What Would Kentucky Gain from More Business Tax Cuts?

For a state like Kentucky—with high levels of poverty, low wages and too few jobs—a perpetual issue is how government can do more to promote prosperity. For years, the state has focused heavily on reducing business taxes and providing special tax incentives with the hope of attracting industry.

In truth, business tax cuts are not a formula for long-term economic development. Yet a focus on that strategy continues in the recently-released consultants’ report to Governor Beshear’s Blue Ribbon Tax Reform Commission.

The report argues that Kentucky needs to improve its tax competitiveness, and puts forward several large business tax cuts as options. But two critical questions should be asked about this strategy. First, how competitive are Kentucky’s business taxes already compared to other states? And second, how important are taxes compared to other factors that drive economic development, including investments in public services that are funded by tax dollars?

How competitive are Kentucky’s business taxes already?

The first question is answered by the consultants’ research, which in fact shows that Kentucky’s business taxes are already low compared to most nearby states—begging the question of how we would benefit from lowering them further.

The main study of competitiveness cited in the report compares states on how much they tax new private investment. Rather than performing poorly, Kentucky does well by this measure, ranking fourth-best among the 13 states identified by the consultants as competitors.¹ In another study cited by the consultants Kentucky also performs very well—ranking fifth out of the 13 states for mature firms and third among those states for new firms.²

The consultants’ report also shows that Kentucky’s corporate income tax rates are lower than almost all of the comparison states, and its tax on limited liability entities (which are like corporations) is so negligible that 82 percent of those businesses pay only the $175 minimum.

The only measure in the report that could possibly be interpreted as an indicator of less competitive business taxes is from a study looking at business taxes as a percentage of private sector gross state product. Kentucky has the 3rd-highest rate among the 13 states. However:

• The authors of that study say the measure “is not a clear indicator of the competitiveness of a state’s business tax system in terms of attracting new investment” and note that it “does not provide sufficient information to evaluate a state’s competitiveness.”³
• Kentucky’s rate is only 0.3 percentage points higher than the median of the 13 states—hardly a substantial difference.
• The authors acknowledge that the measure includes severance taxes, resulting in states like Alaska, Wyoming and North Dakota having the highest effective rates in the country largely because they are well-endowed with natural resources, not because they overtax businesses. Kentucky has a significant severance tax because of its coal resources, while many of the 13 competitor states have no comparable resource.

Despite providing evidence that Kentucky’s business taxes are actually not out of proportion with other states, the consultants’ report presents ways to cut them further. One of the major business tax cut options included is the elimination of personal property taxes. But the report cites research showing that property taxes are a smaller share of business taxes in Kentucky than in the nation. A separate paper shows Kentucky having the 11th lowest business property taxes in the country.⁴

It should not be surprising that Kentucky’s business taxes are already low. Ever since Toyota came to Kentucky in the late 1980s, the state has regularly expanded a set of very aggressive business tax incentives. Just in recent years, special sessions were called in 2006 and 2009 to cut business taxes and/or expand tax incentives, and new incentives were enacted as recently as the 2012 session for large manufacturers.

How important are taxes anyway?

The answer to the second question—how much do taxes matter?—also calls the consultants’ focus on tax competitiveness into question.

While most of the economic literature suggests a relationship between business taxes and economic development, it is in fact a very modest relationship. That means business tax cuts are an expensive way to create jobs, and are even less beneficial once the negative impact on public services from decreased revenue is taken into account. Taxes play a modest role in part because state and local business taxes are a very small percentage of the cost of doing business, and tax differences between states pale in comparison to other differences.⁵

What’s more, the consultants did not look at the role of taxes in funding investment in public services needed for economic development, including a skilled and educated workforce, a well-maintained transportation system, a healthy populace, efficient courts, adequate public safety and an overall high quality of life. The relationship between investments like early childhood education and economic growth are well documented.⁶

Our ability to finance those services decreases to the extent that we cut taxes. And while Kentucky tends to perform well in rankings of business taxes, the state does not rank well in our levels of education or the health of our population, and many vital state services have been cut or underfunded in recent years.

While cutting business taxes allows political leaders to seem like they are doing something to create jobs, doing so is expensive and erodes our ability as a state to invest in the fundamentals needed for economic development. It’s time to put greater emphasis on the investments in education, health and quality of life that are essential for prosperity—and that require taxes.