Davis and Municipal Bonds for Private Activities

May 30, 2008

When the U.S. Supreme Court ruled last week (Kentucky v. Davis, covered here) that states may tax out-of-state bonds at a higher rate than in-state bonds, because doing so supports a legitimate government objective, not discrimination to benefit private interests.

The Court has struggled before to separate “traditional government functions” deserving deference, from other non-traditional functions. (In 1985, confronted with the question of whether providing mass transit services was a “traditional government function” deserving state immunity from federal wage laws, the Court gave up the effort to produce workable distinctions.) In Davis, the Court seems to believe a firm line can be drawn between laws that do hinder interstate commerce but do so for legitimate reasons, and those that do so for discriminatory reasons.

It’s tough because few state legislators say their intent is to discriminate. Tax laws that have discriminatory effects are often couched in the need to help out domestic companies, encourage economic growth, reduce state welfare expenses, etc., etc. In Davis, for instance, states spoke as if they would be unable to raise revenue if they couldn’t discriminate against out-of-state municipal bonds. So Davis opens up a way for states to do otherwise impermissible discrimination but have it be constitutional, and expansion of the previous United Haulers case which merely allowed government to establish a government-run monopoly over a particular service with no in-state/out-of-state discriminatory distinction.

Alan Viard, a scholar at the American Enterprise Institute (and author of the other amicus brief supporting the Davises in the case, brought this up in his brief, since many state and local municipal bonds benefit private activities (stadiums, convention centers, office parks, etc.). He writes yesterday:

If and when it confronts the question, the Court may be unwilling to strike down the selective tax exemption as it applies to private activity bonds. Throughout its Davis opinion, the Court repeatedly expressed its reluctance to strike down longstanding tax arrangements that are supported by all of the states. The footnote itself reinforces this point by alluding to the potential disruption of “important projects” serving “public purposes.”

Yet, the Court may also find it difficult to uphold this aspect of the selective tax exemption. Upholding the exemption when the real underlying borrower is a private entity would open a gaping hole in the dormant commerce clause. States would then be allowed to steer borrowing by in-state private entities toward in-state lenders, a type of balkanization that the Court has never sanctioned based on a vague public purpose.

(The Court had considered the argument in a footnote in Davis, but stated that it would leave the issue for another case.)

More on the Davis case here and here.

The Tax Foundation’s brief in the Davis case is here.

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