With the future shape of the “dormant Commerce Clause” perhaps at stake, the Supreme Court was offered two clearcut theories Monday on how to treat tax favoritism that a state provides for itself, but the Justices gave no clear sign of which they would ultimately choose. On the one hand, a lawyer for the state of Kentucky said the Constitution should put up no barrier to a state that makes a tax bargain with its own citizens that benefits both by financing essential public services. But, on the other hand, a lawyer for a Kentucky couple that has money to invest said that the Constitution should bar a state, when it enters into a national investment market, from using taxes to put up artificial barriers to that market’s functioning.

In Kentucky Department of Revenue v. Davis (06-666), the constitutional issue turns on a system — begun in New York State in 1919 and now spread across the country — of taxing its residents on the interest they get when they buy “municipal” bonds issued in other states, but exempting the interest they earn on bonds issued by the taxing state or its subdivisions. But the Justidces made clear, from the outset, that they saw a good deal more at stake: whether Commerce Clause doctrine may be heading in new directions, and whether a significant decision on that Clause last Term should be read more narrowly or more expansively. (That case, United Haulers Association v. Oneida-Herkimer Solid Waste Management Authority, 05-1345, decided April 30, exposed a notable division within the Court that is looming larger now.)

C. Christopher Trower, an Atlanta attorney representing Kentucky tax authorities, started off by arguing that the Court has never found discrimination under the “dormant Commerce Clause” (which forbids state discrimination aagainst interstate commerce) when a state favored its own governmental entities, and he cited the United Haulers ruling as a key authority. He went on to make repeated references as to how that case and this case were similar.

But he had barely begun before he encountered the author of the United Haulers dissent, Justice Samuel A. Alito, Jr., who wanted to know if a state was free to discriminate in taxes when it floats “conduit bonds” — bonds that raise money tp [au for private activity, like industrial development. Trower said yes, adding that about a fifth of all municipal bonds were for such activity. He quickly accepted a suggestion from Justice Ruth Bader Ginsburg that this case did not involve such bonds; he added that the taxpayers objecting to the tax differential did not own any such bonds, so could not have raised that issue.

Chief Justice John G. Roberts, Jr., soon began testing whether there were parallels with the United Haulers decision (which he wrote), noting that there was a difference in this case in that “Kentucky does compete with other public entities in the market for bond investors.” What Kentucky was doing, the state’s lawyer countered, was carrying out its duty to protect public welfare, and that what was the local government was doing about garbage disposal in United Haulers. “Other states have no responsibility in Kentucky for the public welfare,” so they need not be treated the same in taxing their bonds, Trower contended. The state issusd bonds, he said, not to make a profit, or to assist Wall Street, but “to finance the essential work of government.”

When a skeptical Justice Anthony M. Kennedy wondered if a state could use its taxing system on bonds in order to “keep its market [for bonds] to itself,” and if United Haulers was the authority for that notion, Trower said yes to both. He noted that there was no friction among the states in this approach, saying that 49 states were supporting Kentucky in this dispute.

G. Eric Brunstad, Jr., a Yale law professor and attorney in Hartford, Conn., then took the podium to argue for George and Catherine Davis, Kentuckians who have invested in out-of-state municipals and object to the taxation of the interest on those issues. Immediately, he began drawing distinctions with the United Haulers case. When the Chief Justice brought up that precedent, Brunstad said the Kentucky case was “very different.” There is no monopoly in Kentucky on municipal bond issues, as there was in United Haulers over garbage disposal. And, he said, Kentucky was “trying to regulate the market” for bonds nationally.

“You win,” Justice Stephen G. Breyer told the lawyer, if the bonds were a commodity like milk. But, Breyer said, the bonds Kentucky was issuing were “financing the most governmental of all government institutions — libraries, schools, streets.” Why does that not make a difference, Breyer wondered. Under past precedent, Brunstad said, “purpose has no bearing on whether there is discrimination.” Brunstad also started parrying Breyer’s comments with an insistence on drawing clear distinctions, for Commerce Clause purposes, between taxes, monopolies and subsidies by government.

When Justice David H. Souter suggested that Kentucky was “not acting as regulator” of the municipals market, Brunstad flatly disagreeing, arguing that “what the state is taxing is an out-of-state commodity,” and that “this is downstream regulation” after the state issues the bonds and someone buys them. “The state here is using its taxing power to regulate interstate commerce,” and penalizing its own citizens for taking part in that commerce, the lawyer asserted.

The Chief Justice, who seemed to be warming toward Kentucky’s arguments, told Brunstad that the state was not, as the lawyer had said, taxing an out-of-state commodity, but was only taxing Kentucky residents. Justice Souter said that, if the Court had a choice of analysis, there was “good reason to give the nod to the essential services side of what the state is doing as regulator.” But Brunstad countered that what was going on was “a classic race to the bottom,” where each state was trying to “hoard” its own capital for itself, and all other states fell in line with that.

When Justice Breyer returned to the fray, arguing again that the case was “more like garbage collection,” as in the United Haulers decision, the lawyer disagreed, saying: “This case is about milk.” Bonds, he said, are “traded as commodities.” But Roberts chimed in, citing again to United Haulers and garbage control, Brunstad said that that case did not involve a tax on an out-of-state commodity, but this case did.

In an exchange with Justice John Paul Stevens, the lawyer again insisted that the state, having one sold the bonds, was seeking to impose regulation on what happened to them after they passed from the state’s issuance.” Bonds, once sold, are “a commodity now in the marketplace” and, in that marketplace, Kentucky was trying to discourage the purchase of other states’ bonds. Stevens replied that the supposed victims were the “other 49 states,” Brunstad said that the states were together in this dispute because they simply did not want to issue refunds of taxes they had collected on out-of-state issues.

Roberts then told Brunstad he was relying upon discrimination against out-of-state issuers, but reminded him that the taxpayers were residents of Kentucky, without a right to “argue on behalf of out-of-state issuers.” There is no “overbreadth” doctrine under the Commerce Clause, the Chief Justice commented. Brunstad, though, continued to insist that Kentucky was actively discriminating interstate commerce, and his clients had a right to claim that. And, attempting to persuade the Court that the sky would not fall if Kentucky lost, the lawyer said Kentucky would have to refund about $4 million a year, bond prices might adjust to the different circumstance, but “the market would be free of artificial restrictions.”

Justice Kennedy brought up the Founding Fathers, wondering if the differential taxing system was consistent with the views of the Constitution-makers. Brunstad said it was “completely inconsistent,” and adding that what was going on was a “low-level trade war,” begun in New York in 1919 and now widely spread. Once again, he said, the whole aim was to keep all capital within a state.

The Chief Justice said that Kentuckians did not buy Kentucky bonds only out of some “emotional attachment,” but rather out of “self-interest; they want a hospital next door.” But Brunstad replied that :every tax has a public purpose, and added that a ruling for Kentucky “will open the door to all discriminatory taxes the Court has struck down” over the decades. The Court’s decision, he said in concluding, had set up “a monument of economic freedom” but now the risk was that that monument would be “pulled down.”

In rebuttal, Trower, for Kentucky, said that the Davises were not being peanlized for participating in interstate commerce. They were simply involved in a “quid pro quo,” in which Kentucky tells them that, if they will loan money to that state, they will get a tax benefit, “something in return.” Before he finished, Justice Alito challenged him sharply, saying that “many of your arguments — not all, but many — would mean dormant Commerce Clause jurisprudence is utterly incoherent. What would be left of dormant Commerce Clause jurisprudence if those arguments were accepted?” Trwoer said that all decisions that struck down favoritism of in-state private business would remain “untouched.”

The argument wound down with a discussion of whether Congress had tolerated the system of discriminatory bond financing among the states, and what that mean: was it, in fact, acquiescence after full consideration, as Trower said, or was in simply, as Justice Stevens countered, just that Congress itself had been “dormant”?

The Court is expected to decide the case sometime in later winter or spring.

Posted in Dept. of Revenue of Kentucky v. Davis, Everything Else