Tuesday, July 24, 2007
On July 19, 2007, the Supreme Court was deluged with briefs seeking to overturn Davis v. Kentucky, 193 S.W. 3d 557 (Ky. App. 2006), the Kentucky appellate court decision holding that Kentucky violated the Commerce Clause by exempting in-state municipal bond interest from taxation as income. Kentucky’s argument to the Supreme Court was supported by more than a half-dozen amicus briefs filed by trade groups for the securities industry (brokers and dealers) and municipal bond analysts, by mutual funds who sell single-state bond funds, and by a broad array of groups representing municipal agencies at all levels. Most surprisingly, all of the other 49 States joined together in an amicus brief seeking reversal. One can only marvel at the achievement of getting all of the States – even those that would potentially benefit if the Kentucky decision were to be affirmed (principally, the seven states that do not have an income tax, and the one state that exempts both in-state and out-of-state municipal bond interest from taxation) – to join a single brief asking for reversal.
Each of the supporting briefs emphasizes the fact that millions of investors have relied on the status quo, and that the Court’s affirmance would threaten both the smooth functioning of the $2.1 trillion dollar municipal bond markets and the ability of the States to finance their essential activities. Kentucky puts it this way: “Would the municipal bond market be destabilized? . . . Would the States struggle for years with the fiscal consequences of a radical change in the ground rules of municipal finance? We don’t know. But we do know that it’s bad business to push a 2.1 trillion pound gorilla out of his cage without any idea where he’s headed or what he’s going to do when he gets there.”
Sitting at the other table are in-state bondholders who purchased out-of-state municipal bonds knowing that the interest they collected would be taxed by their States. An affirmance would upset the expectations of all taxpayers, while resulting in a windfall for in-state bondholders who purchased out-of-state bonds. We have yet to see Davis’s reply brief, but one can expect their policy arguments to focus on the future benefits of a free and open municipal bond market. Those benefits seem questionable when the principal beneficiaries of an imagined free market – the state competitors – have now said they do not want a Court-imposed free market.
Any court reading this barrage of briefs would certainly be left gravely concerned about affirming the decision of the Kentucky court of appeals. But although the justices of the Supreme Court cannot help but recognize the practical effect of their decisions, they are duty bound to uphold the Constitution, whatever be the consequences. The Court must therefore decide whether the Constitution mandates what will now surely be seen as an unpalatable result – affirming the Kentucky court of appeals’ decision.
Kentucky’s brief is, in my opinion, very well done, but misses the mark in a couple of respects. Kentucky’s first argument, to which substantial space is devoted, is that Kentucky’s municipal bonds are not similarly situated to its sister State’s municipal bonds because of the use to which the proceeds of the bonds are to be put. Kentucky points out that the proceeds of only Kentucky’s bonds must be used to benefit Kentucky’s citizens.
I believe this argument errs by focusing on the use of the proceeds generated from bond sales rather than focusing on the applicable interstate market activity. Although all bonds, indeed all debt, indeed even all securities, could be considered competitors in a general sense, the direct market competitors of Kentucky’s federally-tax-free municipal bonds are foreign-state federally-tax-free municipal bonds. Investors view federally-tax-free debt instruments differently from taxable debt instruments because of the lack of a tax exemption. If there were no in-state subsidy for municipal bonds, investors in the market would see all federally-tax-free municipal bonds as direct competitors, and would make their investment decisions between them on the basis of relative yield and default risk. Investors would not see taxable bonds as direct substitutes because effective yields would depend on the different personal federal tax situations of each investor.
The fallacy of Kentucky’s focus on the use of bond proceeds rather than on the market is evident when it is extended to private corporate bonds. No one could doubt that Kentucky would violate the Commerce Clause if it imposed a sales tax on the issuance of all private corporate bonds sold in Kentucky, but exempted bonds issued by corporations incorporated in Kentucky. See, e.g., Welton v. Missouri, 91 U.S. 275 (1895); New Energy Co. v. Limbach, 486 U.S. 269 (1988); Boston Stock Exch. v. State Tax Comm’n, 429 U.S. 318, 337 (1977) (steering out-of-state business to in-state entities). [Fn.1]
Fn.1: I use the example of a sales tax rather than an income tax because I believe there should be a constitutional distinction made between taxes on an interstate activity (or license to perform an interstate activity) and a generally-applicable tax on property or income. The Court in Camps Newfound/Owatonna v. Town of Harrison, 520 U.S. 564 (1997), rejected this distinction by treating a property tax as a tax on the interstate activity of selling spaces in a summer camp. I believe the Court erred in Camps by treating an exemption from a generally applicable tax (in that case a property tax) as a form of discriminatory taxation for Commerce Clause purposes. With the exception of Camps, the Court’s Commerce Clause discriminatory tax cases have focused on special taxes imposed directly on the commercial activity, such as sales taxes, license taxes, and other forms of excise taxes. A generally applicable property tax or an income tax is very different, because the tax base (applicable broadly to unrelated activities), is not connected with the particular commerce in issue. It is not a tax imposed on the commercial activity (or the right to engage in the commercial activity). In Camps, for example, the tax was imposed ON the value of the summer camp’s real property, not ON the interstate activity of buying and selling the right to attend the summer camp. Similarly, in Davis, the tax is imposed on the receipt of interest, not on the interstate commercial activity of buying and selling municipal bonds. While the tax on bond interest may have an indirect effect on the interstate commerce activity, it is not imposed ON the commercial activity, as is the case a sales or other traditional excise tax. Equally important, because of its broad general nature, a general property or income tax is not imposed for the purpose of regulating the interstate commerce activity. In a different context, and after very painful experience, the Court soundly rejected the notion that a tax on income from property is the same as a tax on the property itself. See South Carolina v. Baker, 485 U.S. 505 (1988) (overruling the infamous source rule from Pollock v. Farmers Loan and Trust Company, 157 U.S. 429 and 158 U.S. 601 (1895)). The exemption from a generally-applicable income or real property tax should be viewed as a pure tax subsidy and not as discriminatory taxation because the underlying tax is not discriminatory. A pure tax subsidy should be permissible under the Commerce Clause, because the cost of the subsidy is not directly or indirectly being funded by a discriminatory tax on the out-of-state actors. I believe the Court will be forced to reconsider Camps when a competitor (as opposed to a general taxpayer lacking standing) challenges the common property and income tax subsidies that are being offered to encourage local development. Cf. DaimlerChrysler Corp. v. Cuno 126 S. Ct. 1854 (2006). The Court should develop a more durable and subtle theory for distinguishing between an illegal discriminatory tax and a legal discriminatory tax subsidy by focusing on whether the imposition of the tax on the interstate activity is used in whole or in part to pay for the subsidy. The Court will likely not see the need to address this question in Davis, because the governmental immunity exemption will be so much easier to apply. But before long, the Court will have to come to terms with the absurdity of distinguishing between a cash subsidy and a pure tax subsidy.
Yet, the in-state corporations could make the same argument Kentucky makes here – “our bonds are different from every other corporation’s bonds because the proceeds of our bonds benefit exclusively our stockholders.” Focusing on the use of the proceeds to define the market would render every bond or security different from every other, by definition. Instead, the practical realities of the marketplace must be used to determine what competes in the marketplace. Contrary to Kentucky’s argument, the Court in General Motors v. Tracy, 519 U.S. 278 (1997), held that there was a market distinction between the natural gas product sold by regulated utilities and by other non-regulated sellers.
I also question Kentucky’s decision to turn its market participant argument into numerous separate legal theories. Kentucky argues separately that Kentucky’s statute does not discriminate against interstate commerce because the favoritism of its own bonds does not count as discrimination, because Kentucky’s disparate treatment of out-of-state municipal bonds does not violate the principal purposes of the dormant Commerce Clause, and because it has special rights as a state sovereign. Separately, it argues that it is exempt from Commerce Clause scrutiny as a market participant. In my view, these are all justifications for a broad reading of the governmental or market participation exception, not separate legal theories.
I agree with Professors Ethan Yale and Brian Galle, who have published an interesting article on this subject in Tax Notes, Vol. 114, May 29, 2007, that the Kentucky taxing statute discriminates in favor of in-state actors (Kentucky) and against out-of-state actors (foreign States bond issuers). As my example above involving private bond issuers demonstrates, a similar law discriminating in favor of local private interests and against out-of-state private interests would certainly be struck down as facially discriminatory. To me, the right question is whether that discrimination results in a Commerce Clause violation when the in-state actor is the State itself (and, in this case, when the out-of-state actors are other States, not private parties). However, the Supreme Court clouded the analysis in United Haulers Ass’n, Inc. v. Oneida-Herkimer Solid Waste Management Auth., 127 S. Ct. 1786 (2007), by suggesting that the flow control ordinance in issue there favoring the state-owned entity was not discriminatory (rather than suggesting that the discriminatory statute was simply exempt from the rigorous scrutiny test). I assume that the Court reached this conclusion to appease the judges who wrote the concurring opinion applying the deferential so-called “Pike” balancing test. The same result could have been reached in clearer fashion by holding that the State is simply immune from the rigorous scrutiny test, but might nevertheless be subject to “Pike” balancing as a result of the incidental effects on interstate commerce. In the end it is a matter of semantics, but the Court’s prior conclusion that the identity of the taxpayer can turn a discriminatory statute into a non-discriminatory one certainly creates analytical difficulty.
However, unlike Professors Yale and Galle who read the governmental immunity exception narrowly, I believe the identity of the competitors changes the analysis completely. United Haulers and the market participation cases create a broad exemption from strict dormant Commerce Clause scrutiny for governmental actors engaged in traditional governmental activities. Indeed, I believe the Court will have a much easier time dispensing with this Davis case than they had in United Haulers. After all, the municipalities in United Haulers passed an ordinance requiring private parties to deal with a new governmental monopoly in an area previously served by private actors. Recognizing that a municipality could enter a previously-private market and mandate that residents deal with a new publicly-owned monopoly, as long as the activity was part of a broadly-defined “traditional governmental function,” was far more questionable than allowing states to continue a longstanding policy of subsidizing local bond buyers. The municipalities’s flow control ordinance in United Haulers was surely regulatory. Kentucky’s simple tax subsidy does not require any private party to deal exclusively with it. The Court’s use in United Haulers of the broad governmental immunity language originating in National League of Cities v. Usery, 426 U.S. 533 (1976), suggests an intent to give States, when acting on their own behalves, broad immunity from, at least, the rigorous scrutiny test under the dormant Commerce Clause.
Kentucky does a very fine job of using the Supreme Court’s recent United Haulers decision to show that its activities should be exempted from rigorous Commerce Clause discrimination test. The main point: state laws that treat all parties, other than the state itself, the same way are constitutional. Kentucky backs up its argument with strong citations to both early understandings of federalism, and recent interpretations in analogous situations involving sovereign immunity, eminent domain and due process. While I could quibble with some of the organizational choices made in Kentucky’s brief, I think they did a fine job overall of providing a legal framework under which the Court can and should maintain the status quo.
The Amici briefs do not add much to the substantive argument, but nevertheless greatly strengthen Kentucky’s case. For example, the States’ brief (and several of the other amicus briefs) emphasize the terrible problems that the States would face in dealing with the aftermath of an affirmance. They point out that the States would have to choose either to refund hundreds of millions of dollars in taxes, or to attempt to retroactively tax local bond interest (which would result in breach of contract and contract clause claims). The States would also have to comply with a non-discrimination rule with respect to existing municipal bonds, some of which will be outstanding for a long as another 30 years, and virtually all of which were issued with the promise of a state tax exclusion. Prospectively, the States would have to restructure their entire tax and borrowing systems. The Municipal Analysts, who claim to be taking no side in the dispute, minced no words in explaining the terrible effects that an affirmance would have on the bond markets: “the value of outstanding municipal bonds issued in high tax states would decline by billions of dollars”, and, even worse, there would be “a reduction in the number of municipal mutual fund analysts employed within mutual fund complexes.” The Securities Industry made an interesting argument that the Court’s ancient opinion in Bonaparte v. Tax Court, 104 U.S. 592 (1881) (state exemption for local bond interest did not violate the equal protection clause) is stare decisis on the Commerce Clause question because, even though the Commerce Clause was not mentioned in the decision, the tax’s validity under the Commerce Clause was necessary to the Court’s result. The mutual funds and the Multistate Tax Commission point out that the subsidy benefits the States by having a ready market in their own citizens for municipal financing, and benefits state citizens by encouraging them to invest in their own state’s infrastructures. Taken as a whole, the briefs present powerful and compelling legal and policy arguments for maintaining the status quo.
Prior TaxProf Blog coverage:
- Supreme Court Grants Cert. in Davis, Which Prohibits Tax Exemption for In-State Municipal Bond Interest (5/21/07)
- Germain on The Implications of United Haulers on Davis v. Kentucky (5/1/07)
- Taxpayers Respond to Kentucky's Cert. Petition in Davis, Which Prohibits Tax Exemption for In-State Municipal Bond Interest (1/22/07)
- Davis: Another Constitutional Shot Across the Tax Bow (with extensive commentary by Richard Pomp, Kirk Stark, Calvin Johnson & Greg Germain) (9/5/06)
- WSJ on Davis (9/6/06)
- Hellerstein on Davis (9/6/06)
- Kentucky Files Cert. Petition in Davis, Which Prohibits Tax Exemption for In-State Municipal Bond Interest (11/13/06)