Argument preview: Dep’t of Revenue of Kentucky v. Davis

Summary of Petitioners’ Brief

Kentucky taxes a resident individual “upon his entire net income,” whereas a non-resident individual is taxed on net “income received by him from labor performed, business done, or from other activities in this state, from tangible property located in this state, and from intangible property which has acquired a business situs in this state.” Ky. Rev. Stat. Ann. §§ 141.020(1); 141.020(4). While Kentucky permits most deductions permitted by the Internal Revenue Code of 1986, as amended, it does not permit them all. One deduction that is disallowed is the “interest income derived from obligations of sister states and political subdivisions thereof.” Ky. Rev. Stat. Ann. § 141.010(10)(c).

Before focusing on its legal arguments, Petitioners point out that the tax that the State imposes on sister State bonds falls “almost entirely if not exclusively” on Kentucky residents, since income from intangibles such as municipal bonds is taxable by the State of the bondholder’s domicile. The only way another State may tax the bondholder is if the bonds have acquired a “business situs”, i.e., become localized in some independent business or investment outside of the State of domicile.

Petitioners then go on to describe the robust nature of the municipal bond market. By the end of 2006, the market was valued at over $2.4 trillion. Petitioners also offer the following statistics:

Of the $423 billion in municipal bonds issued in 2006, over 27% financed projects and programs related to educations; over 10% financed transportation facilities; another 10% financed utilities projects; 7.3% financed housing projects and programs; 3% financed electric power projects; and 1.8% financed environmental projects. Bonds issued for general purposes, which include financing the daily operations of States and local governments in anticipation of quarterly tax revenues, accounted for 26.6% of the total. Pet. Br. 5.

Such borrowing has been excluded from federal income tax from the time that the very first such tax was imposed in 1913. This exclusion lowers the cost of borrowing for States since bondholders will accept a lower rate of interest given that this interest will be tax-exempt. Petitioners argue that this exclusion demonstrates Congressional belief of the importance of the municipal bond market.

Petitioners divide their main arguments into three parts:

I. Kentucky’s exercise of its power as an independent sovereign to tax sister State bond interest neither “discriminates against interstate commerce” nor threatens any of the principal purposes of the dormant Commerce Clause.

II. The substantial reliance interests and settled economic expectations of the States and their bondholders, as well as Congress’ repeated recognition of the disparate tax treatment of State bond interest, make judicial intervention both unwise and unnecessary.

III. A sovereign State may use its regulatory taxing power to affect economic terms of market participant relationships with its direct trading partners.

We shall examine each argument in turn.

I. Kentucky’s practice is not discriminatory and does not raise concerns under the dormant Commerce Clause.

Petitioners first note that a very similar practice has already been upheld by the Supreme Court. In 1881, the Court upheld the ad valorem taxation of sister State bonds by the bondholder’s State of residence in Bonaparte v. Tax Court, 104 U.S. (14 Otto) 592 (1881). In addition to noting that no provision of the Constitution prohibited such a tax, the Court went on to note within the jurisdiction of the taxing State, its sister State “had none of the attributes of sovereignty as to the debt it owes.” Id. at 595. While Bonaparte was a Full Faith and Credit Clause case, Petitioners argue that its logic is equally applicable to this dormant Commerce Clause case since the issue is whether States have retained the power to raise their own revenues to provide for the needs of their citizens.

Citing the current standard for violations of the dormant Commerce Clause, Petitioners note that the Respondents have not alleged that Kentucky’s tax on sister State bond interest received by individual tax payers lacks a substantial nexus to Kentucky, is unfairly apportioned between Kentucky and other States, or is not fairly related to services provided by Kentucky. That leaves in question only the requirement that Kentucky’s tax not discriminate against interstate commerce. This component of the test would require that the entities at issue be “substantially similar” and “similarly situated.”

Petitioners argue that Kentucky is not a “substantially similar entity” to any other bond issuer (public or private) because no other issuer has the political responsibility of financing public works and projects for Kentucky citizens. Furthermore, Kentucky bonds cannot be considered to be “substantially similar to bonds issued by other entities because of the two most important aspects of any debt instrument: use of proceeds and source of repayment.” The use of the proceeds are solely for the financing of public works and other programs in the State of Kentucky. No other bond issuer even claims to take responsibility for such projects. As Petitioners note, with regard to these unique uses of the bond proceeds, “sister States are no more ‘similarly situated’ to Kentucky than the government of Egypt.” With regard to the source of repayment, the citizens of Kentucky and the project/program revenues collected by the Kentucky bond projects are again unique financiers of these bonds. The ability to finance bonds using these revenue streams is an inherent aspect of Kentucky’s sovereignty. Citing General Motors Corp. v. Tracy, 519 U.S. 278 (1997), Petitioners conclude that there mere fact that Kentucky bonds and sister State bonds are debt obligations purchased by investors does not make the issuers or their bonds “substantially similar” for Commerce Clause purposes.

Petitioners then go on to discuss United Haulers Association, Inc. v. Oneida-Herkimer Solid Waste Management Authority, 127 S. Ct. 1786 (2007), handed down just last term, to support their contention that Kentucky’s practice is not discriminatory. United Haulers, Petitioners argue, drew a line between entities “vested with the responsibility of protecting the health, safety, and welfare of its citizens, and all other entities which do not share that governmental responsibility. In doing so, it focused on four factors: (i) governmental responsibility, (ii) legitimate goals unrelated to economic protectionism for in-state private businesses, (iii) a typical and traditional government function, and (iv) political accountability to those most directly affected by the law. These factors, as applied to the present case, clearly classify Kentucky’s actions are nondiscriminatory. The State is the only entity with the government responsibility of overseeing public projects in and throughout the State that are designed to benefit Kentucky citizens. The tax on sister State bond interests treats in-state businesses the same exact way as it does out-of-state businesses. Furthermore, with regard to the second point, United Haulers observed that a law “favoring local government, [as opposed to local businesses,]…may be directed toward any number of legitimate goals unrelated to protectionism.” Id. at 1795-1796. Petitioners claims that the same conclusion applies when a law favors the State itself in comparison with sister States. Borrowing money to finance State projects is indeed traditional a typical and traditional governmental activity. Finally, the burden of taxing sister State bonds falls almost exclusively upon Kentucky citizens, who have the right to use the political system to change the practice if they so desire.

Petitioners then go on to debunk the notion that the State’s practice violates any of the National interests involved in the dormant Commerce Clause. The Supreme Court has recognized these as: (i) a need for uniform national regulation; (ii) minimizing political friction between States; (iii) promoting a national free market; and (iv) avoiding economic protectionism. Petitioners explain again how none of these concerns are implicated by Kentucky’s practice:

• The Due Process Clause prevents States from taxing individuals on bond interest received by non-residents unless these individuals have the required business situs in the State.
• To the extent the dormant Commerce Clause is geared toward encouraging the States to economically “sink or swim” together, it is in no way affected by the treatment of State bond interest, given the fact that virtually every State utilizes this practice.
• The fear of economic balkanization is not a concern because private businesses are not affected, the players instead are the States themselves, and there is no entity competing with Kentucky to provide the State with roads, sewers, prisons, etc.
• Again, there are no out-of-state competitors who might be able to compete with Kentucky to provide these governmental functions.

The Petitioners conclude the first segment of their argument with the statement that the principles of State sovereignty mandate the application of the United Haulers rule that if a State tax law applies in exactly the same fashion to all entities other than the State itself, the law does not discriminate against interstate commerce for purposes of the dormant Commerce Clause. “The basic principal is geographical: State sovereignty does not cross the state line.” Kentucky’s actions do no such thing, and so should be upheld.

II. The substantial reliance interests and settled economic expectations of the states and their bondholders, as well as congress’ repeated recognition of the disparate tax treatment of state bond interest, make judicial intervention both unwise and unnecessary.

As discussed earlier, the municipal bond market is valued at $2.4 trillion. Petitioners warn that “any change in the status quo would affect the settled economic expectations and contractual rights of at least 42 States and millions of bondholders.” Petitioners note that in similar Commerce Clause cases, the Court determined that restraint was the wiser course of action. See, General Motors, supra; Padell v. New York, 211 U.S. 446 (1908).

Petitioners then go on to discuss several Congressional bills and reports proving not only that Congress has been aware of this practice, but it has endorsed it through Congressional inaction. The fact that Congress has taken such a keen interest in the practice in the past without taking any action supports Petitioners’ advice that “[t]he Court should not rush in where Congress failed to tread.”

III. A Sovereign State may use its regulatory taxing power to affect the economic terms of market participant relationships with its direct trading partners.

Petitioners contend that the Kentucky Court of Appeals was incorrect when it concluded that “the market participant theory is inapplicable as the State’s ‘assessment and collection of taxes’ is, clearly, ‘a primeval government activity.’” Pet. App. A10.

Petitioners note that the Court’s precedence in market participant cases means that if a State is acting as a market participant, the dormant Commerce Clause does not prohibits it from using its regulatory powers to set the terms of its own market participation. In defense of Kentucky’s practice, Petitioners cites Reeves, Inc. v. Stake, 447 U.S. 429, 439 n.13 (1980) (quoting Perkins v. Lukens Steel Co., 310 U.S. 113, 127 (1940)), which stated that “the Government enjoys unrestricted power to produce its own supplies, to determine those with whom it will deal, and to fix the terms and conditions upon which it will make needed purchases.” Petitioners discuss several Commerce Clause cases that involved Court-approved State participation in a market which the State regulated pervasively. See, Reeves, supra; Hughes v. Alexandria Scrap Corp., 426 U.S. 794 (1976); White v. Massachusetts Council of Construction Employers, Inc., 460 U.S. 204 (1983). These cases, Petitioners note, “involved the use of the police power, a regulatory power every bit as primeval as the power to tax.”

The confusion, Petitioners contend, is that the Court of Appeals relied on three cases in which the State was not a market participant at all, but tried to equate taxation or regulation of transactions between third parties to “participation” in the market by the State. See, South-Central Timber Development, Inc. v. Wunnicke, 467 U.S. 82 (1984); New Energy Co. of Indiana v. Limbach, 486 U.S. 269 (1988); Camps Newfoundland/Owatonna v. Town of Harrison, 520 U.S. 564 (1997). These cases did not involve the State using its regulatory powers to set the terms of its direct dealings with trading partners, but instead tried to impose downstream restrictions on the actions of its trading partners. Therefore, Petitioners conclude, “these precedents in no way foreclose the use of a State’s regulatory power to affect the economic terms of its relationship with its direct trading partners.”
Summary of Respondents’ Brief

Respondents argue that Kentucky’s tax scheme unconstitutionally erects a barrier to the purchase of similar out-of-state commodities because it encourages its citizens to purchase in-state municipal bonds by taxing out-of-state municipal bonds. In fact, Respondents argue that Kentucky’s law operates as a tariff – “a law that taxes goods imported from other States, but does not tax similar products produced in state.” Resp’t Br. 1 (citing West Lynn Creamery, Inc. v. Healy, 512 U.S. 186, 193 (1994)). Respondents disagree that the test is the use of the proceeds combined with the source of the financing, but rather that the analysis turns on the impact that the tax has on the municipal bond market.

Respondents also take issue with Petitioners’ “no harm-no foul” argument (that there are no out-of-state competitors who are interested in providing Kentucky citizens with public works projects and programs and that the burden of the tax falls upon Kentucky citizens themselves, who may use the political process to abolish the tax). Instead, Respondents point out that Kentucky’s tax regime taxes municipal bonds that are not under the State’s exclusive control, blocks the access of other issuers and sellers to the private bond market, and inflicts harm on out-of-state issuers and sellers who are unable to cast a vote in the State of Kentucky.

Furthermore, the fact that the proceeds of these bonds are for public works does not make them unique or give them special constitutional status. Every State issues bonds to improve life for its citizens. Kentucky’s municipal bonds are rated by the same agencies, regulated by the same federal law, compete for the same capital and are traded by the same participants in the same national market as out-of-state municipal bonds. A State may not use “public purpose” as an excuse to facially discriminate against out-of-state commerce. Indeed, the Court has stated that “the purpose of, or justification for, a law has no bearing on whether it is facially discriminatory.” Oregon Waste System, Inc. v. Department of Environmental Quality, 511 U.S. 93, 100 (1994).

Respondents then give some background regarding municipal bonds, which are debt instruments representing contractual promises by the governmental issuers to repay the principal of the bonds plus interest. They are generally divided into four categories: (i) general obligation bonds that are backed by the full faith, credit and tax power of the issuing State; (ii) moral obligation bonds that are not so backed; (iii) revenue bonds that are issued to fund publicly owned infrastructure projects such as roads and schools and are backed by pledge of the revenue generated from a specific project; and (iv) industrial revenue bonds that are used to develop commercial or industrial property for the benefit of private corporations and are backed by revenue from that private project or secured by property used in private business. As of June 2006, $7.8 billion of the approximately $33.8 billion in Kentucky bonds are industrial revenue bonds – i.e., approximately 23% of Kentucky’s outstanding municipal bonds finance private businesses in Kentucky.

All municipal bonds are rated by independent agencies (such as the Bond Market Association and Standard & Poor’s) and traded in interstate commerce as financial commodities with generally standard terms. The market would ordinarily price a municipal bond based purely upon relative quality as measured in part by the rating of one of the independent agencies. States distort this market function through tax systems such as Kentucky’s. By taxing out-of-state municipal bonds, States reduce the effective yield on those bonds, giving a competitive advantage to in-state municipal bonds. This practice began shortly after the first federal income tax was imposed. New York began the practice in 1919, and now 43 States offer some for of tax preference for in-state municipal bonds.

Respondents’ arguments can be divided into two general categories: (i) legal arguments as to why the Kentucky tax scheme violates the dormant Commerce Clause and (ii) the negative effects that this and similar tax regimes.

I. Kentucky’s tax scheme violates the dormant Commerce Clause

In response to Petitioners’ reliance on United Haulers Association, Inc. v. Oneida-Herkimer Solid Waste Management Authority, 127 S. Ct. 1786 (2007), Respondents note that in that case, the Court stated that to determine whether a law violates the dormant Commerce Clause, “we first ask whether it discriminates on its face against interstate commerce.” Id. at 1793. The standard for this is whether the law expressly distinguishes between in-state and out-of-state interests. If determined to be facially discriminatory, Respondents note that the Courts precedence applies a “virtually per se rule of invalidity.” Granholm v. Heald, 544 U.S. 460, 476 (2005). Such discrimination is permitted only if the municipality can demonstrate “under rigorous scrutiny” that it has no other means to advance a legitimate local interest. C&A Carbone, Inc. v. Clarkstown, 511 U.S. 383, 392 (1994).

Kentucky’s tax regime very clearly imposes taxes on out-of-state municipal bonds while exempting such in-state bonds – there can be no clearer illustration of facial discrimination. Respondents then go on to discuss several similar cases in which the Court has struck down provisions that erect commercial barriers or otherwise discriminates against goods based upon their place of origin. See, Boston’ Stock Exchange v. State Tax Commission, 429 U.S. 381 (1977); New Energy Co. v. Limbach, 486 U.S. 269 (1988); Bacchus Imports Ltd. v. Dias, 468 U.S. 263 (1984); Fulton Corp. v. Faulkner, 516 U.S. 325 (1996); Camps Newfoundland/Owatanna Inc. v. Town of Harrison, 520 U.S. 564 (1997).

Even if the tax regime is not facially discriminatory, Respondents argue that it is still discriminatory and therefore unconstitutional. When the discrimination is not apparent on the law’s face, the Court looks to whether it has a discriminatory purpose or a discriminatory effect. It operates effectively as an impermissible tariff – increasing the costs of out-of-state municipal bonds to benefit those dealing in in-state bonds. Even if Kentucky does not have a discriminatory purpose, as it claims, t the taxation scheme has a discriminatory effect nonetheless. Respondents observe that Kentucky “baldly asserts that economic protectionism does not arise in the ‘provision of public works by sovereign States to their respective citizens.’” Resp’t Br. 19. This sidesteps the issue, Respondents argue. The question is not whether Kentucky may raise fund for public works, but whether it can impose taxes on out-of-state goods in order to do so.

Respondents then attack Petitioners’ assertion that (i) Kentucky municipal bonds are not substantially similar to other municipal bonds and (ii) Kentucky as an issuer is likewise not substantially similar to any other bond issuer since no other issuer has the responsibility to finance Kentucky projects. Relying on General Motors Corp. v. Tracy, 519 U.S. 278 (1997), Respondents argue that Kentucky municipal bonds are clearly similar to other municipal bonds because they are traded in the same market by the same purchasers. The only difference between Kentucky’s municipal bonds and out-of-state municipal bonds is where they originate – which is the classic example of impermissible discrimination. “The ‘use of the proceeds’, ‘source of repayment’, and ‘responsibility for funding public projects’ has nothing to do with defining the municipal bond market as it exists in the real world.” Resp’t Br. 23. Furthermore, Kentucky is performing all of the same general functions as other government issuers when it finances projects in this manner.

Respondents assert that Petitioners’ reliance upon United Haulers is misplaced. United Haulers found that an in-state public trash facility was not substantially similar to in-state or out-of-state private trash facilities. Here, Kentucky has created a system that treats municipal bonds issued by similarly situated public entities and traded by similarly situated private sellers and investors participating in a single private national market differently.

Similarly, Petitioners’ reliance on Bonaparte v. Tax Court, 104 U.S. (14 Otto) 592 (1881), is faulty in that that case did not deal with the issue presented here. While the Court upheld the right of Maryland to tax the income that a resident earned on state and municipal “stocks” that would have been tax-exempt in the issuing State. Maryland’s law, however, taxed all public bonds– issued by Maryland or a sister State. Moreover, the issue is not whether Kentucky has the sovereign right to tax income earned on out-of-state municipal bonds, but whether it can do so while simultaneously exempting from tax the income earned from in-state municipal bonds.

Petitioners have not even attempted to show that they have no other means to advance a legitimate purpose other than this discriminatory behavior.

The market participation doctrine likewise does not offer Kentucky’s tax regime a safe harbor. If the State wanted to promote its municipal bonds in some other manner, such as by offering a subsidy or selling them only to residents, it could have. Instead, the State chose to unfairly tax out-of-state municipal bonds in order to gain an advantage in the market place. The Court’s precedents clearly direct that Kentucky’s practice be declared unconstitutional. See, Limbach supra; Camps, supra. Moreover, Respondents take issue with Petitioners’ assertion that the State is simply setting the terms of its commercial deals with its direct trading partners. “That a State issues or originates a commodity does not mean that the State is free to restrict interstate commerce by impairing the subsequent private trade of that commodity,…let alone the same commodity issued by others.” Resp’t Br. 38.

Finally, even if the Court held that Kentucky’s taxation system was not discriminatory, the system would still have to be analyzed under Pike v. Bruce Church, Inc., 397 U.S. 137 (1970), to determine whether the burden imposed on interstate commerce is clearly excessive in relation to the putative local benefit. Respondents argue that under this test too, the tax scheme fails to pass Constitutional muster, citing the impact on interstate commerce, discussed below.

II. Kentucky’s tax scheme harms the nation, non-residents, and the free market system.

The purpose of the dormant Commerce Clause is to prevent multiple miniature “trade wars” from erupting between the States. Respondents point to Utah’s tax regime as an example of how this sort of taxation system has created the exact environment the Founding Fathers meant to prevent. Utah does not tax income earned from in-state or out-of-state municipal bonds unless the out-of-state bond was issued by a State that imposes a tax on income from Utah bonds. Utah Code Ann. § 59-10-114(6)(a).

The result of Kentucky’s taxation system is to “hoard” private investor capital in Kentucky. Furthermore, this system is undemocratic in that it burdens out-of-state issuers and out-of-state sellers who have no political recourse to protest this imposition.

As discussed above, Kentucky’s taxation system blatantly distorts the national municipal bond market. Because of this distortion, funds have been created that hold bonds issued by only a single state. These funds are riskier and more costly since they are, by definition, not diversified.

Ironically, Kentucky also suffers because while it can borrow money at a lower rate under its scheme, it forgoes huge amounts in tax revenue that it would otherwise see if its own bonds were taxable.

Respondents assert that the dire consequences that Petitioners predict if the Supreme Court declares this long standing practice unconstitutional will simply not come to pass. Indeed, Respondents declare that:

Affirmance will not cause any State to default on its bonds, will not cause the municipal bond market to collapse, and will not require any State to forego repairing its roads or building its schools. It will simply put an end to Kentucky’s discriminatory, inefficient, and counter-productive tax scheme. Resp’t Br. 46.

Indeed, the Respondents note that one scholar has said that “capital-scarce States” would be able to fair much better under a system not pervaded by this discrimination. Id.

Finally, Respondents note that scholars and other observers of the municipal bond market (and States themselves) have long been aware that the current tax regimes are unconstitutionally discriminatory. State legislatures have even studies the matter. This fact undercuts Petitioners’ argument that “‘substantial reliance interests’ counsel in favor” of upholding its tax laws. Widespread use of a practice known by the participants to be unconstitutional should not itself make the practice acceptable by the Court.