State & Local Tax Blog

Supreme Court Ruling Could Roil Municipal Bond Markets

The Supreme Court will hear arguments Nov. 5 on whether Kentucky violates the Constitution by taxing income earned on out-of- state bonds while exempting interest on ones issued by its own cities, school districts and other debt-issuing authorities. According this article from Bloomberg.com, “barring such preferential treatment would force 42 states, including New York and California, to either tax their own bonds or give identical breaks to out-of-state bonds.”

Most states tax the income from other states’ municipal bonds while exempting the income from their own state’s bonds. This would certainly seem to be an infringement on interstate commerce. The power to regulate interstate commerce is reserved for the Congress. States have been routinely prohibited from taxing out-of-state income more than they tax in-state income. So it would seem that the Court will rule against Kentucky in this case also.

If they do go against KY, then states would most likely have to decide whether they will tax all municipal bond income, or exempt it all. Either of those choices would seem to make the bonds from these 42 states immediately less valuable relative to bonds issued in the other states that presumably offered a higher yield relative to these 42 states.

It will be very interesting to see how this goes. There’s one more aspect to this case that is very intriguing and that is, what if Justice Roberts continues on with this new argument that if a state has legitimate goals in mind and isn’t just trying to favor commercial interests, it may be able to tax out-of-state income more than in-state. See the Bloomberg article for a great discussion on this. But if that reasoning takes hold, brace yourself for a whole new world in state taxation as states figure out ways to tax out-of-staters and exempt in-staters. It’s so easy to tax non-voters isn’t it?

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