WASHINGTON — Supreme Court justices signaled Monday that they were likely to uphold states' long-standing practice of giving tax breaks to residents who buy their municipal bonds, while taxing the bonds of other states.
The justices heard arguments in a Kentucky case that had the potential to upset the $2.6-trillion municipal-bond market.
For decades, most state and local agencies have raised money for schools, roads and other projects by selling bonds that are free from federal and in-state taxes.
To give their bonds even more of a competitive edge in attracting in-state investors, California and most other states assess taxes on the interest earned on out-of-state bonds.
Two Kentucky investors in 2003 challenged the practice as unconstitutional. They contended that Kentucky engaged in a form of protectionism by making its bonds tax-free while taxing debt of other states. Last year, a state appellate court agreed, spurring Kentucky to petition the Supreme Court.
All 49 states joined Kentucky in urging the high court to reverse the state court's ruling. On Monday, most of the justices sounded as though they were inclined to do just that.
"We have an enormous market" in municipal bonds that has been created over many years, said Justice David H. Souter. "That seems to me a very good reason for giving a nod" to the states, he added.
But the court also struggled to make sense of its own conflicting precedents. For 200 years, the Constitution has been interpreted as protecting the free flow of commerce, and the court has struck down state laws that discriminate in favor of home-state products.
For example, the court two years ago struck down laws in Michigan and New York that allowed their home-state wineries, but not out-of-state wineries, to ship bottles and cases directly to customers.
But during Monday's arguments, the lawyer for Kentucky insisted that the government's own products were different from private products that move across state lines.
"This court has never held that a law which favors government . . . rather than private business enterprises violates" the Constitution, said Atlanta-based attorney C. Christopher Trower, representing Kentucky.
But the lawyer for the Kentucky investors said bonds were sold in a national market. "We have this very clear rule that says states cannot engage in facially discriminatory taxation," said G. Eric Brunstad Jr., a business litigator based in Hartford, Conn.
The state tax exemption for muni bonds is seen as particularly important in such high-tax states as California and New York. Their investors are less willing to buy the bonds of other states because they would be giving up a sizable tax break.
The Kentucky tax case has drawn the attention of state officials across the country. If Kentucky were to lose, many states could face demands for refunds from millions of taxpayers.
The case appeared to split the court's leading conservatives.
Justices Samuel A. Alito Jr. and Anthony M. Kennedy questioned why a state should be allowed to favor its own bonds.
"Any favored legislation favoring local industry helps the state," Kennedy said. "That's why the Commerce Clause exists as a check."
But Justices Antonin Scalia and Clarence Thomas have disagreed with this approach. They have noted in the past that the Constitution says only that "the Congress shall have power . . . to regulate commerce" -- and because Congress has not regulated muni bonds, the argument is that states may do as they choose.
Chief Justice John G. Roberts Jr. has not adopted the Scalia-Thomas approach, but he also has said that the court should be wary of acting on its own to strike down long-standing policies.
A ruling in the case, Department of Revenue of Kentucky v. Davis, will be handed down in a few months.