Defending Competitive Neutrality Before the Supreme Court
Special Report No. 158
On November 5, 2007, the U.S. Supreme Court heard oral arguments in a case brought by George and Catherine Davis, a Kentucky couple challenging that state’s income tax exclusion for municipal bond interest. They argue that because Kentucky taxes interest earned on out-of-state bonds, and does not tax Kentucky bonds, the scheme violates the Commerce Clause of the U.S. Constitution. The Tax Foundation filed a brief supporting their challenge.
Taxpayers who invest in bonds issued by state and local governments have enjoyed preferential federal tax treatment since the beginning of the federal income tax in 1913. Interest earned on such bonds is excluded from gross income and thus not subject to federal income taxation.1 In 1919, New York became the first state to extend this preference to the state income tax.
At the state level, all 43 income-taxing states exempt interest earned on bonds from their own state. However, 42 of those states (including Kentucky) tax the interest earned on bonds from all other states. For instance, if a Kentucky resident owns municipal city bonds from both Louisville, Kentucky, and neighboring Jeffersonville, Indiana, the taxpayer is penalized in that he or she must pay Kentucky state income tax on the Indiana bond interest, but not on the Kentucky bond’s interest.
States can constitutionally create incentives to invest within the state. Such actions (lowering tax rates or exempting certain activity from taxation, for instance) foster a competitive business climate consistent with the federalism and liberty protected by the U.S. Constitution. These state “welcome mats” are permissible as long as they are available on a neutral basis to any taker.
But Kentucky’s law goes beyond this. Those who invest out-of-state do not merely lose an incentive; they are penalized with taxes. By taxing out-of-state activity while exempting identical in-state activity from taxation, Kentucky seeks to protect its economic policies from interstate competition. It has imposed an unconstitutional “exit toll,” not a permissible welcome mat.