WASHINGTON — The $2.5 trillion municipal-bond market skirted a land mine Monday 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 for interest on bonds issued by other states.
In the municipal-bond market, 41 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 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 Souter said the state tax exemptions have not hindered commerce among the states.
In dissent, Justices Anthony Kennedy and Samuel Alito said the majority decision “invites other protectionist laws.” Souter responded that the dissent “rightly praises the virtues of the free market.” But Souter 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 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.”
