Is the Municipal Bond Tax
Exemption Protected by the U.S. Constitution?
By Edward McManimon
NJLM Associate Counsel
McManimon & Scotland
There has been much commentary on whether Congress, in an effort to reduce the high deficit it has accumulated, can statutorily remove the exemption on interest paid on municipal bonds to derive additional revenue for the Federal Government. Much of the commentary focuses on the increased costs to states and local governments for borrowing to fund capital and infrastructure needs if in fact that change occurs. The Federal Government’s “gain” would come from an equal cost to state and local governments for funding its capital needs—certainly just a shift of costs from one government to another paid by the taxpayers. Essentially, this debate even at this early stage has become a political one with little discussion about the constitutional foundation for such tax exemption.
The simplest answer to the question raised above is no, the tax exemption is not protected constitutionally at least at the moment. This is despite the early constitutional principle of intergovernmental tax immunity derived from dual federal/state sovereignty established in the Tenth Amendment to the U.S. Constitution and confirmed in the early McCullouch v. Maryland, United States Supreme Court Case (17 U.S. 316 (1819)) and then again, among various cases addressing that and similar points in Pollock v. Farmer’s Loan & Trust Co. in 1895 (157 U.S. 429, 155 & 673).
The reason for this answer is because of the more recent 1988 U.S. Supreme Court decision in South Carolina v. Baker (486 U.S. 1062, 108 S. Ct 2832) which addressed a seemingly narrow legal issue involving Federal legislation requiring, among other things, municipal bonds to be issued in registered form rather than in bearer form and imposing federal income tax on such interest if not so issued.
That decision, though by a divided court, stated clearly that there was “no constitutional reason for treating persons who receive interest on governmental bonds differently than persons who receive income from other types of contracts…” It did not actually seek to generally tax the interest on state and local government bonds. It simply required that such bonds could no longer be issued in “bearer” form. The analysis, however, went further into the question of the federal government’s power to impose taxes in this area.
Despite that decision, the debate on this subject should not be deemed over, particularly if something as draconian as an actual effort to take away with federal legislation the actual tax exemption on state and local government debt issued for typical governmental purposes. Aside from the significant political debate that will ensue over states’ rights and the equally significant financial and economic impact it would have on states and local governments whose costs would increase to provide the federal government with its “savings,” the South Carolina case itself overturned years of U.S. Supreme Court precedent on intergovernmental tax immunity and the meaning of the 10th Amendment and there were three significant dissenting opinions (O’Conner, Powell and Rehnquist).
The U.S. Supreme Court is made up of individuals who make these decisions and circumstances sometimes change opinions and precedents as, in fact, the South Carolina decision did. Such legislation if enacted by Congress would face a stiff judicial challenge by the states and would likely wind up at the Supreme Court again. In the South Carolina dissents, it is noted that “the Court today overrules a precedent that it has honored for nearly 100 years and expresses a willingness to cancel the constitutional immunity that traditionally has shielded the interest paid on state and local bonds from federal taxation” and “Federal taxation of state activities is inherently a threat to state sovereignty” and even citing again the words of Chief Justice Marshall in McCullouch v. Maryland that “the power to tax is the power to destroy.”
In the end, it is important to remember that the federal government was created by the states not the other way around. The U.S. Constitution in the Tenth Amendment made clear that the power of the federal government is derived from the enumerated powers contained therein and that all other powers were retained by the states. While the principle has been eroded over time as the federal government became more powerful, it remains a fundamental foundation of our federal/state government. It will certainly be revisited on a constitutional as well as a statutory basis if any effort is made by the federal government to do something as drastic as tax the interest on state and local government bonds.
Editorial from New Jersey
Municipalities, Volume 89, Number 9, December 2012