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Tuesday, May 1, 2007

Germain on The Implications of United Haulers on Davis v. Kentucky

GermainGregory L. Germain (Syracuse) has written this excellent piece for TaxProf Blog on the impact of yesterday's U.S. Supreme Court decision in United Haulers Association v. Oneida-Herkimer Solid Waste Management Authority, No. 05-1345 (4/30/07), on the pending cert. petition in Davis v. Kentucky, 197 S.W.3d 557 (2006), which held unconstitutional under the dormant commerce clause Kentucky's tax exemption of interest on Kentucky state & local bonds, but not interest on out of state bonds (blogged here):

Discrimination in Favor of Local Municipal Bonds: Thoughts on the Implications of United Haulers on Davis v. Kentucky:

The United States Supreme Court yesterday issued a blockbuster ruling that suggests the existing system of municipal bond financing, under which states provide an income tax exclusion only for in-state municipal bond interest, is constitutional.

In United Haulers Association v. Oneida-Herkimer Solid Waste Management Authority, the Court yesterday recognized an important constitutional distinction between discriminatory governmental regulation that favors of private entities, and discriminatory governmental regulation that favors governmental entities.

The United Haulers case as far removed factually from the white-shoe business of municipal bond financing. Indeed, the United Haulers case involves the dirty business of garbage collection. In United Haulers, the Court upheld against a dormant commerce clause attack a “flow control” ordinance that required all solid waste produced in two upstate New York counties, Oneida and Herkimer counties, to be delivered to a governmentally-owned local processing facility that charged the shipper a relatively high “tipping fee” for disposal. The ordinance was challenged by a private hauler that picked up solid waste from households and businesses within the two counties, and sought to deliver that waste to another in-state or out-of-state processing facility that charged a lower tipping fee.

The Supreme Court had previously struck down as violative of the dormant commerce clause a similar ordance requiring delivery of locally-produced hazardous waste to a putatively private processing facility. Carbone v. Clarkstown, 511 U.S. 383 (1994). The facility in Carbone was nominally owned by a private contractor, but was really utilized by the counties to finance the cost of constructing the processing facility. The processing facility would ultimately be governmentally owned. The factual distinction between the putatively private facility in Carbone and the public facility in United Haulers is very thin, as pointed out by a vociferous dissent written by Justice Alito and joined by Jutices Stevens and Kennedy.

Interesting, Justice Alito, while still a court of appeals judge, had previously joined in an opinion applying the strict scrutiny Carbone test to a government-owned processing facility. Atlantic Coast Demolition v. Board of Chosen Freeholders of Atlantic County, 48 F.3d 701 (3rd Cir. 1995). For some reason, the Supreme Court did not mention the Atlantic Coast decision as creating a conflict among the circuits, relying instead on a more recent Sixth Circuit decision in National Solid Wastes Management Assn. v. Daviss Cty., 434 F.3d 898 (2006).

The United Haulers case resulted in an interesting split among the judges regarding the proper standard to apply. Three of the judges in the majority (Roberts, Scalia and Thomas) would have provided a blanked exemption from the dormant commerce clause for “traditional governmental functions.” Indeed, Justice Thomas said he would not only over-rule Carbone, but would recognize that the dormant commerce clause does not exist. Justice Scalia would limit the dormant commerce clause to its existing precedent, but would not expant the doctrine. The views of Chief Justice Roberts were not entirely clear, but he apparently believes in a broad exemption for governmental actors, would not have applied a balancing test to determine the validity of the ordinance. The other three judges in the majority (Souter, Ginsburg and Breyer) would apply so-called “Pike balancing” test when the government discriminates against interstate commerce and in favor of itself. Under Pike balancing, the Court is somehow supposed to balance the benefits of the regulation to the local government against the burdens on interstate commerce. Interestingly, the Court noted that the financial benefits accuring to the counties from the collection of additional tipping fees goes into the balancing in favor of validity. This is important in the municipal bond context, because the benefit of the tax exclusion to the state is entirely financial (lowering its cost of financing).

The Court also emphasized the importance of waste disposal being “both typically and traditionally a local governmental function.” The “traditional governmental function” test has had a very controversal life. In National League of Cities v. Usery, 426 U.S. 833 (1976), the Court held that Congress could not impose the Fair Labor Standards Act (setting maximum hours and minimum wages) on traditional state activities. Language from National League was used in establishing the market participant exception to the dormant commerce clause. See Hughes v. Alexandria Scrap Corp., 426 U.S. 794 (1976) (issued the same day as National League); Reeves, Inc. v. Stake, 447 U.S. 429 (1980). A divided Supreme Court reversed its position in Garcia v. San Antonio Metro Transit Authority, 469 U.S. 528 (1985), rejecting the “traditional governmental function” test as unworkable, and allowing the Fair Labor Standards Act to be applied to the states. United Haulers marks the return of the “traditional governmental function” test, at least to dormant commerce clause jurisprudence, and at least as a plus factor favoring the government.

What does the United Haulers’ case portend for the Kentucky court of appeals’ decision in Davis v. Kentucky, 197 S.W. 3d 557 (2006), which struck down Kentucky’s tax exclusion for local municipal bond interest? The certiorari petition in the Davis case has been pending since November 9, 2006, and has not been decided (despite being scheduled for determination at several Supreme Court conferences). I believe the Supreme Court wanted to issue the United Haulers decision before ruling on the Davis certiorari petition. I suspect that the Supreme Court will remand Davis to the Kentucky courts to reconsider the ruling in light of United Haulers.

United Haulers involves a very different issue than Davis. The traditional “market participant” exception did not apply easily to the facts in United Haulers, because the government, in requiring all hazardous wastes to be delivered to the governmentally-owned processing facility, was exercising powers that no private market participant has – the power to require others to deal with it exclusively. The Supreme Court in United Haulers has created a broader exemption for regulations discriminating in favor of governmental actors than was embodied in the “market participant” exception.

There is no similar issue in Davis. States do not require local citizens to buy local municipal bonds to the exclusion of other state municipal bonds. The states simply provide a local subsidy in the form of a tax exclusion funded entirely by the local state taxpayers. The discrimination in Davis fits more easily within the traditional “market participant” exception, except that the state provided the benefit through the tax system rather than providing a cash subsidy. The court of appeals in Davis drew a narrow distinction between a state cash subsidity and a state tax subsidy – a distinction that was recognized when the state subsidizes private activities. Compare Hughes v. Alexandria Scrap Corp., 426 U.S. 794 (upholding cash subsidy of private activity under market participant exception); New Energy Company of Indiana v. Limbach, 486 U.S. 269 (1988) (striking down tax subsidy of private local activity). The narrow question in Davis was whether this cash/tax distinction should apply when the discrimination favors the state itself, rather than a private actor. United Haulers does not deal with the market participant exception directly, but indirectly it recognizes a much broader exemption for governmental activities. After permitting a broad flow control ordance which requires private parties to deal with the government, it is difficult to imagine any of the six justice majority voting to overturn the longstanding municipal bond system under which a simple tax subsidy is given for the purpose of encouraging local municipal bond sales.

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I agree with Professor Germain that United Haulers is helpful to the states in their preferential treatment of in-state muni bond interest. However, I don't think this issue is resolved just yet.

There are two key distinctions in Davis:

i) Unlike in United Haulers, where in-state and out-of-state interests were burdened equally, the Kentucky tax preference expressly discriminates against out-of-state interests (i.e., other states).

ii) The benefit this tax subsidy provides to the state of Kentucky comes at the expense of other states. Were it not for this tax preference, Kentucky citizens would be buying more out-of-state bonds. So, while this tax preference supports Kentucky's core state functions, it diminishes other states' ability to perform their core state functions on virtually a dollar-for-dollar basis.

Another distinction worth noting is that in United Haulers, the majority considered how the in-state citizens were essentially burdening themselves to achieve certain goals. Davis is just the opposite, as the burdens of the Kentucky tax preference fall almost entirely on other states. It is true that there is also a burden on Kentucky residents who choose to hold out-of-state muni bonds, but one could easily show that rather than face that burden, most investors just limit their muni bond holdings to those of their home state's.

Posted by: Andrew Dhuey | May 1, 2007 2:54:31 PM