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U.S. Supreme Court Upholds Kentucky’s Discriminatory Municipal Bond Tax Exclusion 7-2

5 min readBy: Joseph Bishop-Henchman

The U.S. Supreme Court this morning upheld 7-2 Kentucky’s discriminatory practice of taxing interest on non-Kentucky bonds, but not Kentucky bonds, as constitutional. The Tax Foundation had submitted a brief urging that the law be found unconstitutional as violating the Commerce Clause and other provisions of the Constitution. The brief also highlighted TaxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. Foundation research that federal and state municipal bond exclusions help high-tax states avoid tax competition.

The Court (Justice Souter for the majority) stays within the general confines of the Commerce Clause framework, which typically would invalidate a law that discriminates against out-of-state activity, as this one does. Instead, the Court expands an exception carved out last year in the United Haulers case, where a state’s power to exclude all competitors (in- and out-of-state) from competing against a state-run trash processing facility.

In our brief, we characterized United Haulers as neutral with regards to interstate commerce, since it excluded all competitors. The Court emphasized that had the facility been private and in-state, the law may have been invalid (citing a prior case, Carbone). However, the Court viewed United Haulers much more broadly, stating that tax preferences supporting government functions cannot violate the Commerce Clause because they are motivated by “legitimate objectives.”

Putting aside the simple idea that laws can have multiple objectives, legitimate and illegitimate, one major problem is that the Court’s test is circular. Governments can only do constitutional things, and to say that something is constitutional because a state does it makes little sense. Any law could be upheld using that logic. The Court responds that a legitimate law is one with a preference for government to do governmental things, not private in-state actors. Of course, laws can do both, and a discriminatory tax that is used for legitimate purposes is still discriminatory and should be unconstitutional.

The Court dangerously points out that most states discriminate like Kentucky and lots of bond funds have been set up to take advantage of the interstate barriers, implying that an unconstitutional action can become constitutional if a lot of states do it. After all, the Constitution exists to restrain popular but unwise governmental action, such as the race-to-the-bottom that is municipal bond exclusions. Justices Kennedy and Alito, in dissent, respond succinctly: “Protectionist interests always want the laws they pass, even if their fellow citizens bear the burden, for they are positioned to profit from the barrier…. That 41 States have local protectionist laws similar to this one proves the necessity of allowing settled principles against discrimination to operate in an important national market….The exemption benefits wealthy, high-tax States, allowing those States to hoard capital that otherwise might travel to issuers who offer a more competitive deal in pretax dollars.” The latter point is one made on page 25-26 of our brief by Tax Foundation Chief Economist Patrick Fleenor: ” The greater a state’s income tax rate, the greater the benefit from the exclusion. States with the highest individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. 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.”

Summing up its main discussion, the Court states that this case is no different from United Haulers: “Kentucky’s tax exemptionA tax exemption excludes certain income, revenue, or even taxpayers from tax altogether. For example, nonprofits that fulfill certain requirements are granted tax-exempt status by the Internal Revenue Service (IRS), preventing them from having to pay income tax. [sic, exclusion] favors a traditional government function without any differential treatment favoring local entities over substantially similar out-of-state interests. This type of law does not ‘discriminate against interstate commerce’ for purposes of the dormant Commerce Clause.” Of course, this ignores all the evidence that Kentucky’s law actually does discriminate against similar out-of-state interests.

A secondary argument the Court makes (one that Justice Stevens found most convincing, and joined only by three justices) is that Kentucky’s preference essentially discriminates in favor of itself as a bond issuer, to lower the costs of borrowing. The Court describes it as a “tool for competition.” There is a whole area of exceptions, called the market-participant doctrine, that outlines this idea, that states can essentially do whatever a private actor could do, such as offering a lower interest rate. But the Court misses the point that the discrimination affects the bond holders not the bond issuers. Justices Kennedy and Alito again point out the absurdity: the Court’s argument is that a law is not discriminatory if the beneficiary receives a benefit. “The question has never been what the beneficiary of the discriminatory law will do with that benefit; that question relates to the ends sought by the discriminatory means.” States raising money is indeed a legitimate function and this law furthers it, but that doesn’t change the fact that states can’t use discriminatory means.

Chief Justice Roberts wrote separately to state that little more had to be said beyond applying United Haulers to this case.

Justices Scalia and Thomas concurred on the grounds of judicial restraint. They believe there is no constitutional basis for judicially restraining states from impeding interstate commerce. Justice Thomas would be more open to doing so under the Import-Export Clause, but he specifically notes that Congress has had the opportunity to tackle state exclusions but has done nothing. Such a view ignores the important role the judiciary has to restrain popular-but-destructive state laws that produce concentrated benefits with dispersed costs.

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.

See the Tax Foundation’s page on the Davis case here.