Amicus Curiae Brief — Department of Revenue of Ky. v. Davis

Supreme Coun, Us. |

9 FILED

No. 06-666 JUL 19 2007

FFI CLERK |

IN THE

Supreme Court of the United States

DEPARTMENT OF REVENUE OF THE COMMONWEALTH OF

KENTUCKY AND FINANCE AND ADMINISTRATION

CABINET OF THE COMMONWEALTH OF KENTUCKY,

Petitioners,

Vv.

GEORGE W. DAVIS AND CATHERINE V. DAVIS,

Respondents.

On Writ of Certiorari to the

Kentucky Court of Appeals

BRIEF OF THE GOVERNMENT FINANCE

OFFICERS ASSOCIATION, NATIONAL

GOVERNORS ASSOCIATION, NATIONAL

LEAGUE OF CITIES, NATIONAL CONFERENCE

OF STATE LEGISLATURES, NATIONAL

ASSOCIATION OF COUNTIES, COUNCIL OF

STATE GOVERNMENTS, U.S. CONFERENCE

OF MAYORS, INTERNATIONAL MUNICIPAL

LAWYERS ASSOCIATION, AND INTERNATIONAL

CITY/COUNTY MANAGEMENT ASSOCIATION

AS AMICI CURIAE SUPPORTING PETITIONERS

RICHARD RUDA*

Chief Counsel

STATE AND LOCAL LEGAL CENTER

444 North Capitol Street, N.W.

Suite 309

Washington, D.C. 20001

(202) 434-4850

* Counsel of Record for the

Amici Curiae

WILSON-EPES ‘RINTINGCO.,INC. - (202) 789-0096 - WASHINGTON, D C. 20002

QUESTION PRESENTED

Whether Kentucky’s income tax exemption for interest on

municipal bonds issued by the Commonwealth or its political

subdivisions violates the dormant Commerce Clause because

Kentucky does not exempt interest earned by Kentucky

taxpayers on bonds issued by other States or their political

subdivisions.

(i)

TABLE OF CONTENTS

QUESTION PRESENTED .o-eseeescsssscsssssesesesssssssssseeeeee

TABLE OF AUTHORITIES ..csssscsccssscssssssssssssssssssseeeeee

I.

Il.

STATE GOVERNMENTS HAVE REASON-

ABLY RELIED ON THE CONSTITUTION-

ALITY OF TAX EXEMPTIONS LIKE

KENTUCKY’S, AND CONGRESS IS IN

THE BEST POSITION TO ALTER THE

SE ID wnectincesenicasissnmmacsniesesianensicenencees

A.

Longstanding Historical Practice Supports

the Constitutionality of State Tax Exemp-

tions for Interest Paid on In-State Munic-

A Judicial Declaration that Kentucky’s

Tax Exemption Is Unconstitutional Would

Disrupt the States’ Substantial Reliance

i iccincinsiiniitcintinidcnsnisciniepeinaniiitaniinsigitiieins

If a Change in the State Tax Treatment of

Municipal Bond Interest Is Desirable,

Congress Is in the Best Position to Make

RD ccctcnscsenntintannctonnnistesemmnnaninsnnan

UNDER UNITED HAULERS, KENTUCKY’S

TAX EXEMPTION FOR _ INTEREST

EARNED ON_ IN-STATE MUNICIPAL

BONDS DOES NOT VIOLATE THE

DORMANT COMMERCE CLAUSE...............

(iii)

12

iV

TABLE OF CONTENTS—Continued

Page

A. A State Tax Exemption for Interest Earned

on Bonds Issued by the Taxing State and

Its Political Subdivisions Does Not Dis-

criminate Against Interstate Commerce ...... 16

B. Kentucky’s Tax Exemption Does Not Im-

pose a “Clearly Excessive” Burden on

SRRUIIND CITI oacccenssscecssenssvesenmsstianins 23

CIO A FIIIITS coveccrscsescasnssnnsoseonsveinentesesusatiitinsiiidiaieatian 27

Vv

TABLE OF AUTHORITIES

Cases Page

Atkin v. Kansas, 191 U.S. 207 (1903) .0.......c0cc0000+ 25

Barclays Bank PLC v. Franchise Tax Bd. of Cal.,

EE 7

Bode v. Barrett, 344 U.S. 583 (1953)... 22

Brown-Forman Distillers Corp. v. New York

State Liquor Auth., 476 U. S. 573 (1986).......... 19-20

C & A Carbone, Inc. v. Clarkstown, 511 U.S.

i stiaraiicertnctned tenteniedncnsnenerescoeiecees 16

Camps Newfound/Owatonna, Inc. v. Town of

Harrison, 520 U.S. 564 (1997)........ccccccceceeeeees 5

City of Philadelphia v. New Jersey, 437 U.S. 617

TA sistIiiliicnestaecestnncaaencensendnemnesenenscessszcssseecee 23

Commonwealth Edison Co. v. Montana, 453

ee 6-7, 13

Complete Auto Transit, Inc. v. Brady, 430 U.S.

ES a aE 23

Edgar v. MITE Corp., 457 U.S. 624 (1982).......... 26-27

General Motors Corp. v. Tracy, 519 U.S. 278

tetas iaedaeieseatieaentnaetneattncensencennssmmennecee 7, 23

Goldberg v. Sweet, 488 U.S. 252, 259-260

iad ara tactcrncnenenanneennnsensnececes 23

Granholm v. Heald, 544 U.S. 460 (2005)............. 19

Harper v. Virginia Dept. of Taxation, 509 U.S.

EET 9, 9-10

Itel Containers Int'l Corp. v. Huddleston, 507

aint cttrcerininentnensnemnesencssennes 23

Joseph v. Carter & Weekes Stevedoring Co., 330

U.S. 422 (1947), overruled on other grounds,

Department of Revenue of Wash. v. Associa-

tion of Wash. Stevedoring Cos., 435 U.S. 734

EE 7

Kassel v. Consolidated Freightways Corp. of

ee 26

vi

TABLE OF AUTHORITIES—Continued

Page

Marsh v. Chambers, 463 U.S. 783 (1983)............. 7

McKesson Corp. v. Division of Alcoholic

Beverages & Tobacco, 496 U.S. 18 (1990)....... 8, 10

Moorman Mfg. Co. v. Bair, 437 U.S. 267

Feel iicnaseneunstenapentetininesenniaentincnnabiaiaiasiliiinnass 5, 12-13

National Bellas Hess, Inc. v. Department of

Revenue of Ill., 386 U. S. 753 (1967) .............0. 14

Oklahoma Tax Comm. v. Jefferson Lines, Inc.,

Fe ee Ce wiiccicnetintnnienniiininintiiionsiin 23

Pike v. Bruce Church, Inc., 397 U.S. 137

Pe nstintanedncumesiencitsinniasinaninpanaseiatinmnniaitaliiia 3, 23, 26, 27

Prudential Ins. Co. v. Benjamin, 328 U.S. 408

[Ti ctiecentcncetesnnsnaiasienididedieiineadainamnenpiiniiiditaadianl 5

Quill Corp. v. North Dakota, 504 U.S. 298

pera csnesecnsemianntismicheticinininenniinientinintinnianidatiial 5, 14, 15

Raymond Motor Transp., Inc. v. Rice, 434 U.S.

ea ikssensesistcnicitiiiecihiesiitineanetbitaniiiiidieainaaiansintaiaiits 26

Reeves, Inc. v. Stake, 447 U.S. 429 (1980)............ 25

Schneidewind v. ANR Pipeline Co., 485 U.S. 293

SI cctesecennisitettentianinaibanneieninntineenniienitabemees 7

South Carolina v. Baker, 485 U.S. 505 (1988) ..... 21

Trinova Corp. v. Michigan Dept. of Treasury,

a a ee ctertenternctenmnaeniininninns 23

United Haulers Assn., Inc. v. Oneida-Herkimer

Solid Waste Mgmt. Auth., 127 S. Ct. 1786

IID crrsnsransvennnnesninenmenninesuinonnapmantnmsnianteiisiies passim

Wyoming v. Oklahoma, 502 U.S. 437 (1992)........ 7

Statutes

Ind. Code Ann. § 6—3—1-3.5.0.......cccccccsseeeeeeeeeeeees 5

Ky. Rev. Stat. Ann. §141.010(09) ..0..... ccc eeceeeees 19

Ky. Rev. Stat. Ann. §141.010(10)(c).........0.0. 19

SE te Wc CID CII carvcnscasenceinadvenmssncorimesnenints

vii

TABLE OF AUTHORITIES—Continued

Se eh AE cccncninrinitetntintiniininantcnesinenimeies 5

Pub. L. No. 108-435, 118 Stat. 2615 .................... 6

Soldiers’ and Sailors’ Civil Relief Act of 1940,

Act of Oct. 17, 1940, ch. 888, § 514, as

amended, 50 App. U.S.C. §571 2........cccceeeeeeeee

I I aainiiincccintcniinsladicccnnsinissitiintensineneenteniones

ITT icininnnetenicanatatpssiateiiaiiinineetinn

STII sitosisissrnenesstsninasentamenumnienneedninitie

BI icles escarineinaneprnitematminanisinnaienagns

STITT TTT inci daiesnatarencsenetianannnemniempiemuniinens |

TTT scccesiscnnsinsunininuienmmneiinnenenasnies

Is UTD cidincisnrareenmentescnnehinnniigunneaninenintte

8 Ee

ET ies iicinpicendninsennementnnesciteninineene

eT sscnersisnninrnrentemnnnnstnnenmmennen

es I tertarccsinrnitiernecesrnennpeninenneuennite

tS \ Ce

Other Authorities

C. Belmonte, Tax-Exempt Bonds, 1996-2002

(SOI Bulletin Summer 2005)................:cccecceeeees 18, 19

Cole et al., The Capitalization of the State Tax

Exemption Benefit in Municipal Bond Yields, 7

J. Financial & Strategic Decisions 67 (1994)... 18

D. Denison et al., Davis v. Department of

Revenue of Kentucky: A Preliminary Impact

Assessment, [FIR Working Paper No. 2007-03

T. DeSue, Ky. Ruling Would Lift Tax on Out-of-

State Bonds, Bond Buyer, Jan. 10, 2006, at 1.... &

J. Hellerstein & W. Hellerstein, State Taxation

Vili

TABLE OF AUTHORITIES—Continued

W. Hellerstein & D. Coenen, Commerce Clause

Restraints on State Business Development

Incentives, 81 Cornell L. Rev. 789 (1996) ........

T. Herman, Justices to Hear Muni-Bond Case—

Kentucky Tax Fight Over Exemptions Affects

Many States, Wall St. J., May 22, 2007, at D3..

J. Mysak, Trash-Hauler Case Muddies Water for

Municipal Market, Bloomberg, May 9, 2007....

Public Finance Network, Tax-Exempt Financing:

PR ee

J. W. Temel, The Fundamentals of Municipal

ee Se citrrctincenrnninenenne

U.S. Census Bureau, Statistical Abstract of the

INES GEDDY isinaesinntensicinenimsesmiinememens

Page

10

21

25

18

18, 21

21

INTEREST OF THE AMICI CURIAE

Amici are organizations whose members include state,

county, and municipal governments and officials throughout

the United States.' Amici have a compelling interest in all

legal issues affecting the essential workings of state and local

government finance, including the constitutionality of state

laws that exempt municipal bond interest from taxation.

They accordingly submit this brief to assist the Court in the

resolution of this case.

SUMMARY OF ARGUMENT

1. Historical and pragmatic considerations provide com-

pelling reasons to uphold Kentucky’s income tax exemption

for the interest earned on municipal bonds issued by the

Commonwealth and its political subdivisions.

First, since the advent of state personal income taxes in the

early 1900s, the States have maintained exemptions similar or

identical to Kentucky’s that favor in-state municipal bonds.

Congress has long been aware of these exemptions and

plainly has the authority to regulate the state taxation of

interstate commerce. Yet it has never seen fit to prohibit this

practice. Where Congress has left undisturbed a longstanding

and nearly universal state tax policy, its tacit approval is

entitled to substantial respect, as this Court has recognized.

Second, a decision by this Court to invalidate Kentucky’s

exemption would impose significant economic hardships on

the States. Presently, the overwhelming majority of States

exempt some or all in-state municipal bond interest from

personal income taxation while taxing the interest earned on

' The parties have filed blanket consents to the filing of amicus briefs

in this case. Pursuant to Rule 37.6, amici state that this brief was not

authored in whole or in part by counsel for any party, and that no person

or entity other than amici, their members, or their counsel made a mone-

tary contribution to the preparation or submission of this brief.

2

out-of-state municipal bonds. Prior to the decision below,

state governments had no reason to believe that these exemp-

tions might be unconstitutional, and have structured their

fiscal affairs accordingly for almost a century. Precisely be-

cause so many States and local governments have incurred

immense financial obligations based on these understandings,

a decision to invalidate Kentucky’s tax scheme would drain

state treasuries of billions of dollars, transition costs that are

manifestly unfair given the States’ longstanding and reason-

able reliance on the exemptions’ constitutionality.

Finally, the principal reason state governments would incur

these costs is that this Court’s decision might well apply

retroactively. States could be forced to refund all recently

paid taxes on out-of-state municipal bond interest, and most

would effectively be required to forego taxing the interest on

all outstanding out-of-state municipal bonds. Only Congress

could craft a purely prospective remedy that applied solely to

municipal! bonds that have not yet been issued. It therefore

makes sense for the Court to stay its hand, as it has done be-

fore in state tax decisions raising similar issues of institu-

tional competence. Even if a rule requiring the States to tax

in-state and out-of-state bonds equally could be shown to be

good policy, Congress is the branch of government best

positioned to fashion a political solution in such a complex

area with massive fiscal ramifications.

2. In United Haulers Assn., Inc. v. Oneida-Herkimer

Solid Waste Mgmt. Auth., 127 S. Ct. 1786 (2007), this Court

held that state laws that “favor the government,” that “treat

every private business, whether in-state or out-of-state,

exactly the same,” and that concern “a traditional government

activity,” “do not discriminate against interstate commerce

for purposes of the Commerce Clause.” /d, at 1790. Ken-

tucky’s personal income tax exemption for interest earned on

in-state municipal bonds meets each of these criteria. It fav-

ors the government, as the exemption applies only to interest

on bonds issued by Kentucky and its political subdivisions. It

3

provides no advantage to Kentucky businesses over their out-

of-state competitors. And it concerns a governmental activity

that dates to the colonial period and, like waste management

in United Haulers, is central to state and local governments’

ability to carry out their governmental obligations. Thus,

Kentucky’s tax exemption does not discriminate against

interstate commerce.

Because Kentucky’s tax exemption is not discriminatory, it

is constitutional if it does not impose a burden on interstate

commerce that is “clearly excessive in relation to the putative

local benefits.” Pike v. Bruce Church, Inc., 397 U.S. 137,

142 (1970). The exemption’s local benefits are substantial,

while its economic impact is not properly understood as a

“burden” on interstate commerce for purposes of the dormant

Commerce Clause, let alone one that is “clearly excessive.”

The exemption’s principal effect is to shift the geographic

distribution of the investors purchasing a given State’s

municipal bonds, such that a larger proportion of those

investors holding Kentucky municipal bonds are Kentucky

residents. But this is a natural and salutary consequence

of the distinctive relationship between a sovereign and its

citizens, not a distortion of interstate commerce.

ARGUMENT

I. STATE GOVERNMENTS HAVE REASONABLY

RELIED ON THE CONSTITUTIONALITY OF

TAX EXEMPTIONS LIKE KENTUCKY’S, AND

CONGRESS IS IN THE BEST POSITION TO

ALTER THE STATUS QUO

Since the inception of modern state income taxes during

the Progressive Era, state governments have granted pref-

erential tax exemptions for the interest earned on in-state

municipal bonds and have had no reason to question their

validity. Congress plainly has the authority under the

Commerce Clause to regulate the States’ taxation of interstate

4

commerce, yet it has never seen fit to interfere with this

practice. Although this Court is generally reluctant to draw

inferences from congressional silence, in this particular con-

text Congress’s inaction warrants significant consideration,

especially given the extensive evidence of Congress’s

awareness of the practice. Currently, 42 States provide

income tax preferences for in-state municipal bonds, and

myriad state and local governments have structured their

budgets in reliance on these exemptions’ constitutionality.

Consequently, a decision to invalidate Kentucky’s tax scheme

would force state treasuries to absorb billions of dollars in

transition costs, a large-scale financial disruption that is

manifestly unfair given the reasonableness of the States’

reliance on the validity of a ubiquitous tax policy.

The principal reason the States would incur these costs is

that this Court’s decision could apply retroactively. State

governments might be forced to refund hundreds of millions

of dollars in taxes paid on out-of-state municipal bond

interest, and most States would effectively be required to

forego taxing the interest on all outstanding out-of-state

municipal bonds. Only Congress could craft a purely

prospective remedy that applied solely to municipal bonds

that have not yet been issued. These practical considerations

Suggest that the Court should stay its hand, as it has done in

several prior state tax decisions raising similar issues of

institutional competence. For even if one concluded that

interstate commerce might benefit from the States’ equal

treatment of in-state and out-of-state municipal bonds, Con-

gress is the only institution capable of crafting an equit-

able transition to such a regime.

A. Longstanding Historical Practice Supports the

Constitutionality of State Tax Exemptions for

Interest Paid on In-State Municipal Bonds

American state and local governments have imposed

various forms of personal income taxes since the colonial

5

period. See 2 J. Hellerstein & W. Hellerstein, State Taxation

q 20.01 (2007). Wisconsin enacted the first modern personal

income tax in 1911, and several other States quickly followed

suit. See id. From their inception, these state income tax

codes have exempted the interest earned on municipal bonds

issued by the taxing State, and they have denied this benefit

to the interest earned on bonds issued by their sister States.

New York adopted such a preference in 1919, see 1919 N.Y.

Laws 1641-42, North Carolina in 1921, see 1921 N.C. Sess.

Laws 207-208, and Virginia in 1926, see 1926 Va. Acts 961.

Today, 42 States offer some form of tax preference for the

interest earned on in-state municipal bonds.” And until the

Kentucky Court of Appeals’ handed down its decision in this

case, no court in the United States, state or federal, had held

that this differential tax treatment of in-state and out-of-state

municipal bonds was unconstitutional. See 1 Hellerstein &

Hellerstein, ¥ 4.13.

As this Court has recognized on several occasions, Con-

gress “unquestionably” has the authority under the Commerce

Clause to regulate the States’ taxation of interstate commerce.

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

U.S. 564, 572 (1997). See also Quill Corp. v. North Dakota,

504 U.S. 298, 318 (1992); Moorman Mfg. Co. v. Bair, 437

U.S. 267, 280 (1978); Prudential Ins. Co. v. Benjamin, 328

U.S. 408, 434 (1946). And Congress has invoked this

authority on numerous occasions to protect interstate com-

merce from various burdens it has deemed inconsistent with

the national interest. See, e.g., Pub. L. No. 86-272, 73 Stat.

55, codified at 15 U.S.C. §381 (prohibiting the States from

imposing income taxes on businesses that keep their contacts

within the taxing State beneath a specific threshold); Internet

? Alaska, Florida, Nevada, South Dakota, Texas, Washington, and

Wyoming impose no taxes on personal income, 2 Hellerstein & Heller-

stein { 20.01 n. 5, while Indiana does not distinguish in-state from out-of-

state municipal bonds, see Ind. Code Ann. § 6—3-—1-3.5.

6

Tax Nondiscrimination Act, Pub. L. No. 108-435, 118 Stat.

2615 (2004) (prohibiting States from imposing taxes on

internet access or “discriminatory taxes on electronic

commerce”); Pub. L. No. 104-95, 109 Stat. 979, codified at 4

U.S.C. §114 (restricting the States’ authority to tax the

retirement income of nonresidents); Soldiers’ and Sailors’

Civil Relief Act of 1940, Act of Oct. 17, 1940, ch. 888, § 514,

as amended, 50 App. U.S.C. §571 (limiting the States’ power

to tax the property and personal income of military

personnel); Railroad Revitalization and Regulatory Reform

Act of 1976 (the 4-R Act), Pub. L. No. 94-210, 90 Stat. 54,

codified at 49 U.S.C. §11501 (prohibiting States from im-

posing higher taxes on railroad property than on other

commercial or industrial property).°

States have maintained these tax preferences for their own

municipal bonds for nearly a century, and Congress has

plainly been aware of the practice. See Br. Am. Cur. North

Carolina et al. at 19-21 (collecting cases and legislative

authorities); Br. Am. Cur. National Association of State

Treasurers at 14-16 (same). Yet Congress, though it “has the

power to protect interstate commerce,” “is so far content to

* See also 15 U.S.C. §391 (prohibiting the States from imposing a tax

on “the generation or transmission of electricity which discriminates

against out-of-State manufacturers, producers, wholesalers, retailers, or

consumers of that electricity”); Pub. L. No. 94-29, 89 Stat. 97, codified at

15 U.S.C. §78bb(d) (limiting the States’ power to impose stock transfer

taxes); Employee Retirement Income Security Act (ERISA), 29 U.S.C.

§1144(a) (dictating that ERISA “shall supersede any and all State laws

insofar as they now or hereafter relate to any employee benefit plan,”

including state tax laws); 49 U.S.C. §§14502(b), 401 16(d)\(2\(A) (extend-

ing the protections of the 4-R Act to property owned by motor and air

carriers); 49 U.S.C. §§14505, 40116(b) (prohibiting the States or their po-

litical subdivisions from taxing the interstate transportation of passengers

by motor carrier or in air commerce); 49 U.S.C. §40116(c) (permitting

state or local taxes “related to a flight of a commercial aircraft or an

activity or service on the aircraft only if the aircraft takes off or lands in

the State or political subdivision as part of the flight”).

7

let the matter rest.” Commonwealth Edison Co. v. Montana,

453 U. S. 609, 637 (1981) (White, J., concurring)

To be sure, “[s]tanding alone, historical patterns cannot

justify contemporary violations of constitutional guarantees,”

Marsh v. Chambers, 463 U.S. 783, 790 (1983), and “[t}his

Court generally is reluctant to draw inferences from Con-

gress’ failure to act,” Schneidewind v. ANR Pipeline Co., 485

U.S. 293, 306 (1988). Moreover, the Court has stated that

Congress must indicate its intent with “unmistakable clarity

. . to permit state regulation that discriminates against

interstate commerce.” Barclays Bank PLC v. Franchise Tax

Bd. of Cal., 512 U.S. 298, 323 (1994). See also Wyoming v.

Oklahoma, 502 U.S. 437, 458 (1992). But, for the reasons set

out in Part II infra, Kentucky’s tax exemption does not

discriminate against interstate commerce. And the Court has

acknowledged that, when the question at hand concerns

whether the States’ tax policies impermissibly burden inter-

state commerce, Congress’s silence is important. See Gen-

eral Motors Corp. v. Tracy, 519 U. S. 278, 304-305 (1997);

Joseph v. Carter & Weekes Stevedoring Co., 330 U.S. 422

(1947), overruled on other grounds, Department of Revenue

of Wash. v. Association of Wash. Stevedoring Cos., 435 U.S.

734 (1978).

In Carter & Weekes Stevedoring, the Court held that,

because “the power lies in Congress under the [Commerce]

Clause to make any desired adjustment in the taxation area,

its acquiescence in [this Court’s] former rulings on state

taxation indicates its agreement with the adjustments of the

competing interests of commerce and necessary state reve-

nues.” 330 U.S., at 428. Of course, the Court has not

squarely addressed whether the economic burdens and bene-

fits attributable to tax exemptions like Kentucky’s are con-

sistent with the dormant Commerce Clause. In this case there

is no judicial ruling in which Congress has acquiesced;

instead, Congress has tacitly endorsed a widespread, long-

8

standing, and uninterrupted practice by the States that, until

very recently, has gone unchallenged. But this distinction

should have no constitutional significance. In our federal

system—and with respect to a matter that Congress is

expressly charged by the Constitution to superintend, see Art.

I, §8, cl. 3—Congress’s tacit approval of the States’ con-

sistent and longstanding judgments should be entitled to the

same consideration and respect as its silent approval of this

Court’s holdings.

B. A Judicial Declaration that Kentucky’s Tax

Exemption Is Unconstitutional Would Disrupt

the States’ Substantial Reliance Interests

In light of the exemptions’ deep historical roots, all but

eight States have structured their financial affairs around the

assumption that providing a tax preference for the interest

earned on in-state municipal bonds is constitutional. A

decision by this Court to invalidate Kentucky’s tax scheme

would therefore impose severe financial hardships on state

governments, transition costs that are patently unfair given

the States’ reasonable reliance on the constitutionality of

exemptions like Kentucky’s.

Perhaps these consequences would not be disquieting had

the States persisted in imposing income taxes that they had

good reason to believe were unconstitutional. Cf. McKesson

Corp. v. Division of Alcoholic Beverages & Tobacco, 496

U.S. 18, 46-50 (1990) (discussing Florida’s continued impo-

sition of a liquor tax that was blatantly protectionist and only

cosmetically different from a Hawaii liquor tax that the Court

had previously invalidated). But that is not the case here.

The States, like most other observers, were caught completely

off guard by the Kentucky Court of Appeals’ decision. See

T. DeSue, Ky. Ruling Would Lift Tax on Out-of-State Bonds,

Bond Buyer, Jan. 10, 2006, at 1 (quoting a bond industry

executive who called the decision “earth shattering”). Before

9

January 2006, state governments had little reason to believe

that these tax exemptions were constitutionally suspect, and

they acted accordingly. To force the States to shoulder these

breathtaking transition costs, despite their reasonable and

substantial reliance on extant understandings of the dormant

Commerce Clause, is wholly inequitable.

To appreciate what is at stake for the States, it is useful to

isolate the implications of this-case for two distinct (but

overlapping) groups of taxpayers. The first group is tax-

payers who have recently paid state income tax on interest

earned on out-of-state municipal bonds. The second and far

more significant group is taxpayers who presently own out-

of-state municipal bonds. With respect to the first group, a

decision to invalidate Kentucky’s tax exemption may well

require the States to disgorge hundreds of millions of dollars

in tax refunds. With respect to the second group, it would

effectively force the States to forego billions of dollars in

income tax revenue well into the future. These are dollars on

which the States’ budgets critically depend. And these are

transit »n costs that the States would be forced to shoulder

merely because they have incurred debt obligations based on

a reasonable understanding of the dormant Commerce Clause.

1. Taxpayers who have recently paid taxes on interest

earned on out-of-state municipal bonds. As a threshold

matter, there is a significant possibility that a ruling by this

Court to invalidate Kentucky’s tax exemption would apply

retroactively. Granted, this Court’s precedent has “left

unresolved the precise extent to which the presumptively

retroactive effect of this Court’s decisions may be altered in

civil cases.” See Harper v. Virginia Dept. of Taxation, 509

U.S. 86, 96 (1993). But the Court held in Harper that

“(w]hen this Court applies a rule of federal law to the parties

before it, that rule . . . must be given full retroactive effect in

all cases still open on direct review and as to all events,

regardless of whether such events predate or postdate our

10

announcement of the rule.” 509 U.S., at 97. Thus, a decision

invalidating Kentucky’s tax exemption could apply retro-

actively to all similarly situated taxpayers nationwide.

Further, the Due Process Clause could require that this

retroactive remedy “provide meaningful backward-looking

relief to rectify any unconstitutional deprivation.” McKesson,

496 U.S., at 31. Ina case like this, where the claim is that the

State’s tax scheme discriminates against interstate commerce,

such relief could take three forms, any of which would

remedy the constitutional problem: (1) the States could refund

all taxes paid on any interest earned on out-of-state municipal

bonds; (2) the States could retroactively impose a tax on any

interest earned on in-state municipal bonds; or (3) the States

could enact some combination of the two that results in the

equal tax treatment of all municipal bond interest during the

relevant time period. See id., at 40-41.

Although each of these options would be open to the States

in theory, “[i]n the real world, . . . the practical and political

difficulties of fashioning any retroactive remedy other than a

refund (as well as legal difficulties presented by federal and

State strictures regarding retroactive legislation) make solu-

tions that require back-tax collections unlikely.” W. Heller-

stein & D. Coenen, Commerce Clause Restraints on State

Business Development Incentives, 81 Cornell L. Rev. 789,

873 (1996). Thus, the States could be required to award

refunds to every taxpayer who had paid income tax on

interest earned on out-of-state municipal bonds within the

relevant limitations period, unquestionably a substantial

liability. For instance, in 2003 New York residents reported

$636.4 million of interest income from out-of-state municipal

bonds. D. Denison et al., Davis v. Department of Revenue

of Kentucky: A Preliminary Impact Assessment, IFIR Work-

ing Paper No. 2007-03 (2007), at pp. 13-14, available

at http://www. ifigr.org/publication/ifir_ working papers/IFIR-

WP-2007-03.pdf (last visited July 16, 2007). New York's

11

estimated tax revenue from this interest was $45.8 million.

Id., at 14. For Connecticut, the estimated income tax revenue

in 2004 from out-of-state municipal bond interest and the

dividends paid by municipal bond mutual funds was $70.9

million. /d Thus, the immediate tax refund liability for the

States as a whole could run well into the hundreds of millions

of dollars.

2. The tax treatment of outstanding municipal bonds.

While substantial, the States’ immediate liability for tax

refunds would pale in comparison to the fiscal consequences

related to the taxation of the interest yet to be earned on

outstanding out-of-state municipal bonds. Again, a decision

invalidating Kentucky’s tax exemption would require the

States to treat all municipal bonds equally. For the interest

earned on municipal bonds that have already been issued, the

States would have two choices in providing an adequate

remedy: (1) they could tax the interest earned on in-state

municipal bonds, or (2) they could exempt the interest earned

on out-of-state municipal bonds.

For most States, the option of taxing the interest earned on

in-state municipal bonds that investors have already pur-

chased would be impracticable, if not legally foreclosed. In-

state investors have purchased these bonds in reliance on their

favorable state (ox treatment. For most in-state investors, the

state tax exemption is a critical aspect of the transaction:

They have accepted a lower yield in exchange for the state

income tax benefit, such that they still receive a competitive

after-tax rate of return on their investment. Thus,-taxing the

interest on in-state municipal bonds that taxpayers have

already acquired would be inequitable, if not a breach of

contract. It would change the rules on the bondholders

midstream, forcing them to accept an after-tax rate of return

well below that of comparable investments.

This means that to treat in-state and out-of-state municipal

bonds equally, most States would likely be forced to abstain

12

from taxing any interest earned by their taxpayers on

outstanding out-of-state municipal bonds. The fiscal reper-

cussions of such a mandate would be astounding. As

discussed above, the revenue loss for the States for a single

year would run well into the hundreds of millions of dollars.

See Denison et al., supra, at pp. 13-14. Given that many

outstanding bonds will not mature for another thirty years,

affirmance of the judgment below would cost state govern-

ments billions of dollars in foregone tax revenue.

C. If a Change in the State Tax Treatment of

Municipal Bond Interest Is Desirable, Congress

Is in the Best Position to Make that Change

For the reasons discussed in Part II, infra, amici believe

that Kentucky’s tax exemption is constitutional. Even if

respondents were correct on the law, however, all of the

attendant transition costs could be avoided if the substantive

rule that they seek—the equal state tax treatment of in-state

and out-of-state municipal bonds—could be applied purely

prospectively. That is, these financial dislocations would

disappear if any mandate of equal tax treatment were to apply

only to municipal bonds issued in the future. For the rea-

sons discussed earlier, however, this Court generally cannot

fashion such relief. The only branch of government capable

of adopting such a rule, without simultaneously imposing

massive costs on state treasuries, is Congress.

There is a strong tradition of this Court deferring to

Congress’s superintendence of interstate commerce in cases

raising similar issues of institutional competence, particularly

when they involve matters of state and local taxation. For

example, Moorman Mfg. Co. v. Bair addressed lowa’s single-

factor formula for apportioning the income of interstate

businesses. The plaintiffs demonstrated that lowa’s method

of apportionment likely subjected a number of out-of-state

taxpayers to multiple taxation, and thus disadvantaged inter-

13

state commerce. See 437 U.S., at 276-277. But the Court

reasoned that it was ill-suited to resolve the controversy, as

doing so would have effectively required the Court to choose

a particular method of apportioning income under the guise of

interpreting the dormant Commerce Clause, which it declined

to do. /d., at 278-280. “It is clear,” the Court held, “that the

legislative power granted to Congress by the Commerce

Clause of the Constitution would amply justify the enactment

of legislation requiring all States to adhere to uniform rules

for the division of income. It is to that body, and not this

Court, that the Constitution has committed such policy

decisions.” /d., at 280.

Commonwealth Edison Co. v. Montana involved a sev-

erance tax that Montana imposed on all coal mined in the

State. Because the tax rate was extremely high, and because

its incidence fell predominantly on out-of-state electricity

consumers, the plaintiffs asserted that Montana had effec-

tively exported its tax burden to other States. See 453 U.S., at

617-618. But because a holding in favor of the taxpayers

would have forced the Court to make a range of difficult

empirical economic judgments, it upheld the State’s tax

scheme and left the ultimate resolution to Congress: “Under

our federal system, the determination is to be made by state

legislatures in the first instance and, if necessary, by Con-

gress, when particular state taxes are thought to be contrary to

federal interests.” Jd, at 628. Despite some reservations, this

Court declined to intervene. See id, at 637 (White, J.,

concurring) (“This is a very troublesome case for me, and |

join the Court's opinion with considerable doubt and with the

realization that Montana’s levy on consumers in other States

may in the long run prove to be an intolerable and unac-

ceptable burden on commerce” but “Congress has the power

to protect interstate commerce from intolerable or even unde-

sirable burdens”).

14

Perhaps the most analogous case is Quill Corp. v. North

Dakota, which addressed whether a State could require an

out-of-state vendor to collect use taxes on sales to the taxing

State’s consumers, even when the vendor had no physical

presence in the taxing State. See 504 U.S. at 301. The Court

had invalidated an identical collection obligation 25 years

earlier in National Bellas Hess, Inc. v. Department of

Revenue of ill., 386 U.S. 753 (1967), and “the Bellas Hess

rule . . . engendered substantial reliance and has become part

of the basic framework of a sizable industry.” Quill, 504

U.S., at 317. Despite some evident ambivalence, see id., at

315, 317 (conceding that the physical presence requirement

“appears artificial at its edges” and that the Court had rejected

a “similar bright-line, physical-presence requirement” in

other state tax cases), the Court reaffirmed the rule of Bellas

Hess. \t concluded that, although there were problems with

the rule, Congress was in the best position to alter the status

quo. See id., at 317-318. “[T]he underlying issue is not only

one that Congress may be better qualified to resolve, but also

one that Congress has the ultimate power to resolve. No

matter how we evaluate the burdens that use taxes impose on

interstate commerce, Congress remains free to disagree with

our conclusions.” /d_, at 318 (footnote omitted).

Moorman, Commonwealth Edison, and Quill together rep-

resent a critical strand of this Court’s dormant Commerce

Clause jurisprudence. Specifically, they show that even when

state laws arguably burden interstate commerce, the judicial

disruption of the status quo may not be the wisest course,

particularly in the field of taxation. Reasons of institutional

competence can dictate that the controversy is simply not

meet for judicial resolution.

This is such a case. Even assuming some change in state

tax treatment of bond interest were needed, Congress is the

only institution capable of devising an equitable transition to

a system in which the States’ tax the interest on in-state and

out-of-state municipal bonds equally. Cf. United Haulers,

15

127 S. Ct. at 1797 n. 7 (“Congress retains authority under the |

Commerce Clause as written to regulate interstate commerce,

whether engaged in by private or public entities.”).

In the concluding paragraph of the majority opinion in

Quill, the Court offered the following insight:

[E]ven if we were convinced that Bellas Hess was

inconsistent with our Commerce Clause jurisprudence,

this very fact might give us pause and counsel with-

holding our hand, at least for now. Congress has the

power to protect interstate commerce from intolerable or

even undesirable burdens. In this situation, it may be

that the better part of both wisdom and valor is to respect

the judgment of the other branches of the Government.

504 U.S., at 318—19 (internal quotation marks, alterations,

and citations omitted). The same is true here. Given the

enormous reliance interests at stake, Congress is the branch of

government best suited to craft a solution if one is needed.

II. UNDER UNITED HAULERS, KENTUCKY’S

TAX EXEMPTION FOR INTEREST EARNED

ON IN-STATE MUNICIPAL BONDS DOES

NOT VIOLATE THE DORMANT COMMERCE

CLAUSE

In United Haulers, this Court held that state laws granting

a preference to the government generally do not discriminate

against interstate commerce for purposes of the dormant

Commerce Clause. Specifically, “laws favoring local govern-

ment” with respect to “a customary and traditional gov-

ernment function,” but which trea “all private companies

exactly the same,” “do not discriminate against interstate

commerce.” 127 S. Ct., at 1795-1797 & n. 7 (order of

quotations altered). The tax exemption challenged here meets

all three of these criteria. It favors the government, as it only

covers interest earned on bonds issued by Kentucky and its

municipalities; it treats all private businesses exactly the

16

same; and it concerns an activity—borrowing money—that is

a traditional and core governmental function. It therefore

does not discriminate against interstate commerce. Finally,

because the economic impact of Kentucky’s tax exemption Is

not a cognizable “burden” on interstate commerce, let alone

one that is clearly excessive relative to its local benefits, the

exemption does not violate the dormant Commerce Clause.

A. A State Tax Exemption for Interest Earned on

Bonds Issued by the Taxing State and Its

Political Subdivisions Does Not Discriminate

Against Interstate Commerce

In United Haulers, a coalition of waste haulers contended

that two county “flow control” ordinances violated the dor-

mant Commerce Clause. In particular, they argued that the

ordinances discriminated against interstate commerce because

they prohibited the haulers from delivering trash to out-of-

state processing facilities at lower cost. /d, at 1792. The

Court had confronted a nearly identical ordinance thirteen

years earlier in C & A Carbone, Inc. v. Clarkstown, 511 U.S.

383 (1994), and found the regulation unconstitutional. The

“only salient difference” between the two cases was that the

favored facility in Carbone was privately owned, whereas the

favored facilities in United Haulers were owned and operated

by local government. United Haulers, 127 S. Ct., at 1790.

This sole difference was “constitutionally significant”’—

indeed, dispositive—leading the Court to conclude that the

flow control ordinances did not discriminate against interstate

commerce. /d As the Court noted, there are several

“(clompelling reasons” that justify treating laws that benefit

the government differently from those that bencfit in-state

private businesses under the dormant Commerce Clause. /d.,

at 1795.

First, unlike private businesses, “government is vested with

the responsibilty of protecting the health, safety, and welfare

17

of its citizens.” Jd. (citing Metropolitan Life Ins. Co. v.

Massachusetts, 471 U.S. 724, 756 (1985)). Laws favoring

state and local governments therefore “may be directed

toward any number of legitimate goals unrelated to pro-

tectionism.” -/d., at 1796. Second, treating public and private

entities alike for purposes of the dormant Commerce Clause

“would lead to unprecedented and unbounded interference by

the courts with state and local government.” Jd. Though the

Commerce Clause plays an important role in preventing state

and local governments from engaging in economic pro-

tectionism, it “is not a roving license for federal courts to

decide what activities are appropriate for state and local

government to undertake.” Jd. Finally, courts should be

“particularly hesitant to interfere with [government] efforts

under the guise of the Commerce Clause” when the activities

in question are “both typically and traditionally a local

government function.” /d. (internal quotation marks and

citation omitted).

The essential holding of United Haulers was succinct:

“laws that favor the government” in areas of “traditional

government activity,” but which “treat every private business,

whether in-state or out-of-state, exactly the same,” “do not

discriminate against interstate commerce for purposes of the

Commerce Clause.” /d, at 1790. The logic of that holding

dictates that Kentucky’s tax exemption is not discriminatory.

First, Kentucky’s tax exemption favors the Commonwealth

and its political subdivisions, not private business interests.

Because of the tax exemption, Kentucky taxpayers are willing

to eccept a lower pre-tax rate of return on in-state municipal

bonds. This means that Kentucky and its political sub-

divisions can issue their bonds at a considerably lower

interest rate than the market would require absent the

exemption. Thus, the beneficiaries of the tax exemption are

not Kentucky bondholders; the market largely accounts for

their favorable tax treatment by reducing their yield on the

18

tax-preferred bonds. See Cole et al., The Capitalization of the

State Tax Exemption Benefit in Municipal Bond Yields, 7 J.

Financial & Strategic Decisions 67, 68 (1994), available at

http://www.studyfinance.com/jfsd/pdffiles/v7n2/cole.pdf (last

visited July 16, 2007) (finding 100% capitalization of the

state tax exemption benefit in the yield of municipal bonds).

The beneficiaries are the Commonwealth and its political

subdivisions, which are able to borrow at a considerably

lower interest rate, reducing their costs in raising capital.

This, in turn, enables them to finance a range of public

services and public works. See J. W. Temel, The Funda-

mentals of Municipal Bonds 53-55 (Sth ed. 2001) (explaining

that lower debt-service costs enable state and local govern-

ments to finance such public works as schools, roads, bridges,

airports, public power facilities, sewers, hospitals, fire sta-

tions, affordable housing, mass transit facilities, and uni-

versities).* Of course, it is conceivable that the tax exemption

* Municipal bonds fall into two basic categories: governmental bonds

and private activity bonds. See C. Belmonte, Tax-Exempt Bonds, 1996-

2002 at 151-52 (SOI Bulletin Summer 2005), available at http://www.

irs.gov/pub/irs-soi/02govbnd.pdf (last visited July 17, 2007). Govern-

mental bonds have no statutory definition. See Public Finance Network,

Tax-Exempt Financing: A Primer 3 (rev. ed., n.d.). They are generally

issued to finance facilities that are owned, controlled, and operated by

state or local governments, such as schools, streets, and utilities. See id.,

at 2; Belmonte, supra, at 155.

Private activity bonds are defined by § 141 of the Internal Revenue

Code. See 26 U.S.C. §141. In brief, a municipal obligation will be

considered a private activity bond, “irrespective of the purpose for which

it is issued or the source of payment, if (1) more than 10 percent of the

proceeds of the issue will finance property that will be used by a

nongovernmental person in a trade or business, and (2) the payment of

debt service on more than 10 percent of the proceeds of the issue will be

(A) secured by property used in a private trade or business or payments in

respect of such property, or (B) derived from payments in respect of

property used in a private trade or business.” Temel, supra, at 25}.

Roughly three-fourths of the municipal bond market consists of govern-

19

actually costs Kentucky more in foregone tax revenue than it

delivers in reduced borrowing costs. See Cole et al., supra, at

68, 72. But the relevant point for purposes of United Haulers

is that, to the extent the exemption provides a benefit, that

benefit runs to the government.

Second, Kentucky’s tax scheme treats all private busi-

ness interests identically. The Kentucky tax code includes

all bond interest in income, with the sole exception of

the interest earned on bonds issued by the Commonwealth

or its political subdivisions. See Ky. Rev. Stat. Ann.

§§ 141.010(9), 141.010(10)(c). Every private issuer of debt

is treated the same, regardless of its location. The law grants

no advantage to Kentucky businesses—whether they are bond

issuers, bond dealers, bond brokers, or bond holders—over

their out-of-state competitors.°

Consequently, Kentucky’s tax exemption does not repre-

sent the sort of economic protectionism with which the

dormant Commerce Clause is chiefly concerned. This is not

a law that “burden[s} out-of-state producers or shippers

simply to give a competitive advantage to in-state busi-

nesses.” Granholm v. Heald, 544 U.S. 460, 472 (2005) (em-

phasis added). Nor is it a law that “give[s] local consumers

mental bonds, and one-fourth of private activity bonds. See Belmonte,

supra, at 151 (between 1996 and 2002 more than $1.5 trillion in

governmental bonds and $548 billion in private activity bonds were

issued).

> As discussed in more detail infra at 20 & 25-26, Kentucky’s

exemption also furthers the legitimate objectives of decentralizing control

over the Commonwealth’s fiscal affairs and encouraging more state

citizens to become genuine stakeholders in their community.

° Of course, the issuance of municipal bonds will produce benefits for

private contractors that perform the projects that are financed by the

bonds. But the same is true of any public spending, whether financed

through bonds, taxes, license fees, or a grant from the federal government.

This Court has never considered the existence of such benefits, in itself,

“protectionist.”

20

an advantage over consumers in other States.” Brown-

Forman Distillers Corp. v. New York State Liquor Auth., 476

U.S. 573, 580 (1986).

Instead, the exemption operates as an implicit, intrastate

transfer from the Commonwealth’s pool of general revenue to

those governmental units (including the Commonwealth

itself) that choose to raise capital through the issuance of

municipal bonds. The decision whether to issue municipal

bonds is vested by state law in various governmental units

and, through elections, their respective constituents. When

these governments issue debt, the exemption offers an

implicit subsidy by reducing the interest rate that the market

will demand. The cost of this subsidy, however, is fully

funded by Commonwealth itself: The Kentucky government

must pay for it by relinquishing personal income tax revenue.

In this sense, the tax exemption is indistinguishable in prac-

tical effect from a program under which the Commonwealth

offered no tax exemption but made direct cash payments to its

municipalities when they issued bonds, a program that would

plainly be constitutional.

The exemption is therefore best understood as a policy

choice by the Commonwealth about how to structure the

financing of its various governmental units. Through the

mechanism of the exemption, Kentucky has decided (1) to

raise less revenue through personal income taxes and more

through municipal bond issues, and (2) to decentralize the

decisionmaking process concerning how much capital to raise

and which public works to pursue. Those governmental units

with the authority to issue bonds are empowered to use state

general funds (in the form of foregone income tax revenue) to

pursue projects that they believe are beneficial to their

respective jurisdictions. Structuring state and municipal

finances in this fashion is thus a political choice. And like the

decision by Oneida and Herkimer Counties and New York

State to displace private competition in waste processing with

21

a government-run monopoly, “nothing in the Commerce

Clause vests the responsibility for that policy judgment with

the Federal Judiciary.” United Haulers, 127 S. Ct., at 1796.

Finally, the activity of borrowing money to finance the

construction of infrastructure and other necessary public

improvements is a “traditional government function.” First,

the practice has deep historical roots, predating the issuance

of corporate debt by several centuries. See Temel, supra, at

49 (noting that Italian city-states borrowed from major

merchant banking families during the Renaissance). Ameri-

can cities incurred debt as early as the seventeenth century.

See id. New York City issued the first officially recorded

municipal bond in 1812 to finance the construction of the Erie

Canal. See Shafroth, Which State Taxes Are ‘Preferred’ for

Infrastructure?, 40 State Tax Notes 237 (2006). By 1843,

U.S. cities had accumulated approximately $25 million in

outstanding debt, and the number of municipal bond issues

has grown exponentially ever since. See Temel, supra, at 49-

50. State and local governments issued $26 billion in

municipal bonds in 1975, and they issued more than ten times

that amount ($263.8 billion) in 1999. See id, at 3. Presently,

the value of outstanding U.S. municipal bonds is roughly $2.4

trillion. See T. Herman, Justices to Hear Muni-Bond Case—

Kentucky Tax Fight Over Exemptions Affects Many States,

Wall St. J., May 22, 2007, at D3.

Second, and more fundamentally, borrowing money is

indispensable to state and local governments’ capacity to

provide essential but costly governmental services. See South

Carolina v. Baker, 485 U.S. 505, 531 (1988) (O’Connor, J.,

dissenting) (“Long-term debt obligations are an essential

source of funding for state and local governments.”). There

are approximately 87,000 state and local governments in the

United States, U.S. Census Bureau, Statistical Abstract of the

United States: 2007, at p. 264 (Table 415), and only the very

largest are capable of financing any significant capital im-

22

provements exclusively from current revenue. Even for state

governments, issuing bonds is often the only practical means

to finance the construction of essential infrastructure, such as

roads, highways, sewers, and utilities. Bond issues make

these public investments possible by allowing state and

local governments to spread the relevant tax burden over

several years.

Issuing bonds is thus a temporal extension of a State’s

authority to tax, a power that is “basic to its sovereignty.”

Bode v. Barrett, 344 U.S. 583, 585 (1953). Municipal bonds

permit governments to extend the time frame of taxation over

the useful life of the capital improvement, rather than forcing

them to impose the entire tax burden at the time of the

improvement’s construction. Moreover, bonds promote fair-

ness in public finance by enabling state and local govern-

ments better to ensure that the citizens who benefit from long-

term capital improvements (those who live in the community

over the life of the assets) are those who pay for them (in

taxes that go toward servicing the debts). Absent such a

spreading of the tax burden, taxpayers required to fund the

entire cost of public works at the time of their construction

would have a strong incentive to undersupply these important

public goods. Thus, there are powerful systemic reasons that

local governments have incurred debt since colonial times,

and that they continue to rely on it heavily today.

In short, Kentucky’s tax exemption falls squarely within

the rule announced in United Haulers: It favors state and

local government, it treats all private businesses equally, and

it concerns a traditional government activity. It necessarily

follows that, for purposes of the dormant Commerce Clause,

Kentucky’s income tax exemption for interest earned on in-

state municipal bonds does not discriminate against interstate

commerce.

23

B. Kentucky’s Tax Exemption Does Not Impose a

“Clearly Excessive” Burden on _ Interstate

Commerce

Because Kentucky’s tax exemption does not discriminate

against interstate commerce, the appropriate test under the

dormant Commerce Clause is that set out in Pike v. Bruce

Church, Inc., 397 U.S. 137 (1970), for laws that are “directed

to legitimate local concerns, with effects upon interstate

commerce that are only incidental.” City of Philadelphia v.

New Jersey, 437 U.S. 617, 624 (1978).’ To pass muster,

Kentucky must only show that the burden on interstate

commerce attributable to the tax exemption is not “clearly

excessive in relation to the putative local benefits.” Pike, 397

U.S., at 142. Kentucky has made that showing here.®

” Since 1977, this Court has typically applied the 4-part test originally

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

to determine whether a challenged state tax provision is consistent with

the dormant Commerce Clause. See, e.g., Oklahoma Tax Comm. v.

Jefferson Lines, Inc., 514 U. S. 175, 183 (1995); Itel Containers Int'l

Corp. v. Huddleston, 507 U. S. 60, 73 (1993); Trinova Corp. v. Michigan

Dept. of Treasury, 498 U. S. 358, 372 (1991); Goldberg v. Sweet, 488

U.S. 252, 259-260 (1989). Under Complete Auto, a state tax is

permissible so long as it “is applied to an activity with a substantial nexus

with the taxing State, is fairly apportioned, does not discriminate against

interstate commerce, and is fairly related to the services provided by the

State.” Complete Auto, 430 U.S., at 279. Here, Respondents’ only

Commerce Clause claim appears to be that Kentucky’s tax exemption

discriminates against interstate commerce. See J.A. 24. Thus, if the

Court concludes that the exemption is non-discriminatory, further analysis

under Pike may be unnecessary. Cf. General Motors v. Tracy, 519 U.S. at

824 n. 12 (suggesting that Pike balancing is not required if Complete

Auto’s apportionment prong is satisfied).

* Because the trial court upheld Kentucky’s tax exemption on the

ground that the Commonwealth was acting as a market participant, it did

not reach the question whether the exemption satisfied Pike’s balancing

test. See Pet. App. 18a-19a. Likewise, because the Kentucky Court of

Appeals invalidated the exemption on the ground that it discriminated

24

First, Kentucky’s tax exemption furthers several legitimate

government objectives. It reduces the interest rate that

Kentucky and its political subdivisions must pay when they

issue bonds. It devolves greater power over the Common-

wealth’s fiscal affairs—-how much money to spend, and

which projects to fund—-to local governments, which are

better positioned to respond to their respective communities’

needs. And it encourages Kentucky citizens to become

personally invested in the construction of the Common-

wealth’s infrastructure, and indeed its future—its schools,

universities, roads, utilities, hospitals, and low-income

housing.

Second, the exemption’s economic impact is not properly

understood as a “burden on interstate commerce,” let alone a

burden that is “clearly excessive in relation to its putative

benefits.” The principal economic effect of the exemption is

to alter the residential distribution of those persons holding

Kentucky municipal bonds. It creates a financial incentive

for Kentucky citizens, when they are purchasing municipal

bonds, to purchase Kentucky bonds rather than those issued

by another State. As a result, the proportion of investors

holding Kentucky municipal bonds who are Kentucky

citizens is substantially greater than it would be absent the

exemption. The same is almost certainly true, to greater and

lesser degrees, for all 42 States that offer a tax preference for

the interest zarned on in-state municipal bonds.” This ex-

against interstate commerce, it did not address the Pike balancing ques-

tion, either. See Pet. App. 4a—lla. Thus, no court has evaluated the

exemption’s local benefits or its impact on interstate commerce. For the

reasons stated infra, we believe that, as a matter of law, the exemption’s

impact on interstate commerce is not a cognizable “burden” for purposes

of the dormant Commerce Clause, and that this Court should therefore

uphold the exemption under Pike.

* The strength of this incentive turns on the taxpayer’s marginal state

income tax rate. The effect is apt to be strongest for bonds issued by

states like California, where the top marginal income tax rate is 9.3

25

plains the existence of the 400-odd state-specific mutual

funds that various investment companies now market to

investors. '°

Though this practical consequence is rather obvious, it is

not a “burden on interstate commerce.” Although the

exemption steers more Kentucky residents towards Kentucky

municipal bonds, the Commonwealth’s relationship to its

residents is qualitatively different than that between a typical

debtor and its creditors: It is the relationship between a

sovereign and its citizens. “[A]s the guardian and trustee for

its people,” Atkin v. Kansas, 191 U.S. 207, 222 (1903),

Kentucky has a strong interest in encouraging its citizens to

be more than just consumers of the State’s public services.

Like any sovereign, it naturally desires its citizens to be genu-

ine stakeholders in the Commonwealth and its municipalities

An investor’s decision to purchase a municipal bond issued

by his or her home State is also distinctive from the investor’s

perspective. After all, it is Kentucky citizens who will

directly benefit from the projects financed by Kentucky’s

municipal bonds, and it is Kentucky citizens who, through

their tax dollars, will pay off the interest on these bonds. Cf

Reeves. Inc. v. Stake, 447 U.S. 429, 442 (1980); United

Haulers, 127 S.Ct. at 1797. A citizen’s decision to invest in

his or her own State therefore implicates important, non-

financial considerations that are inapplicable to other

commitments of capital. For all of these reasons, the fact that

Kentucky taxpayers are more heavily invested in Kentucky

percent, while it less significant for bonds issued by states like

Connecticut, where the top marginal rate is 5 percent.

' According to the Investment Company Institute, at the close of 2006

there were 482 single-state municipal bond mutual funds with combined

assets totaling $155 billion. See J. Mysak, Trash-Hauler Case Muddies

Water for Municipal Market, Bloomberg, May 9, 2007, available at

http://www.bloomberg.com/apps/news?pid=2060 1039&sid=aaVU49WiU

SFs&refer=columnist mysak (last visited July 16, 2007).

26

municipal bonds—both literally and figuratively—is not a

“distortion” of interstate commerce. Instead, it is a natural

and salutary consequence of the Nation’s federal structure.

Moreover, Respondents’ arguments about the beneficial

economic effects that would flow from invalidating Ken-

tucky’s tax exemption are empirically unsupported and

logically flawed. For instance, Respondents assert that,

without theses tax exemptions, States “will compete for

investors’ dollars . . . on the merits of the projects funded by

the investment sales,” and that, “[a]s a result, the market will

provide incentives for governments to be more careful in

selecting and funding projects through bond sales.” Brief in

Opp. 11 n. 5. But that incentive already exists, and strongly

so. For purposes of assessing the States’ incentives, what

matters are the effects of changes in their creditworthiness at

the margin. Because the state tax exemption is largely

capitalized into municipal bonds’ yields, the tax exemption—

while lowering the interest rate that state and local govern-

ments must offer—does nothing to diminish the marginal

importance to them of remaining a good credit risk. Stated

differently, a change in a state or local government’s bond

rating in a State with an exemption like Kentucky’s is apt to

have the same impact on that government’s borrowing costs

as it would absent the exemption.

Finally, the economic impact attributable to Kentucky’s tax

exemption is quite unlike the harms that this Court has found

to constitute “clearly excessive” burdens on interstate com-

merce in its prior applications of Pike. It is not an

idiosyncratic state regulation that, when combined with the

laws of surrounding States, clogs the channels of interstate

commerce. Cf. Kassel v. Consolidated Freightways Corp. of

Del., 450 U.S. 662 (1981); Raymond Motor Transp., Inc. v.

Rice, 434 U.S. 429 (1978). It is not a law that operates

extraterritorially, regulating commercial transactions that oc-

cur in other States. Cf. Edgar v. MITE Corp., 457 U.S. 624

27

(1982). And it is not an explicit embargo that prohibits

private businesses from transporting certain goods across

state borders, as was the case in Pike itself. See 397 U.S. at

139.

Kentucky’s tax exemption represents a preference by a

sovereign for itself, in selling to its own citizens, over other

sovereigns. Its effects are simply not comparable to anything

this Court has previously held to be an a burden

on interstate commerce.

CONCLUSION

The judgment of the Kentucky Court of Appeals should be

reversed.

Respectfully submitted,

RICHARD RUDA*

Chief Counsel

STATE AND LOCAL LEGAL CENTER

444 North Capitol Street, N.W.

Suite 309

Washington, D.C. 20001

(202) 434-4850

July 19, 2007 * Counsel of Record for the

Amici Curiae