Tuesday, May 20, 2008

Does the Supreme Court Have an Anti-Chaos Rule?

In a recent post, Mike Dorf (tongue firmly in self-referential cheek) announced "Dorf's Law," which "states that courts do not provide a remedy for really really big constitutional problems where doing so would create chaos." He applied this anti-chaos rule to an argument by my GW Law colleague John Duffy that, if accepted by the courts, could invalidate patents worth hundreds of billions of dollars to their holders. Mike suggested that the Supreme Court regularly faces such possibilities, given that the Court is frequently asked to declare a constitutional principle that could upset years or even centuries of precedent. If, for example, the Court found a constitutional infirmity in the jury selection process, one could imagine such a result leading to a finding that every jury trial in the history of the country was invalid. That would, by any standard, create chaos.

If the anti-chaos rule exists, however, any student of the law would want to know just what constitutes enough chaos to be problematic in the eyes of the Court. Since every decision by the Court will upset some expectation or recalibrate someone's interests in property, etc., when will the Court say that they will set aside what otherwise would seem to be the correct Constitutional interpretation in the interest of not upsetting the status quo too much? If a ruling in an obscure tax case yesterday is any indication, the threshold for unacceptable chaos is surprisingly low.

In Dept. of Revenue of Kentucky v. Davis, a 7-2 majority of the Court held that the Commerce Clause does not prohibit a state from giving a tax preference to its citizens who own that state's bonds over its citizens who own another state's bonds. Put as simply as possible, Kentucky (which, like the great majority of states, has a state income tax that generally imposes a tax on income derived from any source whatever, including interest income) allows its citizens who put some of their savings into bonds issued by Kentucky or its subdivisions to exclude the interest on those bonds from state income tax. (The interest is already exempt from federal income tax, under a longstanding rule that applies to all state and local bonds.) The Davises were Kentucky taxpayers who had invested in other states' bonds and who thus paid Kentucky's income tax on the interest earned on those bonds. As this scheme clearly discriminated against other states, the Davises claimed that this violated the "negative" version of the Commerce Clause. The Kentucky Court of Appeals agreed, but the U.S. Supreme Court reversed.

In the context of the above discussion of an anti-chaos rule, the interesting aspect of the Court's ruling is its clear reliance on the idea that a contrary holding would be too disruptive to the world as we know it. Linda Greenhouse's article about the case in today's New York Times carries the sub-headline: "Supreme Court Votes 7 to 2 for Status Quo." As Greenhouse noted, every other state had signed onto an amicus brief urging the Court to uphold the tax preference, and the opinion "cited the states' unanimity as evidence of the enormity of what the court was being asked by the plaintiffs to do." The opinion rejects the idea that it was "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."

Strikingly, the evidence that this would create chaos is both completely lacking in the opinion and incredibly weak in any case. As Justice Kennedy argued in dissent, the states' unanimity in arguing for continuation of the preference is evidence that states want to continue to discriminate against outsiders, not that preventing them from doing so would be chaotic. Moreover, at least if applied prospectively, a ruling in favor of the Davises would be the kind of thing that financial markets are actually quite good at handling. The very size of the municipal bond market (over a trillion dollars), rather than increasing the risks of chaos, would serve to reduce or even eliminate it. Each person would be able to recalculate the returns from various bonds, and portfolios would be reshuffled. The idea that the market would collapse into chaos, though, is hard to swallow -- particularly because the ruling would mean that every state would be simultaneously required to eliminate its tax preferences. Subsequently, each state would need to determine whether it is raising more or less money in bonds and whether it is paying higher or lower interest rates, and it would have to determine whether there are better ways to subsidize local projects. Again, though, this is the bread and butter of local public finance. The real implications for states would play out over years, not overnight.

Whether or not the Court is right, though, that there is a grave risk of chaos, their ruling states pretty explicitly that the perceived risk of chaos trumps any Commerce Clause concerns. In other words, the anti-chaos rule seems to be a background Constitutional principle that trumps all other Constitutional principles. As a tax policy scholar and not a constitutional law professor, I'll leave for others a discussion of whether that is a good idea or a bad idea (or even all that surprising). I do, however, think that it would at least behoove the Supreme Court to hold litigants to higher (and more explicit) standards of what constitutes unacceptable levels of potential chaos. Without that, every case could ultimately come down to the Court's answering the following question: "Sure, this is unconstitutional; but dare we say so?" That may or may not be a prudent judicial approach, but at least as applied in Davis, it appears to have no coherent standards of evidence or proof.

Posted by Neil H. Buchanan


Michael C. Dorf said...

Justice Souter's majority opinion, in addition to worrying about chaos, nominally relies on the longstanding principle that states do not run afoul of the dormant Commerce Clause when they act as "market participants." But this is a very weak claim in this case. Although the issuance of debt is not uniquely a governmental function---i.e., it is the sort of thing that market actors do---TAXATION of income is not market participation but sovereign activity. And it was the unequal taxation of in-state versus out-of-state bonds that the plaintiffs challenged. Accordingly, it's hard to believe that the doctrine as such---rather than the anti-chaos rule---is doing the work here.

Neil H. Buchanan said...

The market-participant doctrine is so inapposite here that Roberts and Scalia explicitly disavow it in separate opinions. Given that Thomas repeats his rejection of the entirety of Dormant Commerce Clause jurisprudence in his concurring opinion, that means that only 4 justices (Souter, Ginsburg, Breyer, and Stevens) endorse the flawed market-participant analysis. Whatever else I might think of "The Gore Four," they're out to lunch on this one.

egarber said...

So are you guys saying that the ruling was ostensibly about the commerce clause, but it was the chaos fear that was doing the real lifting?

Why not just make it prospective and acknowledge it would be too tough to undo for current bond issuances, etc? Is that taboo?

BDG said...

Nice comment, Neil. This whining about how the economy is complicated, and the Court wishes Congress would just come fix it, rather than leaving the poor Court to have to guess about what will cause "chaos," is not new in tax cases. in fact, my whole state & local tax seminar is structured around the Court's claim that courts can't effectively police interstate tax effects.

Tam said...

What?? The Court heard a tax case???

LegalThoughts said...

Does the anti-chaos rule apply to lower courts as well? If so, how do we account for the D.C. Circuit's ruling that paper currency unlawfully discriminates against the blind?

Andrew Oh-Willeke said...

The key empirical fact is that a large share of municipal bonds are purchased by people who would not pay state and local income taxes upon them. Ohio billionaires buy bonds from Ohio municipal debtors, Colorado billionaires buy bonds from Colorado municipal debtors. Wealthy investors who live in Florida and Nevada buy municipal bonds from across the nation.

This happens for the simple reason that almost all municipal bond investors are highly tax motivated in doing so.

Thus, the impacted class -- municipal bonds held by people who pay state and local income taxes on the interest, turns out to be quite modest. If SCOTUS had ruled the other way, the likelihood is that states would have ceased to tax out of state municipal bonds -- their existing bond interest rates depending upon being free of state and local income taxes, and the revenue generated from out of state municipal bonds is modest.

In all likelihood, a change would have helped municipalities in states with fewer wealthy residents, by deepening the market for munis in those states, and hurt states with more wealthy residents, who benefit from competition to invest from their large pool of potential muni investment money.

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