Supreme Court Upholds Muni Bond Exemptions

The US Supreme Court voted 7-2 to uphold the current law that allows a state to exempt its residents’ municipal bond income from taxation while taxing that of residents of other states. The case stemmed from a Kentucky couple who held non-Kentucky municipal bonds, and a Kentucky state court agreed that this was discrimination in interstate commerce. The majority held that this was not the case, thus protecting the bond market from a nasty crash.

What is particularly interesting is the fact that the other 49 states filed a brief asking the Supremes to throw out the Kentucky ruling. Justice David Souter, writing for the majority, stated, “It would miss the mark to think that the Kentucky courts, and ultimately this court, are being invited merely to tinker with details of a tax scheme. We are being asked to apply a federal rule to throw out the system of financing municipal improvements throughout most of the United States.”

How enormous is this? Some $432 billion in municipal bonds were issued in 2006 alone, and there are $2.6 trillion outstanding. In 2004, some 4.4 million investors earned $52 billion in interest on municipal bonds. New York State said a different decision would have resulted in forced refunds that could have totaled $200 million, plus cost the state $70 million a year in lost revenue.

In the minority opinion, Justices Samuel Alito and Anthony Kennedy maintained that different tax treatment was effectively “protectionist” and has had the effect of creating a “distorted market for state and municipal bonds.” Quite why states must uniformly treat bond dividends is unclear; there is no requirement that every state tax sales within their own borders, nor tax income earned any other way. All state taxes effect the market, but that is what comes of having lawyers rather than economists on the bench.

The court didn’t have much to say about the tax treatment of private activity bonds, those sold on behalf of businesses and non-profits, because the lower courts had not spoken on them. These account for about 25% of the muni bond market, but Justice Souter suggested that the court would resist undermining that much of the market. Treating them differently than the rest of the market would be bad. He wrote, “We must assume that it could disrupt important projects that the states have deemed to have public purposes.”

© Copyright 2008 by The Kensington Review, Jeff Myhre, PhD, Editor. No part of this publication may be reproduced without written consent. Produced using Fedora Linux.

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