LeAnn Luna

Supreme Court Upholds States' Differential Tax Treatment of Municipal Bond Interest

Leaves municipal bond rules intact but defers decision on private activity bonds for another day.

June 12, 2008
by LeAnn Luna

In May 2008, the Supreme Court affirmed the century-old tradition of allowing states to exempt from state income tax the interest on their own municipal bond issues, but still impose tax on equivalent securities issued by other states. In Department of Revenue of Kentucky v. Davis (Docket # No. 06-666), by a margin of seven to two, the justices overturned the Kentucky State Court of Appeals decision and rejected the argument that a state improperly interferes with commerce by providing a tax preference to in-state offerings.

The long-awaited decision avoided a potential upending of the $2.5 trillion municipal bond market. As Justice David Souter noted, “We are being asked to apply a federal rule to throw out the system of financing municipal governments throughout most of the United States.” The ruling preserved the status quo regarding the taxation of municipal bonds to the relief of Kentucky as well as the other 49 states which had unanimously argued for Kentucky’s position. Furthermore, the decision significantly reduces the uncertainty around the taxation of Section 529 college savings plans, which are deemed to be municipal securities. Nearly half of the states have income tax laws that provide tax deductions for taxpayers’ contributions to in-state 529 plans, but don’t allow deductions for contributions to out-of-state plans.
State Tax Treatment of Municipal Bonds

In general, most states do not tax individuals on the interest income they earn from investing in tax-exempt bonds issued by that state, its agencies or its political subdivisions. However, the reverse is true with respect to bonds issued by out-of-state agencies or political subdivisions, with most states taxing the interest from such bonds.

For example, Indiana treats in-state and out-of-state municipal bond interest the same, exempting all interest on bonds issued by any state and its subdivisions. However, 42 states do discriminate against out-of-state municipal bonds (PDF). Thirty-seven of these 42 states follow the general rule, exempting interest on in-state bonds and taxing out-of-state bonds; four states (Illinois, Iowa, Kansas and Wisconsin) exempt some (but not all) in-state interest but impose tax on all out-of-state interest. Utah exempts interest on all Utah bonds as well as bonds from states that do not impose an income tax. The remaining states (Alaska, Florida, West Virginia, South Dakota, Texas, Washington and Wyoming) do not impose an individual income tax.

This differential treatment provides in-state bonds with a competitive advantage by increasing the after-tax yield on a bond issued in one’s own state relative to a similar bond issued out-of-state. For example, for a taxpayer that pays a state tax at an effective tax rate of five percent (after considering the federal deduction allowed for state income taxes), an in-state bond bearing a seven percent interest rate is the equivalent to an out-of-state bond earning a 7.37 percent rate of return.

Unresolved Questions

States, local governments and their agencies often issue municipal bonds for private businesses (private activity bonds) to spur economic development and jobs. The income from these bonds is excluded for federal tax purposes but the income is included in the calculation of the alternative minimum tax. In Footnote 2 of Davis, the court declined to address whether private activity bonds should be treated differently than other municipal bonds, saying only that “it is best to set this argument aside” because the issue had not been fully developed in the record before the Supreme Court.

In addition, the decision raises the question of when a state can discriminate with its tax laws. The dispute in Davis centered around the dormant commerce clause, which governs states’ abilities to discriminate against interstate commerce by favoring local businesses over those from other states. For Davis, the court relied on a series of cases establishing a “market participant exception” as well as the “traditional government function” rationale behind United Haulers v. Oneida Herkimer Solid Waste Management Authority (550 U.S. ___ (2007)). In that case the Court upheld a municipal ordinance that required trash haulers to deliver solid waste to a processing facility owned and operated by a public authority. The Court argued that waste processing is a traditional government function and therefore, it allowed the state to exclude all competitors from competing with a state-run trash processing facility.

But the Supreme Court has ruled in several previous decisions that state tax policies are unconstitutionally discriminating and violate the dormant commerce clause. These include Ohio’s sales tax credit for in-state produced ethanol, New York’s lower stock transfer tax for in-state exchanges, Hawaii’s exemption for certain locally produced beverages, Massachusetts’s subsidies to in-state dairy farmers and Maine’s property tax exemption to certain Maine institutions (Edward Zelinsky, State Tax Notes, June 2007).

In the controversial case Cuno v. DaimlerChrysler, Inc. (386 F.3d 738 (6th Cir. 2004)), the Court struck down targeted Ohio tax credits, potentially impacting economic development efforts in all 50 states. But the Supreme Court dodged the debate and vacated and remanded the case based on standing issues. The case left policymakers on both sides of the debate disappointed and confused.

The South Dakota Supreme Court recently held that insurance premiums and an annuity tax based on residence did not discriminate against foreign insurers (Metropolitan Life Insurance Co. et al. v. Kinsman et al. (2008 SD 24). South Dakota is one of eight states trying to protect its domestic insurance companies by imposing heavier taxes on out-of-state companies that do business in the state.

Davis differs from Cuno and Kinsman because the decision in Davis appears to rest in part on whether the tax policy favors a government, rather than a local business. In fact, the discrimination against out-of-state bonds simply puts those bonds on an equal playing field with commercial bond offerings. However, until bright line standards are established, the debate over when a state can discriminate with its tax laws will probably continue. Several of the Justices penned separate, but generally concurring opinions, addressing their concerns about the potential impact of the Davis majority opinion on a wide variety of state initiatives.

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LeAnn Luna is an assistant professor and holds a dual appointment with the Department of Accounting and Information Management and the Center for Business and Economic Research, both at The University of Tennessee.