Department of Revenue of Kentucky v. Davis

553 U.S. 328

Case Year: 2008

Case Ruling: 7-2, Reversed and Remanded

Opinion Justice: Souter

FACTS

When calculating net income for income tax purposes, Kentucky exempts the interest earned by its residents on its own bonds (as do many states), but collects taxes on the interest earned on bonds from other states. Kentucky’s motivation for such a policy is to make its tax-exempt bonds more attractive to its citizens.

After paying state taxes on the interest they had earned from out-of-state bonds, Kentucky residents George and Catherine Davis sued the state’s tax collectors arguing that the state’s differential taxation scheme discriminates against interstate commerce, thereby violating the Constitution’s commerce clause. The trial court found in favor of the state, but the Court of Appeals reversed.

 

JUSTICE SOUTER DELIVERED THE OPINION OF THE COURT, EXCEPT AS TO PART III–B.

I (omitted)

II

The modern law of what has come to be called the dormant Commerce Clause is driven by concern about “economic protectionism--that is, regulatory measures designed to benefit in-state economic interests by burdening out-of-state competitors.” The point is to “effectuat[e] the Framers’ purpose to ‘prevent a State from retreating into [the] economic isolation,’ ” “that had plagued relations among the Colonies and later among the States under the Articles of Confederation.” . . .

. . . A discriminatory law is “virtually per se invalid,” and will survive only if it “advances a legitimate local purpose that cannot be adequately served by reasonable nondiscriminatory alternatives.” Absent discrimination for the forbidden purpose, however, the law “will be upheld unless the burden imposed on [interstate] commerce is clearly excessive in relation to the putative local benefits.” State laws frequently survive this scrutiny.

Some cases run a different course, however, and an exception covers States that go beyond regulation and themselves “participat[e] in the market” so as to “exercis[e] the right to favor [their] own citizens over others.” This “market-participant” exception reflects a “basic distinction . . . between States as market participants and States as market regulators,” “[t]here [being] no indication of a constitutional plan to limit the ability of the States themselves to operate freely in the free market.” . . .

Our most recent look at the reach of the dormant Commerce Clause came just last Term, in a case decided independently of the market participation precedents. United Haulers [ Assn., Inc. v. Oneida-Herkimer Solid Waste Management Authority,2007] upheld a “flow control” ordinance requiring trash haulers to deliver solid waste to a processing plant owned and operated by a public authority in New York State. We found “[c]ompelling reasons” for “treating [the ordinance] differently from laws favoring particular private businesses over their competitors.” State and local governments that provide public goods and services on their own, unlike private businesses, are “vested with the responsibility of protecting the health, safety, and welfare of [their] citizens,” and laws favoring such States and their subdivisions may “be directed toward any number of legitimate goals unrelated to protectionism.” That was true in United Haulers, where the ordinance addressed waste disposal, “both typically and traditionally a local government function.” . . .

III

A

It follows . . . from United Haulers that Kentucky must prevail. . . . [A] government function is not susceptible to standard dormant Commerce Clause scrutiny owing to its likely motivation by legitimate objectives distinct from the simple economic protectionism the Clause abhors. This logic applies with even greater force to laws favoring a State’s municipal bonds, given that the issuance of debt securities to pay for public projects is a quintessentially public function, with the venerable history. . . . Bond proceeds are . . . the way to shoulder the cardinal civic responsibilities listed in United Haulers: protecting the health, safety, and welfare of citizens. . . .

. . . Kentucky’s tax exemption favors a traditional government function without any differential treatment favoring local entities over substantially similar out-of-state interests. This type of law does “not ‘discriminate against interstate commerce’ for purposes of the dormant Commerce Clause.”

B

This case . . . may also be seen under the broader rubric of the market participation doctrine. . . .

. . . [T]here is no ignoring the fact that imposing the differential tax scheme makes sense only because Kentucky is also a bond issuer. The Commonwealth has entered the market for debt securities. . . . It simply blinks this reality to disaggregate the Commonwealth’s two roles and pretend that in exempting the income from its securities, Kentucky is independently regulating or regulating in the garden variety way that has made a State vulnerable to the dormant Commerce Clause. . . . [W]hen Kentucky exempts its bond interest, it is competing in the market for limited investment dollars, alongside private bond issuers and its sister States, and its tax structure is one of the tools of competition. . . .

The Kentucky tax scheme falls outside the forbidden paradigm because the Commonwealth’s direct participation favors, not local private entrepreneurs, but the Commonwealth and local governments. The Commonwealth enacted its tax code with an eye toward making some or all of its bonds more marketable. When it issues them for sale in the bond market, it relies on that tax code, and seller and purchaser treat the bonds and the tax rate as joined just as intimately, say, as the work force requirements and city construction contracts were in Boston. . . .

C

A look at the specific markets in which the exemption’s effects are felt both confirms the conclusion that no traditionally forbidden discrimination is underway and points to the distinctive character of the tax policy. The market as most broadly conceived is one of issuers and holders of all fixed-income securities, whatever their source or ultimate destination. In this interstate market, Kentucky treats income from municipal bonds of other States just like income from bonds privately issued in Kentucky or elsewhere; no preference is given to any local issuer, and none to any local holder, beyond what is entailed in the preference Kentucky grants itself when it engages in activities serving public objectives. . . .

There is little doubt that many single-state funds would disappear if the current differential tax schemes were upset. . . .

This probable indispensability of the current scheme to maintaining single-state markets serving smaller municipal borrowers not only underscores how far the States’ objectives probably lie from the forbidden protectionism for local business; it also tends to explain why the States are so committed to a taxing practice that much scholarship says often produces a net burden of tax revenues lost over interest expense saved.

In sum, the differential tax scheme is critical to the operation of an identifiable segment of the municipal financial market as it currently functions, and this fact alone demonstrates that the unanimous desire of the States to preserve the tax feature is a far cry from the private protectionism that has driven the development of the dormant Commerce Clause. . . .

IV

Concluding that a state law does not amount to forbidden discrimination against interstate commerce is not the death knell of all dormant Commerce Clause challenges. . . . even nondiscriminatory burdens on commerce may be struck down on a showing that those burdens clearly outweigh the benefits of a state or local practice. . . .

Even if [many] drawbacks . . . eventuate from the system, it must be apparent to anyone that weighing or quantifying them for a cost-benefit analysis would be a very subtle exercise. It is striking, after all, that most of the harms allegedly flowing directly or indirectly to Kentucky’s sister States and their citizens have failed to dissuade even a single State from supporting the current system; every one of them, including States with no income tax, have lined up with Kentucky in this case.

. . . Is any court in a position to evaluate the advantage of the current market for bonds issued by the smaller municipalities, the ones with no ready access to any other bond market than single-state funds? . . .

While it is not our business to suggest that the current system be reconsidered, if it is to be placed in question a congressional forum has two advantages. Congress has some hope of acquiring more complete information than adversary trials may produce, and an elected legislature is the preferable institution for incurring the economic risks of any alteration in the way things have traditionally been done. And risk is the essence of what the Davises are urging here. It would miss the mark to think that the Kentucky courts, and ultimately this Court, are being invited merely to tinker with details of a tax scheme; we are being asked to apply a federal rule to throw out the system of financing municipal improvements throughout most of the United States. . . .

***

The dissent rightly praises the virtues of the free market, and it warns that our decision to uphold Kentucky’s tax scheme will result in untoward consequences for that market. But the warning is alarmism; going back to 1919 the state regimes of differential bond taxation have been elements of the national commerce without wilting the Commerce Clause. The threat would come, instead, from the dissent’s approach, which to a certainty would upset the market in bonds and the settled expectations of their issuers based on the experience of nearly a century.

We have been here before. Our predecessors on this Court responded to an earlier invitation to the adventurism of overturning a traditional local taxing practice. Justice Holmes answered that “the mode of taxation is of long standing, and upon questions of constitutional law the long settled habits of the community play a part. . . . [T]he fact that the system has been in force for a very long time is of itself a strong reason . . . for leaving any improvement that may be desired to the legislature.”

The judgment of the Court of Appeals of Kentucky is reversed, and the case is remanded for further proceedings not inconsistent with this opinion.

It is so ordered.

JUSTICE STEVENS, CONCURRING.

In my judgment state action that motivates the State's taxpayers to lend money to the State is simply not the sort of “burden” on interstate commerce that is implicated by our dormant Commerce Clause jurisprudence.

JUSTICE THOMAS, CONCURRING IN THE JUDGMENT.

I agree with the Court that Kentucky’s differential tax scheme is constitutional. But rather than apply a body of doctrine that “has no basis in the Constitution and has proved unworkable in practice,” I would entirely “discard the Court’s negative Commerce Clause jurisprudence.” Because Congress’ authority to regulate commerce “among the several States,” necessarily includes the power “to prevent state regulation of interstate commerce,” the text of the Constitution makes clear that the Legislature--not the Judiciary--bears the responsibility of curbing what it perceives as state regulatory burdens on interstate commerce.

As the Court acknowledges, Kentucky’s differential tax scheme is far from unique. For nearly a century, some States have treated income derived from out-of-state bonds differently than that derived from their in-state counterparts. At present, the vast majority of the States do so. The practice is thus both longstanding and widespread, yet Congress has refrained from preempting it. In the “face of [this] congressional silence,” United Haulers (Thomas, J. concurring in judgment), we have no authority to invalidate Kentucky’s differential tax scheme. I would reverse the judgment below on that basis.

JUSTICE KENNEDY, WITH WHOM JUSTICE ALITO JOINS, DISSENTING.

Eighteenth-century thinkers, even those most prescient, could not foresee our technological and economic interdependence. Yet they understood its foundation. Free trade in the United States, unobstructed by state and local barriers, was indispensable if we were to unite to ensure the liberty and progress of the whole Nation and its people. This was the vision, and a primary objective, of the Framers of the Constitution. . . . The national, free market within our borders has been a singular force in shaping the consciousness and creating the reality that we are one in purpose and destiny. . . .

These general observations are offered at the outset to underscore the imprudent risk the Court now creates by misinterpreting our precedents to decide this case. True, the majority opinion, wrong as it is, will not threaten the whole economy or national unity on these facts alone. . . . This market perhaps can absorb the costs of discrimination; our jurisprudence, unless the decision stands alone as an anomaly, cannot. . . .

Protectionist trade laws and policies, pursued to favor local interests within a larger trading area, invite prompt retaliatory response. This dynamic was one the Framers understood in theory and saw in fact. Under the Articles of Confederation the States enacted protectionist laws. It proved difficult and costly, even in terms of political energies, to remove trade barriers by negotiated agreements; and the few resulting compacts seemed destined to favor the more powerful States. The immediate prospect of escalating trade barriers was real, and a national power to regulate national trade and remove local barriers soon was deemed urgent. . . .

. . . [O]ur commerce cases have invalidated two types of local barriers: laws that impose unreasonable burdens upon interstate commerce; and laws that discriminate against it.

. . . [L]aws with either the purpose or the effect of discriminating against interstate commerce to protect local trade are void. . . .

The Court defends the Kentucky law by explaining that it serves a traditional government function and concerns the “cardinal civic responsibilities” of protecting health, safety, and welfare. This is but a reformulation of the phrase “police power,” long abandoned as a mere tautology. It is difficult to identify any state law that has come before us that would not meet the Court’s description. That is why, with the unfortunate recent exception of United Haulers, the Court had ceased to view the concept as saying anything instructive. A law may contravene a provision of the Constitution even if enacted for a beneficial purpose.

The police power concept is simply a shorthand way of saying that a State is empowered to enact laws in the absence of constitutional constraints; but, of course, that only restates the question. That a law has the police power label--as all laws do--does not exempt it from Commerce Clause analysis. . . .

The Court holds the Kentucky law is valid because bond issuance fulfills a governmental function: raising revenue for public projects. . . . [T]he premise is wrong. The law in question operates on those who hold the bonds and trade them, not those who issue them. . . . Not a word in the terms and conditions of the securities promises favored tax treatment for certain holders. . . . It is simply not commercial or investment practice to make payment obligations turn upon either the residence of the holder or the State of the issuer. . . .

Even if the Court were correct to say the relevant legal framework is bond issuance, not taxation of bonds already issued, its conclusion would be incorrect; for the discrimination against out-of-state commerce still would be too plain and prejudicial to be sustained. The insufficiency of the Court’s reasoning is even more apparent, however, because its own premise is incorrect. The challenged state activity is differential taxation, not bond issuance. . . . Kentucky gives favored tax treatment to some securities but not others depending solely upon the State of issuance, and it does so to disadvantage bonds from other States.

Our cases establish this rule: A State has no authority to use its taxing power to erect local barriers to out-of-state products or commodities. . . . The tax imposed here is an explicit discrimination against out-of-state issuances for admitted protectionist purposes. It cannot be sustained unless the Court disavows the discrimination principle, one of the most important protections we have elaborated for the Nation’s interstate markets. . . .

Differential taxation favoring local trade over interstate commerce poses serious threats to the national free market because the taxing power is at once so flexible and so potent. . . .

. . . The argument that Kentucky bonds are in a discrete market has no basis in the record. Kentucky state and local bonds compete with other bonds, as any investor knows. Within the national bond market there is a discrete submarket for all state and municipal bonds because they are tax exempt under the Internal Revenue Code. . . .

That the people in each of 49 States that joined a brief in support of Kentucky are alleged to want the law is irrelevant. Protectionist interests always want the laws they pass, even if their fellow citizens bear the burden, for they are positioned to profit from the barrier. The circumstance that the residents choose to bear the costs of a protectionist measure (assuming this to be so even though entrenched interests are the usual source for the law) has been found by this Court to be quite irrelevant. . . .

That 41 States have local protectionist laws similar to this one proves the necessity of allowing settled principles against discrimination to operate in an important national market. . . .

In the wake of one trade barrier, retaliatory measures follow, as the Framers well knew. The widespread nature of these particular trade barriers illustrates the standard dynamics of politics and economics, demonstrating once more the need to avoid validating this law as somehow in the States’ own interests. By misapplying the rationales of the controlling precedents, the Court invites further erosion of the Commerce Clause, which must remain as a deterrent to experiments designed to serve local interests at the expense of a national system. . . .

Throughout the Court’s argument is the concern that, were this law to be invalidated, the national market for bonds would be disrupted. The concern is legitimate, but if it is to be the controlling rationale the Court should cast its decision in those terms. The Court could say there needs to be a sui generis exception, noting that the interstate discrimination has been entrenched in many States and for a considerable time. That rationale would prompt my own statement of disagreement as a matter of principle and economic consequences, but it would be preferable to a decision that misinterprets the Court’s precedents. Instead, today the Court weakens the preventative force of the Commerce Clause and invites other protectionist laws, thus risking further dislocations and market inefficiencies based on the origin of products and commodities that should be traded nationwide and without local trade barriers.

For these reasons, in my view, the judgment of the Court of Appeals of Kentucky should be affirmed.