The U.S. Supreme Court heard oral arguments in a case that could end state income tax breaks for municipal bonds.

The case, Kentucky Department of Revenue vs. Davis, examines tax exemptions for the $2.5 trillion market. A lower court had ruled that tax breaks that favor in-state over out-of-state firms violate interstate commerce rules.

The case involves a couple who sued the Kentucky Department of Revenue for giving preferential treatment to its own state's bonds. The Kentucky Court of Appeals ruled in their favor in January 2006, and Kentucky appealed to the Supreme Court.

The other 49 states have filed a brief supporting Kentucky's position, citing the importance of municipal bonds to their budgets. Many of them do not tax interest on their own bonds but do tax interest on bonds from other states. The case is likely to be decided by early next year.

The Justices seemed inclined to support the states' position.  "This is an area where Congress can regulate if it wants to, and it has never shown the slightest interest in interfering with state tax exemptions for their own bonds," said Chief Justice John Roberts.

However, the justices are likely to be divided on the case. "You have, in effect, a pact among states to favor their own residents," said Associate Justice Anthony Kennedy.

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