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Earlier today the Supreme Court issued its ruling in the case of Department of Revenue of Kentucky v. Davis, stating that Kentucky's tax rules which exempt the interest earned on Kentucky muncipal bonds while taxing the interest of other state's bonds is not a violation of the so-called dormant commerce clause of the Constitution. The ruling spared what may have been a tumultuous disruption to the municipal bond market, but the Supreme Court's decision still leaves the door open for several issues...

For those who aren't familiar with the case, the basic issue at hand was that a Kentucky taxpayer (Davis) filed suit against the state of Kentucky's Department of Revenue, alleging that their assessment of taxes on Davis' out-of-state municipal bonds was a Constitutional violation. Under the dormant commerce clause of the Constitution, states effectively are not allowed to tax commerce in a way that discriminates against other states (e.g., a state can't tax goods from other states at a different rate than goods from its own territory in an effort to boost its own local economy). The Davis case claimed that Kentucky's tax structure around municipal bonds (which is shared by 41 other states besides Kentucky) was a violation of the commerce clause because it created such a tax-others-states-but-not-our-own regime.

If the court opinion issued (which was 'only' 7-2 in favor of Kentucky) had gone the other way, it would have potentially caused a suddenly disruption in the municipal bond market. As long as states can tax out-of-state municipal bonds while exempting in-state bonds, they create a level of 'artificial' demand for the bonds in their state (assuming the state has an income tax to create a differential). As a result of the current rules, an investor that can receive a 3.0% yield from any municipal bond would choose an in-state bond (tax-exempt) instead of another state's bond. To the extent that some states (e.g., California or New York) are much more populus with far more investment dollars available, compared to others (e.g., Wyoming), this creates an enhanced ability for large states to issue bonds by supporting their own in-state demand, which in turn means that (on average) the states can command a slightly lower yield and still successfully issue bonds. For example, an in-state bond at 3.0% might be more desirable than an out-of-state bond at 3.1% after accounting for state taxes. Had the Supreme Court ruled in favor of Davis, it would have suddenly meant that a lot of investment dollars in larger states could suddenly shop for yield in any municipal bond market - potentially equalizing the differences between yields amongst states rather quickly, and possibly marking a brutal end to single-state municipal bond funds.

However, that didn't happen. The Supreme Court ruled in favor of Kentucky. Nonetheless, several potential issues and concerns still remain. First of all, the court was careful to point out that this was not to be considered an explicit ruling on so-called private activity bonds - municipal bonds that are issued to back certain types of commercial activity for businesses or occasionally nonprofit groups. In the case of private activity bonds - arguably already viewed differently by Congress in light of the fact that such bonds receive different tax treatment for Alternative Minimum Tax purposes under IRC Section 56(b)(1)(C)(iii) - the fundraising efforts of the state (with preferential tax treatment) are arguably more directly applicable to commerce, and thus potentially may still be running afoul of the Constitution's commerce clause. It remains to be seen whether another taxpayer in the future will take up the challenge to the courts on this particular issue.

Although the case of Kentucky v. Davis was focused on municipal bonds, the ruling was also viewed by many as a warning sign for the 529 industry as well. Numerous states currently effect a similar tax treatment for 529 plans as they do for municipal bonds - taxing the interest on out-of-state 529 plans but not in-state 529 plans - and if the treatment was ruled unconstitutional for the latter, it certainly raised a significant potential challenge for the former. However, it has thus far been a state-by-state issue. In point of fact, a challenge has already been raised directly against 529 plans in this matter - Maryam Ahmed v. Illinois was filed last May (2007), and is a class action suit challenging the constitutionality of the Illinois preferable tax treatment for in-state 529 plans. Some have argued that the issue of state parity for in-state versus out-of-state taxation might be even more applicable to 529 plans. For 529 plans it is particularly problematic, since many states also have a revenue-sharing agreement with the 529 plan investment sponsor, which means that the states with unequal tax treatment are providing an incentive for residents to invest in the in-state plan where the state itself makes money, and not the out-of-state plan where the state has no revenue sharing opportunities. The trend in recent years has been towards so-called "529 plan parity" where states provide a level tax playing field for in-state and out-of-state plans, but many states will provide dissimilar treatment. We will see how the Maryam Ahmed case plays out in the months and years to come. But the Kentucky v. Davis case will almost certainly weigh in now on a court's subsequent decision regarding 529 plan state parity; the Ahmed case will now need to draw a distinction between the municipal bond treatment to distinguish itself from municipal bonds if Ahmed hopes to prevail.

For now, though, it's simply a relief to see the municipal bond issue resolved. Given the size of the municipal bond market, an external disruption like a tax law change could have brought about significant turmoil. Although any such disruption would likely be short-lived, the disruption of bond pricing in an environment already characterized as a "credit crunch" could have created new challenges for many institutional investors, as investors sought out more favorable yields on a tax-level playing field and many single-state municipal bond funds potentially saw an exodus of funds. At least the single-state municipal bond funds dodged the bullet... but we'll see how the private activity bonds and the 529 plans weather the potential storms still on the horizon!

  • Vig Oren

    Thanks Mike for the info on munis. While talking about munis I got this question:

    How do you “tax-loss harvest” muni bonds, and could I do it myself?

    Here is an excerpt from another website:

    “This is one area where a larger finnancial advisor could add value. Larry Swedroe has mentioned they tax loss harvest muni bonds for their customers. I imagine they are large enough they can move the bonds between customers to tax loss harvest, but keep transaction costs down because they aren’t buying / selling into the “market.” “

  • Shane

    Hi Michael, I hope this issue with municipal bond is now resolved. I like how the “court was careful to point out that this was not to be considered an explicit ruling on so-called private activity bonds – municipal bonds that are issued to back certain types of commercial activity for businesses or occasionally nonprofit groups.” Please keep us updated with this issue, ok? Thanks!

Michael E. Kitces

I write about financial planning strategies and practice management ideas, and have created several businesses to help people implement them.

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