WASHINGTON - 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 to 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.
The states have said that throwing out the system of exemptions that began some 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."
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."
Some $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 and the construction and improvement of public buildings, transportation systems and water and sewer facilities.
A category of municipal bonds called private activity bonds supports nongovernmental entities including hospitals and healthcare facilities, small manufacturing plants, colleges and universities, airports, even the rebuilding of areas hit by the Sept. 11, 2001 terrorist attacks.
Kentucky taxpayers George and Catherine Davis of Jefferson County, challenged state law because it required the couple to pay income tax on bonds they held from other states.
Were Kentucky to have lost the case, most states could have been faced with refunding taxes going back several years. New York State said such refunds could total $200 million, plus $70 million a year in lost revenue.