Kentucky's lawyers appealed to the Supreme Court. "The outcome ... has broad implications for the municipal bond market at large, far beyond Kentucky's borders," John R. Farris, Kentucky's secretary of finance, said in a written statement.
If the justices uphold the Kentucky court's ruling, states that exempt their bonds while taxing those from other states would either have to tax municipal bonds from all states equally or exempt all bonds in order to come into compliance, several legal experts said.
But based on a separate Supreme Court decision last month involving interstate commerce, which ruled in favor of local governments in New York, many observers think the Court is likely to overrule the Kentucky decision and maintain the status quo.
By exempting municipal bonds from state taxes, governments can offer in-state investors lower interest rates and as a result lower their cost of borrowing. Muni bonds, which are used to fund roads, schools and other public projects, are also exempt from federal taxes.
The bonds can be particularly appealing to investors from high-tax states such as California, New York and Massachusetts. There are hundreds of mutual funds comprised of muni bonds from single states, with over $160 billion in assets, bond analysts said.
State and local governments issued approximately $400 billion in municipal bonds in 2006, one bond analyst said.
Like Kentucky, more than 40 states exempt at least some of their in-state bonds from taxation, the National Association of State Treasurers said in a friend-of-the-court brief.
Kentucky's policy was challenged by George and Catherine Davis, who argued it is unconstitutional and requested a refund of the taxes they paid on out-of-state muni bonds.
If the Davises prevail at the high court, Kentucky and the other states could be forced to pay those refunds, said Alan Viard, a resident scholar at the American Enterprise Institute.
The case could also impact the Section 529 college savings plans offered by many states, said Leonard Weiser-Varon, a public finance expert at the Mintz Levin law firm in Boston.
Bond fund managers downplayed the issue. Tom Metzold, a vice president and portfolio manager at Eaton Vance Corp., said that a ruling against the states could result in a one-time reduction in the value of muni bonds. Otherwise, "it will be much ado about nothing," he said.
Ronald Fielding, who manages the municipal bond funds group at Oppenheimer Funds, estimated that investors who own bonds from high-tax states could see the value of their portfolios decline by 1.5 percent to 2 percent if the Supreme Court rules in favor of the Davises.
But many legal experts think the justices are likely to rule in favor of Kentucky instead. Last month, the justices found that local governments in New York could compel private trash haulers to use government-owned facilities, even if it would be cheaper to dispose of it at out-of-state dumps.
Gregory Germain, an associate professor at the Syracuse University College of Law, said that ruling carved out "a very broad exemption" to the commerce clause for laws that may discriminate against interstate commerce but favor a government entity.
The case is Kentucky v. Davis, 06-666. It won't be argued until the Court's next term, which begins in October.