The Supreme Court has agreed to hear a case challenging states' tax policies that have partitioned the $2-trillion-plus municipal bond market along state lines. By striking down these protectionist systems, the Court can reaffirm its constitutional commitment to unfettered interstate trade and bring economic freedom to more than 4 million municipal bondholders.
More than three dozen states give income tax exemptions to their residents for interest on home state municipal bonds while taxing them on their out-of-state muni bond interest. The states have done this for decades, even as the Supreme Court has struck down many other state practices that discriminate against interstate transactions. Legal commentators have excused the discrimination on the ground that these transactions involve borrowing by state and local governments rather than sales by private firms.
The distinction makes no economic sense, but an Ohio court relied on it in 1994 to turn away a lawsuit challenging that state's selective muni bond exemption. That time around, the Supreme Court chose not to get involved.
Fortunately, a Kentucky couple, George and Catherine Davis, stepped forward in 2003 with a lawsuit challenging their state's refusal to give out-of-state munis the same tax break as home state munis. Last year, a state court ruled in their favor, striking down the selective exemption as an interference with interstate commerce. This time, the Supreme Court took the case. It will now have the final say.
A simple analogy explains why the selective muni bond tax breaks harm the national economy. Suppose Idaho gave a tax credit to its residents for any purchases of the state's celebrated potatoes, but not for purchases of out-of-state potatoes. With a bigger demand for Idaho potatoes at home, the price would be bid up, restricting the supply available to the rest of the country. Outsiders would pay more for Idaho potatoes, bringing more money into the state. And residents wouldn't mind paying more, since they'd be getting the tax credit.
Although this scheme would inflict higher prices on the rest of the country and interfere with consumers' choice of potatoes, it would be good for Idaho. Until, of course, every other state responded in kind, restricting interstate trade in its own products.
Idaho hasn't adopted this policy in the potato market. But, it pursues a similar policy in the municipal bond market. By giving tax breaks to in-state, but not out-of-state, muni bonds, Idaho restricts the supply of its bonds to the rest of the country, thereby driving down its interest payments to outsiders. Most of the other states follow the same inward-looking policy, each trying to gain at the expense of the others.
The results are just what you'd expect. Investment guides don't tell investors to hold a diversified portfolio with munis from many states--they tell investors to load up on home state munis for the tax break. More than 1,000 single-state municipal bond mutual funds, holding $150 billion in assets, have been formed to help investors carry out this advice. Each of these funds holds bonds issued in a particular state and caters primarily to that state's residents.
So, a big chunk of muni bond money is trapped inside state lines, even as Treasury and corporate bond money moves freely around the world. The flow of funds from states with abundant capital to those with pressing financing needs is impeded. Investors are forced to buy and sell in a less liquid market and are exposed to needless risk due to poor diversification.
The Supreme Court now has a chance to end these inefficiencies. The Court should require that states treat home state and out-of-state munis the same, either exempting both or taxing both. For bonds already outstanding, across-the-board exemption is the better solution--across-the-board taxation would unfairly drive down bond values. Of course, there's bound to be some disruption in any event, but that concern can't justify perpetuating the protectionist and anachronistic status quo.
For more than 150 years, the Supreme Court has been the guardian of free interstate trade. By preventing the interstate commercial warfare that existed before the Constitution was adopted, the Court has fulfilled one of the framers' key objectives. The Court has vigilantly blocked the "rival, conflicting and angry regulations" of which James Madison complained and warded off the "deep-rooted jealousies and enmities" between the states that James Monroe lamented.
To remain faithful to that historic commitment, the Court must rule in favor of the Davises and bring the municipal bond market into the 21st century, on a par with the potato market.
Alan Viard, a Resident Scholar at the American Enterprise Institute, previously served as a senior economist at the Federal Reserve Bank of Dallas.
|
