WASHINGTON — The Supreme Court ruled Monday that states will be allowed to continue a 90-year-old practice of not taxing interest on in-state municipal bonds while taxing residents on out-of-state bond interest.
In a 7-2 decision, the court reversed a decision by a Kentucky appeals court, which had declared unconstitutional the traditional practice of offering preferential tax treatment on bonds used to fund highway, school and other government projects.
The case stemmed from a lawsuit filed in 2003 by George and Catherine Davis of Jefferson County, Ky., who were taxed on bonds issued by another state.
The Davises maintained, and a Kentucky appeals court agreed, that the state's law violates the commerce clause of the U.S. Constitution by discriminating against interstate commerce. In overturning that decision, the Supreme Court addressed an issue that has gripped the $2.5 trillion municipal bond market; 41 states have laws similar to Kentucky's.
"For the better part of two centuries states and their political subdivisions have issued bonds for public purposes, and for nearly half that time some states have exempted interest from their state income taxes, which are imposed on bond interest from other states," Justice David Souter wrote in the majority opinion. "The question here is whether Kentucky's version of this differential tax scheme offends the commerce clause. We hold that it does not."
Dissenting Justices Anthony Kennedy and Samuel Alito worried that upholding Kentucky's bond taxing method would result in "untoward consequences for that market" and could invite other "protectionist laws." Critics called the decision marketplace discrimination.
If Kentucky had lost the case, most states could have been faced with refunding taxes going back several years.
"We are very pleased with the court's ruling and are relieved that this matter of great interest to municipal bond investors is now resolved," said Jonathan Miller, secretary of the Kentucky Finance and Administration Cabinet.