May 19 (Bloomberg) -- The U.S. Supreme Court ruled that dozens of states can continue to offer special tax breaks on municipal bonds issued within their borders, preventing disruptions in a $2.6 trillion market.

The high court, voting 7-2 in a Kentucky case, said the Constitution lets states exempt interest earned on in-state bonds while taxing the income from bonds issued elsewhere. The decision preserves tax rules in 42 states, including New York and California.

A ruling against Kentucky might have transformed the industry. States would have faced billions of dollars in refund claims and been forced to either eliminate the tax breaks or extend them to out-of-state bonds. Such a ruling also would have undermined the appeal of the hundreds of single-state bond funds, which held $155 billion as of 2006.

Barring in-state tax exemptions would ``radically'' change the way municipal projects are financed and ``upset the market in bonds and the settled expectations of their issuers,'' Justice David Souter wrote for the court.

The ruling injects some stability into what has been a turbulent year for the municipal bond market. Bonds lost 0.82 percent in total return on average in the first quarter, the worst start since 1996, amid the collapse of the auction-rate market and selling by hedge funds, according to Merrill Lynch & Co.'s Municipal Master Index. Municipal bonds have since rebounded.

Meeting Expectations

``This is one of the few things in the municipal bond that has gone as expected this year,'' said Matt Fabian, managing director at Concord, Massachusetts-based Municipal Market Advisors, a research firm. ``Now we can all go back to normal.''

State and local government bonds were little changed today after the Supreme Court announcement. Yields on top-rated, 20- year municipal bonds held at 4.57 percent, the same as on May 16, according to an index compiled by Municipal Market Advisors, a Concord, Massachusetts-based research firm.

A California general obligation bond maturing in 2028 saw its price fall to 98.25 cents on the dollar to yield 4.886 today from trading at par May 16 to yield 4.75 percent, according to MSRB trade data published at Investinginbonds.com. The state faces a widening deficit amid declining revenue.

A New York state general obligation bond maturing in 2020 traded today at 100.911 cents on the dollar to yield 3.8 percent, up from $100.009 cents on the dollar to yield 3.998 percent on May 16..

Preserving the System

The securities industry and all 50 states fought to preserve the existing system. The Securities Industry and Financial Markets Association said in a statement that a ruling against Kentucky would have been ``extremely disruptive to the long established market for municipal bonds.''

The case affected only state tax laws, not the federal exemption on municipal bonds. The dispute centered on the so- called dormant commerce clause, a judge-created rule that bars states from discriminating against out-of-state business without authorization from Congress.

The majority said the dormant commerce clause generally doesn't restrict what officials can do to favor a ``government function,'' such as a bond issue.

``The issuance of debt securities to pay for public projects is a quintessentially public function,'' Souter wrote.

Chief Justice John Roberts and Justices Antonin Scalia, Clarence Thomas, John Paul Stevens, Ruth Bader Ginsburg and Stephen Breyer joined Souter in the majority.

`Very Definitive'

``This decision is very definitive,'' said John Miller, chief investment officer with Nuveen Asset Management, which handles $65 billion of municipal bonds. ``This should help things considerably by resolving one of the undecided issues hanging over the market.''

Justices Samuel Alito and Anthony Kennedy dissented, saying the differential tax treatment is ``protectionist'' and has created a ``distorted market for state and municipal bonds.''

The ruling didn't explicitly resolve whether states violate the Constitution by offering special tax breaks on so-called private activity bonds, those issued on behalf of businesses and nonprofit groups. Souter said the court would leave that question ``for another day'' because the lower courts hadn't addressed it.

At the same time, Souter hinted the justices would be skeptical of any challenge to the tax treatment of private activity bonds, which account for about a quarter of the market. ``We must assume that it could disrupt important projects that the states have deemed to have public purposes,'' he wrote.

Blocking Challenges

That language, and the reasoning of the opinion, suggests the court wouldn't be receptive to a challenge to the tax treatment of private activity bonds, said Leonard Weiser-Varon, a public-finance lawyer at Mintz Levin in Boston.

``They're sweeping it under the rug and hoping it stays there,'' Weiser-Varon said.

Some investors said the ruling may prompt more investments in state-specific funds, whose status had been in doubt.

``Although there will be no specific impact upon prices, there may well be a pick up of fund flows into state specific mutual funds,'' said James Colby, senior municipal bond strategist with New York-based money management firm Van Eck Global.

The in-state tax exemptions have drawn fire from economists and free-market advocates.

The ruling means that ``state tax laws will continue to impede a municipality in Silver Spring, Maryland, from borrowing from an investor a few miles away in Arlington, Virginia,'' said Alan D. Viard, a scholar at the American Enterprise Institute in Washington.

Not Private Businesses

Tom Dresslar, spokesman for California Treasurer Bill Lockyer, said the court was right not to treat government bond issuers like private businesses.

``We're not trying to make a buck here,'' he said. ``We're trying to provide public services and that's what this type of financing allows us to do.''

The ruling recognizes the sovereignty of state and local governments in deciding how to pay for services such as schools and roads, said Jeff Esser, executive director of the Government Finance Officers Associations, which represents finance officials of more than 17,500 local governments in the U.S.

``If it had gone the other way, it would have resulted in higher interest costs for states that offer exemptions for their bonds,'' Esser said.

The case is Department of Revenue v. Davis, 06-666.

To contact the reporter on this story: Greg Stohr in Washington at gstohr@bloomberg.net.

Last Updated: May 19, 2008 16:55 EDT