UPDATE to The Municipal Market Goes to Court:

In the May 28, 2007 edition of this publication, we informed investors that the U.S. Supreme Court had agreed to hear the case of Davis vs. Kentucky. An investor (Davis) sued the state of Kentucky for taxing his out-of-state municipal bonds while simultaneously offering a tax exemption to Kentucky-issued municipal bonds. Davis claimed this violated the Interstate Commerce Clause. Initially Davis lost the case, only to win on appeal, setting the stage for a U.S. Supreme Court decision.

This past week, two legal scholars released a paper1 touting their opinion of what the Court’s outcome may be. Ethan Hale from Georgetown University and Brian Galle from Florida State published in the periodical “Tax Notes” that they believed the outcome of the Court will rule in favor of Davis, meaning the taxes over 42 state governments impose on out-of-state municipal bonds would be deemed unconstitutional. These authors claim that the U.S. Supreme Court has consistently found that state tax rules discriminating in favor of in-state activities are unconstitutional. If that indeed is the outcome, these states would have to decide whether to not tax out-of-state bonds or start taxing their own in-state bonds - decisions that would likely have a profound impact on the $2.3 trillion municipal bond market. Given that there are almost 500 single-state municipal bond funds with assets of more than $155 billion, an outcome as predicted by these professors would leave little reason for investors to choose these bond funds. Another, more significant issue arises when one considers that this outcome may force states to choose to tax all municipal bonds, pushing their borrowing costs of issuing additional municipal bonds to rise significantly, as investors would not have a tax-advantaged reason for buying these bonds. Speculation has also ensued about the potential for bond investors to sue states for reimbursement of taxes they have paid on out-of-state bonds in past years.

The reality is that this case may have profound and significant impact to the municipal bond market; an important investment vehicle to the nation’s banking system. Stay tuned for further updates.