Will eliminating the state’s income tax blow ‘a hole’ in its revenue stream? 

Mark Payne
Mark Payne
Mark Payne is the government and politics reporter for LINK nky. Email him at [email protected]

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In a series of tweets, the Executive Director of the Kentucky Center for Economic Policy, Jason Bailey, said that what Kentucky is doing by cutting the income tax and replacing it with sales tax revenue is “blowing a huge hole in KY’s revenue stream.”

But, others argue that getting rid of the income tax will be a boon for the state’s economy. 

“The immediate impact of that won’t be apparent because the state has temporary surpluses and money in the rainy day fund,” Bailey said. “But those one-time conditions (inflation, federal aid) will pass, and the state will be forced to deal with the big hole that the tax cuts create. The General Assembly can deplete the rainy day fund first, but that will only last a few years.”

Bailey’s tweets come after the Center for Economic Policy released a November report titled the “Mirage of Inflation-Driven Surpluses Is No Basis for Permanent Tax Cuts.” 

In the report, the Center argues that the state has record surpluses because the federal stimulus money during the COVID-19 pandemic led to a faster-than-expected recovery from the pandemic recession and high inflation. 

“The revenue surpluses we see today will be a thing of the past,” Bailey said. “At some point, things will return to the historic norm in which Kentucky has very tight budgets and modest revenue growth.” 

In the spring, the legislature passed House Bill 8, which aims to eliminate the income tax in half-percentage increments over the next 10 years until it’s at zero. In order to cover the missed revenue stream, the bill incorporated widening the sales tax base by adding user fees to many digital products, such as books, ringtones, movies, and digital news products. 

It would also raise the sales tax on digital platforms such as Uber and Lyft. 

“The legislature added sales taxes to 35 services in HB 8 along with creating a mechanism to cut the income tax rate,” Bailey said. “However, the revenue impact of the former is a tiny fraction of the revenue losses resulting from the latter. If the legislature reduces the income tax rate to 4%, for every $1 that HB 8 raises in new sales tax revenue, it cuts $12 of revenue because of the income tax cuts.”

The bill initially would have reduced the income tax by one percent, but in the version that became law, it settled on the smaller amount. There is a formula to hit preset revenue triggers that the state must meet, including revenue exceeding expenses. 

The first decrease is based on Fiscal Year 2021’s revenue triggers and is expected to save taxpayers around $500 million, according to statistics from the legislature. 

“We were very, very contemplative in how we did these tax cuts, and they all require a degree of overly conservative financial success,” said Sen. Chris McDaniel (R-Ryland Heights), chair of the Senate Appropriations and Revenue Committee. 

But Bailey said the income tax cut is a big giveaway to the wealthy. 

“A total of 65% of an income tax cut goes to the highest-earning 20% of people,” Bailey said. “Millionaires will get an $11,000 annual tax cut on average. Meanwhile, working-class Kentuckians will get pennies but will bear the brunt when there are cuts to Medicaid and public schools and when regressive sales taxes are hiked or applied to items like groceries.” 

The first cut is scheduled to take place on Jan. 1, 2023, reducing the income tax from 5 to 4.5%. The reductions each year will depend on money in the balance reserve trust fund, general fund appropriations, and general fund moneys against the individual income tax expenditure — or, more generally, how the state is doing financially. 

The cut in 2023 is due to the positive financial numbers from 2021. The cut in 2024 will be based on the 2022 numbers. 

“The way the bill is written, there’s a series of triggers and safeguards that have to be met before the tax would actually decrease,” McDaniel said, elaborating that the Center for Economic Policy is willfully disregarding some of the safeguards put in place by the legislature. 

“The income tax cannot go down by more than half of the overall increase in revenues, so it simply can’t happen,” McDaniel said of the state losing revenue due to the decrease in income tax. 

Over the summer, the state announced it had again recorded another record surplus. 

“We took in roughly about $1 billion more than was forecast,” McDaniel said at the time, indicating that the state would be moving forward with the 2023 income tax reduction.  

This comes after Kentucky recorded a surplus of more than $1.1 billion for fiscal year 2021. 

But, according to the report from the Center for Economic Policy, understanding the role of the fleeting surpluses make them much less impressive than they seem, and the tax cuts under HB 8 are dangerous for Kentucky’s future — and even a small reduction in Kentucky’s income tax will be expensive.

“Going from a 5% income tax to 4%, which the General Assembly will vote on in the upcoming session, costs more than the General Assembly spends on all of higher education—8 universities and 16 community colleges,” Bailey said. “We won’t be able to address the housing and infrastructure needs following two natural disasters, reinvest in education including addressing the teacher shortage, funding the coming cliff in child care funding, and much more if we continue to implement the income tax cuts in House Bill 8.”

McDaniel acknowledges that the current surpluses in Kentucky are fleeting, but consensus forecasting predicts the surpluses will last for another three years. He also said the legislature has worked to reign in the state’s long-term spending. 

“I think we’ll see stability,” McDaniel said. “These 14 and 10% spikes [in revenue] we saw in some of these numbers is not realistic to sustain in any large measure.” 

While Bailey and the Kentucky Center for Economic Policy say the income tax reduction will cause issues with the state’s revenue streams, others think that getting rid of the income tax will be a boon to the state’s economy, similar to Texas and Florida. 

Those two states, however, bring a significant amount of revenue from other sources — Florida has a strong tourist economy, and Texas relies on mineral revenue income, such as oil and natural gas. 

Speaking at the Northern Kentucky Chamber of Commerce “Where We Stand” legislative preview on Dec. 6, McDaniel said that Kentucky needs to play to its strengths, though the state is still developing some of those ideas. 

McDaniel said that those natural resources in other states are out of everybody’s control. Still, Kentucky does have some natural resources that it could use to its strength, such as the vast waterways network and water reserves — something that states out west don’t have, he said. 

“We’ve got great infrastructure in terms of air, rail, waterway, navigation, all those kinds of things,” McDaniel said. “And so those are strengths we have to play on.”

He also pointed to the life sciences sector growing in Covington and other “next generation” economies such as medicine and information technology growing around the state. 

The Kentucky Chamber of Commerce — including the NKY Chamber — has supported these tax cuts, which they believe will attract businesses and workers to the state. The NKY Chamber said it is interested in “creating a more competitive and simplified tax code. 

“This is several thousand a year more in the pocket of everyday Kentuckians, which they can then go and spend and, you know, use to help otherwise stimulate the economy,” McDaniel said. 

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