Department of Revenue of Kentucky v. Davis

The docket number of this case looks inauspicious for the State of Kentucky. It, like 41 other states, taxes the income that its residents derive from interest on out-of-state bonds, while exempting the income of its residents from KY municipal or state bonds from taxation. The question is, simply put, whether this practice violates the Commerce Clause of the United States Constitution. I have a larger question, to which I haven't found the answer, and that is why this practice, which has been in place for a long time in 42 states, now comes to the US Supreme Court. If this practice is declared unconstitutional, which I think it will be, why is it only now that such a finding will be made? Why not in 1957? 67? 77? You get my question. But, in order to understand the issue a little more, let's take a trip down the state financing road.

A Word on State Finance with Bonds

States and local governments rely heavily on the issuance of debt obligations (i.e., bonds) to fund public projects. For example, Justice O'Connor noted in an earlier case:

"Long-term debt obligations are an essential source of funding for state and local governments. In 1974, state and local governments issued approximately $23 billion of new municipal bonds; in 1984, they issued $102 billion of new bonds. State and local governments rely heavily on borrowed funds to finance education, road construction, and utilities, among other purposes. As the Court recognizes, States will have to increase the interest rates they pay on bonds by 28-35% if the interest is subject to the federal income tax. South Carolina v. Baker, 485 US 505, 511 (1988).

Though her comment related to a slightly different issue, the implications for state revenues are clear. If KY and the other states are not allowed to exempt their state bonds from income tax, then the cost of its capital will rise by about 1/3.

But how much in state and local bonds do municipalities or the state issue these days?

"State and local governmental units issued nearly $2.1 trillion of tax-exempt bonds between 1996 and 2002. The majority ($1.5 trillion) of these tax-exempt bonds were Governmental bonds, the proceeds of which helped finance public projects (such as schools, streets, and utilities). The balance, $0.5 trillion, comprised private activity bonds, the proceeds of which were used for qualified facilities (such as airports, docks and wharves, and solid waste disposal facilities), as well as to benefit Internal Revenue Code section 501(c)(3) organizations (such as hospitals and private universities)," quoted in Petition for a Writ of Certiorari, at *9.

Basically, the State of KY is relying on the Court to confirm a practice that has been in place for a long time, is done by nearly everyone and brings unquestioned benefits to states in the funding of municipal projects. In short, it appears to be a "win-win" situation for all concerned. It provides incentives for residents of a state to buy their local bonds and thus take an interest in their communities; it provides revenues to governmental units; it provides needed services for us all. Who are the spoil sports that want this to end?

The Law in the Case

The only problem with this line of thought just quoted, however, is that it might just not comport with the US Constitution. The specific provision of the Constitution it is said to violate, however, is not the Commerce Clause but the "unwritten" or "dormant" Commerce Clause. My former colleague Prof. Norman Williams is an expert on the subject, and I will refer you to his articles if you really want to know about it. Suffice it to say that you first have to understand the Commerce Clause ("the Congress shall have Power..To regulate commerce with foreign nations, and among the several States, and with the Indian tribes," Art I, sec. 8, cl. 1) and then realize that the "dormant" or hidden part of the clause is what is "not said" in the words "among the several states." The Supreme Court has long ruled that these four words prohibit states from taxing each other in a discriminatory way.

The lower court (the KY Court of Appeals, 197 SW3d 557 (2006)) had no difficulty concluding that this KY practice was "facially" unconstitutional. That means that you don't need to understand a particular set of "facts" to make your decision. The practice, according to the court, so obviously offends the dormant commerce clause that it must be struck down. On appeal, the state argues, in addition to the economic arguments cited above, that in issuing bonds the state becomes a "market participant" and thus is not just a "market regulator," in which latter role the state might be brought into difficulty with the dormant commerce clause. As a market participant, however, the discriminatory rules don't apply. Finally, an argument in favor of the state is that if the Court strikes down these bonds, the state can simply "go around" the Court's decision by subsidizing the purchase of state and municipal bonds. The state could do this by providing an income tax credit or other form of subsidy for purchasers of municipal/state bonds that would do the same thing as is currently being done.

Conclusion

This is a very big case. NY Times Supreme Court columnist, Linda Greenhouse, wrote that this is a case "with the potential to rattle, if not reshape, the market for state and municipal bonds," ("Supreme Court to Address State Tax Breaks for Bonds," May 22, 2007). It turns on lots of things, not least of which is a Justice's view on how much leeway a state should have in devising its own system of taxation. Don't count on KY to prevail, however...

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