Muni Bond taxation under fire.

Kentucky exempts from income taxes the interest earned from in-state municipal bonds, but interest on the bonds issued by other states is fully taxable. Nothing unusual about this, it's standard operating procedure throughout the country. However, Mr. and Mrs. Davis challenged this discrimination under the Commerce Clause of the U.S. Constitution. They lost in the trial court but won in the Kentucky Court of Appeals. That Court held that such discrimination is unconstitutional on its face, and it could find no exception for allowing it.

The decision of the Commonwealth Of Kentucky Court of Appeals is here. The Department of Revenue has filed for certiorari from the U.S. Supreme Court, and the taxpayer has asked that cert be denied. An Ohio court considered the question and found no consitutional violation, a decision that was distinguished by the Kentucky panel. The split of opinions makes it more likely that the U.S. Supreme Court will accept the case. For a debate about the correctness of the Kentucky Court's reasoning, try this.

I think that the Kentucky Court is clearly correct. The problem is that the constitutional remedy is either exempt all muni bond income or tax it all, and given the government's craving for cash, it's likely to more taxes for everyone. If the U.S. Supreme Court upholds the Kentucky decision and applies it nationally, there will be a quick round of refunds for all open tax years for the unconstitutionally collected taxes.

By the way, my understanding is that there is no constitutional impediment to the federal government taxing municipal bonds. I would cheerfully give up that tax preference in order to kill off the AMT. However, that's not on the table yet, so far as I know.