The Dormant Commerce Clause and the Balkanization of the Municipal Bond Market

Resident Scholar Alan D. Viard
Resident Scholar
Alan D. Viard
The U.S. Supreme Court will soon hear arguments in Davis v. Kentucky Department of Revenue, in which the taxpayer-plaintiffs contend that Kentucky violates the dormant commerce clause (DCC) of the U.S. Constitution by granting its residents a state income tax exemption for interest on home-state municipal bonds while taxing out-of-state municipal bonds. This selective exemption for home-state municipal bonds, also practiced in some form by 42 other states, is a significant barrier to interstate commerce and has balkanized the municipal bond market. The Supreme Court should affirm the Kentucky Court of Appeals' ruling and strike down the exemption under the DCC.

I. Summary

State taxes and subsidies obstruct interstate commerce if they favor within-state sales over interstate sales; import tariffs and export tariffs are the paradigmatic examples. In contrast, uniform taxes on purchases made within the state (whether from in-state or out-of-state sellers) do not obstruct interstate commerce, nor do uniform taxes on sales originating within the state (whether to in-state or out-of-state buyers). A policy's relative treatment of within-state and interstate sales is a real economic property that does not depend upon whether the policy is called a "tax" on interstate sales or a "subsidy" to within-state sales. Also, the relevant question, whether a policy favors within-state sales over interstate sales, should not be confused with the question of whether the policy favors in-state parties over out-of-state parties. Misunderstandings on this point have led to much confusion in discussions of the DCC, including discussions of Davis.

The selective municipal bond exemption obstructs interstate commerce. By taxing residents on their purchases of out-of-state municipal bonds, but not on their purchases of home-state bonds, Kentucky imposes an import tariff on municipal bonds. Nothing changes if, as is convenient, the Kentucky tax system is relabeled as combining a neutral income tax on residents' entire bond income combined with a subsidy that applies only to residents' purchases of home-state bonds. Under either label, the Kentucky tax system favors within-state bond holdings over interstate bond holdings. . . .

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Alan D. Viard is a resident scholar at AEI.

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