Reply Brief — Department of Revenue of Ky. v. Davis

71 52439 FILED

OCT 26 2007

aS P45 GB) OFFICE OF THE CLERK

No. 06-666 SUPREME COURT, U.S.

IN THE

Supreme Court of the Gnited States

DEPARTMENT OF REVENUE OF THE COMMONWEALTH OF

KENTUCKY, AND FINANCE AND ADMINISTRATION CABINET

OF THE COMMONWEALTH OF KENTUCKY,

Petitioners,

v.

GEORGE W. DAVIS AND CATHERINE V. DAVIS,

Respondents.

°

ON WRIT OF CERTIORARI

‘TO ‘THE COURT OF APPEALS OF KENTUCKY

.

REPLY BRIEF FOR PETITIONERS

Douglas M. Dowell C. Christopher Trower

Donald S. Guier vounsel of Record

Office of Legal Services electriclaw.com

for Revenue 3159 Rilman Rd., N.W.

Finance and _ Atlanta, GA 30327-1503

Administration Cabinet (404) 816-5066

Commonwealth of Kentucky

200 Fair Oaks Lane Gwen R. Pinson

P.O. Box 423 Office of General Counsel

Frankfort, KY 40602 Finance and

(502) 564-3112 Administration Cabinet

-———————

Commonwealth of Kentucky

\ 188 Capitol Annex Building

Frankfort, KY 40601

(502) 564-6660

Counsel for Petitioners

October 26, 2007

a

—a_ — LL

TABLE.OF CONTENTS

Page

(sg, TN NEN a On i

Te Ce FF a rtnctesevsstcccesecsnscrncscesssscescorsssesies ili

REPLY BRIEF FOR PETITIONERG...............cscccsoscsssssoceeses l

I. THE KENTUCKY LAW DOES NOT

“DISCRIMINATE” AGAINST INTER-

Ey ei iicnnieetecetnatetenistntntetneeennesere: I

A. United Haulers makes private business

taxes and tariff analogies inapposite................... |

B. “Public” means SOVETCIQD .........0.+...ececsecsseceeeeseres 4

Il. THE ALLEGED PAST HARMS AND FU-

TURE BENEFITS ARE UNSUPPORTED

REE ea ee 7

Il. A TAX EXEMPTION FOR BOND IN-

TREST RECEIVED IS EQUIVALENT TO

THE PAYMENT OF ADDITIONAL IN-

IE itiiiclidedaeaictenliaiiitainilantncisitaniaiinbiectnceninipeinanes 10

A.All market participants treat the exemp-

tion as additional interest ...................eeeseeeeee es 11

B. Economic substance is the touchstone.............. 12

C.The exemption-equals-subsidy issue is

SEES Ee ae 13

D. Economic reality shows no market harms

and no “discrimination” .............:...scccssseseeseeees 14

E. A quid pro quo tax exemption is not a

TUITE” sctiessbciedieleiuslieds Sicthiandiaetaintealéiaideaseibuemnimibiiten 15

IV. A MARKET PARTICIPANT STATE MAY

USE ITS TAX POWER AS PART OF A

NS REESE

V. RESPONDENTS’ IMPORT-EXPORT

CLAUSE ARGUMENT IS NEITHER

TIMELY NOR APPLICABLE TO INTER-

STATE COMMERCE OR TO INTEREST

UID cccpieorinninnseesineennninvisneunemapnanaseenenteasetatan

TABLE OF AUTHORITIES

Cases:

Best & Co. v. Maxwell, 311 U.S. 454 (1940)... ccctgieiibasideniigied 12

Bonaparte v. Tax Court, 104 U.S. (14 Otto) 592 (1881) ...6, 7

Boston Stock Exchange v. State Tax Comm’n, 429 U.S. 318

GOD ceinsstatrntencteapevtenanennngemneentnieammeeeninemiapinnepitia 17

Camps Newfound/Owatonna, Inc. v. Town of Harrison, 520

| S| Eee een a 13, 16, 19

Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977)..2

DaimlerChrysler Corp v. Cuno, 126 S.Ct. 1854 (2006) ........ 4

General Motors Corp. v. Tracy, 519 U.S. 278 (1997).....9, 10

Kentucky v. Stincer, 482 U.S. 730 (1987) .........c:ccsseeeeseeees 18

McGoidrick v. Campagnie Generale, 309 U.S. 430 (1940). 18

New Energy Co. v. Limbach, 486 U.S. 269 (1988)

eainmeseonenetnnogeeneprensenertonssnepeenonennenninsetaninetviatetate 13, 15, 16, 17

Pike v. Bruce Church, Inc., 397 U.S. 137 (1970)......00.sseseee 2

Reeves, Inc. v. Stake, 447 U.S. 429 (1980)............:00008 3, 13, 16

South-Central Timber Dev., Inc. v. Wunnicke, 467 U.S. 82

PID sistiincchccincensdinrnnttutionhnianinidensiaibindiiianeituigeitit 12, 15, 16

United Haulers Ass'n, Inc. v. Oneida-Herkimer Solid Waste

Management Auth., 127 S.Ct. 1786 (2007)............... passim

iil

West Lynn Creamery, Inc. v. Healy, 512 U.S. 186 (1994)....2,

12, 13

White v. Massachusetts Council of Construction Employers,

Ss AI ccichsdctisisichineiuitpicintidiennichciiiatiliinclatedesnatie 17

Woodruff v. Parham, 75 U.S. (8 Wall.) 123 (1868)............. 18

Constitutional Provisions, Statutes, and Regulations:

FE ENCE ede Je ONDE NSE Cee PE ZR 4

ee ee NT iach icici sntiahictpneicianetbiichtnpeiiiie biti 4

Miscellaneous:

Belmonte, Tax Exempt Bonds, 1996-2002 (IRS Statistics of

SU isc nsiseesits esipenntilatenicniniaeninticacibiictingl 4

Belmonte, Tax-Exempt Bonds, 2003-2004 (IRS Statistics of

ES Fe chcherectiitiscinicititincindiniannieiliestcies 4,10

Enrich, Saving the States from Themselves: Commerce

Clause Constraints on State Tax Incentives for Business,

Si Pees Eins GND OFF CIO sniicosssieendesnsconieinoniepiatemnsenion 13

Philip M. Tatarowicz & Rebecca F. Mims-Velarde, An

Analytical Approach to State Tax Discrimination Under

the Commerce Clause, 39 Vand. L. Rev. 879 (1986) ......18

iv

Proceedings and Acts of the [Maryland] General Assembly,

March 30, 1868, vol. 142, p. 2742, Laws of Maryland ch.

DB ertatuinspeesincinticimnonstineahenisemmbanacstinttieanniapatiiininhleavinens 7

Temel, The Bond Market Association, 7he Fundamentals of

Municipal Bonds (5™ ed. 2001).......2.ovs-ssusesvsessoesssseessesseee 11

Van Bergen, Weighing the Tax Benefits of Municipal

Securities, Investopedia.com (July 28, 2004).............:++++ 12

Walter Hellerstein and Dan T. Coenen, Commerce Clause

Restraints on State Business Development Incentives, 81

Cornell L.Rev. 789, & © -09 (1996) ........csccsccscesseseeeeenens 18

REPLY BRIEF FOR PETITIONERS

The dormant Commerce Clause should not be ex-

panded beyond laws that involve differential treatment of

private businesses. A capital markets free-for-all pitting the

States and their 87,000 local governmental units against each

other would be politically and economically destructive.

I. The Kentucky law does not “discriminate” against

interstate commerce.

A. United Haulers makes private business tax-

es and tariff analogies inapposite.

Language from pre-United Haulers cases which

struck down tax laws treating in-state private businesses

more favorably than out-of-state private business competi-

tors, Resp. Br. 12-17, does not apply to this case. Neither the

holdings nor the language of those cases impeded the Court’s

conclusion in United Haulers Ass'n, Inc. v. Oneida-Herkimer

Solid Waste Management Auth. 127 S.Ct. 1786, 1795

(2007), that laws which “benefit a clearly public facility,

while treating all private companies exactly the same” do not

“discriminate against interstate commerce.” United Haulers

expressly found a long line of cases invalidating local

processing laws, “every one of which involved discrimina-

tion in favor of private enterprise” to be “readily distinguish-

able,” and declined to extend those cases “to cover

discrimination in favor of local government.” Jd at 1794 &

n.4. There is no good reason to expand the language of tax

cases involving private business enterprises, to a case which

instead involves the financing of public projects and pro-

grams by State and local governments.

“ea

The notion that the Kentucky law is “equivalent to a

tariff,” Resp. Br. 18-19, similarly misses the point of United

Haulers. If differential treatment of in-state trash processing

services provided by a sovereign government, versus all oth-

er trash processing services, both in-state and out-of-state,

does not constitute “discrimination against interstate com-

merce,” then differential treatment of in-state interest paid by

a sovereign government, versus all other interest paid by bor-

rowets, both in-state and out-of-state, does not constitute

“discrimination against interstate commerce.”'

Nor does the analogy between the Kentucky law and

a “protective tariff,” the “paradigmatic example of a law dis-

criminating against interstate commerce,” West Lynn Crea-

mery, Inc. v. Healy, 512 U.S. 186, 193 (1994), fit the facts of

this case. The other 49 States, including all seven States that

do not impose an income tax, are the out-of-state competitors

whose bonds are subject to this imaginary tariff, yet they

support Kentucky’s position here. The in-state entity “pro-

' The Kentucky law thus satisfies the only prong of the four-part test of

Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977), put in issue. -

The law also meets the other three requirements, see Pet. Br. 15-17, an

observation not disputed by the Brief for Respondents. The belated sug-

gestion that this case be remanded for a Pike balancing inquiry, see Resp.

Br. 42-43, is neither warranted by the Court’s decisions in tax cases over

the past 30 years, see Pet. Br. 15 & n.14, nor necessary. The other 49

States and their local governments, as well as the Multistate Tax Com-

mission, the National Association of State Treasurers, the Government

Finance Officers Association, and the Securities Industry and Financial

Markets Association, support Kentucky’s position, negating any serious

thought that the “burden imposed” on interstate commerce “is clearly

excessive in relation to the putative local benefits” to Kentucky and its

local governments of obtaining market access for their own bonds on

favorable credit terms, see Pike v. Bruce Church, Inc., 397 U.S. 137, 142

(1970).

tected” by this imaginary tariff is the sovereign government

of Kentucky, not private businesses in the local dairy indus-

try, the local liquor business, or the local stock exchange.

The Court has pointedly noted that the “label of protection-

ism [is] of little help” when, as here, a State itself participates

in the relevant market as a buyer or seller, Reeves, Inc. v.

Stake, 447 U.S. 429, 442 (1980); accord, id. at 447 n.1

(Powell, J., dissenting) (“By ‘protectionism,’ I refer to state

policies designed to protect private economic interests within

the State from the forces of the interstate market.”)

The tariff analogy breaks down completely when we

recognize that the law upheld in United Haulers was the ex-

act equivalent of a “home embargo,” the other chief exemplar

of laws that “discriminate against interstate commerce.” Si-

milarly, the laws upheld in Alexandria Scrap and White fo-

reclosed competition by out-of-state workers for in-state jobs

just as effectively as a blockade at the state line.

Respondents’ argument by analogy does not advance

the analysis in this case. Laws “like” home embargoes and

“like” border blockades have been upheld against dormant

Commerce Clause challenges in those cases where the law

favored a governmental entity (United Haulers) or where the

State or local government was a market participant (Reeves,

Alexandria Scrap, and White). This case involves both a law

which favors only a State and its local governments, and a

fact pattern in which the market participation of the State and

its local governments is undisputed. No doubt the tax laws

of 42 States treat sister State bond interest differently than

interest paid on their own bonds. The issue is whether the

reasoning of United Haulers, which speaks directly to a law

that favors the State or local government itself, should chan-

nel the inquiry here, rather than cases involving different tax-

ation of in-state versus out-of-state private business firms.”

B. “Public” means sovereign.

Respondents apparently concede that Kentucky’s ex-

emption for interest paid on Kentucky bonds does not violate

? Amici Viard ef al. argue that the state tax exemption for interest paid on

“private activity bonds” should not be sustained under United Haulers

because “private parties are the actual borrowers, not state or local gov-

ermments.” Viard Am. Cur. Br. 26. This is both an oversimplification

and a non-sequitur. “Private activity bonds” issued by States and local

governments finance projects and programs that serve overwhelmingly

public purposes. Over 80% of all “private activity bonds” issued from

1996-2004 financed (i) tax exempt entity projects (primarily hospitals

owned by 501(c)(3) entities), (ii) airports, (iii) multifamily housing

projects and low-to-moderate income mortgage loan programs, and (iv)

student loan programs. Belmonte, Tax-Exempt Bonds, 2003-2004, pp.

246, 255-256 (IRS Statistics of Income Division 2006); Belmonte, Tax

Exempt Bonds, 1996-2002, pp. 151-158 (IRS Statistics of Income Divi-

sion 2005). Congress has expressly authorized “private activity bonds” to

be treated the same as “governmental bonds,” i.e., as a permissible use of

public finance to support Congressionally specified types of projects that

are in turn approved by State and local governments as means of accom-

plishing State and local governmental objectives. Such bonds must be

approved by a State or local government, see 26 U.S.C. § 147(f), and are

used to finance public infrastructure facilities such as docks and wharves,

mass commuting facilities, solid waste disposal facilities, sewage facili-

ties, and high-speed intercity rail facilities, see 26 U.S.C. § 142(a) (defini-

tion of “exempt facility bonds” classified as “private activity bonds”).

The issue sought to be raised by Amici — that state tax exemptions for

private activity bonds should be invalidated even though the exemption

for other State and local bonds is sustained —- was never raised in the

courts below, and should not be considered by the Court now. Nothing in

the record reveals whether the sister State bonds held by Respondents are

governmental bonds or “private activity bonds,” so Respondents have no

standing to raise any claim related exclusively to “private activity bonds.”

DaimlerChrysler Corp v. Cuno, 126 S.Ct. 1854, 1867 (2006) (“a plaintiff

must demonstrate standing for cach claim he secks to press”).

4

the dormant Commerce Clause notwithstanding that Ken-

tucky taxes interest paid on bonds or other debt obligations

issued by all private borrowers, both in-state and out-of-state.

Respondents argue nonetheless that Kentucky treats “similar-

ly situated public entities” differently than Kentucky itself,

Resp. Br. 24-25, an argument which begs the question

whether sister States and local governments are “public” enti-

ties within Kentucky.

A sister State has no powers or responsibilities within

Kentucky that are any different than the powers and respon-

sibilities of a private business corporation in its business

dealings with Kentucky creditors. The only relationship of

the sister State to a Kentucky resident bondholder is contrac-

tual (debtor and creditor), not political (sovereign and citi-

zen), just like the relationship of a private business debtor to

its creditors. If the sister State defaults on its bonds, it may

be sued in Kentucky just like any private business borrower.

Conversely, a sister State has none of the powers and

responsibilities within Kentucky that are unique to “public”

entities in Kentucky. A sister State has no police power in

Kentucky, either directly through its law enforcement offic-

ers or indirectly through the extraterritorial application of its

laws. A sister State cannot tax Kentucky rea! property or in-

tangible property owned by a Kentucky resident.

That municipal bonds issued by different States may

be “similar financial commodities traced in the same mar-

ket,” Resp. Br. 20-25, is irrelevant. The out-of-state trash

processing facilities in United Haulers were no doubt “simi-

lar” to the in-state public facility, and were viable competi-

tive alternatives in the market. The effort to distinguish

United Haulers because it was a police power case rather

than a tax case, Resp. Br. 31-32, is a distinction without a

5

has

=

difference. The claim that, unlike United Haulers, the bur-

den of the Kentucky law falls on those who cannot vote in

Kentucky, Resp. Br. 28-29, 32-33, is mystifying. Respon-

dents and every other Kentucky resident bondholder 18 or

over who pays tax on sister State bond interest, are eligible to

vote in Kentucky. The arguments that a law which favors a

sovereign government versus all other entities, non~theless

treats in-state and out-of-state entities in “a facially © «parate

manner” and constitutes "simple economic protectionism” in

violation of the dormant Commerce Clause, Resp. Br. 7, 12-

17, 19-20, were considered and rejected in United Haulers.

Bonaparte, Georgia v. Chattanooga, Nevada v. Hall,

and the Court’s federalism cases, see Pet. Br. 29-35, apply

the constitutional principle that one State is not a “public”

entity within another State’s jurisdiction, which Respondents

try to deflect by noting that these decisions were not Com-

merce Clause cases. This mistakes the trees for the forest.

Bonaparte v. Tax Court, 104 U.S. (14 Otto) 592

(1881), is most instructive on the specific issue: “[I)f a State

could protect its securities from taxation everywhere, it might

succeed in borrowing money at reduced interest; but, inas-

much as it cannot secure such exemption outside of its own

jurisdiction, it is compelled to go into the market as a bor-

rower, subject to the same disabilities in this particular as in-

dividuals.” 104 U.S. at 595.

Respondents misread this crucial holding as referring

to the taxing State, rather than the borrowing State, see Resp.

Br. 40. That Bonaparte referred to the borrowing State is,

however, clear from its holding in the immediately preceding

that “the debtor State is in no respect his [the resi-

dent of the taxing State] sovereign, neither has it any of the

attributes of sovereignty as to the debt it owes.” 104 U.S. at

6

595.° It is the sister State as borrower that “cannot secure

such exemption outside of its own jurisdiction,” i.e., within

Kentucky, is “subject to the same disabilities . . . as individu-

als” and other private borrowers within Kentucky.

Precisely because a debtor State with no sovereign

power or responsibility within Kentucky is no different than

a private business borrower, the Kentucky law challenged

here should be sustained by a straightforward application of

the United Haulers analysis. United Haulers would have

reached the same result, by the same reasoning, if the out-of-

state trash processing facilities had been owned by a sister

State rather than a private business entity.

Il. The alleged past harms and future benefits are un-

supported in the record.

The Brief for Respondents claims that the Kentucky

law “harms out-of-state issuers” and “out-of-state private sel-

lers (underwriters, individuals, and investment funds)” by

“blocking their access” to capital in Kentucky; “harms the

> Respondents attempt to dilute Bonaparte’s strength by pointing out that

the 1876 Maryland property tax statute at issue in Bonaparte did not gen-

erally exempt State bonds, Resp. Br. 39-40. But no such exemption

would have been necessary: Maryland had exempted its own bonds un-

der the statutes authorizing the issuance of State bonds, see, e.g., Pro-

ceedings and Acts of the [Maryland] General Assembly, March 30, 1868,

vol. 142, p. 2742, Laws of Maryland ch. 235 § | (amending and re-

enacting 1865 legislation authorizing Treasurer of the State “to issue

bonds or certificates of debt, which said bonds or certificates of debt shall

be exempt from State, county and municipal taxation . . . in the name and

on behalf of the State of Maryland, to an amount not exceeding four mil-

lions of dollars”), available at Maryland Archives Online,

http://aomol.nct/megafile/msa/speccol/sc2900/sc2908/00000 1/000 142/ht

mi/am142--2742.html.

States by compelling them” to enact laws “that decrease their

net revenues”; and imposes a tariff “on out-of-state municipal

bonds” that “hoards private capital” and “impedes interstate

commerce” by “creating a barrier to the sale of out-of-state

municipal bonds in Kentucky.” Resp. Br. 9, 3, 18, 28, 26.

Nothing in the record supports this jeremiad.

The only “out-of-state issuers” are the other States

and their local governmental units. Nothing in the record

demonstrates that the borrowing costs of other States, or the

demand for their bonds, is in any way negatively affected by

the Kentucky law. The other 49 States and their local gov-

ernments support Kentucky’s position as Amici Curiae.

Nothing in the record shows that any transactions of

“underwriters” or “investment funds,” cither in the national

bond market or with Kentucky investors, have been negative-

ly affected by the Kentucky law. The Securities Industry and

Financial Markets Association, whose members account for

90% of the nation’s municipal bond underwriting and trading

activity by volume, supports Kentucky’s position as Amicus

Curae, as do several large fund sponsors and underwriters.

The only “individuals” in the record are Respondents

themselves, who merely alleged that they paid Kentucky in-

come tax on interest “derived from obligations of sister

states,” Complaint J 14, J.A. 20, held by national bond mu-

tual funds, Resp. Br. 4. Thus the composition of Respon-

dents own portfolio — and the holdings of the national bond

funds which account for about 20% of the market, or $500

billion — disprove rather than support Respondents’ unsup-

ported allegations that “access to capital” is blocked by the

Kentucky exemption.

Respondents’ pollyanna prediction that “the market

will adjust quickly,” Resp. Br. 46, if the Court invalidates the

laws of 42 States, is neither credible nor supported by any-

thing in the record.‘ If the municipal bond market has been

“distorted” for decades by the laws of 42 States, it is difficult

to imagine anything less than a sudden and violent reversal of

the “inefficiencies” allegedly caused by the bond interest ex-

emption, and we can be sure that it won’t be pretty. This is

no time for the Court to plunge public finance into cold, deep

water with no idea of where the bottom is. “[T]he Court is

institutionally unsuited to gather the facts upon which eco-

nomic predictions can be made, and professionally untrained

to make them.” General Motors Corp. v. Tracy, 519 U.S.

278, 308 (1997).

Nor is any precipitous action necessary. Congress

exhaustively studied the effects of State taxation on interstate

commerce, and was fully informed about the differential tax-

ation of sister State bond interest by the States, yet did noth-

ing. See Pet. Br. 37-39. “The clear implication is that

Congress finds the benefits” of the longstanding and wide-

spread public finance practices of the States “well within the

realm of what the States may reasonably promote and pre-

serve.” General Motors, at 305. If something now needs to

be done to protect interstate commerce, Congress can do it.

It would be reckless to ignore the assessments of in-

dustry experts about the effects of invalidating the current

system, which range from “significant disruption to munici-

pal bond markets,” National Association of State Treasurers

“ Nor are the assertions that Kentucky and the 49 other States “would all

be better off” to abandon the policy decisions of their legislatures because

the States “lose more revenue” through the exemption “than they gain by

borrowing at lower rates,” Resp. Br. 29-31.

9

Br. Am. Cur. 17, to “instability and price uncertainty in the

national municipal bond market,” Securities Industry and Fi-

nancial Markets Association Br. Am. Cur. 4. Concern that

“disruption to the existing municipal bond market, and the

adjustment from a system that has prevailed for close to a

century, would be substantial,” National Federation of Mu-

nicipal Analysts Br. Am. Cur. 16, is well-founded. Nor is it

alarmist to fear that many loca] government issuers would be

lost in the shuffle and might be deprived of market access

altogether, with no alternative for the “funds that they other-

wise would have been able to raise for needed improve-

ments,” Nuveen Investments, Inc. Br. Am. Cur. 18. In 2004,

for example, almost half of the 14,419 new money long term

tax exempt governmental bond issuances was for small

bonds with an entire issue price of less than $1.0 million, and

bonds with an entire issue price of less than $5.0 million ac-

counted for about 75% of all issues, but only 6.7% of total

proceeds. A total of 437 bond issues (3.0%) exceeded an is-

sue price of $75 million, but the combined proceeds of this

three percent comprised 59.1% of total proceeds. Belmonte,

Tax Exempt Bonds 2003-2004, p. 252 (IRS Statistics of In-

come Division 2006). Hazarding the access to capital of

thousands of local governments would not be judicious.

“Still less is that msk justifiable in light of Congress’ own

power and institutional competence to decide upon and effec-

tuate any desirable changes” in the public finance practices

of the States “that [have] evolved” over the past 100 years.

General Motors, at 309.

Ili. A tax exemption for bond interest received is

equivalent to the payment of additional interest.

The economic reality of the municipal bond market is

that both the federal exclusion and any applicable state level

exemption are treated by creditor bondholders, debtor gov-

10

ermments, and all other market participants as the payment of

additional interest.

A. All market participants treat the exemption

as additional interest.

All the borrowers are sovereign States or their politi-

cal subdivisions. Their chief financial officers regard the tax

exemption as the payment of additional interest. See Br.

Amicus Curiae National Association of State Treasurers 10

(“Kentucky’s tax exemption is economically equivalent to a

higher interest rate for Kentucky taxpayers.) All the lenders

are bondholders, each of whom regards the exemption as the

payment of additional interest. See Br. Amicus Curiae State

of North Carolina, et al. 2 (“Bond purchasers . . . are moti-

vated by the net return on the investment (i.e., the income

stream produced by the bond less taxes imposed on this in-

come).”’).

Municipal bond analysts, investment bankers, and

other industry professionals all evaluate municipal bond in-

vestments by comparing the effective “taxable equivalent”

yield or the “net after tax” yield on bonds to the returns

available from competing investments. Temel, The Bond

Market Association, The Fundamentals of Municipal Bonds,

28-29 (5" ed. 2001). That comparison treats the federal ex-

clusion and the applicable state exemption as additional in-

terest paid by the issuing State. See Br. Amicus Curiae

Nuveen Investments, Inc. 3 (“the economic reality of the

Kentucky exemption . . . is the fact that the exemption is the

equivalent of an additional interest payment”).

Respondents apparently agree. “Kentucky citizens are

willing to accept less interest because they pay no state in-

come tax on their earnings.” Resp. Br. 6. That is, the tax

1]

exemption is a substitute for additional interest. Respon-

dents’ industry source confirms that “the yields on [bonds]

are therefore often articulated in terms of the taxable interest

rate that would be required to provide the same after tax in-

terest rate,” and provides a “formula for determining the

equivalent taxable interest rate.”

B. Economic substance is the touchstone.

The Court has often remarked that “it is the substance

of the transaction, rather than the label attached to it, that go-

verns Commerce Clause analysis,” South-Central Timber

Dev., Inc. v. Wunnicke, 467 U.S. 82, 99 n.1l (1984);

“eschewed formalism for a sensitive, case-by-case analysis of

purposes and effects,” West Lynn Creamery, Inc. v. Healy,

512 U.S. 186, 201 (1994); and focused on the “practical op-

eration” of a statute, Best & Co. v. Maxwell, 311 U.S. 454,

455-456 (1940).

The economic reality and practical effect of the ex-

emption for bond interest should not be ignored. Rather,

where a tax exemption applies directly and exclusively to the

payment of money by a State to a third party, such as the

payment of interest on the State’s own debt obligations, the

exemption should be treated as the payment of additional

money by the State for Commerce Clause purposes, not as a

“discriminatory tax.”

* Van Bergen, Weighing the Tax Benefits of Municipal Securities, Inves-

topedia.com (July 28, 2004). The same formula to determine the equivs-

lent taxable interest rate is illustrated and explained by the National

Association of State Treasurers in its Amicus Curiae Brief in Support of

Petitioners, at pages 5-6.

12

G The exemption-equals-subsidy issue is not

implicated here.

The Court’s reluctance to equate tax exemptions for

in-state private businesses, with direct subsidies to in-state

private businesses, derives from the ineluctable tension be-

tween the “essential purpose” of state government and the

principal objectives of dormant Commerce Clause adjudica-

tion. On the one hand the “essential and patently unobjec-

tionable purpose of state government [is] to serve the citizens

of the State.” Reeves, Inc. v. Stake, 447 U.S. 429, 442

(1980). Hence “a pure subsidy funded out of general revenue

ordinarily imposes no burden on interstate commerce, but

merely assists local business.” West Lynn Creamery, Inc. v.

Healy, 512 U.S. 186, 199 (1994). On the other hand are the

dark side scenarios that if tax exemptions, standing alone, are

(i) treated as a purchase of some service or product by the

State “the ‘market participant’ exception would swallow the

rule against discriminatory tax schemes,” Camps New-

found/Owatonna, Inc. v. Town of Harrison, 520 U.S. 564,

594 (1997), or (ii) treated as direct subsidies, then tax exemp-

tions for in-state private business that are denied to out-of-

state private business entities or transactions could claim

constitutional shelter under the rule that “direct subsidization

of domestic industry does not ordinarily run afoul” of the

dormant Commerce Clause, New Energy Co. v. Limbach,

486 U.S. 269, 277 (1988).

If the Court respects the economic reality of the bond

market, it would do no violence to New Energy, Camps New-

found, or West Lynn, the three Commerce Clause cases in

which the exemption-as-direct subsidy issue has been raised,

or to the results or the reasoning of Boston Stock Exchange,

Bacchus, or Fulton Corp., all of which involved taxes on

transactions between third parties or on property owned by

13

third parties, not transactions in which a State was directly

involved.

D. Economic reality shows no market harms

and no “discrimination.”

Attention to the economic reality of the market should

allay any concerns that the principal purposes of the dormant

Commerce Clause are threatened or that there is any “dis-

crimination” against interstate commerce.

At the very least, the economic reality of the bond

market scuttles the notion that the exemption “distorts” or

“balkanizes” the market. Investment capital seeks the high-

est “taxable equivalent yield” or “net after tax return” in any

market, not just the municipal bond market. Investing to

generate capital gain rather than ordinary income, and in-

vestment through a nontaxable ERISA account rather than a

taxable brokerage account, are two familiar examples. This

is no “distortion” or “inefficiency,” it is economic reality.

Capital is not “hoarded” if it seeks the highest “taxable

equivalent yield,” whether that yield is produced by the state

bond interest exemption or the federal exclusion for bond

interest. “Economic balkanization” is properly invoked only

when subdivision of larger market territory produces weak-

ness and instability. Yet the bond market functions well in

providing the Nation’s 87,000 local governments with essen-

tial financing.

At a greater magnification, an economic reality analy-

sis forces the question whether a tax exemption applicable

exclusively to the payment of interest owed by a borrower

State, can ever correctly be said to “burden” or “discrimi-

nate” against interstate commerce. If Kentucky simply in-

creased the contract intcrest rate on its bonds, and gave

14

Kentucky residents first dibs, it could not be seriously main-

tained that the dormant Commerce Clause would be trans-

gressed. The economic substance and practical effect of the

bond interest exemption — treated by all market participants

as additional interest — are no different.

E. A quid pro quo tax exemption is not a “pe-

nalty.”

The suggestion that the Kentucky exemption “pena-

lizes” Respondents for their “participation in interstate com-

merce,” Resp. Br. 4, misconceives the quid pro quo

relationship between borrower States and creditor bondhold-

ers. The bondholder provides credit to Kentucky on favora-

ble terms, and Kentucky in retum makes cash interest

payments to the bondholder and pays additional interest

equal to the value of the tax exemption. By comparison, if a

Kentucky resident chooses to loan money to California, there

is no benefit to Kentucky, no quid pro quo, for which the tax

exemption should be granted. °

IV. A market participant State may use its tax power

as part of a quid pro quo.

Respondents apparently concede that Kentucky is a

“market participant” in the municipal bond market (without

reference to the tax exemption in issue). Language yanked

out of context from New Energy, South- Central Timber, and

* The same quid pro quo analysis undermines the argument for a “prin-

ciple of competitive neutrality which prohibits States from taxing activity

out of state while not taxing identical activity in state.” The Tax Founda-

tion Am. Cur. Br. 3-5. This idea has no application here: the out-of-state

activity (a loan made to another State or any other debtor, for which Ken-

tucky receives no consideration) is not identical to the activity in-state (a

loan which makes capital available to Kentucky itself at favorabic terms).

15

Camps Newfound, Resp. Br. 36-39, is therefore not helpful:

those cases dealt exclusively with the question whether the

State was a participant in the relevant market, not whether

the dormant Commerce Clause limits the means by which the

economic terms of that participation may be implemented.

South-Central Timber answers that question: “Our

cases make clear that if a State is acting as a market partici-

pant .. . the dormant Commerce Clause places no limitation

on its activities.” 467 U.S. at 94.

The assertions that the market participation cases only

“allow the State the nights of private parties,” and only apply

when “the State [is] acting as if it were a private party,”

Resp. Br. 3, 36, read Reeves backwards. Reeves held that

when a State participates in a market as a buyer or seller (in

that case, of state-manufactured cement), the State then

“shares” with “private market participants” their “existing

freedoms from federal constraints, including the inherent lim-

its of the Commerce Clause.” 447 U.S. at 439. There is no

good reason this rule should suddenly be suspended when

other States, each of which has the power to tax, are market

participants as well. The contentions that “the Court has con-

fined” the market participation doctrine to situations where

the State participates “on the same terms as a private party,”

and that the Court “has held” the doctrine inapplicable when

“the State imposes conditions only a state actor could im-

pose,” Resp. Br. 36, are not supported by citation to authori-

ty, because the Court has never said any such thing in its

opinions.

To be sure, New Energy held that a tax credit, stand-

ing alone, could not constitute market participation by a State

which was neither a buyer or a seller of a product, and re-

ferred to the “assessment and collection of taxes” as a “pri-

16

meval governmental activity.” 486 U.S. at 277. The word

“primeval” means “primordial” or “from the first,” and it was

in this context that New Energy rejected Ohio’s attempt to

treat naked taxation of sales of a product, as “participation”

in the sale. New Energy simply held that exercise of a power

that governments have always exercised, such as the taxing

power or the police power — does not constitute “participa-

tion” by a State in a market in which the State is neither a

buyer nor a seller of products or services.

Where, as here, Kentucky’s market participation as a

buyer or seller (without reference to the tax exemption in

question) is uncontroverted, the dormant Commerce Clause

simply does not apply. See, e.g., White v. Massachusetts

Council of Construction Employers, 460 U.S. 204, 209-210

(1983). All the participants in the relevant market economi-

cally treat the tax exemption as additional interest or yield to

the bondholder. It blinks reality to invoke the dormant

Commerce Clause and prevent Kentucky (or any other State)

from using its taxing power to pay, in part, for the use of cap-

ital. The Court has been careful to confirm that its cases in-

volving private businesses do “not prevent the States from

structuring their tax systems to encourage the growth and de-

velopment of intrastate commerce and industry,” Boston

Stock Exchange v. State Tax Comm'n, 429 U.S. 318, 336

(1977). That limit on those cases applies even more forceful-

ly when the States structure their tax systems to help them

obtain essential financing for public projects and public

works.

If the Commerce Clause does not constrain the States’

use of their tax systems to compete with each other for new

industry, or the widespread use of State tax incentives for job

17

creation, urban revitalization, or agricultural diversification,’

then it would be anomalous indeed if the Commerce Clause

prevents States from structuring their tax systems, vis-a-vis

each other, to facilitate financing for public projects and pro-

grams.

V. Respondents’ Import-Export Clause argument is

neither timely nor applicable to interstate com-

merce or to interest payments.

Respondents’ Import-Export Clause argument was

neither presented to nor decided by the state courts, and

should not be entertained by this Court on certiorari. See,

e.g., Kentucky v. Stincer, 482 U.S. 730, 747 n.22 (1987).

This is no “exceptional case” that might justify a departure

from the rule. McGoldrick v. Campagnie Generale, 309 U.S.

430, 434 (1940) (refusing to consider respondents’ Import-

Export Clause argument raised for the first time on certiorari

review of state court dormant Commerce Clause decision).

The longstanding construction of the Import-Export

Clause is that the Clause applies only to imports from and

exports to foreign countries, not to interstate commerce.

Woodruff v. Parham, 75 U.S. (8 Wall.) 123 (1868). Even if

this precedent were revisited, the scope of the Clause would

extend only to (i) “imposts” and “duties” on (ii) “imports”

and “exports.” An income tax on annual interest from an in-

” See Enrich, Saving the States from Themselves: Commerce Clause Con-

straints on State Tax Incentives for Business, 110 Harv. L. Rev. 377

(1996); Philip M. Tatarowicz & Rebecca F. Mims-Velarde, An Analytical

Approach to State Tax Discrimination Under the Commerce Clause, 39

Vand. L. Rev. 879 (1986); Walter Hellerstein and Dan T. Coenen,

Commerce Clause Restraints on State Business Development Incentives,

81 Cornell L.Rev. 789, 806-09 (1996).

18

tangible already owned by a resident bears little relationship

to an “impost,” which was “a tax levied on goods at the time

of importation,” Camps Newfound, 520 U.S. at 637 (Thomas,

J., dissenting), or a “duty,” which “though broader than an

impost, which still a tax on particular goods or written in-

struments” such as bills of lading, id. at 639. Payment of a

monetary obligation is not an “export” of money from the

debtor’s state or an “import” of money into the creditor’s

State.

CONCLUSION

The judgment of the Kentucky Court of Appeals

should be reversed.

Respectfully submitted,

Douglas M. Dowell C. Christopher Trower

Donald S. Guier Counsel of Record

Office of Legal Services electriclaw.com

for Revenue 3159 Rilman Rd., N.W.

Finance and Atlanta, GA 30327-1503

Administration Cabinet (404) 816-5066

Commonwealth of Kentucky

200 Fair Oaks Lane Gwen R. Pinson

P.O. Box 423 . Office of General Counsel

Srankfort, KY 40603 Finance and

(902) 564-3112 Administration Cabinet

Commonwealth of Kentucky

188 Capitol Annex Building

Frankfort, KY 40601

(502) 564-6660

October 26, 2007 Counsel for Petitioners