High Court May Protect States’ Taxation of Bonds
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The Supreme Court appears hesitant to declare unconstitutional the widespread practice among states of giving tax breaks for in-state municipal bonds.
New York is one of 38 states that tax the interest earned by out-of-state municipal bonds while exempting from taxation income earned from its own state or municipal bonds. Whether such an effort to raise funds for local public projects illegally interferes with interstate commerce is the central question of an appeal from Kentucky, which the federal high court heard yesterday.
A decision by the court saying that the Constitution’s commerce clause forbids states from enacting such tax discrepancies would shock the municipal bond market. Such a ruling could require states and municipalities to refund recent taxes collected from residents on interest earned on out-of-state bond investments. In New York alone, those claims could amount to $200 million, according to a brief filed by 49 states, including New York, in support of the Department of Revenue of Kentucky. What is unclear is how such a ruling would affect taxation of future bonds, as states would need to decide whether to either tax instate bonds or expand the tax breaks to also cover out-of-state bonds.
While some states have a constitutional proscription against taxing interest from local bonds, New York does not. In New York, where city and state income taxes can top 10%, tax protections are especially crucial in making bonds attractive to local investors. On the other hand, a Supreme Court decision against the tax protections would mean “there are 280 million other Americans who would be more receptive to New York investments,” an attorney at the Tax Foundation, Joseph Henchman, who assisted in drafting a court brief arguing against tax favoritism for in-state bonds, said.
The prospect that the Supreme Court may force states to scrap tax codes benefiting only local bonds has not received much consideration at the state level across the country, one expert said.
“This issue has been pretty much below the radar,” the director of the national state attorneys general program at Columbia Law School, James Tierney, said. “If most governors were told they couldn’t do this any more, they would say, ‘Why not?’ I don’t think the issue has really percolated to the top of the agenda.”
During yesterday’s oral arguments, the questions of several justices seemed to suggest that they weren’t eager to upset the bond market.
One justice suggested that government’s use of taxes to encourage investment in local public projects wasn’t the same as other types of trade interference.
“Of course you win as soon as we say the commodity is the same as milk,” Justice Breyer told a lawyer for the plaintiffs, G. Eric Brunstad, according to a transcript of yesterday’s argument. But neither milk, nor any other commodity was at issue, Justice Breyer said. The bonds at issue are “financing the most basically governmental of all governmental institutions — libraries, schools, streets,” Justice Breyer said.
Mr. Brunstad represents a Kentucky couple, George and Catherine Davis, who sued over the state’s policy of taxing their out-of-state bond investments.
In 1919, New York became the first state to give tax benefits to local bonds, and the practice has spread since, largely unchallenged. Chief Justice Roberts appeared willing to leave the setup alone.
“So this is an area where Congress can regulate if it wants to, and it has never shown the slightest interest in interfering with State tax exemptions for their own bonds,” Justice Roberts said.