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Supreme Court to Hear Muni Bond Case

At issue is whether states can exempt their muni bonds from taxation.

The U.S. Supreme Court agreed Monday to decide whether states can continue to exempt interest on bonds issued by their own munipalities if they tax interest on bonds of out-of-state issuers.

A Kentucky court ruled last year that this violates the Constitution, which prohibits states from discriminating against out-of-state commerce. Kentucky's lawyers appealed to the Supreme Court.

The case could have a big impact on the $3 trillion muni bond market, where local governments raise money for new roads, schools and other public works and programs. More than 40 states currently exempt in-state bonds from taxation; this increases their appeal to local investors and lowers municipalities' funding costs.

Muni bonds can be particularly appealing to investors who live in high-tax states such as California, New York and Massachusetts. There are hundreds of mutual funds that invest exclusively in muni bonds from a single state, according to Morningstar.

Dan DeSimone, director of the office of federal relations at the The National Association of State Treasurers, says that if the justices uphold the Kentucky court's ruling, states that currently discriminate would have to decide between exempting all muni bonds from income tax or taxing all of them.

DeSimone says it would probably be easier not to tax anyone. (While this could raise states' funding costs, it's not clear what would happen. "What about the bonds already sold? Do they make them all taxable or exempt?" he says. "It raises a lot of complicated issues.")

The ruling would not impact the nine states without income taxes -- Alaska, Florida, Nevada, South Dakota, Texas, Washington, Wyoming, New Hampshire and Tennessee.

Hugh McGuirk the head of municipal investments for

T. Rowe Price

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says a level playing field would probably raise funding costs for high-tax states because their residents would be indifferent about where to invest. But low-tax state like Illinois and Texas could see their funding costs fall as they attracted more investors.

McGuirk says that, despite the confusion a change in law could create, there has been "no perceptible change" in the existing municipal bond market. He believes that a majority of market participants believe, like he does, that the Supreme Court will not uphold the current Kentucky ruling.

The case won't come before the Surpreme Court unilt the next session, which begins in October.

Michael Katz joined

TheStreet.com

in 2007. Michael has previously worked as a reporter at

Forbes

and an editor for two custom publishers, SmartMoney Custom Solutions and HNW Inc. He also worked in London as a freelance media reporter and correspondent for

Broadcasting & Cable

magazine. Michael has a B.A. in English from the University of Virginia.