In a case that could revolutionize the country's $2.5 trillion municipal bond market, the U.S. Supreme Court wrestled on Monday with whether a municipal bond is mainly a commodity or a means of financing unique public services that only state and local governments can provide.

In the Department of Revenue of Kentucky vs. Davis, the court must decide if Kentucky can give tax breaks on interest from municipal bonds sold within its borders, while taxing interest earned on bonds sold in other states.

Justice David Souter disagreed with a characterization by Eric Brunstad, a lawyer for George and Catherine Davis -- Kentucky residents who hold out-of-state bonds -- that municipal bonds, like other securities, were traded like commodities.

"Yes, but it's not taxing an out-of-state commodity in the sense of a commodity which is manufactured or produced out-of-state," Souter said.

Still, Justice Anthony Kennedy said the tax breaks go against the commerce clause of the U.S. Constitution.

"All states want to protect their residents and make it look like they're doing something for their residents. And that's exactly the purpose of commerce clause prohibition against explicit discrimination, which is what this is," he said.

The justices also plumbed the strength of the municipal bond market. Justice Souter noted it was "enormous" and the Supreme Court did not know what would happen if it were interrupted.