Dwight V. Denison Merl Hackbart University of Kentucky Michael J. Moody University of Kansas When States Discriminate: he Non-uniform Tax Treatment of Municipal Bond Interest Fostering Fiscal Responsibility: International, Federal, and Local Government Perspectives Dwight Denison is an associate professor of public and nonprofit finance in the Martin School of Public Policy and Administration at the University of Kentucky. His areas of teaching and research include municipal bond markets, nonprofit financial management, and tax administration. E-mail: dwight.denison@uky.edu Merl M. Hackbart is a professor of finance and public administration and associate dean for administration and academic affairs in the Gatton College of Business and Economics at the University of Kentucky. E-mail: m.hackbart@uky.edu Michael J. Moody is an assistant professor in the Department of Public Ad- ministration at the University of Kansas. His research interests include public debt policy and management and tax policy. E-mail: mjmoody@ku.edu here is a long history of states using tax systems to encourage residents to invest in bonds issued by jurisdictions within their state. his preferential or discriminatory tax treatment was ruled unconstitutional in 2006 by the Kentucky Court of Appeals. he Kentucky court decision, which sets the stage for this essay, was overturned by the U.S. Supreme Court in 2008. his essay addresses the possible implications of this and similar discriminatory tax policies. Such discriminatory policies are the foundation of the municipal bond market, and altering the practice would have significant implications for revenue collections and borrowing costs in most states and localities. While the Supreme Court’s position has been rendered, the case has caused policy makers and administrators to scrutinize discriminatory tax policies and their impact on budgets and borrowing costs. I n recent decades, state and local governments have increasingly relied on municipal bonds to finance their capital budgets. he issuance of tax-exempt municipal bonds has grown in response to state and local government capital investment needs, and the total outstanding municipal issues are estimated to be approximately $2.3 trillion (Herman 2006). As the interest on most municipal bonds is exempt from the federal income tax, this subsidizes a municipal bond issuer’s interest cost and also benefits investors. In addition to the federal tax exemption, there are 36 states that also exempt municipal bond interest from state income taxes. Bonds with interest income exempt from state taxation as well as federal taxation, referred to as “double exempts,” are an additional subsidy for the state and its localities. he revenue loss resulting from double-exempt bonds has been partially miti- gated by policies that grant the tax exemption only for bonds issued within a state. In other words, states provide the income tax exemption for state-based issues while taxing interest on munici- pal bonds issued in other states. Scholars have long debated the pitfalls and mer- its of the discriminatory tax on municipal bond interest. However, a recent court case, Davis v. Department of Revenue of Kentucky (197 S.W.3d 557 [2006 Ky. App.]), brought these issues into the national limelight; the decision declared unconstitu- tional Kentucky’s statutes limiting the state income tax exemptions to “in-state” issues. Based on the “dormant” commerce clause of the U.S. Constitution, the Kentucky Court of Appeals found that treating nonstate issues differently than state-based issues was an infringement on interstate commerce, which is pro- hibited by the commerce clause. he court’s declara- tion was appealed to the U.S. Supreme Court, which recently overruled the Kentucky Court of Appeals position (Docket no. 06-666, 553 U.S. __ [2008]). he issues raised by this and similar discriminatory tax policies of other states and localities highlight impor- tant policy concerns for state and local governments. his article, which addresses the possible implica- tions of this and similar discriminatory tax policies, was written and accepted for publication prior to the Supreme Court’s decision. Although the Supreme Court has rendered a decision, the case has caused policy makers and administrators to scrutinize discriminatory tax policies and their impact on bor- rowing costs. Our objective in this paper is to consider the implications of discrimina- tory tax treatment on municipal bond interest in the context of the issues raised in the Davis case. A primary objective is to analyze the impact of the state tax exemption on the yields of municipal bonds. We discuss the basis of the Davis ruling by the Kentucky Court of Appeals. We also identify several policy and market implica- tions that would result from reversing the traditional In addition to the federal tax exemption, there are 36 states that also exempt municipal bond interest from state income taxes. 458 Public Administration Review • March | April 2009