The question is whether the in-state preference erects an unconstitutional barrier to interstate commerce. The courtroom rang with the names of Supreme Court precedents, famous and obscure, months old and decades old, reflecting the many permutations in which the court has considered the validity of state preferences, as well as the fact that no single precedent clearly dictates a result in the case.
To boil down the justices’ inquiry to its essence: are municipal bonds more like milk or more like garbage?
If they are a commodity like milk, as the lawyer for the Kentucky couple who challenged that state’s tax policy argued, then the preferential exemption is unconstitutional: the court has ruled in cases going back to the 1940s that states cannot put up protectionist barriers around their dairy industries.
“This case is like milk,” declared the lawyer, G. Eric Brunstad Jr.
But if municipal bonds are more like garbage, as the lawyer arguing for Kentucky maintained, then a state has a good deal more leeway to discriminate on its own behalf.
In a decision in April, the Supreme Court upheld the requirement that trash haulers in two upstate New York counties deliver their waste to publicly owned disposal facilities, even though the rates charged by the state-created monopoly were higher than those charged by private-sector competitors. A state government can discriminate in favor of itself, Chief Justice John G. Roberts Jr. said in his majority opinion.
The lesson, said Kentucky’s lawyer, C. Christopher Trower, “is that the Commerce clause does not extend to activities by a state on behalf of all of its people.”
Justice Samuel A. Alito Jr., who dissented from the chief justice’s opinion in the New York trash case, commented to Mr. Trower at one point that many, if not all, of the state’s arguments “would demonstrate that the Commerce clause jurisprudence is utterly incoherent.”
The case, Department of Revenue of Kentucky v. Davis, No. 06-666, actually concerns not the Commerce clause itself, which is a grant of power to Congress to regulate interstate commerce, but rather the concurrent restraint on state power that the court calls the “dormant” Commerce clause. By implication, in the court’s view, although not in its text, the Constitution bars states from interfering with interstate commerce.
Two justices, Antonin Scalia and Clarence Thomas, reject the 150-year-old dormant Commerce clause. So Kentucky can count on at least their votes in its appeal of a 2006 decision by the Kentucky Court of Appeals. That court ruled in favor of a couple, George and Catherine Davis, Kentucky taxpayers who own out-of-state bonds and invoked the dormant Commerce clause to challenge Kentucky’s refusal to grant them an equivalent tax exemption.
For the $2.5 trillion municipal bond market, the stakes are substantial. Thirty-eight states, nearly every state that has an income tax, exempt state bond interest from residents’ taxable income while taxing the interest on other states’ bonds. All 49 other states have supported Kentucky’s position that the practice is valid.
Justice John Paul Stevens asked Mr. Brunstad, the lawyer for the couple, to explain the failure of the other states to support his case. “The victims under your approach, as I understand it, are the 49 other states,” Justice Stevens said, adding that nevertheless, “all of them seem to support your opponent.”
“True, Justice Stevens, but they don’t want to issue refunds,” Mr. Brunstad said. “You can understand that.”
If the Supreme Court upholds the state court’s ruling, states would have a choice of how to equalize their tax treatment: exempt the interest on all municipal bonds, as the federal government does, or tax all the interest. The Supreme Court would not dictate a remedy. Some states’ constitutions, however, require that state bonds be tax-exempt.
Chief Justice Roberts asked Mr. Trower, Kentucky’s lawyer, whether the result of taxing municipal bond interest might not be “a wash.” The states would have to pay a higher interest rate to attract investors, he said, but at the same time would receive more tax revenue.
“It may be a wash at the end of the day, but that’s a decision that the Commerce clause leaves to the states to make,” Mr. Trower replied.
Single-state municipal bond funds, which hold 13 percent of all municipal bonds, would feel the most immediate impact. A group of the funds filed a brief on the state’s behalf.