U.S. justices preserve municipal bond tax breaks

By Chris Rizo | May 19, 2008

David Souter

WASHINGTON (Legal Newline) - The U.S. Supreme Court ruled Monday that states can continue giving tax breaks on interest from municipal bonds sold within their borders.

The decision, which is seen as protecting one of the benefits of investing in the municipal bond market, reverses a Kentucky court decision that the state's tax breaks on in-state securities violates the U.S. Constitution.

The 7-2 decision continues to allow states exempt interest earned on in-state bonds, while taxing the income from bonds issued outside of its borders.

Alan Viard, a resident scholar at the American Enterprise Institute, said an important component to the court's ruling is that the justices declined to uphold, at least for now, the tax exemption for private-activity bonds.

More than 40 states exempt either some or all interest on bonds issued in their states from income taxes, while taxing interest on bonds sold by other states.

Kentucky residents George and Catherine Davis brought the case, arguing that the tax breaks violate the Commerce Clause, which gives the federal government power to regulate trade among states.

"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 on their own bonds from their state income taxes, which are imposed on bond interest from other states," Associate Justice David Souter wrote for the court's 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," Souter wrote.

Chief Justice John Roberts and Associate Justices Stephen Breyer, Ruth Bader Ginsburg, Antonin Scalia, John Paul Stevens and Clarence Thomas joined Souter in the majority.

Dissenting in the decision were Associate Justices Samuel Alito Anthony Kennedy. They called the special tax breaks "protectionist."

Proponents of the tax breaks for municipal bond investors say they keep down the costs of debt for local governments and school districts that issue the bonds because they are able to pay bondholders a lower rate of return since the tax breaks help attract investors.

From Legal Newsline: Reach reporter Chris Rizo by e-mail at chrisrizo@legalnewsline.com.

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