Protecting Competitive Neutrality Before the Supreme Court: Kentucky Department of Revenue v. Davis

September 21, 2007

U.S. Supreme Court No. 06-666
Amicus Curiae Brief In Support of Respondent
Filed September 21, 2007
Argued November 5, 2007
Decided May 19, 2008

Summary
The Tax Foundation filed an amicus brief supporting the respondents in the case of Kentucky Department of Revenue v. Davis, brought by a Kentucky couple against their state tax authorities. The Tax Foundation brief urged the Supreme Court to uphold a lower court ruling that invalidated Kentucky's practice of taxing interest on non-Kentucky bonds, but not Kentucky bonds, as a way to punish out-of-state investment. In May 2008, the Supreme Court upheld Kentucky's law in a 7-2 decision, which preserved Commerce Clause jurisprudence but created an exception for the municipal bond exclusion.

"The Davis case is the perfect opportunity for the Supreme Court to affirm that the Constitution defends competitive neutrality," said Chris Atkins, then-senior tax counsel for the Tax Foundation. States can encourage investment through low tax systems, but cannot discourage out-of-state activity with discriminatory taxes."

The Tax Foundation's friend-of-the-court brief, written by Atkins and Brian Bailey of Ice Miller LLP, argued that the Kentucky scheme violates the Commerce Clause of the U.S. Constitution, which bans burdens on interstate commerce. The brief also highlighted Tax Foundation research that federal and state municipal bond exclusions help high-tax states avoid tax competition.

"The greater a state's income tax rate, the greater the benefit from the exclusion," said Tax Foundation chief economist Patrick Fleenor. "States with the highest individual income tax rates have a stronger interest in preserving the municipal bond tax exclusion, because it enables them to protect those higher rates from interstate competitive pressures."

The brief also noted that striking down Kentucky's law would not harm state financing, that courts should scrutinize discriminatory subsidies as well as taxes, and that Kentucky's law may also violate the Import-Export and Privileges or Immunities Clauses of the Constitution.

The Tax Foundation will continue to examine the issue of municipal bond exclusions, and the problems they create for public finance and sound tax policy. The issue was outlined in a paper, "Defending Competitive Neutrality Before the Supreme Court."

"We agree that states can constitutionally lay out ‘welcome mats' by designing tax systems that create incentives to invest within the state," stated the Tax Foundation's article on the Davis case. "But Kentucky's law is not a welcome mat; it's an exit toll. By taxing out-of-state activity while exempting identical in-state activity, Kentucky seeks to shield its economic policies from interstate competition."

The Tax Foundation's brief joined one other brief submitted in support of Mr. and Mrs. Davis, compared to nine filed by agencies and organizations with vested interests in the tax exclusion.

U.S. Supreme Court opinion.
Transcript of the U.S. Supreme Court oral argument.

Special Report:

Defending Competitive Neutrality Before the Supreme Court, by Joseph Henchman, November 30, 2007

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