Originally published in the American Bar Assciation Winter 2008 State and Local Law News

On November 5, 2007, the U.S. Supreme Court heard arguments in the case of Kentucky v. Davis1. The Commonwealth of Kentucky appealed a decision that the state's taxing scheme for interest earned on municipal bonds was invalid because it violated the dormant Commerce Clause of the U.S. Constitution2. Although some legal commentators were ready to declare victory for the State of Kentucky after the oral arguments were presented, history teaches that a Supreme Court decision is never a foregone conclusion. What might an adverse ruling for Kentucky yield?

As discussed by Caryl Stephens Johnson in the Spring 2007 issue of this publication, the Davis case has important implications for Commerce Clause jurisprudence. Because the legal implications of Davis have been well-covered in a variety of publications to date3, this article turns to other considerations raised by the case. Ponder these facts:

  • The municipal bond market saw more than $432 billion in debt issued in 20064.
  • The aggregate amount of state and local debt outstanding is greater than $2 trillion dollars5.
  • Estimates suggest that more than two-thirds of municipal debt is held by individuals, either directly or indirectly6.
  • Although generally not taxable by the federal government, more than forty states count interest earned on select municipal bonds as taxable income for individuals.

Certainly, the legal implications of Davis are matched by its financial and practical implications.

A Little Background: The Davis Case

The Kentucky Revised Statutes require that "interest income derived from obligations of sister states and political subdivisions thereof"7 be included in a person's adjusted gross income (AGI) for taxation purposes, but excludes interest income from municipal bonds issued by the Commonwealth or its municipalities in the computation of AGI. George and Catherine Davis, Kentucky taxpayers, alleged that the discriminatory treatment of interest on bonds violated the dormant Commerce Clause, which prohibits a state from enacting regulatory measures "designed to benefit in-state economic interests by burdening out-of-state competitors."8 The Court of Appeals of Kentucky agreed.

The Commonwealth argued in its brief that the sheer size of the market and the fact that Congress has failed to take action to change the state taxation laws regarding interest on municipal bonds speak in favor of upholding the status quo. The Davis brief maintained that the Court has never accepted congressional silence or the difficulty of correcting a practice as reasons for upholding a law that is unconstitutional. Regardless of the perspective one takes, it is hard to argue that a Supreme Court decision affirming the taxing scheme as unconstitutional would not have widespread and immediate effects on the municipal market and state taxing regimes.

The Muni Market: The Basics

Municipal bonds are debt obligations issued by states, cities, counties, school districts, and other political subdivisions to raise revenue for various projects. The projects financed by municipal bonds are generally public in nature, but can be, in some cases, private projects. The debt obligation can be secured by the full faith and credit of the issuer (a "general obligation" bond) or by a specific stream of income, such as rents, special assessments, or tolls (a "revenue" bond).

The issuance of municipal debt in the United States is not a new phenomenon. In 1896, The Bond Buyer began compiling annual statistics for municipal debt offerings, reporting that 1,283 issuances were made, totaling $129.5 million dollars9. The chart shows the growth of the municipal market in the last 50 years. Last year, 16,194 issuances were made by state and local entities, for a total of S432.6 billion10. In aggregate, outstanding state and local debt obligations totaled $2.13 trillion at the end of the second quarter of 200711.

The municipal market has grown increasingly complex over time, as well: today, individuals can invest in the municipal bond market either directly, by purchasing bonds, or indirectly, by investing in a variety of municipal bond funds. The U.S. Securities and Exchange Commission estimates that 36 percent of municipal securities are owned directly by households, and up to another 33 percent of municipal securities may be held by households indirectly through money market funds, mutual funds, and closed-end funds12.

One investment product in the bond market is a direct product of the discriminatory taxation scheme existing in Kentucky and her sister states; the single-state municipal bond fund. Each of these funds is comprised solely of municipal bonds issued, by a single state and its political subdivisions, with the explicit purpose of allowing investors to retain the tax benefits of holding in-state bonds while diversifying risk across different types of bonds within the state (while municipal bonds are generally considered low-risk investments, some risk exposure still exists, as an issuing agency could default on its obligation). As of May 31,2007, 642 single-state bond funds existed in the United States and were valued at $192.2 billion13. A significant portion of these bond funds exist in states that issue many municipal bonds, have relatively high income taxes, and have a significant population of high-income residents -- namely California, New York, Texas, Illinois, Florida, Pennsylvania, New Jersey, and Michigan.

A Survey of State Taxing Statutes

The practice of taxing interest earned on state and local debt holdings is widespread among states. As of July 2007, only eight states did not have a discriminatory taxing scheme on interest earned on municipal bonds: seven do not collect personal income taxes, and Indiana exempts interest earned on all municipal bonds from income tax. Five additional states (Illinois, Iowa, Oklahoma, West Virginia, and Wisconsin) tax both in-state and out-of state municipal bonds but provide specific exceptions for select in-state municipal bonds. Thirty-six states, including Kentucky, exempt all interest earned on state municipal bonds but tax interest earned on out-of-state obligations14.

Utah is unique in its taxation scheme for municipal bonds?it exempts interest earned on in-state and out-of-state municipal bonds, unless the state issuing the bonds taxes interest earned on Utah-issued municipal bonds. The Davises cited Utah's retaliatory taxing law as proof that the discriminatory taxation of out-of-state municipal bonds is nothing more than economic protectionism designed to make in-state bonds more attractive investments to in-state residents15.

What Change May Come

If the Supreme Court finds Kentucky's disparate treatment of the interest earned on in- and out-of-state bonds unconstitutional, most states will be left with the option of either taxing all interest earned on municipal bonds, or taxing none. Some states, however, may not have the option of taxing interest earned on their own municipal debt, California, Kentucky, and Ohio are among the states that have constitutional provisions that may prevent taxation of interest on municipal debt issued within the state16.

Some states have estimated the lost revenues they might incur should the Kentucky taw be found unconstitutional A legislative analyst for the State of Minnesota estimates that the state will lose roughly $13 million in tax revenues from taxing interest on out-of-state bonds in tax year 2007. For comparison, the state will forego an estimated $59.3 million by exempting interest earned on Minnesota bonds, and the total revenues expected in 2008 are in excess of $15 billion17. The amicus curiae briefs submitted to the Supreme Court indicate that in 2003, New York collected $45.8 million in taxes on interest earned on out-of-state municipal bonds and Connecticut collected $70.9 million on the same in 200418.

Although the change in state incomes can be estimated in a reasonable fashion, the change that will occur in the municipal bond market is considerably harder to predict. State and local issuers, for example, may incur costs in the form of increased interest rates on their municipal offerings to be competitive on the national market. Currently, preferential tax treatment permits states to issue debt with a lower interest rate than otherwise would be issued because investors are willing to trade off increased interest earnings for the tax break they receive on their investments.

As noted above, the mid-1990s saw the growth of single-state mutual funds. As investors realized that certain state tax schemes did not provide specific benefit, the demand for single-state bond funds in those states dropped considerably. Investors moved from single-state bond funds to multi-state bond funds that tended to diversify risk. One would expect a similar phenomenon if the Kentucky law is found unconstitutional. To what extent this would actually harm the market is unclear: although demand for secondary instruments (the single-state bond funds) would likely change, demand for the primary instruments (the debt itself) may not change. If investment funds merely shift their bond fund offerings to create multi-state offerings from the muni bonds they already hold, little change could occur.

Further complicating the crystal ball's picture around Davis is Congress. That Congress can authorize states to act in a way that otherwise violates the dormant Commerce Clause is a long-standing tenet of Commerce Clause jurisprudence: in 1945, the Supreme Court observed in Southern Pacific Co. v. Arizona that "Congress has undoubted power to redefine the distribution of power over interstate commerce. It may permit the states to regulate the commerce in a manner which would otherwise not be permissible[.]"19. Should the Court find Kentucky's taxing scheme unconstitutional, Congress has the option to "reinstate" such a taxing scheme through legislation. Whether Congress would act to restore the current status quo and how quickly it would act to do so would certainly affect the severity and duration of any adjustment period in the financial markets because of a Court finding that Kentucky's taxing scheme is unconstitutional.

Despite the difficulty of estimating changes to the market, one thing is clear: the ramifications of an affirmance in Kentucky v. Davis will not only be found in the context of Commerce Clause jurisprudence, but also in the financial markets and in practical considerations. Some state general funds could feel some effects because tax collections might fall. Practically, more than forty states will need to adjust their tax codes and collection practices. Financial markets will certainly see some adjustment in the short term?the long-term implications are harder to estimate.