Five months into Kentucky’s experiment in reducing the individual income tax rate, the verdict is unsurprising. Cutting the rate is causing income tax receipts to fall despite low unemployment and still-high inflation that are pushing incomes up.
It’s the first glimpse of how continued cuts to the state’s largest revenue source – which previously paid for over 40% of the state budget — will increasingly hamper Kentucky’s ability to pay for vital public services even while providing tax breaks skewed to the wealthy.
Revenue losses will get much bigger
The legislature reduced the state income tax rate from 5% to 4.5% starting in Jan. 2023. The effects of this cut first show up in “withholding,” which is the income tax revenue collected from individuals’ paychecks. In the first six months of the current fiscal year – before the cut went into effect – withholding tax revenues grew by an impressive 7.7% compared to the prior year due to strong national job growth and elevated inflation. But since the half point cut went into effect, withholding revenues have fallen by 2.6%. That decline means about $172 million less so far from withholding income alone, resources that could’ve gone to public schools, infrastructure and other needs but instead went disproportionately to high-income earners.
Since a cut from a 5% to a 4.5% rate is a 10% cut, this roughly 10% drop in revenues is what one would expect. But this reduction is only the beginning.
The legislature reduced the rate further, from 4.5% to 4%, beginning Jan. 1, 2024 with the passage of HB 1 in the 2023 session. And since the cuts go into effect halfway through each fiscal year, the annual revenue loss from the reductions already enacted will be four times larger in fiscal year 2025 than they are today. The cost to the state will rise from an estimated $292 million this fiscal year to $1.28 billion in 2025, or more than Kentucky spends on all its universities and community colleges combined.
The state of the overall economy will also affect future income tax receipts. The unemployment rate is at a record low and inflation is higher than it has been in 40 years. Both of those factors push tax receipts above what they would otherwise be, but are not expected to last. Pandemic-induced inflation is coming down, and the Federal Reserve has quickly increased interest rates, which they project will push unemployment up.
Straining to justify more cuts
In early July, the commonwealth will close out its budget year. Revenues are expected to be near what was forecasted, meaning no meaningful revenue surplus. However, there will still be a budget surplus because the state’s spending was based on a previous, lower revenue estimate made in December 2021. In December 2022, the state’s forecasting body met and raised the revenue projection for this year by $1.4 billion, primarily due to higher-than-anticipated inflation and corporate profits. The legislature then held spending down in the 2023 session to allow the budget surplus at the end of this year to occur.
The General Assembly has also increased the size of the rainy day fund (known as the Budget Reserve Trust Fund) after a period of 30 years in which it contained less than 5% of the annual General Fund budget. The fund’s balance is now expected to reach $4 billion next year, or 28% of the annual budget.
These two actions are part of a broader effort by the legislature to meet the conditions they established in 2022’s HB 8 that would allow them to lower the income tax rate by 0.5% increments until it’s completely eliminated. This flawed formula, which relies on a one-time snapshot of the state’s fiscal picture to make permanent tax cuts, includes a two-part trigger. The first is that the rainy day fund balance must be greater than 10% of General Fund receipts during the fiscal year. This portion of the trigger will clearly be met this year.
However, the cuts that have happened already are so expensive, there is a good chance that the conditions for the second part of the trigger – which requires that revenues exceed spending by at least the cost of a 1% income tax, or around $1.2 billion – may not be met. We’ll find out in Sept., when the trigger conditions are certified.
Don’t call it a surplus
In an attempt to meet the trigger conditions, the General Assembly has suppressed spending in the current budget despite Kentucky’s pressing needs and the temporary opportunity provided by pandemic stimulus. For example, spending on public schools declined as a share of the General Fund budget – from its historic norm of 44%-45% of state spending to 37% – even with the serious teacher shortage and the fact that core SEEK school funding is 27% below inflation-adjusted 2008 funding levels. Other important budget demands to which additional money could go range from meeting the tremendous housing need from the eastern Kentucky floods, addressing the post-pandemic overdose and mental health crises, and stemming rising student loan debt linked directly to state budget cuts to higher education.
The legislature cannot pass the kind of deep tax cuts some envision and still meet their obligations to the commonwealth. Just with the rate cuts enacted so far, total General Fund tax revenues are projected to decline next year (not just income tax receipts). That would mark only the fourth time in the last 50 years that’s happened; the other three times were because of recessions, but this wound is self-inflicted.
The legislature will create a new two-year budget in early 2024 with a potentially weaker economy, a lower tax rate on its largest revenue source and without over a billion dollars annually in federal pandemic aid that has propped up Medicaid, child care and more. The $4 billion in the rainy day fund is substantial, but only translates to four months of budget resources should it have to be tapped to fill holes.
The individual income tax is a cornerstone of a fair and adequate tax system that allows Kentucky to fund critical services that benefit all of us. Cutting it in the way the legislature is attempting is not wise, just or practical.
