The $2.5 trillion municipal bond market skirted a land mine yesterday when the Supreme Court ruled that states could continue to give special tax breaks on the bonds that fund hospitals, roads, schools and other services.
The justices ruled 7-2 in a case from Kentucky that states can exempt interest on their own bonds from taxation while taxing residents on interest on bonds issued by other states.
In the municipal bond market, 41 other states have systems similar to Kentucky’s. Seven states do not impose taxes on personal income — Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming. Indiana has a tax exemption for interest on municipal bonds from all states.
The states affected by the Supreme Court case have said that throwing out the system of exemptions that began about 90 years ago would have a devastating impact on state finances.
Industry groups warned of possible turmoil in the municipal bond market if the existing setup were dismantled.
In the majority opinion, Justice David H. Souter said that the state tax exemptions have not hindered commerce among the states.
In dissent, Justices Anthony M. Kennedy and Samuel A. Alito Jr. said the majority decision “invites other protectionist laws.”
Justice Souter responded that the dissent “rightly praises the virtues of the free market.” But he said that overturning the tax exemptions now would upset the market in bonds.
“It would miss the mark” to think that the courts “are being invited merely to tinker with details of a tax scheme,” wrote Justice Souter. “We are being asked to apply a federal rule to throw out the system of financing municipal improvements throughout most of the United States.”
Thalia Meehan, managing director and team leader of the tax-exempt group at Putnam Investments in Boston, said the ruling “is good for the market at a difficult time.”
“This issue is one we can cross off the list of potential disruptions,” she said.
About $432 billion in municipal bonds were issued in 2006 alone. In 2004, some 4.4 million investors earned $52 billion in interest on municipal bonds.
Municipal bonds finance the operations of state and local governments, education, the purchase of public lands as well as the construction and improvement of public buildings, transportation systems, and water and sewer facilities.