Dept. of Revenue of Kentucky v. Davis

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Authorship: Susan Ruge.

Contents

[edit] Briefs and Documents

Docket: 06-666

Oral Argument: Transcript

Judgment:

Merits briefs

Amicus briefs

Certiorari Filings

[edit] Pre-Argument Articles

[edit] Grant write-up

This section was written by Amy Howe on May 21, 2007, for SCOTUSblog.

Three weeks ago, in No. 05-1345, United Haulers Association v. Oneida-Herkimer Solid Waste Management Authority, the Court upheld – over a Commerce Clause challenge – a municipal ordinance that requires trash haulers to deliver their trash to a publicly operated processing site. In so doing, the majority reasoned that “it does not make sense” to subject laws favoring local government to the same level of scrutiny as laws that “favor[] in-state business over out-of-state competition,” as the latter often seek to achieve “simple economic protectionism.” But what about state laws that favor the state over other states? The Court will take up that question next Term in No. 06-666, Kentucky Department of Revenue v. Davis, in which it granted cert. today.

At issue in Davis is a provision in Kentucky’s income tax law that taxes interest income from bonds issued by other state and local governments while providing an exemption for interest from Kentucky bonds. Two Kentucky taxpayers challenged the law, arguing that the tax discriminated against holders of out-of-state bonds and thus violated the Commerce Clause. Kentucky’s intermediate appellate court agreed. It held that the state’s scheme for taxing bond interest was unconstitutional, “as it obviously affords more favorable taxation treatment to in-state bonds than it does to extraterritorially issued bonds.” The market participant doctrine did not save the law, the court explained, because the state’s “issuance of bonds is not the issue. Rather, the sole issue is Kentucky’s decision to tax only extraterritorial bonds” – which is “clearly[] ‘a primeval governmental activity.’”

After the Kentucky Supreme Court denied review, the state sought certiorari. Although the petition begins by alleging a split with a decision of Ohio’s intermediate appellate court (which, according to the petition, “upheld against Commerce Clause challenge a state income tax law indistinguishable from Kentucky’s law”), the petition focuses primarily on what it describes as the dire consequences of allowing the lower court’s ruling to stand: in addition to Kentucky and Ohio, forty other states have similar laws. Moreover, state and local governments “rely heavily upon the issuance of debt to finance public projects,” with the interest exemption in turn playing an important role in the states’ ability to issue such bonds. In any event, the state asserts, its tax law is not a matter of the “economic protectionism” prohibited by the Court’s Commerce Clause jurisprudence, but instead “one where a sovereign is acting on its own behalf in the service of its citizens in a manner that favors itself over other sovereign states.”

Opposing certiorari, respondents emphasize that the lower court’s decision invalidating the state tax scheme is fully consistent with the Supreme Court’s Commerce Clause jurisprudence because the Kentucky law is facially discriminatory and is motivated solely by economic protectionism. And although “it may be true that Kentucky acts as a market participant in the sale of its bonds,” respondents reiterate, “it clearly does not do so in taxing the income from the bonds of other states while exempting the income its residents derive from intrastate bonds.” Finally, respondents caution, “[t]o adopt the Petitioners’ argument that the Commerce Clause does not apply to a state’s taxation ‘on behalf of itself where the end result is to provide the taxing state with a competitive advantage over another sovereign’ would render the dormant Commerce Clause utterly meaningless and undo over a century of Commerce Clause precedent.” (This is obviously not an argument aimed at Justices Scalia and Thomas, who made clear in United Haulers that they wouldn’t mind doing precisely that.)

Interestingly, court observers had speculated that Davis – which was first considered by the justices at their February 16 conference, but then was held for nearly three months – might have been slated for a GVR in light of United Haulers. Instead, after being re-distributed for conferences on May 10 and May 17, the case showed up as a grant on today’s order list – perhaps indicating that at least four justices may be ready to write another chapter in the Court’s Commerce Clause jurisprudence.

[edit] Argument Preview

Summary of Petitioners’ Brief

Kentucky taxes a resident individual “upon his entire net income,” whereas a non-resident individual is taxed on net “income received by him from labor performed, business done, or from other activities in this state, from tangible property located in this state, and from intangible property which has acquired a business situs in this state.” Ky. Rev. Stat. Ann. §§ 141.020(1); 141.020(4). While Kentucky permits most deductions permitted by the Internal Revenue Code of 1986, as amended, it does not permit them all. One deduction that is disallowed is the “interest income derived from obligations of sister states and political subdivisions thereof.” Ky. Rev. Stat. Ann. § 141.010(10)(c).

Before focusing on its legal arguments, Petitioners point out that the tax that the State imposes on sister State bonds falls “almost entirely if not exclusively” on Kentucky residents, since income from intangibles such as municipal bonds is taxable by the State of the bondholder’s domicile. The only way another State may tax the bondholder is if the bonds have acquired a “business situs”, i.e., become localized in some independent business or investment outside of the State of domicile.

Petitioners then go on to describe the robust nature of the municipal bond market. By the end of 2006, the market was valued at over $2.4 trillion. Petitioners also offer the following statistics:

Of the $423 billion in municipal bonds issued in 2006, over 27% financed projects and programs related to educations; over 10% financed transportation facilities; another 10% financed utilities projects; 7.3% financed housing projects and programs; 3% financed electric power projects; and 1.8% financed environmental projects. Bonds issued for general purposes, which include financing the daily operations of States and local governments in anticipation of quarterly tax revenues, accounted for 26.6% of the total. Pet. Br. 5.

Such borrowing has been excluded from federal income tax from the time that the very first such tax was imposed in 1913. This exclusion lowers the cost of borrowing for States since bondholders will accept a lower rate of interest given that this interest will be tax-exempt. Petitioners argue that this exclusion demonstrates Congressional belief of the importance of the municipal bond market.

Petitioners divide their main arguments into three parts:

I. Kentucky’s exercise of its power as an independent sovereign to tax sister State bond interest neither “discriminates against interstate commerce” nor threatens any of the principal purposes of the dormant Commerce Clause.
II. The substantial reliance interests and settled economic expectations of the States and their bondholders, as well as Congress’ repeated recognition of the disparate tax treatment of State bond interest, make judicial intervention both unwise and unnecessary.
III. A sovereign State may use its regulatory taxing power to affect economic terms of market participant relationships with its direct trading partners.

We shall examine each argument in turn.

I. Kentucky’s practice is not discriminatory and does not raise concerns under the dormant Commerce Clause.

Petitioners first note that a very similar practice has already been upheld by the Supreme Court. In 1881, the Court upheld the ad valorem taxation of sister State bonds by the bondholder’s State of residence in Bonaparte v. Tax Court, 104 U.S. (14 Otto) 592 (1881). In addition to noting that no provision of the Constitution prohibited such a tax, the Court went on to note within the jurisdiction of the taxing State, its sister State “had none of the attributes of sovereignty as to the debt it owes.” Id. at 595. While Bonaparte was a Full Faith and Credit Clause case, Petitioners argue that its logic is equally applicable to this dormant Commerce Clause case since the issue is whether States have retained the power to raise their own revenues to provide for the needs of their citizens.

Citing the current standard for violations of the dormant Commerce Clause, Petitioners note that the Respondents have not alleged that Kentucky’s tax on sister State bond interest received by individual tax payers lacks a substantial nexus to Kentucky, is unfairly apportioned between Kentucky and other States, or is not fairly related to services provided by Kentucky. That leaves in question only the requirement that Kentucky’s tax not discriminate against interstate commerce. This component of the test would require that the entities at issue be “substantially similar” and “similarly situated.”

Petitioners argue that Kentucky is not a “substantially similar entity” to any other bond issuer (public or private) because no other issuer has the political responsibility of financing public works and projects for Kentucky citizens. Furthermore, Kentucky bonds cannot be considered to be “substantially similar to bonds issued by other entities because of the two most important aspects of any debt instrument: use of proceeds and source of repayment.” The use of the proceeds are solely for the financing of public works and other programs in the State of Kentucky. No other bond issuer even claims to take responsibility for such projects. As Petitioners note, with regard to these unique uses of the bond proceeds, “sister States are no more ‘similarly situated’ to Kentucky than the government of Egypt.” With regard to the source of repayment, the citizens of Kentucky and the project/program revenues collected by the Kentucky bond projects are again unique financiers of these bonds. The ability to finance bonds using these revenue streams is an inherent aspect of Kentucky’s sovereignty. Citing General Motors Corp. v. Tracy, 519 U.S. 278 (1997), Petitioners conclude that there mere fact that Kentucky bonds and sister State bonds are debt obligations purchased by investors does not make the issuers or their bonds “substantially similar” for Commerce Clause purposes.

Petitioners then go on to discuss United Haulers Association, Inc. v. Oneida-Herkimer Solid Waste Management Authority, 127 S. Ct. 1786 (2007), handed down just last term, to support their contention that Kentucky’s practice is not discriminatory. United Haulers, Petitioners argue, drew a line between entities “vested with the responsibility of protecting the health, safety, and welfare of its citizens, and all other entities which do not share that governmental responsibility. In doing so, it focused on four factors: (i) governmental responsibility, (ii) legitimate goals unrelated to economic protectionism for in-state private businesses, (iii) a typical and traditional government function, and (iv) political accountability to those most directly affected by the law. These factors, as applied to the present case, clearly classify Kentucky’s actions are nondiscriminatory. The State is the only entity with the government responsibility of overseeing public projects in and throughout the State that are designed to benefit Kentucky citizens. The tax on sister State bond interests treats in-state businesses the same exact way as it does out-of-state businesses. Furthermore, with regard to the second point, United Haulers observed that a law “favoring local government, [as opposed to local businesses,]…may be directed toward any number of legitimate goals unrelated to protectionism.” Id. at 1795-1796. Petitioners claims that the same conclusion applies when a law favors the State itself in comparison with sister States. Borrowing money to finance State projects is indeed traditional a typical and traditional governmental activity. Finally, the burden of taxing sister State bonds falls almost exclusively upon Kentucky citizens, who have the right to use the political system to change the practice if they so desire.

Petitioners then go on to debunk the notion that the State’s practice violates any of the National interests involved in the dormant Commerce Clause. The Supreme Court has recognized these as: (i) a need for uniform national regulation; (ii) minimizing political friction between States; (iii) promoting a national free market; and (iv) avoiding economic protectionism. Petitioners explain again how none of these concerns are implicated by Kentucky’s practice:

  • The Due Process Clause prevents States from taxing individuals on bond interest received by non-residents unless these individuals have the required business situs in the State.
  • To the extent the dormant Commerce Clause is geared toward encouraging the States to economically “sink or swim” together, it is in no way affected by the treatment of State bond interest, given the fact that virtually every State utilizes this practice.
  • The fear of economic balkanization is not a concern because private businesses are not affected, the players instead are the States themselves, and there is no entity competing with Kentucky to provide the State with roads, sewers, prisons, etc.
  • Again, there are no out-of-state competitors who might be able to compete with Kentucky to provide these governmental functions.

The Petitioners conclude the first segment of their argument with the statement that the principles of State sovereignty mandate the application of the United Haulers rule that if a State tax law applies in exactly the same fashion to all entities other than the State itself, the law does not discriminate against interstate commerce for purposes of the dormant Commerce Clause. “The basic principal is geographical: State sovereignty does not cross the state line.” Kentucky’s actions do no such thing, and so should be upheld.

II. The substantial reliance interests and settled economic expectations of the states and their bondholders, as well as congress’ repeated recognition of the disparate tax treatment of state bond interest, make judicial intervention both unwise and unnecessary.

As discussed earlier, the municipal bond market is valued at $2.4 trillion. Petitioners warn that “any change in the status quo would affect the settled economic expectations and contractual rights of at least 42 States and millions of bondholders.” Petitioners note that in similar Commerce Clause cases, the Court determined that restraint was the wiser course of action. See, General Motors, supra; Padell v. New York, 211 U.S. 446 (1908).

Petitioners then go on to discuss several Congressional bills and reports proving not only that Congress has been aware of this practice, but it has endorsed it through Congressional inaction. The fact that Congress has taken such a keen interest in the practice in the past without taking any action supports Petitioners’ advice that “[t]he Court should not rush in where Congress failed to tread.”

III. A Sovereign State may use its regulatory taxing power to affect the economic terms of market participant relationships with its direct trading partners.

Petitioners contend that the Kentucky Court of Appeals was incorrect when it concluded that “the market participant theory is inapplicable as the State’s ‘assessment and collection of taxes’ is, clearly, ‘a primeval government activity.’” Pet. App. A10.

Petitioners note that the Court’s precedence in market participant cases means that if a State is acting as a market participant, the dormant Commerce Clause does not prohibits it from using its regulatory powers to set the terms of its own market participation. In defense of Kentucky’s practice, Petitioners cites Reeves, Inc. v. Stake, 447 U.S. 429, 439 n.13 (1980) (quoting Perkins v. Lukens Steel Co., 310 U.S. 113, 127 (1940)), which stated that “the Government enjoys unrestricted power to produce its own supplies, to determine those with whom it will deal, and to fix the terms and conditions upon which it will make needed purchases.” Petitioners discuss several Commerce Clause cases that involved Court-approved State participation in a market which the State regulated pervasively. See, Reeves, supra; Hughes v. Alexandria Scrap Corp., 426 U.S. 794 (1976); White v. Massachusetts Council of Construction Employers, Inc., 460 U.S. 204 (1983). These cases, Petitioners note, “involved the use of the police power, a regulatory power every bit as primeval as the power to tax.”

The confusion, Petitioners contend, is that the Court of Appeals relied on three cases in which the State was not a market participant at all, but tried to equate taxation or regulation of transactions between third parties to “participation” in the market by the State. See, South-Central Timber Development, Inc. v. Wunnicke, 467 U.S. 82 (1984); New Energy Co. of Indiana v. Limbach, 486 U.S. 269 (1988); Camps Newfoundland/Owatonna v. Town of Harrison, 520 U.S. 564 (1997). These cases did not involve the State using its regulatory powers to set the terms of its direct dealings with trading partners, but instead tried to impose downstream restrictions on the actions of its trading partners. Therefore, Petitioners conclude, “these precedents in no way foreclose the use of a State’s regulatory power to affect the economic terms of its relationship with its direct trading partners.”


Summary of Respondents’ Brief

Respondents argue that Kentucky’s tax scheme unconstitutionally erects a barrier to the purchase of similar out-of-state commodities because it encourages its citizens to purchase in-state municipal bonds by taxing out-of-state municipal bonds. In fact, Respondents argue that Kentucky’s law operates as a tariff – “a law that taxes goods imported from other States, but does not tax similar products produced in state.” Resp’t Br. 1 (citing West Lynn Creamery, Inc. v. Healy, 512 U.S. 186, 193 (1994)). Respondents disagree that the test is the use of the proceeds combined with the source of the financing, but rather that the analysis turns on the impact that the tax has on the municipal bond market.

Respondents also take issue with Petitioners’ “no harm-no foul” argument (that there are no out-of-state competitors who are interested in providing Kentucky citizens with public works projects and programs and that the burden of the tax falls upon Kentucky citizens themselves, who may use the political process to abolish the tax). Instead, Respondents point out that Kentucky’s tax regime taxes municipal bonds that are not under the State’s exclusive control, blocks the access of other issuers and sellers to the private bond market, and inflicts harm on out-of-state issuers and sellers who are unable to cast a vote in the State of Kentucky.

Furthermore, the fact that the proceeds of these bonds are for public works does not make them unique or give them special constitutional status. Every State issues bonds to improve life for its citizens. Kentucky’s municipal bonds are rated by the same agencies, regulated by the same federal law, compete for the same capital and are traded by the same participants in the same national market as out-of-state municipal bonds. A State may not use “public purpose” as an excuse to facially discriminate against out-of-state commerce. Indeed, the Court has stated that “the purpose of, or justification for, a law has no bearing on whether it is facially discriminatory.” Oregon Waste System, Inc. v. Department of Environmental Quality, 511 U.S. 93, 100 (1994).

Respondents then give some background regarding municipal bonds, which are debt instruments representing contractual promises by the governmental issuers to repay the principal of the bonds plus interest. They are generally divided into four categories: (i) general obligation bonds that are backed by the full faith, credit and tax power of the issuing State; (ii) moral obligation bonds that are not so backed; (iii) revenue bonds that are issued to fund publicly owned infrastructure projects such as roads and schools and are backed by pledge of the revenue generated from a specific project; and (iv) industrial revenue bonds that are used to develop commercial or industrial property for the benefit of private corporations and are backed by revenue from that private project or secured by property used in private business. As of June 2006, $7.8 billion of the approximately $33.8 billion in Kentucky bonds are industrial revenue bonds – i.e., approximately 23% of Kentucky’s outstanding municipal bonds finance private businesses in Kentucky.

All municipal bonds are rated by independent agencies (such as the Bond Market Association and Standard & Poor’s) and traded in interstate commerce as financial commodities with generally standard terms. The market would ordinarily price a municipal bond based purely upon relative quality as measured in part by the rating of one of the independent agencies. States distort this market function through tax systems such as Kentucky’s. By taxing out-of-state municipal bonds, States reduce the effective yield on those bonds, giving a competitive advantage to in-state municipal bonds. This practice began shortly after the first federal income tax was imposed. New York began the practice in 1919, and now 43 States offer some for of tax preference for in-state municipal bonds.

Respondents’ arguments can be divided into two general categories: (i) legal arguments as to why the Kentucky tax scheme violates the dormant Commerce Clause and (ii) the negative effects that this and similar tax regimes.

I. Kentucky’s tax scheme violates the dormant Commerce Clause

In response to Petitioners’ reliance on United Haulers Association, Inc. v. Oneida-Herkimer Solid Waste Management Authority, 127 S. Ct. 1786 (2007), Respondents note that in that case, the Court stated that to determine whether a law violates the dormant Commerce Clause, “we first ask whether it discriminates on its face against interstate commerce.” Id. at 1793. The standard for this is whether the law expressly distinguishes between in-state and out-of-state interests. If determined to be facially discriminatory, Respondents note that the Courts precedence applies a “virtually per se rule of invalidity.” Granholm v. Heald, 544 U.S. 460, 476 (2005). Such discrimination is permitted only if the municipality can demonstrate “under rigorous scrutiny” that it has no other means to advance a legitimate local interest. C&A Carbone, Inc. v. Clarkstown, 511 U.S. 383, 392 (1994).

Kentucky’s tax regime very clearly imposes taxes on out-of-state municipal bonds while exempting such in-state bonds – there can be no clearer illustration of facial discrimination. Respondents then go on to discuss several similar cases in which the Court has struck down provisions that erect commercial barriers or otherwise discriminates against goods based upon their place of origin. See, Boston' Stock Exchange v. State Tax Commission, 429 U.S. 381 (1977); New Energy Co. v. Limbach, 486 U.S. 269 (1988); Bacchus Imports Ltd. v. Dias, 468 U.S. 263 (1984); Fulton Corp. v. Faulkner, 516 U.S. 325 (1996); Camps Newfoundland/Owatanna Inc. v. Town of Harrison, 520 U.S. 564 (1997).

Even if the tax regime is not facially discriminatory, Respondents argue that it is still discriminatory and therefore unconstitutional. When the discrimination is not apparent on the law’s face, the Court looks to whether it has a discriminatory purpose or a discriminatory effect. It operates effectively as an impermissible tariff – increasing the costs of out-of-state municipal bonds to benefit those dealing in in-state bonds. Even if Kentucky does not have a discriminatory purpose, as it claims, t the taxation scheme has a discriminatory effect nonetheless. Respondents observe that Kentucky “baldly asserts that economic protectionism does not arise in the ‘provision of public works by sovereign States to their respective citizens.’” Resp’t Br. 19. This sidesteps the issue, Respondents argue. The question is not whether Kentucky may raise fund for public works, but whether it can impose taxes on out-of-state goods in order to do so.

Respondents then attack Petitioners’ assertion that (i) Kentucky municipal bonds are not substantially similar to other municipal bonds and (ii) Kentucky as an issuer is likewise not substantially similar to any other bond issuer since no other issuer has the responsibility to finance Kentucky projects. Relying on General Motors Corp. v. Tracy, 519 U.S. 278 (1997), Respondents argue that Kentucky municipal bonds are clearly similar to other municipal bonds because they are traded in the same market by the same purchasers. The only difference between Kentucky’s municipal bonds and out-of-state municipal bonds is where they originate – which is the classic example of impermissible discrimination. “The ‘use of the proceeds’, ‘source of repayment’, and ‘responsibility for funding public projects’ has nothing to do with defining the municipal bond market as it exists in the real world.” Resp’t Br. 23. Furthermore, Kentucky is performing all of the same general functions as other government issuers when it finances projects in this manner.

Respondents assert that Petitioners’ reliance upon United Haulers is misplaced. United Haulers found that an in-state public trash facility was not substantially similar to in-state or out-of-state private trash facilities. Here, Kentucky has created a system that treats municipal bonds issued by similarly situated public entities and traded by similarly situated private sellers and investors participating in a single private national market differently.

Similarly, Petitioners’ reliance on Bonaparte v. Tax Court, 104 U.S. (14 Otto) 592 (1881), is faulty in that that case did not deal with the issue presented here. While the Court upheld the right of Maryland to tax the income that a resident earned on state and municipal “stocks” that would have been tax-exempt in the issuing State. Maryland’s law, however, taxed all public bonds– issued by Maryland or a sister State. Moreover, the issue is not whether Kentucky has the sovereign right to tax income earned on out-of-state municipal bonds, but whether it can do so while simultaneously exempting from tax the income earned from in-state municipal bonds.

Petitioners have not even attempted to show that they have no other means to advance a legitimate purpose other than this discriminatory behavior.

The market participation doctrine likewise does not offer Kentucky’s tax regime a safe harbor. If the State wanted to promote its municipal bonds in some other manner, such as by offering a subsidy or selling them only to residents, it could have. Instead, the State chose to unfairly tax out-of-state municipal bonds in order to gain an advantage in the market place. The Court’s precedents clearly direct that Kentucky’s practice be declared unconstitutional. See, Limbach supra; Camps, supra. Moreover, Respondents take issue with Petitioners’ assertion that the State is simply setting the terms of its commercial deals with its direct trading partners. “That a State issues or originates a commodity does not mean that the State is free to restrict interstate commerce by impairing the subsequent private trade of that commodity,…let alone the same commodity issued by others.” Resp’t Br. 38.

Finally, even if the Court held that Kentucky’s taxation system was not discriminatory, the system would still have to be analyzed under Pike v. Bruce Church, Inc., 397 U.S. 137 (1970), to determine whether the burden imposed on interstate commerce is clearly excessive in relation to the putative local benefit. Respondents argue that under this test too, the tax scheme fails to pass Constitutional muster, citing the impact on interstate commerce, discussed below.

II. Kentucky’s tax scheme harms the nation, non-residents, and the free market system.

The purpose of the dormant Commerce Clause is to prevent multiple miniature “trade wars” from erupting between the States. Respondents point to Utah’s tax regime as an example of how this sort of taxation system has created the exact environment the Founding Fathers meant to prevent. Utah does not tax income earned from in-state or out-of-state municipal bonds unless the out-of-state bond was issued by a State that imposes a tax on income from Utah bonds. Utah Code Ann. § 59-10-114(6)(a).

The result of Kentucky’s taxation system is to “hoard” private investor capital in Kentucky. Furthermore, this system is undemocratic in that it burdens out-of-state issuers and out-of-state sellers who have no political recourse to protest this imposition.

As discussed above, Kentucky’s taxation system blatantly distorts the national municipal bond market. Because of this distortion, funds have been created that hold bonds issued by only a single state. These funds are riskier and more costly since they are, by definition, not diversified.

Ironically, Kentucky also suffers because while it can borrow money at a lower rate under its scheme, it forgoes huge amounts in tax revenue that it would otherwise see if its own bonds were taxable.

Respondents assert that the dire consequences that Petitioners predict if the Supreme Court declares this long standing practice unconstitutional will simply not come to pass. Indeed, Respondents declare that:

Affirmance will not cause any State to default on its bonds, will not cause the municipal bond market to collapse, and will not require any State to forego repairing its roads or building its schools. It will simply put an end to Kentucky’s discriminatory, inefficient, and counter-productive tax scheme. Resp’t Br. 46.

Indeed, the Respondents note that one scholar has said that “capital-scarce States” would be able to fair much better under a system not pervaded by this discrimination. Id.

Finally, Respondents note that scholars and other observers of the municipal bond market (and States themselves) have long been aware that the current tax regimes are unconstitutionally discriminatory. State legislatures have even studies the matter. This fact undercuts Petitioners’ argument that “‘substantial reliance interests’ counsel in favor” of upholding its tax laws. Widespread use of a practice known by the participants to be unconstitutional should not itself make the practice acceptable by the Court.

[edit] Oral Argument Recap

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 its…bonds.”

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, would…demonstrate 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.

[edit] Opinion Analysis

A copy of the opinion is available here.

Lyle Denniston write the following for SCOTUSblog.


One obvious motivation, and one somewhat more subtle, drove the Supreme Court on Monday to salvage the most common form of state taxing of money that investors make when they buy state or local government bonds — “municipal bonds,” in market parlance. The Court in Kentucky Department of Revenue (06-666) upheld the differing treatment that 41 states give to bonds’ interest — exempting the return on their own issues, while imposing a tax on the income on those sold by other states. The Court, most obviously, was determined to avoid the bold stroke of throwing out what it called “the system of financing municipal improvements throughout most of the United States.” Not so clear, but quite apparent, is that the Court is turning out to be more generous than perhaps had been thought about finding valid public purposes behind some discriminatory economic actions of state and local governments.

Those two observations emerge out of the Court’s new examination of state economic action under the so-called “dormant Commerce Clause” — an examination that, on Monday, led the Justices to issue seven opinions from widely varying perspectives. The “dormant” Clause is the one, invented by the Court, that limits state authority to add burdens to interstate economic activity by discriminating in favor of in-state business. In the face of the fervent opposition of two Justices, the remainder of the Court is not about to abandon that version of the Commerce Clause.

But version is clearly undergoing change. The majority opinion of Justice David H. Souter, in one of its more provocative sections (supported by only five of the nine members), hinted at a change that may come in the future, but did not emerge full-blown Monday. The Court, it seems, is moving away from one aspect of dormant Commerce Clause analysis — the use of the so-called “Pike balancing test” that limits states’ authority when they do not discriminate economically, but take action that still burdens interstate commerce without really producing much local benefit (the test derived from the 1970 decision in Pike v. Bruce Church). The test was put forth as one of the challenges to Kentucky’s different way of dealing with municipal bond interest. But Souter’s opinion refused to apply that test, and the rationale for the refusal was contained in a strongly worded essay on the hazards of having the judiciary make the “very subtle exercise” of weighing costs against benefits in a complex economic setting. (Justice Antonin Scalia wants to abandon the Pike test altogether, but there does not appear to be a majority for that sharp break – at least not yet.)

In the course of his essay on that point, Souter also reinforced the impression that the Court validated the differential system of taxing municipal bond interest out of a genuine concern about disrupting virtually the entire system of raising money in the market to pay for public works. The challengers to Kentucky approach, the opinion said, did not simply ask the Court to “tinker with details of a tax scheme,” but rather to expose the states to the uncertainties of experimentation with their traditional method of financing civic improvements. Souter called that “adventurism,” threatening to undercut “the experience of nearly a century.”

In fact, Souter’s opinion as a whole clearly was motivated by the twin facts that this differential taxing mode has prevailed for so long, and that all 49 other states joined in supporting Kentucky’s right (and their right) to treat their own bonds more favorably tax-wise than their sister states’. So much of Souter’s writing, on all points in dispute, grew out of the unappealing prospect – as he saw it – of compelling the states to start over in “funding the work of government.”

The other motivation was the “public purpose” rationale that Souter deployed. This rationale actually began to emerge most clearly on April 30 of last year, in Chief Justice John G. Roberts Jr.’s main opinion for the Court in United Haulers v. Oneida-Herkimer Solid Waste Management Authority. Under that approach, a state (or local) government’s action that would otherwise violate the dormant Commerce Clause is constitutional if it advances a government, as opposed to a private, economic interest.

On Monday, Souter wrote: “In United Haulers, we explained that a government function is not susceptible to standard dormant Commerce Clause scrutiny owing to its likely motivation by legitimate objectives distinct from the simple economic protectionism the Clause abhors.” Souter went on to judge the Kentucky bond scheme under that precedent, finding that raising money for civic works of government “is a quintessentially public function.” It would be, the opinion added, an “unprecedented interference” to use the dormant Commerce Clause to nullify that kind of function.

It is thus apparent that, as future dormant Commerce Clause cases arise, the concept of “government function” may expand, rather than contract, further enlarging state and local government powers to take economic measures that they deem advisable for the public good as they see it. The Kentucky ruling seems sure to embolden them to craft programs so that they fit the rationale.

On a more immediate level, the opinion does raise a significant question about whether the “public purpose” rationale will be extended beyond municipal bonds so as to allow states to have different tax treatment for ”industrial revenue” bonds or similar issues designed to finance private projects, rather than public works, as such. A footnote in Souter’s opinion said the Court was not deciding that issue, since the issue had not been addressed in lower courts. But, tellingly, perhaps, the footnote at least implied that disrupting such a differential tax system could interfere with “important projects that the states have deemed to have public purposes.”

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