Department of Revenue of Kentucky, et al. v. Davis

FACTS Kentucky, like forty other states, exempts from state income taxes interest on bonds issued by it or its political subdivisions but not on bonds issued by other states and their subdivisions. The differential tax scheme in Kentucky benefits its residents who buy its bonds by effectively lowering interest rates. After paying state income tax on out-of-state municipal bonds, plaintiffs sued Kentucky for a refund, claiming that Kentucky’s differential tax impermissibly discriminated against interstate commerce. The trial court ruled for Kentucky. The State Court of Appeals reversed, finding that Kentucky’s scheme violated the Commerce Clause. The U.S. Supreme Court granted certiorari.
DECISION The judgment is reversed, and the case is remanded.
OPINION The significance of the differential tax scheme is immense. Between 1996 and 2002, Kentucky and its subdivisions issued $7.7 billion in long-term bonds to pay for spending on transportation, public safety, education, utilities, and environmental protection, among other things. Across the United States during the same period, states issued over $750 billion in long-term bonds, with nearly a third of the money going to education, followed by transportation (13%) and utilities (11%). Municipal bonds currently finance roughly two-thirds of capital expenditures by state and local governments.
The “dormant” Commerce Clause implicitly restricts state regulatory measures designed to benefit in-state economic interests by burdening out-of-state competitors. Under the dormant Commerce Clause a challenged law that discriminates against interstate commerce is “virtually per se invalid” and will survive only if it “advances a legitimate local purpose that cannot be adequately served by reasonable nondiscriminatory alternatives.” Absent discrimination for the forbidden purpose, however, the law “will be upheld unless the burden imposed on [interstate] commerce is clearly excessive in relation to the putative local benefits.”
Kentucky treats income from municipal bonds of other states just like income from bonds privately issued in Kentucky or elsewhere; no preference is given to any local issuer, and none to any local holder, beyond what is entailed in the preference Kentucky grants itself when it engages in activities serving public objectives. These facts suggest that no state perceives any local advantage or disadvantage beyond the permissible ones open to a government and to those who deal with it when that government itself enters the market. The differential tax scheme is critical to the operation of an identifiable segment of the municipal financial market as it currently functions, and this fact alone demonstrates that the unanimous desire of the states to preserve the tax feature is a far cry from the private protectionism that has driven the development of the dormant Commerce Clause.
INTERPRETATION State law exempting from state income taxes interest on bonds issued by that state or its political subdivisions but not on bonds issued by other states and their subdivisions does not impermissibly discriminate against interstate commerce.

CRITICAL THINKING QUESTION

Had the Court invalidated Kentucky’s taxing scheme, what would the impact have been on the states’ ability to finance their operations?