When States Discriminate: The Non‐uniform Tax Treatment of Municipal Bond Interest

• Published date: 01 May 2009
• DOI: http://doi.org/10.1111/j.1540-6210.2009.01992.x
• Date: 01 May 2009

Dwight V. Denison

Merl Hackbart

University of Kentucky

Michael J. Moody

University of Kansas

When States Discriminate:  e Non-uniform Tax Treatment

of Municipal Bond Interest

Fostering Fiscal

Responsibility:

International,

Federal, and Local

Government

Perspectives

Dwight Denison is an associate

professor of public and nonprof‌i t f‌i nance

in the Martin School of Public Policy and

Administration at the University of Kentucky.

His areas of teaching and research include

municipal bond markets, nonprof‌i t f‌i nancial

management, and tax administration.

E-mail: dwight.denison@uky.edu

Merl M. Hackbart is a professor of

f‌i nance and public administration and

associate dean for administration and

academic affairs in the Gatton College of

Business and Economics at the University

of Kentucky.

E-mail: m.hackbart@uky.edu

Michael J. Moody is an assistant

professor in the Department of Public Ad-

ministration at the University of Kansas. His

research interests include public debt policy

and management and tax policy.

E-mail: mjmoody@ku.edu

 ere is a long history of states using tax systems

to encourage residents to invest in bonds issued by

jurisdictions within their state.  is preferential or

discriminatory tax treatment was ruled unconstitutional

in 2006 by the Kentucky Court of Appeals.  e Kentucky

court decision, which sets the stage for this essay, was

overturned by the U.S. Supreme Court in 2008.  is

essay addresses the possible implications of this and similar

discriminatory tax policies. Such discriminatory policies

are the foundation of the municipal bond market, and

altering the practice would have signif‌i cant implications

for revenue collections and borrowing costs in most states

and localities. While the Supreme Court’s position has

been rendered, the case has caused policy makers and

administrators to scrutinize discriminatory tax policies

and their impact on budgets and borrowing costs.

In recent decades, state and local governments

have increasingly relied on municipal bonds to

f‌i nance their capital budgets.  e issuance of

tax-exempt municipal bonds has grown in response

to state and local government capital investment

needs, and the total outstanding municipal issues are

estimated to be approximately $2.3 trillion (Herman

2006). As the interest on most municipal bonds is

exempt from the federal income tax, this subsidizes a

municipal bond issuer’s interest cost and also benef‌i ts

investors.

In addition to the federal tax exemption, there are 36

states that also exempt municipal bond interest from

state income taxes. Bonds with

interest income exempt from

state taxation as well as federal

taxation, referred to as “double

exempts,” are an additional

subsidy for the state and its

localities.  e revenue loss

resulting from double-exempt

bonds has been partially miti-

gated by policies that grant the

tax exemption only for bonds issued within a state. In

other words, states provide the income tax exemption

for state-based issues while taxing interest on munici-

pal bonds issued in other states.

Scholars have long debated the pitfalls and mer-

its of the discriminatory tax on municipal bond

i nterest. However, a recent court case, Davis v.

Department of Revenue of Kentucky (197 S.W.3d

557 [2006 Ky. App.]), brought these issues into the

national limelight; the decision declared unconstitu-

tional K entucky’s statutes limiting the state income

tax exemptions to “in-state” issues. Based on the

“d ormant” commerce clause of the U.S. Constitution,

the Kentucky Court of Appeals found that treating

nonstate issues dif‌f erently than state-based issues was

an infringement on interstate commerce, which is pro-

hibited by the commerce clause.  e court’s declara-

tion was appealed to the U.S. Supreme Court, which

recently overruled the Kentucky Court of Appeals

position (Docket no. 06-666, 553 U.S. __ [2008]).

 e issues raised by this and similar discriminatory tax

policies of other states and localities highlight impor-

tant policy concerns for state and local governments.

 is article, which addresses the possible implica-

tions of this and similar discriminatory tax policies,

was written and accepted for publication prior to the

S upreme Court’s decision. Although the S upreme

Court has rendered a decision, the case has caused

policy makers and administrators to scrutinize

d iscriminator y tax policies and their impact on bor-

rowing costs. Our objective in this paper is to consider

the implications of discrimina-

tory tax treatment on municipal

bond interest in the context of

the issues raised in the Davis

case. A primary objective is to

analyze the impact of the state

tax exemption on the yields of

municipal bonds. We discuss

the basis of the Davis ruling by

the Kentucky Court of Appeals.

We also identify several policy and market implica-

tions that would result from reversing the traditional

In addition to the federal tax

exemption, there are 36 states

that also exempt municipal

bond interest from state income

taxes.

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