Kentucky Debating a Tax Overhaul — Again

By: - July 16, 2012 12:00 am

Kentucky Governor Steve Beshear introduces the members of the Blue Ribbon Commission on Tax Reform in February. (AP)

“We stand ready,” former Kentucky Governor Paul Patton said in his State of the Commonwealth speech, “to address, on a bipartisan basis, comprehensive and revenue neutral tax reform.” That was in 2002, and he was wrong.

For the last 10 years — and even longer — Kentucky has regularly studied, discussed and debated how to redesign its tax system. But the state wasn’t ready to approve wholesale changes in 2002. It wasn’t ready any of the next nine years, either.

The question is whether anything will be different this year or next. This January, nearly 10 years to the day after Patton spoke, Governor Steve Beshear announced he was appointing a Blue Ribbon Commission on Tax Reform. The commission is meeting around the state this summer, so that it can produce a plan in the fall to present to the legislature.

Most of the focus in Kentucky for the last decade has been on one major problem: The state’s tax revenue hasn’t been keeping up with growth in the economy. Many observers expect the trend to continue in the years ahead, leaving the state with a structural deficit that will make it impossible to afford the services it has offered in the past.

Kentucky’s situation is noteworthy not because it is unusual, but instead because it is typical. Like many states, Kentucky’s tax code is poorly positioned to keep up with today’s economic and demographic trends, such as the shift to more consumer spending on services instead of tangible goods.

Even when lawmakers agree on the basic contours of the problem, they rarely act. Recommendations of tax reform commissions in Vermont and South Carolina leading into the 2011 legislative sessions, for example — much the like the commission in Kentucky — haven’t resulted in changes.

In Kentucky and elsewhere, the biggest obstacle is politics. Since 2000, the Kentucky Senate has been controlled by Republicans, while the House of Representatives has been controlled by Democrats. No one has come up with a proposal yet that could win approval in both houses. Finding such a proposal is the most difficult job the new commission faces.

“I want to see us develop the best possible plan,” says Jason Bailey, director of the Kentucky Center for Economic Policy and a member of the Blue Ribbon Commission, “but we’ve had plans before and reports before. What we haven’t had is legislative action.”

Still Running Short

This spring, Kentucky wrapped up work on what is the latest in a succession of grim budgets. The state cut funding for most state agencies by 8.4 percent, reduced funding for higher education and eliminated cost-of-living increases for people in the state pension system.

Despite the cuts, the state still had a structural deficit as recurring revenue hasn’t kept up with recurring spending. In the last two budgets, the state has delayed paychecks for state workers, offered a tax amnesty, scooped money from other funds into the general fund and furloughed state workers — all techniques to balance the budget with one-time revenue or one-time savings.

One key reason for this imbalance, of course, is the aftermath of the recession. There’s also a case to be made that the budget problems are a consequence of unsustainable spending commitments. The Kentucky Chamber of Commerce, for example, points out that health care has consumed a greater portion of the budget, making it harder for the state to find money for other areas, such as education. Still, there’s also strong evidence that long-term weaknesses in the state’s revenue system are part of the story.

Michael Childress and William Hoyt, two researchers at the University Kentucky who are both servings as consultants to the Blue Ribbon Commission, reported in February that between 2000 and 2010, the state’s general fund revenue grew only about three-quarters as fast as the economy. They cited that situation as a key cause of the state’s structural deficit.

Most observers agree that tax exemptions are a big reason the revenue system is struggling. Kentucky, for example, offers some of the nation’s most generous income tax exemptions for pension income. Those exemptions already cost the state hundreds of millions of dollars a year and are expected to grow in the future: The proportion of Kentucky’s population that is 65 and older went from 12.5 percent in 2000 to 13.3 percent in 2010 and is on track to surpass 20 percent by 2050.

Kentucky also goes even further than most states in exempting services from its sales tax. It doesn’t tax accounting, legal services or dry cleaning, for example, despite efforts by Republican State Representative Bill Farmer to pass legislation to extend the sales tax to those services and others. Nor does it tax limousine rides, landscaping or country club memberships, despite Democratic State Representative Jim Wayne’s proposal to do so. While Farmer and Wayne’s bills are very different in some respects, they share the bedrock value of tax reform: that broader tax bases are the key to modernizing state tax systems.

In Kentucky, that concept isn’t new. Ten years earlier, when Patton was pitching tax reform, University of Tennessee economist Bill Fox reported to the legislature that revenue wasn’t keeping up with economic growth in a study that’s remained a reference point for the debate ever since. Even then, Fox’s report identified many of the factors that are relevant today, including the failure of the sales tax to cover services and the difficulty Kentucky and other states were having collecting sales taxes on online purchases. This year, Fox is back again as a consultant to the commission.

Despite Fox’s report, Patton’s efforts at tax reform were stymied by the sex scandal that consumed his final year in office. In 2005, the state did make some notable changes, trading a higher cigarette tax for lower corporate taxes, but only took limited steps to tackle the bigger structural issues. More recently, proposals to extend the sales tax to more services haven’t advanced in the legislature. “This is something that has been kicked around in this state for a long, long time,” Farmer says. “Basically, 10 years ago the Fox report got put on the shelf. We’re now realizing that 10 years ago we should have done something.”

Searching for Consensus

Still, there’s no agreement yet on what that something is. Key players agree on broadening the base — but almost nothing else.

Removing tax exemptions is hard enough because almost invariably the group that is benefiting resists. In Kentucky, though, that challenge has been compounded by disagreements over the balance of taxes between rich and poor and whether the state needs an additional infusion of revenue right now. For example, Bailey wants to increase the income tax on the wealthy to make Kentucky’s mostly flat income tax more progressive, but David Williams, Kentucky’s Republican Senate President, has proposed eliminating the income tax entirely.

Given the depth of those disagreements, some key players are skeptical of the commission. Williams called it “a joke,” pointing to members who favor higher taxes. Even House Speaker Greg Stumbo, a Democrat like Beshear, wondered what the point was: Why conduct another study when the state had been talking about tax reform for so long?

Defenders of the commission argue that there’s still more they need to learn about how the state’s tax system is working. More than that, though, they say the point isn’t just a study, but to establish the political will that has been missing.

Tellingly, Beshear mostly left tax experts off the group. Instead, its membership is heavy on businesspeople, with some advocates for government services too — the makings of a potentially powerful coalition. “The purpose of the commission from the perspective of the governor,” Bailey says, “is to build momentum and consensus.”

Whether any consensus can survive in Frankfort remains to be seen. In the November elections, Stumbo’s Democratic majority in the House is at greater risk than Williams’ Republican majority in the Senate. As long as Republicans hold at least one chamber, a plan that raises revenue immediately will face long odds. That wouldn’t necessarily preclude, however, a plan that starts out as revenue neutral, but allows revenue to grow more strongly over time.

Even under that model, no one is predicting sweeping changes with confidence after a decade of false starts. “There’s been a lot of discussion about the need from both Democrats and Republicans in Kentucky,” says State Representative Rick Rand, a Democrat who chairs the Appropriations and Revenue Committee. “I’m interested to see if there are at least some things we can agree on as we go forward.” But Rand adds: “I would be surprised that if there’s a report that goes out there and everybody says, ‘That’s great, let’s adopt it.’”

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Josh Goodman

Josh Goodman helps lead research on fiscal management and place-based economic development programs as part of Pew’s state fiscal health project. Goodman has served as a primary author for Pew studies that examine how states should evaluate tax incentives and maintain budget discipline when implementing those incentives.