Dormant Commerce Clause and State Treatment of Tax-Exempt Bonds
Dormant Commerce Clause and State
Treatment of Tax-Exempt Bonds
Erika Lunder
Legislative Attorney
American Law Division
Summary
Most states exempt from state income taxes the interest earned on bonds issued by
that particular state and its political subdivisions, while taxing the interest earned on
bonds issued by other states and their political subdivisions.1 Some argue that these
state tax schemes violate the Commerce Clause by discriminating against out-of-state
bonds. Courts in two states have examined this issue. On November 5, 2007, the U.S.
Supreme Court heard oral arguments in one of these cases, Department of Revenue of
Kentucky v. Davis.
The Commerce Clause provides that “Congress shall have Power ... To regulate
Commerce ... among the several States....”2 The Supreme Court has long held that the
Clause prohibits states from unduly burdening interstate commerce even in the absence
of federal regulation. This restriction, known as the dormant or negative Commerce
Clause, “reflect[s] a central concern of the Framers” that “the new Union would have to
avoid the tendencies toward economic Balkanization that had plagued relations among
the Colonies and later among the States under the Articles of Confederation.”3 Thus, the
dormant Commerce Clause “prevent[s] a State from retreating into economic isolation or
jeopardizing the welfare of the Nation as a whole, as it would do if it were free to place
burdens on the flow of commerce across its borders that commerce wholly within those
borders would not bear.”4 A further rationale is that out-of-state entities subject to any
burden are likely not in a position to use the state’s political process to seek relief.5
1 For more information on government-issued bonds, see CRS Report RL30638, Tax-Exempt
Bonds: A Description of State and Local Government Debt, by Steven Maguire.
2 U.S. CONST. art. I, § 8, cl. 3.
3 Okla. Tax Comm’n v. Jefferson Lines, 514 U.S. 175, 180 (1995).
4 Id.
5 See Southern Pacific Co. v. Arizona, 325 U.S. 761, 768 (1945).
The dormant Commerce Clause prohibits state laws that discriminate against
interstate commerce.6 Thus, while a state law that “regulates even-handedly to effectuate
a legitimate local public interest” and has “only incidental” effect on interstate commerce
is constitutionally permissible “unless the burden imposed on such commerce is clearly
excessive in relation to the putative local benefits”7 (“the Pike test”), a discriminatory
state law is “virtually per se invalid.”8 Traditionally, such laws have only been
permissible if they meet the high standard of “advanc[ing] a legitimate local purpose that
cannot be adequately served by reasonable nondiscriminatory alternatives.”9 It would
appear, therefore, that the bond taxing schemes used by almost all of the states, which
exempt the interest on state-issued bonds while taxing the interest on other states’ bonds,
are facially discriminatory and should be subject to a high level of scrutiny.
However, a wrinkle to this analysis was added in April 2007 when the Supreme
Court decided a case, United Haulers Ass’n, Inc. v. Oneida-Herkimer Solid Waste Mgmt.
Authority,10 in which a plurality of the Court subjected a facially discriminatory state law
to a lower standard of scrutiny because it benefitted a public entity, as opposed to an in-
state private entity. The challenged law required trash haulers to deliver waste to a
processing facility owned by a public entity. The Court had previously struck down a
similar law,11 but distinguished the two cases because the processing facility in the prior
case was privately owned while the United Haulers facility was publicly owned.
In United Haulers, the Court found “[c]ompelling reasons” for distinguishing
between state laws that favor governmental units and those that favor in-state private
entities over their competitors.12 The Court, stating that “any notion of discrimination
assumes a comparison of substantially similar entities,” reasoned that state and local
governments are not substantially similar to private entities due to their public welfare
responsibilities.13 These responsibilities, the Court explained, meant that laws favoring
governmental units have “any number of legitimate goals,” while laws favoring in-state
private entities generally represent “simple economic protectionism.”14 Thus, the Court
6 See Complete Auto Transit, Inc. v. Brady, 430 U.S. 274, 279 (1977).
7 Pike v. Bruce Church, Inc., 397 U.S. 137, 142 (1970).
8 Camps Newfound/Owatonna, Inc. v. Town of Harrison, 520 U.S. 564, 575 (1997) (internal
citations omitted).
9 New Energy Co. of Indiana v. Limbach, 486 U.S. 269, 278 (1988).
10 United Haulers Ass’n Inc. v. Oneida-Herkimer Solid Waste Mgmt. Auth., 127 S. Ct. 1786
(2007).
11 C & A Carbone, Inc. v. Town of Clarkstown, 511 U.S. 383 (1994).
12 United Haulers, 127 S. Ct. at 1795. In dissent, Justice Alito, joined by Justices Stevens and
Kennedy, disagreed that United Haulers could be distinguished from the prior case and wrote that
the “public-private distinction drawn by the [majority opinion] is both illusory and without
precedent.” Id. at 1804 (Alito, J., dissenting).
13 Id. at 1795 (internal citations omitted).
14 Id. at 1795-96 (internal citations omitted).
reasoned, such laws should not be viewed with “equal skepticism.”15 The Court explained
that treating them equally “would lead to unprecedented and unbounded interference by
the courts with state and local government,” which was particularly inappropriate when
the challenged law addressed a traditional government function such as waste disposal.16
A majority of the Court could not agree on the standard under which to examine laws
favoring public entities. A plurality of four justices stated that the proper standard was
the Pike test — that is, whether “the burden imposed on interstate commerce is clearly
excessive in relation to the putative local benefits.”17 The plurality did not find the
challenged law’s burden to be excessive to its benefits, which included providing health
and environmental benefits and an effective way to finance waste-disposal services.18
Market Participant Doctrine. The dormant Commerce Clause is not implicated
when a state acts as a market participant as opposed to a market regulator. This is because
the “Commerce Clause responds principally to state taxes and regulatory measures
impeding free private trade in the national marketplace,” and “[t]here is no indication of
a constitutional plan to limit the ability of the States themselves to operate freely in the
free market.”19 The market participant doctrine does not apply when the state is acting20
in its governmental capacity by assessing and computing taxes.
Court Cases
It appears only two cases have addressed whether state laws taxing interest earned
on bonds issued by other states while exempting interest earned on bonds issued by that
state violate the Commerce Clause. In 1994, an Ohio appellate court held in Shaper v.21
Tracy that such treatment was constitutional. In 2006, the Kentucky court of appeals
held the opposite in Kentucky Department of Revenue v. Davis.22 In November 2007, the
U.S. Supreme Court heard oral arguments in Davis.
15 Id. at 1795.
16 Id. at 1796.
17 Id. at 1797 (internal citations omitted). Justice Scalia, who otherwise joined the majority
opinion, did not agree with the application of the Pike test. He wrote that he would follow
precedent despite his belief that the Commerce Clause did not restrict state actions, but did not
find any prior cases that required him to strike down the challenged law. Id. at 1798-99 (Scalia,
J., concurring in part). Justice Thomas concurred only in the judgment and wrote to say that he
“would discard the Court’s negative Commerce Clause jurisprudence” because it had “no basis
in the Constitution and has proved unworkable in practice.” Id. at 1799 (Thomas, J., concurring
in judgment).
18 See id. at 1797-98.
19 Reeves, Inc. v. Stake, 447 U.S. 429, 437 (1980).
20 See New Energy Co. of Indiana v. Limbach, 486 U.S. 269, 277-78 (1988); Camps
Newfound/Owatonna, Inc. v. Town of Harrison, 520 U.S. 564, 593-94 (1997).
21 Shaper v. Tracy, 647 N.E.2d 550 (Ohio Ct. App. 1994), appeal denied, 645 N.E.2d 1257 (Ohio
22 Dep’t of Revenue of Kentucky v. Davis, 197 S.W.3d 557 (Ky. Ct. App. 2006), cert. granted,
Shaper v. Tracy. In the Shaper case, an Ohio court of appeals rejected the claim
made by an Ohio taxpayer that the state’s bond taxing scheme was unconstitutional. The
court began by agreeing with the taxpayer that the market participant doctrine did not
apply because Ohio was acting as a market regulator, and not participant, when it23
determined how to tax out-of-state bonds. However, the court then ruled that the taxing
scheme did not implicate the Commerce Clause because the scheme benefitted the state.24
The court based this conclusion on its analysis of the Supreme Court’s Commerce Clause
jurisprudence, which the court found to only involve challenges to state actions giving in-
state private entities a competitive advantage over out-of-state entities, and not challenges
to state actions benefitting the state itself.25
The court, while noting that no Supreme Court decision was directly on point, found26
two cases to be useful. The first was Bonaparte v. Tax Court, in which the Supreme
Court determined that a state law exempting state-issued public debt held by residents,27
while taxing non-residents, did not violate the Full Faith and Credit Clause. The court
placed significance on the Supreme Court’s statements in Bonaparte that “the
Constitution does not prohibit a State from including in the taxable property of her
citizens so much of the registered public debt of another State as they respectively hold,
although the debtor State may exempt it from taxation or actually tax it” and “[w]e know
of no provision of the Constitution of the United States which prohibits such taxation.”2829
The second case was South Carolina v. Baker, in which the Supreme Court held that the
federal government could tax state-issued bonds.30 While noting that the tax in Baker was
not challenged under the Commerce Clause, the Shaper court quoted the Supreme Court’s
statement that “[t]he owners of state bonds have no constitutional entitlement not to pay
taxes on income they earn from the bonds and States have no constitutional entitlement
to issue bonds paying lower interest rates than other issuers.”31
The court, after noting that Ohio had a “legitimate interest in tapping a major source
of tax revenue” and bond purchasers are “major beneficiaries” of the public purposes for
which the bond proceeds would be used, concluded by stating it could not hold the Ohio
law unconstitutional “given the lack of any precedent to apply the Commerce Clause to
this type of taxation scheme.”32
23 See Shaper v. Tracy, 647 N.E2d. at 552.
24 See id. at 552-53.
25 See id.
26 Bonaparte v. Tax Court, 104 U.S. 592 (1882).
27 U.S. CONST. art. IV, § 1 (providing, in part, that “Full Faith and Credit shall be given in each
State to the public Acts, Records, and judicial Proceedings of every other State”).
28 Shaper, 647 N.E.2d at 553.
29 South Carolina v. Baker, 485 U.S. 505 (1988).
30 Shaper, 647 N.E.2d at 553.
31 Id.
32 Id. at 553-54.
Dep’t of Revenue of Kentucky v. Davis. In the Davis case, the Kentucky court
of appeals held that the state’s bond taxing scheme violated the Commerce Clause. The
court began by noting that the “‘fundamental command’ of the Commerce Clause is that
‘a State may not tax a transaction or incident more heavily when it crosses state lines than
when it occurs entirely within the State,’” and therefore discriminatory state laws were
presumptively invalid.33 Based on this, the court reasoned that “[c]learly, Kentucky’s
bond taxation system is facially unconstitutional as it obviously affords more favorable
taxation treatment to in-state bonds than it does to extraterritorially issued bonds.”34
The court rejected the state’s argument that it should adopt the Shaper court’s
holding, stating that the Shaper analysis was incomplete because “a potentially
problematic and constitutionally infirm statute does not become permissible simply35
because it has not been previously found to be unconstitutional.” The court also
dismissed the relevance of the Bonaparte decision because it dealt with the Full Faith and36
Credit Clause and not the Commerce Clause. Finally, the court rejected the argument
that Kentucky’s taxing scheme did not implicate the dormant Commerce Clause because
the state was acting as a market participant, explaining that Kentucy was a market
participant when issuing the bonds but a market regulator when choosing how to tax its37
citizens.
The U.S. Supreme Court heard oral arguments in the Davis case on November 5,
2007. A transcript of the oral arguments is available on the Supreme Court’s website at
[ h ttp://www.supremecourtus.gov/oral_arguments/argument_transcripts/06-666.pdf] .
Effect of United Haulers on Davis. As discussed, the Supreme Court decided
United Haulers just prior to granting certiorari in Davis. Under the Court’s jurisprudence
prior to United Haulers, it seems there was a significant chance that Kentucky’s bond
taxing scheme would be unconstitutional because it facially discriminates against out-of-
state entities, and the Court’s jurisprudence suggested that such laws were impermissible
unless the state could show the law served a legitimate state purpose and there were no
other reasonable ways to advance that purpose. This high level of scrutiny is generally
fatal to the challenged state law.
The United Haulers decision suggests a different outcome by indicating that a less
stringent analysis applies when the state law benefits state and local governments as
opposed to in-state private entities. Questions exist about how the Court may apply
United Haulers to Davis, in part because only a plurality in United Haulers agreed it was
appropriate to use the Pike test in examining the permissibility of state laws benefitting
public entities. Furthermore, it is possible the Court will distinguish Davis from United
Haulers. One basis for doing so is that the state law in United Haulers benefitted a
33 Dep’t of Revenue of Kentucky v. Davis, 197 S.W.3d 557, 562 (Ky. Ct. App. 2006)(quoting
Associated Industries of Missouri v. Lohman, 511 U.S. 641, 647 (1994) and Armco Inc. v.
Hardesty, 467 U.S. 638, 642 (1984)).
34 Id.
35 Id. at 563.
36 See id. at 564.
37 See id.
publicly owned entity over private entities, while the one in Davis benefits states over
other states.38 The Court’s analysis in United Haulers was based on its finding that while
“any notion of discrimination assumes a comparison of substantially similar entities,”
governmental units and private entities are not “substantially similar” because the former
have public welfare responsibilities not imposed on the latter. Thus, a key question in
Davis seems to be whether Kentucky is “substantially similar” to the other states whose
bonds it taxes;39 if so, that could be constitutionally fatal for Kentucky’s bond taxing
scheme. On the other hand, if the Court does apply an analysis similar to United Haulers
in Davis, this suggests that Kentucky’s taxing scheme would be constitutionally
permissible. Policy concerns, such as a desire to not upset the state bond market and the
expectations of bond purchasers, could provide additional justifications for the Court to
find the taxing scheme to be constitutional.40
Congressional Authority to Address the Issue
Congress’s authority under the Commerce Clause has been described as plenary and
limited only by other constitutional provisions.41 Congress may, therefore, regulate by
expressly authorizing the states to take an action that would otherwise be an
unconstitutional burden on interstate commerce.42 Thus, if the Court were to hold that
Kentucky’s taxing scheme violates the dormant Commerce Clause, it appears Congress
could authorize such tax treatment so long as it did not violate any other constitutional
provision.
38 See also Ethan Yale and Brian Galle, Muni Bonds and the Commerce Clause After United
Haulers, TAX NOTES, at 1042-1046 (June 11, 2007) (putting forth additional justifications for
distinguishing the cases, including that there are no burdened in-state entities in Davis who could
represent the views of burdened out-of-state entities in the Kentucky’s political process).
39 Compare Brief for Petitioners at 17-18, Dep’t of Revenue of Kentucky v. Davis, No. 06-666
(U.S. July 19, 2007) (arguing Kentucky is not substantially similar to other states because no
other state has the “political responsibility of financing public works and public projects for
Kentucky citizens” or the responsibilities for bond repayment), with Brian D. Galle and Ethan
Yale, Can Discriminatory State Taxation of Municipal Bonds Be Justified? TAX NOTES, at 158-
59 (Oct. 8, 2007) (arguing that the proper comparison is between Kentucky’s bonds and other
states’ bonds, and that the bonds are substantially similar because they are clearly “competing
alternatives”).
40 See Joann M. Weiner, Panelists: Court Will Uphold Status Quo in Municipal Bond Case, TAX
NOTES, at 441-42 (Oct. 29, 2007) (reporting that Professor Walter Hellerstein stated he believes
the Court will use United Haulers as an “escape hatch” to uphold Kentucky’s bond taxing
scheme in order to not disrupt the expectations that have arisen from the states’ tax treatment of
bonds); see also, Edward A. Zelinsky, Davis: Incoherence of Dormant Commerce Clause
Nondiscrimination, TAX NOTES, at 59-60, 61 (July 2, 2007) (arguing that the Supreme Court
should use Davis to reconsider the dormant Commerce Clause’s nondiscrimination concept
because it makes no sense that “any tax expenditures can be transformed into an economically
and procedurally equivalent direct expenditure” and the focus on protectionism and economic
effect is overly broad because all state activity is “protectionist in nature”).
41 See, e.g., Prudential Insurance Co. v. Benjamin, 328 U.S. 408, 434 (1946).
42 See Quill v. North Dakota, 504 U.S. 298, 318-19 (1992).