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Muni bonds dodge a bullet, as court OKs state tax favoritism

May 19, 2008 |  9:03 am

For the municipal bond market, no news is good news today.

The Supreme Court issued its long-awaited ruling in a 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 ruled 7 to 2 that the practice doesn't violate the Constitution, so the decision preserves the status quo in the muni market.

Read Bloomberg's report on the ruling here.

The case, brought by a couple of Kentucky investors in 2003, contended that the muni tax regime was unfair and protectionist because it in effect created a captive audience for a state's bonds.

The interest on most municipal bonds -- debt issued by states, counties, cities, school districts and other local government bodies -- is exempt from federal income tax. When a state also exempts its own bonds from its income tax, but taxes interest on other states' debt, investors in that state often have little reason to buy out-of-state muni securities.

That's particularly true for investors who live in high-tax states such as California.

If the court had ruled in favor of the Kentucky investors, every state could have faced one of two options: tax interest on all muni bonds, including a state's own issues, or exempt all from taxation. Either way, that could have been very expensive for muni issuers in California, and extremely disruptive to the $2.6-trillion muni market in general.

The Kentucky case didn't challenge the federal tax exemption on muni bonds.