On Monday, the Supreme Court ruled that states may offer special tax breaks to residents for investing in municipal bonds issued by them and local governments within the state. The 7-2 decision, in Kentucky Department of Revenue v. Davis was widely expected. But even if the Court wanted to bar states from preferring their own bonds over those from other jurisdictions, the current troubles of the $2.6 trillion municipal bond market probably made that impossible. With muni auctions failing and the first quarter average total return on outstanding muni-bonds down 0.82%, the largest decline since 1996, a negative decision could have had catastrophic results in a market that has only recently calmed down. But the court has left unresolved one big question—do private purpose muni bonds qualify for the same special treatment?

Here are some thoughts from Alan Viard, a scholar at AEI and a close follower of the case:

The Court's decision was expected. The Court noted its reluctance to disrupt existing market institutions and a policy supported by all of the states. It grounded its decision, however, in last year's United Haulers ruling, reiterating that the dormant commerce clause (DCC) has little application when state and local governments are themselves parties to the transactions in question.

While the Court repeatedly stated that Kentucky is entitled to prefer its own bonds over other states' bonds, those statements miss the real issue. The problem is the fact that Kentucky prefers the holdings of Kentucky bonds by Kentucky residents over cross-state bond holdings, not that it prefers its own bonds over other bonds. There would be no problem if Kentucky promoted its own bonds to residents and nonresidents alike while providing no similar promotion to other states' bonds. I explored this in the October 22, 2007 State Tax Notes.

One interesting aspect of the decision is the Court's refusal to uphold (for now, at least) the selective tax exemption as it pertains to private-activity bonds. While the legal parties treated public-activity and private-activity bonds as interchangeable, the brief that I filed with other AEI and Brookings scholars argued that the rationale for upholding the exemption does not apply to bonds issued on behalf of private borrowers. The Court acknowledged the potential distinction and decided to "leave for another day" the validity of the exemption as it pertains to these bonds. If and when the Court rules on private-activity bonds, it faces a difficult dilemma. On the one hand, the Court's reluctance to disrupt existing institutions and policies would support upholding the exemption. But, allowing state and local governments to escape DCC restrictions while aiding private firms and nonprofits would open a gaping hole in the DCC.