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Monday, May 19, 2008

Magic Muni Munificence

The Supreme Court finally issued the muni ruling, which allows states to tax income from the muni bonds of other states while exempting their own bonds. This will be very good for munis in some states!!! Bloomberg article.

One thing to note is that the SC didn't address taxation of non-government bonds, which are sometimes issued under state imprimatur by a private venture the state wants to lure (a manufacturer, a sports team). The reasoning used to excuse government bonds from the Commerce clause here might not hold for such bonds:
The logic that a government function is not susceptible to standard dormant Commerce Clause scrutiny because it is likely motivated by legitimate objectives distinct from simple economic protectionism applies with even greater force to laws favoring a State’s municipal bonds, since issuing debt securities to pay for public projects is a quintessentially public function, with a venerable history.
The actual ruling (55 pages) as published on the SC website. Kennedy dissented, joined by Alito, and Kennedy's dissent is scathing, but the overall majority was 7-2.

This is a very important ruling. Consider, for example, California. It has a high state income tax, and therefore a big advantage in marketing muni bonds to local residents. California is not the most creditworthy state by a long shot, and some of its municipalities are in deep fiscal trouble. Therefore if government issues had to compete with bonds across the nation, many issues would probably have to increase the rates paid in order to compete with bonds of other states. A state with a lower tax rate has less comparative advantage internally.

And this will be very bad for proper pricing in the muni market. In essense it creates 50 pools of captive capital which have strong incentive to be invested internally to each state rather than invested nationally. Rates will be higher for states with large capital investments relative to their captive pools. Rates will be lower in states with large captive pools regardless of how much risk those investments pose. I cannot see how mispricing of risk and misallocation of capital can be considered a good thing. Good for California, perhaps, but hardly good for investors or for the nation as a whole.
WSJ,I do not believe that this will be god for california except in the short run.Misallocation of capital and mispricing of risk have consequences,and california has an extremely dysfunctional government.Anyone who looks at how CA is run could well believe the system was devised by Kafka on a day he had a bad hangover and ergot poisoning.Tom Stone
John - well, the SC's decision is a continuation of the status quo, so no new inefficiencies will be introduced into the system.

But you and Tom are correct in commenting that overall economic inefficiencies hurt the economy.
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