Business Law and the Regulation of Business 11th Edition by Richard Mann, Barry Roberts

Exercise 17

FACTS Kentucky, like forty other states, exempts from state income taxes interest on bonds issued by it or its political subdivisions but not on bonds issued by other states and their subdivisions. The differential tax scheme in Kentucky benefits its residents who buy its bonds by effectively lowering interest rates. After paying state income tax on out-of-state municipal bonds, plaintiffs sued Kentucky for a refund, claiming that Kentucky's differential tax impermissibly discriminated against interstate commerce. The trial court ruled for Kentucky. The State Court of Appeals reversed, finding that Kentucky's scheme violated the Commerce Clause. The United States Supreme Court granted certiorari.
DECISION The judgment is reversed, and the case is remanded.
OPINION Souter, J. The significance of the scheme is immense. Between 1996 and 2002, Kentucky and its subdivisions issued $7.7 billion in long-term bonds to pay for spending on transportation, public safety, education, utilities, and environmental protection, among other things. [Citation.] Across the Nation during the same period, States issued over $750 billion in long-term bonds, with nearly a third of the money going to education, followed by transportation (13%) and utilities (11%). [Citation.] Municipal bonds currently finance roughly two-thirds of capital expenditures by state and local governments. [Citation.]
Funding the work of government this way follows a tradition going back as far as the 17th century. [Citation.] ***
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The Commerce Clause empowers Congress ''[t]o regulate Commerce…among the several States,'' Art. I, § 8, cl. 3, and although its terms do not expressly restrain ''the several States'' in any way, we have sensed a negative implication in the provision since the early days, [citation]. The modern law of what has come to be called the dormant Commerce Clause is driven by concern about ''economic protectionism-that is, regulatory measures designed to benefit in-state economic interests by burdening out-of-state competitors.'' [Citation.] The point is to ''effectuat[e] the Framers' purpose to 'prevent a State from retreating into [the] economic isolation,''' [citation], ''that had plagued relations among the Colonies and later among the States under the Articles of Confederation,'' [citation].
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Under the resulting protocol for dormant Commerce Clause analysis, we ask whether a challenged law discriminates against interstate commerce. [Citation.] A discriminatory law is ''virtually per se invalid,'' [citation], and will survive only if it ''advances a legitimate local purpose that cannot be adequately served by reasonable nondiscriminatory alternatives,'' [citation.] Absent discrimination for the forbidden purpose, however, the law ''will be upheld unless the burden imposed on [interstate] commerce is clearly excessive in relation to the putative local benefits.'' Pike v. Bruce Church, Inc., [citation]. State laws frequently survive this Pike scrutiny, [citation], though not always, as in Pike itself, [citation].
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*** In [citation], 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, [citations]. This logic applies with even greater force to laws favoring a State's municipal bonds, given that the issuance of debt securities to pay for public projects is a quintessentially public function, with the venerable history we have already sketched, [Citation.]. By issuing bonds, state and local governments ''sprea[d] the costs of public projects over time,'' [citation], much as one might buy a house with a loan subject to monthly payments. Bonds place the cost of a project on the citizens who benefit from it over the years, *** and they allow for public work beyond what current revenues could support. [Citation.] Bond proceeds are thus the way to shoulder the cardinal civic responsibilities listed in [citation]: protecting the health, safety, and welfare of citizens. It should go without saying that the apprehension in [citation] about ''unprecedented … interference'' with a traditional government function is just as warranted here, where the Davises would have us invalidate a century-old taxing practice, [citation], presently employed by 41 States, [citation], and affirmatively supported by all of them, [citation].
[T]he Kentucky tax scheme parallels the ordinance upheld in [citation]: it ''benefit[s] a clearly public [issuer, that is, Kentucky], while treating all private [issuers] exactly the same.'' [Citation.]
Kentucky's tax exemption favors a traditional government function without any differential treatment favoring local entities over substantially similar out-of-state interests. This type of law does ''not 'discriminate against interstate commerce' for purposes of the dormant Commerce Clause.'' [Citation.]
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A look at the specific markets in which the exemption's effects are felt both confirms the conclusion that no traditionally forbidden discrimination is underway and points to the distinctive character of the tax policy. The market as most broadly conceived is one of issuers and holders of all fixed-income securities, whatever their source or ultimate destination. In this interstate market, Kentucky treats income from municipal bonds of other States just like income from bonds privately issued in Kentucky or elsewhere; no preference is given to any local issuer, and none to any local holder, beyond what is entailed in the preference Kentucky grants itself when it engages in activities serving public objectives. *** These facts suggest that no State perceives any local advantage or disadvantage beyond the permissible ones open to a government and to those who deal with it when that government itself enters the market. [Citation.]
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In sum, the differential tax scheme is critical to the operation of an identifiable segment of the municipal financial market as it currently functions, and this fact alone demonstrates that the unanimous desire of the States to preserve the tax feature is a far cry from the private protectionism that has driven the development of the dormant Commerce Clause. ***
INTERPRETATION State law exempting from state income taxes interest on bonds issued by that state or its political subdivisions but not on bonds issued by other states and their subdivisions does not impermissibly discriminate against interstate commerce.
CRITICAL THINKING QUESTION Had the Court invalidated Kentucky's taxing scheme, what would the impact have been on the states' ability to finance their operations?