Municipal Bond Case Before the Supreme Court Has Sweeping Implications, Says AEI Tax Expert Alan D. Viard

Media inquiries: Véronique Rodman
vrodman@aei.org (202.862.4870)

FOR IMMEDIATE RELEASE: November 5, 2007

As the Supreme Court hears oral arguments today in Davis v. Kentucky Department of Revenue, AEI Resident Scholar and former Federal Reserve Bank of Dallas economist Alan D. Viard offers the following observations about the case challenging Kentucky's policy of taxing interest on out-of-state municipal bonds while exempting interest on home-state municipal bonds:

  • The Supreme Court should uphold the lower court's ruling in favor of the taxpayers and allow the free interstate movement of funds in the municipal bond market. Forty-one other states follow Kentucky's practice of taxing interest on home-state municipal bonds more favorably than out-of-state municipal bonds. These policies give investors an incentive to inefficiently concentrate their holdings in home-state bonds. This incentive has balkanized the $2 trillion municipal bond market, driving money into single-state municipal bond mutual funds that suffer from poor liquidity, limited diversification, and high costs. While Treasury and corporate bond money flows freely across international borders, a big chunk of municipal bond money is trapped inside state lines.
  • A decision for the taxpayers would have sweeping implications. If the Supreme Court rules in favor of the taxpayers, states will be required to equalize their treatment of municipal bonds–either extending the exemption to out-of-state bonds or revoking it for home-state bonds. States will also have to refund taxes paid on interest on out-of-state bonds or to retroactively tax interest on home-state bonds. The values of outstanding municipal bonds will rise or fall, depending on states' response to the ruling.
  • A decision for Kentucky would also have far-reaching implications. The state argues that it has free rein to use tax policy to obstruct interstate transactions, so long as it (or one of its municipalities) is a party to the transaction. If the Supreme Court accepts this argument, it will give states a green light to erect other barriers to interstate trade and financial flows.

AEI Resident Scholar Alan D. Viard researches tax and budget policy. He filed an amicus brief, joined by five other AEI scholars and a Brookings Institution scholar, in support of the taxpayers in this case. He recently published an article about this case in State Tax Notes.

To interview Alan Viard, please contact him at 202.419.5202 (office), 703.909.3763 (cell), or aviard@aei.org.

For all other media inquiries, please contact Véronique Rodman at vrodman@aei.org or 202.862.4870.

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