Yes, vanity plates of all kinds are potentially distracting to drivers. The very purpose of vanity plates is to make people take notice. There really is no good purpose for vanity plates. License plates should be a practical solution to identification problems on the road and nothing more or less.
There is no reason to have a license plate that is distracting. A license plate is for the purpose of identifying vehicles and helping law enforcement. A person shouldn't choose to try to be offensive or to interject controversy into something like that. There are so many other license plates to choose from.
However, this one in particular seems to be just a tad distasteful, and I can see where the state is coming from in denying the request. I believe that since license plates are state issued, they do have the right, within reason, to deny any request that they find to violate their policy.
I can understand the concern about vanity plates distracting drivers, but it really shouldn't be a problem. If you are too distracted by a license plate to drive properly, then you shouldn't be driving in the first place.
In this particular case, the reasoning makes no sense. If that license plate is a potential distraction, then vanity license plates should not be allowed, because they are all potentially distracting. It's clear that this particular license plate was denied for religious reasons.