A bomb in the muni market?

An obscure Kentucky court case challenges state tax laws. Fortune's Jon Birger reports.

By Jon Birger, Fortune senior writer

(Fortune Magazine) -- The Supreme Court is weighing whether to hear a Kentucky tax case that could turn the municipal bond market on its head.

The case was originally filed in 2003 by George and Catherine Davis, retirees who contend that Kentucky's policy of taxing out-of-state municipal bonds but not income from Kentucky bonds violates the Commerce Clause and the Equal Protection Clause of the U.S. Constitution.

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A Kentucky appeals court ruled in the Davises' favor last year, prompting the state to appeal to the U.S. Supreme Court. The high court is expected to decide by February whether to hear the case. (The odds are that it will, legal experts say.)

Though nearly all municipal bonds are exempt from federal taxation, state tax policy varies. Like many states, Kentucky exempts income on bonds issued there but not on those issued out of state. The goal: to enhance demand for local bonds, thereby lowering public borrowing costs. The yields on bonds from states with in-state tax advantages are often ten to 25 basis points lower than those from states without them.

Should the high court side with the Davises, muni-bond experts like Oppenheimer Funds' Ron Fielding believe the ruling would trim between 1 and 4 percent from the value of munis from California, Missouri, New York, Rhode Island and other states with big in-state tax advantages.

The potential beneficiaries: bonds from Illinois, Texas, Washington and other states where the lack of in-state tax breaks has required issuers to offer higher yields.

A ruling in favor of the Davises would also call into question the raison d'être of the 1,300 single-state municipal bond mutual funds that exist to capture in-state tax breaks.

For investors in individual bonds - particularly those who buy them for income and hold them to maturity - a small change in their bonds' market value won't have much impact (assuming states don't choose to comply with a Davis victory by taxing their own munis, as opposed to exempting all of them).

But the total dollars at stake in the $2.3 trillion muni market are substantial - perhaps $50 billion in value shifting among various states' bonds.

The Davis case has implications for college savings plans as well. States such as New York offer special tax deductions to residents who use in-state college savings plans but not to those who invest in plans sponsored by other states. David Pearlman, chairman of the College Savings Foundation, believes a ruling against Kentucky in the Davis case would endanger such in-state tax breaks.

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