The United States Supreme Court is listening to arguments regarding the issue of whether interest earned on municipal bonds issued in one state should be exempt from income tax in another state.

Current law in most states is that earnings on municipal bonds are tax-free in the home-state, but earnings on munis purchased out-of-state are subject to taxation in the home state. The theory behind this tax restriction is to encourage state residents to invest in their own state.

According to a report in the Los Angeles Times, two Kentucky investors in 2003 challenged the practice as unconstitutional. They contended that Kentucky engaged in a form of unconstitutional protectionism by making its bonds tax-free while taxing debt of other states. Last year, a Kentucky appellate court agreed, spurring Kentucky to petition the Supreme Court.

All of the states have taken a stand supporting Kentucky in maintaining the current home-state tax exemption for munis, and analysts expect the Supreme Court to do so as well.

However, the Court is examining the issue from the standpoint of its own conflicting precedents. For 200 years, the Constitution has been interpreted as protecting the free flow of commerce, and the Court has struck down state laws that discriminate in favor of home-state products, according to the Los Angeles Times report.

The ruling is expected in a few months.