Davis v. Kentucky (Muni Bond Case)

Story: http://www.financialweek.com/apps/pbcs.dll/article?AID=/20070806/REG/70803026/1036 The basics: A group of taxpayers in Kentucky claimed that the following practice was unconstitutional. "providing an exemption from state income tax for interest income derived from bonds issued by the state and its political subdivisions, while treating interest income realized from bonds issued by other states and their political subdivisions as taxable to the same extent and in the same manner as interest earned on bonds issued by commercial entities, whether domestic or foreign.” The U.S. Supreme court has decided to hear the case and it may happen by early 2008. I wanted to see what everyone’s thought are if the Supreme court decides that the taxation on out of state bonds is unconstitutional. This could be a nice benefit to muni bond investors as it will allow greater diversification across state lines without the additional tax that is currently in affect. However, what happens to the taxes the states would normally receive? Where would that be made up? I would imagine that the most likely course of action is for the states to begin taxing all muni bond issues (even their own). So what happens then? States start taxing all muni bond issues, investors start requiring higher yields and states begin to issue munis with higher yields. The muni bond market would probably get quite competitive between states and like the article mentions, states like California would need to up their yields due to it’s creditworthiness. But what do you think?

Ive been following this for a few months now. This is gonna be interesting. It certainly works in the favor of the investor - will allow them to diversify their muni portfolio across geopgraphic regions. I dont think states will tax all muni bond issues…rather, i think that states will no longer tax income on out of state issues. As a result, states will lose revenue and they will be forced to bring more competitive issues to mkt.

If KY loses, states will begin taxing ALL muni bonds. Never met a government entity that was going to give up tax revenue. Not sure what the final numbers would look like for all states, but some would see a net gain in tax revenues (new tax revenues from all muni bonds held by residents less higher interest expense the state would pay on their bonds). Yields will rise (some), but it’s not going to make much of a difference for issuers…so you raise taxes (or whatever the security is) by a hair more to cover debt service. Investors would benefit from a diversification standpoint, and maybe higher after state tax yields. FL experienced something similar when they revoked their intangibles tax. Yields rose, but not by much. With that said, I think the USSC is going to side with KY. They ruled on a somewhat similar case dealing with trash hauling the last session. They were kind of forced to take this case because the 33 other states that have a similar tax structures as KY would have seen similar suits, with most getting appealed to the USSC.

Assuming KY loses the case and all states start taxing muni bond interest, I would expect yields to increase by the average state income/intangibles tax rate. Most states seem to fall in the 6 - 8% range, so coupons would rise just a little and yield dispersion would certainly tighten. Assuming KY loses the case and all states DON’T tax muni bond interest, states that have gotten away with low coupons will see their funding costs increase significantly. Either way, it would be bad news for state-specific muni bond mutual funds. They either become national muni bond funds or they fold. A question to jbisback; wouldn’t siding with KY essentially be legislation via judiciary? Since lower courts have sided with the plaintiffs, it would appear the USSC would have to pull a rabbit out of their hat to overturn the previous legal rulings.

^ Further to that, remember that the Supremes are a conservative court now, and will not change the standard unless there is an obvious infringement on constitutional rights. My feeling is that the Court is hearing this to affirm the decision which will stand for quite a while. But why would they choose to hear this case in the first place then? Perhaps they have other opinions.