The matter came on for oral argument before the Court at 11:05 a.m. on November 5, 2007. C. Christopher Trower represented the Petitioners and G. Eric Brunstad, Jr., represented the Respondents.

Petitioners

Mr. Trower opened with the statement that the law at issue treats all private entities alike, and only favors Kentucky and its political subdivisions, and that the "Court has never held that a law which favors government, whether the State or local government, rather than private business enterprises violates the dormant Commerce Clause."

Justice Alito asked Mr. Trower if that statement was correct with regard to conduit bonds, which are used to finance private construction. Mr. Trower noted that the Justice actually raises two questions: (i) whether governments may use their tax-exempt borrowing power to further a private project that the government believes furthers the public interest and (ii) whether a tax preference for a State's own conduit bonds over those of sister States violates the Commerce Clause. Congress has already answered the first question in the positive.

Before Mr. Trower was able to speak to the second question, Justice Souter asked whether the second question illustrated a distinction between C&A Carbone, Inc. v. Town of Clarkston, 511 U.S. 383 (1994), and United Haulers Association, Inc. v. Oneida-Herkimer Solid Waste Management Authority, 127 S. Ct. 1786 (2007). In the former, the facility did not belong to the government, whereas it did in the latter. Mr. Trower agreed. Justice Souter then concluded that therefore, in Justice Alito's example, Kentucky's tax system was indeed benefiting private entities by allowing them to borrow money at a lower rate, and that the distinction between the two cases, for purposes of this case was "not a relevant distinction." Mr. Trower agreed because the key to the issue was the ultimate beneficiary, which here is the people of Kentucky.

Justice Alito then expanded upon his example, theorizing that Kentucky could lure a company to build a plant within the State by offering to issue private activity bonds so that the company could finance the construction more cheaply than it could in another State. He asked whether this sort of situation was "exactly what the dormant Commerce Clause is supposed to prevent". Mr. Trower disagreed because the Clause "in no way restricts the ability of States to provide economic incentives for in-State business activity."

Justice Ginsburg refocused the discussion, noting that the lower courts never discussed private activity bonds. Mr. Trower added that the record contains no evidence that Respondents even own private activity bonds.

Justice Breyer admitted that he was finding the case "quite difficult" because he could not see the difference between farmers asking the State to tax out-of-state milk so that they can sell more milk and municipalities asking the State to tax out-of-state bonds so that they can finance the construction of schools at a better rate. Mr. Trower explained that there are two differences: (i) in the first example, the favoritism is directed toward private industry, whereas in the second example, it's directed toward "the most public of industries, education", and (ii) in the first example, the tax on out-of-state milk has no detriment on in-State dairy farmers, whereas in the second example, the tax is on a transaction where the government itself it paying out money. The effect of a tax in the second example is "to impose a "dollar-for-dollar reduction in the government's tax revenues equal to the amount of the exemption," which actually causes a detriment to an in-State entity rather than benefiting that entity. When Justice Breyer asked if it made a difference if the State operated the dairy farms in the first example, Mr. Towers argues that this fact made a big difference because "the Commerce Clause does not extend to activities by a State on behalf of all of its people."

Chief Justice Roberts then noted that there was a distinction between this case and United Haulers in that Kentucky does compete with other public entities in the municipal bond market. He noted that he believed Petitioners have a strong case with regard to discrimination against private bond, but asked why the discrimination against sister State bonds was permissible. Mr. Trower responded that the "key distinction" in United Haulers was "between an entity with the responsibility for the welfare of the citizens within the jurisdiction versus all other entities." He argued that United Haulers would have come out the same exact way if the trash haulers wanted to take the garbage to public facilities in other States. He noted also that within the State of Kentucky, public bond issuers are no different than private bond issuers and have no responsibilities in Kentucky for the public welfare. He argued that the fact that municipal bonds are issued not for profit, but rather "to finance the essential work of government." He argued that respect for a State's sovereignty outweighs the free trade aspect of this case.

Justice Stevens then proposed situations where the State would offer its taxpayers a higher interest rate than non-resident purchasers or where the bonds could only be owned by Kentucky residents. He asked whether those activities would be permissible, and Mr. Trower agreed they would be. Mr. Trower noted that the Commerce Clause was "not a grant of power to the national government to enact free trade laws, but rather it was a grant of power to the national government to prevent Union-dividing friction between the States." No such friction exists here, as evidenced by Kentucky's support of the 49 other States, and so "the need for judicial invalidation of the laws of 42 States is commensurately less."

Chief Justice Roberts then gave an example whereby Kentucky would prohibit out-of-state car dealers from selling cars in Kentucky, and then imposed a special tax on Kentucky car dealers to fund local hospitals, airports, and other public works. He asked Mr. Trower if that would be permissible, and Mr. Trower said that he did not think it was, since it would be "the West Lynn Creamery case in reverse." The Chief Justice then asked whether the use to which the proceeds are put could save an otherwise discriminatory activity. Mr. Trower failed to answer the question directly, but simply responded that the use to which the proceeds are put is what "determine the Commerce Clause situation."

Respondents

Mr. Brunstad opened with the observation that this is not a situation whereby a State has created a monopoly. Instead, it is imposing a facially discriminatory tax on commodities that compete with State-created commodities.

Justice Breyer was the first to question Mr. Brunstad. He asked why this is unlike education, where the State charges in-state students less than it charges out-of-state students. Mr. Brunstad responded that in one instance, the State is providing a service. Several of the Justices (Breyer, Souter and Ginsburg) went on to press Mr. Brunstad about why there should be a constitutional difference between a subsidy and a tax when there is no economic difference and whether the State's participation in the market made activity that was unacceptable in Boston Stock Exchange v. State Tax Commission, 429 U.S. 318 (1977), or Fulton Corp. v. Faulkner, 516 U.S. 325 (1996), permissible. Mr. Brunstad floundered a bit under this line of heavy questioning, and argued that essentially what the State is doing in this instance is akin to the down-stream regulation found in South-Central Timber Development, Inc. v. Wunnicke, 467 U.S. 82 (1984). He added that the State is misusing its taxing power to regulate interstate commerce in a manner that smacks of economic gamesmanship: "They want to sell their bonds nationally but hoard their own investment dollars locally".

Chief Justice Roberts pointed out that Kentucky is not taxing the out-of-state commodity, but rather Kentucky taxpayers. Mr. Brunstad responded that this was the issue confronted in New Energy Co. v. Limbach, 486 U.S. 269 (1988), where the Court held that the "Commerce Clause does not prohibit all State action designed to give its residents an advantage in the marketplace, but only action of that description in connection with the State's regulation of interstate commerce."

Justice Souter went on to comment that the Court has only required States to show that they have no other alternative to a facially discriminatory tax when there is not market participation. He then mentioned the enormous size of the municipal bond market and the historical practice of exempting from tax only in-state municipal bonds, and asked Mr. Brunstad why the case should not simply be analyzed under Pike v. Bruce Church, Inc., 397 U.S. 137 (1970). Mr. Brunstad responded that these discriminatory tax laws have created a race to the bottom all because New York began the practice in 1919. Justice Breyer observed that then the States have options if they do not like this race to the bottom: they can enter into a compact with each other or go to Congress.

Chief Justice Roberts echoed this sentiment, and noted that in General Motors Corp. v. Tracy, 519 U.S. 278 (1997), the Court decided that in close cases, such decisions should be left to Congress "[b]ecause, after all, the Commerce Clause talks about Congress' power. The dormant Commerce Clause is not mentioned." He added that Congress has thus far chosen to not legislate on the issue. When Mr. Brunstad argued that the same could have been said in other cases where the Court invalidated the State law, Chief Justice Roberts responded that "[i]t strikes me as much more fundamental, whether or not a State can issue a tax exemption for itsbonds."

Justice Breyer again began pushing Mr. Brunstad about whether this case is "more like milk" or "more like garbage collection". Mr. Brunstad responded that it is more like milk because in United Haulers, there was no tax imposed on the out-of-state commodity and because United Haulers dealt with a government monopoly. Justice Stevens disagreed with Mr. Brunstad's first point, reminding him that this is not such a tax, but instead a tax on Kentucky taxpayers who own out-of-state bonds. Furthermore, he pointed out that the "victims" of this tax "“ the 49 other States "“ all support Kentucky on this issue. Mr. Brunstad replied that this was because the States do not want to issue refunds and are giving up a long-term solution in order to take advantage of a short-term gain.

Chief Justice Roberts noted that much of what Mr. Brunstad said supported claims by out-of-state issuers, but that Mr. Brunstad's clients are not such issuers, but simply residents of Kentucky who own out-of-state bonds. Mr. Brunstad responded that his clients were arguing "about the discriminatory effect of the law on the marketplace as a whole, because they are participants in the market." The Chief Justice then asked how Mr. Brunstad wanted the Court to remedy the situation. He replied that the remedy "would be for the State to decide whether it wants to make all municipal bonds tax-exempt or to make them all taxable." He then noted that because Kentucky's constitution limited its actions, the only course of action the State could take would be the former.

Chief Justice Roberts made the astute observation that the difference between the two arguments presented to the court was what the definition of the market should be. Respondents argue the market at issue is the national municipal bond market; Petitioners argue it's the persons who issue bonds for public works in Kentucky. Mr. Brunstad responded that it is clear that the market is the former because that is where the bonds are sold.

Justice Stevens chimed in that it seemed to him that "Kentucky bonds are characteristically more attractive to Kentucky citizens than they are to out-of-state citizens" even without the tax preference because Kentucky citizens have an interest in the improvements that these bonds are financing.

Rebuttal

Mr. Trower began his rebuttal statement by disagreeing with the notion that Kentucky penalizes its respondents for participating in interstate commerce. Instead, he argued, Kentucky is simply striking a deal with its direct trading partner that if the partner lives within the State, the interest on the bond will be exempt from taxes.

Justice Alito posed an interesting question:

It seems to me you're making a lot of arguments that, if accepted, woulddemonstrate that the Commerce Clause jurisprudence is utter incoherent. If taxation is the same thing as a subsidy, if congressional inaction is the same thing as approval, if Kentucky bond are not really in the same market as out-of-state bonds, what would be left of Commerce [sic], of dormant Commerce Clause jurisprudence if those arguments were accepted?

Mr. Trower responded that the majority of the Court's jurisprudence would be left alone, that Petitioners were seeking only a rule that applied to "transaction[s] between the State itself and the bondholder."

Justice Kennedy then began to question Mr. Trower about why a situation that has effectively created "a pact among States to favor their own residents". The Justice kept pressing Mr. Trower for a reason why this tax, which he declared to be "explicit discrimination", should be permitted. Mr. Trower argued that it acts just like a permissible subsidy. Furthermore, he added that this situation is analogous to General Motors "because there you had a well-established, long-established market that the Court was loath to jump in [sic] without any institutional competence or information to evaluate the effects, where Congress could take action if any was necessary." This prompted Justice Alito to ask whether Congress' awareness of discrimination and lack of action would thereby permit States to engage in discriminatory behavior. Furthermore, the Justice continued, was not Congress aware of the types of ordinances invalidated in the Carbone case? Mr. Trower said that perhaps there was the same type of Congressional acquiesce in Carbone and that if the case were before the Court today, it might come out differently.

Posted in Dept. of Revenue of Kentucky v. Davis, Everything Else