Ahead of the Bell: Municipal Bond Case

Forty-two states do not tax the interest earned on some or all of their municipal bonds, while taxing interest from other states' bonds. At issue is whether the practice is an unconstitutional interference with interstate commerce.

Many legal experts believe the justices will conclude it is not unconstitutional, maintaining the status quo. A ruling is expected by early next year.

A ruling against the states that eliminate the tax advantage, however, could reduce the value of the muni bonds that individual investors own, either directly or through hundreds of mutual funds. If this happens, states would have to choose whether to tax bonds from all states equally or exempt all bonds, legal experts said. The case wouldn't affect muni bonds' exemption from federal taxes.

State and local governments issue muni bonds to finance the construction of roads, schools and other public infrastructure.

The bonds are popular with investors, particularly those from high-tax states. About 230 mutual funds with $210 billion in assets invest in muni bonds nationwide, according to the Investment Company Institute, a mutual fund trade association. There are another 481 single-state funds with $155 billion in assets, the ICI said.

Walter Hellerstein, a professor of tax law at the University of Georgia Law School, said a Supreme Court decision in an April case bodes well for the states.

In that case, United Haulers v. Oneida-Herkimer, a majority of the justices said that laws favoring local government shouldn't be subject to the same scrutiny as laws favoring private businesses.

"The court seems to have carved out an exception for public entities when they discriminate," Hellerstein said.

Matt Fabian, managing director at research provider Municipal Market Advisors, said single-state funds would likely become obsolete if the Supreme Court rules against the states.

The case began in April 2003, when a Kentucky couple, George and Catherine Davis, filed a lawsuit charging that Kentucky's practice of taxing other states' bonds while exempting its own is unconstitutional.

A Kentucky court ruled in favor of the Davises in 2006, becoming the first court to rule against the exemption since New York first gave its own bonds a tax break in 1919.

Kentucky's state government appealed to the Supreme Court, arguing that its tax system isn't unconstitutional because it doesn't discriminate against out-of-state businesses and it furthers a legitimate government goal of financing public projects.

The other 49 states filed a brief supporting Kentucky. State governments will face higher borrowing costs if the tax exemption is struck down because they will have to offer higher interest rates on their bonds, the brief said.

The case is Kentucky v. Davis, 06-666.