Retirement Income Growing Much Faster than Wages, Spelling Trouble for State Revenues

Kentucky must begin an active search for revenue options to begin fully paying down our pension debt and make public investments that will move the state forward. One issue that must be on the table is the state’s huge exemption of retirement income from the income tax — especially given that retirement income has been growing in recent years even while the wage income Kentucky does tax has been more sluggish.

From 2007 to 2012 (the latest year available), retirement income from pensions and IRA distributions in Kentucky increased by 24 percent, while wage and salary income grew by only 7 percent, according to IRS data. Total federally taxable retirement income (also including Social Security, which Kentucky does not tax) grew from 7.6 percent of Kentuckians’ adjusted gross income in 1997 to 13.7 percent in 2012 (see graph below).

retirement income

Source: KCEP analysis of IRS Statistics of Income data.

While stagnation in wages for many currently working Kentuckians explains part of the disparity, the aging of the baby boomer population is also a significant factor. The oldest baby boomers turned 65 in 2011 and many have already begun to retire. Kentuckians over 65 will grow from 13 percent of the population now to 20 percent by 2030.

But in this state, we exempt the first $41,110 in retirement income from the individual income tax regardless of how high a person’s total income is, at a loss of $441 million in state revenue. That’s a huge tax break compared to most all other states and is on top of the fact that contributions to many retirement plans are not taxed, nor are investment returns when they are earned. And those over 65 in Kentucky can claim a homestead exemption of $36,900 that lowers state and local property taxes.

Not only should the retirement income tax break be scaled back for higher-income retirees in order to raise more revenue, it must be addressed to keep revenue from eroding further, given the underlying trend.

See more about this issue from our 2014 report here.

Kentucky General Fund Receipts Increase 5.3 percent in FY2015, Exceeding Estimate by $165 million

Exceeding Expectations, Kentucky Has $165.4 Million Budget Surplus

Kentucky’s Revenues Are Up 5 Percent for the Year, but Road Fund is Down and Pensions in Shortfall

Road Fund Helped by 2015 Fix but Still Feeling Funding Challenges

Kentucky ended budget year 2015 with a $20 million shortfall in Road Fund receipts, meaning slightly less money has come in than what was budgeted to invest in and maintain our transportation network.

Drops in the average wholesale price of gasoline — to which Kentucky’s gas tax is tied — are largely to blame. Taken together, all other Road Fund revenue was essentially flat with 0.3 percent growth, but gas tax receipts fell by 4.0 percent compared to budget year 2014. In dollars, the gas tax generated $35.9 million less in 2015 than in 2014. Since about 50 percent of motor fuels receipts go back to local governments through the County, Municipal and Rural Road Aid programs, funding for local roads and bridges are harmed as well.

Despite previous proposals from Gov. Beshear and the House to prevent these price drops by raising the gas tax floor, the legislature did not act until 2015. As a result, the tax fell by a steep 4.3 cents in the second quarter of fiscal year 2015. In the final moments of the 2015 session, the General Assembly prevented two-thirds of the additional 5.1 cent drop slated to take effect on April 1 by raising the gas tax floor to 26 cents (this figure includes the variable portion of the tax based on the price of gasoline, the 5 cent supplemental user fee and the 1.4 cent underground storage tank clean up fee).

And that’s where the tax will stay through budget year 2016 — about 4.4 cents lower on average than was forecast when the biennial budget was created. Transportation officials estimate that each penny amounts to $30 million in revenue over the course of a year.

To somewhat blunt the impact of gas tax losses in budget year 2015 on local governments, in the 2015 session lawmakers also boosted General Fund revenue sharing with the County and Municipal Road Aid Programs by $7.8 million. To support that increase, they transferred $3 million from the petroleum storage tank clean-up fund to the General Fund — on top of $7.5 million in 2015 and $7.7 in 2016 transferred from that fund in the 2014-2016 biennial budget.

The changes the legislature made to the gas tax in 2015 were important. By raising the floor, shifting to an annual rather than quarterly rate-setting process, and ensuring it falls by no more than 10 percent from year to year, they mitigated future losses and limited volatility.

But the state’s problems with transportation funding need a more comprehensive strategy that addresses increasing fuel efficiency standards and keeps up with the true cost of building and maintaining a state-of-the-art transportation network. Recent headlines about the Transportation Cabinet’s challenge with inadequate salaries for engineers who are fleeing the public sector show that cost-cutting has real consequences.

Year-End Revenues Highlight Importance of Individual Income Tax

Kentucky ended its budget year with General Fund revenues $165.4 million more than anticipated, equaling growth of 5.3 percent from the year before. The individual income tax is the main source of this bit of good news because of its ability to generate revenue from wealthier individuals whose incomes have soared in recent years.

For the year, individual income tax receipts grew 8.5 percent compared to 2014, meaning all other revenue grew by only 3.2 percent. Sixty-three percent of total net new revenue for the year was from the individual income tax. Income tax receipts were particularly high in April, when the state collected $535 million, or 39.5 percent more, in income taxes than it had the year before. This “April surprise” wasn’t unique to Kentucky, as almost all states with income taxes saw huge growth that month.

Capital gains taxes key to growth

In addition to encouraging growth in the Kentucky economy overall, a central explanation for the extra income tax revenues is likely a surge in capital gains taxes, or income taxes paid on growth in the value of assets, like stocks, when they are sold. The stock market was particularly strong during tax year 2014 (which benefits this year’s state budget), with average annual growth in the S&P 500 of 17.5 percent. Also, capital gains taxes were weak last year because of a federal tax law change that encouraged people to sell capital gains at the end of the prior year rather than hold them longer. Weak growth last year made for a lower bar to hop over this year.

Capital gains taxes are disproportionately paid by wealthy people—in Kentucky about two-thirds of capital gains are claimed by those with more than half a million dollars in income. And those same wealthy individuals have seen their incomes rise rapidly in recent years, while others’ wages have sagged. The highest-earning 1 percent of Kentuckians captured 38 percent of state income growth in the first 3 years of recovery from the Great Recession.

This year’s receipts are a reminder of the importance of income taxes in an era of rapidly climbing inequality. In fact, Kentucky should be doing even more to ensure wealthy individuals pay their fair share of taxes. The richest one percent in Kentucky pay only six percent of their income in state and local taxes, compared to nearly 11 percent of income for Kentuckians in the middle.

One of the many reasons for that inequity is that we never tax capital gains made on assets that are held by an individual until death, meaning a loss of about $78 million a year in revenue. And we allow unlimited deductions against individual income taxes no matter how high a person’s income, even while a growing number of states limit deductions and some don’t allow them at all.

If Kentucky was less reliant on income taxes, we would’ve faced more of a budget challenge in this year and previous years. Since 2007, individual income tax revenue has grown by 3.9 percent on average each year compared to 1.9 percent growth in the sales tax and a decrease of 0.2 percent in all other sources (see graph below). Cutting income taxes and moving to a so-called consumption based tax system based more on sales taxes would mean big tax cuts for the rich and less revenue to pay pension liabilities and invest in education, health and other needs. Just ask Kansas.

income tax

Source: KCEP analysis of Office of the State Budget Director data

Good revenue news today but not enough

The extra revenue this year is helpful, especially after last year’s $91 million shortfall. But while we dodged another shortfall this year, the fiscal outlook is still bleak. Although the economy is picking up, income taxes aren’t likely to continue growing at such a rapid pace and the stock market is flat so far in 2015. Extra revenues this year will go first toward payments to the SEEK education formula and drug treatment that were added to the budget this session, necessary governmental expenses like natural disasters and the state’s rainy day fund, which contains an amount equal to only 1.4 percent of the budget—far less than the 15 percent that many experts say is needed.

The latest interim forecast projects revenue growth in the first two quarters of next year to be only around 2.7 percent. And the state faces major funding needs, including the necessity of putting more money into its underfunded pension systems and filling funding gaps all across the budget.

Today is a moment of relief in an otherwise troubling picture that will improve only through tax reform that ends exemptions and loopholes to raise more revenue.

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