The governor announced this morning that he will veto both the executive branch budget bill and the tax bill passed by the General Assembly last Monday. Legislators return to Frankfort on Friday and Saturday of this week to complete their work for the 60-day session. The options they have are to override the vetoes, let them stand, or revise another bill to include new versions of either or both documents. If the General Assembly fails to override the vetoes, the Commonwealth will be left without a budget for the 2018-20 biennium, which begins July 1, 2018.
There are substantial concerns about both the tax plan and the budget bill that can be improved by the General Assembly in a second attempt.
Revenues Fall Short in Tax Plan
The tax plan that passed the legislature last week contains a big tax shift from high-income individuals and corporations over to low-income Kentuckians and working families. It also creates revenue challenges for the budget, some of which were noted by the governor in his veto address.
The plan relies considerably on new revenues from conforming to the federal tax code, including the Trump tax plan that passed in December. But the revenue impact of conformity is uncertain, as it includes a number of complex changes some of which will result in more revenue and some of which will result in less. One big change is a new loophole that allows owners of pass-through entities to deduct 20 percent of their pass-through income from their income taxes. This huge tax break will result in lost revenue —a revenue hole that grows bigger over time as more companies reorganize as pass-throughs. Kentucky could have decoupled from this change in its tax plan, but HB 366 did not.
Other increases and decreases in revenue from HB 366 create additional uncertainty. While the substantial cost from moving to a flat income tax rate of 5 percent is fairly easy to predict (approximately $500 million in lost revenue), the new revenue generated from taxing services is uncertain because some of these services have never been taxed before. Also, the income tax reductions will have an immediate effect on current year revenue as reductions are reflected in estimated income tax payments, but the sales tax increases will take time to generate new revenue as systems will have to be set up to collect them and new taxpayers brought into the system.
As we noted previously, the plan also has a harmful long-term effect on revenue. The move away from our most productive revenue source, income taxes, toward slower-growing cigarette and sales taxes will reduce the rate of revenue growth, causing further erosion in the General Fund relative to the economy. The income tax rate cut in HB 366 has damaging long-term consequences for our revenue stream.
The base-broadening measures in the tax plan in both the income and sales taxes are good tax policy. But they will be negated over time by the plan’s harmful cut in the income tax rate. The plan could be made better by keeping the base expansions but not changing the individual and corporate income tax rates at all. The legislature should also decouple from the federal exemption for pass-through entities, keep the existing limit on itemized deductions for very high-income individuals (known as Pease) and remove the provision for single sales factor. Making those changes would result in the bill no longer being a tax cut for the wealthy and would generate more than $500 million in additional revenues to better invest in Kentucky’s many budget needs.
Concerns About the Continued Use of Gimmicks to Balance the Budget
The budget enacted by the General Assembly relies on a large amount of fund transfers, sweeps and Necessary Government Expenses (NGEs) to balance the budget. The continued reliance on these sources does not address the growing structural deficit, which is the gap between what our tax code generates, and what is needed for our budget.
Among the most serious resource issues with the budget involves funding Kentucky Wired as an NGE. Kentucky Wired is a project to establish a statewide broadband infrastructure. The project has been plagued from the beginning by delays and cost overruns and although it will be much more expensive than anticipated to complete the project, government officials testifying about the project before legislative committees have said that it will be more expensive to halt the project than to complete it. Despite this, the General Assembly did not provide a line item appropriation for the project, but instead designated an amount not to exceed $77.7 million over the biennium as an NGE, which means that when these expenditures are made, they will reduce the amount available for the state’s rainy day fund. The budget also continues to allow any excess expenditures in the Department of Corrections due to growth in the inmate population beyond projections to be made as an NGE. To provide some context, for the current fiscal year, total NGEs are projected to be $85.7 million, without any Kentucky Wired expenditures. Designating additional expenditures as NGEs increases the likelihood that resources will not be available if Kentucky actually does face an emergency.
The General Assembly also continues the practice of transferring money from funds designated for other purposes to the General Fund to help fill the gap between the revenues raised by our tax code and those needed to balance the budget. HB 200 includes $593 million in fund transfers over the biennium—including $310 million from the Kentucky Employees Health Plan—and lapses an additional $12 million in excess fees collected by the Public Service Commission the General Fund.
Budget Continues Underfunding of Vital Areas
Although the budget does include targeted funding in key areas, such as increased funding for public defenders, social workers and pensions, it makes cuts of 6.25 percent to big parts of state services ranging from higher education to Aging and Independent Living and preschool. It cuts funding for the SEEK K-12 funding formula (not counting pension contributions), and will mean inflation-adjusted SEEK funding per student will be 16 percent less than it was in 2008. It also provides no funding to a number of important areas including textbooks and teacher professional development. These budget cuts will come on top of a decade of cuts since 2008, which have reduced funding for many areas of government by between 15 and 50 percent.
Making the tax plan better, as described above, would put us in a position to restore more funding for vital investments in our commonwealth now and into the future.