Greater Interest in State Bonds?

A hearing in early November that potentially has significant importance to investment strategies within the tax context slipped under the radar screen amid the flurry of proposed major tax-reform legislation ensnared by political rhetoric. Over one year ago, the Kentucky Supreme Court held that the state law granting exemption to interest income on its own state’s bonds while taxing the interest income on the bonds of other states violated the commerce and equal protection clauses of the U.S. Constitution. Kentucky’s best argument, since on its face the statute creates discriminatory barriers to its financial markets from out-of-state public financing, is that this is an area of "traditional government activity." There is an important exception to discrimination prohibited by the commerce clause that allows government-favored laws at the expense of third parties, regardless of an interstate commerce connection.

The taxpayers assert that the purpose of or justification for a law has no bearing on whether the law is discriminatory. While this has substantial merit, it seems likely to most commentators that the words of the constitution will be bent to the reality of the nation’s financial fabric.

This case presents an issue that has been hovering for decades. Tax practitioners have regularly had to read through brokerage statements to determine the percentage of municipal-bond-fund interest allocable to the home state for the very reason that the bond markets have been operated on the premise that such interest was not only exempt from federal taxation but also from taxation by the issuing state (or political subdivision). Greater integrity would be given to the principle of a competitive market if such bonds could trade equally among investors regardless of the investor’s domicile, but the system is so fully entrenched, its overthrow seems unlikely.

Nevertheless, if the court were to affirm the taxpayers’ position, the immediate impact would be to render the Kentucky (and all other states having similar rules) bonds less competitive and therefore worth less. States must either increase the yield on their bonds or change the rules so that municipal and state bond interest is exempt from taxation regardless of the state of the issuer. If such bonds now bear a higher interest rate, investors in states without an individual income tax, such as Texas, will benefit from that change; if the latter, investors may focus more on the underlying fundamentals of the issue rather than on the state of origin in constructing their portfolios.

These and other issues are examined in The Best Federal Tax Update Course by Surgent McCoy (BFTU).