Will Kentucky Build Upon Its 2018 Reforms This Year?

Like many states, Kentucky is experiencing another year of robust budget surpluses while projecting several years of continued revenue growth, and policymakers are looking for ways to return some of the extra tax collections to taxpayers as they budget for the upcoming fiscal biennium. With regular legislative proceedings winding down, the House and Senate (both with Republican supermajorities) will work to resolve their differences in short order. 

The House-passed bill, HB 8, is a comprehensive tax reform bill that would reduce—and eventually phase out—the individual income tax, starting with a reduction from 5 to 4 percent in 2023. Among other changes, the bill would broaden the sales tax base to additional services. The Senate-passed bill, SB 194, would issue more than $1 billion in income tax rebates of up to $500 for single filers and $1,000 for joint filers. 

Given Kentucky’s continued revenue growth projections, policymakers should take advantage of this large revenue cushion by returning extra collections to taxpayers in a manner that permanently improves tax structure. This would make the Commonwealth more attractive for business investment at a time when states across the nation are trying to stand out as appealing places to live and work. Reducing income tax rates while broadening the sales tax base to additional consumer services is a good place to start.

In 2018, Kentucky legislators took a commendable first step toward tax modernization by consolidating six individual income tax brackets into one, reducing the rate from 6 to 5 percent, and broadening the sales tax base to some consumer services that had not previously been taxed, among other changes. Those reforms substantially improved Kentucky’s tax structure, reflected in its State Business Tax Climate Index rank improving to 18th overall today, up from 37th in the U.S. before the 2018 reforms.

Consolidating six brackets into one was a particularly beneficial reform, as it increased the payoff to work on the margin, reducing the tax disincentive previously associated with earning additional income. Economists have found graduated-rate income taxes can negatively impact workforce participation, entrepreneurship, and the adequacy of the labor supply in an area. 

The 2018 reforms were a good and necessary first step in improving the Commonwealth’s tax structure and competitiveness, but certain impediments remain, such as continued overreliance on taxes on productivity at both the state and local levels. In fiscal year (FY) 2019, even after the 2018 reforms had already taken effect, Kentucky generated nearly 33 percent of its state and local tax collections from individual income taxes compared to the national average of 24 percent. 

Furthermore, of the 10 states with a flat tax on wage income, Kentucky is tied with Massachusetts for having the highest rate. An initial rate reduction to 4 percent, as proposed in HB 8, would give Kentucky taxpayers the third-lowest flat rate in the nation and the fifth-lowest top rate among all states with an individual income tax.

Over the past decade, states without individual income taxes have experienced population growth at twice the national rate and have seen gross state product grow 56 percent faster than states with an income tax. But for the past two decades, Kentucky’s population has grown at less than two-thirds the national rate; gross state product has grown at a slower-than-average rate; and personal incomes have grown 6 percent slower than in the U.S. at large. While taxes are just one factor influencing business and personal location decisions, they are an important factor and one that is within policymakers’ control. 

It is also important to keep in mind that reducing the flat individual income tax rate would benefit all income taxpayers, even those with very low incomes, allowing them to keep more of what they earn. Kentucky’s standard deduction is $2,770 for single filers and $5,540 for joint filers, so the vast majority of income earned in Kentucky is subject to the 5 percent rate. 

It is also worth noting that, as currently structured, the tax triggers in HB 8 would take a long time to achieve. After a tax cut, the bill would require revenue to grow to significantly more than it was before the tax cut before another triggered reduction would take effect. As such, reaching these triggers would be more a matter of waiting for inflation to reach a certain level than about returning excess revenues to taxpayers as a response to real economic and revenue growth. 

Even if large-scale comprehensive tax reform is an effort for another year, near-term income tax rate reductions would be worthwhile, and broadening the sales tax base is a good way to reduce the revenue impact while making the tax code more structurally sound in the process. In any plan to modernize the sales tax base to additional services, it is important to avoid newly capturing business inputs. Taxing business inputs creates tax pyramiding, where taxes get embedded in the costs of goods and services sold, increasing underlying costs and therefore also increasing sales taxes collected on the final goods and services sold.

If Kentucky adopted income tax rate reductions this year, it would be one of many states doing so. In 2021 alone, 16 states enacted or implemented individual and/or corporate income tax rate reductions, including neighboring Ohio and Missouri and nearby North Carolina. Indiana policymakers recently enacted a bill reducing the individual income tax rate, already the third-lowest in the nation at 3.23 percent, to 3.15 percent next year, with the potential to reach 2.9 percent by 2029 if certain fiscal conditions are met. In total, four states—Indiana, Idaho, Iowa, and Utah—have enacted income tax rate reductions thus far in 2022, and more are poised to follow. Given this increasingly competitive state tax environment, permanent tax policy improvements should remain a priority for Kentucky lawmakers. 

In addition to reducing the income tax rate, further structural reforms would go a long way to making the Bluegrass State more competitive, such as shifting away from local occupational license and net profit taxes, repealing the Limited Liability Entity Tax (LLET), an alternative minimum tax on business gross receipts, and repealing the inheritance tax. Our recent Kentucky tax reform options guide, Aligning Kentucky’s Tax Code for Growth, identifies specific combinations of tax policy improvements that would push Kentucky into the top one-third or top 10 states on our State Business Tax Climate Index. 

As Kentucky policymakers make final decisions on tax relief this year, they should make the most of this opportunity to return excess tax collections in a manner that would also enhance the Bluegrass State’s prospects for long-term economic growth.

Sophie Tremblay

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