High-yield/macroeconomics (fka YIELD)

[DewDiligence]

Supreme Court Hears Challenge to Muni-Bond Tax Exemption

[Based on the vibes reported in this write-up, it looks like the Court will likely retain the tax break for in-state munis.]

http://online.wsj.com/article/SB119426995434382472.html

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By MARK H. ANDERSON
November 5, 2007 3:55 p.m.

WASHINGTON -- An attack on tax exemptions for state and local municipal bonds Monday faced resistance at the Supreme Court, which heard arguments in a challenge to Kentucky's practice of exempting interest on local municipal bonds purchased by state residents.

Although the case appears to be closely divided, the challengers must, among other things, overcome the views of several justices who recently ruled state and local governments can in some instances enact policies that discriminate against out-of-state commerce. Kentucky and 41 other states offer tax breaks to residents who buy in-state bonds, a practice that has grown unchallenged since New York first enacted a tax exemption in 1919.

G. Eric Brunstad Jr., a Hartford, Conn., attorney who represented challengers of the tax breaks, argued the interest exemption is "facially discriminatory" and barred under the Supreme Court's commerce clause precedent. "This is nothing more than an ongoing low-level trade war," Mr. Brunstad said of the 42 states that offer tax breaks on their bonds.

Kentucky's attorney, C. Christopher Trower, on the other hand, said his state was simply offering an incentive for its residents to purchase its bond products, thereby helping create local demand for products that might not generate interest in the $2.5 trillion national muni bond market. "If a Kentucky resident loans money to Kentucky, then Kentucky gives the resident a tax exemption," Mr. Trower said.

Chief Justice John Roberts Jr., who authored the majority ruling in the 6-3 United Haulers appeal in the last term, led the charge for allowing the states to continue using the tax exemption. "This is an area where Congress can regulate if it wants to, and it has never shown the slightest interest in interfering with state tax exemptions for their own bonds," Justice Roberts said in one of numerous statements about the case.

Justice David Souter was also critical of the challenge and worried aloud about disrupting the municipal bond market. "We have an enormous market, the effect of interrupting which we really as a court cannot tell very much," Justice Souter said.

Justice Ruth Bader Ginsburg also appeared to support the tax breaks while Justice Stephen Breyer, who was also in the majority in the garbage regulation case, said he found the case difficult to decide. Justices Antonin Scalia and Clarence Thomas don't think the Supreme Court has the authority to police interstate commerce and could ultimately join with a majority that allows the tax breaks to continue.

Justices Samuel Alito, Anthony Kennedy and John Paul Stevens all expressed some level of skepticism about whether the tax break is permitted by interstate commerce limits. All three of those justices dissented in the United Haulers appeal last year.

The lawsuit began in 2003 when two Louisville residents, George and Catherine Davis, filed a class-action lawsuit against Kentucky arguing it was wrong for the state to tax interest on their out-of-state bond investments while exempting in-state bond interest. A trial judge ruled against them. But the Kentucky Court of Appeals reversed, ruling the state interest exemption violated the Constitution because the same break isn't extended to out-of-state bond products. The Kentucky Supreme Court in 2006 let the lower court ruling stand.

More than 40 states exempt interest on in-state municipal bonds from income taxes, creating what is a tremendous nationwide market for bond products carved up by state boundaries. According to the Bond Buyer/Thompson Financial 2007 Yearbook, state and local government bonds are increasingly popular with $891 billion issued in 2005 and 2006 alone.

States that offer the tax breaks and Wall Street participants in the municipal-bond market all favor leaving the tax breaks on municipal bonds in place. States fear change in a system that allows them to create incentives for their own bond offerings. Wall Street is concerned an end to the tax breaks would upend the muni bond market, creating price uncertainty and forcing the industry to reorganize itself in a post-tax system.
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