A case questioning the legality of a Kentucky law that exempts the interest on most municipal bonds from being taxed by the state -- when the investor is a resident of the state -- could have far-ranging effects for the $2.3 trillion municipal-bond market.

This week, Kentucky's Supreme Court declined to review an appeals-court decision that found it to be unconstitutional for the state to tax only out-of-state bonds. A Chicago couple -- George and Catherine Davis -- brought the case, and similar cases are reportedly on the docket in Arizona and North Carolina. Most other states with a state income tax have rules similar to Kentucky's, arguing that the tax break incentivizes investors to keep their money local.

At the federal level, most interest on state bonds is tax-free across the board.

The Kentucky Finance and Administration Cabinet, which includes the state Department of Revenue, said it would ask the U.S. Supreme Court to review the case on constitutional grounds. Kentucky's Court of Appeals ruled earlier this year that Kentucky's system of taxing only out-of-state bonds does not meet the U.S. Constitution's Commerce Clause, which gives Congress the power to regulate commerce among the states.

Nearly 4.4 million federal income-tax returns reported tax-exempt interest income for 2004, according to the Internal Revenue Service. The total amount of tax-exempt interest income these investors reported came to nearly $50 billion.

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