In an article in State Tax Notes, Viard critiques the recent U.S. Supreme Court decision in Kentucky Dept. of Revenue v. Davis, which upheld state income tax exemptions for residents' holdings of home-state municipal bonds. He argues that the decision rested on a flawed understanding of nondiscrimination and an unfounded distinction between public and private activities. Viard notes, though, that the Court left open the validity of such exemptions in the private-activity-bond segment of the municipal bond market, in response to an amicus brief that he and other AEI scholars filed.
Alan D. Viard
On May 19 the U.S. Supreme Court decided Kentucky Department of Revenue v. Davis, ruling that states generally do not violate the U.S. Constitution when they grant their residents a state income tax exemption for interest on home-state, but not out-of-state, municipal bonds (the selective exemption). The decision upheld the policy that has balkanized the municipal bond market by prompting investors to concentrate a significant part of their holdings in home-state municipal bonds. The Court reserved judgment, however, on the validity of the selective exemption as it applies to private activity bonds, permitting future challenges to the balkanization of that important market segment.
In its decision in Kentucky Department of Revenue v. Davis, the U.S. Supreme Court relied on a flawed understanding of nondiscrimination to uphold the selective tax exemption, and the resulting market balkanization, for governmental municipal bonds.
In this article, I argue that the Court's decision relied on a mistaken concept of nondiscrimination and an unfounded distinction between public and private activities. I also discuss the Court's reservation of judgment on the status of private activity bonds. Throughout this article, I draw on the analysis in an article that I wrote in State Tax Notes last year about the case.
I. Where the Court Went Wrong
In Davis, the Supreme Court reversed a decision of the Kentucky Court of Appeals and ruled that the selective exemption does not burden interstate commerce in violation of the dormant commerce clause of the U.S. Constitution. The Court decided the case 7 to 2, with Justices Anthony Kennedy and Samuel A. Alito in dissent.
The case produced seven opinions, although the only two lengthy opinions were the Court opinion written by Justice David Souter and a dissenting opinion by Justice Kennedy. Justice Clarence Thomas did not join any portion of the Court's opinion, but concurred separately to reiterate his position that the dormant commerce clause does not exist. The other six members of the majority joined the Court opinion, except that Justice Antonin Scalia refrained from joining one section. Also, another section of Justice Souter's opinion did not constitute the opinion of the Court because it was joined by only two other justices.
The Court relied heavily on its April 30, 2007, decision in United Haulers Ass'n, Inc. v. Oneida-Herkimer Solid Waste Mgmt. Auth. Indeed, the Court stated early in its opinion, "It follows a fortiori from United Haulers that Kentucky must prevail." The crucial role of that precedent arose from how the Court framed the issues in Davis. As explained in subsection B, below, the Court viewed the objection to the selective tax exemption as its preference for Kentucky municipal bonds over other bonds. The Court dismissed that objection by turning to United Haulers, which validated similar preferences for public entities.
Unfortunately, the Court's formulation of the problem was flawed. To understand that point, it is necessary to briefly review the difference between trade neutrality and the nondiscrimination principle that the Court employed.
A. Nondiscrimination and Trade Neutrality
The relevant economic question in dormant commerce clause cases is whether a state tax or subsidy treats interstate sales less favorably than within-state sales. The question, in other words, is whether the policy violates trade neutrality, the equal treatment of within-state and interstate sales. This criterion measures whether the policy obstructs interstate commerce.
Some Supreme Court opinions have framed that issue correctly. Indeed, the third part of the Court's four-part Complete Auto test requires that a tax "not discriminate against interstate commerce." Similarly, the Court has said that a tax "may not discriminate between transactions on the basis of some interstate element" and that a state "may not tax a transaction . . . more heavily when it crosses state lines than when it occurs entirely within the State."
That precept could be referred to as a nondiscrimination principle, as some of the above quotations indicate, because it prohibits discrimination against interstate transactions relative to within-state transactions. I shall call it the trade neutrality principle, however, to distinguish it from the version of the nondiscrimination principle that the Court has set forth in some of its other opinions. That nondiscrimination principle asks whether a challenged policy discriminates against out-of-state parties. That criterion is very different from trade neutrality and using it quickly leads to incoherent results, as can be seen by looking at a few examples.
Consider a destination-based subsidy that applies to all purchases by in-state parties, including imports from out-of-state parties as well as purchases from other in-state parties. Also, consider an origin-based subsidy that applies to all sales by in-state parties, including exports to out-of-state parties as well as sales to other in-state parties. Neither subsidy obstructs interstate commerce by giving in-state parties any incentive to prefer within-state transactions over interstate transactions. Both subsidies apply equally to cross-state and within-state sales and are therefore trade neutral.
Nevertheless, both subsidies violate the nondiscrimination principle by "discriminating" in favor of in-state parties. In each case, the subsidy applies to transactions between two in-state parties and to one type of transaction between in-state and out-of-state parties (imports in the first case, exports in the second), but not to transactions between two out-of-state parties. Of course, the state could avoid that "discrimination" only by subsidizing all transactions throughout the world, a breadth of generosity to which no state is likely to aspire.
The absurdity of that conclusion reveals that the nondiscrimination principle is hopelessly flawed. It is neither realistic nor appropriate to demand that a state treat the rest of the planet's population the same as its residents, whom it exists to serve. Moreover, the commerce clause contains no reference to any such concept of equal treatment. In contrast, it is perfectly reasonable to expect states subsidizing their residents to do so in a trade-neutral manner and thereby not obstruct the "Commerce among the Several States" referred to in the Constitution. Despite their "discrimination," the above subsidies should be upheld because they are trade-neutral.
Although courts and commentators who espouse the nondiscrimination principle recognize the absurdity of its conclusions, they do not abandon the principle or embrace trade neutrality. Instead, they avoid the absurd conclusions by granting all subsidies a blanket exception from the nondiscrimination principle. Of course, the blanket exception does far more than validate the trade-neutral subsidies discussed above. It also validates trade-obstructing subsidies, those that exclude both imports and exports and therefore apply only to transactions between in-state parties. Those subsidies give in-state parties incentives to transact with each other rather than with out-of-state parties and thereby impede interstate trade.
The blanket exception therefore allows states to obstruct interstate trade without limit, provided that they do so through subsidies. But worse is yet to come. Because there is no meaningful distinction between taxes and subsidies, the validation of trade-obstructing subsidies makes it impossible to coherently object to trade-obstructing taxes.
As one might guess from the above discussion of subsidies, destination-based taxes on all purchases by in-state parties are trade neutral. Origin-based taxes on all sales by in-state parties are also trade neutral. Neither of those taxes gives in-state parties an incentive to transact with each other rather than out-of-state parties.
Proponents of the nondiscrimination principle recognize that those taxes are valid. Viewed through the prism of that principle, the taxes actually "discriminate" in favor of out-of-state parties. The taxes apply only to transactions between two in-state parties and to one type of transaction between in-state and out-of-state parties (imports in the first case, exports in the second case) while exempting transactions between two out-of-state parties. Of course, the state could avoid that "discrimination" only by taxing all transactions throughout the world, which would be impossible because states cannot tax transactions to which they have no nexus. The absurdity of the nondiscrimination principle is again apparent: How can a state treat equally its residents, whom it has the power to tax, and the rest of the world, whom it is forbidden to tax? In any case, because the nondiscrimination principle prohibits only discrimination against out-of-state parties, proponents of the principle accept those taxes as valid.
Now, consider a tariff that applies solely to imports. An import tariff clearly violates trade neutrality by giving in-state parties an incentive to deal with each other rather than out-of-state parties. Proponents of the nondiscrimination principle also profess to reject the import tariff, citing its alleged discrimination against out-of-state parties. Their reasoning is flawed on its own terms because an import tariff does not actually discriminate against out-of-state parties.
More important, though, their objection is incoherent when combined with their conclusions about subsidies. A 20 percent import tariff is identical to a 20 percent destination-based tax on all purchases by in-state parties combined with a 20 percent subsidy to transactions between in-state parties. If the destination-based tax is valid (as everyone rightly agrees) and if the subsidy is valid (as the blanket exception to the nondiscrimination principle asserts), how can the import tariff formed by combining them be invalid?
All of those problems vanish under the trade neutrality principle. The principle applies in a unified manner to taxes and subsidies, avoiding the need to distinguish those indistinguishable categories, and a combination of trade-neutral policies is always trade neutral, avoiding incoherence. Uniform destination-based taxes and subsidies and uniform origin-based taxes and subsidies are trade neutral.10 Policies that obstruct trade include subsidies that apply only to within-state transactions, import tariffs, export tariffs, and taxes that apply to both imports and exports as well as to within-state transactions.
B. Nondiscrimination in United Haulers and Davis
In Davis, the Court viewed the selective exemption through the prism of the nondiscrimination principle, consistently describing the exemption as favoring a particular category of bond issuers, namely the state and its local governmental units, over other issuers. After referring to "laws favoring a State's municipal bonds," the Court concluded that "there is no forbidden discrimination because Kentucky, as a public entity, does not have to treat itself as being 'substantially similar' to the other bond issuers in the market . . . Kentucky's tax exemption favors a traditional government function without any differential treatment favoring local entities over substantially similar out-of-state interests." The Court also said that "no State perceives any local advantage or disadvantage beyond the permissible ones open to a government and to those who deal with it when the government itself enters the market."
Having framed the issue as whether Kentucky may prefer itself (and its local governmental units) over other borrowers, the Court turned to United Haulers for the answer. In that case, the Court upheld county ordinances requiring local businesses to deal exclusively with local public waste-disposal facilities. More important, it created a new exception (the United Haulers exception) to the dormant commerce clause for policies involving transactions by state and local governments. The United Haulers Court stated:
Unlike private enterprise, government is vested with the responsibility of protecting the health, safety, and welfare of its citizens. . . . Given these differences, it does not make sense to regard laws favoring local government and laws favoring private industry with equal skepticism . . . when a law favors in-state business over out-of-state competition, rigorous scrutiny is appropriate because the law is often the product of simple economic protectionism. . . . Laws favoring local government, by contrast, may be directed toward any number of legitimate goals unrelated to protectionism.
The Davis Court applied that principle to conclude that Kentucky may prefer its own bonds over other bonds. That conclusion is correct, but irrelevant.
It is, of course, perfectly permissible for Kentucky to subsidize only its own bonds and to do so as extravagantly as it pleases. Kentucky may devote billions of dollars to advertising that praises the virtues of its own bonds and excoriates the deficiencies of other bonds. Any claim that states cannot "discriminate" in favor of themselves is even more incoherent than the claim that they cannot "discriminate" in favor of their residents. Indeed, it is unclear how Kentucky could avoid preferring its own bonds, because it necessarily pays the interest and principal on those bonds but not on all other bonds issued throughout the world.
That Kentucky's selective exemption gives a preference to Kentucky's bonds over other bonds is therefore not a problem. By focusing on that perceived problem, the Court found Davis a relatively easy case. In short, the Court viewed the selective exemption as a violation of the nondiscrimination principle and concluded that it did not make sense to apply that principle to public entities. It is hard to quarrel with that conclusion, because it does not make sense to apply the principle to any entities.
If the Court had instead viewed the selective exemption through the prism of trade neutrality, it would have understood the real objection to the exemption, an objection that cannot be so easily dismissed. The problem is not that the exemption prefers Kentucky bonds over other bonds. The problem is that it prefers within-state bond holdings over cross-state bond holdings. The selective exemption's fatal flaw is that it gives only Kentucky residents an incentive to hold Kentucky bonds; it promotes Kentucky bonds to Kentucky residents without promoting them to residents of other states. Kentucky may promote its own bonds to an unlimited extent if it does so to residents and nonresidents alike, because that promotion does not impede interstate transactions. When Kentucky promotes its bonds only to its own residents, however, it impedes interstate transactions.
The Kentucky income tax system begins with a neutral destination-based tax on bonds, taxing (the interest income on) all bonds purchased by residents, including bonds imported from out-of-state issuers as well as those purchased from in-state issuers. The selective exemption, however, adds a trade-obstructing subsidy that applies only to bonds issued by in-state parties to in-state holders. Adding the trade-obstructing subsidy to the trade-neutral tax yields a trade-obstructing tariff on imported bonds.
The selective exemption, which has been adopted by 40 other states as well as Kentucky, has predictably resulted in significant balkanization of the municipal bond market. Of those municipal bonds that are held in mutual or money market funds, 30 percent to 40 percent are held in funds that specialize in a particular state's bonds and are marketed exclusively to residents of that state. A similar degree of concentration is believed to exist for bonds held directly by individuals. In contrast, without the selective exemption, bondholders would probably hold nationally diversified portfolios, implying that the typical bondholder would have only 2 percent of his or her holdings in home-state bonds. The single-state mutual and money market funds suffer from lack of diversification, poor liquidity, and high administrative costs. In an era in which the U.S. Treasury and American corporations readily borrow from investors thousands of miles away in London and Tokyo, state tax systems that impede a municipality in Silver Spring, Md., from borrowing from investors a few miles away in Arlington, Va., are anachronistic.
If the Court had focused on trade neutrality rather than nondiscrimination, it would not have needed the public-private distinction drawn by United Haulers. The state should be free to favor either public or private in-state borrowers if it does so in a trade-neutral manner. For example, the typical state income tax system includes an itemized deduction for mortgage interest on owner-occupied homes. Each state properly grants that tax break only to its own residents rather than to all homeowners throughout the world. Although that provision "discriminates" against nonresidents, it is a trade-neutral destination-based subsidy that applies to borrowing from both out-of-state and in-state lenders. Of course, if the deduction applied only to residents' borrowing from in-state lenders, it would be trade-obstructing.
In summary, in both Davis and United Haulers, the Court improperly focused on the alleged problem of "discrimination" against out-of-state parties. In both cases, the Court concluded that that discrimination is not a problem when the in-state party is the state itself or a local governmental unit. The real problem, however, is the obstruction of interstate transactions, a concern that is little allayed merely because one of the parties is public. The United Haulers exception would be innocuous if it merely shielded trade-neutral preferences for state and local governments; indeed, it would be redundant, because trade-neutral preferences for any in-state parties should be permissible. Unfortunately, the exception also shields trade-obstructing preferences, such as the selective exemption.
C. No Balancing Required
In one critical respect, the Davis Court went beyond United Haulers. The opinions in the latter case had suggested that a state policy covered by the United Haulers exception still remained subject to some scrutiny. A four-member plurality (Chief Justice John Roberts and Justices Souter, Stephen Breyer, and Ruth Bader Ginsburg) held that the challenged practice must still satisfy the balancing test set forth in Pike v. Bruce Church, Inc. Because another three justices (Justices Kennedy, Alito, and John Paul Stevens) rejected the United Haulers exception altogether, it appeared that any policy that invoked the United Haulers exception, but failed to satisfy Pike balancing, would be invalidated by seven members of the Court.
The Pike balancing test compares the burden on interstate commerce with the local benefits of the challenged practice. In United Haulers, the plurality upheld the county ordinances after finding that the ordinances promoted recycling and raised revenue for the county governments. In my article last year, I noted the analytical and factual weakness of the asserted benefits of the selective exemption: the gains said to arise because bondholders allegedly make better residents and residents allegedly make better bondholders and the alleged aid to small municipalities seeking to market their debt. I concluded that "the selective exemption cannot survive any reasonable version of Pike balancing. . . . If such a large disruption of interstate commerce can be justified with such flimsy rationales, Pike balancing is truly toothless."
Ironically, the Court's opinion confirmed that conclusion. Although the Court did accept one of those rationales, the aid to small municipalities, as sufficient to justify the selective exemption, it did not engage in a reasonable, nontoothless, version of Pike balancing. Indeed, the Court's statements reveal it did no actual balancing at all.
Instead, the Court said that "the current record and scholarly material convince us that the Judicial branch is not institutionally suited to draw reliable conclusions of the kind that would be necessary for the Davises to satisfy a Pike burden in this particular case." The Court did not balance the benefit for small municipalities against the large disruption to interstate commerce, expressing doubt whether "any court [is] in a position to evaluate" those matters. The Court stated:
What is most significant about these cost-benefit questions is not even the difficulty of answering them or the inevitable uncertainty of the predictions that might be made in trying to come up with answers, but the unsuitability of the judicial process and judicial forums for making whatever predictions and reaching whatever answers are possible at all.
The Court's approach appears to require only that some benefit from the challenged policy be identified; it eschews any weighing of that benefit against the disruption of interstate commerce. David W.T. Daniels pointed out to me that that approach is similar to the rational-basis review that the Court has applied, in the context of economic regulation, to classifications challenged under the equal protection clause of the 14th Amendment and the equal protection component of the due process clause of the Fifth Amendment. Under that type of review, any conceivable reason that would provide a rational basis for the classification is sufficient to uphold it. The Davis approach seems only slightly less deferential. It is certainly different from the approach taken in United Haulers, which cited lower-court findings based on "years of discovery" to justify its balancing.
Although it may be true that small municipalities can more easily market their debt in a market segmented along state lines, the alleged benefits cannot justify the loss of liquidity and diversification and the increase in administrative costs caused by the selective exemption. That concern can be addressed by trade-neutral policies, including state-level borrowing, pooled credit arrangements, and direct aid to small municipalities.
In any event, the Court's refusal to do genuine Pike balancing expands the United Haulers exception beyond its initial scope.
D. Whither the Market-Participant Exception?
When it was created last year, the United Haulers exception took its place alongside the much older market-participant exception to the dormant commerce clause. The latter exception gives states the same freedom to boycott interstate transactions that a private party would have. That exception would not have justified the result in United Haulers, because the governmental unit in that case required other parties to deal with it, something that a private party could not do. Indeed, in Davis, the Court reiterated that United Haulers was "decided independently of the market participation precedents."
There has been heated debate about whether the market-participant exception should apply in Davis. Although the transactions between the governmental units and the bondholders are voluntary transactions similar to those between private parties, the state implements the selective exemption through its tax system, a tool not available to a private party. Having upheld the selective exemption under the United Haulers exception, the Court opinion in Davis ultimately found no need to address the market-participant exception.
In any case, it is unclear whether the market-participant exception retains much of a separate role, in view of the Court's latest treatment of the United Haulers exception. After all, the United Haulers exception is the broader of the two because it applies to governmental units' actions that could not be undertaken by private parties. The restrictive feature of United Haulers had appeared to be that Pike balancing was required before the challenged policy could be upheld; that balancing has never been required under the market-participant exception. That difference now seems attenuated in view of the Court's willingness in Davis to dispense with Pike balancing in the normal sense, although it may still be necessary to at least identify a benefit of the challenged practice.
Indeed, the Court seemed to blur the two exceptions in Davis. The Court said the need for any type of Pike balancing in "a case of this sort" was "an open question," noting that that balancing was done in United Haulers but not in market-participant cases. In future cases, the market-participant exception may be subsumed into the United Haulers exception.
II. Court Leaves Private Activity Bonds 'For Another Day'
The one ray of hope for those seeking free interstate financial markets was the Court's reservation of judgment about the validity of the selective tax exemption as applied to private activity municipal bonds. The door remains open for challenges in that area, although it is unclear how receptive courts will be to them.
The majority of bonds issued by state and local governments are governmental bonds issued to finance the operations of governmental units. Private activity bonds play a different role. The Joint Committee on Taxation explains that:
present law permits qualified governmental units to issue qualified private activity bonds to provide tax-exempt financing for certain private activities. In these cases, the qualified governmental unit generally acts as a conduit, that is, the qualified governmental unit issues the bonds, but the nongovernmental person receiving the benefit of tax-exempt financing ('the conduit borrower') is the obligor on the bonds.
Congress has recognized that the federal tax exemption granted to state and local governments can be inappropriately expanded if governments can claim those benefits while acting as conduits for private entities. Accordingly, Congress has placed limitations on the availability of the federal tax exemption for private activity bonds.
For federal tax purposes, Internal Revenue Code section 141 classifies a municipal bond as a private activity bond if more than 10 percent of the proceeds are used in the trade or business of a private person and if more than 10 percent of the proceeds are secured by property used by private business or derived from payments regarding such property. Section 141 also classifies a municipal bond as a private activity bond if more than 5 percent of the proceeds (or, if less, $5 million) are loaned to private entities. There are some exceptions and modifications to these general rules.
If a municipal bond is classified as a private activity bond, its federal tax treatment becomes less favorable in several respects. Private activity bonds are tax exempt only if they fall into one of the seven categories listed in section 141(e)(1)--exempt facility bonds, qualified mortgage bonds, veterans' mortgage bonds, small issue bonds, redevelopment bonds, 501(c)(3) bonds, and student loan bonds--or some other categories listed elsewhere in the code. Also, some, but not all, types of private activity bonds are subject to a volume cap under section 146. Section 147 also imposes various restrictions on private activity bonds, including a public-approval requirement and a limit on issuance costs.
Moreover, even if a private activity bond meets the above criteria and thereby qualifies for exemption under the regular federal income tax, its interest may be subject to the alternative minimum tax. Section 57(a)(5) requires that interest on most private activity bonds issued after August 7, 1986, be added back into income for AMT purposes.
Private activity bonds constitute a significant share of the municipal bond market. Internal Revenue Service data show that state and local governments issued $110.3 billion of tax-exempt private activity bonds in 2005, alongside $364.5 billion of governmental bonds, so that private activity bonds were 23 percent of all municipal bonds issued. The share was up from 21 percent in 2004.31 In the past, private activity bonds have sometimes commanded a higher market share; the activity bonds constituted more than half of total municipal bond issuance in 1985.32 One observer has estimated that private activity bonds constitute about 25 percent of all outstanding municipal bonds.
Nearly half of all private activity bonds issued in 2005 were 501(c)(3) bonds, divided about equally between nonprofit hospitals and other organizations. Mortgage bonds composed another one-fifth of private activity bonds.
Some bonds commonly viewed as private activity bonds, notably bonds to finance sports stadium construction, are not so classified under the IRC. Since the Tax Reform Act of 1986 took effect, private activity bonds used for that purpose do not qualify for federal tax exemption. Although states and localities continue to issue tax-exempt bonds to finance stadiums, they structure the bonds to avoid private-activity classification under section 141. Although more than 10 percent of the proceeds are normally used by private businesses (because of sports teams' use of the stadium), states and localities use generally applicable taxes to finance bond repayment, ensuring that no more than 10 percent of the proceeds are secured by, or paid from, property used by private business.
B. Does United Haulers Apply to Private Activity Bonds?
As discussed above, United Haulers draws a sharp distinction between "laws favoring local government" and "laws favoring private industry," freeing the former from scrutiny under the dormant commerce clause. Given the intertwined roles of local government and private industry (or nonprofits) in private activity bonds, it is not immediately clear which side of the line those bonds fall on.
Soon after the Court agreed to hear Davis, some market observers wondered whether the selective exemption would be upheld for private activity bonds, even if it were upheld for governmental bonds. That issue was discussed at length in a subsequent article in this journal by Joel Michael  and I also touched on it in my article last year.
In their brief, the Davises did not raise the question of private activity bonds. On September 21, 2007, however, I filed an amicus brief in Davis, joined by five other American Enterprise Institute scholars and a Brookings Institution scholar. In our brief, my fellow amici and I contended that the United Haulers exception "applies to state and local governments, not private firms. . . . With private-activity bonds, however, private parties are the actual borrowers, not state or local governments."
In its reply brief, the Kentucky Department of Revenue predictably took a different view. In a footnote consuming most of a page, the DOR argued that private activity bonds:
finance projects and programs that serve overwhelmingly public purposes. . . . Congress has expressly authorized 'private activity bonds' to be treated the same as 'governmental bonds,' i.e., as a permissible use of public finance to support Congressionally specified types of projects that are in turn approved by State and local governments as means of accomplishing State and local governmental objectives. Such bonds must be approved by a State or local government . . . and are used to finance public infrastructure facilities such as docks and wharves, mass commuting facilities, solid waste disposal facilities, sewage facilities, and high-speed intercity rail facilities.
The issue surfaced at the November 5, 2007, oral argument. When counsel for the DOR asserted that the selective exemption favors government while treating in-state and out-of-state private business entities the same, Justice Alito inquired whether that statement held true for "conduit bonds, where Kentucky issues bonds to finance private construction." Justice Souter noted that the immediate beneficiary of the bond, the party allowed to borrow at a lower interest rate, was a private entity, and Justice Alito further noted that the availability of private activity bonds might change the location decisions of private businesses. The counsel for the DOR replied that Congress has approved a federal tax exemption for those bonds and that the dormant commerce clause allows states to provide economic incentives for in-state business activity. The line of questioning was cut off when Justice Ginsburg noted, and counsel agreed, that the treatment of private activity bonds was not addressed by the Kentucky courts and that the record did not reveal whether the Davises owned out-of-state private activity bonds.
In footnote 2 of its opinion, the Court addressed, but did not resolve, the issue of private activity bonds:
An argument raised by one of the Davises' amici focuses on so-called "private-activity," "industrial-revenue," or "conduit" bonds, a subset of municipal bonds used to finance projects by private entities. These bonds are often (but not always) exempt under the Kentucky scheme. Amici contend that Kentucky's exemption of these bonds, at the very least, plainly violates the Commerce Clause. See Brief for Alan D. Viard et al. as Amici Curiae 25-26. This argument, however, was not considered below, was never pressed by the Davises themselves, and is barely developed by amici. Moreover, we cannot tell with certainty what the consequences would be of holding that Kentucky violates the Commerce Clause by exempting such bonds; we must assume that it could disrupt important projects that the States have deemed to have public purposes. Accordingly, it is best to set this argument aside and leave for another day any claim that differential treatment of interest on private-activity bonds should be evaluated differently from the treatment of municipal bond interest generally.
By declining to resolve the question, the Court left the door open for challenges to the selective tax exemption, as it applies to private activity bonds. Any such challenges will initially be heard by state courts. It is likely that many state courts will be inclined to uphold the selective tax exemption as it applies to private activity bonds. If all state courts adopt that position, the Supreme Court may simply deny taxpayers' petitions for certiorari, leaving the state court decisions in place without ruling on the matter itself. If one or more state courts were to invalidate the selective tax exemption as it applies to some or all private activity bonds, however, a grant of certiorari and a Supreme Court ruling on the merits would become much more likely.
It is unclear how the Supreme Court will rule if and when it confronts the question. In that situation, the Court may face a painful dilemma. Although one set of powerful considerations will support upholding the exemption, another will support striking down the exemption, at least for some private activity bonds.
C. Unresolved Dilemma
The long-established nature of that aspect of the selective tax exemption and its support by the states will point toward upholding it. In Davis, the Court repeatedly referred to its reluctance to strike down long-established tax systems, particularly ones that are supported by all of the states.46 The unanimous state support for the selective exemption undoubtedly extends to its application to private activity bonds. That aspect of the exemption is also long-standing, although the issuance of tax exempt bonds to finance private activities did not become widespread until the 1960s. The Court alluded to those concerns in its footnote 2 by referring to "important projects" and "public purposes."
Nevertheless, upholding the selective tax exemption in that context would have troubling implications. It would be particularly difficult to justify applying United Haulers when a governmental unit functions as a mere conduit for a private entity. That application would permit a wide range of protectionist practices. Joel Michael has ably stated the issue at stake, "This approach could allow states to use nominally governmental entities to provide differential tax benefits."
Some private activity bonds allow pure conduit borrowing. Applying the selective tax exemption to them steers borrowing by in-state private entities to in-state bondholders, a form of market balkanization that the Court has never previously sanctioned. In section I.B, above, I noted that a tax deduction for residents' payments of mortgage interest is a trade-neutral destination-based subsidy if it applies to borrowing from both in-state and out-of-state lenders. Similarly, the issuance of private activity mortgage bonds to finance borrowing by state residents is trade-neutral, if the bonds are marketed to both residents and nonresidents. With the selective tax exemption in place, however, the private activity bonds are steered toward in-state bondholders. As a result, within-state lending is promoted over cross-state lending, in much the same manner as if a state allowed its residents to deduct only mortgage interest paid to in-state lenders. Because the latter policy would surely be struck down under the dormant commerce clause, the former should also be struck down.
To add further complexity, there is no reason that the contours of the public-private distinction in United Haulers should perfectly track the distinction between governmental and private activity bonds delineated in Code section 141, particularly as Congress amends the latter from time to time. Some private activity bonds finance governmentally owned projects, albeit ones used by private businesses that are responsible for the debt repayment; those bonds have more of a "public" flavor. Conversely, some governmental bonds, such as those used to finance sports stadium construction, have a "private" flavor.
Ultimately, the difficulty of answering those questions illustrates the weak conceptual basis for the public-private distinction drawn in United Haulers. It reinforces the point that trade neutrality should be the touchstone of the analysis.
If a state uses private activity bonds as a trade-neutral origin-based subsidy to in-state firms, there is no obstruction of interstate commerce, despite the exclusion of out-of-state firms. Of course, trade neutrality requires that the bonds be available equally to firms that sell to in-state consumers and those that export, those that buy supplies within the state and those that import supplies, and so on. Trade neutrality also requires that the bonds be promoted impartially to residents and nonresidents. No problem then arises under the dormant commerce clause, regardless of whether the bonds are considered public or private.
Trade neutrality is violated, however, when state residents, but not nonresidents, are given an incentive to hold those bonds. In that case, why should labeling the bonds as public validate the obstruction to interstate commerce? No matter how worthy the projects funded by the bonds may be, why is it necessary to obstruct interstate lending?
Ideally, the Court should abandon United Haulers' public-private distinction. If it is maintained, though, the Court should not allow it to be evaded through the use of governmental units as conduits or proxies for private entities.
In its decision in Kentucky Department of Revenue v. Davis, the U.S. Supreme Court relied on a flawed understanding of nondiscrimination to uphold the selective tax exemption, and the resulting market balkanization, for governmental municipal bonds. It left the door open, however, for challenges to the similar balkanization that the selective exemption has produced in the market for private activity municipal bonds. The ultimate resolution of that issue will shed further light on the scope and vitality of the constitutional commitment to free interstate trade.
Alan D. Viard is a resident scholar at AEI.
1 "The Dormant Commerce Clause and the Balkanization of the Municipal Bond Market," State Tax Notes, Oct. 22, 2007, p. 241, Doc 2007-21711 [PDF], or 2007 STT 205-4 (hereafter Viard article).
2 U.S. Constitution, Article I, section 8, cl. 3. ("Congress shall have Power. . . . To regulate Commerce with Foreign Nations, and among the Several States, and with the Indian Tribes.") Although the text merely confers power on Congress, it has long been interpreted to also limit state authority to impede or burden interstate commerce when Congress has not spoken. See Viard article, supra note 1, p. 243.
3 550 U.S. __, 127 S. Ct. 1786 (2007).
4 Department of Revenue of Kentucky v. Davis, slip opinion, available at http://www.supremecourtus.gov/opinions/07pdf/06-666.pdf (hereafter "Davis slip opinion"), p. 5. (For the decision, see Doc 2008-11012 [PDF] or 2007 STT 98-8 .)
5 Complete Auto Transit v. Brady, 430 U.S. 274, 279 (1977).
6 Boston Stock Exchange v. State Tax Comm'n, 429 U.S. 318, 332 n. 12 (1977).
7 Armco Inc. v. Hardesty, 467 U.S. 638, 642 (1984).
8 For further discussion, see Viard article, supra note 1, pp. 243-247.
9 The import tariff applies to a transaction that involves an in-state party and an out-of-state party, while exempting transactions between two in-state parties and also those between two out-of-state parties. The two groups therefore enjoy parity of treatment. Put differently, because the tariff applies only to purchases by in-state parties from out-of-state parties, its discrimination against out-of-state sellers is offset by its discrimination in favor of out-of-state buyers.
10 Things are more complex if the tax or subsidy applies to only some products. Trade is obstructed by destination-based taxes on, or origin-based subsidies to, products that the state imports and by origin-based taxes on, or destination-based subsidies to, products that the state exports. See Viard article, supra note 1, pp. 244-245.
11 Davis slip opinion, supra note 4, pp. 12-13.
12 Id., p. 21. To be sure, the Court made a few statements that can be read as allusions to trade neutrality, when it cautioned against "economic isolation" (p. 7), "economic Balkanization" (p. 8), and provisions that "discriminate against interstate commerce" (p. 8).
13 127 S. Ct. at 1795-1796.
14 For further discussion, see Viard article, supra note 1, pp. 255-257.
15 For further discussion and references, see id., pp. 253-255.
16 As discussed in section II.C, below, a trade-obstructing policy similar to that described in the text actually arises from the selective tax exemption as applied to private activity mortgage bonds.
17 397 U.S. 137 (1970).
18 Viard article, supra note 1, pp. 263-264.
19 Davis slip opinion, supra note 4, pp. 24-26.
20 U.S. Constitution, Amendment XIV, section 1 ("No State shall . . . deny to any person within its jurisdiction the equal protection of the laws") and Amendment V ("Nor shall any person . . . be deprived of life, liberty, or property, without due process of law").
21 The Court has said that, "In areas of social and economic policy, a statutory classification that neither proceeds along suspect lines nor infringes fundamental constitutional rights must be upheld against equal protection challenge if there is any reasonably conceivable set of facts that could provide a rational basis for its classification . . . those attacking the rationality of the legislative classification have the burden to negative every conceivable basis which might support it. . . . Moreover, because we never require a legislature to articulate its reasons for enacting a statute, it is entirely irrelevant for constitutional purposes whether the conceived reason for the challenged distinction actually motivated the legislature . . . a legislative choice is not subject to courtroom fact-finding and may be based on rational speculation unsupported by evidence or empirical data," Federal Communications Comm'n v. Beach Communications, Inc., 508 U.S. 307, 313-315 (1993) (internal quotation marks omitted).
22 127 S. Ct. at 1797.
23 For further discussion, see Viard article, supra note 1, p. 264. As far as I am aware, the Kentucky Department of Revenue did not advance the small-municipality argument in its briefs. The Court cited to the discussion of this issue in the amicus brief filed in support of neither party by the National Federation of Municipal Analysts. I noted in my article last year that the argument was also raised in two of the amicus briefs filed in support of the Department.
24 See Viard article, supra note 1, pp. 259-260.
25 Davis slip opinion, supra note 4, p. 9.
26 For discussion, see Viard article, supra note 1, pp. 262-263.
27 Justice Souter presented the market-participant exception as an alternative ground to uphold the exemption, but that part of his opinion was joined only by Justices Stevens and Breyer and therefore did not constitute the opinion of the Court.
28 As discussed by Viard article, supra note 1, p. 261, some language in United Haulers also suggested that its exception applied only to "traditional" governmental functions, a restriction that has not appeared in the market-participant cases. In Davis, however, the Court appeared to also dispense with that restriction. Davis slip opinion, supra note 4, p. 11 n.9.
29 Davis slip opinion, supra note 4, p. 24.
30 Joint Committee on Taxation, Present Law and Background Relating to State and Local Government Bonds (JCX-14-06), Mar. 14, 2006, p. 4.
31 Cynthia Belmonte, "Tax-Exempt Bonds, 2005," Statistics of Income Bulletin, Fall 2007, pp. 156-173.
32 Joint Committee on Taxation, supra note 30, pp. 14-15.
33 Joel Michael, "Department of Revenue of Kentucky v. Davis: Implications for State Tax Policy and Dormant Commerce Clause Doctrine," State Tax Notes, Sept. 17, 2007, p. 753, Doc 2007-18392, or 2007 STT 181-2 .
34 Belmonte, supra note 31, p. 158.
35 Joint Committee on Taxation, supra note 30, pp. 21-22.
36 Andrew Ackerman and Peter Schroeder, "High Court to Hear Davis Case," Bond Buyer, May 22, 2007, report speculation about this question.
37 Michael, supra note 33.
38 Viard article, supra note 1, pp. 264-265.
39 Brief of Alan D. Viard, Alex Brill, Christopher DeMuth, Jason Furman, Kevin A. Hassett, R. Glenn Hubbard, and Kent Smetters as Amici Curiae Supporting Respondents, available at http://www.aei.org/publication26853. We received excellent pro bono legal representation from Lucinda O. McConathy, David W.T. Daniels, and Jon Connolly of Richards Kibbe & Orbe LLP in connection with the filing of the brief.
40 Id., pp. 25-26.
41 Reply Brief for Petitioners, available at http://www.abanet.org/publiced/preview/briefs/pdfs/07-08/06-666_PetitionerReply.pdf, p. 4 n.2.
42 Transcript of oral argument, available at http://www.supremecourtus.gov/oral_arguments/argument_transcripts/06-666.pdf, pp. 3-7.
43 Davis slip opinion, supra note 4, p. 2 n.2. The Court was correct to say that we "barely developed" the argument, as we devoted only a paragraph to it; the argument was one of many that we discussed in a brief with tight page limits.
44 The Tax Injunction Act, 28 U.S.C. section 1341, generally requires that challenges to state tax systems, including challenges based on the U.S. Constitution, be filed in state courts.
45 The Supreme Court has repeatedly noted that denial of certiorari does not imply any view on the merits of the decision below.
46 The Court stated, "The Davises would have us invalidate a century-old taxing practice . . . presently employed by 41 States . . . and affirmatively supported by all of them . . . we are being asked to apply a federal rule to throw out the system of financing municipal improvements throughout the United States. . . . The dissent's approach . . . would upset the market in bonds and the settled expectations of their issuers based on the experience of nearly a century," Davis slip opinion, supra note 4, pp. 12, 27.
47 Joint Committee on Taxation, supra note 30, p. 12.
48 Michael, supra note 33, p. 761.