Justices to hear challenge to muni bond exemption

October 28, 2007|By Tom Petruno | Tom Petruno,LOS ANGELES TIMES

The Supreme Court is about to take up a case that could change the world for municipal bond investors and make financing more expensive for some state and local governments.

The court will hear a lawsuit on Nov. 5 by two Kentucky investors who say it's unfair for that state to exempt its own bonds from state income tax while taxing the interest generated by other states' bonds.

That has long been standard practice in this country, and it in effect creates a captive audience for a state's IOUs.

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's bonds also are exempt from its own income tax, 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.

For instance, the muni tax structure helped the Golden State sell $2.5 billion in general obligation bonds earlier this month, part of a $62 billion backlog of debt the state must float over time to fund voter-approved infrastructure projects.

But Kentucky investors George and Catherine Davis, in a suit filed in 2003, contended that the muni tax system was unconstitutional because it interfered with commerce.

After a Kentucky appellate court agreed, the state asked the Supreme Court to uphold the current tax regime.

Most analysts and big investors in the $2.6 trillion muni bond market expect the court to strike down the challenge to the muni system and affirm that the states' tax practice doesn't violate the Constitution.

"The market isn't preparing for anything adverse," said Thomas Doe, president of Municipal Market Advisors, a muni research firm in Concord, Mass.

Some legal experts say other Supreme Court decisions on states' rights strongly hint at support for the muni tax structure.

Nonetheless, the case is being closely watched because the stakes are so high. A ruling by the justices is expected in the first half of next year.

"It would be a terrible disruption to the states" if the court tossed out the status quo, said Gregory Germain, a law professor at Syracuse University.

In a rare show of unity, every state in the union has joined Kentucky's cause, filing friend-of-the-court briefs in hopes of a favorable ruling.

If the justices were to side with the Kentucky investors, every state could face one of two options: tax interest on all muni bonds, including a state's own issues, or exempt all from taxation.

Paul Rosenstiel, head of public finance for California Treasurer Bill Lockyer, said the state Constitution required that the state's debt must be tax-exempt.

"So we'd have no choice but to make all bonds tax-free," he said.

With a level playing field, Californians who had limited their muni investments to bonds of the state or its municipalities might well begin to look at other states' IOUs.

Still, Rosenstiel said he didn't foresee "doomsday" if the Supreme Court were to throw out the current tax system.

"I think it's absolutely likely that some Californians would buy bonds of other states," he said. "But I think others would buy our bonds as well. It should wash out."

Other experts agree. "It could broaden the market for California paper" over time, said David Hitchcock, an analyst at credit-rating firm Standard & Poor's in New York.

Even if the states were to lose in the Supreme Court, that might not spell the end of the muni tax regime, experts note. Germain, the law professor, believes states would immediately petition Congress to pass a law preserving their rights to offer exclusive tax breaks on their own bonds.

Tom Petruno writes for the Los Angeles Times.

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