In a letter to the editor of Tax Notes, Alan D. Viard discusses the U.S. Supreme Court's recent ruling in Kentucky Department of Revenue v. Davis, which upheld current state income tax treatment of public activity municipal bonds. Viard notes that, in response to arguments he and other AEI scholars made in an amicus brief, the Court chose not to resolve the validity of the current state treatment of private activity bonds. Viard explores the possible implications of the Court's actions.

Resident Scholar Alan D. Viard

I write to supplement Cara Griffith's recent article[1] about the U.S. Supreme Court's May 19 decision in Department of Revenue of Kentucky v. Davis, in which the Court generally upheld states' selective tax exemptions for interest on home-state, but not out-of-state, municipal bonds. Griffith provides a good description of the Court's reasoning and holding and I am gratified that she quoted my criticism of the decision. I wish to call attention, however, to one aspect of the decision not mentioned in the article, namely the Court's refusal to uphold, at least, for now, the selective tax exemption as it applies to private activity municipal bonds.[2]

In its Davis opinion, the Court emphasized a distinction, drawn from its decision last year in United Haulers Assn., Inc. v. Oneida-Herkimer Solid Waste Mgmt. Auth.,[3] between the obstruction of private interstate transactions (presumptively invalid under the dormant commerce clause) and similar obstruction of interstate transactions involving state and local governments (presumptively valid). Based on this distinction, the Court concluded that states may generally obstruct cross-state holdings of municipal bonds.

An amicus brief that I filed with five other American Enterprise Institute scholars and a Brookings Institution scholar argued, however, that this principle cannot validate the selective tax exemption as it applies to private activity municipal bonds. We contended that such bonds fall on the private side of United Haulers' private/governmental distinction.[4]

In a footnote to its Davis opinion, the Court cited our brief in reserving judgment on the validity of the selective tax exemption as it applies to private activity bonds. The Court first observed that our argument had not been raised by the parties or considered by the Kentucky courts and was "barely developed" in our brief.[5] The Court then stated:

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.[6]

The Court thereby left open the validity of the current state tax treatment of this important segment of the municipal-bond market. If and to the extent that this issue is raised in future litigation, state courts will presumably evaluate this aspect of the tax exemption in light of the Court's footnote and the remainder of its opinion, as well as United Haulers and other precedents. Depending on the pattern of state-court rulings and other factors, the Supreme Court may, or may not, someday hear a case on this issue.

If and when it confronts the question, the Court may be unwilling to strike down the selective tax exemption as it applies to private activity bonds. Throughout its Davis opinion, the Court repeatedly expressed its reluctance to strike down longstanding tax arrangements that are supported by all of the states. The footnote itself reinforces this point by alluding to the potential disruption of "important projects" serving "public purposes."

Yet, the Court may also find it difficult to uphold this aspect of the selective tax exemption. Upholding the exemption when the real underlying borrower is a private entity would open a gaping hole in the dormant commerce clause. States would then be allowed to steer borrowing by in-state private entities toward in-state lenders, a type of balkanization that the Court has never sanctioned based on a vague public purpose.

For now, the Court has avoided this dilemma by neither upholding nor striking down the selective tax exemption as it applies to private activity bonds. Tax practitioners and participants in the municipal bond market should be aware that this issue remains unresolved. Its ultimate resolution may 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.

Notes

1. "Supreme Court Upholds Kentucky Municipal Bond Tax Exemption," Tax Notes, May 26, 2008, p. 810.
2. Jennifer Carr and Cara Griffith do note this aspect of the Court's opinion in "Was Davis Outcome-Based Jurisprudence?" State Tax Notes, May 26, 2008, p. 663, at p. 666 n. 20.
3. 127 S. Ct. 1786 (2007).
4. Brief for Alan D. Viard, Alex Brill, Christopher DeMuth, Jason Furman, Kevin A. Hassett, R. Glenn Hubbard, and Kent Smetters as Amici Curiae Supporting Respondents, http://www.aei.org/publication26853, pp. 25-26. Richards Kibbe & Orbe provided excellent pro bono representation in the filing of this brief.
5. Because the argument was one of many that we discussed in a brief with tight page limits, our discussion was indeed somewhat incomplete.
6. Davis slip opinion, p. 2 n.2. This part of the opinion reflected the views of six members of the Court: Souter, Stevens, Breyer, Ginsburg, Scalia, JJ., and Roberts, C.J.