Bond Bliss

The U.S. Supreme Court expresses its fondness for muni bonds and accepts the way things are.
July 1, 2008
John E. Petersen
By John E. Petersen  |  Columnist
John E. Petersen was GOVERNING's Public Finance columnist. He was a Professor of Public Policy and Finance at the George Mason School of Public Policy.

municipal market, and there finally is some: the U.S. Supreme Court's decision in Davis v. Kentucky.

The case centered on the practice of states granting tax exemption to the interest on bonds issued by themselves or their subdivsions, while taxing the interest on bonds issued by others. Most states -- 40 of them, including Kentucky -- follow this practice. These state taxing distinctions have led investors to favor holding their own state and local governments' bonds and to the creation of "single-state" bond funds.

In May, by a 7-to-2 decision, the court upheld the constitutionality of Kentucky's taxing practice and reversed a Kentucky appellate court's holding that the state's laws discriminate against interstate commerce and violate the U.S. Constitution's "dormant" Commerce Clause. That clause has generated lots of litigation over the years and piled up a series of Supreme Court decisions.

The underlying concern is that the indivdual states can throw up protectionist barriers that impede interstate trade. Unfortunately, there are no hard and fast rules to distinguish between what is violative protectionist behavior and what is a legitimate prerogative of a state to regulate and encourage commerce within its borders. But one thing is clear: The sovereign states have special powers when it comes to regulating their progeny, their own behavior and their access to the markets.

According to some observers, the Supreme Court's majority opinion was guided by practical considerations. Namely, that the practice of interstate tax discrimination has been "entrenched" in states for a long time, and were the existing discriminatory tax treatments invalidated, the muncipal bond market would be disrupted. In other words, the states have done this for so many years that the market has fashioned itself around the discriminatory practice. Were things to change, small-government issuers would be particularly affected, since the single-state investment funds are of special importance to them.

Upsetting the municipal bond apple cart was not on the court's "common-sense" agenda. The early parts of the majority opinion provide a brief history of the state and local bond market and turn somewhat rhapsodic on the subject of the market raising capital for meeting public purposes. (The Massachusetts colony selling bonds to pay soldiers for an unsuccessful raid on Quebec in 1690 gets reverently cited.) With $2.7 trillion in state and local debt outstanding, the court decided not to tread on the traditional operations of the municipal bond market.

In Commerce Clause cases, the Supreme Court often has remanded the case back to the lower court to work out an approprate balancing of interests between a state's legitimate regulatory needs and the interstate commerce concerns. But in this case, the justices decided no further judicial fooling around was justified. The majority opinion said that sorting out the burdens and benefits of tax statutes should be left up to the legislative branch, which is better positioned to judge the "economic risks of any alteration in the way things have traditionally been done."

With the burst of springtime sunshine that the Davis decision provided, the municipal market also found a little cloud smudging the horizon. The thrust of the Supreme Court's decision ran to the "governmental purpose" of municipal bonds, citing with admiration how billions of dollars are raised in that market for hospitals, water and sewer plants, and schools. These bonds are sold for financing facilities owned by governments and available to the general public. But there is another class of municipal bonds that finance facilities used in private activities. These private-activity bonds represent about $200 billion in corporate-backed debt (industrial revenue bonds), $250 billion in other non-governmental debt (not-for-profit debt), plus $150 billion or so of private-activity bonds that are taxable in the federal code but are usually exempt from state taxes. The court acknowledged in a footnote that such debt might be suspect in applying its public-purpose reasoning but that the "private-activity" issue was not a critical component in the Davis case and could await deciding on "another day."

The dowager queen of the U.S. capital markets, the municipal bond market, dodged a bullet in the Davis decision. She did so mainly because of her age, a ladylike image that radiates public purpose, and her remarkable poltical pedigree. By tradition, the Supreme Court ruled, she gets to do some things to improve her status that her private-sector counterparts couldn't get away with. Yes, age has its advantages.