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MUNICIPAL BONDS FACE UNCERTAIN STATE INCOME TAX TREATMENT AT THE "LEARNED HANDS" OF THE UNITED STATES SUPREME COURT

In a post from December 28, 2005, "Municipal Bonds Face Challenge from new Retiree Healthcare Benefits Accounting Rule" , the Author addressed the potential disruption that a new accounting rule might cause the municipal bond market.

Another recent development could also bring undulations of uncertainty to the municipal bond market. The US Supreme Court "agreed on Monday to decide whether states can continue to exempt interest on their own bonds from their residents’ taxable income, while taxing the interest on bonds issued by other states," according to an article in the New York Times.

The NYT article goes on to state:

The preferential tax treatment for in-state bonds is longstanding and very common, offered by nearly all the states that have an income tax. State and local governments issued more than $350 billion worth of bonds a year from 2002 to 2006.

The practice was, in fact, largely taken for granted until it was declared “facially unconstitutional” in January 2006 by the Kentucky Court of Appeals. That state court, ruling in a case brought by a Kentucky couple, George and Catherine Davis, who own bonds issued by other states, said the preferential tax treatment erected a barrier against interstate commerce in violation of the Constitution’s commerce clause.

In the only previous decision on the subject, an Ohio state appeals court upheld that state’s preferential treatment of bond interest, in a 1994 decision that the Supreme Court declined to review. The fact that two state courts now disagree on such a fundamental question probably led the justices to conclude that the issue required their attention.

Municipal bonds, one of the safer investments for income investors, are debt instruments issued by cities, states and governmental units to pay for public buildings, schools and public projects. Municipal bonds are only attractive to high income investors, however, because they are free from federal taxes, and often free from state taxes. This favorable tax treatment allows municipalities to offer lower interest rates than comparable taxable bonds.

Municipal bonds are also safe investments because they are backed by either specific revenues or the taxing power of the city or state.

Many states engage in the preferential practices that the Supreme Court will apparently address. New Mexico, for example, exempts New Mexico (and its city and county units) municipal bond income from New Mexico State Income tax. However, New Mexico does not exempt income from the bonds of other states from state income tax.

Indiana, however, exempts from Indiana Income tax interest on all other states' municipal bonds.

There are intra-state benefits for states that only exempt their own bonds from state income tax. This treatment makes in-state bonds more attractive than out-of-state bonds. For small states that issue few bonds, this preferential treatment is beneficial to the marketability of its bonds.

The name of the case is Department of Revenue of Kentucky v. Davis, No. 06-666.

LIVING, AS HE DOES, IN THE DESERT OF THE REAL, THE AUTHOR HAS LITTLE INTEREST IN MUNICIPALITIES.