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WASHINGTON, D.C. - Municipal bond investors take heed: The Supreme Court is considering an issue that could roil the market.
Monday the Court considers whether to treat in-state and out-of-state municipal bonds differently for income tax purposes. Currently, 38 states exempt interest on their own municipal bonds from state income tax, but tax revenue on bonds from other states.
The practice has been going on for nearly 90 years, but is it constitutional? The Tax Foundation, a D.C.-based research group, doesn’t think so.
"[The law] imposes a tax on activity out of state, while leaving identical activity in-state untaxed," the foundation says in its brief on the case, Kentucky Department of Revenue vs. Davis.
The Justices won't decide the case for months; they're only hearing arguments Monday. But the case commands a great deal of attention because it would transform the country's fixed income markets if the Court determines out-of-state bond holders should get refunds for the interest they've paid on these investments.
That's why, right or not, the Court will likely keep the status quo in place.
"If they affirm [the Appeals Court's decision], there could be a lot of disruptions in the municipal bond market," says Ethan Yale, a law professor at Georgetown University.
A brief filed by the attorneys general of the other 49 states in favor of Kentucky, says treating the two types of bonds as equals for tax purposes, would be "devastating" for states and bondholders financially. For one thing, they argue, it would throw a wrench in state budgets. If the Court determines that interest on out-of-state bonds should be exempt from income tax, New York alone could face claims of $200 million since 2001, not to mention $70 million in lost revenue annually, the states say in their filing.
Another problem: Many states are contractually obligated (under the state constitution in some cases) to exempt interest on their municipal bonds from state income tax. "They basically couldn't remedy the problem by taxing both [in-state and out-of-state bond revenues] says Bradley Joondeph, a law professor at Santa Clara University who also clerked for former Justice Sandra Day O'Connor. "The only way they could remedy the problem is by exempting both."
Why the difference in tax treatment? States pay low interest rates on their own municipal bonds so that they can curb costs of new buildings and infrastructure. Investors accept this rate because of the tax exempt interest. States worry taxing interest on their bonds would stunt local investment.
The case argued Monday dates to 2003, when a Kentucky couple argued taxation of out-of-state bonds allowed the state to block interstate commerce. A lower court ruled against them, but the Kentucky Court of Appeals overturned this decision, saying the state's bond taxation system is "facially unconstitutional as it obviously affords more favorable taxation treatment to in-state bonds" than to out-of-state bonds.
While the Tax Foundation supports the couple, a host of influential groups filed briefs supporting Kentucky. They include the U.S. Conference of Mayors, the National Governors' Association, the Securities Industry and Financial Markets Association and--perhaps most significantly--every other state in the Union.
The Court provided some hint earlier this year on how they might rule. In United Haulers Association vs. Oneida-Herkimer, a case on the same constitutional issue, the Court determined laws that don't discriminate against private industry should also not be considered in violation of interstate commerce laws.
The area of law may be murky. But 50 states say it’s not.
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