Kentucky Fried Bonds

A Supreme Court case on state exemptions of interest income from muni bonds could fire up big changes in the bond market.
July 1, 2007
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.

For more than a year now, the municipal bond market has been dealing with a small fire in the legal oven. An appellate court decision in Kentucky (Davis et. al. v. Department of Revenue) held that the state could not exempt investors from state taxes on the interest income from its bonds while denying the same exemption on muni bonds issued by other states.

Kentucky is not the only state to have such an exclusion - some 40 other states do as well. It's a major attraction in single-state bond funds and in-state college savings programs, as well as for individual investors in bonds. The idea is to induce citizens to hold bonds issued in their own state, thereby improving the market for those bonds and lowering borrowing costs. The Kentucky appellate court decision found, however, that such discrimination was in violation of the U.S. Constitution's Commerce Clause, which generally prohibits states from discriminating among activities in such ways as to restrict interstate commerce. The court said the state's tax policy did just that by favoring Kentucky municipal bonds over those issued in other states.

Last summer, the Kentucky Supreme Court refused to take up an appeal, but this past May, the U.S. Supreme Court decided to hear the case.

The practical consequences of the Kentucky case are considerable. States do lots of things to encourage in-state activities using their regulatory and taxing powers. The purposes for which those powers may be used have been on the judicial firing line before, leaving a very muddy terrain in terms of what states can and can't do. In the case of tax preferences, many states have tax policies that favor in-state activities, not only for their own debt obligations but also for private debt and equity income, such as dividends paid by in-state corporations. Conflicting judicial decisions have arisen. For example, an Ohio court faced with pretty much the same facts came to an opposite decision from that in Kentucky, holding that it was not a violation of the commerce clause to grant selective exemptions to in-state government obligations.

As a practical matter, no one knows the magnitude of the tax exemption now granted by states to in-state municipal bonds or how much state income tax is paid by bondholders that hold out-of-state bonds. But the inducement to hold in-state municipals is there. How much of that benefit the in-state investors get versus how much state and local borrowers enjoy in lowered borrowing costs depends on demand and supply. But states that have higher marginal rates (such as California and New York) can provide greater savings, and thus they tend to pay somewhat lower interest costs as their home-state investors compete for their bonds. States without an income tax (such as Texas) or those that do not provide tax-exemption for their in-state securities (such as Illinois) pay a bit more to borrow since they offer no in-state bond exemption. It is unlikely that a Supreme Court ruling supporting the Kentucky decision would be a financial disaster were it to apply only to future bond issues. But were it to be retrospective in application, applying to all outstanding bonds, that could lead to a huge fiscal, legal and administrative mess.

To get a sense of how the bond community views the Supreme Court's decision to take up the Kentucky case, I checked in with James Spiotto, the current president of the Society of Municipal Analysts. He noted that the Court, which had several previous opportunities to do so, took up the Kentucky appeal only after making a key decision (United Haulers v. Oneida-Herkimer) that effectively broadened the ability of states and localities to regulate solid waste disposal where the regulation involved government-owned (as opposed to privately-owned) facilities. Thus, a majority of the Court may want to sharpen the lines of where states and localities can regulate or tax in ways that do not run afoul of the commerce clause. With two opposing state-level decisions (Kentucky and Ohio) on the bond-exemption issue, there is a need to get things straight.

Spiotto notes that the justices may decide that the in-state exemption works only when it applies to "traditional" governmental activities. So, the Court might set forth guidance as to what constitutes "traditional" functions. That definition could erode the use of state tax exemption that is now available to various private-activity bonds where the legal owners of facilities are non-governmental entities.

It appears unlikely that the Supreme Court will fan a small bond fire into a three-alarm blaze. But states have had a long menu of ways to favor in-state municipal bonds, and some of them may get singed.