Municipal bonds making big waves over Lawsuit Fears

The Chicago Tribune reports:

Chicago class-action lawyer John Wylie and his colleagues have the normally staid municipal bond industry on the edge of its seat.

Wylie's challenge, on behalf of a Kentucky couple, of state tax incentives that help fuel the $2.4 trillion municipal bond market will be argued in the fall term of the U.S. Supreme Court that begins Monday. The case has provoked emotional responses from market participants because it could shake up the industry, from hurting the attractiveness of a very popular investment to raising the borrowing costs for states and local municipalities.

Chicago-based Nuveen Investments Inc., which manages more than $63.6 billion in municipal securities, even suggested in court papers that the issue is too important to be decided by the courts and should be left for Congress to debate.

Given the money at stake, Wylie is not surprised by the outpouring of opinion -- more negative than positive, judging by the briefs filed with the court -- stirred by his case. "This is an important issue for states and taxpayers and something that ought to be decided by the Supreme Court so there is some uniform law," he said.

At issue is a Kentucky law that taxes interest income on non-Kentucky municipal bonds while exempting interest on bonds issued within the state. The case extends beyond the Bluegrass state, however, because 37 other states have similar rules that favor bonds issued within their own state. Wylie is handling similar cases for taxpayers in Arizona and North Carolina. Illinois taxes all municipal bond interest, but the legislature has carved out exceptions for several in-state bonds.

The policy of taxing only out-of-state bonds is discriminatory, Wylie argues, and violates the U.S. Constitution's commerce clause, which gives Congress the power to regulate trade among states. A Kentucky state court sided against the couple, George and Catherine Davis; a state appeals court reversed; and Kentucky's Supreme Court declined to take the case.

In taking up the issue, the U.S. Supreme Court will have the final word on a topic that has been debated by tax professors for years. Municipal bonds have long been a popular investment with individuals because they are exempt from federal tax. New York was the first state to exempt state-issued bonds from taxes in 1919, according to court documents. Other states soon followed -- Kentucky in 1936 -- in retaliation, the Davis' court brief said.

Because of the tax break, investors are willing to accept lower interest rates on in-state bonds, which lowers the cost of borrowing. The system led to the development of single-state municipal bond funds. There are almost 500 such mutual funds today with assets of more than $155 billion, according to the Investment Company Institute.

The high tax states are more than a little worried.