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

GYD fb

3A NY

No. 06-666

IN THE

Supreme Court of the United States

DEPARTMENT OF REVENUE OF

KENTUCKY, ET AL.,

Petitioners,

v.

GEORGE W. DAVIS, ET UX.,

Respondents.

On Writ of Certiorari to the

Court of Appeals of Kentucky

BRIEF OF THE TAX FOUNDATION

AS AMICUS CURIAE

IN SUPPORT OF RESPONDENTS

CHRISTOPHER D. ATKINS BRIAN E. BAILEY*

Senior Tax Counsel *Counsel of Record

TAX FOUNDATION ICE MILLER LLP

2091 L Street NW, One American Square

Suite 1050 Suite 3100

Washington, DC 20036 Indianapolis, IN 46282

(202) 464-6200 (317) 236-2426

WILSON-EPES PRINTING Co., INC. - (202)789-0096 - WasHiINcTON, D.C. 20002

QUESTION PRESENTED

Whether a state violates the dormant

Commerce Clause by providing an

exemption from its income tax for interest

income derived from bonds issued by the

state and its political subdivisions, while

treating interest income realized from

bonds issued by other states and their

political subdivisions as taxable to the same

extent, and in the same manner, as interest

earned on bonds issued by commercial

entities, whether domestic or foreign.

li

TABLE OF CONTENTS

Oe EE TE scciccenssincbesenadenmnnncsmmisnesesctaneuinnnsion I

Se a TIER wobiiiesintecsinnesccmenerensnenicinpecsoeianensieet II

ee Ber is cecttettccseccnccccevecssnessesensnensvsin IV

INTEREST OF THE AMICUS CURIAE ..........c..cccccsceseeees 1

SUMMARY OF ARGUMENT.................ccsscssssrsssssssssresenees 2

UII Sic tcicdiaichccpcienicryncininddappeenntuniiiecencdaticnnidunbinedeictitahres 3

I. THE COMMERCE CLAUSE EMBRACES THE

PRINCIPLE OF COMPETITIVE NEUTRALITY,

WHICH PROHIBITS STATES FROM TAXING

ACTIVITY OUT-OF-STATE WHILE NOT

TAXING IDENTICAL ACTIVITY IN-STATE. ...... 3

A. The Commerce Clause, as interpreted by this

Court’s precedents, prohibits states from

imposing a tax on activity out-of-state while

leaving identical activity in-state untaxed.......5

B. Kentucky’s law imposes a tax on activity out-of-

state, while leaving identical activity in-state

i icethtcicnaceisiiasithociibliatiinddnisintaiamiiasieoneniseusiutinnsiiin 10

C. This Court should recognize that kentucky’s

law taxes activity occurring out-of-state, and

thus differs from valid laws that do not. ........ 11

Il. THIS COURT SHOULD CONSIDER WHETHER

THE KENTUCKY EXCLUSION VIOLATES THE

IMPORT-EXPORT CLAUSE AND THE

PRIVILEGES OR IMMUNITIES CLAUSE. ........ 15

A. The Import-Export Clause of Article I, Section

10 prohibits states from penalizing activity

thant eromnes State TIMES. ............00c.cceescrcsecsccesecs 15

ili

B. The Privileges or Immunities Clause of the

fourteenth amendment protects the right of

citizens to cross state lines in pursuit of an

ID: iacieesiciscnitssissinsiilinedinittinnideiaaiinuniaicaiiatiies 18

Il.A RULING FOR RESPONDENTS WOULD

NEITHER UNDULY INFRINGE KENTUCKY'S

STATE SOVEREIGNTY NOR EXCESSIVELY

IMPACT MUNICIPAL BOND MARKETS. ......... 22

A. A ruling for Respondents would not unduly

infringe state sovereignty, as states could still

allow a non-discriminatory municipal bond

interest exclusion, or tax all municipal bond

i aiitiisncinnncthioniaidiianestestinesabenadinaniaa 22

B. A ruling for Respondents would not excessively

impact municipal bond markets. .................... 23

C. Invalidating Kentucky’s discriminatory

taxation of out-of-state municipal bond interest

income will affect some states more than

i iciicinasnsdevisisicnsnatinnicstnissnclsicnaataaiatmatctiaaiin, 25

IV. THIS COURT SHOULD BE CAUTIOUS NOT TO

SUGGEST THAT DISCRIMINATION ANALYSIS

APPLIES TO TAXES BUT NOT SUBSIDIES. .... 26

A. This Court has in the past rejected formalism

in favor of economic reality, but has not

extended that fully into the realm of

discriminatory subsidies................:.ccssesseseeees 27

B. A state subsidy program with the identical

economic «ffect of Kentucky law here

should be subject to the same discrimination

SI ncspidsciennbinnbinnsinndiclaseniniubineubbinameipinaidieats 28

ITD coticiienisisninsnaicsineninduceisionnrniitubinnmntercuananiaiit 29

iv

TABLE OF AUTHORITIES

Cases

Almy v. California, 65 U.S. 169 (1861)...............cccececeeeeees 17

Am. Yearbook Co. v. Sakew, 409 U.S. 904 (1973)............ 14

Am. Trucking Ass’n v. Scheiner, 483 U.S. 266 (1987)........ 7

Bacchus Imps., Ltd. v. Dias, 468 U.S. 263 (1984)..7, 28, 29

Baldwin v. G.A.F. Seelig, Inc., 294 U.S. 511 (1935) ........ 21

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

Gane Wi hcsersiviccociicsewiciieniaiebesiialassadibinibtaianiisadtiameiaiamauiidial 4,6

Brown v. Maryland, 25 U.S. (12 Wheat.) 419 (1827).......17

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

Fee Ss Se GOD teccnviemninnsisennstvaniceeaonnteninnns 8, 16, 17

Colgate v. Harvey, 296 U.S. 404 (1935) ...... ec eeeeeeeee 20

Complete Auto, 430 U.S. 274 (1977) .......cccceeceereeseeeeeeeees 27

Crowell v. Benson, 285 U.S. 22 (1932).............ccceeceseeeeeeees 27

Cuno v. DaimlerChrysler, Inc., 386 F.3d 738 (6th Cir.

Spe cnsweinctncnsedouincinmevenssnnensnanesssibesineiteiaiadaiimaaiiaiamimlias 12

DaimlerChrysler Corp. v. Cuno, 547 U.S. __; 126 S. Ct.

BE aE rcrensniesnnsnsinnnsipusnininiieiulaivaticieiiitesgimaialidiplaaiae 11

Dean Milk Co. v. Madison, 340 U.S. 349 (1951) ................ 5

Edwards v. California, 314 U.S. 160 (1941) ................... 20

Gibbons v. Ogden, 22 U.S. 1 (1824) ....cscecscssssssecssesssseseseves 5

Henneford v. Silas Mason Co., 300 U.S. 577 (1937) .......... 8

Madden v. Kentucky, 309 U.S. 83 (1940).................... 20, 21

Maryland v. Louisiana, 451 U.S. 725 (1981) ...........-...0-0- 6

Michelin Corp. v. Wages, 423 U.S. 276 (1976) ................. 17

Molloy v. Gov’t of the Virgin Islands, No. 2006-51 (D.V.L.

SSE AE oC ee ee 9

New Energy Co. v. Limbach, 486 U.S. 269 (1988) .8, 14, 28

New York v. United States, 326 U.S. 572 (1946).............. 27

Patterson v. McLean Credit Union, 491 U.S. 164 (1989). 23

Quill v. North Dakota, 504 U.S. 298 (1992) ....................0.. 9

Reeves, Inc. v. Stake, 447 U.S. 429 (1980).................000000- 13

Saenz v. Roe, 526 U.S. 489 (1999)...........cccccccceceeeeeerees 20, 21

Shapiro v. Thompson, 394 U.S. 618 (1969)...................... 21

Slaughterhouse Cases, 83 U.S. (16 Wall.) 36 (1873)..19, 21

Tax Comm’r of the State of West Virginia v. MBNA

America Bank, N.A., 640 S.E.2d 226 (W.V. 2006), cert

denied, No. 06-1228 (Jun. 18, 2007) .........cccccccccereeeeeeeees 9

Thomas v. Union Carbide Agric. Products, 473 U.S. 563

EE 27

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

Waste Management Authority, 550 U.S. __ (slip op.

es IS ID ccccccccecceccccnsescescssesescecsseses 14

United States v. Classic, 313 U.S. 299 (1941).................. 27

West Lynn Creamery, Inc. v. Healy, 512 US. 186

TT scissiisinananesibacibieniininiaiinateransiatestaiinianasititaanmeatinitiel 5, 8, 28

Westinghouse Elec. Co. v. Tully, 466 U.S. 388 (1984)..........

In EA ET ETE See 6, 7, 28, 29

Willson v. The Black Bird Creek Marsh Co., 27 U.S. 245

A aE Nae Owe ART SERN IAA 5

Woodruff v. Parham, 75 U.S. 123 (1868)..................:2000+- 17

Constitutional Provisions

ee ee HE Bs GIN Oi cenetcceraseccnenesententnemnssniooneanitiont 5

RO 8 eee 16

Be aay Bt i cncaintinreencennnscngannoniienepsnnmennaniniiins 19

ka Se eee 18

ARTICLES OF CONFEDERATION art. IV ................ceccccceeeeee: 19

Statutes

Ns OF SET ncrenttennncinesncsnenepicnsenenenenmmnaidasmnnsensntinnitaptnied 4

ts TTT otssnrrintenetacnedinmentiginiandtnnniontsiaiiaéiaiiiil 4

KY. REV. STAT. § 141.010 ef seq............ccccccsssceeeeseeereeees 4,11

KY. REV. STAT. § 141.020(8)(a) ........-..c-cccccceeececeseerereeeneeees 10

Other Authorities

Akhil R. Amar, The Bill of Rights and the Fourteenth

Amendment, 101 YALE L.J. 1193 (1992)........0.0000000000. 19

Brannon P. Denning, “The Import-Export Clause” in THE

HERITAGE GUIDE TO THE CONSTITUTION 176 (David F.

Brian D. Galle & Ethan Yale, Can Discriminatory State

Taxation of Municipal Bonds Be Justified? Thoughts on

the Davis Topside Briefs, TAX NOTES (forthcoming

2007), available at http://ssrn.com/abstract=1014138.24

Brief of Council on State Taxation and National

Association of Manufacturers as Amicus Curiae In

Support of Petition for Writ of Certiorari,

DaimlerChrysler Corp. v. Cuno (2005) (No. 04-1704)..13

Brief of Tax Foundation as Amicus Curiae Supporting

Petition for Writ of Certiorari, Daimler Chrysler Corp.

yp. Cuno, (2005) (No. 04-1704)............cc.cccscceccccsoccesesceeees 12

Brief of the Securities Industry & Financial Markets

Association as Amicus Curiae Supporting Petitioners,

Kentucky v. Davis (2007) (No. 06-666)................. a 22

Chris Atkins, Federal Court Ruling May Hurt Tax

Competition, State Tax Reform, TAX FOUNDATION

Oe 29

Clayton P. Gilette, Business Incentives, Interstate

Competition, and the Commerce Clause, 82 MINN. L.

ee, GF Ca eB erccecnccesczssesscecsnensnesiceuienemmnessonmassaseemennians 4

ERWIN CHEMERINSKY, CONSTITUTIONAL LAW (2d ed. 2002)

vill

Ethan Yale & Brian D. Galle, Municipal Bonds and the

Dormant Commerce Clause After United Haulers, 44

STATE TAX NOTES 877 (Jun. 18, 2007)...................... 4,14

JOHN HART ELY, DEMOCRACY AND DISTRUST (1980) ....... 19

Laurence H. Tribe, Taking Text and Structure Seriously:

Reflections on Free-Form Method in Constitutional

Interpretation, 108 HARV. L. RPV. 1221 (1998)............. 19

Patrick Fleenor, “Tax-Exempt State and Local Bonds: A

$20 Billion Gift to the Nation’s Wealthiest Investors,”

in Fixing the Alternative Minimum Tax: AMT Reform

Requires Changes to Regular Tax Code, Tax

FOUNDATION SPECIAL REPORT NO. 155 (May 2007), at

9, available at http://www.taxfoundation.org/files/

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

Analytical Approach to State Tax Discrimination Under

the Commerce Clause, 39 VAND. L. REV. 879 (1986) .... 12

RANDY BARNETT, RESTORING THE LOST CONSTITUTION

i 19

ROBERT BORK, THE TEMPTING OF AMERICA: THE

POLITICAL SEDUCTION OF THE LAW (1990)................... 19

ESSA RAS SR Ms ERS Oa 16

SUPPLEMENT TO MAX FARRAND’S THE RECORDS OF THE

FEDERAL CONVENTION OF 1787 (James H. Hutson ed.,

No. 06-666

IN THE

Supreme Court of the United States

DEPARTMENT OF REVENUE OF

KENTUCKY, ET AL.,

Petitioners,

Vv.

GEORGE W. DAVIS, ET UX.,

Respondents.

On Writ of Certiorari to the

Court of Appeals of Kentucky

BRIEF OF THE TAX FOUNDATION

AS AMICUS CURIAE

IN SUPPORT OF RESPONDENTS

INTEREST OF THE AMICUS CURIAE

The Tax Foundation submits this brief as amicus

curiae in support of Respondents in the above-captioned

matter.’

The Tax Foundation is a non-profit research

' No counsel for a party authored this brief in whole or in part, and no

person or entity, other than amicus curiae, has made a monetary

contribution to the preparation or submission of this brief. Written

consent of the Petitioners and Respondents have been obtained and

filed with the Clerk of the Court.

organization founded in 1937 to educate taxpayers about

sound tax policy. To this end, we disseminate information

on taxes and promote tax systems that are simple, fair,

and conducive to economic growth. The Tax Foundation

works to further this mission by educating the legal

community on issues relating to tax law, by explaining

tax law concepts to lawmakers and the public in an

understandable and relevant manner, and by advocating

that judicial decisions on tax law promote principled tax

policy. Accordingly, the Tax Foundation has a direct

stake in the outcome of this case.

SUMMARY OF ARGUMENT

The Commerce Clause prohibits state laws like

Kentucky’s that effectively tax activity out-of-state while

exempting identical activity occurring in-state. This

Court has recognized, however, that this does not prohibit

every state law that may affect economic decision-making,

because permitting states to design tax systems that

foster a competitive business climate goes hand in hand

with the federalism and liberty that the Commerce

Clause protects. By clarifying that “tax neutrality” means

“competitive neutrality,” this Court will reach the proper

result here and remain consistent with its precedents.

This case also provides an opportunity for this Court

to consider the domestic application of the Import-Export

Clause of Article I, Section 10, which would prevent states

from penalizing activity that crosses state lines. Further,

this case could implicate the Privileges or Immunities

(leuse of the Fourteenth Amendment, which protects the

mg at of citizens to cross state lines in pursuit of an honest

living.

A ruling for Respondents in this case would not

unduly infringe Kentucky’s sovereignty, as states could

still permit exclusion of all municipal bond interest from

taxable income, as is done at the federal level and in

Indiana. Nor would a ruling for Respondents excessively

impact the municipal bond market, as states would stil!

have access to capital at competitive interest rates.

Finally, this Court should be cautious about

suggesting that discriminatory taxes should receive

greater constitutional scrutiny than discriminatory

subsidies. A state subsidy program with identical

economic effects as Kentucky’s tax should undergo

identical constitutional scrutiny; otherwise, states could

continue discriminatory schemes in a different but

equally harmful form.

ARGUMENT

I. THE COMMERCE CLAUSE EMBRACES THE

PRINCIPLE OF COMPETITIVE NEUTRALITY,

WHICH PROHIBITS STATES FROM TAXING

ACTIVITY OUT-OF-STATE WHILE NOT TAXING

IDENTICAL ACTIVITY IN-STATE.

By clarifying that “tax neutrality” means “competitive

neutrality,” and that states cannot tax activity out-of-

state if identical activity in-state is left untaxed, this

Court can reach the proper result in this case, remain

consistent with its precedents, and chart a course that

lessens the tension between discriminatory taxation and

permissible state tax experimentation. Competitive

neutrality means that this Court can uphold state tax

“welcome mats” that foster new investment in labor and

capital within a state, while retaining the power to

invalidate state tax “exit tolls” that seek to protect a

state’s existing industry from interstate competition.

Kentucky’s exclusion is just such an “exit toll.” Since

1913, federal tax law has allowed taxpayers to exclude

from gross income the interest generated by state and

local municipal bonds. See 26 U.S.C. § 103.2 Kentucky

tax filers are instructed to start with federal gross income,

then to add back in any municipal bond income earned

from “other states and their political subdivisions.” Ky.

REV. STAT. § 141.010 et seg. Kentucky is among 42 of the

43 income-taxing states that exclude interest from in-

state municipal bonds but tax interest from out-of-state

bonds. See Ethan Yale & Brian D. Galle, Municipal

Bonds and the Dormant Commerce Clause After United

Haulers, 44 STATE TAX NOTES 877, 878 (Jun. 18, 2007).

While this Court has consistently invalidated state

statutes that discriminate against interstate commerce,

those rulings have not resolved the tension between

forbidden tax discrimination and _ permissible tax

experimentation. On one hand, this Court has held that

the Commerce Clause prohibits state laws like

Kentucky’s, which channel investment into the state by

penalizing investments made out-of-state, thus

“foreclos|ing] tax neutral decisions.” Boston Stock Exch.

v. State Tax Comm'n, 429 U.S. 318, 331 (1977). But this

Court has recognized that not every state law that may

affect economic decision-making is_ discriminatory,

because permitting states to enact a lower tax rate, for

instance, fosters a competitive business climate consistent

with the federalism and liberty that the Commerce

Clause protects. See e.g., Clayton P. Gilette, Business

Incentives, Interstate Competition, and the Commerce

Clause, 82 MINN. L. REV. 447, 448 (1997) (arguing that

state competition promotes the goals of the Commerce

Clause). The Commerce Clause should be held to forbid a

state from taxing an out-of-state activity if the state solely

exempts identical in-state activity from taxation.

* But gains realized from the sale of exempt bords are taxed. Also,

interest from private-activity municipal bonds is taxed federally under

the Alternative Minimum Tax (AMT), which denies tax preferences to

many high-income taxpayers. See 26 U.S.C. § 57(aX5XC).

A. The Commerce Clause, as interpreted by this

Court’s precedents, prohibits states from

imposing a tax on activity out-of-state while

leaving identical activity in-state untaxed.

The people of the United States adopted the

Constitution in large part because their existing national

government had no power to stop states from imposing

trade barriers between each other, to the detriment of the

national economy. “[States’ power over commerce,]

guided by inexperience and jealousy, began to show itself

in iniquitous laws and impolitic measures . . ., destructive

to the harmony of the States, and fatal to their

commercial interests abroad. This was the immediate

cause, that led to the forming of a convention.” Gibbons v.

Ogden, 22 U.S. 1, 224 (1824) (Johnson, J., concurring).

Consequently, among the powers granted to Congress by

the new Constitution was that “[tlo regulate Commerce . .

. among the several States,” a provision known as the

Commerce Clause. U.S. CONST. art. I, § 8, cl. 3. Congress

and the courts thus have the power to strike down laws

that discriminate against interstate commerce.’

Nevertheless, states still have incentives to impede

interstate commerce, as ‘ey always will. See, e.g., West

Lynn Creamery, Inc. v. Healy, 512 U.S. 186, 193 (1994)

(“A tariff] violates the principle of the unitary national

market by handicapping out-of-state competitors, thus

artificially encouraging in-state production even when the

same goods could be produced at lower cost in other

States.”); Dean Milk Co. v. Madison, 340 U.S. 349, 354

(1951) (“In thus erecting an economic barrier protecting a

major local industry against competition from without the

State, Madison plainly discriminates against interstate

* The power of federal courts to act when Congress is silent was

inferred from the Commerce Clause (the “dormant” or “negative”

Commerce Clause). See e.g., Willson v. The Black Bird Creek Marsh

Co., 27 U.S. 245 (1829).

commerce.”). When examining a statute under the

Commerce Clause, this Court has looked for evidence that

the state is foreclosing competitive neutrality—penalizing

activity out-of-state while solely and effectively leaving

identical activity in-state untaxed. Where a state is

discriminating in this manner, the Court has invalidated

the tax.

For instance, in Boston Stock Exchange, 429 U.S. at

318, New York had imposed a tax on stock transfers that

used out-of-state brokers instead of in-state brokers. Ifa

taxpayer switched from in-state to out-of-state brokers,

New York would levy a higher tax. While this effective

tax on activity out-of-state was correctly held to violate

the Commerce Clause, this Court was careful to note that

“(o)ur decision today does not prevent the States from

structuring their tax systems to encourage the growth

and development of intrastate commerce and industry. . . .

We hold only that in the process of competition no State

may discriminatorily tax the products manufactured or

the business operations performed in any other State.”

Id. at 336-37. The Court’s ruling was concerned not with

imposing uniformity, but rather with preventing the state

from solely taxing activity out-of-state while leaving

identical activity in-state untaxed.

In Westinghouse Elec. Co. v. Tully, 466 U.S. 388

(1984), this Court described taxes invalidated in Boston

Stock Exchange and Maryland v. Louisiana, 451 U.S. 725

(1981), as having impermissibly “imposied] greater

burdens on economic activities taking place outside the

State than were placed on similar activities within the

State.” Id. at 404. In Westinghouse, New York imposed a

franchise tax but then gave a credit for in-state, but not

out-of-state, activity. See id. at 390-94. The Court ruled

that because the credit solely exempted activity in-state

from a tax levied on activity both in-state and out-of-state,

it was no different from a discriminatory tax. “Nor is it

relevant that New York discriminates against business

carried on outside the State by disallowing a tax credit

rather than by imposing a higher tax. The discriminatory

economic effect of these two measures would be identical.”

Id. at 404. The Court was persuaded not only by the fact

that New York had exempted activity in-state, but also

that it had simultaneously imposed a tax on identical

income earned out-of-state.

In Bacchus Imports, Ltd. v. Dias, 468 U.S. 263 (1984),

Hawaii imposed a 20 percent tax on wholesale liquor sales

but exempted local producers. The Court framed the

exemption in terms of “burden,” rejecting the state’s claim

that the tax merely benefited in-state production without

burdening production for out-of-state markets. “Virtually

every discriminatory statute allocates benefits or burdens

unequally; each can be viewed as conferring a benefit on

one party and a detriment on the other. . . . Consequently,

it is irrelevant to the Commerce Clause inquiry that the

motivation of the legislature was the desire to aid the

makers of the locally produced beverage rather than harm

out-of-state producers.” Jd. at 273. The issue in Bacchus

Imports was that Hawaii had applied a tax on activity

both in-state and out-of-state, but solely exempted

activity in-state. This resulted in an impermissible

effective tax on activity out-of-state, because identical

activity in-state was left untaxed.

The Court applied this same rule in four other cases

where states applied a tax to activity in-state and out-of-

state, but effectively left activity in-state exempted:

e Pennsylvania could not impose fees on all trucks while

reducing other taxes for trucks in-state only. See Am.

Trucking Ass’n v. Scheiner, 483 U.S. 266, 286 (1987)

(“[A] state tax that favors in-state business over out-

of-state business for no other reason than the location

of its business is prohibited by the Commerce

Clause.”).

e Ohio could not grant a tax credit to all ethanol

producers, but disallow it for non-Ohio producers. See

be

New Energy Co. v. Limbach, 486 U.S. 269, 273 (1988)

(“This ‘negative’ aspect of the Commerce Clause

prohibits economic protectionism—that is, regulatory

measures designed to benefit in-state economic

interests by burdening out-of-state competitors.”).

e Massachusetts could not impose a general dairy tax

and distribute the revenues to domestic producers

only. See West Lynn Creamery, 512 U.S. at 199 (“The

pricing order in this case, however, is funded

principally from taxes on the sale of milk produced in

other States. .. . The pricing order thus violates the

cardinal! principle that a State may not ‘benefit in-

state economic interests by burdening out-of-state

competitors.”).

e Maine could not provide a general charitable

deduction to all taxpayers, but disallow it only for

organizations that primarily serve non-Maine

residents. See Camps Newfound/Owatonna, Inc. v.

Town of Harrison, 520 U.S. 564, 581 (1997) (“A State

may not tax a transaction or incident more heavily

when it crosses state lines than when it occurs

entirely within the State.”).

The concept of competitive neutrality is also clearly

seen in two other areas of Commerce Clause law not

directly at issue in this case: the constitutionality of

compensating use taxes and the physical presence rule in

business taxation.

This Court upheld the _ constitutionality of

compensating use taxes in Henneford v. Silas Mason Co.,

300 U.S. 577 (1937). There, Washington state had

imposed a tax on the use of certain personal property in-

_state, except where the property had been subject to the

or.

state’s sales tax. See id. at 580-81. The purpose was to

ensure that all property in-state was subject to tax,

regardless of origin. The Court upheld the tax because it

was compensating and did not discriminate against

interstate commerce. See id. at 583-84 (“Equality is the

theme that runs through all the sections of the statute.

There shall be a tax upon the use, but subject to an offset

if another use or sales tax has been paid for the same

thing.”). Use taxes are thus constitutional even though

they tax activity out-of-state, because they do not exempt

identical activity in-state from tax. If a state were to

impose a higher use tax than sales tax, the state would be

effectively penalizing activity out-of-state in violation of

the Commerce Clause, as one court recently held. See

Molloy v. Gov’t of the Virgin Islands, No. 2006-51 (D.V.I.

Jul. 25, 2007) (holding that a use tax imposed without a

sales tax violates the Commerce Clause).

In Quill v. North Dakota, 504 U.S. 298 (1992), this

Court reaffirmed under the Commerce Clause its rule

that a state cannot impose a sales tax collection obligation

on a business unless that business is physically present in

the state. “Undue burdens on interstate commerce may

be avoided . . . by the demarcation of a discrete realm of

commercial activity that is free from interstate taxation.

[The physical presence rule] create[s] a safe harbor for

vendors whose only connection with customers in the

taxing State is by common carrier or the United States

mail.” Jd. at 314-15. While North Dakota in that case

had argued that borders are irrelevant in our modern

economy, this Court recognized that subjecting non-

present businesses to state taxation often means that

activity out-of-state is being unconstitutionally taxed.

Many states seek to export their tax burdens and

impose taxes on businesses not physically present in the

state, which by definition are taxes on activity occurring

out-of-state. See, e.g., Tax Comm’r of the State of West

Virginia v. MBNA America Bank, N.A., 640 S.E.2d 226,

236 (W.V. 2006), cert denied, No. 06-1228 (Jun. 18, 2007)

(upholding state income taxation of out-of-state business).

This Court understood in Quill that limiting states to

taxing only businesses that are physically present is a

way to ensure that states are not burdening activity out-

10

of-state more than activity in-state.

In this case, this Court has the opportunity to clarify

that the Commerce Clause embraces the principles of

competitive neutrality as outlined here and in the

precedents. States cannot impose a tax on activity both

in-state and out-of-state, and effectively exempt solely

activity in-state, or impose a penalty on activity out-of-

state while not penalizing identical activity in-state. This

Court has consistently invalidated such laws under the

Commerce Clause, and should do so again here.

B. Kentucky’s law imposes a tax on activity out-

of-state, while leaving identical activity in-

state untaxed.

Kentucky residents who file the individual income tax

form are instructed to start with their federal calculation

of gross income, which excludes all municipal bond

interest. See KY. REV. STAT. § 141.020(8a). Kentucky

then requires that filers add in all interest income from

non-Kentucky municipal bonds. See KY. REV. STAT. §

141.020(8)(a)(1). At no point are filers instructed to

report, much less pay tax on, interest earned from

Kentucky municipal bonds. The state therefore subjects

individuals who have earned municipal bond interest

outside of the state to reporting and payment obligations

that are not imposed on those who have earned identical

interest income in-state.

The law challenged here penalizes disfavored activity.

Those who hold out-of-state municipal bonds are

penalized because they engage in activity disfavored by a

state practicing protectionism. The state tax code is

designed to make investing in Kentucky bonds the only

way such individuals can lower their effective tax rate on

municipal bond income. The state has gone beyond

differential treatment, which can be constitutional.

Instead, it is penalizing activity simply because it crosses

state lines. 7

11

C. This Court should recognize that Kentucky’s

law taxes activity occurring out-of-state, and

thus differs from valid laws that do not.

The Commerce Clause cannot require absolute

neutrality in state tax systems because to do so would

destroy the states’ sovereign tax powers. Permitting

states to design tax systems that foster a competitive

business climate is a feature of federalism that is

protected by the Commerce Clause. Consequently, many

state tax laws that affect economic decision-making or

impose differential treatment are _ constitutionally

permissible. For instance, states are free to reward

certain activity in the form of exemptions or deductions

from taxes without national uniformity. Also, different

states can enact different tax rates, creating more

favorable fiscal and economic climates, in which

businesses might locate capital and labor.

If a state imposes a tax vhat applies both in-state and

out-of-state, it cannot then solely exempt activity that

occurs in-state from the tax. Similarly, a state may not

effectively tax activity out-of-state while leaving activity

in-state untaxed. Because Kentucky taxes the worldwide

income of its residents, see KY. REV. STAT. § 141.010 et

seq., it cannot solely exclude income earned within the

state from tax. Additionally, Kentucky cannot tax out-of-

state bond investments while leaving in-state bond

investments untaxed.

In DaimlerChrysler Corp. v. Cuno, 547 U.S. __; 126 S.

Ct. 1854 (2006), this Court faced* the question of whether

a state’s investment tax credit, conditioned on the location

of new capital within the state, violated the Commerce

* The Supreme Court ultimately dismissed the case for lack of

standing, holding that the plaintiffs had not demonstrated any injury

(i.e., the state had imposed no penalty on them). See Cuno, 547 US. at

__, 126 S.Ct. at 1854.

12

Clause. The lower court had held Ohio’s investment tax

credit to be unconstitutional because it was not “tax

neutral.” “[{T)he economic effect of the Ohio investment

tax credit is to encourage further investment in-state at

the expense of development in other states and that the

result is to hinder free trade among the states.” Cuno v.

DaimlerChrysler, Inc., 386 F.3d 738, 745 (6th Cir. 2004).

Under this reasoning, any state tax law that differed from

tax laws in other states would be constitutionally suspect.

The case was also unusual because unlike many

Commerce Clause cases, it did not involve an out-of-state

taxpayer seeking to use the Clause to invalidate a

protectionist law, but rather in-state taxpayers seeking to

use the Clause to protect their state from interstate tax

competition.

In the Tax Foundation’s amicus curiae brief

supporting a writ of certiorari, we argued that the Sixth

Circuit’s conception of “tax neutrality” under the

Commerce Clause was restrictive, not protective, of

interstate commerce. “[I]f taken literally, [it] mean[s]

that a state cannot develop a tax policy that encourages

growth and investment. Not even tax rate reductions or

exemptions would be allowed under this literal language.”

Brief of Tax Foundation as Amicus Curiae Supporting

Petition for Writ of Certiorari, Daimler Chrysler Corp. v.

Cuno, (2005) (No. 04-1704), at 12. The reason is that

virtually any tax change has some economic effect that

may encourage or discourage behavior. Instead, we

explained there, as we have explained here, that a better

standard is “competitive neutrality’—forbidding laws that

impose tariff-like punishment on out-of-state activity to

protect native industry, but authorizing laws that seek to

encourage the formation and deployment of new labor and

capital. See also Phillip M. Tatarowicz & Rebecca F.

Mims-Velarde, An Analytical Approach to State Tax

Discrimination Under the Commerce Clause, 39 VAND. L.

REV. 879 (1986). The key question for determining

13

impermissible discrimination is whether a state is taxing

or otherwise penalizing activity occurring out-of-state.

Here, the municipal bond exclusion punishes out-of-state

activity to protect in-state activity.

The investment tax credit at issue in Cuno was

constitutional because it was competitively neutral—Ohio

did not tax business income earned outside the state, nor

did it exempt activity in-state from taxation while taxing

activity out-of-state. See Brief of Council on State

Taxation and National Association of Manufacturers as

Amicus Curiae In Support of Petition for Writ of

Certiorari, DaimlerChrysler Corp. v. Cuno (2005) (No. 04-

1704), at 9 (“[T}he calculation of the Ohio investment

credit includes no refererce to out-of-state activity, which

is neither incented or disincented.”). Contrast that to the

present case, where the effect of Kentucky’s exemption is

to tax only the income generated by investment in out-of-

state municipal bonds. The Ohio investment tax credit

was a “welcome mat,” available on a neutral basis to any

company from any state that invested capital in Ohio,

while the Kentucky exclusion is an “exit toll,” penalizing

taxpayers who choose to do business in other states.

The Respondents in this case have suffered injury—

they have had to suffer a penalty for engaging in activity

out-of-state, while those who engaged in identical activity

solely in-state have been exempted. Only those who have

earned interest income out-of-state are required by

Kentucky to report the amount and pay tax. The state

seeks to influence economic behavior by imposing a

penalty on those who invest in municipal bonds out-of-

state.

Kentucky’s law is also different from laws upheld by

this Court that discriminate against interstate commerce,

but do so only where the state is acting like any other

market participant. See, e.g., Reeves, Inc. v. Stake, 447

U.S. 429 (1980) (holding that a state in the business of

14

selling cement to buyers may discriminate against out-of-

state buyers); Am. Yearbook Co. v. Sakew, 409 U.S. 904

(1973) (holding same for printing services). In taxing

interest income, Kentucky is not acting as a market

participant, but as a sovereign state exercising the power

of mandatory taxation. Cf. New Energy Co., 486 U.S. at

277 (“[Ajssessment and computation of taxes [is] a

primeval governmental activity.”). Even if it could be said

that Kentucky is “competing” with the private bond

market, the relevant action in this case is its use of the

taxing power, which is an exercise of governmental

authority that no other market participant could exercise.

Some amici may point to this Court’s recent decision

in United Haulers Ass’n, Inc. v. Oneida-Herkimer Solid

Waste Management Authority, 550 U.S. ___ (slip op. Apr.

30, 2007) (No. 05-1345), which held that a state may

require waste haulers to use a state-run processing

operation. See id. But there, the state law made no

reference to activity out-of-state. The state did not

effectively penalize out-of-state activity by leaving

identical in-state activity unpenalized, nor was solely in-

state activity exempted from burdens otherwise imposed.

Non-governmental activity was barred regardless of

where it occurred. Here, in contrast, Kentucky penalizes

only some private investors—those who invest in bonds

out-of-state. The Commerce Clause forbids the use of

effective penalties on activity out-of-state while leaving

identical activity in-state unpenalized, not the legal

protection of a government-run enterprise from all private

competitors. “(Wihile United Haulers lifts the

presumption of unconstitutionality from laws favoring

state-run businesses in competition with private business,

it is doudtful that the Court would turn such a favorable

eye on laws shielding state officials from the pressure of

competition with rival state-run enterprises.” Yale &

Galle, supra, at 895.

15

Federalism guarantees that states retain autonomy

over their tax systems so long as they do not enact

protectionist measures that punish only out-of-state

activity. This policy encourages competition conducive to

economic growth. The Commerce Clause protects this

competitive neutrality and does not prohibit states from

bestowing benefits on a favored activity while leaving all

other actors as they were. There is no injury in such a

case, and to hold otherwise would essentially force states

to subsidize out-of-state activity.

But where a state imposes a tax on activity out-of-

state, while leaving identical activity in-state untaxed,

the state is discriminating against interstate commerce

and has run afoul of the Commerce Clause. Kentucky has

done so here, and its punitive tax treatment of out-of-

state bond interest should be invalidated.

Il. THIS COURT SHOULD CONSIDER WHETHER

THE KENTUCKY EXCLUSION VIOLATES THE

IMPORT-EXPORT CLAUSE AND THE

PRIVILEGES OR IMMUNITIES CLAUSE.

This Court might consider two other provisions of the

Constitution that provide additional textual and historical

support for the concept of competitive neutrality. This

case provides an opportunity for this Court to hold that

the [mport-Export Clause of Article I, Section 10 applies

domestically and prevents states from penalizing

economic activity because it crosses state lines. This

Court could also hold that Kentucky’s taxation of out-of-

state municipal bond interest violates the Privileges or

Immunities Clause of the Fourteenth Amendment, which

protects the right of citizens to engage in interstate

transactions.

A. The Import-Export Clause of Article I,

Section 10 prohibits states from penalizing

activity that crosses state lines.

16

Article I, Section 10 of the Constitution states that

“{njo State shall, without the Consent of the Congress, lay

any Imposts or Duties on Imports or Exports, except what

may be absolutely necessary for executing its inspection

laws. ...” U.S. CONST. art I, § 10, cl. 2. The rationale for

the Import-Export Clause was the same as the Commerce

Clause: to stop states from endangering the national

economy by imposing trade barriers. “[T]here is . . .

wisdom and policy in restraining the states themselves

from the exercise of the same power [taxation] injuriously

to the interests of each other. A petty warfare of

regulation is thus prevented, which would rouse

resentments, and create dissensions, to the ruin of the

harmony and amity of the states.” 1 STORY CONST. § 497

(discussing the Import-Export Clause).

The Import-Export Clause was thus conceived as

barring states from imposing taxes on activity that

crossed state lines. See, eg., Brannon P. Denning, “The

Import-Export Clause” in THE HERITAGE GUIDE TO THE

CONSTITUTION 176, 176-77 (David F. Forte ed., 2005)

(“Evidence from the Constitutional Convention and the

ratification debates suggest that the Framers intended

the Import-Export Clause to complement congressional

power to raise revenue and regulate interstate commerce

by restricting the states’ ability to tax commerce entering

and leaving their borders.”). Applied, the Import-Export

Clause would provide a more focused and textual basis for

the invalidation of any state tax “that is levied

exclusively, or even primarily, on imports.” Camps

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

564, 640 n.22 (Thomas, J., dissenting). Here,

Respondents are importing municipal bond income from

other states, and Kentucky is taxing that import.

The original meaning of the Import-Export Clause

included domestic application, although the Supreme

Court held otherwise in Woodruff v. Parham, 75 U.S. 123

17

(1868), when it stated that the restriction applied only to

goods originating outside the United States. In doing so,

the Court distinguished two prior cases that suggested

the Clause applied domestically. See Brown v. Maryland,

25 U.S. (12 Wheat.) 419, 449 (1827); Almy v. California,

65 U.S. 169, 172-74 (1861). The basis for the Woodruff

Court’s conclusion was a lack of evidence to deny that the

word “imports” was meant to be an “exclusive reference to

foreign trade.” Id. at 136. Subsequent research has

undermined this ground, with scholars uncovering

examples of the Founders and contemporaneous ratifying

conventions, newspapers, laws, and writers using the

word “imports” to describe interstate trade.” “The

evidence suggests that the Woodruff Court was too hasty

in its dismissal of Marshall’s dictum in Brown, and wrong

to recharacterize Almy v. California, because Justice

Miller’s reading of the Import-Export Clause was too

narrow.” Denning, supra, at 213. “Commerce” as used in

the Constitution comprises both foreign and interstate

commerce; a consistent reading of “imports and exports”

would include foreign and interstate trade as well.

Kentucky’s tax on municipal bond interest that

crosses state lines, or the activity that generates such

interest, is an impermissible duty on imports even if it is

the activity that is taxed and not the goods. Cf Camps

Newfound /Owatanna, 520 U.S. at 574-75 (stating that a

tax on activities used in relation to imported goods is the

legal and functional equivalent to a tax on the imported

goods). Not all interstate taxation is impermissible. This

Court has held that “the Import-Export Clause prohibited

only exactions on the right of importation,” Michelin Corp.

v. Wages, 423 U.S. 276, 295 (1976), that “create special

protective tariffs or particular preferences for certain

* See generally Camps Newfound/Owatanna, 520 U.S. at

621-33 (Thomas, J., dissenting) (detailing these examples);

Denning, supra, at 188-215 (same).

18

domestic goods ....” Jd. at 286 (emphasis added). “[T]he

prohibition would not apply to a state tax that treated

imported goods . .. in a manner that did not depend on

the foreign origins of the goods.” Jd. at 298. A general tax

on all municipal bond income would not violate the

Clause. But here, a duty is imposed on all municipal bond

interest not generated in Kentucky, and that duty is

designed to discourage interstate activity and encourage

domestic investment.

This case is an example of what the Import-Export

Clause was designed to prevent: a state imposing a

penalty on economic activity that crosses state lines.

Rising at the Constitutional Convention to voice a concern

that led to the Clause’s adoption, Gouverneur Morris

warned that states would try to tax each other to the

detriment of national unity. “These local concerns ought

not to impede the general interest. There is great weight

in the argument, that the exporting States will tax the

produce of their uncommercial neighbors.” SUPPLEMENT

TO MAX FARRAND’S THE RECORDS OF THE FEDERAL

CONVENTION OF 1787, at 360 (James H. Hutson ed., 1987).

Kentucky imposes a penalty on activity that crosses state

lines. This Court should reconsider Woodruff and hold

that Kentucky’s law runs afoul of the Import-Export

Clause.

B. The Privileges or Immunities Clause of the

Fourteenth Amendment protects the right of

citizens to cross state lines in pursuit of an

honest living.

The Fourteenth Amendment, enacted after the Civil

War, reads in part:

“No State shall make or enforce any law which

shall abridge the privileges or immunities of

citizens of the United States... .”

U.S. CONST., amend. XIV, § 1. The U.S. Constitution also

19

requires that the privileges and immunities enjoyed by

citizens of a state must also be extended to other U.S.

citizens in that same state. See U.S. CONST., art. IV, § 2.

See also ARTICLES OF CONFEDERATION art. IV (“The better

to secure and perpetuate mutual friendship and

intercourse among the people of the different States in

this Union, the free inhabitants of each of these States .. .

shall be entitled to all privileges and immunities of free

citizens in the several States. . . .”). Not until

Recenstruction, however, was it considered necessary to

adopt a constitutional amendment to protect citizens’

basic civil rights from infringement by state governments.

Chief among these was the right to earn an honest

living, which many states systematically violated in order

to keep African-Americans in constructive bondage

following the Civil War. In the Slaughterhouse Cases, 83

U.S. (16 Wall.) 36 (1873), the Supreme Court adopted a

narrow view of the scope of rights guaranteed by the

Clause, over four dissents. This decision has been harshly

and consistently criticized by a distinguished assortment

of judges and scholars. See, e.g., RANDY BARNETT,

RESTORING THE LOST CONSTITUTION 195-203 (2004);

Laurence H. Tribe, Taking Text and Structure Seriously:

Reflections on Free-Form Method in Constitutional

Interpretation, 108 HARV. L. REV. 1221, 1297 n.247 (1995);

Akhil R. Amar, The Bill of Rights and the Fourteenth

Amendment, 101 YALE L.J. 1193, 1258-59 (1992); JOHN

HART ELY, DEMOCRACY AND DISTRUST 22 (1980). But see

ROBERT BORK, THE TEMPTING OF AMERICA: THE

POLITICAL SEDUCTION OF THE LAW at 10 (1990)

(describing the Clause as “a constitutional provision

whose meaning is largely unknown.”).

Even after the Slaughterhouse Cases, this Court has

identified “pursuit of a common calling” as a privilege of

national citizenship protected by the Constitution. See

United Bldg. & Constr. Trades v. Mayor, 465 U.S. 208,

20

219 (1984). See also ERWIN CHEMERINSKY,

CONSTITUTIONAL LAW 450 (2d ed. 2002) (“The vast

majority of cases under the [Article IV] privileges and

immunities clause involve states discriminating against

out-of-staters with regard to their ability to earn a

livelihood.”).

This Court has also consistently held that the

Privileges or Immunities Clause protects the right to

cross state lines without interference. Most recently, in

Saenz v. Roe, 526 U.S. 489 (1999), this Court applied the

Clause to strike down a California welfare benefits law

that applied differently to California residents based on

their prior interstate travel. See Saenz, 526 U.S. at 504

(“Because this case involves discrimination against

citizens who have completed their interstate travel, the

State’s argument that its welfare scheme affects the right

to travel only ‘incidentally’ is beside the point.”). The

Court specifically grounded the right to interstate travel

in part in the Privileges or Immunities Clause, noting

that while the law did not restrict travel per se, it

discouraged the crossing of state lines with a punitive and

discriminatory law. “It was the right to go from one place

to another, including the right to cross state borders while

en route, that was vindicated in Edwards v. California,

314 U. S. 160 (1941), which invalidated a state law that

impeded the free interstate passage of the indigent.”

Saenz, 526 U.S. at 500. See also id. at 511 (REHNQUIST,

C.J., dissenting) (“The right to travel clearly embraces the

right to go from one place to another, and prohibits States

from *mpeding the free passage of citizens.”).

The Court has thus invalidated laws that discourage

individuals from crossing state lines and enjoying the

benefits of national citizenship, such as pursuit of an

honest living. In Colgate v. Harvey, 296 U.S. 404 (1935),

overruled by Madden v. Kentucky, 309 U.S. 83, 90-93

(1940), Justice Sutherland wrote for the Court: “[W)hen

21

[a citizen] trades, buys, or sells, contracts or negotiates

across the state line . . ., he exercises rights of national

citizenship. .. .” Id. at 433. In Madden, which overruled

Colgate’s broader reading of the Privileges or Immunities

Clause, the Court nevertheless stated that the Clause

protects “privileges and immunities arising out of the

nature and essential character of the national

government, and granted or secured by the constitution of

the United States.” Madden, 309 U.S. at 92 n.21. The

Privileges or Immunities Clause protects the right of “all

citizens to be free to travel throughout the length and

breadth of our land uninhibited by statutes, rules, or

regulations which unreasonably burden or restrict this

movement.” Saenz, 526 U.S. at 499, quoting Shapiro v.

Thompson, 394 U.S. 618, 629 (1969). States can neither

penalize the crossing of state lines nor impose burdens on

those who exercise that right, such as with the California

law invalidated in Saenz.

Here, Kentucky penalizes those who pursue a calling

and engage in honest commercial activity that crosses

state lines, while not imposing similar burdens on those

whose activity does not cross state lines. As Justice

Cardozo wrote, “The Constitution was framed . . . upon

the theory that the peoples of the several states must sink

or swim together, and that in the long run prosperity and

salvation are in union and not division.” Baldwin uv.

G.A.F. Seelig, Inc., 294 U.S. 511, 523 (1935). Because this

Court has held that pursuit of a common calling is such a

privilege of national citizenship, and that states cannot

enact laws that discourage the crossing of state lines, a

law such as Kentucky's must be invalidated, for it

discourages Respondents from commercially crossing

state lines in pursuit of an honest living. This Court

should consider re-evaluating the Slaughterhouse Cases

and protect the rights of Respondents in a way that would

be faithful to history and text.

22

Il. A RULING FOR RESPONDENTS WOULD

NEITHER UNDULY INFRINGE KENTUCKY’S

STATE SOVEREIGNTY NOR EXCESSIVELY

IMPACT MUNICIPAL BOND MARKETS.

A ruling for Respondents in this case would not

infringe Kentucky’s state sovereignty, as states could still

permit exclusion of all municipal bond interest, as is done

at the federal level and in Indiana, or tax all municipal

bond interest. Nor would a ruling for Respondents

excessively impact the municipal bond market, as state

and local governments would still have access to capital at

competitive interest rates.

A. A ruling for Respondents would not unduly

infringe state sovereignty, as states could

still allow a non-discriminatory municipal

bond interest exclusion, or tax all municipal

bond interest income.

This Court has been conscious that its rulings can

have serious consequences, and that preserving a

controversial rule is sometimes preferable to unleashing

uncertainty and disrupting settled expectations. At least

one Amicus urges this Court to reverse on this ground.

See Brief of the Securities Industry & Financial Markets

Association as Amicus Curiae Supporting Petitioners,

Kentucky v. Davis (2007) (No. 06-666), at 5 (“If the

municipal bond tax incentive evaporates, the demand for

such bonds may likewise vanish, thus drying up a major

source of funding for State projects.”). But this case is not

one of fiat justitia ruat caelum; a ruling for Respondents

need not cause the sky to fall.

This Court should consider these concerns, but they

neither dictate a result nor are they ultimately

persuasive. The effect on settled expectations is just one

consideration this Court has outlined for purposes of

reversing lower courts and _ reconsidering previous

23

decisions. See, e.g., Patterson v. McLean Credit Union,

491 U.S. 164, 173-74 (1989) (outlining said

considerations). .

Some of the amici erroneously assume that any ruling

for Respondents would result in this Court barring states

from exempting or excluding municipal bond interest.

This is not so. Kentucky could exempt all municipal bond

interest, or none; the decision would be left to the

commonwealth. If Kentucky chooses to exempt all

municipal bond interest income from taxation, the state

law would no longer discriminate against interstate

commerce. Neither constitutional amendments nor

upheaval would be required. Because the state’s action

would not be preordained from the judicial result, and

because the state would still be able to select from many

policy choices, its sovereignty is not threatened.

Kentucky would simply be following in the path of

Indiana and the federal government, both of which

exempt all municipal bond interest without distinction.

B. A ruling for Respondents would not

excessively impact municipal bond markets.

The municipal bond market is admittedly large. But

tax exclusions, exemptions, and deductions are matters of

legislative grace. They can he increased, decreased,

rewritten, or repealed with little or no notice. As recently

as 1986, the U.S. federal income tax code was overhauled,

with many expectations repealed or revised. Many states,

including Michigan, Ohio, and Texas, have recently

overhauled their tax codes as well. Markets that exist

solely to take advantage of the tax code, such as “state-

specific” bond mutual funds, can be channeled into more

productive uses after such changes. “States raised money

from the bond market long before there were state-specific

funds.” Brian D. Galle & Ethan Yale, Can Discriminatory

State Taxation of Municipal Bonds Be Justified? Thoughts

on the Davis Topside Briefs, TAX NOTES (forthcoming

24

2007), available at http://ssrn.com/abstract=1014138, at 8.

Of course, it is preferable that such revisions be done

legislatively rather than judicially. But this Court is not

being asked to rewrite Kentucky's tax code; it is instead

being asked to uphold the Constitution.

This Court will hear arguments that an adverse ruling

for Kentucky would result in deprivation of the states’

access to capital. This will not occur, for two reasons.

First, even assuming that all bonds (municipal and

private) must be treated identically for tax purposes, this

would simply mean that municipal bonds would have to

compete on credit risk, rate of return, and the merits of

the project rather than on tax benefits. Kentucky could,

for instance, increase the rate of interest paid to

bondholders in order to attract more _ capital.

Furthermore, the reliability of tax revenues to repay debt

might make these investments more attractive than

private bonds. Only states with unsalvageable credit

would have no access to capital in today’s markets, and

that fact would not change with or without the tax

exclusion at issue here.

Second, the federal tax code will still exclude income

earned from municipal bond interest from gross income.

This exclusion has existed since 1913, and is not at issue

here, nor in a conceivably related case. Municipal bonds

will still enjoy this federal tax advantage over private

bonds, regardless of any state action, and because federal

rates are greater than state rates, the federal exclusion is

more valuable. Of course, if states opted to exclude all

municipal bond interest, rather than just domestic bonds,

municipal bonds would become more valuable than they

are at present, and demand for them would rise, not fall.

A ruling for Respondents still leaves Kentucky and

other similarly situated states with the autonomy to

indepdently structure their tax systems, provided that

they are in conformity with the requirements of the

25

Constitution. This Court has not resorted to reliance on

expectations regarding laws that discriminate against

interstate commerce to sustain an otherwise invalid law.

Here, where a ruling for Respondents would still enable

states to exclude municipal bond interest, such arguments

should not discourage this Court.

C. Invalidating Kentucky’s discriminatory

taxation of out-of-state municipal bond

interest income will affect some states more

than others.

High-tax states use the municipal bond interest

exclusion to shield their higher taxes from interstate

competition. This is because the higher a state’s tax rate

is, the more the exclusion is worth to its taxpayers. This

Court should consider this protectionist motivation when

evaluating whether the Kentucky law discriminates

against interstate commerce.

To understand why high-tax states benefit from the

exclusion, first assume that the exclusion did not exist. If

a $1,000 state or local government bond had to pay a 10

percent return annually, or $100, to attract enough bond

buyers, every investor would benefit equally. See

generally Patrick Fleenor, “Tax-Exempt State and Local

Bonds: A $20 Billion Gift to the Nation’s Wealthiest

Investor ,” in Fixing the Alternative Minimum Tax: AMT

Reform Requires Changes to Regular Tax Code, TAX

FOUNDATION SPECIAL REPORT NO. 155 (May 2007), at 9,

available at http://www.taxfoundation.org/files/sr 155. pdf.

However, because of the exclusion, investors who pay

higher taxes get a better interest rate. Again assuming a

$1,000 bond paying 10 percent, investors in the highest

federal tax bracket (say 35 percent) are willing to buy the

bonds for interest payments of 6.5 percent since the $35

in tax savings brings their annual earnings from the bond

to the desired 10 percent. The $35 gain to state and local

26

governments would equal the $35 in lost federal tax

revenue. Investors in the 25 percent tax bracket would

have to have a minimum interest rate of 7.5 percent, the

point where the amount they save in taxes, $25 (25

percent of $100), brings their annual earnings from the

bond to 10 percent.

Because state and local governments need to attract

other investors, and not just those in the highest tax

brackets, the highest rate necessary to clear the market

must be given to all bond investors. So if a state offers a

. 7.5 percent interest rate to attract investors in the 25-

percent tax bracket, bondholders in the 35-percent tax

bracket get a better deal. They annually earn $110,

instead of $100.

Consequently, the greater a state’s income tax rate,

the greater the benefit from the exclusion, and the

interest rate the state must offer can be lower. States

with the highest-tax individual income tax rates therefore

have a stronger interest in preserving the municipal bond

tax exclusion, because it enables them to protect those

high tax rates from interstate competitive pressures.

States with the lowest tax rates suffer because their

comparative advantage in lower tax rates is eroded. This

protectionist motivation for the exclusions is additional

evidence that their purpose is, at least in part, to

discriminate against interstate commerce.

IV. THIS COURT SHOULD BE CAUTIOUS NOT TO

SUGGEST THAT DISCRIMINATION ANALYSIS

APPLIES TO TAXES BUT NOT SUBSIDIES.

The current Kentucky law cannot accurately be

described as a subsidy, and the constitutional scrutiny of

discriminatory taxes is well-settled. But this Court

should be cautious not to suggest that discriminatory

taxes are more constitutionally suspect than

discriminatory subsidies. The competitive neutrality

27

protected by the Commerce Clause prohibits states from

imposing burdens on activity out-of-state and in-state

while solely exempting activity in-state from those

burdens. Similarly, a state cannot impose burdens on

activity out-of-state while leaving unburdened identical

activity in-state. Both subsidies and taxes that violate

these principles should undergo identical constitutional

scrutiny.

A. This Court has in the past rejected formalism

in favor of economic reality, but has not

extended that fully into the realm of

discriminatory subsidies.

On numerous occasions, this Court has distinguished

constitutional statutes from unconstitutional ones by

looking at actual facts, rather than merely the words the

statute uses or the form it takes. See, e.g., Complete Auto,

430 U.S. 274, 288-89 (1977) (“There is no economic

consequence that follows necessarily from the use of the

particular words . . . and a focus on that formalism merely

obscures the question whether the tax produces a

forbidden effect.”); Thomas v. Union Carbide Agric.

Products, 473 U.S. 563, 586 (1985) (quoting Crowell v.

Benson, 285 U.S. 22, 53 (1932)) (“In deciding whether the

Congress, in enacting the statute under review, has

exceeded the limits of its authority . . ., regard must be

had, as in other cases where constitutional limits are

invoked, not to mere matters of form, but to the substance

of what is required.”); New York v. United States, 326 U.S.

572, 583 (1946) (“[Wle reject limitations upon the taxing

power of Congress derived from such untenable criteria . .

. .”); United States v. Classic, 313 U.S. 299, 313 (1941)

(considering the practical operation of an election law that

was formally open but restrictive in practice). Where a

statute uses unconstitutional means or pursues

unconstitutional ends, this Court should not cut short its

inquiry just because the form is not unconstitutional.

28

Unfortunately, while this Court gives proper scrutiny

to discriminatory taxes, comparable scrutiny is not given

to discriminatory subsidies. Nineteen years ago, this

Court wrote, “Direct subsidization of domestic industry

does not ordinarily run afoul of [the Commerce Clause];

discriminatory taxation of out-of-state manufacturers

does.” New Energy Co., 486 U.S. at 278. See also West

Lynn Creamery, 512 U.S. at 199 (“We have never squarely

confronted the constitutionality of subsidies, and we need

not do so now. We have, however, noted that direct

subsidization of domestic industry does not ordinarily run

afoul of the negative Commerce Clause.”).

These dicta contrast with statements by this Court

suggesting that existence of discriminatory treatment

merits constitutional scrutiny regardless of form. E.g.,

Westinghouse, 466 U.S. at 404-05 (“Nor is it relevant that

New York discriminates against business carried on

outside the State by disallowing a tax credit rather than

by imposing a higher tax. . .. We have declined to attach

any constitutional significance to such formal distinctions

that lack economic substance.”); Bacchus Imps., 468 U.S.

at 273 (“The determination of constitutionality does not

depend upon whether one focuses upon the benefited or

the burdened party.”).

The Court should take this opportunity to clarify that

subsidies do not get a constitutional free ride. The

question to ask regarding permissive and barred state

action should not be whether it is in the form of a tax or a

subsidy, but whether it imposes a penalty in a

discriminatory way.

B. A state subsidy program with the identical

economic effect of Kentucky’s law here

should be subject to the same discrimination

analysis.

States should not be able to convert a discriminatory

29

tax into a discriminatory subsidy, and _ escape

constitutional scrutiny. The Tax Foundation criticized

the Sixth Circuit decision in Cuno for this reason. See

Chris Atkins, Federal Court Ruling May Hurt Tax

Competition, State Tax Reform, TAX FOUNDATION FISCAL

FACT NO. 16 (2004) (“Making a distinction between

subsidies and tax incentives seems highly formalistic. . . .

Ohio can bypass the Cuno ruling by simply changing the

tax incentive program into an investment subsidy.”). The

touchstone should not be the formal structure, but the

economic effect.

The same danger is faced here. To avoid this result,

courts should analyze a challenged subsidy for

discrimination against interstate commerce no differently

from an analysis of a challenged tax. Kentucky's statute

challenged here effectively penalizes activity out-of-state

by exempting solely identical activity occurring in-state.

The competitive neutrality protected by the Commerce

Clause prohibits states from imposing burdens on activity

out-of-state and in-state while solely exempting activity

in-state from those burdens, or imposing burdens on

activity out-of-state while leaving unburdened identical

activity in-state. Any law that does so should be held

unconstitutional, be it tax or subsidy. This case presents

an opportunity for this Court to reaffirm its statements in

Westinghouse and Bacchus Imports, and value economic

reality and presence of penalties over formalized

categories.

CONCLUSION

Because the challenged statute penalizes those who

engage in activity out-of-state by subjecting investment in

out-of-state municipal bonds to tax burdens not borne by

taxpayers investing in-state, this Court should hold the

Kentucky exclusion unconstitutional. In doing so, this

Court would not unduly infringe upon state sovereignty

30

nor excessively impact municipal bond markets.

This Court could also consider the Kentucky exclusion

in light of the Import-Export Clause and the Privileges or

Immunities Clause, because it imposes an impermissible

duty on activity that crosses state lines and burdens

individuals who cross state lines in pursuit of an honest

living, in contravention of the rights those clauses are

designed to protect. This Court should also be cautious

not to suggest that discriminatory taxes are scrutinized

more intensively than discriminatory subsidies.

For the foregoing reasons, Amicus respectfully

requests that this Court affirm the decision below.

Respectfully submitted,

BRIAN E. BAILEY*

ICE MILLER LLP

One American Square

Suite 3100

Indianapolis, IN 46282

(317) 236-2426

CHRISTOPHER D. ATKINS

Senior Tax Counsel

Tax Foundation

2001 L Street NW,

Suite 1050

Washington, DC 20036

(202) 464-6200

* Counsel of Record

September 21, 2007