Court May Rule on States' Bonds
By JESS BRAVIN and SHEFALI ANANDNovember 5, 2007; Page A4
The Supreme Court will today hear arguments in a case that could upend how states finance capital projects and also reshuffle the $2.5 trillion municipal-bond market.
For decades, many state governments helped keep capital within their borders by offering residents a deal: buy the state's own bonds and pay no state income tax on the interest. Interest from other states' bonds was usually taxable. Last year, a state court in Kentucky struck down the practice, ruling that the Constitution doesn't allow states to favor their own bonds that way.
• The Setting: The Supreme Court today will hear arguments on whether the Constitution allows states to favor their own bonds by making them tax-free while taxing the interest on other states' bonds. The case could upend how states finance capital projects and also reshuffle the $2.5 trillion municipal-bond market.
• The Background: Last year, a state court in Kentucky struck down the practice, ruling that the Constitution doesn't allow states to favor their own bonds that way.
• Status Quo May Stay: The circumstances of the appeal suggest the Supreme Court may be inclined to overrule the Kentucky decision, preserving the tax advantages. If not, Congress could step in to authorize the tax deductions.
If the Kentucky decision stands at the Supreme Court, some states likely would find it costlier to raise capital. That is especially true of high-tax states, such as California, Minnesota and New York, which can currently raise money relatively cheaply. The tax advantage enables these states to offer lower yields to in-state investors, which makes state borrowing less expensive.
Some small states could lose local investors who buy only their state bonds, and would therefore be forced to look for other sources of funding. In that case, "almost certainly, the costs are going to be higher," says Richard Cordray, the state treasurer in Ohio.
Such a decision would also make mutual funds focusing on single-state bonds irrelevant; many would likely be merged with national funds. These funds hold $155 billion in assets out of $365 billion in all municipal-bond mutual funds as of 2006, according to fund-trade group Investment Company Institute.
The circumstances of the appeal suggest the Supreme Court may be inclined to overrule the Kentucky decision, preserving the tax advantages. The Supreme Court rarely takes appeals from midlevel state courts, which are binding on at most a single state. Moreover, since states are practically unanimous in approving the practice, Congress could step in to authorize the tax deductions even if the Supreme Court finds the states have no inherent power to authorize them.
The market seems to expect the status quo to prevail. New York bonds are commanding a premium over some others, notes Dan Loughran, a portfolio manager of municipal-bond funds at OppenheimerFunds Inc. "The market is telling you that the Supreme Court is going to overrule the ruling in Kentucky," he says.
The legal dispute stems from the Constitution's Commerce Clause, which authorizes Congress to regulate commerce among the states. Even when Congress hasn't legislated in a particular area, courts have generally interpreted the provision to bar state governments from engaging in economic protectionism.
The Supreme Court hasn't been clear about its scope. In April, a 6-3 court upheld an ordinance requiring trash haulers in two upstate New York counties to use a dump owned by the local authorities. Two years ago, though, a 5-4 court struck down state laws restricting residents from ordering wine from other states.
The municipal-bond case is likely to turn on how the justices view state bond sales. If they consider capital financing a fundamental part of the state's sovereign authority, they are likely to leave the practice intact. If they see Kentucky as obstructing trade to give its own products an advantage, it could fall.
"These are the kind of trade barriers and trade retaliation that we don't want states to be entangled in," said Eric Brunstad, a partner with Bingham McCutcheon in Hartford, Conn., who will argue at the court today against the Kentucky policy.
Scott Attaway, a Washington lawyer with Kellogg, Huber, Hansen, Todd, Evans & Figel PLLC, counters that municipal finance is different from the private enterprise the Commerce Clause was intended to foster.
"There aren't any private entities that are issuing municipal bonds. This goes to a core state function, which is raising money to spend for the public good," says Mr. Attaway, who isn't involved in today's case.
Interest payments on a majority of municipal bonds are free from federal income tax. State-specific deductions began in 1919, when New York imposed an income tax and exempted interest paid by its own municipal bonds. Other states followed, with Kentucky adopting a similar provision in 1936. Today, more than 40 states exempt all or some in-state bonds from their income taxes.
In 1994, an Ohio state court upheld the practice, which remained unchallenged until last year's contrary decision by the Kentucky Court of Appeals in Frankfort. The Kentucky Supreme Court declined to review the decision, leading the state Department of Revenue to petition the U.S. Supreme Court.
Several groups representing state officials, including the National Association of State Treasurers and the Multistate Tax Commission, have sided with Kentucky in asking the justices to reverse the lower court decision.
Dwight Denison, a professor of public and nonprofit finance at the University of Kentucky, says even low-tax states, which might benefit from the Kentucky decision, are worried about the implications for their tax systems. Many want to retain tight control.
If the Supreme Court decides in-state exemption is unconstitutional, states would have a choice to exempt all bonds, or tax all bonds, including its own. Market observers say many states would choose to make all bonds tax-exempt.
A change in the status quo would primarily hurt so-called specialty states such as California and New York, which see strong demand for their bonds because of high taxes and large concentrations of wealthy people. They can issue large numbers of bonds with interest rates lower than that of Texas and Florida, which have no state income tax and thus lower in-state demand.
If the court affirms the lower-court ruling, "yields on California bonds would rise, and Texas bonds would fall, meeting in the middle," Mr. Loughran of OppenheimerFunds says. That means individuals and investors holding California bonds would find their bonds' prices have declined, while holders of Texas bonds would see a rise in value.
For now, advisers suggest investors hold tight. Investors wanting to buy municipal bonds right now, should do a comparative analysis of the advantages of buying national bonds versus state specific bonds, says Ram Kolluri, a fee-only planner in Princeton, N.J.
