Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.
Conor J. Bennett-Ward
Kentucky v. Davis: A Better Approach to Saving Differential Taxation of Municipal Bonds
What began as a downturn in national housing prices has subsequently degenerated into a global economic crisis. Domestically, the federal government has propped up corporate giants and flooded the markets with billions of dollars in capital to increase liquidity. Furthermore, it has dedicated hundreds of billions of dollars to bailout the country’s financial sector and stimulate the economy. Foreign governments have taken similar measures to support failing banks. The crisis has been deemed by the media, politicians, and the private sector as the worst economic downturn since the Great Depression. As financial lending has come to a standstill, the global economy stands in the midst of recession. In these steadily deteriorating conditions, the Supreme Court’s recent decision in Department of Revenue of Kentucky v. Davis will fortunately preserve an important source of state funding in the states’ differential taxation of municipal bonds.
Computation of Kentucky income tax liability begins with a taxpayer’s “gross income.” Kentucky’s income tax statute provides that, for taxpayers other than corporations, “gross income” means “‘gross income’ as defined in Section 61 of the Internal Revenue Code.” Section 61(b) provides a cross reference to several sections that create specific exclusions from “gross income.” Section 103 creates an exclusion for “interest [earned] on any State or local bond.” Like 40 other states, however, Kentucky includes “interest income derived from the obligations of sister states and political subdivisions thereof” as taxable income. The Court in Davis held that Kentucky’s law does not violate the strictures of the Commerce Clause because the state is not required to “treat itself as being ‘substantially similar’ to the other bond issuers in the market.”
Part I of this Note discusses the relevant facts and reasoning of the Court’s decision in Davis. Part II provides a brief survey of Dormant Commerce Clause jurisprudence. Part III of this Note argues that the Court’s reasoning contradicts established Commerce Clause jurisprudence, mischaracterizes the Court’s holding in Bonaparte v. Tax Court, ignores the technological innovations that have occurred since 1882, and establishes a dangerous precedent for future discriminatory tax regimes in interstate commerce. Despite these criticisms, Part IV argues that the Court ultimately came to the correct conclusion, preserving an important source of revenue for state governments. Accordingly, it outlines an alternative jurisprudential approach that would allow the states to retain this exemption while limiting the likelihood of abusive discrimination by states in the future.