A decision is still months away, but there will be some general press about the infamous U.S. Supreme Court case affecting municipal bonds. That is because argument briefs by Kentucky and its supporters were just filed to meet a July 19 deadline.
The National Association of State Treasurers filed a friend-of-court brief to support Kentucky. According to a press release, the treasurer's group is making three principal arguments:
1. "State tax exemptions for in-state municipal bonds are a longstanding and widely-accepted exercise of sovereign authority. Before this decision by the Kentucky Court of Appeals, no court had ever held that these tax preferences are unconstitutional. Moreover, Congress knows that many states provide tax preferences for in-state municipal bonds. Furthermore, Congress has never acted to restrict the practice and has affirmatively approved interstate compacts that provided such preferences."
2. "Kentucky's tax exemption for in-state municipal bonds is constitutional because it treats all private businesses the same and thus does not discriminate against interstate commerce."
3. "Declaring state tax exemptions for in-state municipal bonds unconstitutional would harm state and municipal economies and weaken the bond market by defeating investors' expectations."
Kentucky, other states, single-state mutual funds, and other municipal bond
investors and market participants want the High Court to overturn the lower
court decision. We won't go over all the briefs because the Bond
Advisor has discussed the case enough recently. Subscribers know
what we've said and where we stand.
A case pending before the U.S. Supreme Court could decide whether state tax systems unfairly discriminate when they tax the interest earned on out-of-state municipal bonds. What would happen in a world where all munis, not just in-state sales, became state tax-exempt? And what happens if the High Court doesn't have the final say? The Bond Advisor recently discussed these matters in-depth and also explained how some investors can pursue refunds depending on the case's outcome. Subscribe now to stay on top of this key case.
The tragic bridge collapse in Minneapolis already is spurring discussions about the nation's infrastructure. We wouldn't be surprised if all the talk ultimately leads to action, and that probably means more municipal bond issuance.
But remember, you also read about another angle here first (August 3). We think the tragedy could impact the Kentucky case discussed below.
If, and it is still a big if, the states lose at the High Court in this case, the Bond Advisor believes local governments will press Congress to keep the current system in place. (By "current system" we mean California can exempt interest earned on in-state municipal bonds from state income tax, while taxing interest on out-of-state munis.)
High-tax states such as California could complain to Congress that an adverse Kentucky ruling raised their borrowing cost at a time when they need to save as much money as possible to make critical infrastructure improvements. The tragedy in Minneapolis would put a human face on their arguments and provide an emotional connection that resonates in Congress. It is a sad way to win an argument, but we think this tragedy could help the states prevail in Congress if they lose at the U.S. Supreme Court.
(Nov. 5) -- Certain key U.S. Supreme Court justices appear sympathetic to the current system that lets states exempt municipal bond interest from income taxes, while taxing the interest on out-of-state municipal bonds. That was our initial take on the matter and is still the same after digesting a full transcript of the oral arguments.
(UPDATE: Early morning, Nov. 6 -- We have thought about the matter overnight and still believe there are signs the oral arguments went well for keeping the status quo in the municipal market. But we warn you, nothing is certain. Even a "positive" decision in 2008 for the market could be close (6-3 or 5-4), and there is always some risk it could go the other way. Most of the "general press" accounts we saw early Tuesday also seem to lean toward saying the justices favored the status quo in the muni market, though a handful of reports suggested it is still too close to call.)
A Kentucky appellate court decided the current system violates the dormant Commerce Clause of the federal constitution. The U.S. high court agreed to hear Kentucky's appeal of that ruling.
During oral arguments on Nov. 5, Chief Justice John Roberts noted that Congress had the ability to tackle this issue, but had never stepped in to change the current system. (His comments seem in line with a friend-of-the-court brief by state treasurers that is summarized in a July story below.)
A lawyer for the Kentucky couple who challenged the current system told the High Court that the practice in Kentucky discriminates against other states. However, Justice John Paul Stevens pointed out that the 49 other states have sided with Kentucky in its appeal, not with the Kentucky couple. The lawyer for the couple responded that "they don't want to issue refunds" on out-of-state municipal bonds.
After wading through 57 pages of transcripts from the oral arguments, we still stand by our initial "gut feeling" that the court could give the states a win and overturn the lower court decision in Kentucky. The ruling isn't expected until early 2008.
However, we are making a key assumption in saying this. We believe that an April decision by the Supreme Court (in a New York trash-hauling case) has relevance to the Kentucky case because it distinguished between private companies and governments in applying the dormant Commerce Clause. The Supreme Court favored "government" interests by a 6-to-3 margin in the trash-hauling case.
Will the same six justices (Roberts, Scalia, Thomas, Ginsburg, Breyer, and Souter) also back the State of Kentucky and the existing municipal bond market? Based on the Nov. 5 oral arguments and past reasoning in the trash-hauling case, we believe most if not all of the six would in fact back the State of Kentucky. The other three (Alito, Stevens, Kennedy) probably won't join them, so don't expect any unanimous decisions.
However, be cautious here: Justice Breyer even said on Monday that "I'm finding the case quite difficult." The oral arguments show why, as complex hypotheticals and analogies discussed whether municipal bonds are more like garbage or milk when thinking about interstate trade and fairness issues. Some justices also wondered, for example, whether private-activity municipal bonds run afoul of interstate commerce issues when they get in-state exemption. But one justice noted that private-activity bonds weren't part of the case.
It can be tricky reading the tea leaves from oral arguments alone, but enough justices seemed skeptical about the Kentucky court's ruling to suggest a reversal is possible. Concern also was expressed about upending a market practice that has been in place for decades.