Paul L. Caron
Dean



Monday, May 19, 2008

U.S. Supreme Court Upholds Discriminatory Taxation of Municipal Bonds

The Supreme Court today, in a 7-2 decision, upheld Kentucky's exemption of interest on in-state municipal bonds while taking interest on out of state bonds.  Department of Revenue of Kentucky v. Davis, No. 06-666 (5/19/08).  Gregory Germain (Syracuse) and Bradley Joondeph (Santa Clara) offer detailed analysis of the decision below the fold:

Gregory Germain (Syracuse):

As I have long predicted, the Supreme Court ruled today that the State of Kentucky may exclude from state taxation the interest on municipal bonds issued within the state while taxing the interest on municipal bonds issued by other states. Seven of the nine justices recognized an extremely broad exemption from the dormant commerce clause for discrimination favoring the state or municipal government itself as opposed to private parties. The decision found common cause between the Court's most liberal and the most conservative justices in agreeing that the dormant commerce clause simply does not apply to traditional state and municipal activities. In fact, Justice Souter, a master in the art of sophistry, contended that the local municipal bond market should be viewed as entirely separate from the market for interstate municipal bonds. As so viewed, there would be no discrimination taking place in the locally-defined market. This theory, which defines the relevant market without regard to the economic motives of those engaged in the market, escapes me. But the broader argument, recognizing that the dormant commerce clause simply does not apply to the traditional functions of governmental entities, is entirely consistent with the holding first advanced last term in United Haulers. This broad doctrine of abstention, adopted by seven of the nine justices, should give pause to anyone seeking to challenge on commerce clause grounds discrimination favoring the government itself rather than favoring local private interests. Even Justice Stevens (who had dissented in United Haulers and appeared to be on the fence at the hearing) joined the majority because the discrimination involved an activity (issuance of municipal bonds) in which the state did not compete with private trades or businesses. The remaining six judges appear to stand firm behind the broader notion of "traditional governmental functions" applied in United Haulers.

Although there was broad agreement on the outcome, Justice Souter could not help himself from raising additional arguments and issues over which the justices did not broadly agree. Only three justices agreed with Justice Souter's contorted (and unnecessary) attempt to apply the old market participant exception to Kentucky's bond issuance activities. I commend this portion of the opinion to those who enjoy reading a detailed analysis of how many angels can dance on the head of a pin. Four justices did not join in Justice Souter's market participant excursion, because it was not needed to resolve the case after the Court had reiterated the far broader exception for governmental immunity in the first part of its opinion.

A bare majority of the court (five justices) joined in the extremely confusing fourth part of Justice Souter's opinion, in which the Court first stated that so-called "Pike balancing" should be applied to non-discriminatory statutes that have a discriminatory impact on interstate commerce, and then declined to perform the balancing. The "Pike balancing" test was established in 1970, and is supposed to be applied whenever a law does not discriminate on its face or in its practical effect against interstate commerce. It requires the Court to identify and weigh the law's burdens on interstate commerce against the benefits to the state of the law as written. But strangely, after asserting that "Pike balancing" should normally be performed, the Court then concludes that Pike balancing would not be applied in this particular case because the judiciary is not the proper forum for carrying it out. The Court said to the petitioners, "go to Congress if you do not like the law." Apparently, the five justice majority wanted to preserve the "Pike balancing" test for future cases, although as Justice Scalia pointed out it is equally difficult in any case for the benefits and burdens of discrimination to be quantified and weighed. I believe the majority simply wanted to preserve its future ability to tinker with the language of state laws to minimize any discriminatory impact, and recognized that there was nothing to tinker with here.

One question intentionally left open by the opinion is the constitutional validity of state laws granting an in-state tax exemption for private activity bonds. Private activity bonds are municipal bonds issued to fund private activities for local economic development or charity. The Court recognized in a footnote that the private activity issue had not been argued or developed below, and was thus not appropriate for determination. Given the Court's prior rulings applying the dormant commerce clause to non-profits (Camps Newfound), and the broad distinction drawn between illegal flow control ordinance favoring a public/private partnership (Carbone) and legal ones favoring a purely governmental entity (United Haulers), we can expect the courts to struggle with future challenges to the discriminatory tax treatment of private activity bonds.

Only two justices, Kennedy and Alito, dissented. They have both accepted the argument that the Commerce Clause contains an implicit adoption of the economic argument for unbridled free trade, at least absent specific Congressional permission for discrimination, and would apply this sub-silencio free trade policy to even traditional governmental functions outside of the former market participant cases. This was an unusual case in which the traditional swing-voters found themselves in isolated dissent.

Bradley Joondeph (Santa Clara):

I worked on the amicus brief for the Government Finance Officers et al., so my comments should be taken with that bias in mind. But here are my brief reactions:

To me, the opinion is largely unsurprising. The Court lined up almost exactly as it did last term in United Haulers Assn., Inc. v. Oneida-Herkimer Solid Waste Management Authority, and the justices essentially rehashed the arguments made there. Here, as in United Haulers, the law in question (1) favored the state government, (2) with respect to a traditional governmental activity, and (3) provided no advantage to any private entities over their out-of-state competitors. Of course, there were some lingering questions, the most significant of which was whether the Court had really meant what it said in United Haulers. Apparently it did. The only change in sides was Justice Stevens, who went from dissent in United Haulers to join the majority in Davis. Stevens concluded that discrimination in this context (public finance) was much more justifiable than when a state participates in a commercial market, such as that for waste disposal.

Perhaps the most interesting development in Davis is that the Court has signaled its potential willingness to reconsider Pike v. Bruce Church. That case, long reviled by Justices Scalia and Thomas (among others), holds that a non-discriminatory state law can still violate the dormant Commerce Clause if the burdens on interstate commerce are "clearly excessive" relative to its putative local benefits. In Part IV of the Court's opinion, Justice Souter essentially refused to apply Pike because the Court, in his view, is institutionally incompetent to weigh the various benefits and burdens that flow from state income tax preferences for municipal bonds. But, as Scalia noted in his concurrence, this argument could easily be extended to virtually any state law challenged under the dormant Commerce Clause.

Given that Part IV of Souter's opinion garnered the votes of Roberts, Stevens, Breyer, and Ginsburg, and that Scalia and Thomas are already on record as wanting Pike overruled, there may well be five votes to take that step. Indeed, Justices Kennedy and Alito seemed to see this possibility, and thus went out of their way to assert that Pike should be sustained, even though the question was not really at issue in the case. Some enterprising state governments, given proper cases, might well raise some challenges to Pike's continuing validity in the coming terms.

Press and blogosphere coverage:

Prior TaxProf Blog coverage:

https://taxprof.typepad.com/taxprof_blog/2008/05/us-supreme-cour.html

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