Tax Debt

This article was originally on a blog post platform and may be missing photos, graphics or links. See About archive blog posts.

California taxpayers may be among the big winners in the U.S. Supreme Court’s decision on Monday not to upset the apple cart in the world of municipal-bond finance.

But some individual investors might well have liked to have had the cart overturned. It might have provided them with more diversification options for their muni portfolios.

The high court issued its much-awaited ruling in a Kentucky case that challenged the rights of states to exempt their own muni bonds from state income tax while taxing the interest generated by other states’ bonds.

The court voted 7 to 2 that the long-standing practice by the states doesn’t violate the Constitution, so the decision maintains the status quo in the muni market. (For more on the ruling, and some background on the case, go here.)

The upshot is that California and other high-tax states get to preserve their captive investor audiences: If you’re given a double tax exemption (federal and state) on a California muni bond, why would you buy a bond of another state that would be subject to California’s steep income tax?

The captive-audience factor helps California and its counties, cities and other local issuers finance government operations. Without that tax favoritism -- that is, if California issuers had to compete for individual investors’ attention with muni issuers across the nation -- California bonds might have to pay higher yields (same for the debt of New York, Massachusetts and other high-tax states).

That’s a headache California Treasurer Bill Lockyer didn’t need. Given the state’s low credit rating and deteriorating fiscal situation, ‘Taxpayers could ill afford to see any additional money go out the door’ to pay bond interest costs, said Tom Dresslar, a spokesman for Lockyer.

The mutual fund industry also breathed a sigh of relief after the court’s decision. All those single-state muni bond funds would have lost their reason for being if the justices had decided otherwise. ‘This removes a cloud of uncertainty’ over the single-state fund business, said John Miller, who heads the muni investing team at Nuveen Investments in Chicago.

Yes, but what of muni investors? True, an adverse decision could have disrupted the market just as yields have settled back after spiking in winter in a sell-off fueled by Wall Street’s credit crunch. Many muni investors like the market the way it usually is: uneventful.

Still, diversifying a muni portfolio could be to a California investor’s advantage in the long run. One obvious danger faced by owners of the state’s bonds is that a major earthquake could financially devastate the state or some municipalities, threatening their ability to pay their debts.

You can, of course, diversify on your own, and some people do. But that double-tax-exemption for in-state debt, now blessed by the Supreme Court, is a powerful incentive to remain a captive investor in California.