The Kentucky General Assembly returned to Frankfort last weekend to finish its business for the 2018 regular session. With just two days before they were constitutionally required to adjourn, the legislature was faced with a gubernatorial veto of both their executive branch budget (HB 200) and the revenue bill (HB 366) that accompanied the budget, both of which we discussed in earlier briefs. On Friday, both houses voted to override the governor’s vetoes. And on Saturday, the General Assembly adopted two new pieces of legislation amending the budget (SB 200 and HB 265) and passed a new revenue bill that incorporated the same provisions as HB 366 with some changes (HB 487).
The Governor has until midnight on April 26 to veto these measures and has the ability to line item veto the two measures that amend the budget. If any of these bills are vetoed, the original HB 200 and 365 will stand as enacted. If HB 487 stands, it will replace HB 366 as the final tax law.
Overall, Changes Produce Less Revenue and Include More Spending
The changes made in HB 487 result in $82.4 million less in new revenues over the biennium than originally projected in HB 366. The budget and revenue changes combined also result in reduced contributions to the budget reserve trust fund or “rainy day fund” compared to the amounts included in HB 200 by $54 million in 2019 and $13.7 million in 2020. The undesignated balance (available resources not appropriated in the budget bill) is also $85.2 million less at the end of 2020 than it was in the original budget bill, leaving only $10.6 million. Thus, the changes made on the last day of the session by these three bills have an overall negative impact on the finances of the commonwealth.
The summaries below identify significant changes made to HB 200 and 366 by the three bills passed on the last day of the session. To the extent that provisions in HB 200 and 366 were not changed, they are not discussed.
The primary changes included in HB 487 that impact revenues are as follows:
- The expansion of the sales tax base in HB 366 to include labor charges for repair and installation was scaled back to exclude these charges within the production chain for businesses. By limiting the taxation of business on the purchase of these services, it will reduce the sales tax revenue generated.
Individual Income Tax
- Internal Revenue Code Decoupling – In HB 366, Kentucky adopted the changes made to the federal tax code in December of 2017 (Kentucky uses federal definitions as the starting point for determining taxes owed to the state). In HB 487, the state decoupled from the 20 percent income deduction for pass through entities that was included in the federal income tax changes. This change avoids creating a new state loophole to accompany the federal loophole that is likely to be exploited by companies reorganizing as pass through entities to lower their taxes.
- Angel Investor and Investment Fund Tax Credits – HB 366 suspended the Angel Investor and Investment Fund Tax Credit programs for the biennium. HB 487 allows the programs to use approximately $1.5 million left under the $40 million combined overall cap for applications received prior to December 31, 2018. After that, both programs are suspended through December 30, 2020. Following that date, they resume with separate annual caps of $3 million each. The angel program is an extremely generous subsidy to wealthy investors with no requirement that the investment be in start-up businesses or that it create new jobs.
Corporate Income Tax
- Reporting Method Change – HB 487 requires a new reporting method for corporations doing business both within and outside of Kentucky. Beginning in January of 2019, businesses will be required to use a mandatory water’s-edge combined reporting for unitary groups, or may elect to make a consolidated filing. This issue was not addressed in HB 366. This change will make it more difficult for multi-state businesses to shift taxable income between subsidiaries in order to avoid taxation in Kentucky.
- Carve Out for Communications Providers – HB 487 creates a carve out from the single sales factor/market based sourcing regime established in HB 366 for companies that sell communications, cable or internet services. These companies, who benefit more from the existing three-factor formula and cost of production sourcing, will be able to continue to use the existing methods for calculating tax due to Kentucky. They will contribute less in corporate income taxes than they would under HB 366 because of this change.
Bills Amending the Budget
- Reduced Funding for Some School Districts – HB 200 originally provided for an emergency loan fund of $7 million in the current biennium and $10 million in grants in 2019 from coal severance funds to 31 school districts impacted by reduced unmined mineral assessments. HB 265 removed the $10 million in grants and allocated the coal severance funds back to county governments, removed the emergency loan fund completely, and instead used $7 million in the current year to provide smaller grants to the school districts. Overall, these districts lost $10 million in funding between HB 200 and HB 265.
- Reallocation of Coal Severance Receipts – HB 265 reallocated funds from the coal severance tax so that coal counties receive more revenues from that source over the biennium than they would have under HB 200. More funding is provided to these counties than in HB 200 by not providing assistance to schools as discussed above, and by transferring funds from the coal county endowment fund — which was created and first funded in the 2016-18 biennium — directly back to assisting local governments. The endowment fund was intended to help the region with economic diversification. Language was also added requiring any coal severance receipts above the estimates to be distributed to the counties, rather than remaining in the General Fund.
- Relief for Employer Retirement Contributions – HB 265 adds language to the budget to delay by one year the increase in employer contributions to the Kentucky Employees Retirement System non-hazardous plan for local health departments, regional universities and community colleges, community mental health centers, domestic violence shelters, rape crisis centers and child advocacy centers. The total employer contribution starting July 1, 2018 will be 49.5 percent rather than 83.4 percent, but will go up to 83.4 percent starting July 1, 2019.
- Reduction in the Budget Reserve Trust Fund Appropriation – Appropriations to the Budget Reserve Trust Fund were reduced by $54 million in 2019 and $13.7 in 2020 compared to the appropriations provided in HB 200. The state is projected to end the biennium with $237 million in the rainy day fund. Also, as mentioned previously, the state will end the biennium with an undesignated fund balance of $10.6 million compared to $95.8 million in HB 200.
- Funding for Kentucky Wired – SB 200 addresses funding for Kentucky Wired, which did not receive a line item appropriation in HB 200. Instead, the expenditure was authorized as a “necessary government expense” which would reduce the rainy day fund. SB 200 remedies this situation by providing a line item appropriation for these expenditures.