Municipal-bond market dodges a bullet

WASHINGTON - The multitrillion-dollar municipal-bond market skirted a land mine yesterday when the U.S. Supreme Court said states could continue to give special tax breaks on the bonds that fund hospitals, roads, schools and other services.

The justices ruled, 7-2, in a case from Kentucky that states can exempt interest on their own bonds from taxation while taxing residents for interest on bonds issued by other states.

In the $2.5 trillion municipal-bond market, 41 states, including Pennsylvania and New Jersey, have systems similar to Kentucky's.

The states have said throwing out the system of exemptions that began 90 years ago would have a devastating impact on state finances.

Industry groups warned of possible turmoil in the municipal-bond market if the existing setup were dismantled.

In the majority opinion, Justice David Souter said the state tax exemptions had not hindered commerce among the states.

In dissent, Justices Anthony Kennedy and Samuel Alito said the majority ruling "invites other protectionist laws."

Souter said their dissent "rightly praises the virtues of the free market" - but he added that overturning the tax exemptions now would upset the market in bonds.

"It would miss the mark" to think that the courts "are being invited merely to tinker with details of a tax scheme," Souter wrote. "We are being asked to apply a federal rule to throw out the system of financing municipal improvements throughout most of the United States."

About $432 billion in municipal bonds were issued in 2006. In 2004, about 4.4 million investors earned $52 billion in interest on munis.

These securities finance the operations of state and local governments, education, the purchase of public lands, and construction and upgrades of public buildings, transportation systems, and water and sewer facilities.

Kentucky taxpayers George and Catherine Davis challenged state law because it required them to pay income tax on bonds they held from other states.

The Davises said Kentucky law violated the commerce clause of the U.S. Constitution giving Congress authority to regulate interstate commerce. It is well established in the courts that the commerce clause prohibits states from discriminating against interstate trade.

Were Kentucky to have lost the case, most states could have been faced with refunding taxes going back several years. New York state said such refunds could total $200 million, plus $70 million a year in lost revenue.

Kentucky argued that the tax exemption for its bonds did not discriminate because it treated all bond issuers other than Kentucky itself in the same fashion.