High Court OKs Tax on Income From Muni Bonds

The Supreme Court, sending a shock wave through communities of investors and state and local officials, overturned a century-old precedent Wednesday and declared that Congress may tax income from municipal bonds.

But congressional leaders quickly said they had no plans to impose federal taxes on bonds issued by state and local governments.

House Ways and Means Committee Chairman Dan Rostenkowski (D-Ill.), insisting that Congress has presumed for 20 years that it had the power to tax municipal bond income, said that the ruling would neither “prompt nor deter future congressional action.”

Nevertheless, the Supreme Court’s 7-1 ruling called into question the long tradition of allowing state and local agencies to use tax-free bonds to finance roads, hospitals, schools and other capital projects.

States and municipalities long have understood that the 10th Amendment, which reserves to the states and the people “the powers not delegated to the United States by the Constitution,” made income from their bonds off limits to federal taxation. The Supreme Court confirmed that view in 1895 by ruling that the federal government may not intrude on the state’s power to issue tax-free bonds.

O’Connor Dissents

The high court changed that rule Wednesday.

“States must find their protection for congressional regulation through the national political process, not through judicially defined spheres of unregulable state activity,” said Justice William J. Brennan Jr. for the court. “Nothing . . . in the 10th Amendment authorizes courts to second-guess the substantive basis for congressional legislation.”

In 1984, states and municipalities raised $102 billion in new bond issues, the court said.

Investors now are willing to accept relatively low interest rates on municipal bonds because they pay no federal taxes on their earnings. If the income were taxed, government agencies would have to pay about one-third higher interest rates to attract buyers for their bonds, according to tax analysts.

Justice Sandra Day O’Connor, the high court’s strongest supporter of state interests and the lone dissenter to Wednesday’s ruling, said that government operations “will be severely hindered if the cost of capital rises by one-third. If Congress may tax the interest paid on state and local bonds, it may strike at the very heart of state and local government activities.”

State and local officials reacted more vehemently. The ruling, said Alan Beals, executive director of the National League of Cities, “is tantamount to a decree of unconditional surrender imposed on state and local government by the national government they created 200 years ago.” He called the decision a “butchery of the Constitution.”

The Reagan Administration, which has supported the principle of returning governmental powers from Washington to the states, urged the high court to rule as it did.

This case arose after Congress declared in 1982 that all newly issued municipal bonds must be registered with the federal government so that the Internal Revenue Service could track income and avoid tax evasion.

The state of South Carolina challenged the law, arguing that the 10th Amendment sheltered the states from such congressional directives.

A special master, appointed by the Supreme Court, found that the law was constitutional. The state and the National Governors Assn. appealed the case (South Carolina vs. Baker, No. 94) to the justices to reverse that result.

Instead, Justice Brennan wrote an expansive opinion, not only rejecting the state’s argument about the registration of bonds but giving Congress broad authority to regulate matters dear to the states. Referring to a 1985 Supreme Court decision allowing Congress to set minimum wage and maximum hour rules for state and local government employees, Brennan said Congress had ample authority to tax municipal bonds.

Conservatives have often complained that the high court has virtually written the 10th Amendment out of the Constitution by trampling on state powers.