It is hard to imagine a more destructive and less constitutional
way for the US government to raise revenues than with a new tax
proposal now afloat in Washington.
In February, the US Senate passed a budget resolution calling for
taxation of previously tax-exempt municipal bonds. In April,
President Obama's budget repeated the call. For the first time since
1913, when the 16th amendment - which established the income tax -
was ratified, the federal government is considering taxing
investors' municipal bond income.
Presented as closing high-end "tax loopholes," taxing municipal
bonds, known as "munis," would impose crushing new expenses on US
states and municipalities - the consequences of which would be felt
by citizens at every income level.
If taxes are imposed on muni bond income, will investors lend US
states and municipalities money at all? Investors already have more
reasons than they need to say "no" to state and local government
paper: rising interest rates that have sent the bond market into
decline, mounting dangers of default (Detroit has declared
bankruptcy), and poor financial disclosure. Detroit is not alone.
With one city after another on the edge of bankruptcy and some
states not far behind, the proposal could not come at a worse time.
By some estimates, the hike in state and municipal borrowing
costs could exceed 70 percent. Some states simply could not afford
to borrow for new projects.
Consider what that means. Three quarters of US infrastructure
projects are the work of state and local governments. Tax-exempt
bonds finance them. But the bonds' uses don't stop there. Yes, bonds
fund roads, bridges, schools, libraries, hospitals, prisons, and
sewer systems. But bonds also provide disaster relief. And when old
debt matures (comes due), municipalities must issue new bonds to pay
off the old - a process known as "rolling."
A report by the National League of Cities finds that had the
Obama administration's proposal to tax muni bonds been in place over
the past decade, it would have cost states and localities a
staggering $173 billion in additional interest.
Indeed such profound destructiveness to state and local
government raises questions about whether the courts would see
taxing munis as a direct assault on the federal system of government
and, therefore, unconstitutional. It is true that in South Carolina
v. Baker (1988) the Supreme Court upheld a federal tax on municipal
"bearer" bonds. But this was a very special case in a very different
The bonds in question at that time were constructed not just to
exempt income but to hide ownership. Congress feared that these
untraceable instruments would encourage evasion of estate and gift
taxes. On appeal, the Supreme Court found that taxing them would
have little impact on state finances as few had been issued. Even
so, Justice Sandra Day O'Connor's dissent questioned whether the
federal government could constitutionally step across the line to
impose such a burden on states at all. Her concern echoed Chief
Justice John Marshall, who famously wrote that "the power to tax is
the power to destroy."
Today's Supreme Court takes federalism and state sovereignty much
more seriously than did the Court on which Justice O'Connor sat in