States retain tax advantage on muni bonds
The U.S. Supreme Court on Monday preserved states’ rights to exempt their own municipal bonds from state income tax even if they tax the interest of other states’ debt.
The long-awaited decision maintains the status quo in the $2.6-trillion muni bond market -- a relief to states such as California, which might have had to pay higher bond rates if the court had ruled the other way.
“It would have been a real problem” for many muni issuers, said Thomas Doe, president of Municipal Market Advisors, a Concord, Mass.-based muni bond research firm.
The interest on most municipal bonds -- debt issued by states, counties, cities, school districts and other local government bodies -- is exempt from federal income tax. When a state also exempts its own bonds from its income tax but taxes interest on other states’ debt, investors in that state often have little reason to buy out-of-state muni securities.
That’s particularly true for investors who live in high-tax states such as California.
That tax regime has been standard among the states for decades. But a couple of Kentucky investors in 2003 sued, contending that the set-up was unfair and interfered with commerce because it in effect created a captive audience for a state’s bonds. After a Kentucky appellate court agreed, the state asked the Supreme Court to hear the case.
If the high court had ruled in favor of the Kentucky investors, every state could have faced one of two options: tax interest on all muni bonds, including a state’s own issues, or exempt all from taxation.
If all muni bonds were treated equally by states, some California investors who had long owned local bonds exclusively might have been tempted to buy other states’ debt. That might have required California issuers to pay higher interest rates to hold on to investors.
Given the state’s weak fiscal situation, “Taxpayers could ill afford to see any additional money go out the door” to pay bond interest costs, said Tom Dresslar, a spokesman for California Treasurer Bill Lockyer.
Justice David H. Souter wrote for the majority in upholding the muni tax regime. Justices Anthony M. Kennedy and Samuel A. Alito Jr. dissented.
The Kentucky case didn’t challenge the federal tax exemption on muni bonds.
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