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Tuesday, May 20, 2008

Triumph for federalism in Roberts Court

Yesterday, the Court handed down the biggest decision of the term (measured by financial stakes), when it uphold Kentucky's tax exemption for interest on Kentucky's state and local bonds in Kentucky Dep't of Revenue v Davis (06-666) . For friends of federalism, the result was gratifying. Along with last term's decision in United Haulers Assn., Inc. v. Oneida-Herkimer Solid Waste Management Authority, Davis puts the Roberts Court on the path of deference when states' "market participation" is at stake.

But Souter's reasoning was a bit obscure. The opinion seemed to rest on three arguments, two of which won a majority vote from the Court. First, Souter rested heavily on the fact that Kentucky used the bond proceeds to benefit public infrastructure rather than private firms (Part III(A)). Second, Souter noted that the tax exemption was distinct from exemptions for private activity, because it complemented the state's "market participation" -- the commercial marketing of its own bonds (Part III(B), from which Part Scalia and Roberts bailed out, depriving this part of the opinion of a majority, given the dissents of Kennedy and Alito and Thomas' concurring only in the judgment). Third, Souter noted that the tax exemption was critical for the creation of small "single-state" muni bond issues, a fact that allegedly suggested that the discrimination served a public purpose. Throughout, Souter emphasized that 41 states had adopted this form of tax exemption, indicating -- somehow -- that the practice was not protectionist.

But this sort of reasoning surely proves too much. Suppose that Kentucky decided to boost the marketability of its bonds not merely by exempting them from Kentucky taxes but also by imposing a special tax on the interest of muni bonds issued by other states. Such discrimination would obviously be unconstitutional even though the purpose would be identical to the purpose of the exemption that the Court upheld -- to fund public infrastructure and so forth. And it surely would not matter if every state adopted such a war against every other state: The point of the doctrine is to prevent such retaliatory measures, after all, which are collective action problems, not a collective endorsement of sensible practices.

It seems to me that there is a straighter and more formalistic route to the Court's result.

Simply put: Kentucky did not discriminate against foreign bonds. Instead, Kentucky treated them exactly like domestic private bonds, taxing them at the same rate applicable to interest earned from any source other than domestic munis. This equal treatment placed a practical ceiling on the benefits conferred on local bond issuers by the tax exemption that Kentucky adopted. Holders of Kentucky munis could save no more in taxes than Kentucky was willing to impose on its private issuers of debt. This built-in restraint on discrimination is the best practical justification for the market participant doctrine, and yet the Court essentially devoted one sentence to the fact of equal treatment. (The Court noted, on page 20 of the slip opinion, that "[i]n this interstate market, Kentucky treats income from municipal bonds of other States just like income from bonds privately issued in Kentucky or elsewhere; no preference is given to any local issuer, and none to any local holder, beyond what is entailed in the preference Kentucky grants itself when it engages in activities serving public objectives. A more specialized market can be").

The best aspect of the opinion was Part IV, in which the Court all but overruled the Pike "balancing" test. It has been a long time coming, but, ever since my former colleague, Don Regan savaged that test in his seminal 1986 article on the dormant commerce clause, the Pike test has been an embarrassment to courts and scholars. It has also been an irritant on constitutional law final exams, as I had to endure banal student efforts to "balance" the unbalanceable, always resulting -- of course! -- in the upholding of the state law in question.

All in all, a good day for federalism, and an OK day for clear doctrine. Two cheers, then, for Davis.

One small worry: Kennedy, Alito, Thomas, Roberts, and Scalia all refused to join parts of the opinion, the first two for vaguely libertarian reasons relating to the benefits of free markets. Steven concurred on the ground that the beneficiary of the bond proceeds was the state. Of course, the assertions about the ultimate destination of the funds is nonsense: The proceeds might well go to a mall developer or some such. Will some new majority of libertarian, anti-Kelo justices converge around the idea that state-sponsored private development is illegal? I'd deplore such a move, because I believe with Mencken that the point of federal democracy is to let the people get what they want good and hard -- including festival malls and other possible white elephants. But I doubt that every Republican judge has my stomach for local experiments. Fortunately, the redoubtable Justices Scalia and Thomas would either put the entire dormant commerce clause doctrine in the hospice of grudging stare decisis or euthanize it forthwith, so my worries are quelled).

Posted by Rick Hills on May 20, 2008 at 10:28 AM in Constitutional thoughts | Permalink


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Yes, the distinction between "generally applicable taxes" and taxes that discriminate against out-of-state bond issuers is surely one of degree rather than kind. When the classification grows ever closer to the the forbidden discrimination, the Court will likely grow ever more suspicious that the classification is a mere proxy for attacking the out-of-state issuer.

An interesting counterpoint to Kentucky Dep't of Revenue v Davis is Davis v. Michigan Dept. of Treasury, 489 U.S. 803 (1989). This other "Davis" case held that Michigan could not give its own employees a tax exemption without extending the tax exemption to federal civil servants as well. Of course, Michigan's tax exemption no more discriminated against the feds than Kentucky's discriminated against foreign bond issuers. But the Michigan decision defined "discrimination" very broadly because it was more solicitous about protecting the feds from possible discrimination than the Kentucky Court was about protecting sister state issuers from discrimination.

Posted by: Rick Hills | May 21, 2008 10:18:06 PM

Colorado has a state constitutional provision prohibiting state competition with private enteprise and I'm sure it is not the only state to have such a provision.

Congress also makes a distinction (not shared by SCOTUS which has held that neither's federal tax exclusion is constitutional in stature) between private activity bonds and true municipal bonds.

Posted by: ohwilleke | May 21, 2008 2:34:14 PM

Rick, at what level of abstraction are we supposed to analyze your "taxed at the same rate" test? For example, suppose Kentucky were to impose an "intangibles" tax on securities at a rate of 15%, and a general income tax on income from tangibles of 5%. Suppose further that most of the intangibles subject to tax are found to compete with Kentucky-sourced bonds. Do we still have a "built-in restraint on discrimination"? Or do we instead have the kind of targeted excise you rightly condemn? (And note that this is almost exactly identical to the problems raised by simultaneous taxes and subsidies on the same industry.)

Incidentally, I read the opinion as tying together what you identify as points one and three offered by Souter -- that the way the Court will identify what is "public" rather than "private" is by deciding whether there is any plausible non-protectionist purpose, which in this case was said to be the creation of markets for small-jurisdiction bonds. Any thoughts as to whether a state like New York can claim the benefits of this rationale?

Posted by: BDG | May 21, 2008 10:12:38 AM

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