The renewed battle over tax exemption of interest on state and local government debt obligations.

• Author: Spiotto, James E.

To place the borrowing capacities of the state and its governing agencies at the mercy of the federal taxing power would be an impairment of the essential right of state which, as its officer, I am bound to defend." New York Governor Charles Evans Hughes said in his 1910 Message of Submission of the Proposed Sixteenth Amendment to the State Legislature. (1) Thus, even before the passage of the Sixteenth Amendment, the question had been raised about how an income tax would affect the ability of state and local governments to finance infrastructure and essential governmental services as they deemed appropriate. Hughes' words could be uttered today by any governor of any state or any mayor of any city In times of economic downturn, federal, state, and local governments all need to find additional sources of tax revenues. When the traditional sources of tax revenue, income, sale, property, and business activity are in decline, the federal government typically explores "creative solutions," and recently, it has renewed interest in revisiting the traditional exemption of state and local debt obligations from federal income tax--a line the federal government has not chosen to cross for more than 200 years. (2)

The ability of state and local governments to incur debt in order to finance the uneven flow of tax revenues, infrastructure, or other essential governmental services is well established and fundamental to their basic operation. Without that access, decisions about necessary infrastructure or services could not be made, funded, or implemented locally without the approval, or possibly the interference, of other governmental entities. That would be a fundamental change in the form and substance of government as we know it, which has provided the nation's extensive and sophisticated public works system on a state and local level.

Further, while everyone appreciates the need for the federal government to find new sources of revenue and the difficulty of cutting costs and increasing tax rates, taxing interest on state and local government debt would not, as a practical matter, increase federal revenues or address the problem. Rather, taxing interest on municipal bonds merely shifts the cost of tax expenditures, creating unfunded mandates on the state and local government level. Unfunded mandates have increased over the past 50 years, as federal assistance has decreased, and it has become more apparent that states and local governments have weathered economic downturns (11 since 1949) successfully, for the most part, without federal assistance. (3) Further, the cost of roads, highways, water and sewer systems, and other forms of infrastructure and public improvements over the past 50 years has increasingly been borne by state and local governments, which now pay more than three quarters of those costs, with decreasing participation by the federal government. In past history, the equation was almost the reverse.

When the federal government considers its options for cutting overall indebtedness, the resulting solutions should not shift new burdens to the state and local governments. Further, real solutions should not threaten to increase state and local governments' costs and expenses or adversely affect their ability to make local decisions regarding the matters reserved to them. Any other result would adversely affect state and local governments' access to and cost of borrowing, and their ability to address local matters and concerns, infrastructure, and services.

Accordingly, in reviewing the practical realities, the legal bases, and the appropriate relationship between co-sovereigns, the federal government, and the states with their sub-sovereigns, the true philosophy of the Constitution should not be altered or modified by legislation. (Given our unique form of federalism in the United States, the federal government and states are co-sovereigns, and municipalities are the sub-sovereigns of our state governments.) The Constitution recognizes the essential rights of states and their citizens to deal with the matters reserved to them without inappropriate interference or influence on those decisions. Imposing a heretofore non-existent tax on the interest on state and local government debt payments raises the fundamental question of whether such legislation is a fundamental change in the form of government that can only be accomplished by amending the Constitution; no court would be justified in assuming the people intended to permit a drastic alteration in the structure of government unless that intention was unmistakably expressed in an amendment approved by the people.

THE COURT BATTLES

The Tenth Amendment and Sovereign Tax Immunity. The roots of the constitutional restriction on taxation of municipal bonds can be traced to the Tenth Amendment to the Constitution, which states that all powers not expressly granted to the national government under the Constitution are reserved to the states and the people. This amendment embodies the doctrine of state sovereignty, the dual system of government that provides for two distinct governmental entities: a national government and state governments as co-sovereign. This principle received an important judicial test following the enactment of a federal income tax law.

The Pollock Case and the Federal Income Tax Law. In 1894, Congress enacted a federal income tax law. Not unexpectedly, this law was challenged on a number of grounds, including that imposing a tax upon income received from state and municipal bonds made the law invalid. The challenge was ultimately reviewed by the United States Supreme Court in the case of Pollock v. Farmers' Loan &amp...