepts this argument, it will give states a green light to erect other barriers to interstate trade and financial flows.
- The municipal bond market faces many months of profound uncertainty. The Supreme Court will hear oral arguments in late 2007 and will probably decide the case in early 2008. Until then, the state tax treatment of municipal bonds will remain uncertain.
AEI Resident Scholar Alan D. Viard researches tax and budget policy, as well as Social Security. To interview Alan Viard, please contact him at 202.419.5202 (office), 703.909.3763 (cell), or aviard@aei.org.
If you have any other questions, please contact Veronique Rodman at vrodman@aei.org or 202.862.4870.
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