By a vote of 7 to 2, the justices rejected the argument that a state engages in unconstitutional discrimination against interstate commerce by exempting the interest on its bonds from residents’ taxable income while taxing the interest earned on the bonds of other states.
A state appeals court in Kentucky had accepted this argument, put forward by a Kentucky couple who has a portfolio of other states’ municipal bonds. With a potential to unsettle the $2.5 trillion municipal bond market, the case, argued more than six months ago, had been watched with mounting anticipation.
All 49 other states had filed a brief urging the Supreme Court to overturn the Kentucky court and uphold the state preference. In his majority opinion, Justice David H. Souter cited the states’ unanimity as evidence of the enormity of what the court was being asked by the plaintiffs to do.
“It would miss the mark to think that the Kentucky courts, and ultimately this court, are being invited merely to tinker with details of a tax scheme,” Justice Souter said, adding: “We are being asked to apply a federal rule to throw out the system of financing municipal improvements throughout most of the United States.”
In a dissenting opinion, Justice Anthony M. Kennedy called the states’ uniform position “irrelevant” to the constitutional argument. “Protectionist interests always want the laws they pass,” he observed.
The other dissenter was Justice Samuel A. Alito Jr., who signed Justice Kennedy’s opinion and also filed a brief dissenting opinion of his own.
While the 7-to-2 decision appeared to be a comfortable endorsement of the status quo, the outcome was far from assured. The case, Department of Revenue of Kentucky v. Davis, No. 06-666, lay at the intersection of contradictory lines of precedent dealing with what is known as the “dormant” or “negative” Commerce Clause.
In its actual text in Article I of the Constitution, the Commerce Clause grants Congress the power to regulate commerce “among the several states.” The Supreme Court has long interpreted this affirmative grant of power as containing a negative implication: the states themselves may not regulate interstate commerce.
Many protectionist efforts by individual states, including favoritism in tax treatment of local industries, have fallen because of this interpretation, which the Kentucky Court of Appeals relied on in striking down the state’s municipal bond preference.
But another line of cases gives the states more leeway when they themselves are providing goods or services as a public function. Last year, the court upheld a waste disposal ordinance under which two New York counties established a monopoly and required private trash haulers to deposit all their waste in a publicly owned facility, which charged rates higher than those in the private market.
That decision dictated the victory for Kentucky in this case, Justice Souter said.
“The issuance of debt securities to pay for public projects is a quintessentially public function,” Justice Souter said. He added that “there is no forbidden discrimination because Kentucky, as a public entity, does not have to treat itself as being ‘substantially similar’ to the other bond issuers in the market.”
Among those in the majority, Justices Antonin Scalia and Clarence Thomas declined to sign Justice Souter’s opinion. Both reiterated their long-held view that the dormant Commerce Clause doctrine is illegitimate.
In his dissenting opinion, Justice Kennedy warned that the decision would encourage the growth of state protectionism and “market inefficiencies.