Summary, November SGE Monthly Luncheon
"The Dormant Commerce Clause and the Balkanization of the Municipal Bond Market"
Review of Remarks by Alan D. Viard, Resident Scholar, American Enterprise Institute
Rapporteur: Brian W. Sloboda
US Postal Service
At the November SGE luncheon, Alan Viard presented some of his work on the legal issues of the transactions/subsidies and interstate commerce as it has been presented in the Davis v. Ky Dept. of Revenue 2004. More specifically, states with income taxes are frequently exempt municipal bond interest from taxation. These exemptions are tax expenditures that reduce state revenues but can be seen as a subsidy to the cost of capital for the states. All but a few states provide the income tax exemption for state based issues while taxing interest from municipal bonds issued by muni issuers in other states. A recent court case, Davis vs. Department of Revenue of Kentucky, declared state statutes limiting the state income tax exemptions to ”in-state” issues unconstitutional. This case is currently being heard by the US Supreme Court with a decision to be presented in early 2008, and the effects of this decision would be applied to all states leading to losses in tax revenue for the states.
Some policy-makers see a fatal combination resulting from this decision: encourages Kentucky residents to hold only Kentucky bonds and does not encourage nonresidents to hold Kentucky bonds. For the residents of Kentucky, the interest rate on the bonds would fall which would mean higher returns for the residents of Kentucky and lower returns for nonresidents of Kentucky. Given this, the residents of Kentucky would substitute towards Kentucky bonds while the nonresidents would substitute away from Kentucky bonds. Consequently, interstate holdings of these bonds would be reduced. Even though the residents of Kentucky would receive higher earnings, nonresidents would lose from the lower returns which ultimately lead to a net national loss. This case was presented to the Kentucky Court of Appeals ruled it is unconstitutional for Kentucky to tax interest earned on out-of-state issues while exempting interest earned on in-state muni bonds. In fact, their ruling was based on the Commerce Clause of the U.S. Constitution which gives the federal government authority to regulate commerce between states and with foreign nations. After upholding the original decision this case was referred to the Kentucky Supreme Court. However, the Kentucky Supreme Court did not want to review this case, which led this case being filed with the US Supreme Court.
If the ruling is not upheld by the US Supreme Court, a transition would be required for the states to meet tthe requirements of the rulings. First, this ruling could result in a change in the market institutions concerning how these products are disseminated in the markets in order to accommodate the rulings. Any invalidation of exemption could also be applied retroactively. Additionally, this ruling would have a major impact on the states:
- refunds would need to be provided which is subject to the statute of limitations
- extend the exemption for the outstanding bonds
Failure to uphold the ruling could provide significant costs for the states, to ameliorate this potential problem, Congress could help in the offsetting of these costs. On the other hand, if the exemption is extended, the outstanding bonds would likely rise in value namely in the present discounted value (PDV) of after tax payoffs.
What is the outlook for this case? Based on the current, there appears to be a lopsided amicus briefs. Moreover, most of the justices are leaning towards the state arguments with the exception of Justice Alito and Justice Kennedy. If this ruling is not upheld by the US Supreme Court, could this also serve as a precedent for private bonds? Additionally, the decision not upheld the decision also serve as a precedent for the charging out of state tuitions for nonresident students. Finally, Alan Viard along with other scholars predicts that the decision will be upheld by the US Supreme Court.