WASHINGTON The Supreme Court on Monday upheld long-standing state tax exemptions for municipal bonds.
In a 7-2 ruling in a case from Kentucky, the justices permitted states to exempt interest on their own bonds from taxation while taxing residents for interest on bonds issued by other states.
In the $2.5 trillion municipal bond market, 42 states exempt some or all interest on their bonds from income taxes, while taxing interest on bonds from other states.
The states have said that throwing out the system of exemptions that began 90 years ago would have a devastating impact on state finances.
Industry groups warned of possible turmoil in the municipal bond market if the existing setup were dismantled.
In the majority opinion, Justice David Souter said that the state tax exemptions go back to 1919 and have not hindered commerce among the states.
In dissent, Justice Samuel Alito said the majority decision "invites other protectionist laws."
Souter responded that that the dissent "rightly praises the virtues of the free market." But Souter said that overturning the tax exemptions now would upset the market in bonds based on the experience of nearly a century.
Some $432 billion in municipal bonds were issued in 2006 alone. In 2004, some 4.4 million investors earned $52 billion in interest on municipal bonds.
Municipal bonds finance the operations of state and local governments, education, the purchase of public lands as well as the construction and improvement of public buildings, transportation systems and water and sewer facilities.
A separate category of municipal bonds called private-activity bonds supports non-governmental entities including hospitals and health care facilities, small manufacturing plants, colleges and universities, airports, even the rebuilding of areas hit by the Sept. 11, 2001 terrorist attacks.
In the case before the court, taxpayers George and Catherine Davis of Jefferson County, Ky., challenged Kentucky law because it required the couple to pay income tax on bonds they held from other states.
The Davises said Kentucky law violates the commerce clause of the U.S. Constitution giving Congress authority to regulate commerce among the states. It is well-established in the courts that the commerce clause prohibits states from discriminating against interstate trade.