Four Revenue Options that Should Be on the Table

The Kentucky legislature is debating ways to address the hole in the state’s Medicaid budget. The options under consideration include immediate across-the-board budget cuts as well as eventual cuts to non-education programs if the governor’s proposed Medicaid savings for 2012 are not achieved. But before enacting painful cuts that are on top of several years of reductions, Kentucky leaders should consider revenue options that are a sensible part of a more balanced approach to the state’s budget challenges.

Since 2009, 40 states have raised taxes or tax-like fees as a part of their approach to addressing the recession-induced decline in revenues.[1]Twelve states have raised overall revenues by more than five percent as a way to help balance their budgets.[2]Rather than harming recovery, revenue increases are often preferable to budget cuts in terms of their economic impact. Former director of the Office of Management and Budget Peter Orszag and Nobel Prize economist Joseph Stiglitz noted in relation to the last recession that “tax increases on higher-income families are the least damaging mechanism for closing state fiscal deficits in the short run. Reductions in government spending on goods and services, or reductions in transfer payments to lower-income families, are likely to be more damaging to the economy during the short run.”[3]

Potential revenue options that should be under consideration in Kentucky include:

1. Apply an income tax surcharge to high earners.

The highest-income Kentuckians have received large federal income tax cuts over the last ten years. Congress’ agreement in December to extend existing federal tax cuts for two more years is resulting in $1 billion in tax cuts for 2011 to the highest-earning five percent of Kentuckians. The top 1 percent of Kentuckians, whose average income is $817,173, are receiving an average tax cut of $31,455 from the deal.[4]

Because high earners have already received generous tax benefits, a number of states have recently put in place temporary or permanent new income tax brackets or surcharges on high earners. Those states include Connecticut, Delaware, Hawaii, Maryland, New Jersey, New York, North Carolina, Oregon and Wisconsin.[5]Not only have high earners received big federal tax cuts—they have also had the largest income gains. The top 20 percent of Kentuckians saw their real incomes go up 41 percent on average from the mid-1980s to the mid-2000s; the poorest 20 percent of Kentuckians saw no statistically significant change in their real incomes over that period.[6]  

An income tax surcharge on the highest-earning five percent of Kentuckians that captures just a portion of the recent federal tax cuts for reinvestment in Kentucky could go a long way in addressing any budget shortfalls. A temporary surcharge to capture just 10 percent of those cuts would raise approximately $106 million. Such a change would increase state income taxes by 0.4 percent of income on average for the top 1 percent of earners and 0.3 percent of income on average for the next highest 4 percent of earners.[7]

2. Curb targeted tax expenditures.

Tax expenditures refer to special tax preferences and breaks for individuals and businesses that are written into the tax code. Kentucky’s most recent tax expenditure report lists 287 different tax expenditures that result in an estimated $8.4 billion in lost General Fund revenue in 2010—an amount greater than the General Fund revenue collected that year.[8]Tax expenditures work just like on-budget spending—they are ways the state allocates resources. But unlike budgeted spending, Kentucky’s tax expenditures receive very little public scrutiny.

Kentucky should comb its tax expenditure report and identify targeted expenditures to temporarily or permanently suspend, modify or end as part of any strategy to close a budget gap. Potential candidates include:

• The tax credit for film production in Kentucky. Recent research has shown that film tax credits are costly, overly generous and of questionable benefit.[9]Kentucky’s film tax credit is refundable, allowing film companies to utilize the credit even if they are not profitable.
• The exclusion of the first $41,110 of private pension income from the income tax will cost Kentucky an estimated $245 million in 2012.[10]The exclusion exists regardless of the retiree’s total income, and is a growing strain on revenue as the Kentucky population continues to age. Kentucky could potentially phase out this exclusion for higher-income retirees as part of a revenue package.

3. Expand the sales tax to selected services.

Kentucky ranks among the states with the fewest services in its sales tax base. Kentucky taxes only 28 of 168 services currently taxed by at least one state.[11]Those exclusions are a growing problem because services make up an increasing share of the economy. Kentucky’s sales tax base has fallen from about 54 percent of state personal income in 1979 to approximately 41 percent in 2008.[12]

Modernizing Kentucky’s sales tax is widely recognized as a critical aspect of needed tax reform. In the immediate term, Kentucky could take a first step by expanding the sales tax to selected services that are primarily used by wealthier Kentuckians. Targeted expansion of the sales tax to eleven selected services identified below would raise an estimated $100 million in Fiscal Year 2012:[13]

• Golf course greens fees and membership fees in private golf clubs and private country clubs;
• Janitorial services, including carpet, upholstery, and window cleaning;
• Garment alteration and garment repair services;
• Non-coin operated laundry and dry-cleaning services;
• Armored car services;
• Security services;
• Exterminating and pest-control services;
• Landscaping services, excluding lawn-care services;
• Non-coin operating automotive washing services and waxing services;
• Commercial linen services, excluding uniform services and linen services to hospitals and nursing homes;
• Limousine services if a driver is included.

4. Raise Kentucky’s low tobacco taxes.

Kentucky has the 10^th-lowest cigarette tax rate among the states, at 60 cents a pack.[14]Yet Kentucky remains one of the unhealthiest states, and addiction to tobacco is a major contributor to those health problems. In the 2010 Gallup-Healthways Well-Being Index, Kentucky ranks dead last among the states in the category “Healthy Behavior” and next-to-last in the category “Physical Health.”[15]

According to recent Legislative Research Commission estimates, a 50 cent per pack increase in the cigarette tax (and accompanying increase in other tobacco taxes) would raise approximately $120 million in Fiscal Year 2012.[16]

The Kentucky Center for Economic Policy (KCEP) conducts research, analysis and education on important state fiscal and economic policy issues. KCEP seeks to create economic opportunity and improve the quality of life for all Kentuckians. Launched in 2011, the center receives support from foundation grants and individual donors and is an initiative of the Mountain Association for Community Economic Development (MACED). Please visit KCEP’s website at www.kypolicy.org.