In recent years, the Kentucky General Assembly has prioritized an effort to reduce its single largest revenue source, the individual income tax. After decades with a graduated income tax and a top rate of 6%, Kentucky will now have a flat 4% income tax rate. Total revenue growth is expected to slow as a result. The Consensus Forecasting Group (CFG), an independent panel of non-partisan economists, predicts General Fund growth will fail to keep up with inflation over the next few years. And revenue will fall even further behind if an additional income tax cut is passed by the General Assembly in 2025.
An additional cut then is possible because the legislature has created a formula that includes triggers for permanent 0.5% cuts in the income tax rate each year if certain conditions are met. The formula requires keeping spending far below revenues. The effort to meet the triggers is leaving critical budget needs unfulfilled and resulting in an excessive balance in the Budget Reserve Trust Fund (BRTF), or rainy day fund.
The next budget presents a choice. Kentucky can use more of its already available one-time and recurring resources to better reinvest in pressing community needs, or continue to aim at a constrained budget and additional tax cuts that will inhibit our ability to build a thriving commonwealth in the future.
Forecast shows modest revenue growth that doesn’t keep up with inflation
After moving to a 5% flat income tax in 2018, the General Assembly lowered the income tax rate to 4.5% in January 2023 and then followed its newly-enacted formula to implement another cut to 4% that will start in January 2024.
As these cuts are implemented, revenue growth rates are slowing despite a strong overall economy. Total revenues grew 3% in fiscal year 2023 and are preliminarily projected to grow 1.6% this year, 0.8% in 2025 and 3% in 2026. These estimated growth rates do not keep up with projected inflation of 3.1%-3.2% annually over the next few years, as shown in the graph below. Fiscal year 2026 comes closest, but that will change if an additional half-point cut in the income tax rate is triggered next year and approved by the 2025 General Assembly (taking effect in January 2026).
These trends are unsurprising given that the individual income tax is the state’s largest single revenue source, responsible for 41% of General Fund receipts as recently as 2022. Reducing the most productive revenue source, and doing nothing to replace it, will inevitably squeeze the resources needed to support schools, health care, infrastructure and other public investments.
The challenge of cutting the budget enough to meet the formula was made clear this fall. Despite an effort to hold down appropriations, the condition requiring suppressed spending was not met in only the second year the formula was in effect. Thus an additional half-point cut will not occur in January of 2025. The considerable costs of disaster relief from the eastern Kentucky floods, among other pressing needs, made hitting the trigger this year impossible.
General Assembly is holding down the budget and excessively building up the rainy day fund
To try to meet the triggers, lawmakers have been suppressing spending relative to revenues since 2021, which has resulted in an excessively large balance in the BRTF. As shown in the graph below, budgeted appropriations regularly exceeded revenues in years prior to 2021, with the legislature using fund transfers — which refer to resources moved from other accounts in state government to the General Fund — to fill the resulting gap. The picture dramatically reversed starting in 2021, with the state now receiving approximately $1 billion more each year in General Fund receipts than it spends through General Fund appropriations. Like nearly all states, revenues rose due to the positive economic effects of federal pandemic stimulus and temporarily higher inflation, but Kentucky largely has not used those added resources to meet budget needs.
Instead, the legislature is using these revenues to justify tax cuts and build up the BRTF. Currently, its balance exceeds $3.7 billion, or 24% of the state’s expected revenues this year. With revenues projected to exceed appropriations by $1.2 billion this year, the rainy day fund balance may grow to $5 billion, or 32% of revenues, by next year. That amount far exceeds a careful savings level of 10%-15% of revenues most experts say is needed to protect against a future recession.
In its efforts to reduce the individual income tax, the legislature is putting aside budget needs and stowing a tremendous amount of resources away in the rainy day fund. But when lawmakers reconvene in January to create a new two-year budget, they will do so with revenues that aren’t keeping up with inflation due to the tax cuts described above, and with the loss of significant federal pandemic monies that have temporarily supported Medicaid, child care, education and other important parts of the budget.
Kentuckians need a budget that delivers
In addition to the end of federal pandemic dollars, Kentucky has not yet reinvested in many public services that were depleted by years of budget cuts after the Great Recession, and faces significant unmet needs in areas ranging from housing to the educator shortage to child poverty. Thanks to federal action to stimulate a fast economic recovery, there are both recurring and one-time state resources that could be used to help address critical needs in the next two-year budget. Such uses should be prioritized over putting away excessive monies and funding harmful tax cuts that go overwhelmingly to those at the top.