The Supreme Court heard arguments today in the municipal bond case involving Kentucky's exclusion for interest on home-state bonds and taxation of interest on other-state bonds. Taxpayer Davis challenges the taxation, arguing that it is discriminatory under the Dormant Commerce Clause (DCC).
I have written, in a Winter 2007 ABA Tax Section News Quarterly Point article entitled "The Tax Exemption for Home State bonds, Misguided Though It May Be, Should Not Be Considered to Violate the Dormant Commerce Clause", that I think the exclusion should withstand a DCC challenge. The question of whether the state is discriminating is not as obvious as it appears at first glance. If you just compare taxation of home state bonds to taxation of sister state bonds, then it looks perhaps discriminatory, but that is too simplistic an approach to understanding discrimination. If one considers all the bonds possibly held by taxpayers subject to tax by the state of Kentucky, they will include domestic corporate bonds, out-of-state corporate bonds, domestic municipal bonds and out-of-state municipal bonds and other bonds (foreign country). The only one favored is the bonds of the state actor itself: all other interest is taxed. In fact, the state is not discriminating against or in favor of any private actor--it is only favoring its own bonds and taxing all other bonds--domestic corporate bonds, out-of-state corporate bonds, and out-of-state government bonds. Favoring its own bonds appears to be within the "market participant" exception that the Court has developed for DCC analysis. The state is participating in the financial marketplace: it creates and protects a specific stream in that marketplace that could not otherwise exist when it issues its own bonds .
I also argued that the concept of federalism that underlies many of the Supreme Court's decisions would support the notion of a state's setting its terms for its own entrance into a market (issuance of bonds) and how other states can enter into its markets. That has to do with basic notions of sovereignty. If we truly have dual sovereignty, state and federal, it must have some consequences. Surely the state's ability to treat other state's bonds differently from its own would be a key realization of that state's sovereignty.
Bradley Joondeph of Santa Clara University makes similar arguments in Practical Consequences, Institutional Competence and the Kentucy Bond Case (noting that home-state exclusions for municipal bond interest is "essentially indistinguishable from the Court's decision last term in United Haulers Assn., Inc. v. Oneida-Herkimer Solid Waste Mgmt. Auth."). He adds another argument--the fiscal situation if states that have issued bonds and determined their revenues based on taxation of other-state bonds and exemption for their own were faced with a decision that a home-state exclusion is unconstitutional. States would either have to tax their own bonds or grant the exclusion for other-state bond interest. The first alternative is not practically possible for already issued bonds. The second alternative would result in substantial revenue losses, especially for some states. There are some $2.4 trillion of state bonds issued and outstanding today, so the question has real consequence for the states.
Eric Brunstad, the attorney for the taxpayers in the case, argues that it is plainly discriminatory. Recalling New York's initiation of the practice of excluding interest on home-state bonds while taxing sister-state bond interest, Brunstead claimed, see this transcript of the oral argument, that "[New York] wanted to hoard its own local investment dollars and yet sell its bonds nationally. Every other state caught on and that creates a problem in the marketplace." But there's no problem. The market for municipal bonds is thriving and there are specialty funds that deal in particular states' bonds. The concern of the founders about states' behaving provincially and making unnecessary hurdles for commerce isn't at issue when there is no disadvantaged private issuer of bonds.
In oral argument today, Trower, arguing for Kentucky, hit the key United Hauler point at the outset--that the law does not disfavor one type of private entity over another but rather favors a governmental entity. Souter seemed to see that as contradicted by the existence of private activity bonds--state bonds the benefits of which are used to fund nongovernmental activities, but Ginsburg pointed out that this question had not been addressed below and not what is at issue in the case at hand.
After a few more questions, Trower got to his other main point--that the policies behind the DCC do not support finding the exclusion unconstitutional. The policies are economic protectionism (not at issue here, since no private industry is being protected), encouraging free trade (not an absolute, since that is balanced by other considerations), and political solidarity (a desire to prevent solidarity-harming friction between the states). Trower pointed out the simple practical reality that all the states that issue bonds have supported Kentucky, so there is no friction between the states because of this issue. That is essentially my point about federalism--when the sovereignty of the state over its own territory and citizens is at stake in how it raises revenues and treats its citizens and when the states are not in disagreement about the default rule (exclusion for home-state interest with taxation of other-state interest), the Court should not be able to intervene under the DCC to change the rule.
Brunstad, arguing for the taxpayers, claimed facial discrimination. He admitted Kentucky wasn't trying to take over the national bond market but claimed it was trying to regulate it by taxing other-state interest. That argument met with resistance from Justice Breyer, who picked up Trower's theme that traditional governmental activity (financing its functions) is a quintessential government function and tried a series of hypotheticals, not too well answered, in my opinion, by Brunstad. Justice Breyer again pushed on the market participation issue, when the State is in fact creating the market by issuing its bonds. Justice Souter pursued the problem of the economic equivalence of a subsidy and a tax exemption, asking why one should ignore the state's role as a regulator in some cases but not in others and suggesting that the State's role as a market participant in issuing bonds and protecting that market through its tax policies should not draw a DCC violation. Souter pushed for a good reason for applying the facially discriminatory test ignoring the market participation reality and the fact that it is a substantial market, but Brunstad did not appear to satisfy him.
Roberts joined in, suggesting that if it isn't clear then it should be left to Congress, especially in the DCC context and a case that appears to involve a "fundamental" function of a state (issuing a tax exemption for its bonds). Breyer then brought the argument back to the question of whether the bonds should be treated like any other commodity or whether there is something special, as in a state's running a trash collection monopoly. But Stevens interrupted to note that this isn't the case of a tax on an out-of-state commodity, but an income tax on the state's own residents on interest, something clearly different. To Brunstad's claim that the tax victimizes other states, Stevens noted that all of the victims support the state that is "victimizing" them. And to Brunstad's claim that Kentucky's rule damages the national markets, Roberts replied that it depends on how you define the relevant market--if one considers only the market for bonds related to Kentucky's projects, there is no harm or discrimination. And too, if it turns out that people in Kentucky buy other states' bonds, then the result is not really the balkanization implied by the market argument. Roberts eventually also noted that there may be some validity to the idea that residents purchase home-state bonds to support the state and, ultimately, to benefit from the use of the proceeds.
As my colleagues on the Tax Prof listserve noted, it isn't clear where the Justices would come out. Roberts seems to favor not applying the dormant commerce clause whenever possible, and Stevens and Souter seem to support the State's ability to determine its revenue streams. Breyer seemed on the edge--sometimes in favor of an extension of the market participation doctrine to this case and other times thinking state bonds should be treated like any other commodity.
Edited and addendum 11/06/07: TaxProf has a compendium of coverage of the oral arguments, at this link.
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