By Larry Jones
June 2, 2008

In a significant victory for state and local governments, the Supreme Court ruled on May 19 that the state of Kentucky’s practice of exempting from its state income taxes interest earned on bonds issued by it or its local governments but not interest earned on bonds issued by other states and their political subdivisions, does not violate the Commerce Clause of the U.S. Constitution. The ruling is significant because 41 states have similar taxing schemes that would have all been invalidated if respondents had prevailed.

The ruling was handed down in the case of Department of Revenue of Kentucky v. Davis. In this case, George and Catherine Davis, residents of Kentucky who paid state income taxes on interest earned from out-of-state municipal bonds, claimed that Kentucky’s differential taxation of interest on municipal bonds impermissibly discriminates against interstate commerce in violation of the dormant Commerce Clause.

The Supreme Court’s decision reverses a Court of Appeals ruling in favor of the Davises – that the Court had “no choice but to find that Kentucky’s system of taxing only extraterritorial bonds runs afoul of the Commerce Clause.” The Court of Appeals explained that modern dormant Commerce Clause law forbids “economic protectionism” or regulatory measures that benefit in-state economic interest by burdening out-of-state competitors. But, the Supreme Courts cites numerous rulings that make an exception to this rule for states like Kentucky that participate in the bond market to exercise the right to favor their own citizens over others, as oppose to those that serve merely as market regulators.

In explaining its ruling, the Supreme Court said, “Many single state funds would likely disappear if the current differential tax schemes were upset and there is no suggestion that the interstate markets would welcome the weaker municipal issues that would lose their market homes after a Davis victory. Financing for long-term municipal improvements would thus change radically if the differential tax feature disappeared. The fact that the differential tax scheme is critical to the operation of an identifiable segment of the current municipal financial market demonstrates that the States’ unanimous desire to preserve the scheme is a far cry from the private protectionism that has driven the dormant Commerce Clause’s development.”