On May 19, in the case of Kentucky v. Davis, the U.S. Supreme Court upheld a Kentucky law which both exempted from state income tax the interest earned on municipal bonds issued by Kentucky cities, and imposed state income tax on interest earned on bonds issued by cities in other states.
Forty-one other states, including Nebraska, have similar income tax laws. According to the U.S. Supreme Court, those states had overwhelmingly expressed support for maintaining these laws, which currently affect the tax treatment of more than $2.4 trillion in municipal bonds, nationally.
The Court relied on two legal principles in holding that Kentucky’s law did not violate the U.S. Constitution. First, the Court noted that this case involved a traditional government function: raising revenue to pay for public projects. Because traditional government functions are generally motivated by legitimate objectives (rather than economic protectionism), they are not subjected to heightened scrutiny under the “dormant commerce clause” of the U.S. Constitution. Second, the Court also pointed to Kentucky’s participation in, as opposed to mere regulation of, its municipal bond market. Because Kentucky acted as a market participant, the Court stated that Kentucky was free to set its own contractual terms for the bonds (including an income tax exemption).
The U.S. Supreme Court’s ruling means that states may continue to exempt municipal bonds issued by their own state’s cities from state income tax, but tax municipal bonds of other states.