Below the fold, you will find commentary from four Tax Profs who take very different positions on the correctness of the Davis decision:
I think the Kentucky Court of Appeals in Davis erred in failing to fully and correctly consider whether the government is acting as a regulator or market participant in allowing an exclusion to local taxpayers for in-state municipal bond interest while not allowing an exclusion to local taxpayers for out-of-state municipal bond interest.
The market participant language has been used by the Court to distinguish between direct subsidies given by the government for local activities (at a cost to the local taxpayers), and cost-free regulation by the government that favors in-state commerce at the expense of out-of-state commerce. Nowak & Rotunda, Constitutional Law, 7th Edition, p. 332-33 (2004)). The Supreme Court has recognized, for example, that a city can constitutionally require city workers to live within municipal boundaries, even though this employment law discriminates against out-of-city workers. This is because the city, in providing municipal employment, is acting as a market participant and not a regulator. Providing state employment is a direct subsidy by the state because the state is paying the wages. See McCarthy v. Philadelphia Civil Service Commissioner, 424 U.S. 645 (1976) (although commerce clause not specifically considered, Court indicated that constitution would not prevent state from discriminating in favor of locals when hiring municipal employees).
In W. Lynn Creamery, Inc. v. Healy, 512 U.S. 186 (1994), the Supreme Court considered whether a combined tax and subsidy would be invalid under the commerce clause. Massachusetts imposed a uniform tax on all milk suppliers (in-state and out of state) and then used the proceeds from the tax to provide a subsidy to in-state milk producers. The net effect was two fold: (1) the in-state producers were essentially refunded their share of the tax, and (2) the in-state producers received a net subsidy from the tax collected from out-of-state producers. Because only out-of-state producers were really paying the tax (since the local producers were receiving a refund of their tax through the subsidy), the Court held that the tax constituted a tariff that violated the negative Commerce Clause. The Court looked to the substance of the combined tax-subsidy rather than the form in reaching its ruling, because viewed independently neither the tax nor subsidy would violate the commerce clause. The Court said "Although the tax also applies to milk produced in Massachusetts, its effect on Massachusetts producers is entirely (indeed more than) offset by the subsidy provided exclusively to Massachusetts dairy farmers. Like an ordinary tariff, the tax is thus effectively imposed only on out-of-state products." Id. at 195.
The Court also responded to the state's argument that the combined tax/subsidy should be legal because each part treated separately would be legal. In rejecting this argument, the Court noted that "[a] pure subsidy funded out of general revenue ordinarily imposes no burden on interstate commerce, but merely assists local business. The pricing order in this case, however, is funded principally from taxes on the sale of milk produced in other States. By so funding the subsidy, respondent not only assists local farmers, but burdens interstate commerce. The pricing order thus violates the cardinal principle that a State may not 'benefit in-state economic interests by burdening out-of-state competitors.' Id. at 199 (citations omitted). Had there been no tax on out-of-state producers to fund the subsidy, so that the subsidy was funded by in-state taxpayers - the subsidy would have been lawful. In a footnote, the Court noted that while it had never formally held that subsidies were constitutional, it had noted in a number of cases that subsidies do not violate the negative Commerce Clause. Id. at 199 n. 15.
Kentucky is not funding its subsidy with revenues from out-of-state citizens. Kentucky does not tax out-of-state citizens who purchase out-of-state bonds. Only in-state residents who buy out-of-state bonds pay a tax. The subsidy is funded from taxes collected by in-state residents (presumably both those who bought out-of-state bonds and other taxpayers).
In addition, the Court of Appeals did not consider the inherently governmental nature of the underlying activity - municipal bond sales. The purpose of the negative Commerce Clause is to prevent state regulation that benefits local industry at the expense of out-of-state industry. However, Kentucky is subsidizing governmental bond sales - a proprietary state activity - not local industry. In encouraging its citizens to buy its bonds, Kentucky is acting as a market participant. The discriminatory effect is only on other states in carrying out their proprietary funding activities. The commerce clause was not designed to inhibit state proprietary activity, but rather state attempts to regulate commercial activity for local benefit. Therefore, the subsidy provided to in-state purchasers of in-state bonds in the form of an exclusion from income tax appears to be a lawful subsidy. The State of Kentucky is simply providing a subsidy in the form of an income tax exclusion for people who buy Kentucky bonds. Kentucky could do the same thing by offering a higher interest rate on its bonds than is being offered by other states, and allowing only in-state residents to buy its bonds. There is no commerce clause objection to a state providing state benefits only to its own citizens.
I therefore believe that the Kentucky Court of Appeals erred on two counts. First, it failed to distinguish the inherently governmental activity of issuing bonds from ordinary non-governmental commercial activity. Second, it failed to distinguish between a valid direct subsidy in the form of a tax exclusion paid for by local citizens from an invalid regulation that burdens out-of-state industry at no cost to local citizens.