Municipal Bonds, State Income Taxes, and Interstate Commerce
Davis v. Kentucky Department of Revenue
About This Event

On November 5, the U.S. Supreme Court is scheduled to hear oral arguments in Davis v. Kentucky Department of Revenue—a lawsuit that threatens the continued existence of hundreds of single-state municipal bond funds, each of which holds a particular state’s bonds and caters to that state’s residents. The Supreme Court is hearing an appeal from a January 2006 Kentucky court ruling that sent shock waves through the $2 trillion municipal bond market. The Kentucky court decided that states could no longer tax interest income from out-of-state municipal bonds while exempting interest income from home-state bonds, ruling that this long-standing practice was an unconstitutional interference with interstate commerce.

Critics of the Kentucky court's ruling fear massive upheavals in the municipal bond market, while supporters see the promise of a more efficient market that can better serve investors and bond issuers. Panelists at this conference will examine the many questions raised by this case. Walter Hellerstein, the Francis Shackelford Distinguished Professor of Taxation Law at the University of Georgia Law School, will explain the legal issues involved. AEI economist Alan D. Viard will discuss the economic effects of the challenged state tax policies. Gerard J. Lian, the executive director of the Morgan Stanley/Van Kampen tax-exempt mutual fund group, will discuss the case’s market implications. AEI research fellow Alex Brill will moderate.

Agenda
9:45 a.m.
Registration
10:00
Panelists:
Walter Hellerstein, University of Georgia School of Law
Gerard J. Lian, Morgan Stanley/Van Kampen
Alan D. Viard, AEI
Moderator:
Alex Brill, AEI
11:30
Adjournment
Event Summary

October 2007

Municipal Bonds, State Income Taxes, and Interstate Commerce
Davis v. Kentucky Department of Revenue 

On November 5, the U.S. Supreme Court is scheduled to hear oral arguments in Davis v. Kentucky Department of Revenue--a lawsuit that threatens the continued existence of hundreds of single-state municipal bond funds, each of which holds a particular state's bonds and caters to that state's residents. The Supreme Court is hearing an appeal from a January 2006 Kentucky court ruling that sent shock waves through the $2 trillion municipal bond market. The Kentucky court decided that states could no longer tax interest income from out-of-state municipal bonds while exempting interest income from home-state bonds, ruling that this long-standing practice was an unconstitutional interference with interstate commerce.

Critics of the Kentucky court's ruling fear massive upheavals in the municipal bond market, while supporters see the promise of a more efficient market that can better serve investors and bond issuers. On October 18, 2007, AEI held a conference to examine the many questions raised by this case. Walter Hellerstein, the Francis Shackelford Distinguished Professor of Taxation Law at the University of Georgia Law School, explained the legal issues involved. AEI economist Alan D. Viard discussed the economic effects of the challenged state tax policies. Gerard J. Lian, the executive director of the Morgan Stanley/Van Kampen tax-exempt mutual fund group, discussed the case's market implications. AEI research fellow Alex Brill moderated.

Walter Hellerstein
University of Georgia School of Law

It should be noted that the constitution itself says practically nothing about state taxation. Any restrictions on state taxation attributed to the constitution are, in fact, implied limitations. These implied limitations are justified jurisprudentially under the dominant commerce clause, which asserts that states are prohibited from unduly obstructing interstate commerce. Strict constructionists like Justices Antonin Scalia and Clarence Thomas dispute the validity of this clause and, by extension, dispute the validity of restricting state taxation, believing neither to have a basis under the constitution.

If we consider the nondiscrimination facets of the commerce clause, as they are widely interpreted, it is clear that there are serious constitutional problems with Kentucky's taxation plan. This is true despite the prevalence of the practice, with Kentucky being only one state among the forty-two following it. Part of the problem is due to the tax plan's discriminatory effects, which lead residents to buy home-state rather than out-of-state bonds. When states have favored their own private-sector institutions over alternatives in the past, the policies have been struck down under the commerce clause.

The Kentucky policy could gain some justification under the constitution so long as it constitutes the only means through which states can lower borrowing costs. The court used a justification along these lines in the case of United Haulers, concluding that a county can play favoritism with its own waste facilities because of waste management's status as a “public good.” But while there might be few other ways of controlling waste, there are plenty of other ways to raise funds besides the discriminatory tactics that states such as Kentucky employ. As a result, the precedent set by the United Haulers case doesn't seem to apply all that well to the Kentucky situation. Nevertheless, in making its ruling, which is likely to be a reversal, the Supreme Court will, in all likelihood, cite the United Haulers case as justification for its decision.

Any economic benefits from these discriminatory tax practices seem to be nonexistent because there is a net economic cost to having the policies in force. Yet, in order to preserve the established order, the Supreme Court is likely to decide in favor of Kentucky, despite the legal and economic arguments in the plaintiff's favor.

Alan D. Viard
AEI

The tax breaks that Kentucky provides to in-state municipal bond holders allow Kentucky municipalities to charge lower interest rates. However, these tax breaks do not lower the overall financing costs for municipality debt because of the implicit costs Kentucky incurs in the funding of exemptions. In fact, as the employment of such tax laws across multiple states ends up limiting each individual state's municipal bond market to its borders, the exemption increases the effective interest rate that municipal bonds must pay. As a result, the subsidies that a state like Kentucky pays in the form of tax exemptions actually end up exceeding the interest saving of Kentucky municipalities. If Kentucky alone has this tax exemption in place, then Kentucky is not significantly better or worse off with it than it is without it. However, if other states have exemptions in place, which is the case here, then it is certainly in Kentucky's own interest to enact exemptions. As a result, we see that subsidies tend to reinforce, rather than offset, one another and that one state's adoption of subsidies provides additional incentives for another to adopt them.

While each state pursues its own interests, as part of this vicious circle of enacting exemptions, the nation endures a net loss. This is because of the resulting reduction in interstate holdings and the inefficiencies that result from such a balkanization in the market. Single-state municipal funds also happen to be less diversified and less liquid and to entail higher expense ratios than the alternatives.

A subsidy provided to all holders of a given state's municipal bonds, dispensed to both residents and nonresidents, would avoid the economic and legal pitfalls of the current system. To this end, such a subsidy would place no restrictions on interstate commerce, while also in no way reducing interstate bond holdings.

Gerard J. Lian
Morgan Stanley/Van Kampen

The Kentucky case is complex because it cuts across a multitude of issues and involves law, finance, and political science.

A municipal bond is a fiscal tool that allows municipalities to provide goods and services and to promote economic growth. An in-state tax exemption on municipal bonds is instituted for the sole purpose of making it cheaper for municipalities to issue bonds. As this exemption is instituted entirely for the sake of the public good, it does not represent discrimination, since the latter is not the explicit aim of the exemption. Another reason why Kentucky's tax plan is not discriminatory is that all other states have the ability to enact the same measure. Kentucky is not alone in its practices--forty-one other states follow the same system.

There is widespread public support for in-state tax exemptions on municipal bonds. There also exists a significant amount of historical precedent in favor of the practice. After all, Congress has been aware of the measure for decades and has not prohibited it, showing that this taxation practice poses no significant consequences and does not need to be eliminated.

AEI intern Boris Vabson prepared this summary.

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