16 Pages Posted: 13 Aug 2007
This report discusses various implications of Department of Revenue of Kentucky v. Davis, the case pending in the Supreme Court challenging the common state practice of exempting interest on in-state municipal bonds from income taxation, while taxing the interest on out-of-state bonds.
A decision for the taxpayers in Davis would transform the municipal bond market from a series of localized markets into a national market. This likely would have long-run benefits for both investors and state and local governments. State tax exemptions are not a cost-effective way for states to reduce borrowing costs. Replacing large numbers of single states municipal bond mutual funds with fewer and larger national funds should reduce costs and provide diversification benefits for investors. However, the short-run effects for state budgets are likely to be disruptive, as states must pay refunds and adjust their tax policies.
Davis will present the Supreme Court with an opportunity to delineate the new government entity exemption under the dormant Commerce Clause doctrine that it created in the United Haulers case. The fact that many municipal bonds are issued to directly benefit private businesses, other entities, and individuals (not governmental entities) may create the opportunity for the Court to clarify the scope of United Haulers' government entity exemption.
Finally, the report points out that the decision in Davis could indirectly affect several justices' state tax liabilities. In 2005, five justices had substantial municipal bond holdings, some in individual bonds or single-state mutual funds and others in national mutual funds. Both Maryland and Virginia have tax policies that parallel's Kentucky's.
Keywords: municipal bonds, dormant commerce clause, state and local tax
JEL Classification: H71
Suggested Citation: Suggested Citation
Michael, Joel, Department of Revenue of Kentucky v. Davis: Implications for State Tax Policy and the Dormant Commerce Clause Doctrine. State Tax Notes, Vol. 45. Available at SSRN: https://ssrn.com/abstract=1005433