Dep't of Revenue v. Davis

Dep't of Revenue v. Davis

Opinion

 [**1804]  [*331]   Justice Souter delivered the opinion of the Court, except as to Part III-B.¹

For the better part of two centuries States and their political subdivisions have issued bonds for public purposes, and for nearly half that time some States have exempted interest  [*332]  on their own bonds from their state income taxes, which are imposed on bond interest from other States. The question here is whether Kentucky's version of this differential tax scheme  [****7] offends the Commerce Clause. We hold that it does not.

Like most other States, the Commonwealth of Kentucky taxes its residents' income. See Ky. Rev. Stat. Ann. § 141.020(1) (West 2006). The tax is assessed on "net income," see ibid., calculated by reference to "gross income" as defined by the Internal Revenue Code, see §§ 141.010(9)-(11)(West Supp. 2007),² [***691]  [**1805]  which excludes "interest on any State or local bond" ("municipal bond," for short³), 26 U.S.C. § 103(a).  [*333]  Kentucky piggybacks on this exclusion, but only up to a point: it adds "interest income derived from obligations of sister states and political subdivisions thereof" back into the taxable net. Ky. Rev. Stat. Ann. § 141.010(10)(c). Interest on bonds issued by Kentucky and its political subdivisions is thus entirely exempt,⁴ whereas interest on municipal bonds of other States and their subdivisions is taxable. (Interest on bonds issued by private entities is taxed by Kentucky regardless of the private issuer's home.)

The ostensible reason for this regime is the attractiveness of tax-exempt bonds at "lower rates of interest . . . than that paid on taxable . . . bonds of comparable risk." M. Graetz & D. Schenk, Federal Income Taxation 215 (5th ed. 2005) (hereinafter Graetz & Schenk). Under the Internal Revenue Code, for example, see 26 U.S.C. § 103, "if the market rate of interest is 10 percent on a comparable corporate bond, a municipality could pay only 6.5 percent on its debt and a purchaser in a 35 percent marginal tax bracket would be indifferent between the municipal and the corporate bond, since the after-tax interest  [****10] rate on the corporate bond is 6.5 percent," Graetz & Schenk 215.⁵  The differential tax scheme in Kentucky works the same way; the Commonwealth's tax benefit to residents who  [***692] buy its bonds makes  [*334]  lower interest rates acceptable,⁶ while limiting the [**1806]  exception to Kentucky bonds raises in-state demand for them without also subsidizing other issuers.

The significance of the scheme is immense. Between 1996 and 2002, Kentucky and its subdivisions issued $7.7 billion in long-term bonds to pay for spending on transportation, public safety, education, utilities, and environmental protection, among other things. IRS, Statistics of Income Bulletin, C. Belmonte, Tax-Exempt Bonds, 1996-2002, pp 169-170, http://www.irs.gov/pub/irs-soi/02govbnd.pdf (as visited Jan. 23, 2008, and available in Clerk of Court's case file). Across the Nation during the same period, States issued over $750 billion in long-term bonds, with nearly a third of the money going to education, followed by transportation (13%) and utilities (11%). See ibid.  Municipal bonds currently finance roughly two-thirds of capital expenditures by state and local governments. L. Thomas, Money, Banking and Financial Markets 55 (2006).

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