Bond taxes stay the same

U.S. Supreme Court says changing exemptions would equal meltdown

Investors who buy bonds that are sold to pay for local government projects still can enjoy state tax exemptions on the interest they earn, but they also will continue to be taxed on bonds issued by other states.

The U.S. Supreme Court, in a 7-2 ruling, upheld a Kentucky law Monday that exempted state residents from paying income tax on municipal bonds issued there but taxed interest on bonds issued in other states.

Some 42 U.S. states, including South Carolina, have similar laws.

The ruling not only prevented a potentially huge disruption of the 90-year-old, $2.5 trillion municipal bond market, it also averted a potential meltdown of local and state finances across the nation, industry experts said.

In the case before the court, taxpayers George and Catherine Davis of Jefferson County, Ky., challenged Kentucky law because it required the couple to pay income tax on bonds they held from other states. The Davises said the Kentucky law violated the commerce clause of the U.S. Constitution, which gives Congress authority to regulate commerce that crosses state lines. It is well-established in the courts that the commerce clause prohibits states from discriminating against interstate trade.

The high court's decision prevented possible turmoil in the bonds market, local financial experts said.

North Charleston-based certified financial planner Doug English of Scientific Investors said removing the in-state tax exemptions could have made bonds less attractive to investors. Rather than earning a tax-free 4 percent return, for example, those investors would have faced state taxes of 7 percent of that 4 percent.

"If you take away the tax exemption, you take away the incentive to buy municipal

bonds," English said.

Paul C. MacDonald, a chartered financial consultant and president of MacDonald Financial Group in Mount Pleasant, said bond issuers might have been forced to offer higher interest rates on future bond issues to draw investors. That could lead to higher taxes.

For example, if South Carolina offers bonds paying an interest rate of 5 percent and Florida offers bonds paying 6 percent, the in-state bonds are more attractive to a Palmetto State resident because the interest on the South Carolina bonds is tax-free, whereas that on the Florida bonds is taxed.

Eliminating either the tax exemption on the South Carolina bonds or the tax on the Florida bonds would mean the higher-interest bonds always would be more attractive to investors. And offering a higher interest rate would increase the state's borrowing costs and reduce its ability to fund needed projects.

"The consequences of that could have been extraordinary," MacDonald said.

Some $432 billion in municipal bonds were issued nationally in 2006. In 2004, some 4.4 million investors earned $52 billion in interest on municipal bonds.

Municipal bonds finance education, the operations of state and local governments and the purchase of public lands, as well as construction and improvement of public buildings, transportation systems and water and sewer facilities.

Private-activity bonds, another category of municipal bonds, supports nongovernment entities such as hospitals, airports, small factories and colleges and universities.

In the majority opinion for the court, Justice David Souter said the state tax exemptions go back to 1919 and have not hindered commerce among the states.

In dissent, Justice Samuel Alito said the majority decision "invites other protectionist laws."

Souter responded that the dissent "rightly praises the virtues of the free market." But Souter said overturning the exemptions now would upset the market in bonds based on the experience of nearly a century.

The Associated Press contributed to this report. Reach Peter Hull at phull@postandcourier.com or 937-5594.